1. Introduction.. 5

1.1. The delegation of custody. 6

1.2. Wider issues linked to the ‘dematerialisation’ of securities. 6

1.3. Previous action by the Commission. 7

2. Procedural Issues and Consultations.. 8

2.1. Procedural issues. 8

2.2. Stakeholder consultation. 9

3. Background and context.. 10

3.1. Economic importance of UCITS funds. 10

3.2. Investor profile of UCITS funds. 11

3.3. Trends in services provided to UCITS funds. 11

3.4. The fee structure applicable to depositary duties. 13

3.5. Remuneration structures in the fund management industry. 14

4. Problem definition.. 15

4.1. Divergent criteria on eligibility to act as a depositary. 15

4.2. Unclear rules on delegation of custody. 15

4.2.1. Conditions of delegation. 16

4.2.2. Third country delegations 17

4.3. Unclear scope of liability in case of loss (including loss when custody has been delegated) 17

4.4. Unclear remuneration practices. 18

4.5. Divergent sanctioning regimes. 19

4.5.1. Differences in levels of administrative fines across Member States 19

4.5.2. Divergences in criteria for setting the level of administrative sanctions 20

4.5.3. Varying enforcement levels 21

4.6. Consequences under the baseline scenario. 21

4.6.1. Impact on investors 21

4.6.2. Impact on the UCITS fund and its management company. 22

4.6.3. Impact on depositaries 23

4.6.4. Impact on other financial service providers 23

4.6.5. Impact on national authorities 23

4.7. Problem tree. 24

4.8. The EU's right to act and justification. 27

5. Objectives.. 28

5.1. Coherence of objectives with other Commission policies. 28

6. Policy options.. 29

6.1. Problem No 1: Divergent criteria on eligibility to act as depositary. 29

6.2. Problem No 2: Unclear rules on delegation of safe-keeping duties. 30

6.3. Problem No 3: Unclear scope of depositary's liability. 31

6.4. Problem No 4: Unclear remuneration practices. 31

6.5. Problem No 5: Divergent sanctioning regimes. 32

7. Comparison of policy options.. 32

7.1. Problem No 1: Divergent criteria on eligibility to act as depositary. 32

7.2. Problem No 2: Unclear rules on delegation of custody. 34

7.3. Problem No 3: Unclear scope of a depositary's liability. 37

7.4. Problem No 4: Unclear remuneration practices. 41

7.5. Problem No 6: Divergent sanctioning regimes. 42

7.6. Choice of preferred legal instrument 45

8. Cumulative and other impacts.. 46

8.1. Social and environmental impacts. 46

8.2. Cumulative impacts of the proposal 46

8.3. Impact on third countries. 47

9. Monitoring and evaluation.. 47

10. ANNEXES.. 49

10.1. ANNEX 1: Related initiatives. 49

10.2. ANNEX 2: Feed-back statements to the public consultations. 60

10.3. ANNEX 3: Shares of Households that invest in UCITS Funds. 91

10.4. ANNEX 4: UCITS Net Assets by Country of Domiciliation. 92

10.5. ANNEX 5: Summary of the 2010 CESR mapping exercise. 94

10.6. ANNEX 6: The Commission's broad Framework on remuneration. 101

10.7. ANNEX 7: Summary of replies to the questionnaire on administrative sanctions. 103

10.8. ANNEX 8: Core violations of the UCITS Directive. 190

10.9. ANNEX 9: Glossary of key terms. 192

1. Introduction

Since its introduction in 1985, the UCITS Directive[1] has offered to European investors a wide range of high quality and safe investment products. The subsequent reforms of the Directive (2001 and 2009) have built upon the high level of investor protection and prudential supervision ensured by the Directive. The standards introduced in the UCITS rules have also contributed to the success of the UCITS brand in third countries (notably in Asia and Latin America) where UCITS funds domiciled in the EU enjoy a significant investor base. The requirements relating to depositaries that act on behalf of undertakings for collective investment in transferable securities (UCITS) are one of the key building blocks within the UCITS framework and aim primarily to ensure a high level of investor protection.

The UCITS depositary must be an entity that must be independent from the UCITS fund and the UCTIS fund's manager. Neither the fund manager nor any prime brokers that act as counterparties to the fund may also act as the fund's depositary. The independence of a depositary is necessary because the depositary essentially acts both as a supervisor (the 'legal conscience') of a UCITS fund, overseeing certain fund transactions (redemptions and investor payments to the fund) and as a custodian over the fund's assets.

A depositary "safe-keeps" the assets in which a UCITS invests and thus maintains the UCITS' and its investors' property interests. While the safekeeping of investors assets is a core task of the depositary, the depositary also performs certain oversight functions, such as verifying that a UCITS fund's sales, repurchase and redemption of units or shares is carried out in accordance with applicable laws, that the net asset value of units is calculated in line with national laws and fund rules, that transactions of the fund manager comply with all applicable laws and that transactions involving the fund's assets are carried out within the customary time periods.

Despite its important role, the UCITS rules relating to depositaries in the Directive have remained mostly unchanged since 1985: there are a number of generic principles applying to depositaries, leaving room for diverging interpretations of their duties and related liabilities. As a minimum requirement, the UCITS Directive does mention, however, that the management of a UCITS cannot be entrusted to the same entity that acts as a depositary. What the UCITS directive does not specify is that the separation between portfolio management and custody should also prevail in case the depositary function is delegated to a third party who, in turn, cannot be portfolio manager and custodian at the same time. This latter conflict of interest was present in the Madoff scenario (described in further detail below).

Different national rules have developed in many of those areas not specifically covered by the UCITS Directive. Especially in respect to entities eligible to act as a depositary, rules on delegation, rules on conflict of interest in case of delegation and rules on liability for the loss of assets in custody, the high level principles contained in the Directive have allowed the emergence of different approaches across the European Union. As evidenced by the Madoff case, this has led to different levels of investor protection depending on where the UCITS fund is domiciled.

1.1. The delegation of custody

The potential consequences of these divergences came to the fore in the course of the Madoff fraud, which hit the headlines on 11 December 2008. The brokerage operation of Bernard Madoff was revealed as a giant Ponzi scheme resulting in the largest investor fraud ever committed by one individual. Huge sums that were allegedly invested by Bernard Madoff turned out to have vanished with no corresponding securities in Mr Madoff's investment fund.

The consequences of the Madoff scandal are not confined to the US. The issue has been particularly acute in some EU Member States. One particular fund that acted as a feeder fund for Madoff recorded losses of around $ 1.4 billion due to Madoff investments which turned out to be fictitious. The losses suffered by this ‘feeder fund’ channelling investments to Madoff, have brought to the issue of depositary's liability to the fore. In this case, both the management of investments and custody in relation to the assets that belong to the fund were delegated to entities operated by Madoff. A ‘feeder fund’ is essentially a vehicle that collects investors’ money and then provides these monies to another financial service provider, usually a broker or another fund, so that the latter can design and execute an investment strategy.

The large scale of the Madoff fraud essentially went undetected for a long period because the depositary responsible for the safekeeping of the fund assets delegated custody over these assets to another entity run by Bernard Madoff, the US broker "Bernard Madoff Investment Securities".

The circumstances of the Madoff case raised several important issues in relation to UCITS funds. First, what are the precise conditions under which the depositary acting on behalf of a UCITS fund can delegate safekeeping of the fund's investment assets to a sub-custodian? The current UCITS Directive is silent on the precise conditions of sub-custody.

But more importantly, the Madoff scandal has also revealed general uncertainties within the UCITS framework, especially, in relation to the principal custodian's on-going liability in case of delegation of custody to a sub-custodian. As will be explained below, the issue of liability in case of delegation, in the absence of harmonised rules in the relevant UCITS Directive, is dealt with differently in individual Member States. The main difference is essentially that, in some jurisdictions, the depositary is obliged to reimburse investors for losses that stem from the decision to sub-delegate custody, while other jurisdictions limit liability to the diligent selection of the sub-custodian.

1.2. Wider issues linked to the ‘dematerialisation’ of securities

While the Madoff scandal triggered a closer look at the consequences of a loss of instruments that are held in (electronic) custody, some of the issue raised by the Madoff fraud are intrinsically linked to the trend toward recording ownership in financial instruments by means of an electronic book entry.

The current gaps in the UCITS rules on depositaries are also linked to the increasing use of electronic book entry ('computerisation of securities') to register and keep track of ownership changes in securities. The current UCITS framework does not take issues and circumstances linked to electronic custody into account.

The trend toward electronic book entry started much before Madoff and the consequences of this development are not at all reflected in the way the 1985 UCITS rules on depositaries are configured. For example, the basic distinction between electronic custody over transferable securities and record-keeping in relation to all "other" assets is not reflected in UCITS. More precise rules on such financial instruments that are to be held in custody and more clarity on the consequences of their loss are therefore driven by the need to keep pace with technology in the depositary sector. The remainder of this section sets out the main problems inherent in the current regulatory framework that governs the activities of UCITS depositaries, i.e., eligibility to act as a depositary, rules on delegation of custody, liability for the loss of a financial instrument in custody, remuneration policies of UCITS managers and sanctions.

1.3. Previous action by the Commission

In 2009, the Commission introduced its proposal on Alternative Investment Fund Managers to regulate the alternative part of the asset management industry that, until then, had not been subject to any regulation and supervision at EU level. The AIFM Directive[2] that was finally adopted in 2010 draws the lessons from the Madoff case and introduces a complete and fully harmonised system on liability related to the performance of depositary tasks for alternative investment funds. These rules, however, apply only to alternative investment funds that are targeted to professional investors. The precedent set by the AIFMD constitutes nevertheless an essential point of reference for the improvement of the current depositary rules for UCITS. It is obviously an unintended anomaly that retail investors remain less protected than the professional investors covered by the AIFM framework.

