Why custodians may not be aware of the risks they are running when acting as brokers for investors in hedge funds.

Liquidity emerged as a major risk for hedge fund investors during the 2008 credit crisis, but it remains a major source of risk for custodians of alternative assets. Again, it is worth comparing the risks posed by alternative assets against those of more traditional securities.

In the world of normal trading, a broker who makes an error can usually rectify it quite speedily. This is because he is trading in a continuous market – the period during which the broker is exposed to his mistake is limited. He might only be at the mercy of price movements for an hour or less. And because systems between counterparties in conventional securities markets are automated, brokers can limit financial losses caused by errors with relative confidence.

Within the alternative investment market, where custodians are acting as brokers for investors in funds, potential errors are magnified because of the time it takes to confirm a trade. Mistakes in orders are uncovered in the reconciliation process, but it can take days before a counterparty will issue a trade confirmation.

Consider then the situation a custodian faces once an error in an order is discovered, for example when a sell order is confused as a buy order. Because shares in hedge funds are so illiquid, it can prove very difficult to have a mistake resolved, particularly as the custodian bank is dealing in a principal market – i.e. the fund is creating the security for the investor.

Funds have very little leeway to address errors, particularly since corporate governance might prohibit them from favouring a specific investor. Redemption terms can mean a trade will not be resolved for six or even 12 months, during which time the price of a fund will change with little or no scope to hedge it.

Custodians participating in the market for alternative funds are not being rewarded for the liquidity risks they are taking on a daily basis. Once such risks are fully understood, many banks may decide that it is not worth the slim rewards they earn. Custodians have improved the language used in agreements with clients as they have started to wake up to the liabilities they face, but another solution would be the introduction of electronic execution, speeding up the trade confirmation process and radically reducing manual errors.

On the other side of the coin, investors may want to use their alternative investments as collateral when raising cash. However, due to the lack of hedge funds’ liquidity, it can often be difficult to discover an accurate price. There is no readily available market data source, requiring significant proprietary effort to procure a recent net asset value (NAV).

Investors will often want to raise cash more quickly than shares in a hedge fund can be redeemed, and the lack of daily or weekly market prices means the lending bank can create significant risk for itself by lending against hard to value assets or assets than themselves can take some time to liquidate (frequently three months or more in the case of many hedge funds). Again, investment in electronic pricing interfaces can ensure more accurate and speedy pricing and support faster decision making.

Pricing remains a key consideration for custodians of alternative assets. By this we don’t mean the price that custodians charge for a transaction, although the cost to process a trade into or out of an alternative fund is higher than for an equity or a bond. The main issue here is procuring the actual fund’s NAV in a timely and accurate format. This valuation is particularly important, because it is used for calculating fees.

The calculation of custody fees needs to be transparent and consistent with the other services offered by the custodian. The cost involved in procuring a price for a traditional security is negligible – many prices are free, and vanilla securities also have the benefit of a reliable security ID code. The pricing of traditional securities can be carried out quickly, with clearly defined data sources and consistent prices. For hedge funds, the picture is much more opaque.

Where to find the data?

For alternative assets, procuring a price represents a much larger challenge, as there is no single data provider that can be consistently accessed.

• Traditional securities data vendors publish the prices of those alternative funds that report directly to them, but pricing is frequently delayed and the funds covered do not represent a sufficient segment of the universe custodians need.
• Specialist hedge fund databases cover a much larger slice of the universe, but rely on funds to report data to them. If a fund chooses not to report, or stops reporting (for example if it closes to new investment), the data series becomes incomplete.
• Custodians can hire a third party agent to procure prices from fund managers on their behalf, but this can be an expensive and time consuming process.
• Alternatively, custodians can go direct to the funds themselves, but this requires considerable investment in terms of time, money and manpower internally.

On top of the above data-related challenges is the fact that accurate pricing is required for a range of tasks, including for loans, bridging finance and leverage. Pricing hedge funds effectively for such functions is still a much greater problem for custodians than it should be.

