Template:Delegate vs subcontractor

Delegate versus sub-contractor

Delegation, according to a natural definition, means “to entrust (a task or responsibility) to another person, typically one who is less senior than oneself.”. Being delegated a custody function — agreeing to act as main custodian to a fund on behalf of the depositary whom the fund has appointed to carry out that function is a different thing from being appointed as a sub-custodian.

• A delegating depositary won't hold the assets at all: it will pass that responsibility to the prime broker, who will record the end client's interests in the custody assets directly in its books and records. It may have to report this all to the depositary, but the depositary will not carry record of the client’s assets in its own books and records.
• A subcustodian is an entity who stands behind the main custodian and holds the custodian's client assets in a single omnibus account, in the custodian's name but marked as "client assets" and therefore unavailable for the prime broker's creditors. A sub-custodian won’t know who the custodian's clients are, let alone which assets are attributable to which clients, much less have a contractual relationship with those clients, and won’t be in a position to rehypothecate any assets it holds.

Why do depositaries delegate their custody function under AIFMD and UCITS then? Market structure is why.

• AIFs and UCITS funds are required to have a local depositary to look after the fund’s interests, make sure it is properly managed, and to look after its assets. The depostiary must be independent and must avoid conflicts of interest with the fund, such as would arise if the depositary lent to or traded with the fund. A depositary typically cannot act as a prime broker (a bank who lends on margin to hedge funds).
• Funds — particularly hedge funds and AIFs, but sometimes UCITS too — like to invest “on margin”, borrowing funds from a prime broker against the security of the assets it purchases with the margin loans.
• Prime brokers like to have assets to it can use them, defray its funding costs and manage its balance sheet.
• Structural problem therefore: Depositary is meant to hold the assets, but it can't lend against them. PB wants to lend against assets, but the depositary is meant to hold them. Answer: the depositary delegates the custody function to the prime broker. Both AIFMD and UCITS allow this in certain circumstances

Because a prime broker needs the assets. To use them.

— quite common under AIFMD and UCITS regulation, where a fund must appoint a local depositary as nominal custodian, but where the fund’s prime broker is usually keen to have custody of assets it has lent against, so it can rehypothecate them —

“Hold on,” says the PB. “If the depositary holds the assets, then I can hardly rehypothecate them, can I, and we know how important rehypothecation is to my business model, don’t we?”

The depositary shrugs. “So, I'll make you my sub-custodian,” he says, “There: re-hypothecate to your heart's content.”

“No can do,” says the PB. “I can only rehypothecate against indebtedness, and you don't owe me anything. Only the fund does. And besides, as a sub-custodian I only see an omnibus account. I don't know who owns what. For rehypo to work, I have to have a direct contractual relationship with the Fund. That's the deal.”

Contrast that with a custodian who sub-contracts his responsibility to a sub-custodian. This is not a delegation in the same way: the custodian stays liable the whole time, whatever the sub-custodian does, and unless the contract says otherwise<fref>Okay, I grant you: this is a big unless.</ref> the client has not direct claim against the subcustodian at all.