accounting for financial derivatives guerard

Administration, Custody & Prime Brokerage Alain Guérard CAIA

8th March 2012

Agenda

• Introduction

• Hedge Fund Administration

• Custody

– Safekeeping

– Depositary

• Prime Brokerage

• Conclusion

Agenda |

Introduction

Introduction | Source: Bank of New York

Hedge Fund Administration

What is Hedge Fund Administration? Core Services • Shareholder Services • NAV Calculation • Financial Reporting • corporate Secretary Non Core Services • Daily NAV and P&L • Middle Office • Risk & Transparency Reporting (Riskmetrics, Measurisk, OPERA, etc...) • FX • Banking • Liquidity Management • Collateral Mgmt

What is Hedge Fund Administration? |

6

Hedge Fund

Trades reported daily Daily profit and loss, and exposure reports Shareholder reporting

Trade reporting and position reconciliation

$$$

Cash Movements

$$$

Subscriptions and redemptions

Prime brokers & ISDA counterparties

Custodians Bank accounts Investors

Securities and collateral movements

NAV reporting

Adm

inis

trati

on

Valuation of all

instruments

Corporate action

processing

NAV calculation

Trade capture

Opera

tions

Trade capture and

validation

Collateral and margin

management

Management fee

calculation

Investor and financial

reporting

Subscriptions and

redemptions

Cash forecasting and

management

Hedge Fund Administration (HFA)

HFA Market

Market Trends

• Specialisation (Managed Accounts, Credit / Loan Strategies, Regulated structures...)

• Consolidation (ex: BNY, GlobeOp)

• Segmentation (global custodian vs. independent vs. PBs)

• Extension of service offering (custody, cash, collateral management)

• Alternative UCITS creating a convergence play

• US is the priority market (Self-Administration)

• AIFMD will be a game changer

HFA Market |

Name AUA

CITCO $507 bn

State Street $416 bn

BNY Mellon $282 bn

Goldman Sachs $212 Bn

Citi HFS $186 bn

GlobeOp $174 bn

Northern Trust $149 bn

Morgan Stanley $128 bn

SS&C $125 bn

HSBC $124 nb

Source: HedgeFund.net HFA Q2 2011 Survey

Initiation - HFA Selection

• AIMA DDQ

• HF Manager RFI/RFP

• Independent Consultant

• Prime Brokerage consulting reports

• League Tables (HFM / Global Custodian)

• On-site visit

• System Demo

• Meeting the delivery and client service teams

• Client References

Initiation – HFA Selection |

Initiation - HFA Agreement

The administration agreement will generally cover the following areas:

• Services offered by the administrator:

1. registrar and shareholder services functions, such as processing subscription / redemption / transfer &maintaining the share register 2. NAV calculation 3. assistance with the preparation of financial statements and reports & liaising with the fund's auditors, 4. Other services such as Corporate Secretarial Services

• Conditions to performance of administrative services • Fees and expenses • Liability/indemnity • Termination • Governing law and jurisdiction • Dispute resolution • AML

Initiation – HFA Agreement |

Initiation - Service Level Agreement (SLA)

• SLAs/Service Level Descriptions are not typically legally binding. It is living document that we evolve with the life of the fund.

• Description of the operational, escalation and communication framework under which the fund, the administrator and other service providers will operate.

• What can you find in the SLA: – contact details – detailed operational responsibilities – workflows – responsibilities for each parties – deliverables and timeline for delivery – KPIs

• Objective of the SLA is to ensure that the fund administration process is documented,

achievable and will result in a satisfactory administration service being delivered.

Initiation - SLA |

Initiation - HFA Comments on PPM HFA will review the PPM and provide on specific comments on section that relates to its activities such as :

• Description and functions

• Interaction with investors - sections dealing with subscription, transfer and

redemption procedures and sub/red docs

• AML and other regulatory issues

• Fees – especially on the performance fees methodology

• Circumstances where the NAV is to be suspended or redemptions deferred

• Valuation of assets – PPM should reflect how the fund is to be valued, including valuation policies, force majeure, suspension provisions and the capital structure of the vehicle. Initiation – HFA Comments on PPM |

Investor Services 1/2 What are the main activities of Shareholder Services (Transfer Agency or Investor Services)?

