coo magazine - issue 1

COO

COO | peer group network | www.cooconnect.com | issue no. 1 | winter 2011

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ContentSCOO EDITORIAL

6 Founder’sletter COOConnectfounderDominicHobsoninvites

youtojoinarevolution.

12 Editor’sletter COOeditorCharlesGubertassessesthe

corporategovernancethreat.

COO COLUMNS

88 Investorsleavebadmergers Pierre-EmmanuelCramaofSignetwarns

managersthatmergerscanbackfire.

116 Theviewfromtheivorytower KevinMirabileofFordhamtrawlsacademic

papersforportentsofthefuture.

COO COVER STORY

16 HowtosurvivetheinvasionoftheIn-betweens

Mandatoryclearingofswapswillincreasecostsandriskforhedgefunds.

27 COOPLUS:Collateralmanagementopportunity

Thecollateralupgradetraderversusthethirdpartycollateralmanager.

COO FEATURE

46 UCITShedgefunds:forandagainst Ifinvestorswantregulatedhedgefunds,

managerswillprovidethem.

56 COOPLUS:HowtobuildaUCITSplatform

MLIShascreatedthehighestprofileplatformforUCITShedgefunds.

70 Whatprimecustodyisdoingtoprimebrokerage

Thirdpartycustodianshipischangingtheeconomicsofprimebrokerage.

75 COOPLUS:Puttingtheclientincontrol GoldmanSachsintroducesassetmovementby

drag-and-drop.

108 Investorswantfundstopreparefortheworst

HedgefundscannolongerignoredemandsfordisasterrecoveryandBCP.

COO ANALYSIS

90 FATCAiscoming:theirmoneyoryoursInadvertentlyorotherwise,itwillnotbedifficultforhedgefundstofailtocomplywiththelatestsweepplannedbytheIRStogarnerasliceoftheuntaxeddollarsofAmericancitizens.

COO INTERVIEW

36 TheinterrogatorMichaelHiebofCairnCapitalsaysthekeytoriskmanagementisfearlessness.

COO PERSON

96 RichMarin COOtalkstothemanwhowaspresentatthe

creationoftheideaofCOOConnect.

COO INVESTOR

104 AnODDperspective StenhamODDheadNicolaStenhamexplains

whatshelooksfor(andlooksoutfor).

COO Q&A

64 PrimecustodianMarinLewinofBNYMellonexplainshowcustodiansarelearningtoworkwithhedgefunds.

112 Thefundadministratorforafatter,lessfree-bootingfutureChrisAdamsofBNPParibasoutlinestheidealfundadministratorofthe21stcentury.

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Citi® Prime Finance: the right answer for hedge funds.

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“ Ever notice our current brokers always say ‘no’...

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© 2011 Citigroup Inc. All rights reserved. Citi, Citi and Arc Design and Citi Never Sleeps are registered service marks of Citigroup Inc.

6 COO

Founder’s Letter

A shorthand for COOConnect is Facebook for COOs. Ours is

an on-line platform, where users can share knowledge, ideas, activities, events and interests. Its services are free, with funding from sponsors. But, like any network, its power depends on numbers. The more people that use COOConnect, the more valuable it becomes to each user. Eventually, membership will reach the point at which its power will change the terms on which fund managers do business with prime brokers, administrators, lawyers, auditors and vendors. It is not jejune futurology to recognise that networks are redistributing power from sell-side to buy-side.

By combining the information capabilities of digital technology with the natural sociability of human beings they are creating new forms of collective knowledge with the power to alter industries. Imagine how the management of buy-side operations would change if managers knew the terms on which hundreds of funds were obtaining finance, borrowing stock, raising capital, calculating NAVs, buying IT, compensating staff, growing headcount, paying lawyers and insuring risks. The barriers to obtaining this knowledge are not technical, but epistemological. Bringing such knowledge into being depends on the willingness of COOs to take the risk of sharing what they know

It seems strange, but by improvingmarket safety,we’ve improved market opportunity.

As recent events have shown,

safer markets are needed if

derivatives are to deliver their

full economic benefits.

A safer derivatives market is

transparent, to inspire trust. It’s

efficient, so processes are simple

and capital costs are lower. It ensures

investors’ positions are protected.

And above all it’s neutral, so that

counterparty risk is mitigated. Which

is exactly what Eurex Clearing helps

to provide.

Eurex Clearing is Europe’s leading

CCP clearing house for securities

and derivatives transactions. We

process gross risks valued at almost

EUR 9 trillion every month across

a wide range of asset classes – both

on-exchange and off-exchange.

At the same time, we’re the

first clearing house to deliver

real-time risk monitoring

for derivatives.

We’re also working with regulators

and participants around the world

to find ways to make markets

safer. Because the more people

have faith in the markets, the more

they’ll feel clear to trade.

www.eurexclearing.com

Eurex Clearing_CooConnect_May19 18.04.2011 10:41 Uhr Seite 1

COOFounding PartnerDominicHobson

[email protected]+44(0)2083789086

Founding PartnerMuzaffarKarabaev


EditorCharlesGubert


Content and Relationship ManagerAnitaCraw


Director of SalesJamesBlanche


Sales ExecutiveAdamAlim


ProductionRafaelZinurov


[email protected]

+44(0)8444843624

Subscriptions and ReprintsBekzodMirahmedov


COO, a publication of COOConnect, the peer group network for alternative fund managers and their investors,

is published four times a year. Subscription is free to authenticated fund managers and investors. The annual

subscription price is £75. The entire content is copyrighted. ISSN 2049-2510

COOSun Alliance House

29 London Road, Bromley, KentBR1 1DG, United KingdomTel.: +44 (0) 844 774 4228

www.cooconnect.com

and co-operating to obtain what they do not know.

Hedge funds are reluctant to share. This is a mistake. Not all information confers an advantage, especially in operations. Failing to share useful techniques also puts the best-run operation at the mercy of the worst-run. Investors want to buy investment risk, not operational risk, and do not always distinguish managers from industries. Above all, it is fallacious to believe any knowledge is so valuable its return will fall if others obtain it. Knowledge is not wealth. Wealth is knowledge. Like any man-made object, no strategy or instrument or algorithm or application is invented exnihilo. Each is a composite of the knowledge of others. Managers compete not on the basis of knowledge only they possess, but on their ability to realise possibilities inherent in knowledge available to everyone. To believe that any innovation entitles its progenitor to a monopoly is to argue for an end to progress, for every product and service will in the end be commoditised.

What cannot be commoditised is how a firm goes about its business. As the current rash of legislation (AIFMD, Dodd Frank), investigation (operational due diligence) and unsolicited advice (corporate governance is the latest) afflicting the industry demonstrates, levels of trust in hedge funds are low.

Founder’s Letter

8 COO

Since the increase in costs occasioned by these measures is equivalent to the savings created by trust, it is indisputable that managers trusted by investors will raise more money at lower cost. To be trustworthy, it is necessary to trust. That means being open, or willing to tell the truth, even about mistakes. This is never easy and harder still across digital networks that span the planet.

In fact, the conservative cultural critic Neil Postman has argued that digital networks are not real social groups at all, but simulacra, for real networks require the “nuance and directness of the human voice, face-to-face confrontations and negotiations with differing points of view, the possibilities of immediate action.” He is not wrong. Trust is easy to maintain among groups so small the members can smell the oxytocin, which is why existing networks in the industry are like that. The number of meaningful relationships we can maintain is limited by the size of our neo-cortex. Indeed, Dunbar’s Number specifies that any group of more than 150 individuals quickly becomes dysfunctional, as members steal time, money and ideas from a group too abstract to command their allegiance.

This is why COOConnect will not be a single network but a network of networks, in which smaller groups coalesce and interact. Postman wrote three years before LinkedIn

was launched, and four years before Facebook incorporated, so could not foresee that digital networks are not replacing authentic forms of sociability but creating wholly new forms of mutuality. Networks of networks are super-organisms, more akin to ant colonies or beehives, in which people do not even know who they are helping. In this sense, those who spend time sharing and categorising information on-line are exemplars of the invisible hand: they benefit themselves first, but make it possible for others to re-combine the information into new products and services.

To join COOConnect is to become part of a massive economic and social revolution, in which people are using technology to break the bonds of time and geography to create informational and trading networks of unprecedented value and extent. The belief in the need to behave differently at the office (homoeconomicus) and at home (homoreciprocans), which even Adam Smith knew was misplaced, was long contradicted by everyday experience, let alone the findings of sociologists and evolutionary biologists. It is technology, of all things, that is rediscovering the true character of our industry, as a sphere of human action.

[email protected]

Founder’s Letter

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12 COO

Welcome to the inaugural issue of COO, a quarterly

publication aimed at members and potential members of COOConnect. We believe the time is right to bring the benefits of social networking to the hedge fund industry and not only because Facebook is preparing for an IPO. This industry is no longer an upstart. Two in three dollars it manages are controlled by institutional investors, which have high expectations. To match them, people who prefer managing money to managing upwards must familiarise with some dreary acronyms and abbreviations: ADV, UCITS, FATCA, RFP, ODD, OTCC, BCP, TPA, and many more.

This is where COOConnect can help. Interacting with peers and experts via MyCOOConnect can help COOs better understand the operational challenges of an institutionalised industry. Take “corporate governance.” It is one of the great can’t phrases of our time, but anyone who doubts its importance should read the Weavering judgement by the Grand Court of the Cayman Islands, which fined two directors of the failed fund US$111 million each for “wilful neglect or default in the discharge of their duties,” such as signing documents without reading them. They were not indemnified.

The crisis of 2007-09 changed investor attitudes. Prior to 2008, hedge fund board meetings were akin to neighbourhood watch committees. Nobody bothered to attend or read the papers until something unpleasant occurred. The general partners did not want directors who took their fiduciary responsibilities too seriously anyway. Hedge fund directors, particularly in offshore jurisdictions, tended to be ineffective, conflicted, inexperienced, over-committed or just plain incompetent. They were not intended to help investors who got gated.

This has changed. A recent Carne Group survey of 100 investors with US$600 billion in AuM found 91 per cent would shun a fund with sub-standard directors. Three quarters had already done so—and the survey pre-dated the Weavering judgement. AIMA has responded to the issue. Its

Editor’s Letter

14 COO

Guide to Institutional Investors’ Views And Preferences Regarding Hedge Fund Operational Infrastructures includes an uncompromising chapter on the subject from Luke Dixon, portfolio manager for absolute return strategies at USS. UBP Asset Management recently released Benchmarking Best Practices: Hedge Fund Corporate Governance.

A campaign for higher standards of corporate governance is well under way in the US, where investors have historically paid even less attention to the issue than their European counterparts. In June last year, the US$14.3 billion Chicago-based fund of hedge funds Mesirow Advanced Strategies wrote to the Cayman Islands Monetary Authority (CIMA) demanding an on-line database of hedge fund directors. Even now, concern that directors are sitting on too many boards is widespread, especially in the Cayman Islands, which remains the domicile of choice for the majority of hedge funds. Four out of five of investors surveyed by Carne said they found it difficult to identify the number of boards directors sat on.

Remuneration of directors is low—about US$5,000 per board—though whether this is a cause or symptom of failings in corporate governance is debatable. Certainly, directors

have to sit on many boards to make a living, but that is how a lot of funds prefer it. Unfortunately, the “rent a director” model cannot survive the institutionalisation of the industry. Many managers are understandably reluctant to accept that meeting international standards of corporate governance will add even one tenth of one basis point to performance, but it is now part of the price of managing institutional money. Why give the operational due diligence people such an easy way to fail your fund?

Change will add cost. Having a high quality, independent director who sits on fewer boards is likely to cost up to US$25,000 a year. It is paid by the fund, but not only smaller funds will find sums of this magnitude a drag on performance. Some have suggested paying directors a lower fee until the fund reaches an AuM threshold. Others propose piggy-backing of directors to create economies of scale. But the most unwelcome suggestion is investor-nominated directors. Having a vocal director on a hedge fund board sounds like a good idea, but an over-zealous approach could easily divert the time and attention of managers from their primary task: generating alpha.

[email protected]

Editor’s Letter

15COO

COO Cover Story

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COO Cover Story

In 2008 one type of institution

failed to fail.

Trades cleared by CCPs

created neither massive

losses nor years of work

for lawyers and liquidators.

Instead, cash or securities

were delivered, and open

positions neutralised.

Policymakers fell in love

with CCPs.

Swaps are now feeling the

force of that love.

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COO Cover Story

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COO Cover Story

In the OTC derivative markets there is, to borrow the phrase popularised

by former US defence secretary Donald Rumsfeld, at least one thing we know we know. The “known known” is that US and European Union (EU) regulators are obliging financial institutions to clear their trades through central counterparty clearing houses (CCPs). That is not going to change. Convinced from an early stage that OTC derivatives in general—and credit default swaps (CDS) in particular—had contributed to the increase in leverage ahead of the crisis and impressed by the facility with which CCPs unwound the Lehman Brothers swap portfolio, regulators on both sides of the Atlantic chose the OTC derivatives markets as one of their earliest targets for re-regulation. Industry experts estimate that up to 70 per cent of existing OTC derivatives instruments could end up being cleared within the next few years. The remaining 30 per cent are currently deemed too exotic for clearing and will probably continue to be intermediated (and collateralised) bilaterally via prime brokers rather than CCPs.

What is much harder to predict is the impact of these reforms on the hedge funds that use OTC derivatives. Prediction is of course complicated by the continuing lack of detailed rules. In the United States (US), the Dodd Frank Act Wall Street Reform and

Consumer Protection Act of 2010 set the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC) an initial target of 16 July 2011—360 days after the signing of the legislation into law on 21 July 2010—to lay down detailed rules implementing centralised clearing, but publication was later postponed to December this year. Intense lobbying by investment banks has also succeeded in re-shaping the initial proposals, most obviously by persuading the US treasury secretary in the spring that it made sense to exclude foreign exchange forwards and swap transactions from mandatory centralised clearing. Meanwhile, the European Commission is still working on the European Market Infrastructure Regulation (EMIR) although this is unlikely to be ready before mid-2012. There is a separate European regulation on Short Selling and Credit Default Swaps grinding through the legislative machinery as well.

Despite the continuing uncertainty, and the accompanying temptation to do nothing, it is worth exploring what mandatory clearing will mean for fund managers. Most obviously, it means their prime brokers will now act as their intermediaries with the CCPs rather than their counter-parties directly. In effect, hedge funds will clear their clearable OTC derivatives trades through their prime brokers as their clearing agents.

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COO Cover Story

In effect, multiple relationships with prime brokers are likely to evolve into a single clearing broker relationship. Instead of meeting multiple margin calls, hedge funds will post initial margin to a segregated account at each CCP and respond to margin calls made by their clearing broker. If the clearing broker fails, the initial margin in the segregated account at the CCP can be “ported” to another clearing broker, enabling the existing positions to remain untouched. However, the margin methodologies of the CCPs are likely to vary. This is unlikely to free hedge funds to direct their business to the cheapest CCP in terms of collateral demands, since “inter-operability” is likely to be limited at first and even if it was not regulators have made clear they will resist a “race to the bottom” on margin terms.

Inter-operability between the CCPs of Europe, a policy goal of the European Commission since November 2006, stalled on the back of central bank and regulatory concerns about the prospect of competition on margin terms. In July this year, Patrick Pearson, head of the internal market directorate at the European Commission—the body responsible for regulating OTC derivative clearing—said that one unidentified CCP had reduced its margin requirements by 60 per cent, and made clear this was not regarded in Brussels as a welcome development.

But there will be competition in netting, says one observer. “Smaller, more specialist CCPs could find themselves economically disadvantaged because they will not be able to offer the same correlated offset benefits as larger CCPs clearing a broad portfolio of contracts,” says Anthony Belchambers, chief executive officer at the Futures and Options Association (FOA), the principal European industry body, which represents more than 160 firms engaged in the derivatives business. “Clearly, risk management controls should not be the subject of unacceptable competitive pressures and if interoperability is to be safely implemented, different clearing houses clearing the same products should be subject to the same standards and use comparable formulae for setting margin.”

If he is right, the larger CCPs, such as Eurex, ICE, CME and LCH.Clearnet are well placed to attract the bulk of the business as OTC derivatives move to mandatory clearing. Whether this will be good for hedge funds, certainly in terms of the cost of collateral but also of counter-party risk, is questionable. Though there will be scope for margin netting at the portfolio level across multiple CCPs, it is probably the clearing broker who will capture these. The opportunity prime brokers have identified in mandatory clearing is to be gross in collateral terms to the

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client and net to the CCPs. In other words, collateral costs will go up, not least because CCPs set strict collateral eligibility criteria. As to risk, hedge funds have since Lehman Brothers collapsed in 2008 worked hard to satisfy demands from their investors to diversify their counterparty risk. They are now using multiple prime brokers and even third party custodian banks, to hold assets. The enthusiasm of legislators for CCPs put this logic into reverse, by making CCPs the counterparty to all clearable trades.

CCPs argue that they are conservatively managed and well-regulated institutions, but the fact is that CCPs do fail. The Paris-based Caisse de Liquidation des Affaires en Marchandises (CLAM) collapsed in 1974 when traders were unable to meet their margin calls. In 1983, the newly established Kuala Lumpur Commodity Clearing House (KLCCH) in Malaysia failed following defaults by six brokers trading palm oil contracts on the Kuala Lumpur Stock Exchange. Most worryingly of all, the Hong Kong Futures Exchange had to be rescued

by the government in 1987. The ability of a CCP to avoid disaster of this kind depends on a variety of factors that are impossible to control in a crisis, notably the ability to work steadily through layers of collateral, default funds, insurance and capital guarantees in an event of default, making good

on legal title to collateral, the capability to realise the value of the collateral in distressed markets

and the ability to transfer transactions they have

cleared and netted without provoking further alarm, to say nothing of the ability of the clearing members to keep their heads when everybody

else is likely to be losing theirs. The truth

is that concentrating risk in CCPs is as likely to

intensify the panic it is designed to avert. If one CCP fails, inter-operability between multiple CCPs is bound to spread the contagion and public funds in multiple jurisdictions will almost certainly have to be committed to avoid a complete disaster. So there is good reason for hedge funds and their investors to be wary of the supposed risk-reducing properties of mandatory clearing.

Now

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COO Cover Story

In the existing system, counter-party exposure is to multiple counter-parties. In a mandatorily cleared environment, counter-party risk is limited to either the CCP (via the clearing broker as agent) or the clearing broker (as principal). “One of the main benefits of CCPs for hedge funds is that it can help reduce their counterparty risk exposure and make it easier to track,” says Ayman Gammall, a vice president in derivatives clearing sales at Barclays Capital in London. “The CCP is there in part to help mitigate the risk of a broker-dealer collapsing. If a hedge fund’s positions were concentrated with that defaulting broker-dealer, their positions in a non-CCP environment could be severely diminished. This would not happen in a CCP. In the event of a clearing member default, hedge funds would not get caught up in the liquidation process as they did with Lehman. The margin requirements would hopefully wind down the risk positions of the defaulting clearing member while its clients’ assets would be transferred to a back-up clearing member.” In the existing system, margin

requirements are set by the prime brokers and initial margin is held by the prime broker or a third party custodian. In the cleared environment, margin requirements will be set by different CCP methodologies and both initial and variation margin held at the CCP.

