myInvestorCircle Issue I www.myinvestorcircle.com
Table of Contents The paradox of price Forces of conservatism
MIC Editor Michael Glenister wonders if the Kay Review has any chance of making a lasting impact.
MIC Editorial Director Dominic Hobson urges end-investors to interrogate fund managers through the use of data.
To clear or not to clear? How you pay governs how you perform
Why spending on non-execution commissions is so high and so poorly controlled and what can be done about it.
Taming the invisible gorilla
A study of costs shows that investors are getting extremely poor value from fund mangers, custodians and administrators.
How can pension funds tackle EMIR legislation and the challenge of mandatory clearing of OTC derivatives?
Outsourcing: the unmanaged risk
Chris Freeman examines the implications of the FSA’s Dear CEO letter for the investment management industry in the United Kingdom.
The truth hurts (your wallet) How to revolutionise investment management
Dominic Hobson finds out how one firm is using technology and big data to reinvent the fund manager selection process.
How new methods of social networking can guide investors into a brighter future
MIC Content Development manager Frances Doherty considers the role of social media in the finance industry.
EuroIRP argues for radical changes in the way managers pay for research that will improve investment performance.
Amazing grace starts work on foreign exchange dealers
A string of litigation has how affected how custodians execute FX business for their clients. The question is whether it has led to meaningful change.
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MIC | Editorial
x o d a r a p e h T
e c i r p f o
a
mong the many absurdities of late capitalist civilization is an insatiable appetite for worthless trinkets. Psychologically, many people would rather pay more for an expensive product than a cheaper one that offers the same or better results. Entire industries (think of champagne, scent and face creams) and even countries (to be fair, France does produce more than smells, gels and bubbles) can be built on this insight. Consumers of investment management advice and its associated services certainly fall into this tautological trap. Buyers are prepared to pay handsomely for them, despite their limited value and even worthlessness, precisely because they are outrageously expensive. Our culture has even evolved a series of aphorisms to reassure buyers that a service is superior (“You get what you pay for”) and its purveyors more refined (“Pay peanuts, get monkeys”). In medicine, this automatic assumption that the economical option is the inferior option is known as the placebo effect. It works in financial services too. End-investors, usually acting on the advice of consultant intermediaries, have confidence in the fund managers they appoint. Consultants and funds obviously feed this need. They want to be regarded as experts, who have worked out the optimum allocation of assets, what is best to buy, what is prudent to sell, how to do these things, and when the next phase of the cycle will begin or end. Experts of this kind relieve end-investors of the burden of responsibility for investing money and accounting for assets, and have always to hand a convenient explanation of why their value rose or fell. Investors buy their idea of what is being done, and by this means become part-owners of a service which is often worse than worthless. Yet to criticise it would be to criticise themselves. This self-delusion extends even to 6
a near-complete lack of curiosity about price. The true genius of pricing in investment management is not that banks, broker-dealers and fund managers do not disclose the prices they charge. It is that their clients never ask them to do so. In the investment business, the clients are actually helping the service providers to keep their prices opaque. Indeed, like any buyer of an over-priced service, investors are persuaded that they are getting a great deal and that this is a competitive advantage. “It is just as well everybody else is not getting prices as good as we are getting,” they argue to themselves. “If they were, their performance might start to be as good as ours.” Even if the individual running a fund can be convinced that the prices the fund is paying for services are too high, he or she does or want anyone to know that - least of all the trustees. After all, discovering evidence of systematic over-charging by suppliers is not necessarily career-enhancing. If it makes an individual feel bad, it certainly does not make him or her look good either. Yet it would be defeatist to succumb to this perverse psychology. It is rightly said that, in a modern economy, the largest costs are transaction costs, and this is even truer of a near-virtual industry such as financial services. As an economy develops, the proportion engaged in making things naturally falls in relation to the proportion engaged in monitoring the making of things. Bean counters increase relative to bean growers. In highly financialised economies such as those of modern Europe and North America, somewhere between half and two thirds of the national income is derived not from making things, but from servicing transactions. In an industry such as investment management and servicing, transaction costs are not 50 to 60% of costs, but 100% of costs. Buyers of securities have to find sellers. Investors have to find fund managers and custodian banks. Prices have to be negotiated. Investors have to agree fees with fund managers and custodians. Issue I
Contracts have to be drawn up, and investors have to sign fund management and custody agreements. Performance has to be monitored. The investment management industry makes extensive use of consultants and accountants to measure performance against benchmarks and key performance indicators (KPIs) and service level agreements (SLAs). Rules have to be enforced. Market participants employ lawyers, and use courts. They rely on central bankers and regulators to define, enforce and monitor the rules of the financial markets. Everywhere, there are administrators to record and process transactions.
