Depositary oversight is the supervisory function that a depositary performs over an investment fund and its manager on behalf of the fund's investors. Under European fund law, every regulated fund must appoint a single depositary, normally a bank, that is independent of the manager. Besides holding the assets, the depositary must verify that key processes, such as the pricing of units and the handling of investor money, are carried out in accordance with the law and the fund's own documents.
The function is one of three duties of a depositary bank, alongside the safekeeping of assets and the monitoring of cash flows. It distinguishes a depositary from an ordinary fund custodian, which holds assets and settles trades but has no duty to check the manager's conduct. The rules are set out in the UCITS Directive for retail funds and the Alternative Investment Fund Managers Directive (AIFMD) for other funds, with detailed requirements in delegated regulations.
The oversight duties
European law lists five specific duties. The depositary must:
- Check dealing in units. Ensure that the sale, issue, repurchase, redemption and cancellation of units or shares are carried out lawfully and under the fund rules, which involves reviewing subscription processing and redemption processing and reconciling orders with cash and units issued.
- Check valuation. Ensure that the value of units is calculated in accordance with the law and the fund rules, by reviewing the policies and procedures behind the net asset value calculation.
- Carry out instructions. Follow the instructions of the management company unless they conflict with the law or the fund rules, which in practice means monitoring compliance with investment restrictions and borrowing limits.
- Check settlement. Ensure that payment for transactions in the fund's assets is received within the usual time limits.
- Check income. Ensure that the fund's income is applied and distributed as the law and the fund rules require.
How oversight is performed
The depositary is not expected to repeat the work of the manager or the administrator. It takes a risk-based approach: at the outset it assesses the fund's strategy, the manager's organisation and the quality of the fund administration, and then designs controls proportionate to the risks. These are mainly after-the-event checks, including sample testing, review of reconciliations, independent recalculation of selected prices, and on-site visits to the manager and its delegates.
When it finds a problem, such as an investment breach or a pricing error, the depositary follows an escalation procedure. It notifies the manager, requires remedial action, and in serious or unresolved cases informs the fund's board and the regulator. It also checks that investors are compensated where required, for example after a NAV error correction.
Oversight operates together with the depositary's other functions. Cash monitoring requires the depositary to see all of the fund's cash accounts, wherever held, to check that investor payments are received and booked, and to identify significant or unusual cash movements. Safekeeping takes two forms. Financial instruments that can be held in custody, such as listed shares and bonds, are held in segregated accounts, often through sub-custody agents. For other assets, such as property, loans or private company stakes, the depositary must verify that the fund really owns them and keep an up-to-date record.
Liability and independence
The depositary's liability is strict where custody assets are lost. If a financial instrument held in custody is lost, including by a sub-custodian, the depositary must return an identical instrument or its value without undue delay, unless it can prove the loss resulted from an external event beyond its reasonable control. For other losses it is liable if it negligently or intentionally failed to perform its duties. Under the UCITS rules this liability cannot be transferred by contract.
These provisions were tightened after 2008, when the collapse of the Madoff fraud exposed European feeder funds whose depositaries had left assets with Madoff's own firm, and when the failure of Lehman Brothers trapped assets held with its prime brokerage arm. The rules also require the depositary and the manager to be independent of each other, with limits on common management and safeguards where both belong to the same group.
National variations
The role exists under different names. In the United Kingdom, the trustee of a unit trust and the depositary of an open-ended investment company perform it under rules that follow the European model. For a hedge fund or private equity fund under AIFMD, a lighter regime allows certain closed-ended funds investing in non-custody assets to appoint a professional firm rather than a bank. The United States has no direct equivalent: the oversight role is played by a mutual fund's board of directors, while the custodian's role is limited to safekeeping.