Should the Alternative Investment Fund Managers Directive be reviewed?

The European AIFM Directive, which came into force in 2013, laid the foundation for regulating the management and distribution of alternative investment funds, as well as the fight against systemic risks associated with alternative management. Nevertheless, there is still room for improvement.

This is what Jean-Pierre Gomez, Head of Public and Regulatory Affairs, and Laurent Marochini, Head of Innovation at Société Générale Securities Services in Luxembourg, have to say about the world of AIFs.

What is the premise of the AIFMD?

Jean-Pierre Gomez: The implementation of the European Alternative Investment Fund Managers Directive (AIFMD) in 2013 gave birth to a new custodian in charge of monitoring other assets in the Collective Investment Scheme (CIS) industry: Alternative Investment Funds. These assets cannot be kept in the custodian’s network or that of its sub-custodians. We are talking about assets that are not financial instruments but rather, for the most part, real-estate or private-equity investments.

With the AIFMD, the responsibilities of the custodian differ from those previously held in the past. The custodian must first record all the assets held by the AIF in its books and verify their ownership. It then sets up monitoring for any cash flow movements based on their inconsistency and a financial threshold to be defined with the AIFM—what’s known as cash flow monitoring. Five final checks, or oversight duties, are carried out.

Similarly to what happened with the UCITS directive, does the AIFMD need to be reviewed?

JPG: The first UCITS directive dates back to December 1985. We are now at UCITS V. The UCITS VI project, which was drafted a few years ago, is currently on hold.

Regarding a possible reform of the AIFMD, the European Commission launched a public consultation last October on the AIFM directive to obtain not only the opinions of AIF asset managers and management companies, but that of their custodians, as well. The responses were collected up until 29 January. Of the hundred or so questions asked, ten concerned the custodian.

As a reminder, the AIFMD is a directive for alternative fund managers (unlike the UCITS directive, which is a “product” directive). In other words, the AIFMD is a passport for AIF managers, who are granted a license to manage any AIF under European law within the EU. Conversely, the UCITS directive serves as a passport for investment funds. It allows funds to be marketed within the EU without having to seek the approval of the local authority of the country in which the units/shares of the UCITS (or undertaking for collective investment in transferable securities) funds are sold.

The position of the Luxembourg CIS industry is that there should not be any changes to the AIFMD Level 1 text. This opinion is shared by most European countries. On the other hand, certain proposals have been put forward to make the custodian's role more efficient by means of technical guidance.

One of the key points relates to the aspects of due diligence that the custodian must carry out with respect to the activity of the AIF in question and/or its management company and its representatives or agents. Collecting the multitude of information requested poses a challenge. It can be difficult to compile depending on the nature of the business. Where does the custodian's job end? Some of the supervision imposed on the custodian doesn’t provide real added value in terms of investor protection.

The custodian passport: what is it?

JPG: It represents the ability to appoint a custodian established outside the country where the AIF is domiciled. The custodian passport doesn't appear to be necessary at this time and doesn’t provide any particular benefit. It could even complicate the role of the Supervisory Authority of the country in which the AIF is domiciled and make the auditor's job more difficult (and certainly more costly). In fact, having a custodian in one country, the AIF in another and the AIFM in a third complicates both supervision and the request for information.

The regulation could be changed through the amendment of the basic text – level 1 of the directive – or the issuance of technical guidelines by the European regulator (e.g. the ESMA) or the local authority. One way or the other, if it happens, should technological development, which is increasingly dominating and impacting the financial world and more precisely the CIS industry, be taken into account?

How does new technology and innovation influence the world of AIFs?

Laurent Marochini: We are on the cusp of a digital revolution and every stakeholder must boost their creativity and agility to remain competitive and stand out. The managers of alternative funds have often leveraged innovation and new technology to select projects that combine both performance and meaning. Asset managers select projects that will meet the needs and values of investors while aiming for the performance expected. It is in this context that funds investing in environmental and/or societal projects appeal to clients looking for meaning, such as millennials—the clients of the future.

Asset servicers have also had to adapt to accommodate this growth in business. In this sector, it is crucial to automate tasks that are often still completed manually as much as possible. Artificial intelligence, and particularly Robotic Process Automation (RPA), coupled with digital capabilities such as electronic data management, were necessary to optimise processes.

Setting up platforms to facilitate communications between stakeholders helps increase efficiency on both sides.

Does technology have the same impact on AIFs as it does on traditional financial instruments?

LM: From an asset servicer’s point of view, traditional financial instruments are managed on an automated basis via efficient infrastructures. As part of alternative investments, teams have to manage a large number of documents and specific processes. The quest for efficiency and risk control are necessary, making the digitisation of information flows and data control key elements.

What tools or technologies can impact the custodian in the short- or medium-term in terms of the custody of alternative assets or traditional securities?

LM: A large part of alternative funds such as hedge funds, private equity and venture capital funds are characterised by low liquidity and limited access, unlike the CIS world. AIFs are therefore prime candidates for tokenisation. This would generate in a significant number of benefits for both investors and asset managers. Assets of the fund can be tokenised via previously illiquid securities (wine, real estate, etc.) or the liabilities of the fund can be tokenised via shares.

Nevertheless, a wave of tokenisation would have an impact on the role of the custodian. The custody of digital assets does not follow the same processes as the custody of traditional assets. The players, infrastructures and the flow of information are completely different. It is therefore crucial to be able to build agile processes to meet client needs.

The digital world also requires significant due diligence in terms of processes and tools given the growing number of cyber-attacks that have come to light in recent years.

For traditional CIS funds, automation is already under way and tokenisation could enable liabilities to gain even more efficiency and provide an additional distribution channel.

What can we expect in the next few years?

JPG: Imagine that one day the role of the custodian goes completely digital. The custodian would then become a function of pure control carried out using high-performance, automated technological tools. Human action would still be necessary, but it would be focused on new, more specific tasks involving reflection and targeted analysis, and would be less operations-based. The question of the custodian passport would then be irrelevant.

The increasing digitisation and tokenisation of assets will force the custodian profession to completely shift gears from the current model with revised controls. When can we expect this to happen? It’s hard to say. We still see companies using old technology that has not completely disappeared, although this is happening less and less. The use of fax machines, landlines and printers are some examples. Even though the current health crisis has ramped up the pace of the digital transformation, there is still a ways to go to transform the role of custodians.

Article published on Agefi Luxembourg