them. After all, the cost of a transaction is at bottom a measure of the degree of trust between the parties to that transaction. Counterparties that cannot be trusted are always subject to a legal agreement, which lawyers are paid to draw up. In the financial markets, counterparties are also asked to post collateral. Bankers must value that collateral, keep it safe, and service it. Accountants are recruited to vouch periodically for the whereabouts and the value of assets, and so on. It is obvious that these transaction costs are maximised in an environment where everyone tries to take advantage of everyone else, and no one moves without a lawyer, and The cost of running a fund is that they are minimised in an pure transaction cost. It folenvironment where counterlows that it is always prudent parties simply trust each other to pay attention to transaction to do the right thing. Nobody DominiC hobson costs. Of course, some argue needs reminding that levels of Editorial Director that transaction costs matter trust in the financial services now only because investment industry are at an all-time low. performance is so poor, and As the annual study by Edelthat, once equity markets revive, costs will be immaterial man shows, only two people in five now expect banks to again. Certainly the indifference to transaction costs in do the right thing.1 It is the lowest level of trust enjoyed bull markets is a large part of the explanation of their by any industry. visibility in bear markets. But the costs are real, not notional. Managing them aggressively is a primary duty of The tsunami of regulation currently washing through any fiduciary. The task is not to eliminate brokers and the financial markets is an apt measure of the practical fund managers and custodian bankers, but to make sure consequences of that absence of trust. It is precisely bethat those intermediaries are making investment man- cause a majority believe that bankers, brokers and fund agement more efficient, not less efficient. This is not a managers cannot be trusted that legislators are charged trivial undertaking. It is at the heart of how a modern with finding detailed and formal methods of forcing them economy works. Contrary to psychological illusions, high to do the right thing. Yet regulation contains a message transaction costs are not a measure of the quality of for the clients of the financial services industry, as well a service. They are a signal of inefficiency – and inef- as its producers. It is telling clients that they cannot be ficiency lowers the standard of living. The only way for trusted either, or at least cannot be trusted to sort out an economy to grow is by getting more for less. Inef- their own problems themselves. It says to end-investors ficiency entails producing less for more. It follows that in particular, “No, you cannot be trusted to take responthe standard of living depends to a high degree on the sibility for what happens to the wealth entrusted to you, ability of every organization to minimise its transaction and then entrusted by you to fund managers, custodian costs in every activity it pursues, including the selection, banks and brokers.” appointment, monitoring and management of investment managers, broker-dealers, custodian banks, consultants and lawyers. Contrary to popular perception, paying 1 Trust in banks in the Edelman study was at 56% in 2008. In closer attention to transaction costs will not jeopardise 2012 it was 40%. See “The State of Trust” at trust.edelman. relations between organisations. Instead it will enhance com/state-of-trust myInvestorCircle
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To assume that responsibility on behalf of investors, the regulators are demanding oceans of data. The sheer volume of information they are demanding requires the construction of purpose built data repositories, such as those to which OTC derivarive trades must in future be reported, yet even these have failed to quell the scepticism about whether the task is actually manageable. In reality, it is not. It is fallacious to believe that responsibility for the assets of a fund can ever be replaced by regulators charged with amassing, understanding and acting upon detailed information on this sort of scale. Instead, end-investors must obtain information about their own assets, and how they are being managed, safekept and serviced, and act upon it. Until now, end-investors have lacked the information necessary to assume that responsibility. But there now exists a number of services which are capable of equipping them with the information they need to measure transaction costs, benchmark them against peers, and monitor them every year to keep providers honest. Trust in financial markets needs, badly, to be rebuilt. The right place to start is by getting at information, for no industry suffers more from information asymmetries than financial services. The sellers of financial services are always at an advantage to the buyers of financial services. True, statistical information has its limitations. The analysis of financial statisticts is bound on occasion to be flawed. But information also makes it much harder to sustain an unfair business practice or an unfounded argument about the value of a product or service. Data is the one thing powerful people and organisations cannot refute. It is the one thing which tells the truth about their performance. It is for that reason that the investment banking and investment management industries have proved so reluctant to see information about their activities in the public domain. Ironically, one reason so much of the regulation of this industry is misguided is that most of it had to be conceived, devised and implemented in the complete absence of meaningful data about what were the causes or the consequences of the financial crisis. Regulation – like investment banking and investment management – is a data-free zone. The task now is to ensure the industry becomes a data-rich zone. But even the best data is useless in isolation. It is of course possible to analyse the prices being paid in absolute terms, but it is much easier to think about prices in relative terms. In particular, end-investors need to compare the price they are paying with the prices other people are paying for the same service. It is necessary, of course, to 8
compare what is comparable. The investor buying custody and stock loan only is likely to be paying less than the investor buying fund accounting, collateral management and performance measurement as well. Portfolios vary too, in terms of composition, and duration, and in terms of their appetite for risk. But that is no excuse for listening to the nay-sayers who argue, largely out of self-interest, that the transaction costs incurred by one end-investor are too complicated or peculiar to bear comparison with those of another. That is an argument not for abandoning the search for meaningful data, but for intensifying it. The more data that is shared by more end-investors, the better each of them will understand exactly what they are paying. That data will free them to ask better questions of their service providers, and to recapture more of the value that they are ceding to them, unseen and unquestioned. But seizing the opportunity this represents requires a revolution in the mentality and methods by which end-investors have proceeded so far. In particular, it requires an end to the marsupial relationship which has developed between end-investors and investment consultants. For decades investment consultants have enjoyed a near-total monopoly over how investment managers are chosen, appointed, monitored and managed. They have penetrated institutional funds at every level they can. They cross-subsidise every price they charge for every service they provide. Yet they are not accountable for the advice they give. In fact, it is not hyperbolic to say that they and not the banks – on which so much venom is expended – are the true predators on the savings of others. It is time for end-investors to demand data, and use it to manage relationships with their suppliers themselves. It is time they backed new, more efficient and less self-interested methods of choosing managers and servicers of their assets. Data can be used not only to cut transaction costs. It can be combined with digital and mathematical technologies to match buyers and sellers of investment strategies more exactly. There is an enormous amount of value to be repatriated to end-investors. It requires bold decisions from brave people. But the alternative is depressing. It is to persist on the present course, paying lavish fees and spreads and commissions to a variety of intermediaries, sustaining massive financial institutions which are not much good at anything except paying themselves a great deal of money. Dominic Hobson Editorial Director dominic.hobson@myinvestorcircle.com Issue I
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MIC | Editorial
Forces Zof
conservatism
Reform of how institutional investment management works in the United Kingdom is as perennial and as pointless as the reform of schools or the National Health Service. Weight of institutional inertia, to say nothing of the moneyed power which the interests arrayed against change of any kind can bring to bear on the advocates of reform, are the chief genius of the British political system. Eight decades and more have elapsed since the Macmillan Committee on Finance and Industry, heavily influenced by John Maynard Keynes, first pointed out that the organisation of the financial system might be faulty. A decade is gone since Paul Myners called on the institutional investment management industry in Britain to reform its incentives and behaviour or face primary legislation. The chances of the Kay Review of Equity Markets and Long Term Decision Making, published in July last year, achieving its goal of lasting change to the misaligned incentives of fund management in the United Kingdom are not high. The only recommendation to attract any serious attention to date is its call for “an investors’ forum ... to facilitate collective engagement by investors in UK companies.”
the report contained 17 separate recommendations, several of which were highly specific. Chief among them were calls for fund managers to disclose to investors all fees and transaction costs and the division of revenue from stock lending. “Asset managers should make full disclosure of all costs, including actual or estimated transaction costs, and performance fees charged to the fund,” read the report.