This is because initial margin is the first line of defence in a default. “In the event of a

clearing member defaulting, the initial margin from

that clearing member is used as the first line of defence to cover the default,” explains Matthias Graulich, executive director of clearing initiatives at Eurex

Group in Frankfurt, Germany. “If that

amount is not sufficient, then the following steps

will take effect. First, the clearing fund contribution of the defaulting clearing member, then Eurex (or CCP) reserves and finally the clearing fund contributions of non-defaulting clearing members. There is counterparty risk to a CCP but the likelihood of it bringing a CCP down is minimal due to the business model of a CCP. A CCP is always balanced and fully collateralised. Additionally, we conduct daily stress tests and operate a real time

Then

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COO Cover Story

risk management.” Graulich concedes that CCPs are ultimately vulnerable to a cataclysmic, black swan event, but says this is “very unlikely.” True, LCH.Clearnet did manage down the risks following the Lehman default in autumn 2008 by using up just a third of initial margin. No clearing funds were touched at all. Belchambers acknowledges that Lehman tested the CCP model and found it was not wanting , but warns that “a significant increase in the clearing of OTC products will change the risk profile of CCPs and they will become the subject of much closer regulation, insofar as they will become as systemically as important as banks.”

This is an important point. Three years on from swooning over the performance of CCPs by comparison with investment banks in the immediate aftermath of the failure of Lehman Brothers, regulators are now waking up to the fact that CCPs concentrate a multitude of bi-lateral counter-party risk in one place and then add the threat of contagion between CCPs themselves. This is dimming their enthusiasm for inter-operability, potentially increasing the transaction charge and collateral costs to hedge funds of using OTC derivatives. Fund managers are voicing concern about the holding of collateral at CCPs even in a segregated account. Stuart Anderson, vice president of BlackRock Multi-Asset Client Solutions,

points out that the clearing broker model will see the collateral of all clearing members pooled into a single omnibus account. “Clients of the clearing member could be at risk,” he says. “Tail risks do happen and sadly once in a thousand year events often happen more than once in a thousand years. In Europe we at BlackRock are advocating the option of omnibus accounts but also the optionality at client request for further segregation. If there was an omnibus account only for BlackRock clients, we would at least have full oversight over these accounts. As things stand, we have no oversight over what clients our clearing member takes on.”

Ironically, regulators in many jurisdictions have long resisted pressure from agent banks to permit them to hold client assets in omnibus accounts in the cash markets on grounds that name-on-register is safer. It is now being suggested that initial margin be held in earmarked accounts in the name of the client at the CCP. Anderson acknowledges that this could be a more costly option, but advocates it as one which gives the highest level of security to client assets and the greatest likelihood of timely porting to a new clearing broker in the event of a clearing member default. But even he accepts that omnibus accounts might make economic sense if there was an opportunity for several funds

25COO

SwapClear, the innovative clearing platform for interest rate swaps, has features that others don’t—such as 14 currencies, some with tenors out to 50 years, OIS discounting, and a unique risk management methodology. Learn why we’re the smarter choice. Visit us at swapclear.com.

LCH_SC_PI-229x170_fullpage_01.indd 1 4/27/11 9:36 AM

26 COO

COO Cover StoryCOO Cover Story

OTCCLEARING:WHATWILLITBELIKE?

CCPs can (and do) fail

Counter-party risk will be greater (sort of)

Collateral costs? UpCollateral upgrades? De rigueur

Transaction fees? Up

Non-clearable=unaffordable

Operational intensity squared

Forget about margin offsets

Pool your collateral with Tom, Dick and Harry

Look out for the lawyers’ invoice

Increase your technology spend

No room at the clearing broker inn

And no loopholes for escape

27COO

COO Cover Story

CCPs do not accept any old collateral. They will all take cash,

sovereign debt with appropriate haircuts plus treasury bills, notes and bonds, and CME will also take government agencies and mortgage-backed securities (with the appropriate haircuts). Although hedge funds tend to be much better collateralised than, say, corporate users of swaps, they will still face regular calls to supply variation margin. When markets are volatile, margin calls could occur six or seven times a day. If the requisite assets are not to hand, hedge funds will have to go to their prime broker for a collateral upgrade trade, exchanging ineligible collateral for eligible collateral.

One certainty about mandatory clearing of OTC derivatives is that it will drive up the demand for eligible collateral. This is the money tree the prime-cum-clearing brokers want to pluck.

Collateralmanagementopportunity

to net their offsetting positions. Unsurprisingly, CCPs are less keen on segregated client accounts, arguing that their procedures are sufficient to protect assets in an event of default. “Clients of clearing members will have the option as to how their position and margin collateral (cash and securities) is held and posted by their clearing member at Eurex Clearing, depending on each individual client’s needs,” says Graulich. “In the event of a clearing member’s default, all client positions with the defaulting clearing member may be transferred to another clearing member.” Ketan Patel, director of OTC risk management at CME Clearing, emphasises the importance the organisation attaches to the protection of client assets and insists CCP procedures have proved resilient in previous episodes. “We have spoken with market participants about client protection,” he says. “We use a customer protection regime and this has been in place for a long time. The omnibus account is something we use for futures participants and this system has come through various events such as

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COO Cover Story

Refco and Lehman Brothers incredibly well. By explaining to clients how the structure works, the risk management approach we employ and the way we look at clearing level exposures on a real-time basis, we are able to provide more comfort that margins are not only replicable but predictable.”

Anthony Belchambers warns that this promise of security is enticing, but it will not be costless. “Increased safety does not come cheap,” he says. “Clearing fees will go up due to the fact that CCPs will be more intensively regulated. Margin calls could be reset at `bomb-proof’ levels and called more frequently, a more limited range of assets will count as eligible collateral and dealers and brokers will look to pass on, where they can, their increased regulatory costs to the end-users.” On top of the costs of paying initial and variation margin in eligible collateral (which they may have to find through costly collateral upgrade trades when they are short) hedge funds will have to pay fees to clearing brokers as well as CCPs. They will have to pay lawyers to document their agreements with clearing brokers and invest in technology to communicate with them. The savings in greater operational efficiency promised by the CCPs are unlikely to offset these costs. In other words, the transaction costs of using OTC derivatives are going to go up.

Steve Mahoney, managing director of prime services with the investment banking division at Credit Suisse in New York, agrees. “Hedge funds will have to post margins to the CCP, which is something they did not need to do before,” he says. “There will be a CCP charge for pushing the transaction to a clearing corporation to be cleared. And finally, they will pay a prime broker a fee to clear the trades for them.” A source at Milan-based Banca MPS Capital Services, which has already cleared swaps through LCH.Clearnet and back-loaded an existing swap portfolio as well, acknowledges that fund managers could well find clearing costly and time consuming. “The buy-side will need to understand what is eligible collateral and what is ineligible collateral,” he says. “This could be time consuming.” CCPs are highly unlikely to accept anything less than cash, government or other highly rated bonds as collateral. Here is one measure of the gap in expectations: A recent survey by technology provider Algorithmics found that over half of buy-side respondents would like to use equities while a third also wanted mutual funds to be eligible. Prime brokers, on the other hand, are looking forward to the collateral upgrade trades hedge funds will have to transact in order to turn equities and mutual funds into collateral eligible at a CCP. “There are financial costs involved, even for large

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COO Cover Story

asset managers, in terms of initial set-up costs, which means systems need to be in place to deal with the transactions and to receive information from new market counterparties,” says BlackRock’s Anderson. “There are resource requirements in terms of the number of people who look at this from a legal, operational, systems and portfolio management point of view.” He should know, because BlackRock cleared its first credit default swap in 2009 and its first interest rate swap last year, through CME. Anderson says BlackRock is “100% behind the concepts of CCPs” and that the firm is not only exploring the offerings of multiple CCPs but expects to use them. However, BlackRock is a US$3 trillion fund manager and smaller funds cannot match its time and resources. “There are some small to medium sized asset managers who have been unable to give these changes their full amount of attention because the details are up in the air,” says Anderson. “Until recently, there have been market participants adopting a ‘wait and see’ approach but fortunately BlackRock is not one of them.”

There seems already to be a mismatch in terms of collateral expectations, from which the prime brokers will be able to profit. A July 2011 survey by technology provider Algorithmics found more than half of respondents (55 per cent) would like to use equities and a third (32 per cent) mutual fund units. Despite regulatory concerns that CCPs will compete with each other on margin terms—to say nothing of the respectable performance of equity collateral in the securities lending and repo markets in the heat of the crisis of 2007-09 and a growing clamour, spearheaded by Clearstream, for mutual fund units to be used as collateral– these asset classes are unlikely to be admitted by any OTC derivative clearing house for the foreseeable future.

There is a secondary concern that hedge funds will struggle with the operational challenge of multiple margin calls intra-day, or at least daily, which is the characteristic timetable of a CCP. Algorithmics is not a disinterested party—it sells collateral management software—but its survey also found that more than half of managers (54% per cent) met margin calls no more frequently than once a week, so even a daily margin call will represent a significant acceleration in processing, quite apart from the fact many funds are clearly leaving daily alterations in collateral posted against net exposure

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StuartAndersonofBlackRock

When they stop waiting and seeing, such fund managers might find the additional costs are not confined to the new clearing arrangements. Any fund using non-clearable OTC derivatives will have to continue to pay and collateralise prime brokers to intermediate those trades, while paying clearing brokers and CCPs to handle their clearable trades. Exotic OTC derivatives transactions may even become prohibitively expensive, because prime brokers will pass on the increased collateral and risk-weighted capital costs of non-clearable trades to hedge funds. “The prime brokerage business dealing with exotic transactions for clients will change over time because the margin and capital rules which the US and EU are proposing will limit the amount of business done in those products,” explains Mahoney. “The business will become too capital intensive and clients will be more inclined to execute transactions that are eligible for clearing.” Proposals contained in the draft Markets in Financial Instruments Directive II (MIFID II) in February 2011 went even further. They recommended banning OTC derivative trades regulators feel are CCP-eligible but which

the CCP refuses to clear. This proposal, according to Belchambers, is a phantom. “If regulators deem a product eligible for clearing, but not one single CCP clears it, the first action should be not to ban the product but reassess the eligibility decision,” he says. “If no CCP will clear the product then, arguably, it was never eligible for CCP clearing in the first place.” That said, CCPs are adamant they will not clear anything that they consider excessively risky. “We have made it clear in discussions with the regulator that they would be ill-advised to force a CCP to clear certain transactions when the CCP does not feel comfortable with managing the risk associated with that trade,” says Graulich.

While these prospects—higher costs and a reduced OTC derivative product range—are unappealing to hedge funds,

there might be some longer term gains from mandatory

clearing. Swapping multiple counterparties for one might reduce the operational burden. “A hedge fund might, for example, have 30 derivatives counterparties and will have operational

staff monitoring all of these relationships

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StuartAndersonofBlackRock

doing portfolio reconciliation,” says Dave Olsen, managing director and global head of OTC clearing at J.P. Morgan in New York. “There are 30 different types of statement formats a hedge fund must go through because all of the information these banks give to them will be different. With mandatory clearing coming into the fold, a hedge fund will go from having 30 bi-lateral relationships to two clearers, for example. There could be some cost burdens but it might even be a less expensive set-up with the whole package, given the renewed operational efficiency.” Hedge funds might even collect a double bonus if a smaller number of counterparties also diminishes their counterparty credit risk, even if it concentrates it at a CCP. “The CCP means everyone plays from a baseline of rules and it adds a huge amount of efficiency to the process,” says Credit Suisse’s Mahoney. Besides, the transaction and collateral costs of clearable OTC derivative transactions might even go down in the long-term. Simon Grensted, the former managing director of business development at LCH.Clearnet, predicts that

neither covered nor collected. The good news is that the overwhelming majority of respondents (84 per cent) were already using a third party vendor or service provider (such as their prime broker or administrator) to manage their collateral.

“Many hedge funds cite their operational limitations and do not have the software or ability to do daily margin calls,” says Neil Murphy, director of the collateral management team at Algorithmics. “Many risk managers in hedge funds have said it is okay to do weekly margin calls but the fact is they need to get to daily. During periods of volatility, CCPs might need to ask for additional collateral on an intraday basis. If the CCP wants more collateral, the funds cannot really question it.” To deliver variation margin of the right type and quantity, hedge funds will need to know what collateral balances they have and where they are; whether they are pledged or not, across repos, margin finance, stock loan and non-cleared CSAs as well as cleared swaps; what the available collateral is worth according to all of the uses to which it can be put; and, once it is identified, be able to instruct its delivery.

Helping hedge funds solve those challenges represents a straightforward commercial opportunity for vendors that sell collateral management software (such as Algorithmics); fund administrators that provide a multi-asset class collateral

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CCPs will bring operational efficiency to the markets and so lower costs in the medium to long term. “The whole process becomes automated and this helps the operational requirements of hedge funds,” he says. “[But] there are a number of CCP initiatives and hedge funds need to decide where to allocate resources.” Less convincingly, prime brokers are promising that they too will trim costs, at least at the operational level. “If a hedge fund trades derivatives, it will have most of the systems in place,” says Michael Zimits, global head of derivatives clearing at Citi in New York. “Furthermore, the prime brokers will do a large chunk of the work, taking pressure off the buy-side. We will make things incredibly simple for our clients and clearing will—in fact—over time reduce the operational burden for hedge funds, which will result in longer-term savings.”

Some hedge funds will have no choice but to out-source the operational aspects of OTC derivative clearing to a clearing broker. CCPs can demand intra-day margining and could theoretically initiate up to six or seven margins calls per day. CCPs are not keen to encourage the idea that clearing will be operationally intense (“Margin calls of, for example, CDS, will only change based on volatility in the market” says CME’s Patel ) but there is understandable concern at the level of preparedness at some hedge

funds. The Algorithmics survey cited earlier found half the funds it polled made only weekly margin calls. “The buy-side is not set up to deal with this yet,” says BlackRock’s Anderson. “Under the existing terms, an asset manager will ask a custodian to issue and pay margin once a day. Depending on the currency, there can be a one or two day time lag on currency settlement. There need to be agreements in place with the clearing member prior to calls in regards to how the end-user can meet them.” JP Morgan’s Olsen agrees that CCP margin calls could prove problematic for hedge funds. “Hedge funds cannot rely on contractual agreements to stick with margin with a simple amount like they are used to in the bi-lateral space” he says.

Predictably, larger managers such as BlackRock are better placed to cope.

AnthonyBelchambersofFuturesandOptionsAssociation

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management service (such as GlobeOp); and especially for prime brokers, though they are now widely admired for their willingness or ability to net client margin across asset classes and business lines. “Collateral is a key issue and margin requirements are going to challenge the investment banks and the buy-side,” says Murphy. “The cost of doing business is going to increase due to higher margin requirements. Furthermore, hedge funds are going to have to pay a fee to the banks for collateral transformation services.” He adds that Algorithmics is looking at providing collateral optimisation tools that hedge funds could use to determine the highest value use of collateral available, taking account of funding costs, concentration and other extraneous factors.

In theory, the same opportunity is available to the custodian banks (notably BNY Mellon and J.P. Morgan) and international central securities depositories (Clearstream and Euroclear) that provide collateral management services on a tri-party basis, mainly to broker-dealers but in some cases to hedge funds as well. They could provide the service as an independent third party manager, in exchange for a fee. “A lot of hedge funds are prepared for the collateral requirements” says Staffan Ahlner, managing director of global collateral management at BNY Mellon. “They know the rules are coming

Anderson predicts that many smaller asset managers will face difficulties when OTC derivative clearing gets going in earnest. “It is a steep learning curve and a lot of the smaller players have been unable to put resources in to look at it. However, awareness has been growing over the last year. If the regulators stick to their current timetable, there could be a rush to market and smaller players will not have the hands-on help that they require. This is one of my concerns.” A lot of hedge funds also have yet to choose their clearing broker. Though prime brokers have an obvious interest in encouraging the idea that they have limited capacity, some hedge funds might indeed find that their business is not wanted when the detailed rules are finally published and clearing takes off. Even major prime brokers might lack the staff and material resources to on-board swathes of hedge funds in November and December this year. “The largest asset managers have been incredibly proactive in finding and securing a clearing member,” says Anderson. “However, if some of the smaller asset managers leave

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it too late, they might be pushed down the prime brokers’ lists of priorities. This will make it difficult for them to get the required legal documentation in place to meet the deadlines.”

Certainly prime brokers are focused on how they can make money out of OTC derivative clearing: this is not going to be a loss-leader. The traditional economics of the prime brokerage business—in which hedge funds put all their cash and securities in custody with the prime broker, who was allowed to re-hypothecate them as it saw fit, in return for financing and stock loan—have crumbled in the face of third party custody and multiple prime brokerage. Helping clients fund eligible collateral for CCPs restores a little of the gilt, as Credit Suisse’s Steve Mahoney points out. “If a client posts eligible collateral, we will pass it on to the CCP and there will be no place for re-hypothecation,” he says. “If clients execute transactions to transform collateral, then the assets they give the prime broker will be eligible for re-hypothecation. For example, a credit hedge fund might be long corporate bonds and might not have cash. If they traded a CDS, they could get a US$10 million margin call. They would need to take their corporate bonds to somebody to raise cash so the cash can be put into the CCP. CCPs today will only take cash in G3 or G5 government bonds.” Hedge fund investors might not like

re-hypothecation, but for clearable OTC derivative transactions, it is likely to become a commonplace way of raising eligible collateral.

Custodian banks and hedge fund administrators could also profit from OTC derivative clearing by offering a pure fee-based, agency only third party collateral management service. This does not obviate the need for collateral upgrade trades with the prime broker-cum-clearing broker, but it does offer the prospect of a more efficient optimisation of collateral between different uses (repo, stock borrowing, margin loan, FX margin trades etc) plus scope for netting of collateral across transactions with the same counter-party in multiple CCPs. “I believe there is scope for fund administrators and it is something that we will see more and more coming through,” says Staffan Ahlner, managing director of global collateral management at BNY Mellon in London. Tim Murphy, head of derivatives clearing for Europe, Middle East and Africa (EMEA) at BNY Mellon Clearing, agrees fund administrators can profit from mandatory clearing providing they have a custody business on which to base collateral management services. “We are a better risk-rated counterparty,” he adds. “We do not have any proprietary trading desk so we do not do proprietary trading. If a hedge fund strategy is exposed to us, there is nothing we can do with it. The client does not have to place

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and they are taking proper action. The smaller hedge funds are also starting to get on top of things.” He says the long experience of the bank and its existing technology platform, makes it relatively straightforward for BNY Mellon to adapt its existing capabilities to CCP margin management for hedge funds.

Ahlner predicts non-specialist banks will struggle. “It is going to be a major challenge for some custodians to move assets from one custody account to another and back again up to seven times per day” he says. “Our system has been built and we can perform these movements across multiple prime brokers and CCPs.” The main challenge for BNY Mellon is an understandable reluctance to compete with its clients: the prime brokers. Clearstream but especially Euroclear face the same political problem but Pascal Morosini, executive director and global head of GSF sales and relationship management at Clearstream, welcomes any hedge fund client that can meet the minimum standards set by the iCSD. “We can perform a margin call every 15 minutes and we can do real-time collateral allocation 24 hours per day,” says Morosini. “There are a lot of new tri-party providers trying to enter the game which are less sophisticated. There is no room in the market for people who are not capable of performing these functionalities.” That warning applies to hedge funds too.

reliance on our Chinese walls as much as they may have to with other providers.”

