As the European Securities and Markets Authority (ESMA) approaches the closing of its consultation on asset segregation and custody services tomorrow, Ross Whitehill, head of strategic regulatory office for EMEA, BNY Mellon Markets, has offered up the following comments.
An area of particular interest contained within the ESMA consultation is the impact that segregation up the custody chain will have on securities financing, collateral management and especially on funding and liquidity. The macroeconomic impact that such segregation would have on funds domiciled in the EU and counterparties of those funds, has been highlighted by service providers and funds themselves. Service providers and funds have also highlighted that the financing of inventories by prime brokers is no longer viable. And, while it was clear that segregation of custody assets is conceptually and actually possible, there are very serious consequences that arguably were not intended when ESMA proposed a couple of segregation model options in their original Consultation Paper in December 2014.
“Many groups now recognise that segregation up the custody chain causes fragmentation of asset and collateral pools which makes it very difficult to move assets since those assets would need to be moved at the market level under a segregated model. The alternative model of books and records, allows the book entry movement of assets and collateral on an almost instantaneous basis and removes the need for market settlements. Obviously market settlements mean delays of T+X in local markets and differences in time zones and the need for certainty over delivery versus payment and receipt, further disturbs and delays asset and collateral movements.
“At its simplest, if segregation up the custody chain is mandated, the industry has determined that AIFs and UCITS could suffer further performance drag as they may become even less attractive counterparties for some borrowers. Already we have seen that borrowers have moved away from borrowing from AIFs and UCITS as they fear that if segregation up the custody chain is mandated, loans will need to be recalled, collateral returned and loans rebooked. Borrowing securities from segregated accounts will mean that borrowers potentially receive multiple shapes from segregated accounts and must pay collateral to those segregated accounts in similar shapes. Apart from the instruction, delivery and processing costs, borrowers do not have the opportunity to optimise their collateral over their collateral pool since the collateral is fragmented across segregated accounts. This can often mean that a securities financing trade becomes uneconomic. At a time when performance and yield is hard to find, actively reducing AIFs and UCITS performance when no other global jurisdiction requires segregated accounts, puts European funds at a major disadvantage.
“Equally, fragmenting collateral pools when collateral is needed now more and more to support other regulatory initiatives, (e.g. margin rules) is counterintuitive.
“The real issue of course is that all of the liquidity which AIFs and UCITS can bring to the market is restricted and the funding and liquidity crunch that we believe follows such segregation, is too high a price for Europe to bear, for a set of obligations which do not bring additional asset safety or expeditious return of securities in the event of default in the custody/investment chain.
“The investment and funds industry in Europe is precariously positioned now ahead of ESMA’s ruling on segregation. We all remain hopeful that ESMA will agree that segregation of AIF and UCITS assets should be a matter for each fund board to decide and ultimately for investors to determine whether any described benefits of segregation are real, and whether the impact of segregation on fund performance is a price worth paying.
“Until then, the spectre of segregation on the investment community, which is reliant upon funding to maintain liquidity and market stability, will continue to steer away from AIFs and UCITS as counterparties.”