Clients are demanding more from administrators in their traditional role. Philippe Ricard, head of asset and fund services at BNP Paribas Securities Services, says investors and managers now insist on independent pricing of OTC derivatives and other illiquid securities. Valuations have become more frequent, particularly for managers that have launched UCITS-qualified funds employing investment strategies similar to their principal hedge funds.
As a result, BNP Paribas built ample processing capacity and has long been able to handle short positions as well as long. “The incremental cost of higher volume is very limited because of our design,” says Ricard, who notes that other fund administrators may not be so fortunate.
The cost varies among clients depending on their own systems capabilities, too. If a manager uses a distributor that cannot send subscription and redemption information electronically, or the client does not use BNP Paribas’s tools for work flow, then the administrator bears higher costs for which it will charge—provided the market is receptive. “It is important to create incentives for efficiency,” says Ricard. “I will offer the best rate for an efficient client, one willing to improve with us. For a less efficient client, I will provide a fee structure that shows the difference between what it pays now and what it could pay if it were more efficient.”
Administrators are no longer prepared to absorb the incremental costs of more frequent valuations, greater transparency, independent pricing verification and other services that have increased their workload. The bundled pricing of yore has given way to a menu of services from which clients can choose what meets their particular needs.
“When a client says it wants to go from weekly to daily pricing, the answer is, ‘Of course, but there is a cost implication’,” says Hans Hufschmid, chief executive officer of GlobeOp, a fund administrator that handles $173bn of fund assets worldwide. “All the administrators are becoming more disciplined about pricing.”
While clients and investors have driven most recent changes, the European fund management industry also faces a slew of new regulations that will take effect over the next few years. The new rules typically do not apply to administrators per se, but the proposed rules will affect their clients. In early January, for example, BNY Mellon hosted a workshop on the EU Solvency II insurance regulations in London—and found the session jammed with fund managers, who do not normally attend such events.
“Managers want to understand what data the insurance companies will demand from them,” says Frank Froud, head of EMEA, BNY Mellon Asset Servicing in London. At the time of going to press, Froud was in the last stages of his tenure in this role at the bank. His role has now been assumed by Hani Kablawi, the bank’s Middle East expert.
“When the companies have worked out what they need, the managers will ask us for detailed solutions,” says Froud. The job is tailor-made for fund administrators, who have enormous capacity to manage and massage wholesale data and deliver the results in whatever format their clients, or regulators, require.
The regulatory onslaught includes UCITS IV and the proposed Alternative Investment Fund Managers Directive (AIFMD), which Anne Deegan, managing director of SEI Investments Trustee & Custodial Services (Ireland), expects to ramp-up demand for risk management reporting. SEI, which has $250bn under administration worldwide including $60bn in Dublin, has a deep commitment to technology that gives the firm a competitive edge. “We need to offer clients timely risk–management reporting so that they can comply with AIFMD,” says Deegan. “We are keeping a close watch on that.” UCITS IV tightened up corporate governance for funds, including a requirement for close monitoring of OTC derivatives—and managers have asked their administrators to generate those risk reports, too.
Administrators are paying more attention to corporate governance in the aftermath of a recent Cayman Islands judgement that held two fund directors personally liable for $111m of losses at the Weavering Macro Fixed Income Fund. The case highlighted the risk for directors who serve in name only on multiple funds and routinely rubber-stamp fund documents presented to them without review. It emphasised the importance of maintaining proper books and records, too. “Administrators will have conversations with fund boards of directors to ensure there is clarity about what services are and are not being provided,” says Deegan. “It will require more monitoring of governance on our part.”
AIFMD as currently proposed would also impose a fiduciary duty on custodians to supervise not only their sub-custodians but even the types of instruments and markets in which their clients invest, a requirement that could extend to regulated funds under UCITS V. In effect, the rule would import the European depot bank model into the Anglo-Saxon world—and pricing would have to reflect the enhanced business risk. “On a day-to-day, transaction-by-transaction basis, we will have to exercise oversight,” Froud says. “If that risk is transferred to the investment services organisations instead of the fund managers, we have to tool up for that and be rewarded for it.”
Like all EU directives, UCITS V and the AIFMD will be subject to local interpretation when each member state enacts legislation to implement the directive. The directive language could change, too—the custody banks are lobbying hard to eliminate or water down the fiduciary obligations—but William Slattery, head of European offshore domiciles at State Street Corporation, worries that in its current form the directive could ratchet-up systemic risk.