In addition, the financial crisis also revealed that the remuneration and incentive schemes commonly applied within financial institutions were themselves exacerbating the impact and scale of the crisis. Remuneration policies contributed to short-term decision making and created incentives for taking excessive risk. These tendencies, in turn, increased levels of systemic risk.

More generally, and in view systemic issues and commitments that were made at the G20 level, the EU is taking coordinated steps across all financial services sectors to introduce consistent requirements governing remuneration policies, as set out in the Commission Recommendation of April 2009.[3] The adoption of CRD III,[4] the AIFM Directive, and the ongoing work on the level 2 measures under Solvency II will confirm the determination of the EU to fulfil these commitments. Extending this work to also cover the remuneration of UCITS investment managers is a natural additional step in this process.

Sanctions are not harmonised in any financial services legislation at EU level and the analysis of national sanctioning regimes carried out by the Commission, along with the Committees of Supervisors (now transformed into European Supervisory Authorities) has shown a number of divergences and weaknesses which may have a negative impact on the proper application of EU legislation, the effectiveness of financial supervision, and ultimately on competition, stability and integrity of financial markets and consumer protection. Therefore, in its Communication of 9 December 2010 "Reinforcing sanctioning regimes in the financial sector"[5] the Commission suggested setting EU minimum common standards on certain key issues, in order to promote convergence and reinforcement of national sanctioning regimes. A significant majority of respondents to the consultation launched by the Communication shared the Commission's analysis of the shortcomings in the existing national sanctioning regimes and were supportive of EU action to set minimum common rules on the key issues identified, which include level of administrative fines; criteria to be taken into account when applying sanctions and mechanisms facilitating enforcement. Therefore, the Commission has included such common rules, adapted to the specifics of the sectors concerned, in all its recent proposals for the review of the sectoral EU legislation concerned (CRD IV, MiFID, Market Abuse Directive, Transparency Directive). Extending this work to the UCITS framework is a natural additional step in this process.

2. Procedural Issues and Consultations

2.1. Procedural issues

The proposed amendments to the UCITS Directive are part of the Commission's 2012 Work Programme in the area of financial services. The impact assessment process was initiated in September 2010 with the first meeting of the Inter-Service Steering Group (ISSG), comprising the following Commission services: Competition, Health and Consumers, Taxation and Customs Union, Enterprise and Industry, Secretariat General, Economic and Financial Affairs, and the Legal Service. Further meetings of the ISSG took place in January, March and September 2011. Subsequent to the last meeting, the IA assessment was adjusted to widen the breadth of policy options to address the key problems that arise in respect of depositaries, their duties and their liability. In order to enhance the overall presentation, the problem definitions in the IA were streamlined. In addition, more economic evidence on the structure of the depositary markets in the EU and overseas was added, more research was conducted on the typical UCITS investor profile and the economic rationale behind the increasingly frequent sub-delegations to third countries is presented in a more detailed manner (Section 3). Finally, more background was added on the precise facts on the Madoff case, as this case largely triggered the need to reform the rules applicable to UCITS depositaries. The new version was communicated to the ISSG on 1 February 2012 and the latter did not request a new meeting to discuss these adjustments.

The report was sent to the Impact Assessment Board (IAB) on 3 February 2012 and discussed before the IAB on 29 February 2012. Subsequent to the meeting of the IAB changes were introduced, in particular relating to the cost of custody, the cost of recordkeeping, the overall custody fee structure (specifying differences in custody fees in different jurisdictions) and the repercussions that regulatory change might have on these parameters. Improvements were also made in explaining the different legal standards that are currently employed to delineate a custodian's liability to return instrument lost in custody and, in particular, instruments lost at the level of a delegate sub-custodian. Significant changes were made to better describe the economic repercussions of inaction on various stakeholders directly or indirectly linked to providing services to UCITS funds (in the baseline scenario).

2.2. Stakeholder consultation

The Commission launched in 2009, in direct response to the Madoff scandal, a first public consultation in order to strengthen the regulation and supervision of UCITS depositaries. A feedback statement[6] published in 2009 showed that the clarification of the UCITS depositary function was an essential step for a comprehensive review of the existing European regulatory principles applicable to depositary functions. The same year, the Commission published a proposal in order to regulate the alternative funds managers (AIFM) which also introduced some provisions relating to the depositary function. The AIFM Directive[7] that was finally adopted in 2010 draws the lessons from the Madoff case and introduces a complete and fully harmonised system on liability related to the performance of depositary tasks for alternative investment funds.

As part of its wider reform on all provisions pertaining to the role and liability of depositaries, the Commission undertook[8] to introduce targeted changes to the depositary provisions in the UCITS Directive[9]. In its Communication of 2nd June 2011 (COM (2010) 31 final, page 7), the Commission proposes to adopt "changes to the legislation applicable to the UCITS depositaries function in response to the Madoff fraud, which revealed the need to further harmonise certain aspects of the level of protection offered to UCITS investors".

On 9 December 2010, the Commission services launched a second public consultation on the UCITS depositary function and on managers' remuneration, which closed on 31 January, 2011. 58 contributions were received and signalled a broad support of the review initiative, particularly with respect to the clarification of depositary functions and to the simplification of the regulatory landscape as a result of the proposed alignment with the AIFM Directive. Respondents however took a more critical stance vis-à-vis the issue of depositary liability[10].

As to the issue of administrative sanctions, this report reflects replies to an ad hoc questionnaire prepared by the Commission services and sent to the European Securities Committee (ESC), as well as to ESMA. A summary of the Member State replies to the questionnaires is presented as Annex 7.

3. Background and context

3.1. Economic importance of UCITS funds

Investment funds are special investment vehicles, created for the purpose of gathering funds from investors, and investing those funds in a diversified portfolio of financial instruments. Since its origin in 1985, the UCITS Directive has been the basis on which a genuine European retail investment fund 'product' has been built. UCITS has created a comprehensive legal framework that offers increased investment opportunities for businesses and households alike. At the same time, the directive also introduced a financial services 'passport', whereby a UCITS fund can be marketed across the EU, following authorisation from the competent authorities of its country of domicile (i.e. the home country) and notification to the competent authorities of the host market.

Cross border subscriptions to UCITS compliant investment funds have grown considerably since the UCITS rules were first introduced in 1985. The UCITS acronym has developed into a strong brand and is nowadays, apart from Europe, also recognized in Asia and South America. The success of UCITS as a cross border vehicle for investments is borne out by the rapid growth of assets that are managed in UCITS compliant funds. Total assets under management (AuM) grew from €3,403bn at the end of 2001 to €5,889bn by end 2010, according to data from the European Fund and Asset Management Association (EFAMA). In September 2011 AuM stood at € 5,515bn.

About 80% of UCITS assets are invested by funds[11] domiciled in four jurisdictions: Luxembourg (32.4%), France (20.6%), Ireland (14.4%), and the United Kingdom (11.5%).

In line with the requirement that the depositary is located in the same Member State as either the UCITS fund or the investment company, most UCITS assets are safe-kept by depositaries located in either Luxembourg, France, Ireland, the United Kingdom. Overall, the European depositary industry is today entrusted with safe keeping of around €5.3 trillion worth in UCITS assets.

3.2. Investor profile of UCITS funds

According to 2010 data[12], EU investors held € 6.9 billion in mutual funds[13], of which about 75% was invested in EU domiciled funds and 25% in funds that are not domiciled in the EU. Non-EU investors invested further € 3,300 billion into the EU domiciled mutual funds. The investor profile of an EU mutual fund is depicted in the graph. As more than 85% of EU mutual fund investments are directed towards UCITS vehicles to (€5,889 out of 6.9 bn in 2010), the graph is representative for the UCITS investor profile as well. The graph shows retail investors are heavily exposed to mutual funds. 28% of fund holdings are made up of direct retail investments while another 61% are intermediated either through insurance policies, pension funds and other financial corporations. Intermediaries, for example pension funds that provide retirement benefits to individual investors, invest monies they collect from retail investors into mutual funds. Essentially this means that around 90% of mutual fund investments are directly or indirectly attributable to retail investors.

Based on data from statistical offices of six Member States[14], it is estimated that about 22.5 million (i.e. 10 %) of EU households are invested in mutual funds. Given the fact that the major EU fund domiciles are concentrated in the above-mentioned four EU jurisdictions, this demonstrates significant cross-border sales of fund units based on the 'passport'.

3.3. Trends in services provided to UCITS funds

A typical UCITS fund uses several service (external or internal) providers to operate and execute its investments. Normally, the fund relies on an investment manager to manage the assets, one or several brokers to execute trades, a fund administrator to calculate the value of the fund’s investments and a custodian to safe-keep investment positions. While being obliged to work together, these service providers should be independent of each other and their functions should be strictly separate. Separation of the above services is an essential tool to avoid fraud. One function that should be separate from all of the others is that of safe-keeping of assets by means of a depositary. A depositary should therefore neither be identical to an investment manager, a fund administrator or a broker. A depositary should also not belong to the same corporate group as any of the other fund service providers.

Recent trends affecting the custody sector include increased competition, the disappearance of local custodians and the emergence of a handful of global players. The largest global custodians, in terms of client assets under custody (AuC) for 2010, are Bank of New York Mellon ($25.5trillion), State Street ($16.7 trillion), J.P. Morgan $16.6 trillion) and Citigroup ($13.5trilllion)[15].

The table provides an overview of the main suppliers of global custody services, in terms of assets under management (AuM), relative changes in AuM and the number of custody clients.