The question is: How much transaction volume does the average hedge fund muster in clearable OTC derivatives anyway? Naturally, the answer will vary from an awful lot to nothing at all, but there is a school of thought that hedge funds doing minimal swap business should not be forced to incur the additional collateral and transaction costs of clearing trades through a CCP. It lost that argument a long time ago. A mixture of carelessness with their own reputations, an appetite for secrecy, some spectacular blow-ups and guilt by association (with the investment banks) means that popular as well as regulatory opinion holds hedge funds to be systemically important. “As we move more business to clearing, it is important we use net risk measures so that we focus on the real risks and issues,” urges Simon Grensted. That is almost certainly a hope that will not be fulfilled. Mandatory clearing is one of the many ways in which hedge funds are being punished for the sins of others, and the punishing will not end soon.

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The interrogatorAs every child knows, it is easy to annoy grown-ups by asking themtoo many questions. Michael Hieb not only takes that risk with hiscolleagues—herunstheriskofannoyinghimself.

The Tour de France is best known for featuring the only famous

Belgian everyone has heard of. But it has also bequeathed to posterity the emblematically persistent but popular loser: Raymond Poulidor, the eternal second. His is not a role model that will appeal to Michael Hieb, chief

risk officer at the London based asset manager Cairn Capital and a sufficiently enthusiastic cyclist to have spent part of this summer completing his fourth L’Etape du Tour, the one stage of the gruelling race where amateurs can join the professionals. The first route this year was certainly

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not for the faint-hearted—it was 109km long, of which 33km is uphill—and, to top it off, it took place in the blistering height of July. “I trained for it” says Hieb. “I cycled a couple of hundred miles each week. I was in Cyprus where there are a lot of good mountains and I visited Italy as well. Unfortunately, there are not that many mountains in southern England.”

Hieb has faced some equally tough tests over his two decades in finance. Prior to joining Cairn Capital in 2010, he was at AIG Financial Products, placing him at the epicentre of the financial crisis when the appetite of the insurer for writing credit default swaps on collateralised debt obligations helped to bring it down. Hieb was part of the team of people sent to London by AIG to assess and deal with the problems the firm had on its credit desk. This experience, and the subsequent US$180 billion government bail-out of AIG, has certainly impressed on Hieb the importance of thinking clearly about credit markets and credit risk. “It was an eye-opening experience but it has stood me in good stead,” he says. “When I arrived at Cairn Capital in 2010, I did not bring the experience of living through a ten year credit bull market where everybody was making money. Instead, I had a deep appreciation and understanding of

what can go wrong in the credit business.”

Cairn Capital is one of the few managers focused on credit to make decent returns in recent years. The firm currently manages a liquid long/short corporate credit fund, a structured credit fund invested in European asset-backed securities, bank hybrid capital and structured finance and a UCITS III-compliant long/short corporate credit fund. It is to the investors that Hieb regards himself as ultimately accountable. “Taking risk purposefully is by nature risky” he explains. “In a hedge fund, risk has to be structured so that it is consistent with the objectives and the mandate that is granted by the investor. That is the guiding principle. All checks and balances are set up to ensure that risk is taken in a way that is consistent with the investor mandate. The portfolio managers have to balance the target profit profile with the risk mandate from the investor. I have the advantage as risk manager to take a one-sided perspective in order to ensure that risk is consistent and protections are consistent. I have to be comfortable that in no event will the downside or negative performance exceed what investors are comfortable with.”

Of course, not all investors want to take the same risk. The Cairn investors

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are a diverse bunch, including pension funds, insurance companies, central banks, banks, money managers, corporates, funds of hedge funds and high net worth individuals. They have different needs and appetites and some are better placed to withstand larger risks than others. Cairn, which exists to run money, naturally tries to satisfy as many appetites as possible. “Some investors come to us saying we do not take enough risk, which is interesting” says Hieb. “Those investors are more concerned with returns, while others are more concerned about the risk mitigants we have in place. This all comes back to the mandate and that is why we try

to have certain funds that are more aggressive, while simultaneously running others, like our UCITS III-compliant product, which are more conservative in their investment approach.”

Market risk is the Hieb speciality. It is an important one, given the lack of yield and the loss of conviction and the heightened anxiety of investors active in the credit markets after the sub-prime disaster. This has not, paradoxically, led to any return to simplicity. “There is a lot of complexity in credit instruments and derivatives,” explains Hieb. “My approach to risk management is detailed and technical. If you understand the instruments you are trading in detail and the mechanics of the markets you operate in, this will guide your models of risk.” Even a plain vanilla bond presents technical challenges, says Hieb. “It is essential to know everything” he says. “How

COO Interview

COO Interview

quickly will the liquidity dry up for the market players? You also need a mathematical perspective. I need to build in place a prediction for how that bond is going to change in valuation as interest rates change and as people’s

appetite for credit risk changes. We

create a model in which we write down all of the risk factors that drive the valuation of a bond and we model and calibrate it—and we will shock these risk factors to see how that valuation changes.”

The AIG experience has certainly jolted Hieb into the world described by Nassim Nicholas Taleb. “We look at extreme events” he says. “We look at history and historical events and stress test them on our portfolios. It is

essential to know the portfolio inside out and what it is exposed to. We also perform hypothetical tests, like moving interest rates and credit spreads up 100 basis points or by 25 per cent to 40 per cent.” This quantitative approach to the management of market risk is of precisely the kind that Taleb has

disparaged as a

useless form of prediction, even while profiting from it himself in both material and intellectual forms, but it is hard to see how else a risk manager can go about his daily work. Hieb, like Taleb, does not have the classic rocket scientist pedigree for quantitative risk management anyway. His undergraduate studies were in French,

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English literature and philosophy at New York University and he went into finance only as a means of paying for them, for it was the early 1980s and funding of higher education was cut.

Unlike his contemporaries, who took out massive loans from banks to fund their university studies, Hieb opted to work for one. His career started on the equities desk at UBS. “If you worked at an investment bank on Wall Street, they would pay for your schooling” explains Hieb. “It made more sense than coming out of school with thousands of dollars of debt and working it off throughout your twenties and thirties. Back then, I had no financial experience whatsoever, but I was fascinated by Wall Street and it prompted me to study economics and higher maths.” UBS and AIG have taught him all about financial markets since then, but the most important lesson Hieb has absorbed from his career is not to trust nobody: it is to challenge and question everything he does. He has moved from an insurer (which purportedly minimised its risks) to a hedge fund (which purposely adds risk) but was careful not to join a firm which consisted of “three men and a Bloomberg.” He wanted to avoid working for a firm where traders were always right until they are wrong. “There is an adverse selection process

in place which encourages a lot of guys to think they are smarter than the market” he explains. “In Cairn, we take our cues from deeply technical, detail-orientated, rigorous analysis that is more usually employed on large trading desks.”

What Hieb fears most is the complacency that accompanies continued success. “The industry had a very long and successful run” is how he recalls the onset of the crisis in 2007-08. “The people who run this firm have been in the industry for 15 to 20 years. Complacency should always be avoided and that is where a lot of managers fell short. They had been through an amazing bull market and had seen wave after wave of innovation in the credit derivatives space. Many people had never seen things go wrong and that is why they got complacent.” The only way to avoid succumbing to the same syndrome, he reckons, is constantly to challenge yourself. “What have I not thought of?” he muses. “If I was on the other side of the table and I desperately wanted to criticise myself, what criticisms would I come up with? What is the flaw? It is this natural scepticism which risk managers must have.” It is a trait which does not make life easy for the traders at Cairn during the weekly risk meeting—Hieb and his colleagues regularly probe and question them—but it undoubtedly

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pays dividends for the firm in testing market conditions.

“The most pressing issue for me is that we have the controls and analysis in place to give me the ability to sleep at night” says Hieb. “I can only do that if we make a statement about risk that is correct and true.” With the increasing institutionalisation of the capital invested in the hedge fund industry, Hieb believes all hedge funds now need excellent risk management systems, since allocations are now dependent on the ability to demonstrate a robust approach to the management of risk in any investment strategy. Yet the more positive markets between the spring of 2009 and the summer of 2011 probably allowed some slackening of the emphasis on risk management at some hedge funds. “Risk management needs to be institutionalised and it needs to grow into more of a robust machine that is more typical of large organisations” warns Hieb. “But it also has to be done in a way that does not damage creativity. I feel confident the controls we have in place are the right ones. But it is essential that hedge funds make these risk systems both scalable and robust—and that is the challenge. To achieve a growth in assets under management, risk management has to be ingrained in the entire management process and [be] wholly efficient.”

But solid and streamlined risk management systems does more than attract institutional money to manage. It also impresses regulators. In fact, Hieb reckons compliance—even with the estimated 2,200 pages of new regulation currently washing over the hedge fund industry on both sides of the Atlantic—is a breeze when a firm has the proper risk management systems and procedures in place. “Regulation is something that people get all worked up over” he says. “But if you run your business well, it should not be that significant a challenge. I have sat in meetings where people complain about regulators, but if I ask tough questions of traders, they have not really got that much more to fear from regulators than from me. Yes, regulation can force you to institute things that may be inefficient or costly. But if a regulator asks you a question that you have not asked yourself, then there is a problem with your business. It is important to note these guys are removed from the business. The regulator should not be coming up with criticisms that you have not thought of yourself. Furthermore, if the regulators propose something that is inefficient, it is important to remember that all your competitors are facing the same challenges. At the end of the day, if you are doing your job well as a risk manager, there is not that much to fear from the regulators.”

For more information, please contact: Europe, Middle East & Africa: Fergus McKeon +353 1 790 3512 Asia-Pacifi c: Aidan Houlihan +852 2840 9756 Americas: Mike McCabe +1 732 667 1378

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Products and services are provided in various countries by subsidiaries, affi liates, and joint ventures of The Bank of New York Mellon Corporation, including The Bank of New York Mellon, and in some instances by third party providers. Each is authorised and regulated as required within each jurisdiction. Products and services may be provided under various brand names, including BNY Mellon. This document and information contained herein is for general information and reference purposes only and does not constitute legal, tax, accounting or other professional advice nor is it an offer or solicitation of securities or services or an endorsement thereof in any jurisdiction or in any circumstance that is otherwise unlawful or not authorised. ©2011 The Bank of New York Mellon Corporation. All rights reserved.

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UCITS hedge funds have not enjoyed the best press over the

last year. In November 2010, investor confidence wobbled following the sudden announcement that the US$630 million BlueTrend UCITS Fund was to be liquidated by BlueCrest Capital Management and Merrill Lynch Investment Solutions. This sudden closure reflected concern that the constraints of the UCITS framework prevented the fund from properly tracking new opportunities in bonds and commodities. A more worrying sign is mounting unease among industry experts and regulators at what they see as increasingly inappropriate strategies and asset classes being shoehorned into UCITS

structures. Some are warning that the UCITS brand (and the jurisdictions that dominate their domiciliation and servicing) could be damaged irretrievably if a fund blows up, and damages widows and orphans.

Inevitably, however, negative publicity has failed to deter return-hungry investors, even of the institutional variety. In February 2011, a Deutsche Bank survey of sophisticated investors predicted that capital allocations into UCITS III absolute return vehicles could significantly outstrip allocations into Cayman Island-domiciled funds over the coming year. The investors polled, albeit overwhelmingly of European origin, said they would allocate more

UCITS hedge funds: For and Against

Hedge fundmanagers exist tomanagemoneyandaUCITS label canmagnify distribution and capital-raising possibilities. But there aregrowingconcernsamongmanagers,aswellasregulatorsandinvestorsand fund promoters, about the suitability of the UCITS structure tohedgefundstrategiesandwhatthismightdotothereputationofhedgefunds,letaloneUCITSfunds.

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than US$185 billion into UCITS absolute return funds over the next 12 months. In the whole of 2010, Cayman-domiciled funds collected just US$55 billion in capital inflows.

Chris Wyllie, partner and chief investment officer at Iveagh, the London-based family office whose clients include members of the Guinness clan, is certainly an ardent fan of UCITS hedge funds and says fears of an embarrassing blow-up are overstated—and he should know, since Iveagh has invested in them for several years. “We were early adopters into the UCITS space even before we launched the Iveagh Wealth Fund in September 2008, which has about a quarter of its investments in UCITS,” says Wyllie. “Even prior to that, in 2006, we used UCITS hedge funds and looked at a lot of the offshore funds which were coming in UCITS varieties. We weighed up the pros and cons and checked to see how much we were giving up in returns to have a UCITS structure.”

The trade-off is better liquidity provisions than direct investment into a hedge fund, where money might be locked up for extended periods. In the years since the crisis, when many hedge fund investors were dismayed to find their investments in offshore vehicles gated, liquidity has become an important criterion in allocation to

hedge fund strategies. UCITS funds offer daily, or at worst weekly, liquidity. That discipline minimises the risk that investors will find themselves exposed to illiquid markets or asset classes such as securitised mortgages. In addition, the UCITS regime does impose restrictions on the range of suitable investments. One pension fund allocator recalls with a shudder that, as the markets tanked in 2007, some of his fund managers even held high value luxury properties in their portfolios, whose value and liquidity was hard to assess outside the boom conditions of the bull market. That cannot happen in a UCITS fund.

That said, sophisticated UCITS funds can and do invest in derivatives and Exchange Traded Funds (ETFs),

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which potentially pose a much greater risk than, say, a straightforward long/short equity or market-neutral strategy presented in a UCITS wrapper. Indeed, Dan Norman of TCF Investment predicts that ETFs and not hedge funds are now the principal threat to the reputation of UCITS. As he points out, swap-based ETFs in a UCITS wrapper create collateral risks that might directly contradict the investment strategy and commodity

funds that use derivatives, run the risk of getting on the wrong side of a discrepancy between the spot and futures prices. The Financial Stability Board issued a paper in April this year warning that collateralised swap-based products and ETFs that were leveraged or engaged in securities lending, posed a potential threat to the stability of the financial markets.

As the FSB paper warns, even on-demand liquidity vehicles such as ETFs can experience “liquidity disruptions.” That is because on-demand liquidity is not always supported by investment in liquid underlying assets. This is where the reservations expressed about hedge fund managers packaging illiquid strategies into UCITS-compliant vehicles is creating reputational risk for the hedge fund industry as well as

the UCITS industry. Magnus Spence, chief executive officer of the US$2.5 billion London-based investment management firm Dalton Strategic Partnership (DSP), acknowledges the temptation to boost returns by putting illiquid assets into a UCITS-compliant fund. “There are a number of hedge fund managers who managed offshore Cayman structures who

Seven things to think about UCITS funds1. They cannot buy anything they like.2. They trade returns for liquidity.3. The scandal-in-waiting entails an ETF.4. Swap collateral can contradict what the

prospectus says.5. Dublin versus Luxembourg versus Cayman is no

holds barred. 6. Feeling esoteric? Try a SIF or a QIF instead.7. Don’t be a whore: think reputation, not money.

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have observed the significant asset raising opportunities available through UCITS” he says. “Some managers have implemented their strategy almost piece-for-piece beautifully through UCITS. However, there are also managers who are adjusting their strategies to force them into UCITS and that group concerns me.”

It concerns him because the weakening of markets could, to adapt a phrase of the Sage of Omaha, expose such naked swimmers. “While the markets are volatile, we have not been in a bear market yet,” explains Spence. “Most of the strategies being run in UCITS are liquid today but what happens in the next bear market? If one occurs, only then will we get a sense of how liquid these strategies are. There are rarely problems when markets are benign but we only realise them when the markets turn ugly. I am fairly certain the next bear market will reveal some of the problems associated with certain UCITS hedge funds. If there is another market meltdown and liquidity is reduced, and people run for the exits, I suspect some UCITS hedge funds will be forced to gate and the perception that the UCITS model is safe will be broken.” There is even debate among some regulators about dividing UCITS hedge funds into “complex” and “non-complex” categories—or what might be

described as retail and professional—to help investors understand exactly what they are putting their money into and the associated risks.

The UCITS IV Directive, which had to come into effect in the member-states of the European Union in July this year, obliges fund managers to provide investors with a short and simple summary of their investment strategy in a so-called key investor information document (KIID). The KIID provides a somewhat flimsy caveat emptor defence against esoteric strategies being sold to retail investors. Nevertheless, Wyllie doubts an embarrassing blow-up is likely because regulators are alive to the risk. “About 12 months or so ago, we were on the lookout for people putting inappropriate hedge fund strategies into UCITS” he says. “There were a lot of people saying a blow-up could be derived from that. Personally, I have not seen people getting involved with such products. The regulators have been incredibly tough and we are scratching our heads to find people offering these illiquid products in UCITS formats. The industry has generally shown restraint. If a manager tries to put a product that is incredibly sophisticated into UCITS, the regulators will scrutinise it. It is quite hard to jump the regulatory hurdles.”

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This helps to explain the findings of a survey published in June 2011 by RBC Dexia Investor Services and KPMG. It found that that 77 per cent of fund managers contemplating a move onshore were more likely to opt for a Luxembourg Special Investment Fund (SIF) or a Dublin Qualified Investment Fund (QIF) than a UCITS fund. This in turn reflected the fact that managers could pursue riskier and more sophisticated strategies in these vehicles than they could within a UCITS structure. QIFs and SIFs are aimed at sophisticated institutional investors rather than their retail equivalents. In theory, they still offer investors the benefits of better liquidity and enhanced transparency, but without the investment constraints of a standard UCITS fund. The fact that managers are eyeing QIFs

and SIFs is a sign that some fund managers reckon it might be easier to secure money to run from onshore investors if they have more latitude in terms of investment strategies.

That latitude, oddly enough, matters to investors as well. That is because an aversion to “esoteric” strategies in UCITS funds creates a risk of its own: a lack of product diversity, leading to correlated returns. “There are a lot of long/short equity, then a few long/short bond, commodity trading advisers (CTA) and global macro funds, and that is about it” opines Wyllie. “Mostly, there are the more ‘plain vanilla’ type strategies, creating a deep but narrowly focused investment universe. It would be nice to see less crowding around these strategies and more diversity, particularly in the uncorrelated space. As and when this happens, the UCITS hedge fund sector will have come of age.” In fact, Magnus Spence says he can see no reason why esoteric hedge fund strategies, of the kind traditionally marketed to sophisticated institutions, should not be accessible by retail investors through UCITS funds, provided they are carefully risk adjusted. “If a UCITS hedge fund finds it hard to provide liquidity, they need to find new ways of satisfying investor demands by extending

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Chris Wyllie,Iveagh

redemption notices or finding new ways of financing” he says.

An evolution of the UCITS brand in this direction would certainly address claims that UCITS hedge funds are poorly diversified. “It will be something that takes time—possibly 15 to 20 years” says Spence. “But it is conceivable that investment strategies such as commodities, bond products which require significant leverage, multi-strategy products which incorporate rates, currencies and equities and merger arbitrage strategies that take relatively concentrated positions could be marketed to retail investors through UCITS.” Certainly investors are not sticking to equity long/short any more. A recent survey by UCITS distribution platform ML Capital found merger arbitrage was the most popular strategy among investors (49 per cent said they would allocate more capital to it), though this might owe more to an anticipated increase in corporate activity. Whatever the incentive, UCITS regulation will have to catch up, says Spence. “With merger arbitrage, for example, I can envisage regulators potentially increasing concentration limits from 10 per cent to 20 per cent” he says.

Whether UCITS hedge funds can successfully balance the potentially contradictory needs for both

conservatism and diversity and returns and liquidity remains to be seen. But Wyllie for one has no doubt that UCITS hedge funds will both survive and thrive. “While there are a few offshore firms that rubbish UCITS, the majority of people recognise that UCITS is here to stay” he says. Even if there was blow-up, he adds, it is unlikely to inflict significant damage on the UCITS brand, or derail the idea of UCITS hedge funds. After all, countless funds imposed tough gating provisions in 2008-09 and many of them appear now to be conducting business as usual. “In the unlikely event of a blow-up, there might be a few unpleasant investment experiences in terms of gates possibly being applied but I do not think even in those circumstances, the impact would be that substantial” says Wyllie. “Funds imposed gates, but does that stop people investing? No, it does not.” This may be too sanguine. Experience suggests that investors rarely blame their own greed when something does go wrong and even if regulators were not anxious to avoid placing the taxpayer on the line again, hedge fund managers ought to be mindful of their own reputation. It takes only one misguided UCITS hedge fund manager to taint the entire sector. As the Madoff scandal showed, that misguided manager does not even need to be a hedge fund.