For example, no electronic feed exists that can readily integrate with other data systems, causing custodians to rely on manual processes, which are slow and prone to errors. Audit trails to prove a price is accurate are both time consuming and expensive. In addition there is a huge burden of associated documentation to be managed.

Financing can be a much more lucrative business for custodians than plain vanilla custody, but even here, lending against alternative assets can be fraught with risks because of pricing issues. Because of the illiquid nature of alternative investments, investors sometimes need to borrow against holdings that are in the process of being redeemed in order to be able to re-invest assets. Such interim funding is frequently provided by custodians because they hold the assets, but this also puts pressure on the custodian to ensure accurate pricing and a detailed picture of the redemption time horizon. Ultimately, the lack of a consistent pricing picture represents a significant risk to the lending side of the custodian’s business.

For more information on how Comada can help you with your custody related risks, please contact Stuart Fieldhouse at sf@comada.com

This is the second in a series of articles from Comada on the subject of custody risk.

The challenge for custodians in safekeeping alternative assets like hedge funds is that there is no Central Securities Depository they can rely on. For conventional securities, CSDs exist to help investors and custodians by providing an easily accessible record of securities owned. Historically, the CSD would take delivery of physical share certificates – today an electronic registry is maintained which allows investors and company registrars to keep track of who owns what.

For the vast bulk of hedge funds, which are not actively traded on stock exchanges, there is no CSD. Nor is there a broker to broker network like the Depository Trust Company’s National Securities Clearing Corporation. Custodians are therefore forced on a monthly basis to request statements of hedge fund holdings from the transfer agents who maintain funds’ registers of shareholders. The problem with this is that there is a large universe of TAs in the market, each acting for only a small portion of the total universe of hedge funds.

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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.

The parties to any single trade, be it the fund manager, the custodian, the investor or the administrator, are incorporating a degree of estimation in the course of the transaction process. It is still difficult to operate otherwise. Each participant is using different parameters to view mission critical data and communications. Each still relies on paper-based processes and spread sheets to manage billions of dollars of alternative investments. But can any of them express with 100% confidence that a specific trade is at a specific location in the transaction trade at any given time of the day? And can they put a value to it when they do find it?

At this juncture in time we stand in an industry that is becoming increasingly institutional, with over 60% of the assets being managed by hedge funds now originating from institutional clients. The client complexion of the industry has changed while the legacy technology in use within many firms harks back to an earlier and simpler era.

Technology issues are becoming a bottle neck for institutional investors, particularly with regard to managing and reviewing hedge fund portfolios. This is creating a demand for a more proactive and integrated approach to client reporting using technology that has the ability to break down the different components of the hedge fund trade. By bridging these operational processes, institutional investors can manage and review accurate data with a higher degree of confidence.

The scale of the problem facing the industry has been highlighted by Swift’s SHARP (Swift Hedge Funds Harmonisation Project) initiative. Swift identified a number of key operational issues within the hedge fund transaction process. While custodians and administrators can handle the paper trail when transaction volumes are low, the largest service providers to hedge funds now process well over 1000 transactions every month. Each order may come with up to 50 pages of documentation attached. A typical team within a hedge fund administrator might be handling 600-700 orders with a dedicated staff of a dozen or so. Apart from reconciling data with their own records, they must also ensure investors are complying with KYC and other regulations.

Because subscriptions processing is time consuming and error prone, the entire cycle from the time when the order is taken to taken until confirmation is received and accounts are reconciled can be as much as a month. Faxes of subscription agreements must be sent to transfer agents, which in turn must be confirmed by phone, with final documents being sent over by courier.

For a fund with monthly liquidity, these transactions can prove costly, particularly if the market has moved. Missing a deadline for an order could lead to a fund holding unnecessary cash, while a missed redemption deadline would leave a fund exposed to an unwanted position for another month, quarter of a year or more.

If funds restrict liquidity, or extend their lock-in periods, or raise gates, the risks of moving transactions in and out of funds grows. It is still very hard for custodians to provide funds of funds with accurate status reports, particularly when they are bombarded by faxes from administrators and transfer agents at the end of the month. For larger custodians, with dozens of service providers to deal with, the problem is only magnified.