GLOBAL CUSTODY ASSETS (all mutual funds)

BNP PARIBAS || 7 trillion || N/D || N/D

BNY MELLON * (* includes assets under administration) || 25,50 trillion || 12,0% || 4700

Brown Brothers Harriman || 3,10 trillion || 31,6% || 346

CITI || 13,50 trillion || 14,5% || N/D

HSBC SECURITIES SERVICES || 5,70 trillion || 9,5% || 1167

JP MORGAN || 16,60 trillion || 8,0% || 2895

NORTHEN TRUST || 4,36 trillion || 17,0% || 1933

RBC DEXIA || 2,23 trillion || 18,1% || N/D

SGSS || 4,76 trillion || 8,0% || 150

STATE STREET || 16,7 trillion || 18,8% || 2645

In this context it is important to note that not even the largest of the above-mentioned global custodians have custody operations of their own in all of the jurisdictions that a UCITS fund might wish to invest in. According to newspaper reports no single custody bank is believed to have operations in more than 40 jurisdictions[16]. This means that local custody is often "outsourced" to non-affiliated sub-custodians operating in those jurisdictions not covered by a global custodian's network.

Markets where global custodians offer DIRECT CUSTODY

|| Europe || Asia || Americas || Middle East || Africa || Total

BNP PARIBAS || 17 || 3 || 1 || - || 1 || 22

BNY MELLON || 5 || - || 3 || - || - || 8

Brown Brothers Harriman || - || - || 1 || - || - || 1

CITI || N/D || N/D || N/D || N/D || N/D || 60

HSBC SECURITIES SERVICES || 6 || 13 || 4 || 6 || - || 29

JP MORGAN || 3 || 3 || 1 || - || - || 7

NORTHEN TRUST || 2 || - || 2 || - || - || 4

RBC DEXIA || 3 || - || 1 || - || - || 4

SGSS || 15 || 1 || - || - || 3 || 19

STATE STREET || 1 || - || 2 || - || - || 3

Markets where global custodians offer CUSTODY VIA SUB-CUSTODIANS

|| Europe || Asia || Americas || Middle East || Africa || Total

BNP PARIBAS || 23 || 16 || 11 || 9 || 21 || 80

BNY MELLON || 35 || 20 || 12 || 10 || 22 || 99

BROWN BROTHERS HARRIMAN || 38 || 17 || 13 || 10 || 15 || 93

CITI || N/D || N/D || N/D || N/D || N/D || 34

HSBC SECURITIES SERVICES || 6 || 18 || 4 || 12 || - || 40

JP MORGAN || 33 || 16 || 12 || 14 || 19 || 94

NORTHEN TRUST || 35 || 17 || 11 || 13 || 22 || 98

RBC DEXIA || 37 || 19 || 10 || 9 || 11 || 86

SGSS || 21 || 16 || 8 || 8 || 8 || 61

STATE STREET || N/D || N/D || N/D || N/D || N/D || 104

3.4. The fee structure applicable to depositary duties

The payment schedule for custody and record-keeping of fund assets is set out in a ‘ratecard’ negotiated with the fund manager which includes a holding fee based on the value of the assets being ‘held’ in custody (or monitored), as well as a transaction fee. Additional elements affecting the cost of such services are the nature of the assets and the size of the fund.

The cost of custody is normally calculated as a percentage of the assets that are held in custody. The cost of custody, on average, in Europe varies between 0.25 and 1.25 bp. This corresponds to a fee ranging between 0.00025% and 0.001 % of the assets held in custody. There are differences in the cost of custody between different Member States. These differences can amount, on average, to 0.25-1.0 bp. Custody in the United States is even cheaper, ranging from 0.2 bp to maximum of 0.5 bp.

The cost of holding assets in custody in third countries is significantly higher. For most developing countries, the cost of custody varies between 25 to 50 bp. Custody in some developing countries may cost up to 60 bp.

The cost of record-keeping (checking ownership records and recording individual contracts that are not suitable for custody) is higher at between 1 and 1.25 bp. This is due to the fact that custody is nowadays based on electronic data entries reflecting the existence of a security. Therefore, moving to a broader scope of instruments to be held in (electronic) custody might entail cost savings of, on average, between 0.5 and 0.75 bp.

The above described cost structure of custody allows for three conclusions. First, the provision of custody services, which is essentially the clearing, servicing and safekeeping of assets, is typically a low margin product by itself. However, when coupled with other value added services like foreign exchange, securities lending, cash management and fund accounting, margins associated with the total bundled service offering can become higher. Nevertheless, global custodians have largely been able to achieve higher margins by deploying large scale operations and technology which lower per unit costs.

Second, price differentials between EU Member States seem a question of max. 1 bp. On the other hand, price differentials between Europe and certain emerging markets can become quite significant. The overall rate of custody is therefore heavily influenced by the composition of a fund's portfolio (e.g., the share of instruments issued in emerging markets). As fund clients are generally charged on a per market basis, with emerging markets attracting higher fees, those with large emerging markets portfolios will usually have a higher blended rate. In addition to portfolio composition, emerging markets will typically have additional settlement related requirements and other logistical related issues which increase costs.

3.5. Remuneration structures in the fund management industry

Typical of a principal-agent relationship, the asset management industry is defined by the division between the control of financial wealth and its ownership. Compensation structures, as an intimate part of this relationship, are as a result shaped by the necessity to align the incentives of those fund managers (i.e. the agents) that control wealth by making investment decisions with those of the unit-holders (i.e. the principals) who own but delegate their wealth for this purpose.

Evidence suggests that remuneration for the individual fund managers consists of a fixed base salary, topped by a bonus based partially on a fund's relative performance with respect the previous performance period (t-1) which is typically quarterly (i.e. high water mark). The high water mark shall be the highest NAV per unit/share and is a benchmark for gauging a manager's performance in the period t0. An independent fund administrator (at times this coincides with the depositary), whose main function is to calculate the NAV of the fund, shall compare performance and authorise a bonus only where NAV exceeds its peak (or high water mark value) of the previous period. References to industry benchmarks (usually standard market indices like MSCI, S&P 500, etc.) or to average peer performance are also more broadly taken into account. Typically, bonuses will be paid from a bonus pool, the size of which is determined by the overall performance of the management company. An individual’s share of the pool will largely be driven by its own performance, but there will also be other 'soft' factors not related to investment performance, such as professional experience, teamwork and seniority. As a result, there is no mechanistic relationship between relative return performance of a fund and an individual manager’s remuneration[17].

According to a pre-financial crisis study by the Bank for International Settlements (BIS), the size of the bonus component in individual asset managers’ compensation varies considerably across countries, with a general trend towards a gradually higher share of variable compensation to total pay. According to gathered evidence, bonuses are, on average, around 25-40% of total pay in Spain, 30% in Germany, and, as a rule, no larger than 50% in France. In Italy, bonuses range from between 15-20% of base pay at the low end, up to 150% at the high end. In the United Kingdom, however, the importance of bonuses seems to be higher: the median fund manager will receive a bonus of about 100% but exceptional asset managers can earn as much as six-times their base salary in the form of bonuses[18]. Many stakeholders stressed in their responses to the consultation that where an individual manager's variable remuneration component is linked to the performance of the fund, multi-year periods are taken into account (between 3 and 5 years) as a safeguard against 'short-termism'.

Besides the direct rewards for achieving higher returns relative to a selected benchmark, performance is also rewarded indirectly through management fees corresponding to a fixed component of total assets under management (AUM), albeit with fee levels differing across management styles and asset classes. In other words, a positive relative performance rewards the fund manager through new fund inflows thereby increasing the AUM. This nexus between relative performance and new fund inflows acts as an implicit incentive structure. Finally, the increasing layers of intermediation within the industry and the growing complexity of UCITS-eligible products all imply a series of hidden costs to investors. These range from product servicing costs throughout an investment's lifecycle, to excessive trading due to high portfolio turnover, etc. Fees from stock lending and other transactions (including the re-use of collateral) involving the fund's assets are generally undisclosed, but may well influence the size of executive pay while mitigating real operating costs reflected in the Total Expense Ratio (TER)[19].

4. Problem definition

4.1. Divergent criteria on eligibility to act as a depositary

Currently, there is little clarity on the institutions that are eligible to act as a depositary for a UCITS fund. According to Article 23(2) UCITS any institution which is subject to prudential regulation and ongoing supervision can act as a depositary for a UCITS fund. According to Article 23(3) UCITS Member States enjoy significant discretion as to the institutions that they can determine as UCITS depositaries[20].

National divergences as to the entities that can act as depositaries for a UCITS fund may be at the origin of significant legal uncertainty and could lead to differential levels of investor protection. This is particularly true as regards the capital that depositaries need to set aside to cover liabilities, especially the obligation to return assets that are held in custody.

More specifically, the eligibility criteria referred to in the Article 23(2) UCITS Directive permit Member States to select the types of entities are suitable to acts as UCITS depositaries at national level. This has led to divergent approaches across Member States: out of the 17 Member States that require depositaries to be credit institutions, 12 impose specific capital requirements for carrying out custody activities or other related UCITS depositary functions.

The results of the public consultation carried out by the Commission in 2009 indicate the following opinions as regards to eligibility criteria:

66% of the respondents[21] agree with harmonisation of rules as to what institutions can be eligible as UCITS depositaries and 49% would like to see only those entities acting as UCITS depositary that are subject to the Capital Requirements Directive (see replies to questions 24 to 26 in the feedback statement).

4.2. Unclear rules on delegation of custody

The fragmentation of the regulatory framework applying to delegation of safe-keeping has become more pronounced due to an increased diversification and internationalisation of UCITS investment portfolios. As more investment opportunities arise in different jurisdictions, the necessity to appoint sub-custodians in these jurisdictions increases (cf. the above tables comparing direct custody with custody through delegation).