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How to build a UCITS platform Bank of America Merrill Lynch recruited Eric Personne to enlarge and accelerate its managed accounts platform. Instead, he and his colleagues built a UCITS platform. Today, Merrill Lynch Investment Solutions is still the largest and best-known UCITS platform in an increasingly competitive field.

Business is different from economics, principally because

its practitioners recognise more readily the need to adapt their models to reality. Merrill Lynch & Co., as Bank of America Merrill Lynch then was, found itself doing exactly this in late 2007. In October that year, the firm had recruited Eric Personne from Société Générale to head its hedge fund solutions group, with the specific brief of supercharging the managed account platform

Merrill had launched a year earlier. Finding it a challenge to replicate the runaway success of the market-leading managed account platform, the investment bank had adopted the obvious solution and hired the CEO of Lyxor Asset Management, the Paris-based managed account business, to do the same for them. Personne was by then the head of such a demonstrably successful platform (Lyxor had more than 100 hedge funds making use of its risk

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management, cash flow and valuation capabilities by 2007) that Merrill was looking for no more than its own version of the same.

Personne and his newly formed team at Merrill Lynch, however, had other ideas. “By the time we entered the changed world of 2008, there was no point in trying to replicate some of the more successful platform providers” says Personne. “It was too late. It was not what was needed.” What was needed was a UCITS platform for alternative funds. The logic was impeccable—the events of the autumn of 2008 had heightened investor interest in regulated funds—but re-positioning a managed accounts platform was far from straightforward. The trick was to make good use of the existing infrastructure. “If we could re-deploy some of the things the company had done, cleverly and around a good strategy, we could build our own business, but one which was better-suited to the post-crisis world,” says Personne.

Before the crisis, the distribution of alternative fund strategies to retail, private banking and institutional investors was dominated by either funds of hedge funds or derivatives-based structured products created

(and often guaranteed) by investment banks to deliver returns that suited the risk appetites of different groups of buyers. Managed accounts—often but mistakenly seen as a purely post-crisis phenomenon, adopted by investors to improve transparency

and insulate their investments from redemption risk—were ideally suited to this combination

because the returns on a structured product could be tailored by varying the contents of the managed account. The crisis not only put fund of funds to a test they almost failed to pass but also hit structured products.

So the search was on for new investment vehicles that could offer investors exposure to alternative funds’ performance without the opacity and illiquidity risks exposed by the crisis. New style managed accounts could address some of those concerns. They offer the segregation of assets at the fund level, the dissemination of position-level information across multiple managers, plus the benefits of a precise tuning of investment strategies to the risk-return profile of an investor. Personne and his colleagues realised that there was an established investment vehicle available which offered a similar

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What was needed was a UCITS platform for

alternative funds.

level of transparency, liquidity and control, with the added advantage of being fully regulated and onshore: the UCITS fund. Investors were already buying traditional strategies in UCITS form, so would welcome their familiarity. Alternative fund managers also liked the idea of UCITS funds, since they promised wider distribution than the traditional Cayman-domiciled vehicles (some investors are restricted to regulated onshore investments) plus the opportunity to distribute single funds directly to end-investors.

For Bank of America Merrill Lynch, there was an added attraction in UCITS: a competitive differentiation which established managed account platforms could not necessarily replicate quickly, not least because an over-eager switch to UCITS funds would almost certainly undermine the confidence of investors in managed accounts. Yet it looked relatively straightforward to adapt certain alternative fund strategies to the constraints of a UCITS structure. With the passage of the UCITS III Directive, fund managers had started to replicate offshore alternative fund strategies, take short positions and

leverage funds up to 100 percent of NAV by using derivatives. The UCITS platform group led by Personne established a Luxembourg-domiciled Sociétéd’investissementàcapitalvariable(SICAV) called Merrill Lynch Investment Solutions

(MLIS). Chaired by Personne, it is supported by dedicated on-boarding, valuation, middle office,

risk and legal teams. They formulate

valuation policies and appoint the fund administrator and custodian. At present, this means just one third party provider, which supplies MLIS with both fund accounting and custody services. The MLIS team also appoints the paying agent in every market where a UCITS fund is distributed.

All the funds on the platform are presently serviced by Société Générale Securities Services (SGSS), which was appointed by MLIS and whose work is of course closely monitored by MLIS. In fact, MLIS reconciles the valuations prepared by the administrator—a relatively straightforward task for investment strategies that tend not to be unduly exotic, since they must comply with

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The AIFMD also had the disadvantage of

rousing the managed account platforms from

their slumber.

UCITS rules—against what it knows the funds hold in their portfolios. “We prepare a financial/risk driven NAV and the administrator prepares an accounting NAV and the two should match” explains Miriam Muller, head of the MLIS platform. “We price the fund every day and if there is any discrepancy with the NAV prepared by the administrator, we have a conversation. When you leverage extensive distribution capabilities, as we do for our UCITS products, you need to be in control of what you distribute.”

Control means that alternative fund managers are free to take investment decisions and to execute them using whatever execution brokers and counterparties they choose, but they are all implemented on behalf of the MLIS SICAV that Bank of America Merrill Lynch owns and directs. The first fund manager to be convinced the model could work was Marshall Wace, which launched its TOPS Market Neutral UCITS Fund as the first sub-fund on MLIS back in 2007. Since then, thirteen more major alternative fund groups—including BlueCrest Capital Management, AQR Capital Management, Graham Capital, York Capital, Zweig-DiMenna and Och Ziff—have launched UCITS funds on the Merrill platform, in pursuit of

fresh sources of capital to manage. BlueCrest has since reversed its decision (see main story) but there are still 14 managers on the MLIS platform running US$1.8 billion.

In making such rapid progress, Bank of America Merrill Lynch has had the advantage of a well-known global brand, but the firm is also selling a product which has obvious attractions to investors in the post-crisis marketplace. Since early 2009 another helpful factor has come into play. That was the decision by the European Commission to launch the Alternative Investment Fund Managers Directive (AIFMD), early drafts of which suggested it would be impossible to distribute offshore funds to European investors. “AIFMD was a useful catalyst, in the sense that alternative funds are required to meet certain regulatory criteria in order to be distributed in Europe” says Personne. “UCITS essentially means that, if alternative funds do a little bit more, from a regulatory compliance perspective, they can access a wider pool of investors.”

For Bank of America Merrill Lynch, the AIFMD also had the disadvantage of rousing the managed account platforms from their slumber. “AIFMD does challenge UCITS platforms, in the sense that it is encouraging managed account

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providers to reinvent themselves” explains Personne. However, he believes a new balance will eventually be struck between managed accounts and UCITS funds. “I am certainly not down on managed accounts” says Personne. “A new generation of managed account platforms may well work like this: what is liquid will be in a managed account in a UCITS format, while what is not liquid will be in a managed account in an AIFMD-compliant format.”

This blurring of the distinction between managed accounts and UCITS funds is more than notional. Like a managed account platform, the alternative fund manager launching a UCITS fund through a platform makes use of a legal entity and a set of support services provided by a third party. “Philosophically and technically, you could say our UCITS funds are managed accounts” says Personne. “The additional flavour is that they are regulated by and operating under the UCITS framework. In fact, you could say UCITS is the ultimate managed account, where you have decided to go the extra mile and do more than AIFMD requires of you.” The

obvious difference between managed accounts and UCITS funds lies in what is distributed and how. UCITS funds could not be distributed in the same way as managed accounts, which depended heavily on structured products. Classic UCITS funds, by contrast, are distributed by long-

established sales forces at banks, private banks, wealth managers and IFAs.

“Distributing UCITS is not

like distributing alternative funds,

because they are not domiciled offshore” explains Personne. “It is different from distributing structured products also. It is more akin to distributing mutual funds. You need people who come from the mutual fund industry and know to whom they should be talking.” Personne has hired several people with experience of mutual fund distribution in Europe to cover funds of funds (not funds of hedge funds either, but those restricted to buying regulated funds only), private banks, banks, insurance companies and discretionary asset managers. “Investment is coming from people who are in need of a UCITS solution because they are restricted from buying offshore

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We will be able to source more investor interest across more separate entities in

more countries.

alternative funds, or they simply prefer an alternative standard to offshore alternative funds” he says. He accepts that alternative fund managers will often know the same people and the same investors and opt to approach them directly, but argues nobody can match the penetration of his sales team. “Yes, the manager will have investor contacts, but we will be able to source more investor interest across more separate entities in more countries” says Personne. “There are so many different pockets, because mutual funds have been around for a very long time and distribution is very de-centralised. Alternative funds have not been around as long, and distribution is very centralised.”

Interestingly, the MLIS sales force is not yet selling the merits of its platform to pension funds or, more surprisingly, the IFAs that dominate the retail market for traditional UCITS mutual funds. Personne is content to wait before tackling the established retail distribution networks, including bank branches. There is of course a widespread expectation that the switch from commission-based to fee-based selling—now being imposed by regulators in the

United Kingdom through the Retail Distribution Review (RDR) initiative launched by the Financial Services Authority (FSA)—will become the norm throughout Europe, shifting the emphasis from selling the funds with the fattest commissions to selling the funds with the best performance. Personne believes this will enable alternative UCITS funds to move into genuine retail distribution.

Indeed, he argues that regulated alternative funds are well-suited to the needs of retail investors, because they offer lower volatility, better value and improved performance. Moreover, adds Personne, an alternative UCITS fund wraps alpha in a regulated, onshore format suitable for retail as well as institutional investors. “I am hopeful that, within five years, the UCITS marketplace will be characterised by a broader set of investment strategies

which have demonstrated a decent track record

throughout the cycle” he says.

“At that point we will see alternative UCITS

comparing favourably with traditional mutual funds.” Indeed, if hedge funds prove better at capital growth and preservation, they will make

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There is nothing wrong with alternative investment for retail

investors.

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better investments than traditional mutual funds. Personne argues that the ability of alternative funds to accrue and capitalise investment performance over a run of years, gradually distancing their overall return from the volatility of the markets, is what makes them the ideal investment product for an ageing population. “There is nothing wrong with alternative investment for retail investors” says.

That judgment obviously depends on maintaining the quality (and liquidity) of the funds retail investors are offered. Personne is clear that his platform has to offer access to the best managers only. “To use our resources efficiently, we had to focus on the top tier managers” he explains. “If we focused on the top tier, inevitably we would have a limited number of them.” So how can an alternative fund become one of the select few? “When we first started, it was difficult” recalls Muller. “But then the phone started to ring, with a lot of requests from alternative fund managers to be included on the platform. We explained that UCITS investors expect us to distribute high quality products and, in order to be successful in asset-raising, we have

to discriminate. We were very clear from the outset that we had to partner with the top tier firms and have on the platform their flagship funds. What we did not want was unknown managers, or even well-known managers with totally unproven strategies.”

To choose managers, Personne established an origination committee, made up of representatives drawn from across the global equity division of Bank of America Merrill Lynch as well as the UCITS platform team. Its brief is to assess which alternative fund managers, strategies and funds should be admitted to the platform, select the ones they want and invite them to join. The firm reckons it works hard to win mandates from its target managers and, although not every manager accepts the

opportunity, inevitably the firm has

disappointed more funds than

it has delighted. “We have pushed back

somewhere between 50 and 100 alternative funds managers that wanted to join” admits Muller. “To get on the platform, you have to be committed to UCITS, you have to be a top tier manager, it has to be a core strategy and you have to be a very good partner, i.e. a firm that is

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How can an alternative fund become one of

the select few?

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willing to team up with us, because we see this as a long term partnership between the two firms.”

Exclusivity has its cachet, of course. The prospect of being on a platform with brands of the same quality has helped attract other leading managers. Indeed, alternative funds on the platform have the assurance that in any investment strategy, MLIS will not support more than two managers and neither will pursue exactly the same strategy. “If they are sufficiently different, we will have two strategies that are in the same category on the platform” explains Personne. “What we will not do is put long/short John and long/short Jane on the same UCITS platform, because that would be confusing for clients. We cannot visit them on Monday and recommend one fund and then visit them on Tuesday and recommend another one pursuing exactly the same strategy.” Even without taking account of competition from Deutsche Bank (which is used by Paulson, Tosca and Traxis), Schroders Global Alternative

Investor Access (which is used by CQS, Egerton and Sloane Robinson), Morgan Stanley Fund Logic Alternatives (which is used by Ascend

Capital, Cohen and Steers and Sandler

O’Neill) and others—to say nothing of the funds that are able to go to market

directly, such as Brevan Howard—this does appear to place a ceiling on the growth of the MLIS platform.

However, Personne dismisses

the constraint, arguing that even if a minority of

managers prove able to deliver alpha consistently, the capital preservation skills of the industry as a whole mean there is ample room for growth. “There is a finite amount of alpha that can be extracted from relative value strategies, but I think there is an unlimited amount of alpha that can come from managing beta carefully” he explains. Certainly, he sees no immediate constraint on the growth of assets under management on the MLIS platform. Personne expects the 14 managers on the platform today to be joined by four further funds by the end of this year.

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There is a finite amount of alpha

that can be extracted from relative value

strategies, but I think there is an

unlimited amount of alpha that can come from managing beta

carefully.

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COO Q&A

What are hedge funds placing in custody with you?

Unencumbered securities and cash. Though the initial focus was on securities, hedge funds have also taken to placing cash with us, because they find we are a convenient and competitive place to hold cash awaiting reinvestment or redemption calls, or which is being

pledged as collateral to swap counterparties. They like the fact that we can hold the cash offshore as well as onshore. In all, we have around

One lasting impact of the collapse of Lehman Brothers is that hedge fund investors want to know that their assets are safe and visible. Capital allocations are now sometimes dependent on the appointment of a third party custodian. This has had a massive impact on the economics of the prime brokerage industry, in which managers traditionally gave investment banks complete control of the assets of a fund in return for stock loan and financing. But it has also forced custodian banks used to dealing with slower-moving and infrastructurally better-equipped traditional fund managers to change their ‘modus operandi’ too. The bank that has adapted most successfully is BNY Mellon, which did not take long to work out that it was already providing most of the services hedge funds wanted—ironically, to broker-dealers. COO asked Marina Lewin, head of global sales at BNY Mellon AIS, what had to change and what did not have to change.

PrimeCustodian

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COO Q&A

US$140 billion in hedge fund assets in custody, which we reckon gives us a share of around 20 per cent of the market for prime custody services.

Talking of cash, it was recently disclosed that BNY Mellon had become such a popular destination for cash that the bank was having to charge a negative rate of interest. What is the background to that?

We offer a mixture of deposit accounts and money market funds, including some managed by third parties. Interest rates remain at exceptionally low levels and the Fed has indicated that they are now likely to remain low through to 2013. In this environment, we could not support unlimited amounts of cash on which we could not earn a return. However, it should be noted that we have not charged any clients to date and the policy remains in place as markets remain unsettled and interest rates remain at historic lows. The deposit fee would potentially affect a small number of institutional clients with extraordinarily high and volatile

deposit levels. The fee was never designed as a revenue source, but only to cover our additional costs in unusual situations.

How does your prime custody product compare with the trust company or bankruptcy-remote offerings developed by prime brokers?

With our model, if there was to be a trigger event at the prime broker, the hedge fund client would be protected from the counterparty risk some funds experienced in 2008. Their assets are held in segregated accounts at BNY Mellon as a fully independent third party custodian. Some primes offer special purpose vehicles as an alternative, but these are untested and rely on a legal opinion which may not count for much in a crisis. So many hedge funds have opted to hold their unencumbered assets completely outside their prime and not in a separate structure within the prime or another unit of the prime. Importantly, assets that are held in custody with us can still be leveraged for other purposes, such as tri-party financing arrangements, in which we continue to hold the assets pledged to the lender.

Hedge funds are not like traditional fund managers—they want everything done yesterday and reported now. How difficult has it been for BNY Mellon to adapt to their demands?

Within AIS, we offer a higher touch service model and are no

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longer considered just a pure custodian. We have built a strong customer service environment for our managers and invested significantly in its development to ensure our services match the evolving requirements of our clients. It is true that most hedge funds do not have the operational infrastructure that a large pension fund or mutual fund might have, so their requirements of us are bound to be different. Every hedge fund strategy is also different and we have to cater for that too.

Can you give us an example of how you service hedge funds differently from traditional managers?

For certain strategies, the trade matching and reconciliation services we offer differ hugely from the services we offer as a traditional custodian. We have invested a lot in our technology, to change how we take receipt of trade files, for example. That has enabled us to enhance our service model to ensure we are responsive to the needs of hedge fund managers by offering faster reconciliations with brokers and pre-matching of trades to minimise the risk of failure.

You can provide a lot more than custody, cash management and trade

settlement. What else are hedge funds buying from BNY Mellon?

We can offer asset-servicing as well, including corporate actions. In addition, we have an integrated and seamless connection to our fund administration services, which enables us to be a full-service provider to all of our clients. Funds that did not use us as an administrator can now use us as a prime custodian and prime custodian clients are now using us as an administrator.

Are there synergies between prime custody and fund administration?

Asset valuations are an obvious one: we value the securities they hold for investment and trading purposes, as well as safekeep them. We also send monthly valuation statements to the investors, which are after all the people driving assets into prime custody. At the end of the year, the administrator also provides financial statements to the auditors to the fund, so we play an important role in corporate governance. Some hedge funds that have not previously used a third party administrator—including some closed funds that do not need to worry about third party investors—have appointed us to provide a so-called ‘NAV-lite’ service, which we call AV/PV, or asset validation/price verification.

COO Q&A

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But many new investors are now demanding third party custody and fund administration as the price of investing and it is operationally convenient as well as better value to combine the two.

BNY Mellon has tri-party securities financing and stock loan services that it has traditionally offered to broker-dealers only. Are you now offering them directly to hedge funds?

Some hedge funds have the willingness and capability to self-finance and are happy to use us as an agent, particularly to post collateral to lenders. We are not willing to act as principal to financing transactions with hedge funds. The more complicated financings tend to remain with the prime brokers anyway. That said, we have formed partnerships with a number of prime brokers, including Deutsche Bank and Goldman Sachs [see separate story, page 76, who continue to provide margin finance against assets in tri-party accounts with us, or against collateral moved to their accounts by us from a custody account with us.

Are you competing, in effect, with prime brokers?

No. We are partnering with them. We have established partnerships

with several large prime brokers to provide hedge funds with the ability to hold their unencumbered assets with BNY Mellon, while continuing to fund and lend those assets through their prime brokerage relationships. Through our platform, hedge funds can seamlessly move their positions to and from their custody accounts to satisfy their activity within their prime brokerage accounts, while benefiting from the diversification of counterparty risk.

Hedge funds are used to posting collateral for repo and margin finance, but centralised clearing will now force them to post initial and variation margin to CCPs as well. Does it make commercial sense—in terms of fees, but also in terms of your relationships with prime brokers as clearing brokers to CCPs—to offer third party collateral management services to hedge funds?

