Secrets of success in the custodian market

The growth of alternative asset classes seems to be here to stay. According to a survey by consultancy PricewaterhouseCoopers (PwC), investors will increase their portfolio allocations to commodities, real estate, infrastructure, private equity and hedge funds. All of these areas have palatable attributes because they have higher returns, create portfolio diversification or offer a long-term, reliable income. But they do not come without complications. Beside talks of inflated prices – as with commodities – or significant hits by the credit crunch, especially in the case of real estate, alternative investments often cause headaches to investors and their service providers when it comes to transparency, valuation and accounting.

“It is not surprising that, in these turbulent times, investors are demanding more from the product providers,” says Pars Purewal, alternative investments leader at PwC. “Investors want to know more about risk, valuation and generally they want more transparency. We expect investors to want more information in the future.”

PwC’s poll also showed that almost half of participants would like the valuation process to be assessed independently and that the end valuation should be validated by a third party.

Investors are also demanding more from their investment services providers.

Over the counter

This is true especially for a financial instrument that has itself become an alternative asset class: over-the-counter (OTC) derivatives, which have grown sharply in recent years and which pose more challenges than other asset classes to securities services providers. According to the Bank of International Settlements, the total outstanding notional amount of OTC derivatives was $298,000bn as of 2005. International Swaps and Derivatives Association figures from a 2006 mid-year market survey show that notional amounts outstanding for credit derivatives grew by 52% in the first six months of the year to $26,000bn, that of interest rate derivatives grew by 18% to $250,800bn and that of equity derivatives by 15% to $6400bn.

“After the exponential growth of derivatives over the past few years – from traded futures and options, which people have become comfortable with – now investors are interested in OTCs, from pension funds to arbitrage fund managers,” says Jonathan Bowler, head of product management for EMEA at BNY Mellon Asset Servicing. “Everybody suddenly wants derivatives experts and the demand for them is bigger than the supply. Attracting and retaining people and developing talent internally are the real challenges.”

Adaptation task

Staffing might be a great challenge but by no means is it the only one. Adapting processes that were initially built for traditional investment products and investment styles is another significant task, which is dividing the global custodians and the alternative investments specialists from the smaller players that would work with more traditional investors, with long-only mandates.

Administering investments that are still heavily paper-based is another key issue. The difficulties behind dealing with products that are not standardised and are often a one-off agreement between two parties, and which, therefore, require special valuation models, are intuitive. The automation of trade execution and post-execution of OTC derivatives has not been able to keep up with the pace at which the market has been growing.

“The biggest problem around administration is that it is such a manual process,” says Jackie Smith, head of OTC derivatives services for UK and Europe at Citigroup. “OTCs, both on a hedge fund and asset management basis, are valued and administered on Excel sheets on models derived from the markets. Also, the confirmation process between brokers and ourselves is very badly regulated. It is not like an equity transaction, which gets confirmed in half an hour. These can take up to five, 10 or even 15 days sometimes. Confirmation and documentation are the big administrative challenges.”

Others say that in the traditional listed world, the error risk is about 1%, 3% at the maximum and that in the OTC world sometimes two-thirds of the trades are not constructed correctly.

The valuation hurdle

If this paints a gloomy picture, there is an even more challenging aspect: valuation. “There are probably about 10 standard derivatives that clients are commonly trading these days but there is also a large number of more esoteric instruments more infrequently traded. The pricing of the more esoteric products can be quite challenging,” says Mr Schoen.

So, what is the solution? Custodians can take three approaches to deal with this. They can either build their own proprietary valuation model, they can buy a model from a vendor or they can use a vendor’s pricing model, data and services to feed the valuation back into their systems and to their clients.

They all require substantial investments but the first one is the most costly and difficult solution because it would require not only building a pricing model but also building a team with the right skills and experience. Acquiring the models can be the easiest option given that there are companies available to sell them. The issue lies in finding data to feed into the model, however, especially for older trades, which do not sit on current trading curves.

Independent third-party valuation seems to be the preferred option for investors who are keen to see a third-party independent provider involved, and solves the issues of sourcing data. Regulation is also pushing towards it. UCITS III, which allows collective investments schemes to operate freely throughout the EU, considers third-party independent valuation of OTC derivatives best practice.

No instant panacea

Third-party solutions do not come without challenges, however. Such services – which some custodians are keen to develop into partnerships – are not cheap. As Ms Smith puts it: “It is certainly not something that any custodian can afford.”

In addition, if outsourcing the modelling and data sourcing alleviates some of the custodians’ headaches, third-party valuation does not provide a silver bullet to the pricing problem because even experienced and well-established firms have to fight with far less than perfect information and systems. This is because the same trade systems that would feed data to custodians apply to third party valuators, too. Some have fully automated links to their systems, others still rely on copies of order confirmations. Furthermore, there is the need to reconcile the various formats that the information is sent out on. Finally, sourcing the data to calibrate the valuation model is a key issue even for the most established valuators.

Client demand for collateral management is increasing as much as it is for third-party valuation. Collateral management is also a facility that can generate very healthy returns to securities services providers, given the volume of money that such activity moves on a regular basis.

“Independent valuation is very popular, as it is collateral management,” says Mr Bowler. “Many [investors] started doing collateral management on a spreadsheet and, now that they have some scale, are looking at custodians to support them. We leverage our broker dealing services to do $1500bn-worth of collateral management every day.”

Short selling

The discussion about alternative investments does not stop at products. It also involves investment styles, such as the ones used by 130/30 funds, which have a mix of short (30%) and long (130%) positions on their portfolios. Short ­selling is the bread and butter of the hedge fund community, along with trading in derivatives and using leverage. As with all funds, these will need to refer to a custodian for the safe keeping of their assets too, but not all players are up to the job.

Accounting systems built around long-only investments are not easily adaptable to short sales. This exercise would require significant investment in processes, which cannot be changed overnight.

Service differentiator

The ability to service the growing hedge fund business is therefore another differentiator between the top custodians and the second-tier ones. And if custodians do not raise their game, there is a group of players that is ready to win their hedge fund business. With clients pursuing long/short strategies, prime brokers have serviced sophisticated investors with shorting capabilities on the stock borrowing side. That is their clear area of expertise. But they have not stopped there and are now providing an element of custody solutions as well.

However, despite the growth of hedge funds and short-selling investment strategies, custodians feel confident that clients will always prefer a long-­standing, solid outfit for the safekeeping of their securities, especially in current uncertain market conditions. “What we have seen now, after the Bear Stearns collapse, is that concentration risk is on investors’ minds,” says Nick Titmuss, head of global custody business in EMEA at Citigroup.

“Investors want the long portion of their portfolio with a safe custodian that keeps their assets off its balance sheet. And then they’d use prime brokers for the shorting aspect of their portfolio. For a short while, we have seen a growth of prime brokers’ custody services as they have the ability to come to market quickly with long/short capabilities. I think that now we have started seeing a reverse of this because investors are concerned about concentrating all of their assets with the prime broker.”

As alternative investment markets develop, investors become more and more information-hungry. In uncertain market conditions, good data and automated processes are vital. Being able to cater for such demands quickly and economically will significantly distance the successful custodians from the ­competition.