Changes to the UCITS directive introduced in 2001 extended the scope of eligible assets for UCITS to new classes of assets.[22] As a result, UCITS managers now invest in a much greater number of countries and in more complex instruments than in 1985.

4.2.1. Conditions of delegation

Despite the enlargement of eligible investment instruments, the UCITS Directive does not define the conditions applicable in case a depositary elects to delegate custody to a sub-custodian.

In order to situate the conditions of delegation of custody functions in proper context, two important issues must be clarified at the outset.

First, custody depends on the characteristics of a financial instrument. Transferable securities (e.g. equities, bonds or money market instruments) have to be held in custody while other assets (e.g., certain derivative contracts or individually negotiated partnerships in non-listed companies) can only be recorded in a position-keeping book.

Second, only custody duties and record-keeping duties can be delegated. For prudential reasons, the depositary's oversight duties (as contained in Article 22(3) UCITS, according to which the depositary supervises compliance of the UCITS manager with legal provisions and investment policies, cannot be delegated. In exercising these duties, the depositary acts as the 'legal conscience' of the UCITS in ensuring that all transactions (sales, redemptions, cancellation of units) are carried out in accordance with applicable national laws and the UCITS instruments of incorporation. This is in line with the principle that quasi-supervisory functions should not be subject to delegation. The lack of clarity pertains both to the conditions under which a delegation of either custody or record-keeping can take place (e.g., objective reason for delegation, level of skill in selecting sub-custodian, intensity of ongoing monitoring of sub-custodian) and to the conditions in which, exceptionally, custody can be delegated to third country custodian who do not match these standards.

CESR's submission to the Commission consultation in 2009 and the CESR mapping exercise published in 2010 both highlight a variety of national regulatory approaches in this respect.[23] Member States impose various conditions in respect of the sub-custodian entity to which a delegation of safe-keeping can take place (e.g., effective prudential regulations, minimum capital requirements and supervision). In particular, Member States' approaches differ in relation to delegations to third country custodians..

4.2.2. Third country delegations

Equally, the UCITS Directive is silent on the conditions that apply when a depositary has, by virtue of national laws, to delegate custody to a third country custodian. Rules on delegations to third country custodians are important as UCITS increasingly seek to invest in third country jurisdictions, primarily in East Asia (Hong Kong, China, Korea). In some of these jurisdictions either practical considerations or local rules may mandate local custody over the financial assets that are issued in these jurisdictions. For that reason, recourse to a local custodian, based on a delegation contract, becomes mandatory. As the above tables comparing direct custody with custody by means of local sub-custodians demonstrate, local sub-custody is rather the rule and direct custody the exception. A local custodian can either be a subsidiary of the principal custodian or an independent entity.

As explained in section 3.2, the Madoff case shed some light on the risks associated with the use of local third country sub-custody networks when they fail to perform their duties appropriately or simply default.

The results of the public consultation carried out by the Commission in 2009 indicate a clear consensus on the following issues with respect to delegation of UCITS depositary duties

- The Commission consultation revealed that "custody risks" associated with financial instruments ", i.e. the "loss of assets", are likely to materialize when safekeeping tasks have been delegated to a third party.

- 82% of respondents[24] agree that conditions upon which the depositary shall delegate its activities should be clarified (see replies to questions 15 and 17 in the feedback statement).

4.3. Unclear scope of liability in case of loss (including loss when custody has been delegated)

According to Article 24 of UCITS Directive, liability for loss of a financial instrument that is held in custody only arises in case of 'unjustifiable failure to perform obligations' or 'improper performance' of these duties. These legal terms have given rise to different interpretations in the Member States and thus differences in investor protection, most notably in the case a custodial instrument is lost after the delegation of custody.

The potential consequences of these divergences came to the fore with the Madoff fraud. In some Member States the depositary was immediately liable to return assets in custody as a consequence of fraud at the level of the sub-custodian, in other Member States the situation is less clear and still subject to litigation.

While the liability rules in the UCITS directive haven't changed since 1985, the UCITS investment environment has evolved. UCITS funds are now able to invest in a wider range of financial assets, which may be more complex and also may be registered outside the EU (for instance, in emerging markets); fund portfolios are increasingly diverse and international. In particular, the fact that the UCITS Directive only contains high level legal principle has the following consequences:

Situation 1: Loss of an instrument in custody with the UCITS fund's principal custodian or a sub-delegate

The UCITS rules are not precise enough to avoid that the depositary's liability is dealt with in a different manner in different Member States[25]. As a consequence, the obligation to return assets lost in custody is not uniform across the Member States. The Madoff case has demonstrated the fundamental difference between the strict liability and the diligence approaches.

Situation 2: Loss of an instrument in custody with a third country sub-custodian

In addition, the current UCITS rules provide no clarity for the situation when custody is delegated to third country sub-custodians. Should the reformed UCITS rules allow delegations of custody, including delegations to third country sub-custodians that do not meet the delegation requirements (in terms of effective prudential regulation, minimum capital requirements and supervision in the country where the sub-custodian is established), the impact of such delegations on the principal custodian's liability needs to be clarified.

The AIFMD currently allows contractual discharge for all instances in which custody is delegated. In line with the retail profile, it needs to be assesses whether such a general discharge is appropriate for a UCITS fund.

4.4. Unclear remuneration practices

Given that remuneration of the UCITS managers is, at least partly, based on the performance of the fund, there is an incentive to increase the level of risk in the funds's portfolio in order to increase the potential returns. However, the higher level of risk can expose the fund investors to higher potential losses. The remuneration structure is typically skewed in the sense that the manager participates in the materialized returns but does not participate in the materialized losses. This creates further incentives to pursue higher risk strategies. In addition, the remuneration structure that does not take into account performance over extended periods induces the manager to pursue strategies with skewed risk return profile, i.e. strategies that are likely to generate higher positive returns at the cost of less frequent but much larger possible losses.

Furthermore, remuneration structures are seldom disclosed in the fund's offering documents, rendering managers largely unaccountable to investors as far as the determinants to executive pay in line with fund performance are concerned.

Another important aspect to consider is expected market developments. Were UCITS funds to be excluded from the scope of the recent international and European standards[26], a potential migration of riskier management practices may occur from the alternative investment into the more risk-averse retail fund industry, albeit insofar as the UCITS Directive allows[27].

4.5. Divergent sanctioning regimes

A preliminary mapping exercise of national rules on sanctions for breaches of obligations contained in the UCITS Directive was carried out in 2010 by the Commission . The results were updated through a consecutive survey in the form of a questionnaire addressed to ESMA, as well as to all Members of the ESC, in May 2011. Replies to the questionnaire revealed three salient features: (i) differences in the amounts of pecuniary sanctions (i.e. fines) applied to the same categories of breaches; (ii) divergences different criteria applicable to determining the amount of administrative sanctions; and (iii) variations in the level of enforcement of sanctions. For an overview of the core violations to the UCITS Directive, see Annex 8 to this report.

4.5.1. Differences in levels of administrative fines across Member States

Among the powers granted to competent authorities under Article 98(2) of the UCITS Directive, there is no explicit reference to fines. Rather, they are contemplated under the following Article 99(1) where Member States shall ensure, in conformity with their national law, that the appropriate administrative measures can be taken or administrative penalties be imposed against the persons responsible where the provisions for the implementation of the Directive have not been complied with.

The results of the Commission's 2011 mapping exercise revealed that all UCITS transposing legislation in twenty-five Member States foresees a maximum fine for both legal and natural persons alike[28]. In twelve Member States there are also statutory minimum amounts. As an alternative, where the amount of the illicit profit or economic advantage from the offence can be precisely quantified, the level of the fine is determined by multiplying the profit by a pre-determined factor[29]. This approach, however, seems to be the exception rather than the rule.

Overall, levels of fines vary greatly across the EU and in some member States those levels appear to be too low to ensure sufficient deterrence, given the large gains that may be obtained from infringing the detailed "product" regulations contained in the UCITS Directive. For legal persons, the maximum fines foreseen for offences range from €100.000 in one Member State[30] to €10 million in another. These figures denote considerably wide spectrum in the application of fines for identical or similar types of breaches. While certain national systems provide that maximum levels of sanctions (or ranges) must be commensurate to the type or nature of the infringement, other Member States apply a maximum (or range) of sanctions without qualifying the type of infringement. For example, in one Member State, the rules on collective investment schemes define three levels of gravity (each corresponding to a statutory maximum amount), i.e. very serious (€300.000), serious (€150.000) and minor (€60.000)[31]. On the other hand, in another Member State, a violation relating to operating requirements triggers a fine ranging from €2.500 to €250.000 for legal and natural persons alike[32]. For violations of disclosure/reporting requirements (e.g. the rules on the offer of units to investors), the corresponding fine, if the amount of the economic damage remains undetermined, may range between €100.000 and €2 million. In cases where economic damage can be determined, the sanction may range from one-fourth of the values marketed to no more than double their value[33]. As these examples indicate, especially in countries with a maximum fine threshold of below € 1 million[34], the economic gains accruing from a variety of violations can often exceed the potential fine.

Concerning fines applicable to natural persons, the same kinds of discrepancies persist. Certain jurisdictions charge the same maximums for legal persons to individuals, whereas others expressly foresee tailored maximums. Competent authorities in twelve Member States are also capable of imposing criminal sanctions.