Appearing before the Business, Innovation and Skills Select Committee of the House of Commons on 26 March, the Secretary of State, Vince Cable, welcomed the news that industry associations had set up a steering group to establish a forum, but agreed with the chairman that “you are quite right that there is always a danger of nice reports that just never happen.” The chairman of the select committee thought the problem was that Kay was long on analysis and short on recommendations. In fact,
The British government will review next year the progress the investment management industry has made towards complying with the recommendations of the Kay report. This review, according to the Department for Business Innovation and Skills, will be conducted by a group of yet-to-be-selected “respected figures from business and the investment industry.” In choosing those “respected figures,” it is to be hoped the Department will follow the example of another report on
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Editorial Director Dominic Hobson dominic.hobson@myinvestorcircle.com +44 (0) 7584 043 006 Editor Michael Glenister michael.glenister@myinvestorcircle.com +44 (0) 7786 074 125 Head of Business Development Nicole Taylor nicole.taylor@myinvestorcircle.com +44 (0) 208 600 2326 Content Development & Relationship Manager Frances Doherty frances.doherty@myinvestorcircle.com +44 (0) 7583 207 566 Production Claudia Lanteri claudia.lanteri@myinvestorcircle.com +44 (0) 7415 898 860 MIC, a publication of myInvestorCircle, the peer group network for end-investors, is published four times a year. Subscription is free to authenticated pension fund professionals. The editorial content is copyrighted. Horatio House 77-85 Fulham Palace Road London W6 8JA Tel: +44 (0) 208 600 2300 www.myinvestorcircle.com
MIC is published by COOConnect Ltd. ISSN 2052-7780
the investment industry: the review of the governance, efficiency, structure and operation of the superannuation system in Australia, otherwise known as the Cooper Review, after its chairman Jeremy Cooper. The body which put together that report included trustees and member-elected directors of funds. In other words, it explicitly sought the views of the end-beneficiaries of the investment chain: pension funds. In contrast, both The Kay Review, and the UK government’s response to it, gave the distinct impression that pension funds should be coaxed into stewarding their equity holdings more effectively and thereby help us all by keeping corporations focussed on shareholder value. As a result, the emphasis has been on reforming the conduct of pension funds and that of their investment managers, rather than encouraging investors to help address the conditions which have allowed the short-termist, highcost investment process to flourish. In its final report, published in 2010, the Cooper Review called on government to amend the Superannuation Industry Supervision Act to force intermediaries to equip fund trustees with the information to manage more aggressively the fees and other costs charged to funds by intermediaries. It led directly to the Stronger Super reform and, among other things, the promise of new low cost retirement savings products under the MySuper label by 2014. That is not to say that the Cooper recommendations were adopted in full. There is also understandable scepticism in Australia about the credibility of the promises which the Australian government has set out to deliver. In the United Kingdom where opt-out rather than opt-in saving and the new National Employment Savings Trust (NEST) are the latest of repeated attempts over the last 20 years to create similar low cost pensions, there is cynicism rather than scepticism. The reason why can be found in the Kay Review. It showed that the management of savings in the United Kingdom has developed in ways that reward fund managers, fund distributors, fund accountants and fund administrators, while punishing savers. The real problem is the cost of financial intermediation and tackling the perpetrators of that costly intermediation. Current reforms must address the root causes of those flaws before they are to have a meaningful impact. Michael Glenister Editor michael.glenister@myinvestorcircle.com
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Issue I
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To clear or not to clear?
MIC | cover story
European pension funds enjoy a temporary exemption from the rigours of mandatory clearing of their OTC derivatives. That exemption could stretch to 2018 but a growing number reckon the costs and risks of delay now outweigh the costs and risks of clearing at a central counterparty.
Why?
Cunctation is always appealing. But keeping options open as long as possible is purchased at the expense of certainty. This is the dilemma European pension funds that make use of OTC derivatives are now wrestling with. This is because, although the central clearing of OTC derivatives is under way already in the United States (US) and is expected to start in earnest in Europe in the middle of next year, end-investors are exempt until at least August 2015 from the provisions of the European Market Infrastructure Regulation (EMIR). This measure has the same effect in Europe that the OTC derivative clearing provisions of the Dodd Frank Act has in the US. It implements the Group of 20 (G20) requirement of 2009 that all eligible OTC derivative transactions be cleared through central counterparty clearing houses (CCPs), and be reported to trade repositories. The exemption, granted by the European Parliament and Council last year, might be extended to 2017 or even 2018. Inevitably, the initial reaction to the exemption was one of relief. Swaps are a surprisingly commonplace tool for end-investors. More than half of pension myInvestorCircle
funds in the United Kingdom, according to a survey by the National Association of Pension Funds (NAPF), make use of them. They use swaps, runs the argument, not to speculate but to hedge their investment portfolios against rising prices and interest rates. Besides, institutional investors have quite enough to do without having to worry about how they might backload their swap portfolios into CCPs, restructure their relationships with clearing brokers from principal to agent, work with them to give up new swap transactions to CCPs, post initial margin for the first time, and formulate a strategy to obtain cash collateral for variation margin from funds that are almost always fully invested. But a growing number of end-investors have reached the conclusion that delay may well turn out to be the riskiest and most expensive strategy of all. The most important reason for reaching that conclusion is that the cost of the bi-lateral OTC derivative transactions end-investors have enjoyed so far is about to rise sharply. The G20 requirements of 2009 included a stipulation that any OTC derivative transaction that is not centrally cleared should be penalised, in the sense that banking counterparties will face a higher capital charge, as part of a declared programme to incentivise swap counterparties to clear their trades or get out of the business. This has found its way into the Basel III capital adequacy regime laid on all banks, and its European expression, the Capital Requirements Directive IV (CRD 4). In 2011 the G20 decided to add special collateral requirements to the load as well, on the grounds that margin could help insulate bank capital from excessive depletion in a crisis. The Basel Committee on Banking Supervision (BOS) and the International Organization of Securities Commissions (IOSCO) were invited to draw up an appropriate and consistent set of margin requirements that could be applied worldwide. These would obviate the risk of regulatory arbitrage. In July last year, the BOS and IOSCO published a consultative document on margin requirements for OTC derivative transactions that are not centrally cleared. 15
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“If the IOSCO rules on initial margin go through in their current format with the exemption under €8 billion, then the threshold will mean most pension funds
ustin
The net result is that, as the new requirements are phased in over a four year period starting in 2015, banks will be asking their bi-lateral counterparties, including end-investors, to pay more to cover the cost of the additional capital they must put up. Costs impacting on banks will trickle through to end-users. And more directly the BOS-IOSCO margin rules will oblige investors to post lavish quantities of expensive cash and securities collateral to cover initial and variation margin payments as well. Even though many – even most – end-investors will fall below the threshold of €8 billion in notional outstandings, larger funds demonstrably will not. Quite how much collateral they will have to post is the subject of considerable uncertainty, since the BOS-IOSCO paper envisages initial margin being levied at 1-4% on the value of interest rate swaps, depending on their duration, but at 15% for other types of OTC derivative, including inflation swaps. In Margin requirements for non-centrally cleared derivatives: a response by the National Association of Pension Funds, the March 2013 formal response of the NAPF to the second BOS-IOSCO consultation paper, the trade association reported that one of its largest members had estimated that it would be required to post between €1.25 billion and €1.7 billion of initial margin if interest rate and inflation swaps were treated identically, but between €2.8 billion and €3.4 billion if they were margined separately.
