Welcome to the first of a series of briefings on custody risk from Comada, the alternative investment transaction technology specialists. In this series, we will aim to highlight some of the key risks confronting custodians of alternative assets. Over the next few months you will be able to learn about some of the challenges and solutions that present themselves to banks and other service providers dealing with alternative investment funds on a regular basis.
#1: Custodian as broker
The key function of a custodian is to be able to hold an asset securely. This requires that a custodian be able to keep track of and reconcile the asset concerned. However, as institutional allocators like pension funds and insurance companies increase their investments in alternative assets, their custodians are being asked to perform this role for shares in funds like hedge funds and private equity partnerships.
Because of the illiquid nature of many alternative funds and the fact that custodians are being called upon to actually place orders and redeem holdings by their clients, significant operational risks are being created. The quality of the connections between the various parties involved in a trade in an alternative investment fund need to be-re-examined in order to avoid a higher level of risk and commensurate expense when trades fail.
Custodians habitually only become involved in a trade once it has been executed: however, with alternative investments they are also being asked to take the place of a broker and place a trade. This is because hedge funds – and other alternative investments – are private placements. There is no broker acting as an intermediary, hence the custodian most often takes on the role of the broker, bringing with it significant execution risks.
In other markets – shares, for example – efficient systems exist to manage execution, but not so with private placements in funds. Manual procedures continue to dominate trades into and out of funds and it is often impossible for custodians to pass this role onto a specialist service provider, as might have been the case with other emerging asset classes in the past. Habitually devolving trades onto third parties will involve a custodian in transactions with dozens of service providers, including transfer agents and administrators, again considerably raising the risk that an order is inaccurately transmitted, or a deadline is missed.
Because systems are manual and paper-based, multiple checks and balances are needed to ensure there are no errors. Every fax requires several levels of completeness and accuracy checks.
Every control measure added to the process, while it cuts down on risk, also adds time and cost to the process of investing in funds. It requires that custodians be aware of closing dates for new investment in alternative funds, and submit orders well in advance. However, custodians’ clients will often push back on deadlines established by for submission of orders. Several days’ lead time will frequently be required, but investors, the end clients, will sometimes consider such deadlines as artificial.
Compressing manual processes in order to cope with client demands adds a considerably higher level of risk for custodians already under pressure as they process higher volumes of transactions in alternative funds. This will, without doubt, create more scope for costly errors. Having compressed the time frame for executing orders into funds, investing clients will be less than happy if errors occur and the custodian will often be asked to compensate them.
If you would like to receive further bulletins from Comada on custody risk, please email Stuart Fieldhouse at sf@comada.com.