Dublin has placed itself in pole position as the European jurisdiction of choice for domiciling hedge funds
For several years, Dublin has been positioning itself as the hedge fund jurisdiction of choice, especially for European-based promoters/managers. European promoters need a regulated EU jurisdiction if they want to sell their product within EU markets.
So, what faces the promoter when they decide on Dublin for their hedge fund? Do they incorporate in the Caribbean with a listing on the Irish Stock Exchange (ISE), or do they domicile the fund in Ireland?
The listing of an offshore-domiciled hedge fund on the ISE is a form of approval, but it is not a guarantee of security and does not label the fund as a regulated fund.
The Irish-domiciled hedge fund has the central bank as its lead regulator and the hedge fund is ultimately responsible to the central bank. The central bank is in the process of change and is moving towards a structure of a single regulatory authority for the whole financial services sector and will include a policy of consumer protection. This process of change continues and the hedge fund product is central in the new regulatory framework although the key regulatory requirements will not change and funds must still be controlled within Ireland and an Irish resident custodian/trustee must be appointed to control/custody the assets of the fund. These requirements mean the Irish- domiciled hedge fund is the first regulated hedge fund in the history of the industry.
As these requirements evolve, so too will the roles of the key players, especially that of the prime broker, which has been pivotal in the past. Although these new requirements are still in draft, they have been applied to the prime broker and require that there has to be control over the assets that the prime broker has under their discretion and charges the custodian/trustee with this control. So while the prime broker remains pivotal, the custodian/trustee now plays a significant part in the relationship between prime broker and the hedge fund manager.
The role of the custodian/trustee is to remove a potential risk of the fund to the prime broker where the assets held by the prime broker versus the indebtedness of the fund to the prime broker is key.
The custodian/trustee has to ensure the prime broker cannot hold more than 100% of the indebtedness of the fund by way of assets, as the central bank is particularly concerned over the ability of the prime broker to re-hypothecate assets of the fund while it is acting in a custodial capacity. The act of re-hypothecation itself is not a problem. It is the co-mingling of the fund's custody assets and prime broker assets in the event of default where the prime broker has re-hypothecated assets of the fund.
The relationship between the fund manager, the prime broker and the custodian/trustee is of paramount importance and will be governed by contractual agreements. In practice, the following agreements will be undertaken:
The fund will appoint an Irish-domiciled custodian subject to a contractual custodian agreement.
The fund will appoint one or more prime brokers subject to a prime brokerage agreement.
The custodian will appoint the prime broker(s) as global sub-custodian subject to a global sub-custodian agreement.
The custodian maintains the primary record of the assets of the fund.
This has the effect of segregating the assets of the fund from the assets of the prime broker who must maintain segregated custody and prime brokerage accounts. The custodian remains responsible for the assets in the custody account and is responsible for ensuring that the prime broker, in his capacity of global sub-custodian, maintains proper control over those assets at all times. Therefore, because the amount of re-hypothecated assets must not exceed 100% of the funds indebtedness and also that there has to be a right of set-off between the two, if the prime broker collapses, although the assets in the prime brokerage account will be lost, so to will the fund's indebtedness to the prime broker. Assets in the custody account are protected. This effectively reduces the prime broker risk of the fund and brings all parties closer together in each transaction and in reporting and controls.
This new practice (new to the prime broker but not the custodian who has lived with the burden of safekeeping and settlement risk for decades) has been accepted by the prime brokers, but not without much debate. It has taken time and effort to structure the relationship between prime broker and custodian and to get the approval of the central bank. The process of approval takes time, between eight and 12 weeks, but this is improving all the time as the central bank becomes more comfortable with hedge funds and although there may be a bottleneck, the process is becoming more streamlined as more clarity in the new guidelines emerge. The process is evolving and while the prime brokers may not be completely satisfied, it has opened the door to a new source of business for them which wasn't there before.
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