are kept out of the regulation and things will remain the same,” predicts Mark Stancombe, head of client management at Insight Investment Management in London. “However, if a pension fund is forced to margin rates and inflation independently then that would have more of an impact if they could not net that down.” It follows that many end-investors will embrace clearing to avoid the costs created by heavidar re er capital and collateral requirements, which could in turn damage returns. “It is our view that EMIR is just one part of the regulation of the derivatives market,” says Darren Bustin, head of derivatives at Royal London Asset Management (RLAM). “You have Basel III and CRD 4, which are in support of EMIR. CRD 4 is heavily penalising uncollateralised trades and counterparty risk exposures. Although pension funds are entitled to an exemption, many of the swaps they will put on will be caught by CRD 4 if they choose not to clear centrally.” Accordingly, RLAM has decided to tackle swap clearing aggressively. It cleared its first £550 million of interest rate swaps for its own funds at the London Clearing House (LCH.Clearnet) in November last year, making it one of the first fund managers to do so. The firm is now offering a swap clearing service to its external clients, four or possibly even five years ahead of it becoming necessary for end-investors. The move is far from being purely defensive: RLAM expects to profit from being able to service liability-driven investment mandates that make extensive use of swaps ahead of its competitors.
nb
This was followed by a second, near-final consultative paper on the same issue in February this year. The paper specifies that, provided they have at least €8 billion in gross notional outstandings, bi-lateral counterparties must exchange liquid collateral on a gross basis up to a threshold of €50 million in both initial and variation margin payments.
Legal and General Investment Management (LGIM) has embraced clearing in much the same spirit. All clearable swaps in pooled investment vehicles are being centrally cleared already. “We felt it was clear that the legislation was not going away and we have elected to provide clients with clarity on clearing and enter that environment,” explains LGIM COO Simon Thompson. Anecdotal evidence suggests that many European pension funds – notably in the Netherlands, though not yet in the British or Nordic markets - have reached the same conclusion, and put clearing arrangements in place already. Issue I
myInvestorCircle
m
to m
Certainly, a strong argument against early adoption is that central clearing of swaps is a regulatory and infrastructural story in flux, and the offerings of
There is also something of a race on between clearing brokers to secure the business of the top 100 or so buy-side swap portfolios, on grounds these are the ones which will prove profitable. There are indications that some clearing brokers are turning away smaller and less profitable clients, by the simple device of levying excessive haircuts on collateral. “We still do not know if and when the clearing brokers will look to change the numbers on this,” says one fund manager. “If they cannot make money, the business model will have to change.” However, there are hopes that some clearing brokers can trade size for volume, and aggregate swap business from smaller funds. Either way, there are strong arguments for appointing clearing brokers now rather than waiting until their capacity is stretched and prices are less flexible, but not everyone is convinced the pioneers will get a head-start. “I have seen instances where people have got in early and the game has changed around them,” says Mark Higgins, head of business development, EMEA, at BNY Mellon Global Collateral Services. “Some got in last year and the offerings that are available have shifted since then.”
clearing brokers have to evolve with the wider environment. After all, as recently as last year, lawyers were still hopeful that end-investor swaps used purely for hedging purposes would be exempted from clearing altogether – an outcome which would waste a great deal of preparatory investment. “It is hard to tell what is going to happen with the industry until it actually starts, until clearing really gathers pace,” says Mark Higgins of BNY Mellon. “You need to remain flexible while having a plan in place. That means the best prepared people will be those that have looked at all the options and thought them through.” According to investment consultants Redington, nine out of ten United Kingdom pension funds that responded to a recent poll had not yet decided if they should take the exemption or switch to clearing ahead of a deadline that could be five years artan c away. “There are c not all that many schemes that have run the analysis to establish the costs associated with the capital r equir ements regulations coming out of Europe in comparison to the cost of clearing trades centrally,” explains Tom McCartan, an associate in manager research at Redington. “One of the biggest difficulties for schemes right now is the volume of regulation which is impacting on them. There are so many elements and a significant challenge exists for them, in that EMIR is coming alongside everything else.”
Another reason for such early adoption is the ability to fix clearing prices at the ouset, amid concern (fanned, naturally, by clearing brokers) about lack of capacity in future. Fund managers that have embraced clearing claim they have had the pick of the clearing brokers that will intermediate their transactions with the CCPs, enabling them to diversify their risk by appointing several, and locking in the clearing fees and collateral terms while capacity is still redundant. Catalyst, a consultancy which has worked for sell – as well as buy-side swap counterparties, says that significant differences are already developing in the margin terms and collateral “buffers” (the degree to which a margin account must be over-collateralised) demanded by clearing brokers of different clients and potential clients. Common sense, as well as anecdotal evidence, suggests large funds and fund managers are better placed to negotiate finer terms with clearing brokers.
