Fund Custody and Administration

323 Pages·2016·20.15 MB·English

by  David Loader

Fund Custody
and Administration
David Loader
Director, Consultancy and Training
The DSC Portfolio Ltd
Managing Director, Loader Associates Ltd
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About the Author
David has worked in the financial markets since leaving college. Initially in-
volved in the debt and equity markets, he then spent a considerable time in the
evolving derivatives markets. David rose through various roles including work-
ing with fund management and externally in various industry committees to
senior management where as a Director with key responsibility for operations
he oversaw much change and development in the processes, procedures, and
risk management profiles of the firms he was associated with.
This wealth of experience has enabled David to author over 12 titles on
subjects including areas such as operations management, derivatives, clearing,
settlement and custody, fund administration, and operational risk.
He also works closely with CLT International and Manchester University
Business School on their Advanced Certificate & Diploma in Fund Administra-
tion. He also provides consultancy services on a wide range of topics.
David is a highly regarded and sought after trainer who works internally
with a wide range of major organizations in the UK and internationally, as well
as leading public training programs for major training companies. He has fre-
quently been asked to speak at major conferences across the world.
Married with a wife, daughter, and three grown up grandchildren, David
enjoys, when time permits, boating on canals and rivers, cooking, and politics.
He also lists football, cricket, and gardening among his favorite pastimes.
David is a member of the Institute of Directors and the Chartered Institute
for Securities and Investment.
xi
Preface
The workflow that personnel in the custody and administration teams deal with
and their role in providing operational support to investment funds is a con-
stantly changing and challenging environment.
Over the years there has been, as has happened across the financial and other
markets, a significant move into automated processes and at the same time
growth in the globalization of activity in these markets.
There has been many developments that have seen more and more central-
izing of the clearing and settlement process, for example, clearing houses for
securities transactions, CLS Bank in foreign exchange and more recently the
central clearing of over the counter (OTC) derivatives.
Most changes relate to the efficiency and risk management both of which
are fundamentally important to any fund and indeed the investors in the fund.
Naturally, they are also important to the regulators and a significant amount
of recent change has been prompted by new legislation and regulation in the
wake of the market crash of the 2007–08 period.
Subprime mortgages in the United States are widely blamed for precipitat-
ing the biggest market falls in modern times and yet while the explosion in this
type of lending was heralded as one of the benefits of a long and unprecedented
period of growth some thought otherwise.
While many saw great prosperity as the subprime market began to explode,
others began to see red flags and potential danger for the economy. Bob Prechter,
founder of Elliot Wave International, consistently argued that the out-of-control
mortgage market was a threat to the US economy as the whole industry was
dependent on ever-increasing property values. (The Fall Of The Market In The
Fall Of 2008 http://www.investopedia.com/articles/economics/09/subprime-
market-2008.asp#ixzz3n1aHnVmz)
The extent of the impact of the crash was however far from anything that
was predicted. Fuelled by the collapse in value of products like collateralized
mortgage obligations that had been sold to financial institutions including banks
worldwide but especially in Europe, bank after bank, institution after institution
needed government bailout or the prospect of going out of business.
More importantly the interbank lending virtually stopped as the collapse of
Lehman Brothers sent a message that banks were not “too big to fail” and as a
result a credit crunch compounded the market collapse.
xiii
xiv Preface
Central banks reduced interest rates to near zero, quantitative easing became
essential to try to stimulate lending to businesses and to kick start economies.
(Definition: An unconventional monetary policy in which a central bank pur-
chases government securities or other securities from the market in order to
lower interest rates and increase the money supply. Source: Investopedia)
The crash was certainly without precedence in terms of its size and reach.
How did it all affect the fund administrators and custodians?
The answer is simple—massively!
In the first instance both were faced with a massive increase in workflow as
managers tried to adjust portfolios and also meet unprecedented levels of re-
demptions as investors exited the funds either because they needed cash or just
out of disillusionment with the huge drop in value of their investment that many
experienced or out of fear.
