Regulators need to be more alert to the potential systemic risk posed by securities depositories, according to an oversight review by the European Securities and Markets Authority (ESMA).
In a report Monday, the regulator detailed the results of its review of the supervision of depositaries, particularly their oversight and safekeeping obligations, which found that supervisory engagement needs to be “more frequent and proportionate to the associated risk,” given the “potential systemic significance” of depositories. The review focused on five jurisdictions: the Czech Republic, Ireland, Italy, Luxembourg and Sweden.
The depositary market is highly concentrated, with a small number of firms responsible for safeguarding a large share of investors’ assets, the report said — with the top five depositaries for mainstream investment funds and alt funds accounting for between 67% and 100% of all assets under custody in the jurisdictions covered by the review.
“Such a sharp concentration can give rise to concerns of overexposure to a small number of entities which could increase systemic risk should these entities face unexpected financial or operational difficulties,” the report noted.
The review also flagged concerns with the depth of regulators’ oversight efforts when it came to them outsourcing significant tasks to external third parties for cross-border oversight — noting that these arrangements “were not sufficiently reviewed and challenged” to ensure compliance.
As a result, ESMA is concerned that “the significant build-up and use of third-party entities and their activities which may encroach on the [investment fund] rules that do not allow for the delegation of depositaries oversight responsibilities and therefore leave some material supervisory risks unaddressed,” the report said.
Additionally, the review found “notable divergences across jurisdictions” in terms of the depth and quality of supervision. While some regulators had “highly developed and granular practices,” others had room for improvement, the review noted.
Based on the findings, the review issued a number of recommendations to regulators to bolster oversight. This includes a recommendation that they “reconsider the regularity of their risk based supervisory cycle to ensure the highest impact entities are subject to intrusive supervisory activities more frequently.”
It also called on the regulators to “enhance their approach to depositary supervision, so that risks inherent in their activities are adequately identified, assessed and mitigated.”
In particular, it stressed the need for regulators to “consider implementing more frequent and intrusive engagement to higher impact entities and therefore move closer to a true risk-based supervisory approach.”
ESMA said the review, which aims to promote consistent oversight and a level playing field across the European Union, is particularly important, given ongoing discussions on “the importance of the investment management sector to European capital markets,” which has seen net assets under management grow from €9.5 trillion in 2012 to approximately €23.4 trillion as of the end of 2024.
“Depositaries play a pivotal role in the investment management ecosystem and in the protection of investors and the orderly functioning of this market,” it said, adding that this “importance only increases in financial markets characterized by significant volatility and technological change.”