Managers have become more sophisticated and institutionalised and many now use a core custody account to feed collateral accounts that enable them to pledge assets to third parties. It is not a great operational challenge for us because prime custody is a lot like collateral management, in the sense that we move assets between a custody

COO Q&A

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account at BNY Mellon and a brokerage account at the prime broker. We are judged by the ease and efficiency with which we do that. Managing collateral across financing and swaps means going a step further and at present we offer that to the largest managers only, because they tend to control their own funding. They use tri-party arrangements between themselves, us and the prime broker. In the derivatives markets, both OTC and exchange-traded, our broker-dealer services group is offering an initial and variation margin management service, in which we will post assets in prime custody with us to the CCPs, or to the prime broker as counter-party to non-clearable swaps.

Are you lending stock directly to hedge funds as well?

Hedge funds tend to be borrowers and some have asked us if we would be prepared to lend stock. For now, we prepare to leave that business with the prime brokers, because our lending clients are not always comfortable with the credit risk. Some hedge funds already use us to lend their assets.

Inevitably, servicing hedge funds has blurred the division of labour

between BNY Mellon and your prime brokerage clients. How awkward has that been?

The division of labour is still intact, in the sense that the prime brokers are servicing the asset side of the hedge fund industry, while we are servicing the liability side. If hedge funds want classic prime brokerage products, they can obtain them from our prime broker subsidiary, Pershing. But we do increasingly partner with prime brokers, who are of course also clients of BNY Mellon in our broker-dealer clearing and tri-party financing business. The partnerships take the form of tri-party arrangements, in which we hold collateral posted against financing or swap transactions between hedge funds and prime brokers. The prime brokers would rather hold the collateral themselves but hedge funds—and especially their investors—are not always comfortable with that any more. Prime brokers are familiar with tri-party and know that we offer the product on standard terms, so no prime broker is getting preferential treatment.

How happy are you with the development of your prime custody services?

The custody business we do with hedge funds is six times larger than

COO Q&A

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it was four years ago. We now have business relationships with most of the top 100 hedge fund managers. We are running one of the fastest growing businesses at the bank. So, yes, we are very happy about the development of the business. Much of the business has of course come to us because alternative investment managers wanted to diversify and move away from their traditional prime brokerage relationships, but we have also had to build a service model that fits their needs. Hedge fund managers need an enhanced service model that includes high touch customer service, research, reconciliation, corporate action processing and a robust core custody service capability.

Do you ever see hedge funds reverting to the ‘status quo ante’ the crisis, in which they used their prime brokers as custodians?

No. We believe the shift that hedge funds made to a multi-prime/custodian model after the events in 2008 will remain in place. As hedge funds continue to be pressurised by their investors and by regulators to be more transparent, establishing a custodial relationship in addition to their primes enables them to accomplish both greater safety and increased transparency.

COO Q&A

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COO Feature

COO 70

John mack was wrong.

Investment banks risked

failure not

Because of shorting,

but because they were

Using the assets of prime

brokerage clients as

if they were their own.

Far from sinking the firm,

shorting funded the firm.

So what happens

when those assets are

elsewhere?

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What prime custody

is doing toprime brokerage

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Prime brokerage was once described as the largest but least

noticed banking system in the world. It worked like this: the prime broker gave the hedge fund manager the opportunity to trade with anybody they wanted and finance any position it adopted, while the hedge fund gave the prime broker everything its investors owned—long positions, short positions, cash—and allowed the prime broker to do more or less whatever it liked with them, including using them to fund the prime broker in the shape of cash collateral, poorly remunerated cash deposits, stock for loan against cash collateral and for collateral upgrade trades and the excess margin buffer (which could of course be altered at will by the prime broker). The credit risk incurred by the prime broker was not only collateralised but rewarded by some of the highest margins on Wall Street and in the City. The credit risk incurred by the hedge fund manager was not ignored, but it certainly remained non-negotiable. Then the crisis of 2007-08 happened and it turned out that the credit risk operated in the reverse of the anticipated direction. When Bear Stearns began to crumble in 2007, investors told their hedge fund managers to move their cash and

securities somewhere else. Multiple prime brokerage, initially favoured to limit information leakage, suddenly became the most popular form of counterparty credit risk management. With prime brokers unable from the summer of 2007 to fund themselves, let alone their hedge fund clients, the terms of the prime brokerage trade changed—though not necessarily in favour of the hedge fund, since prime brokers became more adept than ever at holding on to client cash and securities as they scrambled to save their own firms. But when Lehman Brothers International plunged into its seemingly interminable liquidation proceedings, hedge funds learned that some banks in some jurisdictions represented an even worse counter-party credit risk than American broker-dealers.

By the autumn of 2008 one thing was clear: assets were safer with a US broker-dealer than a UK bank. American prime brokers could fail, but as US broker-dealers their customers were not treated as general creditors. SEC Rule 15c3-3—the customer protection rule for broker-dealers—insisted fully paid-for and excess margin securities had to be segregated from assets pledged to or owned by the broker-dealer and any customer cash

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other than cash pledged as margin had to be locked up in special accounts accessible only by customers. This was why most US broker-dealers were parking unencumbered customer assets in segregated accounts at in-house trust companies long before the crisis broke. So when a broker-dealer failed, as Lehman Brothers did, all customer cash and other assets were given preference over general creditors of the firm. Assets held at US broker-dealers also benefited from the additional protection afforded by the Securities Investor Protection Corporation (SIPC). In an SIPC liquidation, customer property was not caught up in a prolonged liquidation, but returned to customers. Any shortfall in the aggregate—which might easily occur in the case of securities pledged to the firm as collateral—was allocated prorata among all customers, so a 10 per cent shortfall in the total value of customer assets resulted in a 10 per cent haircut for all customers. But the shortfall was covered by SIPC insurance of up to US$500,000 per customer, including up to US$100,000 of cash. None of this applied in London, where Lehman Brothers International operated under a much looser regulatory and insolvency law framework that has tied customer assets up for years in

liquidation proceedings. It did not help that in a number of cases where Lehman Brothers International was contractually bound to segregate client assets in London, it had failed to do so.

Something had to change in hedge fund custody arrangements. An obvious alternative was to follow the example of the traditional investment management industry and appoint a creditworthy, third party bank with a large balance sheet to safekeep the cash and fully paid (or unencumbered) assets of the fund. In theory, a custodian bank—or what Americans still refer to as a trust bank—ostensibly held no customer assets on its balance

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Anthony Byrne, DeutscheBank

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sheet. In theory, trust or custody assets were entirely separate from the activities of the bank. The bank was purely an agent, not a principal. Each customer had securities in the digital records of the bank earmarked as their own. Unfortunately, practice is of course a lot fuzzier than that. Most securities are actually pooled in omnibus or nominee accounts in the name of the custodian or trust bank. Indemnities offered by custodians to encourage clients to do business with them have a habit of ensuring that client assets lent to broker-dealers end up on the balance sheet when something goes wrong. Though customer cash is no longer held in ordinary deposit accounts of the bank as a matter of course—in-house and third party money market funds are made available as an alternative—it is entirely possible that client cash will be used to fund the bank. Customer cash could also end up in collateralised, off-balance sheet conduits or SIVs that were not formally indemnified by the bank. Losses in these vehicles are not always made good by the custodian banks (an honourable exception is State Street). Above all, custodians have long pursued a business model which is less than reassuring: the core custody

product is virtually given away as a loss leader, in order to attract assets which can be exploited for profit through securities lending, fat spreads on cash deposits and even wider spreads on foreign exchange bargains. In other words, even the apparently dull and squeaky-clean custodian banks operate in a fashion not wholly dissimilar from prime brokers: they use the customers’ property to make money for themselves.

So what is a hedge fund manager to do? By late 2008 investors were demanding the assurance of third party custody. But assets cannot be financed if they are not in a prime brokerage account. So the hunt was on for hybrid solutions that kept unencumbered assets at a safe distance from flaky broker-dealers, while also keeping them at hand if they needed to be sold, lent or financed. The initial solution was an obvious one: move prime brokerage accounts from broker-dealers to the prime brokerage arms of banks with big balance sheets (notably Credit Suisse and Deutsche Bank, but also BNP Paribas) and later to banks which might have problems of their own but which are deemed too big to fail (such as Citi and UBS). For the first time, hedge funds started taking a close interest in whether the counter-

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Last October Goldman Sachs unveiled the best solution yet to the

prime custody conundrum. Investors love its counterparty risk-reducing properties, while hedge fund managers adore the degree of control it affords them over the movement of assets. Designed and built entirely in-house, the new GS CustodyPlus service in essence provides a tool within the prime brokerage section of the firm-wide GS 360 portal that allows clients to see the assets they have in their third party custody accounts as well as their prime brokerage account at Goldman Sachs and then move them between the two. Though it is not (yet) a real-time system, it does access information which is updated nightly. “It is not quite drag-and-drop, but the screen gives you a summary of total assets in accounts at Goldman Sachs and your custodian and a set of simple controls to move assets between those accounts,” explains Michael Nachmani, managing director, prime brokerage at Goldman Sachs.

Putting the client in control

party named in the documentation was the parent company in Frankfurt or Paris or Zurich or the broker-dealing subsidiary in New York, which the parent company might be free to abandon in a crisis. Cash flooded into creditworthy custodian banks with no serious prime brokerage capabilities at all, such as BNY Mellon, HSBC, J.P. Morgan and Clearstream, to the point where banks ran out of ideas about what to do with it (something similar occurred this summer, when BNY Mellon started charging a negative rate of interest). Some larger hedge funds opened full custody accounts for the first time. The broker-dealers that survived the crisis of 2008—namely, Goldman Sachs and Morgan Stanley—even turned themselves into banks. They also developed in-house ring-fencing solutions to staunch the outflow of assets, mostly by re-naming or re-marketing or re-designing their existing trust company solutions, or adding something similar in Europe and Asia. “Post crisis, clients wanted to move unencumbered assets away from the broker dealer and wanted to use custodians to perform this service,” says Joe Davis, managing director of prime brokerage at

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Morgan Stanley in New York. “Clients wanted to diversify their risk.” It was in this febrile atmosphere that “prime custody” entered the lexicon of the hedge fund industry. It emerged as the prophylactic of choice among hedge fund managers looking to protect themselves against counterparty risk.

Three years on from the failure of Lehman Brothers, three principal models of prime custody for hedge funds have established themselves: the special purpose (or bankruptcy remote) model, the internal custody model and the external custody model. The first was really developed by Goldman Sachs (which re-named its trust company GS Bank USA and created Montagu Place as a bankruptcy remote entity in the UK) and Morgan Stanley (which in June 2009 re-launched its own trust company as a bank called Morgan Stanley Trust National Association). Both had suffered massive losses of prime brokerage balances in 2007-09. But even Bear Stearns, which accidentally acquired the protection of J.P. Morgan six months before Lehman failed, morphed the custodial trust company it launched for a mutual fund client back in 1997 into the J.P. Morgan Clearing Corporation and began to promote it to edgy hedge fund clients. All three saw the new

services as an answer to the principal challenge posed by the appointment of a third party custodian: the operational difficulty of moving assets between a prime brokerage account and a custody account at a third party bank (the hedge fund had to instruct a custodian to send or receive as well as a prime broker) and keeping track of them (through two different reporting systems whose data could not be united except by clumsy and infrequent file transfers). Then there were the additional costs, which mounted quickly if a fund traded actively. “For actively traded portfolio securities, movements back and forth between a global custodian and a prime broker would have been expensive and have led to operational risk,” explains Davis. “Morgan Stanley used an existing national bank subsidiary to create a custody solution for unencumbered assets. Morgan Stanley’s custody product, which is separate from the broker dealer, provides clients’ assets with safety and soundness for their unencumbered assets. This product enables clients to move unencumbered assets to our bank subsidiary whenever they want and still have access to Morgan Stanley’s technology and service model.”

Morgan Stanley has re-built its prime brokerage balances in the last

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“It incorporates an approval process, so a senior executive can approve the movements proposed by a junior staff member, and a device that alerts the user to impending settlements and upcoming corporate actions, so assets can be held back to settle trades or claim entitlements.”

In practical terms, the CustodyPlus service works like this: the client instructs Goldman Sachs to move the assets, which Goldman executes by sending a SWIFT message to the relevant global custodian bank telling it to send or receive assets from the prime brokerage account. But the client does not see any of that. CustodyPlus gives its hedge fund users the illusion of complete and direct control over their own asset movements. Most importantly, it obviates at a stroke the need for clients to instruct Goldman Sachs and the global custodian separately, making the process much simpler, more efficient and a lot less liable to fail because two separately submitted sets of instructions fail to match. Getting that process right matters even more than it did before the crisis, because the larger hedge fund groups are now posting collateral to dozens or even hundreds of counter-parties every trading day and the range of counter-parties they deal with has increased exponentially since 2008. The mandatory switch to centralised

two years, albeit not yet to former levels, but it is hard to believe that the Morgan Stanley Trust National Association played a big part in that process. Indeed, solutions of exactly that kind have come under critical scrutiny by the practitioners of the new profession of operational due diligence. Pierre Emmanuel Crama, head of operational due diligence at the London-based fund of hedge funds Signet Capital Management, says that bankruptcy-remote vehicles are preferable to the traditional prime brokerage model, but they are completely untested in a crisis. If a prime broker with a bankruptcy remote vehicle attached to it happens to default, there is no legal or practical precedent for determining whether investors whose unencumbered assets are held in such vehicles, will get them back. Of course, prime brokers offering bankruptcy-remote custody services have purchased expensive opinions from counsel attesting to their legal soundness, but hedge fund managers are cynical enough to remember that in the autumn of 2008 possession proved to be nine tenths of the law, especially when the survival of the prime broker was at stake. One prime broker thinks fund managers

are right to be cautious. “Even if client assets are separate from the rest of the bank’s assets, if I was a manager, I would be asking when I could get access to and trade the assets” says Atilla Olesen, head of prime brokerage and securities finance UK, and co-head of SEB Enskilda Equities, in London. “During a period of market turmoil, managers need to trade. There must be people in the special purpose vehicle, adequate systems and clarity that the special purpose vehicle can continue arrangements and meet its obligations to the client. Given the UK’s bankruptcy laws, hedge fund managers are going to be doing a lot of due diligence on prime brokers offering these products to assess the likely scenarios in the event of a default.”

On that point, Joe Davis launches a barrage of assurances. “The prime broker has no claim on the assets in the trust vehicle” he stresses. “We went to UK and US counsels about the bankruptcy independence of the national bank subsidiary and its connection to the US/UK broker dealers. Both counsels issued Morgan Stanley with opinions stating in the event of a bankruptcy or insolvency proceeding at the custodian bank, broker-dealer or parent level, the client assets held in custody would not be treated as the assets of any Morgan Stanley entity. These assets would remain totally unencumbered and there would be no lien on them, so we would deliver them to our clients at their request.” Asked how Morgan Stanley staff would deliver anything if the firm was mired in bankruptcy proceedings—when Lehman failed, liquidators locked the London staff out of the building—Davis says there is no risk of history repeating itself. “We have addressed any operational risk posed by the broker dealer by setting up a secured space away from our facilities that could support the subsidiary’s custodian bank activities in the unlikely event of a business interruption at Morgan Stanley” he explains. “Custodian bank employees

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Joe Davis, MorganStanley

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clearing of OTC derivatives has expanded the range of counter-parties still further.

The average global hedge fund is also having to deliver collateral in multiple jurisdictions. But for now at least the CustodyPlus service is available only for securities that can be matched and moved between accounts at the Depository Trust & Clearing Corporation (DTCC) and FedWire in the United States, Clearstream and Euroclear in Europe and the Canadian Depository for Securities (CDS). Hong Kong and Tokyo are expected to be added later this year. Although the service is also available only to hedge funds that have opened custody accounts at BNY Mellon—a longstanding partner of Goldman Sachs in the tri-party market—the firm will extend it to other custodians as client needs and geographical expansion dictate. With SWIFT-only interfaces to the platform, adding custodians is a straightforward proposition. Although there is no need to use the Goldman Sachs platform to instruct a global custodian to move assets, Nachmani says clients value the fact that the GS CustodyPlus platform is updated in real-time, enabling them to keep abreast of what is going on throughout the trading day, rather than waiting for a fresh file to be loaded by their global custodian overnight. Not

have access to the space which has dedicated and independent technology to allow for communication with our clients. Morgan Stanley has spent significant sums of money ensuring that this system works and we test the facility on a quarterly basis.” The firm believes that this combination of safe custody (albeit one based on legal assurances rather than practical experience), off-site facilities and the operational and reporting advantages of a single prime brokerage platform is an adequate riposte to hedge fund managers sufficiently concerned about the counter-party credit risk of Morgan Stanley to consider appointing a third party custodian. But even if there are operational efficiencies, the service is not without cost. “It is extremely reasonably priced” argues Davis. “We have not done this as a profit-making business. This was something we needed in our arsenal to ensure clients were comfortable with giving us their prime brokerage business.”

Another prime broker, Deutsche Bank, has gone down a different path. It has since 2009 offered clients the option to place unencumbered assets with a third party custodian. Third party custody is now available at Deutsche Bank through BNY

Mellon or Northern Trust, allowing counter-party diversification on the custody side while maintaining the benefits of prime brokerage services and reporting—though it does entail paying fees to BNY Mellon or Northern Trust as well as Deutsche Bank. While the initial launch focused on European clients, the model is also gaining traction in the United States. The operational burden of moving and reporting assets is borne by Deutsche Bank, but daily oversight and control is in the hands of the hedge fund manager. The German bank says it has invested heavily in the technology and consolidated reporting platform to ensure the movements are as uninterrupted and inexpensive as possible. “A lot of our clients are interested in this model” says Anthony Byrne, global head of securities lending and co-head of prime finance at Deutsche Bank in Hong Kong. “Deutsche Bank provides a working model where all of the processes, including moving assets, servicing and reporting are highly automated and integrated, allowing the operational workflow for the manager to be largely unchanged. This is a value-added proposition because clients can outsource the operational aspects of having prime brokers working in

tandem with custodians—something that is an operational challenge and has acted as a disincentive to use this safer route in the past. We invested heavily in the technology, legal review, consulting and infrastructure to provide that protection and [asset] segregation. Everything we do is able to be consolidated and we allow movement of assets between the prime brokerage and custody accounts in a seamless fashion. Our model is the best of both worlds.” Deutsche Bank can of course offer company risk on assets in custody with Deutsche Bank Securities Inc. as prime broker, but allowing clients to opt for an uncompromised, independent custodian such as BNY Mellon or Northern Trust is a powerful sales pitch against the bankruptcy-remote alternative. “One of the challenges of the SPV models is that they have not been tested” says Byrne. “Furthermore, they are deficient in that the vehicles are by definition lowly capitalised, have far smaller infrastructures and staffing and may not be considered systemically important by regulators.”

Though Deutsche Bank sold its global custody business to State Street in 2003, it retains a sub-custody network spanning the world and can offer hedge funds an in-house custody service separate from its prime

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all global custodians can offer real-time updates.

Indeed, the largest single problem reported by hedge funds in working with any prime custody offering has proved to be the reporting and operational inefficiencies. “What clients were really struggling with was not how to leverage the assets in the account” explains Nachmani. “The real problems were around reporting and operations, partly because they had another counter-party to deal with operationally and partly because global custodians are different from prime brokers. They are much more rigid in their processing. They tend to be more settlement date focused. People might think prime brokers are big places, but compared to global custodians we are boutiques. We can offer specialised services to hedge funds individually and cater to their particular strategies.” An obvious case in point was the leisurely timetable for responding to corporate actions. Hedge funds like to keep their options open as late as possible—and not just those running event-driven strategies either—but global custodians used to servicing long-only managers might demand a reply anywhere from 48 to 72 hours before the deadline. A prime broker, on the other hand, might set a deadline as tight as two hours’ notice.