Sales of assets were high even though most were being made at rock bottom
prices and so the processing of both asset transactions and, mostly, redemptions
kept both the administrators including the transfer agency and the custodian
busy (The part of the administration service that deals with the investors).
Of course, not all investors could exit the funds as some types of fund like
property and private equity funds had built into the offering documents restric-
tions and prohibition on redemptions, unlike retail funds which under the regu-
latory environment they operate in are usually required to have redemption on
demand or certainly frequently.
Valuations of portfolios also came under intense pressure both from the gen-
eral illiquid markets to questions about how values had been arrived at and the
independence and robustness of the process (many funds saw dramatic falls in
value with at least some questions as to whether they had been “overvalued”
pre the crash).
The location of and certainty of the assets of the fund also came under in-
tense scrutiny with many issues arising about assets that had been lent under
securities lending or utilized in repurchase (repo) agreements and assets that
had been used as collateral.
As one of the key roles of the custodian is the safekeeping of assets, they
faced significant workload in verifying, validating, and reporting of asset
positions.
Those custodians involved in operating securities lending and borrowing
pools faced several issues including clients withdrawing assets from the pool
and also the revaluation of collateral held against the value of the securities lent.
Securities lending pools allow lenders and borrowers of securities to operate via
a centralised process often managed by custodians, securities depositories and
prime brokers.
Post 2008 collateral management became a major industry hot topic as
regulators and risk managers placed much greater emphasis on managing ex-
posures and counterparty risk as well due diligence on the type of investments
being made. This particularly focused on investment into other funds. Today
Preface xv
the results of a raft of new legislation and regulation, different attitudes to risk,
loss of trust etc. has changed the financial markets and investment extensively
presenting challenges for investment managers, fund promoters, and service
suppliers to funds like custodians and fund administration.
The change and challenges show little sign of abating and so the future for
administrators and custodians is a fluid situation.
An article in Funds Europe published in Oct. 2015 suggests the future of
some service providers like sub-custodians may not be encouraging.
Indeed the whole infrastructure in the financial markets may be in for fur-
ther radical change with new technology developments like block chain as well
as initiatives like Target 2 Securities (T2S) perhaps replacing long established
institutions and methodology in the trading and settlement of securities.
Meanwhile the whole cost structure of fund support is concerning fund pro-
moters and investors and is something that administrators, depositaries, and
custodians will need to address.
It is also something that regulators must take into account.
David Loader
June 2016
Introduction—What Is Fund
Administration and Custody
Fund administration and custody are generic processes that all funds whether
retail products available to all investors or what have become referred to as
alternative investment funds (AIFs) which are restricted in terms of the type of
investor.
There are many tasks and functions that will be carried out by teams under
the services of administration and custody.
Some will be common across funds and others will be quite bespoke to
particular types of fund.
Common tasks and functions will include for the administrator areas such as
1. Fund set up
2. Fund records
3. Pricing and valuation of assets
4. Compilation of the fund accounting records
5. Production of the audit file
6. Calculation of the Net Asset Value (NAV) of the fund
7. Dealing with investors subscriptions and redemptions
8. Communication with investors
9. Secretarial services
10. Reporting
The precise workflow will be very much dependent on the fund and is de-
termined by things such as the investment products and strategies used in the
investment process. In addition the regulatory requirements will affect the work
the administrator is involved in and the level of work will vary from lightly
(relatively) regulated funds like AIFS to the heavily regulated retail funds. Of
course, there are also unregulated funds, which have very little associated work.
Custodians will have common services they provide to funds in particular
the following:
1. Safekeeping of assets
2. Managing the asset settlement process with the market infrastructure
3. Managing activity in securities lending and borrowing
4. Managing activity in corporate actions
5. Dealing with withholding tax (WHT) reclaims
xxvviiii
xviii Introduction—What Is Fund Administration and Custody
In terms of the bespoke services that the administrator and custodian offer
this is perhaps more prevalent in the context of the alternative Investment funds
which in general terms comprises Hedge Funds, Private Equity Funds, and
Property Funds as well as perhaps Commodity funds and those investing in
specific alternatives.
The administrator is in effect, the management of the Fund in virtually all
aspects of the day-to-day operations of the Fund, except the actual investment of
the assets, which is the responsibility of the investment manager.