Higgins accepts the volume of regulation is heavy, but argues that the impact of the same regulations on banks – the counterparties to non-cleared swaps – means that investors already have certainty on one thing: bi-lateral swap contracts are going to be more expensive in future. “The market has already worked out what it needs to do with the new regulation across clearing and the capital rules on bi-lateral trades,” he says. “It has priced that information in. But the exemption can be useful because it buys you time as an investor to work out what you need to do.” 17
What end-investors need to do beyond accepting that swap clearing will be cheaper than bi-lateral trades remains deeply uncertain, even in terms of timing. Indeed, some investors complain that they would prefer a tighter deadline to continuing uncertainty over whether the final date for pension funds to comply with EMIR is 2015 or 2018. This excuse seems increasingly lame. True, exactly which European swaps will definitely be cleared from August 2014 is still uncertain, but the pattern is becoming clear in the US. On 16 November last year the US Department of the Treasury finally announced definitively that foreign exchange swaps and forwards would not be subject to mandatory central clearing. 12 days later the Commodity Futures Trading Commission (CFTC) issued the first rules obliging four classes of interest rate swap (fixed to floating swaps, basis swaps, forward rate swaps in four currencies and overnight index swaps) and two classes of credit swap (untranched North American and European credit default swaps) already being cleared at CME, ICE Clear Credit, ICE Clear Europe and LCH.Clearnet Limited to move into clearing. Swap dealers have complied since 11 March this year, and pension funds follow from 9 September 2013. This is one reason why Darren Bustin of RLAM thinks there is no excuse now for European end-investors to delay making concrete preparations any longer. “There are concerns around the preparation for the legislation and how advanced some people are compared to others,” he says. “It is fair to say there is a very wide spread in levels of preparedness between different groups, from what we see and hear.” Certainly, according to the analysts at Catalyst, when it comes to clearing broker selection, the interest is now in detail rather than principle. “Clients typically base their key assessment criteria around things like fee structure, technical infrastructure, ease of on-boarding, margin calculation tools and services, portability, level of buffer on top of margin and legal process,” says Christian Lee of Catalyst. Of these issues, margin is the most pressing. One benefit to end-investors of transacting swaps bi-laterally was the lack of any need to post initial margin. Funds which are fully 18
invested will also have to find cash, which is the exclusive currency of variation margin payments to CCPs. One view is that funds will have to adjust their portfolios to cope with the demands. “The interpretation many in the market have made is that the three year pension scheme arrangement transitional exemption will allow the pension funds time to consider their asset allocation in order to find the gilts and cash to post as initial and variation margin to cover those OTC derivative positions,” according to Simon Thompson of LGIM. A second view is that investors should not be expected to distort their investment strategies to meet margin requirements, and that the CCPs should widen the range of collateral they are prepared to accept. “The European Union (EU) institutions decided that pension funds and their dedicated investment vehicles should be exempted temporarily from mandatory clearing,” reads a paper published last year by APG Asset Management and Amsterdam-based institutional fund solvency and risk management advisers Cardano. “This would give the CCPs time to adjust for the acceptance of non-cash financial instruments for variation margin purposes.” The outgoing regulator of the United Kingdom securities markets, the Financial Services Authority (FSA), is not opposed. Late last year it issued advice to insurance companies and pension funds indicating that negotiations were underway with CCPs which might allow them to post securities as variation margin. Likewise, speaking in the Hague at a conference on EMIR at the end of March this year, European Securities and Markets Authority (ESMA) chairman, Steven Maijoor, indicated that he expected CCPs eventually to accept non-cash assets from pension funds. “I expect that these arrangements will include the use of other assets held by pension funds, in addition to cash, for central clearing purposes,” he said. The CEO of CME Clearing Europe, Andrew Lamb, says he is already working with pension funds that have approached CME about the possibility of posting non-cash collateral as variation margin. “We have started with a narrow and cautious range of collateral which we feel is appropriate,” he says. Issue I
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“However, we are looking for opportunities to accept other types of collateral that are high quality and liquid, and we hope that, with a modest expansion we can satisfy the needs of collateral-rich but cash-poor institutional investors like pension funds. The message that has come through in a working group we have organised, which includes a number of pension fund managers, is that a broader range of collateral would be of benefit to them.” Pension funds are natural holders of general collateral – GC, or the highest quality of government bonds – and are as a result well placed to meet calls for initial margin. Unlike insurance companies and fund managers looking after open-ended funds, however, pension funds are not natural holders of the cash that CCPs currently demand as variation margin. To obtain it, they have two choices. One is to liquidate investments, and increase the proportion of cash in their portfolio permanently. This will guarantee under-performance. The Investment Management Association (IMA) estimate that the drag on performance for pension funds could be up to 2% per annum if they have to re-allocate large pools of capital to cash or near-cash instruments. The other option is to undertake a series of shortterm transactions in the money markets. Though grandly known as “collateral transformation,” it really means no more than borrowing the cash by selling and repurchasing securities in the repo markets. Those repo transactions can be executed on behalf of end-investors by clearing brokers or third party banks acting as collateral managers 20
on an agency basis. The banks already servicing broker-dealers and cash providers in the tri-party repo markets of Europe and the US are bestplaced to take advantage: BNY Mellon, Clearstream, Euroclear and J.P. Morgan. “If you are awash with cash it is fairly simple,” explains Mark Higgins of BNY Mellon, which is positioning itself more aggressively than others as a supplier of collateral transformation services to end-investors. “You will not have a problem with posting variation margin. Equally, pension funds typically hold enough good quality government bonds that initial margin requirements can be met with existing portfolios. Where it remains simple it is possible to manage collateral in-house.” Even doing the work in-house will entail staff and technology costs, and collateral transformation transactions will not be executed free. Using the repo market to transform assets into eligible assets will add significantly to costs – perhaps as much as 35-40 basis points for, say, swapping equities for eligible government bonds. Cash will be cheaper, but Mark Higgins still predicts that most investors will choose to outsource collateral management to third party providers such as BNY Mellon, not least because they offer convenient access to a wide range of cash-rich counterparties. “There are also new relationships that might be possible,” he argues. “For example, there may be opportunities for pension funds to link up with corporates when they need to find cash, rather than simply resorting to their relationship with an investment bank. That is by no means worked out yet but it is possible that there is an interesting mix between two groups that had not been thought of previously.” Some CCPs have also talked about providing collateral transformation services to their customers. At Catalyst, Christian Lee does not believe that they are yet well-equipped to do so. “It is something that many CCPs would like to offer but we do not foresee in the short-term,” he says. “By taking bonds instead of cash the CCP would be assuming considerable treasury investment risk which should only be handled by a sophisticated treasury division, which would require significant structural change to the market.” Issue I
