UK: Impact of AIFM Reg reform on derivatives and trading relationships

What has happened?

The FCA published Consultation Paper CP26/28, “The UK AIFM Regime” on 14 July 2026 and HM Treasury published a parallel consultation on a draft Statutory Instrument (SI), the Alternative Investment Fund Managers Regulations 2026, together with a policy note, alongside it. These papers set out new rules for UK Alternative Investment Fund Managers (AIFMs) that use derivatives and discuss potential changes that would impact trading arrangements with prime brokers and repo counterparties. 

The new regime starts in 2028. 

Responses to the consultation are due by 14 October 2026.

What should I do?

Managers of hedge funds structured as alternative investment funds (AIFs) should start assessing CP26/28 now. Several proposals need lead time.

• Assess your use of derivatives

Work out whether each fund uses derivatives for hedging only or for investment purposes. This drives which rules will apply.

• Develop your leverage disclosure method

The gross and commitment methods will be repealed. You will be required to develop a method for disclosing leverage that is clear, fair and not misleading. Derivatives used for hedging purposes will not count as leverage.

• Prepare for FRAME reporting

AIFMs managing hedge funds will be required to report to the FCA quarterly with a 45-day lag. FRAME reporting represents genuinely new reporting duties. Map your data gaps.

• Assess potential overhaul to depository regime.

AIFMs managing hedge funds should consider the impact of the discussion chapters relating to depositaries and prime brokers. This would represent a significant departure from the existing regime and the practical implications will need to be considered in detail.

Christine Long, Partner in the Financial Services Team, comments:

“This consultation represents a welcome improvement in how the UK regulates use of leverage in different types of funds and for different purposes. The broad hedging exemption is a sensible reflection of how derivatives are used in practice. Hedge funds managed by UK AIFMs as well as prime brokers and repo counterparties should consider the practicalities of a split depository regime. Accurate record-keeping and data reporting will be paramount and the impact on existing arrangements should not be underestimated.”

What is changing in relation to leverage and liquidity?

Leverage classification and the hedging exemption

The FCA proposes keeping the current broad definition of leverage. Leverage means any method by which the exposure of an AIF is increased, whether through borrowing of cash or securities, or leverage embedded in derivative positions or by any other means.

The proposed new hedging exemption is central. Funds that use derivatives only to hedge out risks that are not part of their core investment strategy and not with the aim of making a return will count as unleveraged for the purposes of the rules. The FCA states explicitly that this is not viewed as a fund incurring a magnitude of counterparty risk (and thereby increasing the ‘exposure’ of the AIF) via derivatives. 

For example:

• a fund with GBP share classes that buys USD assets and swaps back to GBP; or
• a floating-rate fund that buys fixed-rate bonds and swaps back to floating.

On the other hand, a fund that uses derivatives to profit from the difference between fixed-rate bonds and swap rates will count as leveraged. This will be viewed as using derivatives for investment purposes. The fund will be required to apply the fuller risk management and liquidity rules for leveraged AIFs.

The FCA rejected a de minimis threshold for investment-purpose leverage, as it believes this would make the regime unnecessarily complex by reintroducing a leverage calculation. In the consultation the FCA asks for views on this point (at Q10).

Removal of the gross and commitment method calculations

The FCA proposes removing both mandatory leverage calculations. The current commitment method calculates leverage by measuring total exposure relative to net asset value by converting derivative positions into equivalent underlying asset exposures. It currently determines whether an AIF is “substantially leveraged” at three times net asset value. The current gross method aggregates the absolute values of all long and short positions which is then expressed as a ratio against net asset value. All leveraged AIFMs currently disclose the gross method figure to investors.

The FCA says these calculations are complex, burdensome and open to interpretation. It notes that leverage works differently in different strategies, for instance, high-frequency derivative use in hedge funds differs from debt-financed buyouts in private equity. A single formula does not help investors compare funds.

HM Treasury’s draft Statutory Instrument repeals Commission Delegated Regulation (EU) 231/2013 (currently still on the UK statute book as assimilated law) which contains the commitment and gross method rules. The repeal affects all AIFs. Under the new rules, firms will instead disclose leverage to investors using a method that suits their fund and investment strategy. The disclosure must be clear, fair and not misleading.