However, the fact that some Member States provide for criminal sanctions does not seem to be the main reason for the differences identified. Indeed, the scope of criminal sanctions is much narrower: they are usually applied to individuals rather than to legal persons and only for some of the most serious violations of UCITS

4.5.2. Divergences in criteria for setting the level of administrative sanctions

The results from the 2011 stock-taking review of national rules transposing the UCITS Directive reveal that the criteria national sanctioning authorities consider when determining a fine vary considerably between Member States. Whereas all sanctioning regimes take into account the 'gravity' of a violation, gravity is qualified differently by the national sanctioning authorities, e.g. sometimes in terms of economic damage to fund and investors, others in terms of impact on domestic market stability, or sometimes in terms of duration/frequency of the infringement. Moreover, certain laws only account for a limited number of additional criteria apart from that of gravity, making administrative sanctioning practices less flexible and less proportionate to the offence committed. For instance, it emerges from the evidence collected that only twenty out of the twenty-seven Member States would consider the financial strength of an offender (measured either in terms of turnover or professional income) as a factor in the calculation of a fine. Similarly, few of the applicable laws surveyed by Member States take into account voluntary cooperation as a mitigating factor.

4.5.3. Varying enforcement levels

The effectiveness, proportionality and dissuasiveness of national sanctioning regimes not only depend on those sanctions expressly provided for by law, but also on their effective application and/or enforcement. During an observation period between 2008 and 2010, sanctioned violations of the relevant national laws and regulations vary greatly across the EU. This may be partially explained by the industry concentration in the jurisdictions where a higher number of infringements are detected and sanctioned: most UCITS fund providers are domiciled only in a handful of jurisdictions that collectively make up over 80% of the market[35]. However, a low level of enforcement in MS with significant UCITS market could be symptomatic of a weak enforcement of EU rules.

Consultations with Member States have confirmed the effectiveness of their cross-border cooperation arrangements between competent authorities. However, the information available shows that a majority of Member States do not have in place any mechanism encouraging persons who are aware of potential violations of the UCITS to report those violations ("whistle blowing" systems), while whistle blowing can is an important tool which can facilitate detection of violations and therefore improve the application of sanctions. For the purpose of enhancing enforcement, measures to enhance national supervisory powers, among which, 'whistle-blower' programmes, can be considered, in parallel to other proposed financial services legislation as part of the European acquis.

4.6. Consequences under the baseline scenario

4.6.1. Impact on investors

If nothing were done on harmonising depositaries' duties, the delegation of custody and the scope of its liability to return financial instruments that are held in custody, investor confidence in the safety of assets invested through a collective investment vehicle would remain shaken. While the average retail investor certainly has no intimate knowledge of legal proceedings surrounding the loss of assets in the Madoff fraud, the image of investors battling for several years to reclaim instruments were lost as part of this affair, or the reimbursement for the loss of their assets, lingers.

The Madoff affair has not just claimed its victims among a few wealthy "high-net-worth" individuals, banks and hedge funds whose money he apparently invested. The Madoff affair threatens to damage small retail investors and cast a spell on the entire collective investment business.

In this context, three of the above mentioned statistics are relevant. First, as almost 10% of European households are invested in UCITS funds, a further incident in relation to investor assets being lost on account of an unreliable and badly supervised depositary will provide a strong dissuasion for households that invest in mutual fund to accumulate savings or retirement benefits. If nothing were done, the role of mutual funds in provisioning for retirement may be irremediably harmed with negative consequences not just for the mutual fund industry but for the level of EU pension income overall.

Secondly, EU investors overall hold 5,889 billion in UCITS compliant mutual funds. In addition, non-EU investors hold another 3,300 billion in UCITS compliant funds. Any incident in relation to the safety of assets held in a UCITS funds, even in the rather arcane sphere of assets in custody, will cause significant ripple effect on investor confidence.

Thirdly, almost 90% of the assets under management in UCITS fund are, directly or indirectly, held by retail investors. Any incident in this area is therefore bound to mainly affect retail investors, an investor public that is much more vulnerable than the professional investor group. Often UCITS is (still) perceived as one of the few reliable and well-regulated and supervised investment tools available in an uncertain financial environment.

Any event casting doubt on the "safety" and "reliability" of the UCITS investment vehicle will therefore risk eroding investor confidence and lead to net outflows of investments in UCITS funds.

Investors would continue to bear the costs of opaque remuneration practices leading to less informed investment choices. Investor would also suffer from misaligned incentives of fund managers due to skewed remuneration practices which would continue to impinge negatively on the risk management of the fund. Investors would further suffer from ineffective sanction regimes.

4.6.2. Impact on the UCITS fund and its management company

A dramatic loss of assets that are held in custody for a UCTS fund primarily affects investors. But such an event can have dramatic repercussions on a fund administrator or investment manager as well as evidenced in the following short extract:

BOX – MADOFF AFFAIR: FEEDER FUND WITHDRAWN FROM LIST AND LIQUIDATED

On 3 February 2009, in view of the establishment of the responsibilities of the various intermediaries in relation to Madoff scandal, the following two decisions were taken (1) to withdraw the feeder fund[36] from the list of authorized UCIs(2) thereafter to request the judicial liquidation of this fund.

The decision to withdraw the fund from the list of authorized UCIs is based on the fact that it does not observe any longer the provisions in relation to the organisation and functioning of undertakings of collective investments. This withdrawal has as consequence the suspension of all payments made by the fund and the prohibition to perform any acts other than conservatory acts. The decision of withdrawal will become permanent after a period of one month, except in case of appeals. In case of a liquidation decided upon by the court, the court will appoint a liquidator to realize the fund assets.

In relation to remuneration policy, if nothing were done, the remuneration practices would continue to be opaque and would encourage the managers to take on excessive risks. As regards sanctioning regime, the lack of harmonization would continue to present regulatory arbitrage opportunities and would render the sanctioning regime ineffective on cross-border basis.

4.6.3. Impact on depositaries

Depositaries and their reputation would be at stake should a Madoff type incident repeat itself. Naturally, confidence in this system is shaken when sub-delegations of the type experienced in the Madoff case take away the confidence that a shared domicile between fund and depositary intended to create.

Secondly, the loss of assets in custody can have serious repercussions on the operation of a custodian, especially if the matter of liability is not resolved quickly. Apart from the issue of liability to return assets lost in custody, the risk of litigation is most apparent in the case of sub-delegations, a phenomenon that becomes increasingly important as the range of investment opportunities available to UCITS funds increase. Uniform requirements in relation to the sub-custodian are therefore essential to ensure a coherent image of the depositary sector and investors' trust.

Regarding the remuneration policy, there is no direct impact on depositaries. As regards sanctioning regime, as mentioned above, the lack of harmonization would continue to present regulatory arbitrage opportunities and would render the sanctioning regime ineffective on cross-border basis.

4.6.4. Impact on other financial service providers

Litigation involving lost securities will not be confined to fund administrators, investment managers or depositaries. Litigation can also involve other provider of financial services, such as accounting services.

BOX – PONZI SCHEME LITIGATION SPREADS TO AUDIT FIRMS

In the United States, several accounting firm were served with legal action has been hit by lawsuits alleging that they failed to detect problems in the Ponzi schemes ran by New York financier Bernard Madoff. In a Connecticut lawsuit, the audit firm stands accused of negligence for failing to detect the Madoff fraud, in which a fund invested all its $280 million assets.

Legal action against auditors is popular as there is a general feeling among plaintiffs that "auditors are out to detect fraud." "In this case, there is reason to be concerned that auditors acted negligently or acted with some level of requisite knowledge because, for the most part, they appear to have accepted financial statements generated by Madoff's auditor from a very small unknown accounting firm," he said" a plaintiff's attorney has told the court.

Source: The National Law Journal, February 5, 2009[37]

4.6.5. Impact on national authorities

National supervisors are responsible for the authorisation and on-going supervision of UCITS funds, their management companies and their depositaries. On the basis of the fund's and management company's domiciliation, the UCITS Directive assigns supervisory functions to the competent authorities of both the 'UCITS home' and 'management company's home' Member State. These states have to cooperate in order to ensure seamless supervisory cooperation. The UCITS Directive requires the depositary to be domiciled in the same Member State as the UCITS fund. Information sharing in relation to depositaries, their safekeeping duties, oversight arrangements and delegation arrangements will be facilitated if uniform conditions apply in respect of delegations and the duties that are triggered by the loss of a custodial instrument, both at depositary and sub-custodian levels.

In addition, if nothing were done in relation to remuneration policy, the efficiency of risk management policies would be eroded, which impact negatively on supervisory efforts of the national authorities in the context of sound risk management policy. As regards sanctioning regime, as mentioned above, the lack of harmonization would continue to present regulatory arbitrage opportunities and would render the sanctioning regime ineffective on cross-border basis.

4.7. Problem tree

The following ‘problem tree’ visually summarises the problems and their drivers identified so far.

4.8. The EU's right to act and justification

The legal basis of the initiative should be identical to the legal basis of the original UCITS Directive which it intends to amend, namely Article 53(1) TFEU (Article 47(2) of the Treaty establishing the European Community). This article of the Treaty concerns the freedom of establishment and the freedom to provide services, as well as the coordination of the national laws concerning their respective exercise. National laws governing the activities of UCITS funds should moreover be coordinated so as to ensure an approximation of the competitive conditions across the EU for the removal of investment restrictions, while guaranteeing a satisfactory degree of investor protection for unit-holders.

Given the cross-border nature of depositary services for UCITS funds and extent of the problems analysed in the previous sections, EU action is justified on the following grounds:

Problem areas 1, 2 and 3 reflect the lack of a common interpretation in relation to the conditions under which an entity can act as a depositary, the conditions under which certain depositary tasks can be delegated and the liability standard that applies when instruments in custody are lost, either at the level of the depositary or one of its delegates. As the UCITS Directive has exhaustively regulated the product portfolio that a UCITS investment manager can invest in, the counterparty risk that applies to all UCITS transactions and the set of eligible investment tools, it would appear odd that the essential tasks and functions of the UCITS depositary would remain outside the scope of the harmonised framework. Therefore, in order to achieve consistency between the detailed product rules contained in UCITS, the safekeeping of the UCITS' investment tools must also be subject to strict harmonisation requirements.