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Lee adds that it would also make derivatives difficult to price as there would be uncertainty about which bonds would eligible to collateralise the variation margin. This could be partially offset by using a basket product like the CREST GC basket. Reporting only solves half the problem because, if the repo is not through a CCP, all you are doing is taking the risk out of clearing and putting it back into the market, which defeats the point. Ultimately a solution combining an OTC clearing service with a repo clearing service could solve this, but it is big and it is tough, says Lee. Tom McCartan of Redington agrees that posting non-cash collateral as variation margin is fraught with difficulty. “You have to think about where you want to locate liquidity risk in the system,” he says. “Pension fund clients would certainly be interested in the option to post non-cash assets as variation margin but CCPs may be reluctant to do that because it locates the liquidity risk with them. That may potentially impact the stability of the system, which EMIR was brought in to try and assist with.” Indeed, it can be argued that all the regulatory enthusiasm for CCPs is doing is re-packaging counterparty credit risk as liquidity risk in the markets for collateral. Worse, by forcing clearing customers to post cash and securities to CCPs, clearing exposes investors to the risk that their assets will end up being used to pay for other investors that default on their obligations to the clearing house, without them ever knowing who the other customers are. Worse still, longstanding practice in the clearing business places at least some client collateral at the command of the clearing brokers which will intermediate the transactions of investors with the clearing houses. This is because, in traditional futures markets, clearing brokers hold a surplus of client collateral for reasons of operational convenience – to meet margin calls from a CCP. They have held this collateral in pooled, or omnibus accounts, in which the assets of one customer are indistinguishable from those of another. The sums held by clearing brokers on behalf of clients can be large. At the end of March this year, for example, the 105 clearing brokers active in the United States futures markets held $159.2 billion in customer assets, according to the CFTC monthly report. Understanda22
bly, clearing brokers do not want to find themselves using their own money to meet margin calls on behalf of clients. Investors, equally understandably, are reluctant to increase their exposure to the risk of default when forced by regulators to switch from bi-lateral swap trading to cleared swap trading. Anxieties of this kind explain the intense interest of fund managers as well as investors in the legal and structural arrangements for holding assets they post as initial and variation margin. At American CCPs such as CME and ICE Clear Credit, collateral will be legally separated but operationally commingled (LSOC). In this system, collateral is pooled for operational purposes, but if a clearing broker defaults the collateral of particular customers is used for their benefit only and not that of other customers, reducing the risk that client collateral is used to meet the obligations of other clients. It is a compromise between full legal and operational segregation (which would be expensive and inconvenient to operate) and pooled accounts (which are cheap to operate and operationally convenient). In Europe, EMIR lays an obligation on both CCPs and clearing brokers to segregate in their books and records proprietary assets and assets which belong to customers. It also obliges both CCPs and clearing brokers to offer customers a choice of holding collateral in either an individually segregated account or an omnibus account (where assets are held on an LSOC basis equivalent to the regime that prevails in the United States). The European CCPs are indeed offering this choice. What EMIR failed to specify was whether omnibus accounts should be margined on a net (to the CCP across all client positions in the account) or gross (gross to the CCP per client after netting all positions of that particular client). What clearing brokers prefer is to collect collateral gross from the client but send collateral net to the CCP, and keep the balance in a pooled account, so they can profit from lending the surplus collateral. Individually segregated accounts, or CCPs that insist on collateral being posted gross, deny clearing brokers that bonus. This was why, when the FSA, the former United Kingdom regulator, set about amending what it calls its Issue I
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“client assets sourcebook” (CASS) to take account of the client money protection rules stipulated by EMIR, it came under pressure from clearing brokers to permit gross omnibus accounts as well as net omnibus accounts and individually segregated accounts. In the end, the FSA endorsed the demand, amending the CASS rules - in policy statement PS12/23 – to permit omnibus accounts to be run as “a collection of individual client accounts” that are “functionally equivalent” to “an individual client account.” That appetite among clearing brokers for maximum latitude to use client collateral also explains why they have shown such interest in persuading customers to continue to over-collateralise their accounts, no matter what type of account they prefer. “One of the interesting things that came up in our discussion with the clearing brokers was that they were looking to apply protections (for themselves) by asking us to heavily over-collateralise our account beyond the requirements of the CCP,” reports one, somewhat surprised fund manager which has moved its swap portfolio from bi-lateral arrangements into clearing. “They are worried that the CCP has the pin-code to their account.” It follows that individual segregation demonstrably offers better protection to investors. But it is equally obvious that they will have to pay more for it, because clearing brokers no longer collect a spread. An even more expensive variant of individual segregation is for 24
investors to hold their assets not at the clearing broker at all but at an independent third party custodian bank, with assets being pledged to the CCP or moved between accounts at the custodian. “One of the things we are currently involved in looking at is `quad-party’ accounts,” says Mark Higgins of BNY Mellon. “That involves a fully segregated arrangement with the custodian who is managing the intra-day collateral.” CCPs and clearing brokers are unsurprisingly resistant to this model, since it denies them control as well spreads. Clearing brokers are still liable to meet margin calls from the CCP, and are concerned that they will not have quick and efficient access to client collateral. Nevertheless, Andrew Lamb of CME Europe confirms that his organization is involved in negotiations to allow asset owners to hold collateral with third party custodians. “We are looking at models which allow us to hold collateral with the custodian which the clients have a preference for.” The fact that these investigations are in train signifies not only a continuing level of discomfort among investors about the risks which clearing poses to assets posted as collateral, but consciousness that collateral segregation and safety are still unresolved issues. “There remains work to be done around collateral segregation,” agrees Darren Bustin of RLAM. “It is an expense for the CCP to do that, but ultimately it is a risk for the client. We want a segregation model that is operationally and legally robust.” One reason investors want more robust collateral segregation arrangements is that earmarked collateral makes it much easier to port positions from a failed clearing broker to a new one in an event of default. “If there is a problem with a clearing broker the first step is for the positions to be ported to another clearing broker,” explains Simon Thompson of LGIM. “If for some reason that portability could not be invoked, then the likelihood is that the CCP would close out that position, sell whatever collateral it held and return cash to the client. The underlying client is protected from clearing broker default but they will take on Issue I