Deadlines that might require assets to be in the right place at exactly the

brokerage arm as well on a market-by-market basis. That is attractive, in the sense that it replaces Deutsche Bank Securities Inc. counterparty risk with Deutsche Bank AG counterparty risk. But the German bank reckons fund managers and their investors are bound to be less comfortable with any solution that offers asset segregation within the same banking group. “If a client is concerned about the viability of a financial institution, they tell us they do not want to be in another part of that same financial group and would rather hold the assets externally” says Byrne. But internal segregation is precisely the alternative that well-capitalised universal banks such as HSBC, J.P. Morgan and SEB now offer. In fact, in building its prime brokerage business HSBC has chosen to use its creditworthiness and custody capabilities as the twin foundations. Though its ambitions have provoked a sceptical response from market-leading prime brokers, its model is playing well with potential clients. Business is growing and the bank is poised to launch a prime services unit in Asia to complement its existing operation in London. “Yes, all the eggs are in one basket and clients do

have counterparty exposure to HSBC Bank PLC” explains Chris Barrow, global head of sales for HSBC’s prime services in London. “First and foremost, investors and hedge funds need to look at the counterparty they are dealing with and be happy with that counterparty from a credit perspective. Our clients tell us that our model is simple and that they do not have the operational complexities of dealing with more than one party. For example, when we move assets from the unencumbered custody account to the charged custody account and back again, this is all controlled by HSBC. There is no need to wait for third party instructions or time delays.”

There it is again: the battle against the operational clunkiness of prime custody arrangements [see Sidebar,

“Putting the client in control”]. In fact, established prime brokers never tire of predicting that clumsy custodian banks such as HSBC and J.P. Morgan can never match the operational agility and responsiveness of an investment bank. “As soon as you have a bankruptcy remote vehicle or a tri-party custodian, it creates several parties to work with and this can increase the operational burden on the manager” says SEB’s Olesen. He adds that SEB has provided a combined custody and prime brokerage product since long before the crisis. “A lot of our competitors have tried to emulate us post-crisis and we are flattered because it validates what we have been doing all along” he says. “People liked it before the crisis and they like it even more post crisis. It is a custody model so assets are segregated from the bank’s assets. We make things easier for the client.” Chris Barrow argues that he does too. “We have been bridging technology” he says. “We have built new infrastructure and technology that sits between the global markets business and the custody platform.” At J.P.Morgan, on the other hand, the bank was not content to rely on creating technological links between custody and prime brokerage. In 2009 it set up a whole new prime

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Atilla Olesen, SEBEnskildaEquities

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right time: in this case, at the prime broker, so the prime broker can respond to the corporate action on behalf of the client. “So we came up with a solution that is really a technological and operational wrapper around the relationship with the global custodian that enables them to plug into the infrastructure at Goldman Sachs from a reporting perspective” explains Nachmani. The tool in the prime brokerage portal not only makes it easy to move assets between custody and prime brokerage accounts, but also makes it much more convenient to post to Goldman as prime broker any assets held in the custody account which are needed as collateral, or for settlement, or which need servicing (such as collecting an entitlement). “The idea is to give clients maximum control” adds Nachmani. “Rather than us trying to figure out how to optimise the distribution of encumbered and unencumbered assets, the client can go into our tool, select the assets they want to move and as long as they have sufficient excess collateral in their prime brokerage account, they can move the assets to their custody account.”

Importantly—albeit subject to negotiation—there is in most cases no countervailing right for Goldman to recall assets from a custody account to, say, meet a margin call. “We felt

custody solutions group headed by managing director Devon George-Eghdami, who reported initially to Sandie O’Connor (now head of prime brokerage but then head of financing in the custody arm of the bank) as well as Michael Minikes (the former Bear Stearns prime brokerage chief who was then CEO of J.P. Morgan Clearing Corporation, of which he is now chairman and president). “We were well placed to take advantage of the evolving marketplace” recalls Minikes of the period after J.P. Morgan acquired Bear Stearns. “We had the ability to offer the services of a premier custody bank coupled with a prominent prime broker.” Minikes adds that investors still “want their hedge funds to provide transparency and especially want to know where the assets are held. There is significant demand to have hedge funds hold unencumbered securities in a custody bank.” Two years on from the appointment of George-Eghdami, the bank has a number of traditional as well as hedge fund managers using its prime custody model. “One of the main benefits of using our product is that clients have a single point of contact and a high level of service” she says. “When a prime brokerage firm is connected

to a third party custody bank, there is no control over the level or quality of service to clients. Everything is in-house here so we control the quality.” If that service quality is judged chiefly by the ability of the bank to deliver consolidated reporting across prime brokerage and custody, it is not the main reason why hedge fund managers are using prime custody services. Nor is it a guarantee that the model will continue to attract balances. As Pierre Emmanuel Crama of Signet Capital Management puts it, “ever since Lehman, the prime brokerage model has evolved and hedge fund managers are constantly evaluating their options.”

What is clear, however, is that prime custody is here to stay. The unanswered question is what the evolution of prime custody will do to the commercial economics of the prime brokerage business. In its heyday, prime brokerage worked like any other banking business. The prime broker took into custody the cash and collateral of its hedge fund clients, and made a spread on re-lending them. Stock lending and financing in exchange for collateral were just the principal tools by which they did this. It follows that, if assets and cash are no longer in custody with prime

brokers, or being financed on margin by prime brokers, the revenue and profitability of the business is bound to be seriously affected—and it is. According to the six-monthly survey of the major hedge fund groups in London, published by the Financial Services Authority (FSA), borrowing by hedge funds from prime brokers (as opposed to banks and the repo markets) has shrunk from 24 per cent of the whole when the survey was first conducted in October 2009 to 15 per cent in the latest survey, conducted in March this year. The overall value of short sales tracked by Data Explorers has remained flat throughout that period. In fact, if the revenues of all of the major prime brokers have tracked those of Goldman Sachs, they will currently be running two thirds below their pre-crisis peak. Worse still, hedge fund assets in custody with a prime broker are in the nature of a free loan by the customer to the prime broker. In fact, certain prime brokers got so used to having access to hedge fund assets to fund their own business that their inability to recognise that short term-funding using prime brokerage assets was unsustainable played a large part in the demise of Lehman Brothers and the near-demise of Bear Stearns.

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clients would not be comfortable with that” explains Nachmani. “If we had the right to go into their account at the custodian and pull assets out, clients would rightly ask what might happen in a crisis situation. What would there be to stop us as prime broker going into their account and pulling assets back to Goldman? We needed to give them the right to sweep assets out of a Goldman account, but not a right to ourselves to sweep assets into a Goldman account.” That said, Nachmani acknowledges that the firm is developing automatic optimisation tools which will sweep excess collateral into third party custody accounts, and that these could be adapted by clients as a means of moving asset automatically in the other direction—but only in line with standing client instructions. For example, a hedge fund client might allow assets to be moved automatically out of a custody account to meet settlement needs only, or to claim entitlements only. “The amount of control we give to clients is a key distinguishing features of this service” says Nachmani.

In fact, that degree of control is such a revolutionary approach to prime custody that it is not a product that Goldman will want to offer to all of its clients. The bank has not marketed it heavily and the product will by its nature work only for clients large

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Five questions to ask yourself about prime

custody

1. Prime brokers were like banks. They took your stuff and made a spread on it by re-lending it to other people. If you stop them doing that, what happens?

2. Custodians are still banks. They take your stuff, and charge a fee for moving it between your accounts, unless you agree to let them lend it to someone else. Should you?

3. Moving stuff from a custodian to a prime broker and vice versa means twice the work (two sets of instructions) and half the information (their systems can’t talk to each other). Is it worth it?

4. Your prime broker has put a new label on their trust company and paid a lawyer for an opinion that your stuff is safe inside it. How comfortable are you?

5. You borrow money and you borrow stock from your prime broker. You get clearing, settlement and asset servicing from your prime broker. It might be convenient to buy prime custody too but is it wise?

enough to open a custody account, and unleveraged enough not to need to pledge most of its portfolio every day. “Size is a more important factor than strategy” says Nachmani. “We have seen interest across a wide variety of strategies. Most of the clients who have taken an interest in the service so far have over US$1 billion in assets under management. A handful have US$500 million to US$1 billion.” But then CustodyPlus is not the only prime custody service Goldman offers. The firm has offered in-house custody through a bankruptcy-remote trust company since long before the collapse of Lehman Brothers raised the level of investor anxiety about the custody arrangements of their fund managers. The trust company, which became GS Bank USA when Goldman converted itself into a bank in 2008, is still used by some hedge fund clients in the United States.

In Europe, the equivalent is Montague Place Custody Services, a bankruptcy-remote entity specifically designed to address concerns raised by the trapping of assets in the prolonged liquidation of Lehman Brothers International in London. Though the Lehman debacle proved to hedge funds as soon as it happened that an SIPC-protected US broker-dealer was a safer place to custody assets than a London-domiciled bank—which had laid bare

the limited protection of third party assets under UK insolvency law—many of the solutions spatchcocked together by prime brokers to take account of the newly identified risks were distrusted, chiefly because they ultimately relied on an untested legal opinion. GS Bank USA and Montague Place Custody Services are nevertheless used by a number of Goldman Sachs prime brokerage clients. Though they are not offered as options on GS CustodyPlus—currently, Goldman supports custody accounts at BNY Mellon only—they are likely to cost less. While Goldman does charge for the custody service supplied by Montague Place Custody Services, there are no charges of the kind inevitably levied by BNY Mellon as well as Goldman in the GC CustodyPlus service.

That said, Nachmani describes the fees Goldman levies for moving assets to and from a third party custodian as “very nominal” and intended only to cover the operational and technological costs incurred. “We did not develop this as a huge revenue generator” he explains. “In so far as a client wants to use a global custodian, we would rather they kept those assets somewhere within the Goldman Sachs family. That makes it more likely that, when they would like to borrow more and trade more, those assets will come

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back to us rather than go to one of our competitors.” However, it is an inescapable fact of arithmetic that each asset movement will incur transfer charges—global custodians acting as third party custodians naturally charge fees for moving assets too—and those charges will accumulate. Since prime brokers have never charged custody fees for holding unencumbered assets—they traditionally get paid by financing and lending assets—there was no revenue downside for Goldman in facilitating third party custody, but the charges can come as a surprise to clients. It should not. The fact the firm cannot re-hypothecate assets in custody with a third party and does not re-hypothecate assets held at Montague Place Custody Services, is reminder not only of why custody arrangements are being set up in the first place, but of the fact that the right of prime brokers to re-hypothecate meant custody was never “free” anyway: it was paid for through giving the prime broker the right to lend assets to third parties.

So, revolutionary as it is in terms of client control, CustodyPlus is still a service which cannot or will not appeal to every client. Like GS Bank USA and Montague Place Custody Services, it entails prime brokers as well as hedge funds making compromises between investor demands, financing and stock

borrowing needs and counter-party, operational and re-hypothecation risks, costs or revenues. What is obvious is that third party custody accounts for hedge funds are here to stay. Hedge fund clients and their investors like the reduction in counter-party credit risk, the fact the custody accounts segregate the assts and hold them in their own name and the absence of any of the fancy but untested legal structures prime brokers have concocted in an effort to retain custody of hedge fund assets. Brian Ruane, who as CEO of Alternative and Broker-dealer Services at BNY Mellon is co-creator of CustodyPlus, agrees. “As investors increase their demand for more transparency, it is critical that we collaborate to develop and evolve our prime custody services to meet their requirements” he says. To its credit Goldman understood this early on, and has adjusted its prime brokerage offering adroitly to take account of the changed realities. “It was clear that these global custodian relationships were going to be around for a while and we wanted to work out how we could help them to run more smoothly, as a value-add to doing business with Goldman Sachs” says Nachmani. “To be really appealing to people, what we offered had to work in the context of the accounts that people had open already.”

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COO Columns

This is a vintage period for hedge fund mergers. Man-GLG, creating

a mammoth organisation with more than US$71 billion in AuM, was the flagship deal. But Thames River also joined forces with F&C, while BlueBay was purchased by RBC. Funds of funds were not immune. Saguenay Capital and Strathmore announced a US$2 billion merger in May. Richmond Park Capital purchased Olympia Group in February, while Nexar Capital bought Allianz and Ermitage.

These are good times for M&A lawyers. But do the deals make sense for investors? Mergers are like marriages. They can be loving and everlasting or difficult and brief—ending in a painful, costly divorce. So mergers, like marriages, should be considered carefully. The important questions are what motivates the merger and how to maximise its chances of success.

Mergers are happening because asset gathering is hard. Managers reckon size secures capital. The days when smaller funds could rely on private banks or high net worth individuals is passing and funds with less than US$100 million in AuM are unlikely to be considered by institutional investors. Most see managers with up to US$500 million

as “emerging.” Pension and sovereign wealth funds resist allocating to smaller managers because of their large ticket size and fears of concentration risk and they increasingly dominate the industry. A Citi Prime Finance survey found just 13 per cent of managers—all with more than US$1 billion in AuM—now look after the overwhelming majority of the US$2 trillion invested in hedge funds.

But mergers offer managers more than interest from large investors. They enable managers to enter new markets and offer different products. This diversity, providing it is complementary to the existing model, can pay dividends. A less positive reason for consolidation is regulation. Dodd Frank, AIFMD, MiFID II, Basel III, centralised clearing of swaps, Solvency II and FATCA are all adding to the cost of being in the business. The more onerous reporting requirements imposed by the Dodd Frank Act are now a pressing issue. Managers need to provide the SEC with a Form PF to enable the regulator to monitor systemic risk. A fund running US$1.5 billion or more must submit the data quarterly, while smaller managers are required to report annually.

It follows that hedge funds must collect data, including exposures and

Investors leave bad mergers

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liquidity across parent and master-feeder funds and submit it to the SEC. The regulator could demand stress testing and VaR data too. Managers will need to provide the SEC with the Forms ADV I and II—and the latter is detailed. The only way to meet such demands is to hire expensive compliance professionals. Compliance has become another tax on performance and the burden of it is encouraging hedge funds to merge.

But there is risk in mergers, which funds must avoid. First, they should ensure their investors support a merger. They will not back deals designed to allow managers to meet high water marks and claim performance fees or to avoid closing the fund. They will insist on forensic operational due diligence on potential partners, since a string of law-suits or embarrassing revelations after the fact guarantees a collapse of confidence in the management and an exodus of capital.

A larger challenge is realising synergies while maintaining continuity. Continuity is an absolute pre-requisite. Investors do not want to see sudden or repeated changes in management. Systems and personnel must be integrated quickly in the front, middle and back offices. The investment process and

risk levels must be maintained and risk management centralised. Investors will quit if risk criteria are altered, as this can impact performance. Using the same service providers is also sensible, though investors will understand if the larger party makes the choice.

Profit-generating individuals must be retained to avoid redemptions when a key manager departs. Stars do not always welcome a merger, so they must be persuaded of the benefits. It should not be that hard. After all, the whole point of a merger is to create a better company. At their best, mergers free managers to exploit complementary skills and deliver more and better to clients, shareholders and investors. But the risk of failure is high. Sub-standard due diligence, managerial disagreements, product incompatibility, communication breakdowns and poor organisation have all sunk mergers that began with high hopes. Avoid these traps, or lose your investors.

Pierre-EmmanuelCramaisheadofODDatSignetGroup.HeiswritinginapersonalcapacityandtheviewsexpressedheredonotrepresentthoseofSignetGroup,oritsemployees,partnersoraffiliates.

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The major Swiss banks have suffered some embarrassing encounters with

the Internal Revenue Service (IRS) in recent years. But nothing symbolises the rampant extraterritoriality of the US tax authorities better than the Foreign Account Tax Compliance Act (FATCA). This legislation, which comes into effect on 1 January 2013, is likely to have a large impact on how hedge funds operate in general and how they manage relations with their investors in particular. Under the provisions of the Act, hedge funds must identify all of their US investors, and provide this information to the IRS on an annual basis. Some experts have predicted this could generate for Uncle Sam up to US$100 billion in taxes at present foregone.

Others, however, disagree. “I do question the US$100 billion figure,

which has been thrown around” says Robert Mirsky, head of the hedge funds group at KPMG. “I think that number sounds a bit too high.” But this law impacts hedge funds everywhere. Non-US managers are simply classified as foreign financial institutions (FFIs). The legislation even applies to firms without US citizens as investors—they still need to collect information to prove to the IRS that is the case. So it is obvious that the scope of the Act is sweeping and hedge fund managers will be forced to conduct extensive due diligence on their underlying investors to determine whether they are US taxpayers.

In years gone by, a passport was usually enough to prove an investor was not an American. Compliance with the post-9.11 tightening of Know Your Client (KYC) rules would also have sufficed

FATCA is coming:Their money, or YoursTheIRS is famouslyaggressivewhen itcomestocollectingtaxontheworldwide income and assets of American citizens.With the passageoftheForeignAccountTaxComplianceAct(FATCA)anyhedgefundswithAmericaninvestorsnowneedtobealerttotheriskofinadvertentnon-compliance with its provisions. Compliance with FATCA will bepainful,butthepainofnon-compliancecouldbegreaterstill.Notonlycouldhedgefundsandtheirinvestorsbehitfinanciallybyignoringthelegislation—theycouldsufferreputationaldamagetoo.

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to be?







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COO Analysis

in the recent past. Not under FATCA. “The criteria for what constitutes a US citizen are very strict” says Ross McGill, managing director at GlobeTax, a firm specialising in withholding tax issues. “If a hedge fund brings in a new investor, under FATCA, the manager must determine if the investor is an American. That is simple enough if the investor has a form W-9 or a US passport. However, if there is no US passport or W-9, managers will still need to apply other tests including, among others, the green card test and the Substantial Presence Test. If an investor has ever held a green card and not properly revoked it, they will be treated as a US person under FATCA and will have their global income reported to the IRS. Tearing up and binning a green card does not revoke it properly and FATCA will still apply. The green card has to be cancelled within the rules of the US legal system. Another way people could be caught out by FATCA is if they have a parent who was born in the US. Winston Churchill would be classified as a US taxpayer under FATCA, for example.”

Once an investor is identified as a potential American taxpayer, full disclosure by the fund manager on behalf of the investor is required. The penalties for non-compliance are severe. If a US investor fails to disclose the necessary information to the manager, the investor is classified as a “recalcitrant account holder” and subject to a 30 per cent

withholding tax on all dividends, interest and a proportion of gross proceeds paid to the investor. Hedge funds will be required to calculate and publish a so-called Passthru Payment Percentage (PPP) and send it to the IRS on a quarterly basis. The PPP will be used as part of the calculation of the penalty which the manager will need to apply to any investor who does not provide the required information to the IRS. If a fund manager does not send a PPP, they too will be forced to pay a heavy tax. Non-US investors without the proper FATCA documentation will also find themselves ensnared by these penalties.

Since the penalties are exactly that, the investor cannot claim the money back at a later date. “Investors cannot recover this cash and if they continue to be recalcitrant, hedge funds might be forced by supervisory bodies to kick these investors out of the fund” explains McGill. It is not hard to see how this might complicate relations with the most important customers of a hedge fund—their investors—but if the hedge fund fails to give the IRS what it wants, pressure will be exerted via the prime brokers to the fund instead. “Hedge funds will have an account with a prime broker,” continues McGill. “The prime broker has to ask the hedge fund if they are a participating FFI and compliant [with FATCA]. If they are not, the prime broker will be forced to hold back 30

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per cent of the dividends, interest and gross proceeds going to the whole the hedge fund. This disadvantages everyone including the underlying investors.”

