Brussels has opted to abandon the proposed establishment of a ‘European passport’ for depositary banks. While initially touted as an innovative concept, the idea was fraught with potential market challenges and risked undermining the work of supervisors. The alternative approach that has emerged now is being hailed as a success by Luxembourg banking association ABBL.
“It’s a victory for reason and for caution, and for investors and supervisors, that we managed to keep the quality of our funds and of our depositories,” said Antoine Kremer, head of European affairs at ABBL.
EU-level discussions surrounding the potential introduction of a European ‘depositary passport’ within the Alternative Investment Fund Managers Directive (AIFMD) have captured the attention of industry experts and market participants in recent years. The discussions started in 2020 and were signed off by the European Parliament last month.
The outcome of these deliberations holds significant implications for investor protection and the trajectory of depositary banking, particularly in Luxembourg, a key hub in the depositary banking ecosystem serving clients across Europe and the world. Depositary banks in the grand duchy employ some 6,000 people, about a fifth of its total banking staff.
Depositaries: more than mere safekeeping
To comprehend the stakes involved, it’s crucial to revisit the fundamental role of depositary banks in the context of investment funds. A depositary bank serves as the custodian for investment funds, akin to how a retail bank safeguards individual accounts. Its role extends beyond mere safekeeping. A depositary bank acts as the extended arm of the supervisory authorities and a vigilant guardian for investors. Tasked with safeguarding cash, securing securities, and ensuring seamless transaction settlements, the depositary bank also assumes an independent oversight role in monitoring the activities of the fund’s management company.
This oversight responsibility dates back to the 1985 Ucits directive that governs standard European investment funds and subsequent rules developed by Luxembourg’s supervisor CSSF, setting a distinctive European standard absent in the fund management landscape. Unlike U.S. funds, European funds are mandated to appoint a depositary, adding an extra layer of protection for investors.
The EU recently completed a comprehensive review of the Ucits directive and also of the AIFMD rules for alternative investment funds for professional investors first introduced in 2011. During that review process, discussions emerged to give depositary banks the right to provide services across borders in the EU. Talk about a “depositary passport’ was born in some corners of the European parliament.
Concerns about loopholes
However, the suggestion of a depositary passport, allowing for flexibility in the location of the depositary bank and the investment fund, raised concerns about potential loopholes and the impact on effective supervision by the respective national authorities in EU member states.
The Luxembourg bankers’ association ABBL, which counts a considerable number of depositary banks among its members, played an influential role in advocating for a balanced resolution at EU level. Head of banking regulation Gilles Pierre explained that the ABBL proposal sought to address the needs of countries with less developed depositary industries, offered commercial opportunities for matured sectors like Luxembourg, and, most importantly, did not compromise investor protection.
As a fund domicile with some 6.200 billion euro in assets under deposits, Luxembourg has the critical mass needed to convince policy-makers. “The little gain that you could get with a passport was disproportionately small compared to the risk with supervision,” Kremer said.
“And when you speak of supervision, there’s also a risk for investors,” he added. “ Just imagine something goes wrong in a fund. It’s very difficult for the investor to battle in different jurisdictions and find that everybody’s going to point the finger at somebody else. In the end, the commission was not very keen on it. Supervisors were not very keen on it. Member states were not very keen on it.”
Not a passport, but a derogation
The final agreement on AIFMD review reflects a pragmatic compromise in which the idea of the European Parliament’s rapporteur of a ‘depositary passport’ has been dropped in favour of a propped up version of the European Commission’s ‘derogation’.
Alternative investment funds, or AIFs, in 16 EU member states that have a market size of less than 50 billion euro, such as Poland, Malta and Bulgaria, will be permitted, subject to additional safeguards, to appoint a foreign depositary. This solution provides relief for smaller markets while preserving the overall integrity of AIFs’ supervision and investor protection.
AIFs domiciled in the biggest eight EU countries, including Luxembourg, Germany, France and Austria, will not be permitted to appoint a foreign depositary.
“It’s a pragmatic compromise which we believe will preserve the integrity of the markets,” said ABBL’s Pierre. “We are quite satisfied with this compromise.”