market risk in the replacement process.” That risk is non-trivial, especially for a fully invested fund. A long term portfolio whose CCP-eligible fixed income assets are returned to it as liquidated collateral may well find the price of repurchasing the equivalent investment is punitively high, especially in what are likely to be distressed markets characterised by a flight to quality. That price differential can undo the strategic intent of the entire portfolio. “In an extreme event, the likelihood is that the price of a particular bond could move significantly,” says Darren Bustin of RLAM. “If that bond is turned into cash and delivered back to me in the event that a position has to be closed out, then I have lost out if I am requiring that bond to act as part of a hedging strategy.” CCPs have responded to this concern by introducing a delay between default and liquidation. At SwapClear, the OTC derivative CCP run by LCH. Clearnet, users are given a 48 hour window during which a position can be ported before it is liquidated to cash. Porting can only be accomplished at all, let alone to such a tight timetable, if investors have a second clearing broker in place already. Most will in fact appoint at least three, partly to spread their business across more than one counterparty, but also to make it easier to port positions in the event that one fails – and, if necessary, to more than one alternative clearing broker. The unanswered question is how easy it will be to port positions in markets distressed by the failure of a clearing broker. There is understandable concern that solvent clearing brokers will be anxious about assuming assets and liabilities they cannot understand properly within a mere 48 hours. This has not stopped some of the more adventurous clearing brokers from promising potential clients a “guaranteed” porting capacity. In reality, no clearing broker can offer to insulate clients from loss in an event of default, especially in distressed markets. “What we have tried to do is look at how we can minimise the risk of ending up in that position in the first place,” ventures Mark Stancombe of Insight Investment. “We have looked at all the barriers we would have to porting our trades. Part of that has involved us working on a new legal structure over the past 18 months. That has resulted in us having an idenmyInvestorCircle
tical set of legal documents with our five clearing brokers, and all our clients are signed up to that.” Standardising the documentation with multiple clearing brokers is a clever adaptation to a cleared environment of the bi-lateral market, in which end-investors agreed swaps with investment banks, and collateralised the transaction on a daily mark-to-market under rules agreed in a Credit Support Annex (CSA) written to a standard prepared by the International Swaps and Derivatives Association (ISDA). “It means that really we are going back to the logic of the old ISDA idea, having a standard documentation set-up which increases the chance of a clearing broker taking on the trades in the event that another broker defaults,” explains Stancombe. “It reduces the risk that a back-up broker looks at the contract we had with another counterparty and does not feel comfortable with the details or has to pass the contract on to (the) legal (department), which could delay or prevent the porting process taking place successfully.” Unsuccessful attempts to port positions and the threat of collateral liquidation are novel risks for investors. So is the need to post cash only as variation margin. In a bi-lateral transaction with an investment bank, investors had control over the closing out of positions if their counterparty failed, on terms described in standard documentation; faced no deadline for porting them to a solvent investment bank; and could post government, supranational and even corporate bonds as variation margin. In a cleared environment, they have to agree with the counterparty to give up the swap to a CCP, and face the CCP as counterparty according to rules laid down by the CCP. The CCPs, which adopt a neutral, matched-book 25
stance between two equal and opposing sides of a the resources and the appetite to connect directly to trade, naturally cannot accommodate the risk of as- a clearing house, even for a limited amount of time suming a position themselves. This is why they insist to cover an emergency. Even fewer have the capacity on liquidating collateral to cash in an event of de- to assess the possibility of the bankruptcy of a CCP fault, and give investors next to no time to move their itself. This is the risk that dare not speak its name. business elsewhere. The concern expressed by inves- Regulators have promoted CCPs so assiduously as the tors about these demands is not unheeded. Andrew solution to counterparty credit risk, and guarantors Lamb of CME Clearing Europe says he is looking at ways to make the process Eleven things for investors to worry about less hasty and potentially when it comes to clearing their swaps disruptive for investors. “In what you might call The exemption from mandatory submission to swap clearthe `default procedure,’ ing is of uncertain duration and may have no advantages other than the option to procrastinate. we are not establishing a process in which we would Investors that decide to enter clearing ahead of the deadautomatically liquidate the line set by regulators might be able to fix their clearing and collateral in the event of a collateral prices at lower rates. clearing member failing,” Investors that decide to enter clearing ahead of the deadline he says. “We allow a two set by regulators might find the rules have changed by the day period during which time clearing starts, and they are locked in at the wrong price. we can port the position to an alternative clearing The one certainty is that the cost of trading swaps bi-laterally member. Should we not is going to go up because banks must post more capital and demand extra collateral against uncleared swaps. be able to port we would have to liquidate. That Investors that enter clearing will have to post initial margin said, although we have not to clearing houses for the first time, and need to have eliput the final procedure in gible assets to hand. place, there may be scope Clearing houses accept nothing but cash for variation marto put in place an argin payments and investors that do not have cash to hand rangement where we can will have to rent it in the repo market. access collateral directly from the end-user client Posting assets as collateral to clearing houses exposes into give more time to the vestors to the risk that their assets are used to meet the obligations of other members. porting process.” At CME Clearing in the US, users of the CCP can already register in advance for this type of account. Obviously, the CME charges for the service, so it is not a free option. Nor is a direct account at a CCP a choice that any but the most sophisticated pension funds will be able to make. Few investors have 26
Clearing means investors must leave lots of assets at clearing brokers, whose track record (cf. Refco, Lehman, MF Global, Peregrine) with client collateral is not reassuring. Practice and proposals to segregate client collateral in clearing arrangements are not yet robust (and third party custody of collateral is a far from popular idea with brokers). If a clearing broker fails, and positions and collateral cannot be “ported” promptly to a viable alternative, collateral is liquidated, creating replacement costs and risks for investors. CCPs can and do fail.