Firms will report raw leverage data to the FCA through Fund Reporting for Asset Management Entities (FRAME). The FCA will apply its own calculations to this data. This replaces firms self-reporting under a prescribed formula.

Jamie Dunlop, Legal Director in the Financial Services Team, comments:

“The removal of the gross and commitment methods is the most significant change to the UK leverage regime in over a decade. The market will be pleased to see the FCA move away from formulaic calculations that were often difficult for investors to understand. AIFMs should review the leverage positions of their funds now.”

Risk management for leveraged funds

The FCA proposes a tiered risk management framework.

Baseline requirements on research and due diligence apply to all AIFMs. For AIFMs managing exclusively closed-ended, unleveraged AIFs, the baseline requirements are the only risk management rules that apply.

For AIFMs managing any leveraged or open-ended AIF, fuller rules will apply. Medium and large AIFMs must maintain an independent risk management function. This function must be separate from portfolio management in both hierarchy and reporting lines.

Medium and large UK AIFMs must set a maximum leverage level for each leveraged AIF and manage the fund within that limit. They must take into account the fund’s investment strategy, its sources of leverage, and its counterparty exposures. They must set quantitative risk limits covering market, credit, liquidity, counterparty and operational risks.

The FCA identifies three risks to market integrity: 

• First, the risk of forced close-outs of leveraged positions in stressed markets;
• Second, concentration of positions that could disrupt a market;
• Third, the use of models and automated trading.

The FCA says its standards align with International Organization of Securities Commissions (IOSCO) standards for hedge fund regulation.

Liquidity risk management and the closed-ended fund exemption

Under the proposals, an AIF that uses leverage for investment purposes will count as leveraged for liquidity rules too. There is no de minimis threshold. 

A hedging exemption applies to closed-ended funds provided they do not employ leverage for investment purposes. The reasoning behind this is that closed-ended funds do not have redemption risk due to liquidity mismatches nor margin risk due to derivatives being used for investment purposes. A closed-ended vehicle that uses derivatives only for hedging will be exempt from the liquidity rules, and subject only to the baseline risk management rules and the Consumer Duty. This should help private equity and real asset funds.

Under the proposals, small authorised AIFMs also need to give due consideration to the liquidity risks of the AIFs they manage.

What is changing in relation to transparency?

Investor disclosure

Pre-contractual disclosure for leveraged funds will be required under draft rule ALTS 9.3.5. Firms must disclose whether there is a maximum leverage level and, if so, what that level is. They must state the total leverage as at the last accounting period. They must explain how they calculated it, using the method that best reflects the fund’s strategy, exposures and risk profile.

Under the proposals firms will be required to disclose details of any prime brokerage arrangement. They must describe any risks to the fund or investors arising from it. Annual report disclosure will mirror these points. Managers should start developing their disclosure method now.

FRAME reporting

The FCA’s parallel consultation CP26/26, “Fund Reporting for Asset Management Entities (FRAME)”, proposes FRAME as a replacement for the current AIFMD Annex IV returns (AIF001/AIF002). It collects raw leverage data so the FCA can run its own calculations.

Under the proposals, reporting requirements will depend upon fund type and size. Unauthorised AIFs other than hedge funds will report annually with a 120-day lag. Hedge funds will report quarterly with a 45-day lag. 

Reporting requirements are divided into ‘Essential Reporting’ (covering certain ‘common essential requirements’, value-at-risk (“VaR”) and counterparty exposure) and ‘Enhanced Reporting’ which applies to funds with NAV of more than £500m.

Counterparty exposure reporting forms part of the Essential Reporting section, although for funds other than hedge funds, this is only required if leverage used. For hedge funds, counterparty exposure reporting will apply in all cases. This reflects the FCA’s concern about systemic risk from concentrated counterparty relationships. 

The Enhanced Reporting requirements sets out specific categories which apply differently to different types of fund. Hedge funds and other types of unauthorised AIF are generally required to report under most categories including fund profile, strategy, investor rights, investor base, fees, portfolio concentrations, liquidity risk, portfolio exposures, portfolio sensitivities and VaR (hedge funds only).

The FRAME consultation closes on 22 September 2026.  

What is changing in relation to depositaries and prime brokers?

Nothing is changing in the immediate future. However Chapter 13 outlines proposals for a potential radical overhaul of the current rules for depositories of unauthorised AIFs. It summarises the response to a Call for Input on whether depository requirements need to change, noting the diverse range of views expressed particularly in relation to closed-ended funds. 