Problem area 4 needs to be addressed in the light of both the EU’s international policy commitments and the necessity to align the UCITS Directive with other Community initiatives in the financial services sector, i.e. the CRD, the Solvency II and the AIFM Directives, as part of a growing acquis in this field; in particular an alignment of remuneration principles between UCITS and the AIFMD is indispensable to avoid regulatory arbitrage: Now that the AIFMD, which entered into force in June 2011, contains detailed principles on remuneration, the UCITS rules need to contain remuneration principles as well, otherwise there is a risk that certain risky investment strategies migrate toward UCITS, although the latter should be the 'safer' vehicle (AIFMD) is only open to professional investors. As action on AIFM remuneration required a European approach, the avoidance of regulatory arbitrage between AIFM and UCITS call for a coordinated European approach as well.

Problem area 5 relating to the uneven application of administrative sanctions for violations of the UCITS would necessarily require the further harmonisation among national sanctioning regimes. EU action appears justified by the risk of regulatory arbitrage in those more permissive jurisdictions as a result of the cross-border nature of the asset management industry. Furthermore, only one EU Member States has introduced whistle-blower protection. This might lead to a migration of UCITS managers away from jurisdictions that vigorously pursue infringements against the UCITS investment rules (connection with the first sentence unclear). Indeed, UCITS funds are most likely the most tightly regulated pooled investment vehicle in the EU (or even world-wide) and experience with national regulators show that most irregularities are detected at the pre-sanctioning stage. Nevertheless, effective protection for whistle-blowers on the European level might be necessary to further tighten confidence not only into the UCITS rules but also in respect to their vigorous application. The absence of effective whistle-blower protection might lead to the result that certain UCITS related irregularities remain below the radar. As UCITS are a highly regulated and harmonised product, enforcement action to keep the integrity of this product intact should equally take a harmonised and coherent approach.

The ensuing section 6 shall lay out a series of policy options addressing each individual problem area. Each option shall later be measured against the principle of proportionality, i.e. to establish if the identified options are both adequate and necessary to effectively and efficiently meet their purpose.

5. Objectives

Table 1: General, specific and operational objectives

General || Specific || Operational

Investor protection, financial stability and transparency || enhance investor protection, prudential rules and capital requirements applicable to depositaries should be uniform across the EU, ensuring the same level of protection of assets, independent on where the depositary is domiciled increase effective recourse against principal custodians in case a financial instrument is lost in custody increase legal certainty on depositaries duties and liabilities increase legal certainty in case custody duties are delegated, including mandatory delegations to sub-delegates in third countries || Harmonise criteria on eligibility to act as depositary

Introduce a uniform rules on delegation of custody

Introduce a uniform level of depositaries' liability for the loss of an instrument held in custody Introduce a uniform level of liability for cases when the loss occurs at the level of the sub-custodian in the EU Introduce a uniform level of liability in cases when the loss occurs at the level of the sub-custodian in a third country

remuneration practices to be transparent and consistent with sound risk management || Risk alignment and transparency of remuneration practices; introduce principles of sound remuneration policies

clear rules on administrative sanctions and their consistent enforcement || Uniform UCITS sanctioning regime (1)

5.1. Coherence of objectives with other Commission policies

All of the objectives identified above are coherent with the scope of achieving the completion of the Single Market by guaranteeing a high level of consumer protection while ensuring a harmonious and sustainable development of economic activities. The above objectives are furthermore consistent with the European Commission’s reform programme, as endorsed in the Communication of March 2009 ‘Driving the European Recovery’. In this programme, new regulations for the asset management industry will play an important role, alongside those mentioned in section 2.2.

Finally, the objectives pursued in this impact assessment are consistent with a number of proposals outlined in the recently published Commission Communication ‘Towards a Single Market Act’ of November 2010[38]. Here, a sound regulatory environment is instrumental to the proper functioning of financial markets in allocating long-term capital and in mobilizing private savings.

The overarching aim of the current review of UCITS directive is to ensure clarity regarding the rules governing UCITS depositaries also taking into account the provisions relating to the depositary function in the AIFM Directive. However, the review of the liability provisions applicable to the UCITS depositary will also take into consideration specificities linked to the UCITS investment environment and its suitability for retail investors.

In view of G20 commitments, the EU aims to introduce consistent requirements governing remuneration policies in all financial services sectors, as set out in the Commission Recommendation of April 2009. The adoption of CRD III, the AIFM Directive, and the ongoing work on the level 2 measures under Solvency II confirms the determination of the EU to fulfil these commitments. Extending this work to also cover the managers of UCITS is consistent with this process.

In its Communication of 9 December 2010 "Reinforcing sanctioning regimes in the financial sector"[39] the Commission suggested setting EU minimum common standards on certain key issues, in order to promote convergence and reinforcement of national sanctioning regimes. The Commission has included such common rules, adapted to the specifics of the sectors concerned, in all its recent proposals for the review of the sectoral EU legislation concerned (CRD IV, MiFID, Market Abuse Directive, Transparency Directive). Extending this work to the UCITS framework is consistent with this process.

6. Policy options

6.1. Problem No 1: Divergent criteria on eligibility to act as depositary

The eligibility to act as a depositary normally requires that the entity that wishes to act in this role meets certain criteria in relation to effective prudential regulation, the existence of a minimum capital requirements and supervision. At a minimum, a depositary needs to have own funds sufficient to allow for continued operations. The minimum level of own funds for the purposes of operational continuity is set at € 125.000 – this amount is applicable to any investment firm that operates under MiFID. This minimum amount applies to all other investment service providers that operate on behalf of a UCITS fund, such as the investment manager, the broker or the fund administrator. In these circumstances, it appears justified not to assess any further modulations in capital requirements for depositaries only.

|| Option 1 || Option 2 || Option 3 || Option 4

Eligible entities || Rely on Article 23(2): any institution which is subject to prudential regulation and ongoing supervision, as chosen by Member States. || Establish a closed list of eligible entities: (1) credit institutions; (2) investment firms registered in the EU. || Same as Option 2 but with a 'grandfathering clause' allowing all UCITS depositaries that are not in the closed list, but which were operating lawfully on 21 July 2011, to continue operations for e.g., two years before becoming a licensed investment firm. || Only allow credit institutions to act as depositaries for a UCITS fund.

Capital requirements || Subject to national laws, no harmonised threshold || Credit institution (at least € 5 million in own funds) or an investment firm (at least € 125.000). Minimum threshold is therefore € 125.000. || At least € 125.000 in own funds. || At least € 5 million in own funds. Minimum threshold increases to €5 million.

6.2. Problem No 2: Unclear rules on delegation of safe-keeping duties

The premise underlying Options 2 and 3 is that only two depositary duties can be delegated: custody and recordkeeping[40]. The scope of both duties is harmonised across the EU.[41]

|| Option 1 || Option 2 || Option 3

Delegation in general || No specific requirements for delegation of custody or safe-keeping. || Delegations only if sub-custodian is subject to prudential regulation, minimum capital requirements and effective supervision. Sub-custodian has to comply with the conflict of interest and conduct provisions. Delegations have to be justified. The sub-custodian has to be skilfully selected, must remain subject to periodic review by the principal custodian and must be equipped to hold these assets in custody. || Same as Option 2.

Delegation to third countries || Delegations to all third country custodians without any restrictions. || Permit delegations to third parties even if the third country sub-custodian does not comply with the minimum capital and supervision requirements stipulated for delegations in general. In this case, impose three conditions: prior approval of the delegation by the UCITS manager; prior information of the UCITS' investors; and mandatory local custody in the third country. || No delegation of safekeeping duties to non-compliant entities in third countries.

6.3. Problem No 3: Unclear scope of depositary's liability

|| Option 1 || Option 2 || Option 3 || Option 4

Standard of liability || Negligence based standard: Liability for loss only in case of 'unjustifiable failure to perform obligations' or 'improper performance' of these duties || Strict liability to return all instruments lost in custody. Obligation to return a financial instrument of identical type without undue delay. || Same as Option 2 || Same as Option 2.

Burden of proof || Failure in performance of duties has to be proven by the claimant || Exception to the duty to return instruments of identical type in case the depositary can prove that the loss is due to an 'external events beyond its reasonable control'. || Same as Option 2. || Same as Option 2.

Liability in case of delegation || Rely on the general rule expressed in UCITS (Article 22(2)): Delegation does not affect liability. || Principal custodian remains liable for the return of the instrument. || Same as Option 2. || Same as Option 2.

Contractual discharge || || Discharge applies to all situations in which custody is delegated (i.e., voluntary delegation or mandatory delegation to non-compliant sub-custodians). || Discharge only in case of mandatory delegation to non-compliant sub-custodians || No discharge possible

6.4. Problem No 4: Unclear remuneration practices

|| Option 1 || Option 2 || Option 3

Remuneration policies || No specific requirements for UCITS investment managers || Require remuneration policies for all staff that can impact the UCITS' risk profile. || Introduce detailed guidance on the remuneration of UCITS investment managers, provide for uniform rules on base remuneration and bonuses.

Disclosure || No disclosure || Require disclosure of remuneration policies and actual remuneration for all managers that determine the UCITS' risk profile. || Require disclosure of actual remuneration for all investment managers that determine the UCITS' risk profile

6.5. Problem No 5: Divergent sanctioning regimes

Option 1 || Option 2 || Option 3

No specific requirements || Introduce minimum rules on type and level of administrative measures and administrative sanctions. Administrative sanctions and measures would have to satisfy certain essential requirements in relation to addressees, criteria to be taken into account when applying a sanction or measure, publication of sanctions or measures, key sanctioning powers and minimum levels of fines. Introduce whistle-blower provisions. || Introduce uniform types and levels of administrative measures and administrative sanctions across the EU. Introduce whistle-blower provisions.

