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 constantly 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 centralizing 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 precipitating 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.

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 purchases 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 redemptions 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 restrictions and prohibition on redemptions, unlike retail funds which under the regulatory 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 general 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 intense 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 exposures and counterparty risk as well due diligence on the type of investments being made. This particularly focused on investment into other funds. Today 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 further 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 promoters and investors and is something that administrators, depositaries, and custodians will need to address.

It is also something that regulators must take into account.