DFSA publishes its fund management self-custody thematic review

Background

Since January 2021, FMs in the DIFC have been required to submit Periodic Fund Returns (PFR) data for domestic funds. It provides the DFSA with key data on fund operations and custody arrangements. The PFR data for H1 2024 highlights that between December 2023 and June 2024, the number of domestic funds grew by nearly 20 percent to 153 Funds. It identified 23 FMs that made self-custody arrangements for 46 funds. Those funds recorded USD 3.8 billion in assets under management (AUM), representing 45.5 percent of total domestic fund AUM in the DIFC. This is a considerable amount of AUM in the DIFC sitting under self-custody, which brings with it significant responsibility for FMs.

Given the market growth and the potential risks associated with self-custody, the DFSA initiated a thematic review to assess compliance, identify good practices, and highlight areas for improvement.

Key findings

The review focused on four thematic areas: Operational risk; conflicts of interest risk; transparency and disclosure risk; and liquidity risk. We look at each of these in turn.

1. Operational risk
   
   The DFSA expects FMs to have adequate systems and controls to be in place to ensure that fund property is segregated and not available to creditors. While some FMs demonstrated robust practices - such as maintaining electronic custody registers and detailed operations manuals - many lacked adequate written policies and procedures. 
   
   Notable deficiencies included the absence of documented self-custody arrangements or reliance on outdated and incomplete procedures. Furthermore, the review found instances of improper ownership structures, such as FMs holding shares in special purpose vehicles instead of the fund itself, and cases where fund’s legal documents were held by third parties (like property managers) rather than by the FM. 
   
   The DFSA requires FMs to ensure its policies are current, comprehensive, and appropriate to the nature, scale and complexity of their business activities.
2. Conflicts of interest risk
   
   The DFSA expects clear segregation between custody and fund management functions. Part of this is ensuring that employees responsible for custody are independent of those managing the fund. While some FMs had internal controls and disclosures in place, others failed to address self-custody conflicts within their compliance frameworks or to disclose these conflicts in Private Placement Memoranda (PPMs) or Prospectuses.
   
   The DFSA requires FMs to review the adequacy of its existing policies to ensure that conflicts are identified, managed, and disclosed to protect unitholder interests.
3. Transparency and disclosure risk
   
   The DFSA expects FMs to make appropriate disclosures to unitholders in relation to self-custody arrangements through either the Fund’s PPM/Prospectus and in periodic reports to unitholders. Most FMs met baseline expectations, but some failed to disclose self-custody arrangements in PPMs or periodic reports.
   
   The DFSA requires that full and accurate disclosures must be made to unitholders regarding custody arrangements.
4. Liquidity risk
   
   This theme was relevant to two FMs managing open-ended domestic funds. One FM lacked adequate systems and controls as required under CIR Rule 8.6A.1. 
   
   FMs of Open-ended Domestic Funds must have in place the appropriate systems and controls to cover liquidity risk management.

Risk mitigation and oversight

The DFSA found that oversight mechanisms were generally weak. Common issues included the lack of inclusion of self-custody in compliance monitoring programmes, inadequate compliance reporting, and the complete absence of internal audit reviews over self-custody arrangements.

One FM stood out positively by subjecting its arrangements to dual governance reviews and quarterly board reporting.

Conclusion

The DFSA’s review highlights the importance of robust governance and risk management in self-custody arrangements. FMs are expected to review their practices in light of the DFSA’s findings and be prepared to demonstrate improvements during future regulatory engagements.

Perhaps tellingly as to the level of expectation, the DFSA noted its pleasure at the fact that FMs of some Exempt Funds and Qualified Investment Funds went beyond the relevant requirements set out in the DFSA Rulebook, by adopting additional controls and processes applicable to Public Funds. Aim for the stars is the message.

This article has been written by Middle East Partner and Head of Financial Services Regulatory Matthew Shanahan, Counsel Karl Masi and International Trainee Owen Greaves.

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