7. Comparison of policy options

7.1. Problem No 1: Divergent criteria on eligibility to act as depositary

The consequences of keeping the status quo (Option 1) are evaluated against current practice in the Member States, as permitted by Article 23(2). This Article, which allows Member States to choose any institution which is subject to prudential regulation and ongoing supervision, has not led to major divergences in who can act as a depositary in the different Member States. All major jurisdictions where UCITS funds are domiciled already require that a depositary is either a credit institution or a firm regulated in accordance with the standard applied to MiFID investment firms. This means that depositaries in those jurisdictions have to have own funds amounting to either € 5 million or at least € 125.000. In these circumstances, the main differences between Option 1 and the three other options pertaining to the eligibility to act as a depositary are that the latter three options clarify matters of eligibility and thus increase legal certainty.

Options 2, 3 and 4 are all based on the approach of establishing a closed list of entities that can act as depositaries. If Options 2 and 3 were chosen, all depositaries would have to have own funds of at least € 125.000. With Option 4, the minimum requirement for own funds would be that applicable to credit institutions, i.e., € 5 million.

The introduction of a closed list of eligible entities comprising credit institutions and MifID regulated investment firms has met considerable support among stakeholders. The need to be either a credit institution or an investment firm would address the issue of minimum capital requirements and effective regulation and supervision, aspects which are currently not harmonised for UCITS depositaries.

Option 3 can also be considered as an Option that builds on a closed list, even though it allows certain institutions to continue their services under a ‘grandfathering’ arrangement. Option 3 is introduced because in one Member State (Malta), depositary services are performed by a third category of institutions that are neither credit institutions nor investment firms, e.g. insurance companies, national subsidiaries of EU and non-EU banks, etc. The latter are licensed to operate provided they comply with specific requirements established by the relevant national laws[42]. Option 3 would allow these entities to continue to provide depositary services, although subject them to an ad hoc grandfathering clause that would oblige these institutions to transform themselves into eligible entities within a two year period starting from the entry into force of the amended UCITS Directive. As the minimum capital requirements for MiFID investment firms is very low, € 125.000, none of the above mentioned entities would find it difficult to obtain a MiFID authorisation. Most of these institutions, being subsidiaries of credit institutions, would exceed this minimum threshold in any case. The only compliance cost would thus appear the need to seek an authorisation as a MiFID firm. The legal certainty to be obtained from a harmonised minimum range of capital requirement would therefore justify that these operators obtain a MiFID license. This is especially true in light of the fact that all other UCITS service providers to a UCITS fund, investment managers, brokers and the fund administrator, are subject to the identical requirement.

Option 4 would build upon Options 2 and 3 to require all UCITS depositaries to be credit institutions. With this option, the minimum capital requirement applicable to a depositary would dramatically increase from € 125.000 to € 5 million. In terms of prudential rules and continuity, this would be a clear advantage for UCITS investors.

Option 4 would, on the other hand, inevitably disregard an entire sector of depositary services providers that currently provide these services in at least ten different Member States. Option 4 would essentially preclude investment firms covered by the MiFID rules from acting as UCITS depositaries. Eliminating these firms from the role to act as depositaries thus appears to go beyond what is reasonable to ensure that depositaries are subject to effective prudential supervision and minimum capital requirements.

In these circumstances, Option 3 appears the most suitable option to, on the one hand, maintain competition between service providers and, on the other hand, offering the certain residual service providers sufficient time to obtain an authorisation as a credit institution or an investment firm. As the conversion into licensed MiFID firms should not raise particular problems for these entities, the grandfathering arrangements seem an acceptable compromise between prudential supervision and operational continuity. Nevertheless, their gradual phasing out seems justifiable in order to introduce a coherent set of rules and ensure uniform levels of investor protection that is not dependent on where the investment assets are listed and, in consequence, held in custody.

Option 3 would therefore best accommodate the need to establish a harmonised and exhaustive list of eligible depositaries, while at the same time avoiding undue disruptions of established market patterns. Therefore, the preferred option is Option 3.

The economic impact of Option 3 would therefore be limited to the very small minority of firms that presently are not licensed as service providers under the CRD or the MiFID rules. Seeking the relevant license would probably imply one-off costs, coupled with a series of adjustment costs. Overall, given that in a majority of Member States depositaries are already either accredited banking institutions or investment firms and that the few exceptions to whom the grandfathering clause would apply are already subject to similar (albeit not equal) requirements, the Commission services consider the adjustment costs to be manageable.

|| Investor protection and transparency || Efficiency || Coherence

Op. objective Policy options || Consistent criteria on eligibility

Option 1 : baseline scenario || 0 || 0 || 0

Option 2: credit institutions, investment firms || + || + || +

Option 3: same as Option 2 but grandfathering for certain operators || + || ++ || ++

Option 3: credit institutions only || ++ || 0 || 0

7.2. Problem No 2: Unclear rules on delegation of custody

Option 1, which allows delegations of all depositary tasks and imposes no conditions on delegations to third country custodians, is seen as too risky for UCITS investors. Especially the Madoff scenario, where EU investors monies where invested by a manger whose custodial arrangements were not subject to effective supervision in a third country, pleads in favour of a higher level of harmonisation in respect of rules that apply to delegations, including delegations to third countries.

During the consultations, the distinction between financial instruments held in custody and other assets to which record-keeping applies, was very well received and almost 90% of respondents agreed that safekeeping duties should be further differentiated according to the financial type of assets to be safe-kept. There was unanimity as to the desirable EU-wide approximation of depositary duties. The drive towards approximation also derives from the fact that depositary institutions perform their tasks by splitting custody and recordkeeping tasks not just in relation to UCITS funds but that this distinction prevails in relation to the wider range of alternative investment funds; notably the description of depositary's duties in the AIFMD relies on the same bifurcation of depositary custody and record-keeping tasks. The split between (electronic) custody and recordkeeping also reflects the trend toward dematerialised securities that exist almost exclusively in an electronic book entry (see description in Section 4 above).

Options 2 and 3 are therefore built on the premise that only custody and safekeeping duties can be delegated and that all delegations require that the sub-custodian is subject to prudential regulation, minimum capital requirements and effective supervision. The sub-custodian has to comply with the conflict of interest and conduct provisions. Delegations have to be justified by objective reasons (e.g., on account of a gap in the principal custodians' geographical coverage). The sub-custodian has to be skilfully selected, must remain subject to periodic review by the principal custodian and must be equipped to hold these assets in custody.

As these delegation criteria and conditions are universally accepted – as reflected in the AIFMD – no further sub-options or modulations of these criteria are assessed.

On the other hand, the rules on delegation would also need to reflect the specificities of both industries and well as the fact that UCITS funds are open and used to a large extent[43] by retail investors. This issue comes to the fore when examining the conditions for sub-delegations to custodians located in third countries that cannot meet the above delegation requirements.

In this scenario, Option 2 would permit delegations to third parties in certain jurisdictions even if the third country sub-custodian does not comply with the minimum capital and supervision requirements stipulated for delegations in general. In this case, Option 2 would, however, impose two conditions: prior approval of the delegation by the UCITS manager and prior information of the investors in the UCITS fund. Option 2 would also be limited to a situation when local custody is mandatory in the third country.

In this respect Option 2, while being coherent with the policy choice reflected in the AIFMD, would ensure a lower level of investor protection than Option 3, because in Option 3 the principal EU-domiciled depositary would not be entitled to delegate safekeeping duties to non-compliant entities in third countries under any circumstances. Option 3 would ensure a higher standard of custodial safety as delegation of safekeeping would only be permitted if the third party sub-custodian would be subject to effective prudential oversight, minimum capital requirements and supervision in its country of establishment or domicile.

The distinction between Option 2 and 3 would not come to the fore as long as the UCITS manager invests within the European Union. As the scope of custodial duties and liability will be harmonised across the EU, all EU-based custodians would comply with the proposed delegation rules. The difference between Options 2 and 3 would, however, arise in case the UCITS fund manager wishes to invest in a third country whose laws require that safekeeping of locally issued financial instruments is transferred to a local sub-custodian. In that case, the UCITS fund's principal custodian will be obliged to elect a local sub-custodian that does not comply with the above mentioned standards on delegation. For this scenario, Option 3 prohibits delegation to a non-compliant depositary in a third country while Option 2 would allow delegation, under the above mentioned circumstances.

Essentially, the practical consequence of Option 3 is that a UCITS fund manager can no longer invest in certain third country jurisdictions where recourse to a local depositary is mandatory and where no local depositary exits that fulfils the delegation requirements (e.g., capital requirements, effective prudential regulation and supervision). The consideration behind this bar against delegations to non-compliant third country depositaries is essentially linked to the retail nature of a UCITS fund and the need to ensure that small investors should not be exposed to the risk that a financial instrument of the UCITS fund is lost while in custody in those third countries. Furthermore, Option 3 would appear coherent with a more general aim pursued with the UCITS depositary reform, which is to increase investor protection.

On the other hand, Option 3 proposes a remedy, namely the total prohibition of investments in certain third country jurisdictions that might well exceed the scope of the problem. Third country jurisdictions that impose local custody without providing for a custodian that fulfils the delegation requirements (e.g., capital requirements, effective prudential regulation and supervision) are rare. A survey of relevant custodians conducted by the Commission's services has identified only two jurisdictions where this scenario could arise. And even in these two cases, the exact conditions of local custody could not be verified completely, so that a margin of doubt remains even in these cases (which is why these jurisdictions shall not be referred to in this impact assessment).