• maintaining the share register and investor registration detail • processing all dealing transactions including subscriptions, redemptions, switch &

transfers • ensuring proper completion of subscription/application forms, with reference to

requisite qualification & eligibility • maintaining client subscription accounts and ensuring that transfers are made to the

fund's account within cut-off time • holding current authorised signatory lists of investors • tracking underlying beneficial owner information of nominee investors • issuing redemption payments, including the hold back of partial amounts subject to

the finalisation of performance fees, redemption penalties or the fund's annual audit; • issuing dealing confirmation statements and reports to investors and dealing with

investor queries; • providing reporting based on estimated or indicative NAV calculations; • reporting all such dealings to the fund manager in a prompt and efficient manner;

Investor Services 1/2 |

Investor Services 2/2

• completing all appropriate AML and client identification checks or processing of designated body letters;

• maintaining fund documentation in accordance with local regulations, e.g., data protection laws, tracking investor lock in periods, where appropriate;

• where applicable, ensuring compliance with the EU Savings Tax Directive; German tax reporting; UK distributor/reporting fund; tax reporting; Austrian tax; PFIC; ERISA and K1 reporting information to the funds' tax advisors;

• reporting as required to stock exchanges;

• monitoring of maximum authorised share amounts across fund structures;

• processing performance fee equalisation;

• monitoring terms of side letters;

• assisting potential investors in carrying out due diligence;

• providing relevant information to fund auditors.

Investors Services 2/2 |

NAV Calculation – Trade Capture Trade Capture

• Transaction reflecting trading activity • Critical that the trading activity of the fund is properly reflected in the valuation

systems of the administrator. • Trade File/Blotter: Daily electronic trade files detailing all the trades done. • Common methods include SWIFT, FTP or CSV/Excel files • HFA will upload/process the transaction activity into the books and records. • OTC and exotic may require manual intervention • Update of the static data in the security master • Independence is key, trade file is coming from the HF manager and then reconcile to

the Street (PB, Custodian, Trading counterparties) • Critical Drivers: Automation, Trade Volume, Asset Type, Quality of Static Data &

Independence

NAV Calculation – Trade Capture |

NAV Calculation – Security Valuation Two main aspects to the valuation process: price collection and price governance

• Price collection covers the mechanical process of collecting prices from agreed sources at agreed times.

• Price governance covers the process by which the pricing policy, controls, responsibilities, disputes and issues are escalated and resolved.

Essential guiding principles:

• independence of the pricing process (independent sources)

• Competence, Prudence and Fairness

• documented process to insure consistency and transparency (pricing and valuation policy)

• focus on OTC, unquoted instruments or hard to value assets

NAV Calculation – Security Valuation |

NAV Calculation - Pricing Policy • Hierarchy of pricing sources (primary & secondary / reference) for each

instruments

• Escalation procedures

• Tolerance Levels between sources

• Price Override policy

• Approved and reviewed regularly by the board

• Using the AIMA Guide to Sound Practices for Hedge Fund Valuation & IFIA sample is a good starting point

• The Board of Directors and the HFA, together with the investment manager, will then agree on how that pricing policy is to be executed. There may be specific responsibilities placed on the HFA in the execution of this policy but investors should not automatically assume a standard model.

NAV Calculation – Pricing Policy |

NAV Calculation - Pricing Matrix Asset Type Primary Source Secondary

Source Tertiary Source

Cash

Repurchase Agreements

FX Spot

FX Forward

Long Dated FX Forward

Exchange Traded Futures

Exchange Traded Options

OTC Options

CFDs

Interest Rate Swaps

Credit Default Swaps

Variance Swaps

NAV Calculation – Pricing Matrix |

NAV Calculation - Directors • The Board of Directors has ultimate responsibility for the valuation of the Fund.

• The Board delegate this responsibility to an Administrator.

• Documented pricing procedures should be approved by the Board in advance of the Fund's launch and should be disclosed in the Fund's prospectus.

• The Investment Manager and the Administrator must also ensure compliance with the valuation provisions disclosed in the Fund's prospectus.

• Regular and timely communication between parties on valuation issues is essential

• A formalised process for reporting valuation issues (for example, stale pricing, liquidity, price override, difficult trading markets, illiquid assets, side pockets or subjectivity) to allow the Board to delegate the responsibility but also to fulfil the requirement that there is adequate oversight and supervision.

• A clearly stated Pricing Policy, together with clearly stated procedures, should be agreed between the Board, on behalf of the Fund, the Auditors, the Investment Manager and the Administrator and it should be signed off by the Board, the Investment Manager and the Administrator.

