Purpose
– This paper aims to investigate whether enhanced requirements result in the depositories exiting the business. Furthermore, this paper attempts to analyse prospective changes to the operating structures caused by the Alternative Investment Fund Managers Directive (AIFMD). Most importantly, this paper discusses the processes to evaluate and manage counterparty risk relating to prime brokers. AIFMD makes fundamental changes to the depository liability and managing counterparty risk by making a depository bank liable for any losses to investor assets, even those held within third-party custodians appointed by the depository. Depositories will also need to calculate the probability of default of their sub-custodians and use complex credit models to calculate any capital requirements under the fourth Capital Requirements Directive (CRD IV).
Design/methodology/approach
– This paper is based on an insightful secondary analysis of the AIFMD with practical implications drawn for depository banks. The analysis of this topical research has been broken down into the following sections: assessing and managing counterparty risk of prime brokers; insurance against defaults of prime brokers; and regulatory-driven challenges and changes to depository banks.
Findings
– The post-Lehman banking industry has realised that counterparty risk cannot be ignored. This has triggered heated debates among regulators and practitioners whereby any depository bank should clearly separate the assets of its clients from the depository assets and its own assets. This paper argues that the custodian services will witness consolidation with the big players remaining and small custodians forced to leave the business in light of the enhanced liabilities under the AIFMD. In addition to this, this paper has stressed that assessing counterparty risk should be supported by an insightful analysis of the culture of a prime broker; its legal, structural and regulatory safeguards; and quality of assets. Moreover, managing risks associated with prime brokers entails significant costs to depositories. Thus, depository banks are advised to factor these costs into their pricing models.
Originality/value
– Given the magnitude of recent regulatory initiatives and complex challenges faced by depositories, an important question arises whether depository banks would exit the business in light of the regulatory-induced liabilities. This paper addresses the aforementioned question and provides practical implications into managing emerging risks by depository banks. At this point, the majority of depositories are in a process of developing in-house solutions for managing risks related to prime brokers, and hence would benefit from practical insights into these processes that are provided in this paper.
Supervising hedge funds: Will the AIFMD prove an eff ective tool?: Notes on the EU directive on Alternative Investment Fund Managers