Many of those investors will not be US taxpayers under any definition of that term, but this means they are going to be affected by FATCA anyway. No wonder some analysts have speculated that hedge funds would be well-advised to avoid US investors altogether, since that would reduce the burden to convincing the IRS the fund has no US investors. “While it may lead to US investors being more costly to hedge funds, managers still need to check they have no US investors that they know of. If they invest in US assets or if non-US investors act as distributors or intermediaries, hedge funds are going to have to check what exactly lies behind those entities” says Mirsky. “The Alternative Investment Management Association (AIMA) has said that where funds have contractually agreed in their prospectus not to take on US investors, they should be given a compliance pass. However, this will not happen.”

Institutional investors may not regard it as enough anyway. Given the risk-averse nature of most institutional investors, the majority of allocators will not put money in any product that is non-compliant with FATCA. “With the heavy tax consequences outlined by the current version of the legislation, non-compliance with FATCA could ultimately result in

the loss of clients for those hedge funds who fail to comply, as investors may determine that there is too much risk to invest in a fund that is non-compliant with any regulation” says Edward Russo, product marketing manager at Advent Software. “Conversely, we may also see funds cease to invest in US-based assets as they may deem the cost to comply too great. Either way, the comprehensiveness of the legislation as well as the costly ramifications of failing to comply with FATCA makes it essential for firms to start the preparation process now.”

Inside every regulation lurks a business opportunity and an IT vendor is bound to stress the operational implications of FATCA compliance. But they are likely to be profound and coincide with a wave of other regulatory obligations and planning is frustrated by the lack of clarity over what the final rules will actually look like. “Draft regulation is expected by 31 December 2011 and final regulation by summer 2012” says McGill. “The information we have so far from the IRS does not cover all of the issues. Hedge funds certainly fall into the category of an FFI but we do not know what a hedge fund would have to do to be able to avoid the big FATCA issues of documenting all investors and then filing those found to be US under the rigorous tests. The major costs being incurred at the moment are in research and planning to establish what the gap

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is between what hedge funds need to do now and what they might have to do in 2013. Many are just hoping they will not be affected much.”

FATCA also represents an opportunity for hedge fund administrators, which have long managed KYC compliance for their hedge fund clients. Though the larger money managers will almost certainly opt to do it all in-house, administrators are well placed to collect, store and submit the relevant documentation to the IRS. “We are talking to the administrators and getting them up to speed with everything to make sure everything is ready when the law comes into place” says Mirsky. “However, the requirements for additional documentation, research and the collection of information raises the question as to who pays for it. Will it be the manager or the administrator? Ultimately, it will end up as part of expense ratio of the fund and the pain will be borne by investors.”

Leaving the task to the administrator will be the default solution at a lot of hedge funds. But this does not relieve funds of the need to understand the implications of FATCA. A recent survey of fund managers by KPMG revealed 42 per cent had not “yet assessed the time needed to comply” while a mere 32 per cent reckoned they would be ready. McGill suspects “very few” hedge funds are prepared. “Hedge funds should start off by getting senior management up

to speed with the basics of what is out there now and the policy decisions that need to be made” he advises. “They need to set up a project to analyse the current guidance, gap analysis to current practice and estimate compliance costs for the fund. As soon as the regulation is out, they should implement the project plan and try to get fully compliant by 1 January 2013 rather than use the transition rules.”

There is now speculation that the European Union (EU) or even some Asian jurisdictions might introduce their own version of FATCA. Hedge funds are not popular anywhere and the average G7, G8 or G20 communiqué has been replete for years with calls for clamp-downs on tax avoidance. However, the data management implications will give European and Asian tax authorities pause for thought. The IRS could find itself having to look at the details of anywhere between 100,000 and 1 million FFIs. It is unlikely that the tax authorities of the member-states of the EU will want to take on a similar burden. “I do not think the EU will have a directive on tax avoidance in the short-term because there is not enough agreement among the individual nation states” says Debbie Payne, director at PricewaterhouseCoopers (PwC). “However, that is not to say individual countries will not take the lead and pursue their own FATCA-esque legislation.”

COO Analysis

*2010 Global Custodian Survey. † Global Finance Magazine 2010. ‡Moody’s Investors Services. “TD Securities” is a trade-mark of The Toronto-Dominion Bank and represents TD Securities Inc., TD Securities (USA) LLC, TD Securities Limited and certain investment banking activities of The Toronto-Dominion Bank and its subsidiaries. Approved for issuance in Europe by TD Securities Limited, authorised and regulated by the Financial Service Authority.

Steve Banquier • [email protected]

Peter Boffo • 416.983.1356 [email protected]

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Rich MarinRich Marin is a motorcycling enthusiast but no investment biker. For him, the gentle hills of Tuscany and Provence are preferable to the harsh landscapes of ice and desert. The challenges he prefers can found in the markets. Wherever there are distressed assets, or a funding crisis, or both, Rich Marin can usually be found at the centre of the action. He is also the founding father of COOConnect.

COOConnect owes a debt of honour to Rich Marin. He is the

man who first conceived of what is now the COOConnect peer group network of buy-side COOs. It was 9 May 2008 that a group of 40 COOs met at the Cornell Club in New York

under the auspices of the Pointwalk Solutions Network, a hedge fund COO forum created by Rich Marin at the height of a liquidity crisis that forced prime brokers to cut their lending to hedge funds because they could not fund themselves in the

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wholesale money markets. History prefers to remember that the financial crisis really began with the collapse of Lehman Brothers in September that year, but it was as early as the summer of 2007 that investment banks first found their daily counterparties were no longer there for them every morning and it was in March 2008 that the Federal Reserve was forced to lend directly to US broker-dealers for the first time in history

or risk the collapse of the entire financial system. No wonder that meeting at the Cornell Club was given over to managing and mitigating counterparty risk. After all, it was the events of June 2007 to March 2008 that had finally forced Bear Stearns to sell itself to J.P. Morgan. Nobody knew that history better than Rich Marin, since he was chief executive of Bear Stearns Asset Management when the world of investment banking first began to change—and change irrevocably—in that summer of 2007.

By then Rich Marin could look back at 30 years on Wall Street. He had joined the graduate programme at Bankers Trust in 1976, armed with nothing but a BA in economics from Cornell and an MBA from its Johnson Business School and now marvels at the nonchalance with which major financial institutions then threw graduate trainees into the fray. “I was

put on a

training programme by

Bankers Trust and came through that okay” recalls Marin. “I was then put out on the line and told I was in finance.” What proved to be a quarter century at Bankers Trust started in the unglamorous Financial Institutions Group (FIG), which was responsible for settling and servicing the securities trades of banking and insurance clients of the bank and lending their assets to broker-dealers. In those days, the loans were not to cover short sales, but undelivered securities, thereby averting settlement failures.

“We also created a lot of new alternative

products, including a US$2 billion fund of

hedge funds. That was at a time when there

were not many of those around.”

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“The securities lending job is obviously not the same today as it was then, because it is now driven by hedge funds covering short sales” recalls Marin. “Back in the 1970s, it was driven mainly by settlement needs.” But if FIG gave Marin irreplaceable experience of nut-and-bolts securities processing, it was not the place for the ambitious to linger. Marin quickly moved into the sexiest business in the banking industry of the late 1970s and early 1980s: advising multi-national corporations on their multi-currency borrowing needs. With exchange controls still in place in a great many countries, it was a business which drove the exchange-traded interest rate and currency futures and options and spawned the first interest rate and currency swaps—the earliest products in what became the enormous OTC derivatives industry of the 21st century.

“I had a heavy involvement in helping companies hedge their interest rate exposures” explains Marin. “I had to set up Bankers Trust’s first futures and options subsidiary and I did this in New York, Chicago, London and Singapore. We became early leaders in the futures and options world. We transacted for clients in these new markets and because people did not know how they worked, we had to educate them. We then started OTC solutions for clients as they preferred

OTC contracts rather than operating moment by moment on exchanges. We created some of the earliest derivatives because we started creating swaps on the backs of futures that people were trading.” Swaps of another kind—debt for equity—also proved a useful tool for profiting from the great debt crisis of the early 1980s, which assumed its most acute form in Latin America. Though Bankers Trust had relatively limited exposure to bad debt (in fact, its US$4 billion looks positively puny by comparison with the cost of rescuing, say, AIG) the bank needed to find a way to rescuing its Latin American assets from being completely written off. The results was two whole new markets, in debt for equity swaps and sovereign debt trading.

“We had to look for alternative approaches to exit our Latin American debt and what came out of it were two brand new and incredibly lucrative markets” recalls Marin. Bankers Trust set about identifying and securing interests in potentially profitable Latin American companies struggling with an excessive burden of debt. The banks would then look to sell the companies for hard currency to multi-nationals, making a neat profit. In effect, Marin and his colleagues used the Latin American debt crisis to create one of the first emerging markets departments in any major investment bank. Marin

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headed it for a while. “It was a lucrative activity for Bankers Trust and we were able to use the knowledge that we had developed around debt for equity swaps and acquisitions of companies to take full advantage” says Marin. “We looked at every type of company that was out there—hotels on the coast of Mexico, goldmines in Brazil, insurance and utility companies in Chile. We were all over the map as there was debt all over the map. We pretty much formed the rules in most of these countries for debt for equity swaps. We led the way.”

If swaps and emerging markets introduced Rich Marin to the merits of

arbitraging different markets, it was not until he was invited to run the private banking arm of Bankers Trust that he first came across hedge funds. The “architects of value,” as Bankers Trust

liked to dub itself, were as unafraid of using derivatives for investment products as they were for corporate clients (it was in 1994 that Procter & Gamble and Gibson Greetings sued Bankers Trust for losses incurred on derivatives contracts).“During this time, we got private banking clients heavily involved in derivatives” recalls Marin. “We also created a lot of new alternative products, including a US$2 billion fund of hedge funds. That was at a time when there were not many of those around.” It proved a handy segue into the buy-side after Bankers Trust was acquired by Deutsche Bank in 1998 for US$10.1 billion. Marin, who

initially thought he would lose his job after the merger, was instead asked to take over Deutsche

We were all over the map as there was debt all over the map.

We pretty much formed the rules in most of these countries for debt for equity swaps. We led

the way.

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TWITTER BIO: BT '76-00 securities, sovereigns, swaps; Beehive '00-03, private equity; BSAM '03-'07, CEO + crisis; '07-now, hedge funds + real estate

COO Person

Asset Management. “Integrating Deutsche Bank, Morgan Grenfell, Bankers Trust and Alex Brown was a challenge” he says. “When I left, Deutsche Bank Asset Management had approximately US$325 billion in assets under management and was the fourth largest asset manager in the US. I decided to do something smaller.”

Something smaller was a venture capital fund called Beehive Ventures, which Marin set up in 2000 with US$20 million of seed capital from his former employers.

Launched at the very moment the TMT bubble burst, it was hard going at first and Marin lost interest (though he adds that the original investors have now multiplied their initial capital allocations five times over). “In the first few years, it was a tough time to launch a venture capital firm and there was not enough work for me” he recalls. “It was at that point I heard from Warren Spector of Bear Stearns. He asked me if I wanted to become chairman and chief executive officer of BSAM and I obliged.” When he joined in 2003, BSAM was not as small as Beehive, but it was not large

either. In fact, it was a US$150 million business losing US$15 million a year. “It was the one area where Bear Stearns was not on the map” says Marin. “Over the course of the next four years, we grew a lot, to US$550 million in revenues and US$155 million in profits. We set up a small array of hedge funds. We had an aggressive seeding programme and we launched a dozen or so proprietary hedge funds during my tenure. We also started a fund of hedge funds business.

And then 2007 happened.”

What happened was that two Bear Stearns hedge funds—the US$1 billion Bear Stearns High Grade Structured Credit Fund and the US$650 million Bear Stearns High Grade Structured Credit Enhanced Leverage Fund—declared bankruptcy on 31 July 2007, prompting a crisis in the repo market that undermined the funding of all investment banks. Both the BSAM hedge funds had high exposure to the sub-prime mortgages and asset backed securities that the major credit rating agencies had rated somewhere

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TWITTER BIO: BT '76-00 securities, sovereigns, swaps; Beehive '00-03, private equity; BSAM '03-'07, CEO + crisis; '07-now, hedge funds + real estate

COO Person

between AAA and A. The story of how Marin and his colleagues sought throughout May and June of 2007 to rescue investors’ money from the steadily deteriorating mark-to-market value of these assets without destroying Bear Stearns as a whole in the process is well told by Bill Cohan in House of Cards, but even better told by the authors of the Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States. There, readers can learn how the same investment

banks that had sold the two hedge funds its rapidly depleting assets not only refused to fund them but actually marked their prices down—precipitating and exacerbating the crisis in the repo market.

“Our two hedge funds were basically the first bungalows on the beach to be hit by the tsunami and were wiped out in the fairly dramatic June of 2007” recalls Marin. “We were in the trenches fighting as hard as we could to save investors money.” In the end Bear Stearns loaned US$1.6 billion to repay the repo lenders to the High Grade Structured Credit

Fund, effectively becoming its sole repo financier, but concluded, in the words of the National Commission report, that the High Grade Structured Credit Enhanced Leverage Fund was “on its own.” Its losses totaled 100 per cent, while the High Grade Structured Credit Fund was down 91 per cent at bankruptcy. By then, Marin had stepped down as chairman and CEO, following unkind revelations in the New York Times of the contents of a personal blog chronicling his motorcycling trips, his

family life and his movie reviews.

In an entry

penned at the height

of the crisis, Marin described his efforts to save investors’ money from ravenous and predatory investment banks as like “trying to defend Sparta against the Persian hordes of Wall Street. Nothing like a good dog fight 24x7 for a few weeks to remind you why you chose the life you chose. The good news is that after two embattled weeks both I and my loyal staff are still standing to fight another day.” An honourable stance and not only by the too-much-information standards of some celebrity indiscretions, but Marin stood down as chairman and CEO of

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BSAM on the same day as the New York Times article appeared: 28 June 2007. He remained as an advisor until the end of the year.

It was a painful episode. “The blog talked about my personal stuff and it was intended for family and friends only” recalls Marin. “The New York Times tried to paint me as irresponsible because after two, non-stop 16 hour days in the office, I went to the cinema for two hours with my wife. I do not drink so I do not spend my time in bars after work. If going to a movie with my wife is the worst anyone can say about me, then go ahead. Although, I do not blog about films anymore.” Certainly his behaviour at the height of the crisis and his demeanour after it, were more honourable and more diligent than the Nero-like feuding and bridge-playing of Jimmy Cayne (CEO of Bear Stearns) and Warren Spector (the heir apparent who had hired Rich Marin to run BSAM). But inevitably, as chairman and CEO of BSAM at such a critical time, Marin has faced criticism for not anticipating the disaster. As he says, hindsight is a wonderful thing. “I was the captain of a ship that sunk so how can you not wish you either had not set sail or taken the route you did?,” he asks. “The route we took was a well travelled route and was a route which many other institutions in the mortgage area were taking. Mortgages were what

Bear Stearns was all about—it was our expertise and it was therefore a logical place to create funds. Our hedge funds had 40 months of consecutive, positive, steady returns. The funds went along beautifully until they did not, when this freak of nature, which was a black swan, occurred. It caught 99.9 per cent of sophisticated financial investors out and our ships sunk. Short of not launching the funds, there was no way we could have avoided it. If I had chosen not to take helm of the funds, someone else would have and no captain could have negotiated those stormy waters any better than I could have.”

Any fund manager or investor with exposure to sub-prime mortgages or derivatives of sub-prime mortgages lost money in 2008—even Goldman Sachs claims to have lost US$1.2 billion in its mortgage business during the two years of the most intense phase of the crisis—but it was the additional leverage in the one BSAM fund that was unusual. Marin acknowledges high leverage “was what bit the hedge funds in the ass when the proverbial shit hit the fan. In hindsight, we should not have launched the enhanced leveraged fund.” However, it was investor demands for greater returns (and hence more risk) that prompted BSAM to launch the fund in the first place. “Most investors

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put more cash into the higher levered fund” explains Marin. “While the lower levered fund did not survive either, maybe the absence of the higher levered fund would have saved it.” It seems unlikely, given

the magnitude of the crisis that unfolded. Bear Stearns had to sell

itself to J.P. Morgan in March 2008. By then Marin had moved on to the advisory role at Duff Capital, whence he put his direct knowledge of the repo funding crisis to work in setting up the hedge fund COO forum that met at the Cornell Clun in May that year. Later, he took charge of a US$3 billion distressed real estate portfolio owned by the Africa Israel Fund and restructured its financing successfully. He also started teaching graduates at his alma mater—Cornell University—about the practicalities of investment banking and hedge funds. “I am not an academic but a lot of people teach students theory and not the practical issues” says Marin. “I teach the graduates about the back office, the importance of chief operating officers, securities lending and pension funds—some of the great, underappreciated segments of capital markets.”

Certainly, the experience of three decades of triumphs and disasters on Wall Street is worth a ton of textbooks. Rich Marin is also one

of those rare individuals who can imbue his fellow human beings with the conviction that anything is possible—which was how he inspired COOConnect. That capacity to inspire reflects the fact that Rich Marin believes in himself and his ideas so passionately that, even in his lowest moments, he is never tempted to stay on the canvas. His latest challenge is a billion dollar hedge fund focused on the deeply distressed US residential mortgage market. “Trying to solve a problem when markets are distressed and disrupted is exciting and the mortgage market is about as distressed as they get right now” he explains. “Creating this hedge fund and finding a path to create opportunities and solving problems is so rewarding. I would say my time at Bankers Trust during the Latin American crisis and helping to solve that was a career highlight for me. Fixing big problems often creates opportunities. During Bankers Trust’s merger with Deutsche Bank, I learnt a lot about transitioning too.” He is rightly philosophical also about the setbacks he has faced. “I learned a lot from failures, particularly Bear Stearns” he says. “I like challenges, though. Running a steady business and making good money and doing the same old, same old each day does not turn me on.”

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COO Investor

An ODDperspective

As head of operational due diligence at Stenham Asset

Management, Nicola Rendall is at the centre of the profession that has rescued the funds of

funds industry from its own follies in the years immediately after the great financial crisis.

COO visited Rendall at her London office.

As a class, funds of hedge funds (FoHFs) were put to the ultimate

test in 2008-09 and failed it. FoHFs were meant to offer access to the best managers in exchange for relatively small amounts of money, diversification of risk through holding a portfolio of strategies, understanding of the risks inherent to each investment strategy in their portfolio, and sensible shifts in

allocations as those risks loomed on the horizon or faded away. Above all, they claimed to offer a well-informed entry point to an industry which was then more fragmented, opaque and loosely regulated than it is today. Though FoHFs faced criticism from the outset that they were no more than high cost marketing operations, it was their knowledge and access which justified the additional

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(and often outrageously high) level of fees they charged. Yet they not only performed woefully in the crisis, but lost their reputation for knowledge, diversification and due diligence. The money channelled to Bernie Madoff by the Fairfield Greenwich group symbolised how easy it was to raise money then and how low the barriers to entry to the FoHF business had become.

