Template:Delegate vs subcontractor

Delegate versus sub-contractor

Be warned: There are people more learned in the ways of the world than your correspondent who do not share this view. Let’s call it a dissenting judgment therefore.

The difference betwixt

Delegation, according to a natural definition, means “to entrust (a task or responsibility) to another person, typically one who is less senior than oneself.”.

Dear Sir/Madam: Let me introduce you to my glamorous assistant, Igor, who will carry out this work for you under my supervision. while your day-to-day interaction will be with Igor, I remain your loyal servant, and shall be answerable to you for Igor’s timely and competent performance.

Being delegated a custody function — agreeing to act, as AIFMD puts it “as the first level of a custody chain”, as main custodian to a fund on behalf of the depositary whom the fund has appointed to carry out that function is, in our view, a quite different thing from being appointed by the depositary as a sub-custodian.

• Delegate: A delegating depositary won't hold the assets at all: it will pass that responsibility to the delegate — usually a prime broker with designs on a spot of rehypothecation — who will record the end-client’s interests in the custody assets directly in its books and records — that is, it will be “at the first level of the custody chain”. The delegate may well have to report this all to the depositary, but the depositary will not carry the “golden source” record of the client’s assets in its own books and records. It might copy the delegate’s report, but the delegate’s records are what count.
• Subcontractor: A subcustodian stands behind the “first level” 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 main custodian’s creditors. A sub-custodian won’t know who the custodian’s individual clients even are, let alone which assets in its omnibus account are attributable to which of those clients, much less have a direct interpersonal or contractual relationship with those clients. A subcustodian won’t be in a position to rehypothecate any assets it holds — hence it ought to be happy enough signing a no lien letter.

Careful though: Both CASS and AIFMD/UCITS are a little sloppy in their use of the word “delegation”, using it on occasion to mean something that is probably meant to refer to a subcontracting arrangement. CASS only really talks about subcontracts, though AIFMD and UCITS deal with true delegation and subcontracts.

Why delegate?

Why do depositaries delegate their custody functions 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 depositary 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.

“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: rehypothecate to your heart’s content.”

“No can do,” says the PB. “I can only rehypothecate against indebtedness, and you, dear depositary, 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 inside it. For rehypo to work, I have to have a direct contractual relationship with the fund. That’s the deal.”

• Answer: the depositary delegates the custody function to the prime broker. Both AIFMD and UCITS allow this in certain circumstances, but there are complicated rules as to whether the depositary can shift responsibility to the PB.