Alternative Investment Management Association Representing the global hedge fund industry
We are all aware of the four freedoms which characterise the European Union. We all agree that these constitute the fundamental pillars on which the internal market operates….. But is this really the case?
Decades after the establishment of the four freedoms, including the freedom to provide services throughout all European Member States, it appears that these rights are being undermined. What is even more astonishing is that the freedom to provide services is being restricted, or wilfully ignored, by those same European institutions that should be the guarantors thereof.
Originally, the Council and the Commission painstakingly ensured to render effective the freedom of the provision of services by credit institutions and investment firms. Indeed the Banking Directive was the first European legislative instrument which created the concept of a passport right for credit institutions on the basis of a harmonised authorisation regime. That is, in recognition of the fact that the different licensing requirements imposed on banks by each Member State of the European Union effectively constituted a barrier to entry, the Banking Directive sought to (i) harmonise the authorisation requirements for credit institutions in the European Union, and (ii) create a passport right for European credit institutions wishing to provide banking services in other European jurisdictions. In other words, a level playing field was created so that the licensing requirements applicable to credit institutions in any European jurisdiction would not result in a barrier to entry to the provision of banking and ancillary services in any other European Member State. Once national differences were ironed out, credit institutions could provide banking services in all European Member States, either by setting up a branch, or on a cross-border basis. The same passport right was granted by MIFID to investment services firms.
Interestingly, both the Banking Directive and MIFID regulate the provision of custody services. Whereas however, at present, the safekeeping of securities and the provision of safe custody services are principal activities subject to mutual recognition in terms of the Banking Directive, MIFID lists the provision of safekeeping services, including custodianship for financial instruments, as an ancillary service. This should change with the coming into force of MIFID II, which, provided that the current approach is retained, will ensure that the safekeeping and custody of financial instruments becomes licensable as a main activity.
The net effect of this is – or should be – that a credit institution or an investment firm, authorised by a European Member State in terms of the relevant directive to provide custody services, may provide these services in other European jurisdictions simply by exercising the passport rights granted by that same directive.
But is it really so? No. Notwithstanding these passport rights, based on the fundamental principle of freedom to provide services, AIFMD and UCITS IV provide that such funds may only appoint as custodians credit institutions or investment firms established in the home member state of the UCITS or the AIF.
It follows that a depositary for a UCITS or an AIF must have a physical presence in the jurisdiction where the fund is located. In other words, credit institutions or investment firms authorised in any European Member State in terms of the relative directive to provide custody services, may not exercise the passport rights granted by the directive regulating their activities, because another European directive regulating the operations of the fund itself precludes it.
At best this is a contradiction. At worse, it’s a clear disregard of the fundamental freedom characterising the European Union. The next question is obvious: is this difference in treatment justified?
The standard reply would typically be that this is justified in terms of investor protection. But is this really the case? Thinking about it from an investor protection perspective, what distinguishes an investor – retail or otherwise – who opens a managed account, from another investor who invests in a UCITS fund or an AIF? Nothing. In both circumstances, the manager must take into account the risk profile of the investor before making an investment for its client or allowing the investor to invest in the fund. Indeed, the only marked difference is in the obligations imposed on depositaries of funds, which are subject to more onerous obligations in terms of the relative directive. If anything, these obligations are a further safeguard of investors’ interest.
From an investors’ interest perspective, one can argue that the possibility of having “depository platforms” or even a European centre of excellence for depositaries should lead to a reduction of operational costs and achieve economies of scale, thereby increasing competition. As a result, investors would benefit from reduced costs and greater quality of service.
Seen from this perspective, the ‘investor protection’ rationale does not hold water. It is therefore neither justified nor necessary to restrict one of the fundamental freedoms on such grounds.
The restrictive eligibility criteria for depositaries have given rise to a ‘depositary passport’ debate. The truth is that the depositary passport already exists. It is exercisable in terms of the Banking Directive and MIFID. UCITS VI and AIFMD II do not need to cater for it. The best interest of investors and the bolstering of competition in the internal market demand the cessation of such disproportionate and discriminatory treatment in respect of depositaries established in one jurisdiction and not in another. The failure to do so will result in a disproportionate monetary burden being suffered by investors in those Member States which do not have access to a myriad of depositaries.
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