That performance accounts for several of the more obvious changes to hedge fund investing that have taken place since 2008: a preference for investing directly, a more aggressive approach to fees and a more searching

approach to due diligence. Almost 200 FoHFs shut their doors during the first quarter of 2009, a single quarterly record for FoHF failures according to data providers Hedge Fund Research. A May 2011 poll by research specialists Preqin revealed 40 per cent of institutional investors are beginning to favour investing directly into hedge funds instead of through a FoHF. But

FoHFs have worked hard to rebuild their reputation by creating a whole new profession of operational due diligence. Despite the retreat of 2009, it seems to have worked: against the odds, FoHFs have survived. 45 per cent of the investors that took part in the Goldman Sachs hedge fund investor survey last year were funds of hedge funds and they accounted for 49 per cent of the AuM in that study too. In the equivalent study by J.P. Morgan, FoHFs accounted for 46 per cent of respondents.

Nicola Rendell, head of operational due diligence at the US$3.2 billion, London-based FoHF Stenham Asset

Management, is not surprised. A qualified Chartered Management Accountant (ACMA), she arrived at Stenham four years ago from a role as an equity analyst at UBS just as the crisis took hold and reckons the respectable performance of the group in 2008-09 vindicated the Stenham version of the FoHF model. Indeed, she defends FoHFs on the same grounds

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as they were sold—if not always delivered—between 2002 and 2007. “We, as a FoHF, would argue that if you invest directly into a hedge fund you lose the benefits of diversification” she says. “Therefore, an investor is directly exposed to the draw-downs on individual funds. Whereas we feel we can produce a portfolio that limits the downside but delivers absolute returns. We invest into funds that pass our due diligence checks and veto funds which we deem to be risky. Whether an investor has the resources we have to do that is open to debate. Furthermore, our expertise is renowned in this area.”

If the arguments for funds of funds have not changed, it is not because they were ever untrue, but because practitioners and investors forgot them at the height of the boom. What some would see as a short memory on the party of investors, or a case of closing the stable door after the horse has bolted, Rendall prefers to describe as a better understanding of what was right and what was wrong with the FoHF mode. “Operational due diligence has come to the forefront of investor concerns since 2008” she says. “When I first joined the firm, I recall seeing maybe one in three clients and talking about the issues at hand with an investment. Now, everybody wants to see me and discuss operational due diligence.” To say that operational

due diligence is of greater importance since the crisis is an understatement. Investors will not allocate capital to a fund manager or strategy if the head of operational due diligence vetoes it. “At Stenham, if we find a red-flag in a potential investment, there is no investment under any circumstances” explains Rendall. “If the operational due diligence team here say no, it means no.”

So what is Stenham buying? It currently invests in global macro, long/short equity, event driven, relative value and commodities. Rendall says the firm was always a risk-averse investor, not least because many of its clients are inherently conservative pension funds and family offices seeking absolute returns without excessive volatility. Conservatism was a word that played less well with the greedier type of investor prior to 2008, but served Stenham well in the crisis and is helping attract new clients now. “Unlike many firms, we do not accept anything at face value nor do we just tick boxes next to a check list,” says Rendall. “We constantly probe on-site and review managers regularly regardless of whether they are running an emerging or traditional, long-standing fund.” This monitoring role has got a lot easier since the crisis, because a capital-rising market in which investors reject four out of five proposals on lack of transparency

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grounds alone has forced hedge funds to disclose much more information than they did before the crisis. Capital-hungry funds are also readier to engage in a due diligence process that can take months to reach a decision that may not even be favourable.

A June 2011 poll by Preqin found 96 per cent of investors surveyed thought the level of hedge fund transparency had improved—up from 42 per cent as recently as last year. “Many individuals in operational due diligence, particularly pre-2008, struggled to gain access to hedge fund managers who would let them perform on-site visits and checks” says Rendall. “Since the crisis, I have never experienced hostility or reluctance on the managers’ parts when I ask to do an on-site visit. When we are on-site, we expect to meet all members of key operational staff at both the senior and junior levels. We verify and test the system processes and the reconciliations performed—for example, asking to see the net asset value (NAV) pack and requesting demonstrations of the trade flows, among other checks. We want to get a feel for how funds operate on a day-to-day basis. We demand there must be an on-site visit prior to any investment, even if that means flying halfway around the world. Understanding the operational aspects of the trading cycle is absolutely essential. Having been an

accountant and read countless financial statements, it helps me identify whether the fund is providing us with accurate information.”

Better still is information that comes from other sources. Rendall makes investment conditional on third party verification and valuation of assets. “Valuation is of prime importance,” she stresses. “In 2008, many funds were caught out by illiquidity and this problem was only exacerbated by the levels of leverage in the market. We weathered the storm fairly well but that is only because we put a special emphasis on valuation and the quality of the administrators, alongside rigorous monitoring of our underlying exposures.” This emphasis has drawn administrators into the due diligence process. “We also perform due diligence reviews of the administrator and we deem some administrators to be stronger than others” says Rendall. “We always receive confirmations from the administrator for verification of assets and pricing independence. If there are hard-to-value assets in a portfolio, we want to understand the pricing methodologies employed and how the administrator verifies the portfolio independently. We do not accept prices sourced from the manager.” The implication—that FoHFs once did exactly that—is an apt measure of what has changed.

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COO Feature

Investors want funds to prepare for the worst

An operational due diligence (ODD) professional tells the story of

the disaster recovery plan he found at a hedge fund. It was a second server based at the home of a partner. Another says one fund he visited had no back-up plan at all: the data sat on a single server beneath the desk of a trader. But then people do not become hedge fund managers because they are interested in technology, or the management of operational risk. However, indifference or complacency is no longer an option. The rise of ODD means that someone inside or outside their organisation has to ensure that neither flood nor fire nor earthquake nor riot will lead to catastrophic loss of data.

“The investor community allocating capital into hedge funds want these institutions to have solid disaster recovery systems in place” says Bob Guilbert, managing director for marketing and products at Eze Castle Integration. “These investors do not want trading to be restricted in the event of a fire. A hedge fund manager cannot trade stock if they are restricted so disaster recovery systems are essential for protecting operations and investor assets.” The disaster recovery plan is now a standard question in ODD questionnaires. In

fact, the Dodd Frank Act makes one obligatory (see “What Dodd Frank Wants to See”). But exactly what threats should a manager prepare for?

One is infrastructural breakdown. “The worst case scenario for a hedge fund would be a limited interruption affecting its business—for example, a loss of telecommunications or power outage during a period of market stress,” says John Metzner, president at the New York-based long/short fund Plural Investments. “There are so many threats to business continuity out there. Power outages are a serious issue. There is a lot activity on the street, like construction and road works, and all it takes is for someone to cut through some cables. I have witnessed pipes bursting and flooding data centres, and on hot New York days, there is the risk of power problems related to increased overall demand.”

Cyber-attacks are a growing threat, highlighted by the hackings of major corporations. In June, Michael Hintze, founder of London-based CQS, told investors that this was one of his main concerns. “If an individual hacks into a fund manager’s computer, it can cause significant problems” explains Metzner. “The reputational risks to the manager can be severe. Somebody

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COO Feature

could access a manager’s e-mail and start firing off random messages. Or, more seriously, an individual could access portfolio data and possibly even trade, which could have a major effect on the portfolio.” Institutional investors expect managers to take precautions against such eminently preventable risks.

“Some of the preventive measures are fairly basic” adds Metzner. “For example, encouraging staff to regularly change their email passwords and use complex passwords. It is also essential for managers to have a solid firewall and perimeter protection. These systems should be regularly stress-tested. There are service providers out there that businesses can hire to identify vulnerabilities or flaws.” Most major funds have anti-hacking systems of this kind already. “Plural Investments invests in technologies to help avoid these constantly changing threats” says Metzner. Smaller funds may be less prepared, but even large funds can be vulnerable. “Hacking is often down to the user” warns Christian Robertson, COO at Paladyne Systems.

“If somebody clicks on something they should not, for example.”

Preventing the replication of viruses that access systems in this way is one of the claims made for cloud computing, because it can replicate data continuously,

enabling managers to access a recent version in the

event of disaster. “We use something called snapshot

technology” explains Guilbert. “Our disaster recovery systems

ensure that the virus is contained. Snapshot technology effectively takes a snapshot of the data every 15 minutes on the hedge fund’s system and replicates it onto the disaster recovery system. If a virus made it onto the disaster recovery system, we can just go to the previous snapshot and isolate it.”

Most major funds have remote data centres, but investors are now probing the service providers they choose. “This is something that was not done in the past but since 2008 many investors have become significantly more educated and are increasingly diligent stresses” says Julian Stockley Smith, joint CEO at JP Fund Services in Switzerland. “Investors are increasingly conducting compliance and even background checks on the funds’ technology providers.”

Bob Guilbert, EzeCastleIntegration

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Guilbert agrees. “The due diligence has got increasingly vigorous” he says. “Some investors will ask basic questions like, `Is there a disaster recovery system in place? Yes or no?’ Others will be broader and be more in depth. Their questions might include, `Who are the key people with access to data centres and where will they meet?’ These investors want to make sure they understand the key parts of the application to keep the business up and running in a disaster. Many of these investors will demand regular stress testing and will want full confidence about knowing how the system works.”

Investor pressure is encouraging funds to bolster their back-up. “Funds should be able to instantly re-create all of their data and files, at any time of day, from storage at a remote location with a separate power and ideally also at a remote location that has all necessary office equipment” says Hamlin Lovell, a former freelance consultant. Plural Investments, for example, has a data centre outside New York which is synchronised with the primary data centre. It ensures all data and information is replicated so the team can work from the secondary location if a crisis occurs. “In the event of a problem, we adopt two standards: mission-critical and non-mission-critical”

explains Metzner. “Mission-critical includes our trading system, whereas non-mission-critical would be something like human resources. Down time in the latter would not be an immediate, major issue for the business. It is essential

that hedge funds have these systems in place

because they have a fiduciary responsibility and

obligation to the clients for the safekeeping of their assets.”

He thinks prime brokers could help smaller funds by providing them with hosted data centres. “I think the prime brokers could do a tremendous job with that” says Metzner. “But I think they may worry about the liability in the unlikely event of an error.”

There is also a genuine debate about whether all funds need to incur the expense of real-time back-up. The stock answer is to tailor plans to strategy. Funds with large open positions, or high-frequency traders, need real-time recovery, while funds which trade a few times each day do not. “Real-time disaster recovery for internal systems is not necessarily essential to support all fund strategies” says Marshall Saffer, COO at technology provider MIK Solutions. “Greater demands for real-time disaster recovery exist in highly leveraged or quantitative approaches

COO Feature

Greg Collins, JPReis

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where trading may be taking place in fast moving or volatile markets.”

Steve Pailthorpe, group marketing manager at technology firm Commensus, disagrees. He says any meaningful disaster recovery plan depends on real time-synchronisation. “There is not much point having disaster recovery if it is backed up overnight,” he argues. “Real-time synchronisation ensures you never lose any data. It is the best way to fully protect against the unexpected.” Certainly there remain weaknesses in the systems deployed. “People buy these

complex systems and test them for just one disaster—for example, a loss of infrastructure,” says Greg Collins, CEO at technology consultancy JP Reis. “But they do not take

into account other disasters. Take SARS in Canada—the

systems were there but the people were not able to access

them anywhere. How can you do business if people cannot get

into either the office or the data centre? There needs to be remote access of some kind. People need to think about as many scenarios as possible when it comes down to disaster recovery.” Increasingly, capital allocations depend on it.

What Dodd Frank Wants to See• Risk analysis and oversight to identify and minimise sources of operational

risk, through the development of appropriate controls and procedures and automated systems, that are reliable and secure and adequately scalable;

• Emergency procedures, back-up facilities and a plan for disaster recovery that allows for the timely recovery and resumption of operations; and the fulfilment of the responsibilities and obligations of the facility affected;

• Periodic testing to verify that the back-up resources of the facility are sufficient to ensure the continuation of order processing and trade matching, price reporting, market surveillance and comprehensive and accurate audit trails;

• Plans to maintain records of all activities related to the business of the facility, including a complete audit trail in a form and manner that is acceptable to the Commission; and going back for a period of not less than five years.

COO Feature

Source:EzeCastleIntegration

John Metzner, PluralInvestments

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COO Q&A

The fund administrator for a fatter, less free-booting futureHedge fund administration is a curious business, which consolidates and fragments at the same time. The barriers to entry are low and scale is hard to achieve. The private equity funds that persuaded themselves such a fragmented industry was a classic roll-up opportunity have learned to their cost that fragmentation is itself a prophylactic against being acquired. If the biggest provider started buying administrators at the bottom of the current list of 72 providers in order of size, it would have to acquire fifty-five firms before doubling its AuA. One of them would be owned by BNP Paribas. COO asked Chris Adams, global head of hedge fund solutions at the French custodian bank why it bothers to be in the industry at all.

By AuA, BNP Paribas is an eighth the size of the largest provider and half the size of the next biggest global custodian. Catching up will be hard to achieve organically. Are you in the market to acquire and, if so, what sort of AuA is needed to move the dial?

We think the market remains challenging for smaller providers. Consolidation in the fund administration space is similar to what occurred in the global custodian space, whereby businesses needed to achieve a critical mass to survive.

So what explains the long tail of tiny administrators, and the relatively small number of mergers and acquisitions in the industry?

The relatively large number of small administrators is down to the

fact, at least in part, that many have close relationships with a relatively small number of clients, to whom they provide a tailored service, often at a modest cost. However, I cannot say that I agree on the consolidation point—there have been a spate of mergers recently with Northern Trust acquiring Omnium, and Wells Fargo’s move to acquire LaCrosse Global Fund Services. So from our perspective, the pace of consolidation is actually picking up.

Do you ever wonder if it is worth being in the hedge fund administration business at all? What essential capabilities or synergies does it offer BNP Paribas Securities Services?

There are two clear reasons why we are in the business. The first

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COO Q&A

is that major hedge fund groups are increasingly behaving like institutional asset managers, which are of course our historical, core client base. So we are very well equipped to support them. And increasingly, our so-called traditional asset manager and asset owner clients are allocating ever increasing assets into alternatives—and they expect us to be able to service all of the classes in which they invest.

Why should clients choose BNP Paribas rather than, say, Citco?

Our service is different. First and most importantly, we are a universal bank with a strong credit rating. As the largest provider of services to UCITS funds in Europe, we are also able to use a common infrastructure for both regulated and unregulated funds. If a hedge fund manager wants to launch a UCITS fund, or a long only manager wants to launch a hedge fund, our service is identical—in terms of the way the services are rendered, the locations they are delivered from and the infrastructure used. If, for example, a manager has a hedge fund investing in OTC derivatives and needs daily valuations of those assets, we can satisfy that need because it is something we do every day for our regulated clients. We operate off a

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common platform. That is a major differentiator. Furthermore, our NAV calculation capabilities and controls are cutting edge.

Is it really possible to achieve competitive advantage in NAV calculation?

It absolutely is. With our UCITS heritage, it is business as usual for us to provide daily valuations across the broadest range of assets and, realistically, only service providers with a strong regulated or UCITS heritage can readily do this.

What other services do you provide? Investor servicing and middle office capabilities, as well as a range of value added services, including FX hedging, collateral management, OTC valuation and risk and performance reporting. We work across a broad range of hedge fund strategies although, approximately 60% of our clients have equity-based strategies. However, we also have a number of niche areas of specialty including debt structures and we have just launched a service for carbon funds.

What type of clients do you look for?We work with approximately 500 single hedge funds and funds of hedge funds (FoHFs) across 12

locations and jurisdictions. We also have a mix of onshore and offshore clients . We have offices in the Cayman Islands as well as Ireland, Luxembourg and other European Union (EU) jurisdictions, together with the US, Singapore and Australia, from where we service both onshore and offshore clients.

Most people in the industry say BNP Paribas is a fund of funds specialist. How fair is that?

We are happy to be considered a specialist in the fund of fund space. However, we have a similar value of assets in the single hedge fund space as well—in excess of the US$1 trillion worth of assets that we provide administration to overall.

Are you surprised that funds of funds have survived a crisis in which their business model signally failed to deliver on their self-proclaimed raison d’etre, i.e. steady returns at lower risk?

No, we are not particularly surprised, as certain types of investors will always seek strategy diversification through fund of hedge funds structures.

In what ways do you expect regulation of the industry to affect the way your clients go about their business?

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All hedge funds, whether they are domiciled in the Cayman Islands or Luxembourg, are regulated to some degree already. The Alternative Investment Fund Managers Directive (AIFMD) is being implemented gradually and we do not expect it to have a material impact on our clients before it is implemented in full in 2018. We have spoken to clients about it and, while many of them are certainly talking about it, they are not rushing to change their businesses just yet. Dodd Frank, on the other hand, is a different story. Hedge funds need to be registered with the Securities and Exchange Commission (SEC) by March 2012 and fully compliant with its rules and regulations. Because it is now just a matter of months away, more of our clients are discussing Dodd Frank than AIFMD. I do not subscribe to the view that regulation in the EU will push hedge funds onshore en masse. Rumours of the demise of Cayman are over-stated. Although certain investors will remain averse to Cayman funds, Cayman has actually seen an increase in the number of funds domiciled there. Hedge funds moving onshore are doing so regardless of AIFMD. Most are doing it because their investors—typically, pension funds—want them to go onshore.

In what other ways are investors putting more pressure on your clients?

We are getting more demands for daily reporting, which is partially down to investor pressure but the main driver for this is the managers themselves. The decision as to whether to outsource all back and middle office functions remains an interesting issue and there are a lot of divides between managers. Some of the larger shops are considering taking the middle office piece back in house because they want full control over the risk even though it is more costly. Others say completely the opposite. For the smaller managers, it is often less important as their trading volumes are typically lower.

In the early stages of the crisis capital flowed to the larger, institutional quality funds. As they have filled up, have you seen investors showing interest in smaller funds?

We tend to service the bigger funds and funds of funds, so we are seeing a continuing pattern of consolidation among our clients. In some ways, it would be easier to service smaller clients, because the consolidation on the funds side raises challenges for us. We have to deliver an increasingly sophisticated and diverse set of services. But that is something we are committed to achieve.

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Institutional investment in hedge funds owes much to the work of academics

such as Andrew Lo of MIT, Bill Fung of NYU and LBS, Martin Eling of the University of Ulm and Roger Ibbotson, now a professor at Yale.

Their work demonstrated the benefits of hedge funds over traditional asset classes. They improved understanding of dynamic trading over the active or passive buy-and-hold strategies.

Later academic work illuminated the performance and liquidity characteristics of hedge funds, concerns over survivorship bias in indices and other pitfalls in a lightly regulated, self-reporting industry.

The rationale for institutional flows, such as low correlation and absolute return in all conditions, was initially validated by academics. This work supported what consultants and industry practitioners had argued for years: hedge funds are a good investment.

This perception was tested in 2007-09. So are hedge funds still a good idea? The most likely answer is yes. Are institutions still allocating funds to the sector today? The answer is definitely yes, albeit at a slower and more deliberate pace than they did during the go-go years.

An interesting question is the impact of the crisis on academic study of hedge funds and how their current work might influence institutional thinking now. Work is clearly in hand. A Google Scholar search for articles written about hedge funds since 2009 yields over 5,400 results.

The variety of focus within that total is obviously wide, but the texts that have received the highest number of hits from viewers on Google Scholar gives some indication of what hedge fund investors are interested in today.

There is interest in whether hedge funds are generating alpha or beta; the risks associated with different strategies; consistency in performance; the impact of size and age on returns; the effect of failures and survivorship bias in performance reporting; the impact of fee structures on performance; tail risk; correlation with traditional assets; and liquidity.

A systematic examination of the studies being published today can yield valuable insights into how institutional money might move into the industry over the next few years. I will be looking at exactly this in future issues.

Kevin Mirabile,

Professoroffinance

atFordhamUniveisity

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