Back office fraternity set for lead role

The notion of dusty, back office boffins, seldom let out into the asset management spotlight, is certainly changing from the 1990s, when John Serhant, formerly boss of State Street, described custody as a “necessary evil”, which nobody cared about. A major trend setter in this sphere is Citigroup, whose global head of securities and fund services, Neeraj Sahai, has strong plans for restructuring the asset management industry

PWM: Are custodians and prime brokers now expected to play a much more intrusive role in monitoring the exposures of asset managers, particularly in the multi-manager, multi-asset world, to avoid, for example, the purchase of fraudulent funds like Madoff or the overweight of sub-prime related assets?

Neeraj Sahai: I do not see custodians in the traditional sense being expected to take a view on clients’ investment decisions, but there will clearly be an increased regulatory focus looking at the roles of trustees and fiduciary agents in the way they perform their due diligence of sub-custodians and the visibility they have of the underlying assets of the fund clients and the safety of the appointed custodians. There have been demands for more transparency of hedge funds in the wake of the Stanford and Madoff affairs. Banks can use the leverage of twin roles as prime broker and custodian to develop a hybrid service such as ‘prime custody’, allowing a hedge fund’s unencumbered assets to be held by the custody arm while delivering combined reporting for all the assets, including those held at the prime brokerage.

Fund compliance programmes have continued to evolve as compliance departments seek the best methods to improve them. The economic crisis has made this process more challenging because of the new and emerging risks that have been identified. Maintaining an effective compliance programme in today’s market and regulatory environment requires significant resources. Custodians and fund administrators will increasingly work as trusted advisers with their asset manager clients.

PWM: What are your views on the future of hedge fund administration, regarding the changes expected from the new European directive?

Neeraj Sahai: The common view of the industry on the AIFM Directive is that it could have, in its current form, a detrimental effect for the EU, and London in particular, as a financial centre. We could see hedge funds re-locate to other non EU countries, eg Switzerland, or other regions globally such as the Cayman Islands. The hedge fund administration industry will need to be very flexible in the way they offer services.

Given the proposed stricter liability rules for depositaries, some players may have to make strategic choices whether they actually want to remain in this business and if so how they would factor in the increased risk into their pricing. If hedge fund administrators look into exit strategies, this would lead to greater concentration risk of the fund industry as a whole, which is undesirable for the public and private sector alike.

The newly proposed EU legislation will be critical to the future of hedge fund administration, although its ultimate design remains unclear at this point. Given the response of the industry and national securities regulators, the European regulators have made some amendments but there appears to be need for further progress on the design of the law.

PWM: Will Luxembourg, Dublin and perhaps Malta benefit hugely, as fund houses restructure alternative investments under a Ucits III banner in order to escape regulation, or will the Cayman Islands, Bermuda and BVI re-invent themselves with greater expertise, more transparency and begin to co-operate in a politically acceptable way with the US administration? And who will benefit most from the new order envisaged by the European directive?

Neeraj Sahai: This is uncertain and will depend on how the AIFM Directive will ultimately be scoped. Removing regulatory arbitrage through the creation of a level playing field among member states will certainly benefit the EU as a region for the provision of asset management and administration services. It seems that the US and EU administrations are both working to enhance transatlantic co-operation to ensure a globally consistent approach for this industry, which is not local or regional in nature but global.

PWM: What will be the role of custody, back office and technology providers in the so-called ‘flight to quality’, with private clients preferring the safety of well-known institutions and high profile products, after the crisis?

Neeraj Sahai: The crisis has unalterably changed the way asset managers run their businesses. They must provide high-quality customer and operational services in the face of this increased market volatility and fluctuating assets. Even the largest firms are finding the only way they can accomplish this high level of service is by strategically outsourcing more back- and middle-office functions to a full-service provider that can adjust with their needs and provide a long-range vision for growth.

One of the key questions is scale. Before, it was just number of accounts and size of assets. Now the new utopia is getting as close as you can to one platform across the product mix, across service lines and jurisdictions. The recent market dislocation has led to one overriding effect: funds are redefining previous protocols and adopting a more efficient, best-practices operating model. Hedge funds are under intense scrutiny to meet market, statutory and regulatory demands while remaining focused on their investment strategy. They are attempting to generate alpha and control fees and expenses while ensuring proper risk management and transparency demanded by their investor base. In this environment, performance is no longer the primary investment criterion. Investors consider risk management, compliance and transparency to be as important.

We believe the role of a custodian has shifted from safe-keeping and settlement to more of a risk management and cost-containment function and about reducing the total cost of ownership for a client through the entire investment lifecycle. A processing powerhouse is only part of the story. The ability of a custodian to offer a range of services will be key as clients look to push the burden of non-core functions to their providers.

PWM: Will asset management groups reassess their custody needs?

Neeraj Sahai: Investment managers realise they may not have the in-house capabilities they need across the full value chain of investment activities. They are also looking to move from a fixed to a variable cost base and as such are looking for a flexible provider with a wide range of capabilities that can minimise the risk associated with the changing regulatory landscape.

They have the choice of investing and building the missing capabilities, which will take time and must remain current with regulations and new technologies, or they can stay focused on their core competencies, redirecting the bulk of their spending away from middle- and back-office technology and operations. They will look for a long-term partner to align with on transitioning various components of their investment operations. In this way, their primary focus becomes the front office, being close to their clients and investing. Relationships between asset managers and their providers will become much deeper.

PWM: Do you see custodians offering more tailored products, or further standardising their offerings?

Neeraj Sahai: Large outsourcers, in order to gain efficiencies, have developed standardised enterprise platforms on which multiple clients are supported. But asset managers should not see these platforms as being rigid.

The trick for outsourcers is to provide a standardised offering to facilitate economies of scale, but one that is also able to absorb individual client processes. Flexibility is the key.

Copies of "Future of Investment: the next move", a report co-authored by Neeraj Sahai and Professor Amin Rajan of CREATE-Research, are available to PWM readers from amin.rajan@create-research.co.uk