Chapter 14 outlines the FCA’s current position on prime brokers. Full proposals will follow in a second consultation in late 2026 or 2027. 

Depositories

Chapter 13 on depositories discusses the pros and cons of a split depositary regime under which a UK AIF could use more than one depositary for different functions. The FCA agrees that this would be helpful, on the assumption that any depositary would be established in the UK and hold a part 4A permission to act as AIF depositary. Any depositary providing custody of AIF assets would remain subject to strict liability for loss of those assets.

This opens the door for UK prime brokers potentially being appointed as a depositary for the custody of assets under their control. Similarly, stock lending and repo arrangements with tri-party collateral managers could involve appointing the collateral provider as depositary in respect of collateral received temporarily before being transferred to a tri-party collateral manager. 

In order to maintain the safeguard provided by the depository having a single view over all the AIF’s assets, the depository with responsibility for oversight functions will need to maintain a record of ownership of all assets. This depository could rely on reporting from other depositories, noting that any depository responsible for safe-keeping would be subject to CASS 6 record-keeping requirements. As the AIFM would be responsible for appointing depositories, information sharing agreements would be needed between them and the consequential impact under competition law and regulation would need to be assessed.

All these ideas would involve a substantial departure from current arrangements between AIFs and their trading counterparties. UK prime brokers would need to consider how they would comply with the strict liability obligation in respect of custody assets, particularly in the context of their sub-custodian network. The practicalities of complying with the reporting requirements and information sharing between depositaries, including the impact on BAU processes, operating models and documentation will need to be explored. However we expect that any simplification would be broadly welcomed in the market. We note that US prime brokers are excluded from these discussions.

Prime brokers

Current AIFMD rules reflect the potential risks that prime brokers can introduce for AIFs whose assets are held and rehypothecated by their prime brokers. They set out a series of counterparty management measures, including a requirement for the AIFM to conduct due diligence before appointing a prime broker and close regulation of the sub-custody arrangements between the depository and the prime broker. These rules are intended to ensure proper segregation of the AIF’s assets from both house assets and other client assets as well as transparency over rehypothecation arrangements.

The FCA intends to keep but simplify these rules. It states its view that it is reasonable and proportionate to continue to require an AIFM to carry out proper due diligence on prospective prime brokers and to ensure adequate contractual arrangements are in place with the depository. It notes however that detailed prescription will be unnecessary given all parties involved are authorised persons with existing regulatory obligations to one another. 

Consultation Questions

Consultation Question 31 asks whether an AIFM should be able to appoint more than one depositary for the same AIF and what impact this would have on competition.

Consultation Question 32 asks whether the FCA’s analysis of how responsibilities could be shared between depositaries captures all relevant aspects and whether there is anything else they should consider.

Consultation Question 35 asks whether to keep but simplify the prime broker rules. 

Responses on both discussion chapters are due by 18 September 2026.

Our view

The removal of the gross and commitment methods gives managers genuine flexibility to explain their leverage in a way that fits their strategy. The hedging exemption draws a sensible line between derivatives used for managing risk versus derivatives used for incurring risk. Welcome clarification is provided in respect of hedging derivatives not increasing counterparty exposure. Further clarification should be provided for funds using small amounts of investment-purpose leverage alongside significant hedging.

The proposals in relation to depositaries represent an exciting overhaul which would significantly simplify current trading arrangements between unauthorised AIFs and their trading counterparties. Depositaries, prime brokers, collateral managers and repo market participants should consider the practicalities of these proposals and respond to the consultation questions accordingly.

Next steps

The table below sets out the relevant deadlines.

The FCA expects to publish a policy statement and final Handbook rules in 2027. HM Treasury will finalise its legislation at the same time. The target start date is 2028. A second FCA consultation will cover detailed prime broker rules and depositary rules for unauthorised AIFs.

How Eversheds Sutherland can help

Eversheds Sutherland is a leading legal adviser to the investment funds sector in the UK, Luxembourg and Ireland. Our funds team advises AIFMs, depositaries and their boards on UK regulatory change. We can help hedge fund managers assess their leverage classification and hedging exemption position. We can review prime brokerage and depositary arrangements and advise on the impact for existing arrangements and updates required for policies and playbooks.