As mentioned above, a UCITS fund manager, if it were not allowed to delegate custody to certain third country depositaries, would be barred from investing in financial instruments that, by law, have to be held in custody locally. Option 3 would therefore seriously curtail the investment opportunities of a UCITS fund in respect to such third countries, especially since such countries appear to be rare. This prohibition therefore appears disproportionate to the aim of investor protection.

On balance, therefore, the preferred option is Option 2.

From a cost perspective, as corroborated by the investigations carried out by the Commission's services (see Section 3.2), the contemplated changes, even in Option 3, are not expected to significantly impact pre-existing operating cost structures of depositary service providers. This is because the provision of custody services is typically a low margin product. Depositaries do not obtain significant fees from the provision of custody -- prices in Europe are often not more than 0.2 to 1.0 bp. Therefore, custody is regularly coupled with other value added services like cash management and fund accounting and margins associated with the total bundled service offering can become higher.

Second, price differentials between EU Member States seem a question of max. 1 bp. On the other hand, price differentials between Europe and certain emerging markets can become quite significant. Evidence reflected in Section 3.2 indicates that the difference between Europe and certain emerging markets can exceed 59 bp. The overall rate of custody is therefore heavily influenced by the composition of a fund's portfolio (e.g., the share of instruments issued in emerging markets). As fund clients are generally charged on a per market basis, with emerging markets attracting higher fees, large emerging markets portfolios will usually have a higher blended rate. The main driver in the cost of custody is therefore not a change in the regulatory environment in Europe but the extent to which a fund invests in emerging markets.

In this context, it is also relevant that the survey reflected in Section 3.2 appears to indicate that the cost of holding a financial instrument in custody is lower than the cost of recordkeeping. The cost of record-keeping (checking ownership records and recording individual contracts that are not suitable for custody) amounts, on average, to between 1 and 1.25 bp. The cost of custody in Europe varies between 0.25 and 1.25 bp. and, in most Member States examined, rarely exceeds 1 bp. This is due to the fact that custody is nowadays based on electronic data entries reflecting the existence of a security. Therefore, moving to a broader scope of instruments to be held in (electronic) custody might entail cost savings of, on average, between 0.5 and 0.75 bp.

Therefore, even if the harmonisation of financial instruments that must be held in custody would entail that some depositaries must shift these instruments from recordkeeping to custody, there should not be a major negative impact either on cost or on the fees that are charged for the custodial services.

|| Investor protection and transparency || Efficiency || Coherence

Op. objective Policy options || Consistent rules on delegation of custody

Option 1 : baseline scenario || 0 || 0 || 0

Option 2: Delegation limited to safekeeping with opportunity to delegate to non-compliant third country custodians || ++ || +++ || ++

Option 3: Delegation limited to safekeeping with no opportunity to delegate to non-compliant third country custodians || +++ || + || +

7.3. Problem No 3: Unclear scope of a depositary's liability

Option 1, by maintaining a standard based on the failure to perform certain duties, is unable to achieve the requisite a level of harmonisation. The Madoff scandal indicates that the "negligence-based" standard leads to more uncertain results and long court proceedings before the obligation to return certain instruments that were lost in custody is ascertained.

All other options, Options 2, 3 and 4 rely on a strict obligation to return all instruments lost in custody with a narrow exception to the duty to return instruments of identical type in case the depositary can prove that the loss is due to an 'external events beyond its reasonable control'. This reversion of the burden of proof would avoid lengthy litigation as to the negligence of the depositary who lost the instruments in custody or who delegated custody to a sub-custodian that subsequently lost the instruments.

Options 2,3 and 4 would therefore improve the degree of legal certainty and align the liability standards among the Member States. The reversion of the burden of proof inherent in these options would also facilitate legal redress sought by UCITS investors.

In terms of the ability to discharge liability, Option 2 would allow for the emergence of a uniform policy on liability in case custody is delegated (either voluntarily or due to legal requirements) to a third party. This is because Option 2 essentially aligns the discharge provisions in UCITS with those already existing in AIFMD. [44]

However, the "transversal" approach to liability proposed in Option 2 would not make any distinction with respect to the liability standard, depending on whether a fund is open to retail investors or not. Only Options 3 and 4 would allow taking into account the fact that more essentially 90% of the UCITS investor base is (directly or indirectly) made up of private households (see pie-chart in Section 3.1.).

In addition, the approach proposed in Option 2 appears not suitable for retail-oriented investment funds because, even if the discharge of liability in case of either voluntary or mandatory delegation would be disclosed to retail investors, the latter are unable to understand the legal repercussions that such a general discharge may have on their ability to seek redress against the depositary when the instrument is lost at the level of the sub-custodian. Most investors, while they understand that he custody risk (and corresponding cost) is different according to jurisdiction, would not understand the legal principle of discharge and the result that the fund might be left with a relatively worthless direct claim against a third country sub-custodian who is either bankrupt or in financial difficulties. Also, investors would face the onus of pursuing that claim in a third country jurisdiction in an unfamiliar legal environment.

A choice has thus to be made between Options 3 and 4.

The choice between Options 3 and 4 must essentially be made by considering that the issue of delegation of custody and the issue of liability in case custody is delegated are intrinsically linked.

On the issue of delegations, this IA examined two choices: allow delegations of custody, including delegations to third country sub-custodians that do not meet stringent delegation requirements (in terms of prudential regulation, minimum capital requirements and supervision in the country where the sub-custodian is established). The other choice would be only to allow delegations to third country sub-custodians in jurisdictions that meet the above requirements.

In order not to curtail a UCITS investment opportunities, this IA chose to allow delegations to non-compliant third country sub custodians under two conditions: (1) local custody in the country of the sub-custodian is mandatory and the UCITS depositary must receive a clear instruction from the fund manager that he wishes to invest in the relevant third country jurisdiction. This approach reflects the current approach as taken in the AIFMD in relation to professional investors.

The choice to allow third country delegations in case the local custodian does not meet the delegation requirements leads to two basic options when liability in such cases is examined: (1) allow discharge only in case such delegation is mandatory under the relevant third country's laws (Option 3); or (2) not to allow contractual discharge of liability at all (Option 4).

Option 4, as opposed to Option 3 would not allow for a discharge in all cases where custody is delegated, either voluntarily or by virtue of legal requirements in the third country. Option 3 would limit the option of a discharge to the case where delegation of custody is mandatory in the third country jurisdiction where the financial instrument is issued.

Option 3 would therefore expose retail investors to significant recovery risk. These risks result from the above-mentioned fact that retail investors, while being able to appreciate the risk of custody related to third countries, are nevertheless not in a position (in terms of financial resources and expertise) to pursue recovery claims directly against a third party custodian and in accordance with the laws and procedures that prevail in these third countries.

While prospectuses and key investor information documents that are mandatory under the UCITS Directive may address risks linked to the investment profile of certain securities, investors are not, except for the very wealthy, in a position to recover assets that are lost in a third country jurisdiction.

In these circumstances, the stricter standard proposed in Option 4 (no discharge of liability, even if delegation is mandatory) appears more aligned to a general policy orientation that focuses on the best possible protection of the retail investor community.

In addition, the absence of a contractual discharge entails that UCITS investors, unit-holders and shareholder alike, will benefit from legal certainty when seeking redress for financial instruments lost in custody. The strict standard essentially avoids any litigation focusing on the precise scope of discharge possibilities in case of mandatory sub-delegation to non-compliant third country custodians and this litigation takes place in their own jurisdiction.

Representatives of the depositary industry have pointed that any move towards a strict liability standard (and the absence of a discharge option) leads to an increased cost and capital requirements incumbent on the depositary sector. The industry fears that any form of strict liability increases the costs and fees for depositary services, leads to even further concentration in this industry and will force smaller suppliers of depositary services to exit this market.

According to stakeholders, the costs inherent with a higher standard of liability are essentially of two types: (i) costs associated with the need to return financial instruments lost in custody, and (ii) costs associated with higher capital requirements that result from the need to cover the costs specified in (i). These arguments need to be placed into perspective and evaluated against the evidence gathered by the Commission's services.

First, the depositary industry has not been able to document such additional costs, their origin and the impact that a return obligation has on capital requirements. Quite to the contrary, the investigation conducted by the Commission's services (as evidenced in Section 3.2) shows that there is no clear correlation between the level of liability and the amount of depositary costs. The study rather shows that the depositary fees in France are within the European average of between 0.25 and 1.25 bp, despite the fact that the depositary liability standard in France is based on a strict obligation to return all instruments lost in custody, irrespective of whether custody was delegated or not. In addition, there is no evidence that would demonstrate that the same institution that acts as depositary in France and in another Member State, where lower liability standard prevails, would face differences in capital requirements on account of different liability standard.

Second, the fees for custody seem more driven by the asset class that is held in custody, rather than by the liability standard that prevails in a particular Member State. This is evidenced by the fact that certain stakeholders estimate the custody fees for a UCITS fund at, on average between 0.4 and 0.8 bp while the more heterogeneous range of instruments held by alternative investment funds leads to safe-keeping fees of between 1.75 and 2.0 bp[45].

Third, the evidence presented in Section 3.1 indicates that industry consolidation has been underway for some time. As the major providers of custody services enumerated in Section 3.1 imply, consolidation seems more driven by other reasons not linked to the national liability standards.

Fourth, more relevant cost drivers are, for example, the necessity to incur considerable expenditure on technology (linked to dematerialisation of securities accounts) and the trend to increase the range of depositary services to incorporate neighbouring back-office tasks (e.g. fund accounting, corporate actions, cash management and legal reporting). Especially the latter trend toward fully integrated "packages