Slattery is responsible for a business that administers $600bn—half in regulated funds and half hedge funds—in Dublin, and another $350bn of regulated funds in Luxembourg. He points out that if depositaries are held liable they may feel compelled to require clients to abandon a particular market at the first sign of trouble, whether it is the financial distress of a local sub-custodian or a political threat to the legal environment. The herd mentality almost guarantees that if one leading player pulls the plug, others will follow—triggering a stampede for the exits.
“It could create serious systemic instability in either individual or multiple markets,” says Slattery. “Almost no economy is spared the potential threat.”
The markets have a poor track record of evaluating events that are highly improbable but devastating, which are almost always underpriced relative to the havoc they cause. Black Swan events occur in the financial markets with a frequency that belies their statistical probability, too. “They are only supposed to happen once in 1,000 years,” observes Slattery, “but we have had 1987, 1994, 1998, 2000 and 2008.”
Unlike State Street and BNY Mellon, GlobeOp is not a custodian and would not be directly affected by the proposed fiduciary liability. Nevertheless, the firm has a well-deserved reputation for being able to handle OTC derivatives and other complex investment products, a skill that has attracted sophisticated clients whose investment strategies rely on these esoteric instruments. Hufschmid dismisses the very notion that custodians could take fiduciary responsibility for hedge funds. “Administrators can perhaps ensure that instruments and assets are priced independently, that reconciliations are independent and so on,” he says. “It is one thing to take on fiduciary responsibility if you can monitor it completely, but it is naïve to think a custodian bank can supervise a hedge fund.”
The ability to handle anything a hedge fund wants to trade comes at a price to the client: GlobeOp fees run about 12basis points (bps) on average, compared to the industry norm of 6bps-7bps. Net margins are nowhere near double those of its competitors, however; the cost of administering complex instruments is higher than average and Hufschmid says the firm’s clients are “very demanding—the most demanding set of clients you can imagine in any industry anywhere.” The forthcoming shift to central clearing of most OTC derivatives will have a disproportionate impact on GlobeOp relative to its competitors but Hufschmid does not foresee any difficulty in making the transition. GlobeOp already uses DTCC’s matching service for credit derivatives trades, which operates like a clearing house but without the central counterparty guarantee. “One of our core competencies is fully functioning data pipes to all the different service providers: data vendors, exchanges and other trading venues,” says Hufschmid. “It will be just another pipe for us.”
All the major players are preparing for central clearing of OTC derivatives, of course. Clive Bellows, country head, Ireland, at Northern Trust, which administers about $300bn in assets in Europe, has clients who expect clearing to go live during the fourth quarter of 2012—and he will be ready to support them. It requires a significant incremental investment in technology to handle the substitution of a central counterparty, but it also simplifies valuation and improves transparency. “It’s a fantastic idea. It will solve a lot of the issues surrounding OTC derivatives,” says Bellows. “It will go a long way to commoditising the funds that invest in derivatives and make it easier for fund administrators to move up the value chain.”
The ever-increasing demands for technology capacity and capability tilt the playing field in favour of large administrators who already operate on a global basis. The required investment is driving industry consolidation, too. For example, Northern Trust bought Bank of Ireland’s security services business last year, which added $100bn in assets and the ability to service exchange-traded funds. The business was sound—clients have begged Northern Trust not to alter the legacy client service ethos—but lacked scale, and the Bank of Ireland no longer had the balance sheet strength to support it.
Northern Trust also bolstered its ability to service hedge funds when it picked up Omnium, a $70bn administrator that was sold by Citadel, a Chicago-based hedge fund. “The bigger providers who already have good technology in place, the resources to continue to invest and a strong balance sheet, will be the winners,” says Bellows.
Acquisitions have become the easiest way to bring in new clients in the current environment. The more middle office functions fund administrators perform, the deeper they are embedded in clients’ infrastructure and the harder it is for clients to contemplate a change. “A huge amount of our growth does come from our existing clients,” says Bellows. “Without a doubt, the number of managers looking to change providers has decreased. It is done only as a matter of last resort.” In fact, the best new client opportunities do not even originate in Europe: they are non-EU fund managers seeking to set up UCITS funds in Europe—which is why Bellows’ sales team now pitches primarily to managers in the United States and Asia.
In today’s European fund administration market, the global leaders stand to inherit the earth—and the meek to be swallowed whole.