NAV Calculation - Directors |

NAV Calculation - Reconciliations Critical step is a full daily reconciliation of cash and trading positions to the prime broker, custodian and other counterparties ideally, on a traded and settled basis All assets held by the fund should be reconciled between the administrator's records and all relevant third parties and should include assets or collateral held with: • prime brokers, • futures brokers • CFD/Swap counterparties • OTC counterparties • custodians • Specialised counterparties All material differences and breaks understood and documented prior to NAV calculation. The reconciliations should encompass nominal holdings, value and transactions entered into during the period. Three-way reconciliation is now more common (administrator, prime broker and fund manager)

• Critical Drivers: Automation, Speed of Breaks Escalation & Resolution

NAV Calculation - Reconciliations |

NAV Calculation - Expenses • Creation of an expense ladder/expense budget/expense schedule that

will include all fees and accruals/payment frequency • Many funds and administrators will agree this expense budget in

advance of fund launch to govern the accrual process. The annual budget should be agreed with the client at the start of each fiscal year.

• All known variable and fixed fees including management; administration;

custody; performance; audit fees; listing expenses; establishment costs; legal expenses and directors' fees need to be accrued.

• Of these expenses, potentially the most complex fee is the performance

fee, which can be calculated using multiple different methods. • Critical Drivers: Advance planning, performance Fee Calculation

Capability

NAV Calculation - Expenses |

NAV Calculation & Reporting • The final step in calculating the NAV of the fund is to calculate the NAV per share of each class in issue.

In order to do this, the administrator will typically do the following:

• calculate the allocation ratio for each class in issue

• allocate the income, expenses, gains and losses for the fund based on the above allocation ratio;

• adjust for any share class specific items, such as any hedging gain/loss, new issue profits, differing management and performance fees;

• calculate the NAV per share;

• agree the NAV with the fund manager; and

• distribute the NAV.

• Additional steps can be added depending on the fund characteristics:

– multi class/multi currency processing and hedging

– some hedge funds may offer shares at a discount or premium, arising from fees or charges; and

– if the fund is subject to adverse or unusual market conditions, additional market or valuation provisions may be required.

NAV Calculation & Reporting |

22

RESPONSIBILITY

NAV Distribution & Reporting

RELEASE

NAV

SIGN OFF

NAV PREPARATION

FUND PRICING VALIDATION

ASSET PRICING

REVIEW

TRADES EXPENSES RECON

DAILY ACTIVITY FLOWS

ASSET PRICING VALIDATION

INCOME CORP ACTIONS

Fund Accountant process

incoming activity

Reviewers signoff at each

stage

Fund Accountant calculates NAV &

deals with client queries

NAV Validation Process

NAV signoff before release

Functional groups complete

Specified functions

J P

M O

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A N

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G E

F

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R V

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Custody

Depositary / Trustee • In general, across all laws and structures the depository is required to

know where the assets of the fund are at all times and how they are being held (Segregation & Title)

• This involved oversight monitoring of trade settlement, income and corporate action processing and free cash and stock movements within the funds, which is undertaken on a daily basis.

• An annual on site due diligence visit is also conducted at the Transfer Agent when required by law.

• Investment guidelines and legal restriction checks could be carried out by the depository in some jurisdictions for some structures

Depositary / Trustee |

Depositary for Hedge Funds • Governance of the Delegation of safekeeping to a/multiple Prime

broker(s)

– Tri-Partite Agreement

– Sub-Custody Agreement

• Due Diligence & Monitoring on Prime Broker(s)

– Network Management approach

– Credit Monitoring + regular check on CDS Spreads

• Access to Prime Broker(s) systems (Website)

• Segregated Custody Accounts to be opened for each fund as a prudential measure in case of recall of assets

Depositary for Hedge Funds |

Prime Brokerage

What is Prime Brokerage?

What is Prime Brokerage? |

Prime Broker Executing Broker

Repo Desk Stock Loan Desk

CSA Pool

Research Provider Client Hedge Fund

Derivatives Commodities

F & O Swaps & Others

Securities

Cash

Contract

What is Prime Brokerage? Bundle of services offered by Investment Banks:

• Custody and Clearing of Assets

• Financing

• Securities Lending

• Technology

• Cash & Liquidity Management

• Operational support

• Capital Introduction

• Business Consulting

• Other Services

What is Prime Brokerage? |

Conclusion

Conclusion

• HFAs are not born equal - Devil is in the details

• HFA SLA, KPIs and Administrator Report are key governance tools

• Valuation Policy is compulsory

• Ask questions to your Hedge Fund Administrator and Depositary

Conclusion |

THANK YOU [email protected]

accounting for financial derivatives guerard

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