As a result, the administrator is always answerable to the Board of Directors,
General Partner or Trustee and does not have any actual senior management
control. In simple terms, an administrator is responsible for ensuring the effi-
cient operation of a fund leaving the investment manager free to concentrate on
the portfolio of investments.
Some funds are listed on exchanges and if this is the case, the administrator
will ensure that the company and the directors comply with the ongoing obliga-
tions of the relevant stock exchange.
AGREEMENTS
Both administrators and custodians will sign an agreement with the Fund that
will cover the relevant topics listed earlier.
Depending on the terms of its agreement, the administrator may also be
responsible for ensuring that the Fund complies with the terms of its offering
documents such as Offering or Placement Memorandum, Prospectus, Scheme
Particulars etc.
ADVANTAGES OF 3RD PARTY ADMINISTRATORS
AND CUSTODIANS
The market crash and aftermath left investors disillusioned and destroyed the
trust between the Fund and the investor. Regulators and investors both see com-
fort in having key operational aspects of the fund carried out independently.
This includes pricing and valuations of the assets and the safekeeping of the
fund’s assets.
It is important of course to recognize that the majority of directors and gen-
eral partners of funds maintained complete and accurate records and the value
of the fund was likewise accurate.
Assets were recorded and safely kept in the records of the custodians,
however as noted in the Preface, the environment today is one of caution and
prudent management of risk and so independence and transparency are key
issues.
The size as well as the activity and complexity of the assets and strategies
employed by the investment manager will have a significant impact on the
workload and difficulty of the task for both administrator and custodian.
Introduction—What Is Fund Administration and Custody xix
DIAGRAM 1 Fund structure. (Source: The DSC Portfolio Ltd.)
Retail funds can have billions of dollars or pounds or euros under manage-
ment whereas many AIFS can be far less than 500 million.
Also retail funds are mostly open-ended meaning that subscriptions and re-
demptions take place frequently, possibly daily whereas a lot of non-retail funds
are closed with less activity in this area. Naturally, the frequency of subscription
and redemption affects cash flow and therefore portfolio activity.
FUND RELATIONSHIP STRUCTURE
There are several key parties in the fund structure as the Diagram 1 shows.
They range from the parties who own the fund and have governance respon-
sibilities to institutions, which provide access to markets and services.
Also of course, there are the investors in the fund providing capital as share-
holders or unit holders. Unit Trusts have unit holders whereas companies and
partnerships have shareholders.
ADMINISTRATION STRUCTURE
A full service administrator will involve the three key areas shown above and
can often include the services of the fund Secretary, provision of Directors and
assistance with risk management and compliance (Diagram 2).
xx Introduction—What Is Fund Administration and Custody
DIAGRAM 2 Administration workflow. (Source: The DSC Portfolio Ltd.)
Comparison With Retail/Mutual Funds
The term Mutual funds is widely used globally whereas in Europe the term Re-
tail Fund also used. In the rest of this book, we will mainly use the terms Retail
and Alternative Investment Funds. There are a number of areas in which the
administration of alternative investment funds like Hedge Funds differs from the
administration of the more traditional Retail/Mutual Funds or Unit Trusts. These
include the range of investment instruments in the portfolio; and the strategies
used to exploit these instruments; the ability to go short; leverage; fee structures,
including incentive or performance fees; and equalization. A process that seeks
to ensure each investor pays the correct amount of any performance fee due to
the investment manager. The traditional Mutual Funds or Unit Trusts are, for the
most part, retail funds with quite restrictive investment policies, which include:
very broad diversification;
l no short selling;
l no leverage; and
l derivative trading limited to Efficient Portfolio Management, which is a
l term that refers to hedging risk
Hedge Fund strategies can utilise a vast range of derivative instruments,
which can introduce pricing problems for the administrator as many of these
products have bespoke bilaterally negotiated terms with no independently
published value unlike listed products. These instruments range from the rela-
tively straightforward exchange traded commodities, financial futures and op-
tions contracts, to highly complex derivative products, which include swaps