Issue I
against the materialisation of systemic risk, that virtu- CCPs will have to accept a wider range of collateral, ally nobody is worrying about the size and strength of increasing the risk of illiquidity in a crisis. Unsurprisingly, regulators are privately their balance sheets. This accepting the inevitable corolhas a certain logic. CCPs “CCPs have failed in the past. Yet, lary of all this: modern CCPs run matched books – that when the regulators suggested to the are too important to fail, and is to say, what one coun- CCPs of Europe that they might like to must in a crisis be rescued terparty owes to another increase their own ‘skin in the game,’ by the central banks. That is offset exactly by what scarcely amounts to an adanother owes to them – they were told that too much capital vance on the system that had and they net transactions would only encourage their members to be rescued in 2007-08. down to smaller numbers. to take greater risks.” Their customers also ply them with liquid collateral, mostly in the form of cash, Regulation is notorious for perverse outcomes of which makes it possible for the CCPs to pass collateral this kind. But, like characters in a Woody Allen movbetween counterparties without the need to engage ie, end-investors which understand the absurdity in bank-like liquidity provision or run the risk of liqui- of their predicament are nevertheless unable to dating securities to cash in markets which are almost escape it. They must use the time afforded by their exemption to make preparations for entry to clearcertain to be distressed. ing of their swap portfolios now or later. Either way, Yet CCPs have failed in the past. The Caisse de Liqui- they need to choose clearing brokers, work out how dation went down in Paris in 1974, the Kuala Lumpur to obtain high quality bonds and cash to post as Commodity Clearing House in 1983, the Hong Kong initial margin, and almost certainly increase their Futures Guarantee Corporation in 1987, and Hong allocations to cash to secure a regular supply of Kong Exchanges and Clearing in 2008. CCPs also deal cash to post as variation margin. Boringly, there is in large numbers - CME Clearing, the largest clearing no clear answer to the choice between clearing now house in North America, claims to process a billion and clearing later. The decision on when to act will futures and options trades a year, worth more than inevitably be specific to each fund. Every investor $1,000 trillion - which are largely hidden from view must weigh the benefits of clearing (reduction of because most CCPs do not publish their balance counterparty risk, netting down of bi-lateral exposheets. One which does, LCH.Clearnet, was at the sures, keener pricing of cleared swaps, segregation end of 2011 hosting liabilities valued at €541 billion of collateral) against the costs (the need to post inon equity capital equivalent to 0.06% of that figure. itial margin, the expense of obtaining cash, payment When the European Securities and Markets Authority of clearing, clearing broker, custody and collateral (ESMA) and the European Banking Authority (EBA) management fees) and risks (loss of assets comsuggested to the CCPs of Europe that they might like mitted to the CCP default fund, inadequate segreto increase their own “skin in the game,” they were gation of collateral, liquidation of collateral to cash told that too much capital would only encourage their if porting fails) in relation to their own portfolios members to take greater risks. The reality is that CCPs and investment strategies. “For end-investors, it is a depend on cash collateral, and will devour increasing- case of conducting a cost benefit analysis,” explains ly large quantities of it as more and more asset class- Insight’s Mark Stancombe. “The benefits include the es are shifted into clearing. Predictions of a global reduction in counterparty risk, although that comes shortage of eligible collateral are easy to dismiss, but with certain considerations about the risks involved may still materialise, if only because the deteriorating in central clearing. On the other side there are fees public finances of almost every developed state will and costs associated with using a clearing broker force banks to hoard cash and a shrinking range of and CCP to clear centrally and funding the process government bonds eligible for financing at the central by finding liquid assets to post at the CCP. There is banks - to fund their own balance sheets, let alone fa- also an opportunity cost to consider, in so far as cilitate centralised clearing. It is almost inevitable that you need to think about the cost of adapting your myInvestorCircle
27
MIC | features
How
you pay
governs how
you
perform
Nothing demonstrates better the domination of intermediaries than the differential response of broker-dealers and fund managers to demands from regulators for “best execution” and demands from regulators for “best practice” in the use of execution commissions. As equity markets fragmented into dozens of digital platforms, billions of dollars were invested in capturing trade flows, and complex algorithms and transaction cost analysis services were developed to reassure investors they were getting great prices. Now a far more seismic change has come along, and it has the power to transform investment performance - and the accompanying silence from the sell-side is deafening. Spending on non-execution commissions 28
consumes two out of every three dollars spent by investors on overall equity commissions. The investment decisions it drives are the prime determinant of investment performance. For investors, failing to pay attention to its potential is not a mistake. It is negligence. Dominic Hobson talked to Neil Scarth of Frost Consulting and Advisory about why he thinks changes in the way fund managers buy research is the most important trend in investment management today. “Why do asset managers use equity commissions to buy research?” asks Neil Scarth, a principal at Frost Consulting and Advisory in London. “Because it is not their money, of course, and it is charged against fund returns, not the asset managers’ profit and loss account.” Issue I
portfolio to allow you to clear.�
Dominic Hobson talked to Neil Scarth of Frost Consulting about why he thinks changes in the way fund managers buy research is the most important trend in investment management today.
Neil Scarth
Regulators have invested thousands of words in regulating the obvious risk that fund managers will, like everybody else, spend other people’s money less carefully than their own. In the face of repeated assaults, fund managers have fought fiercely to retain their right to use client money to pay for a service they are already charging a management fee to provide.
That defence has proved remarkably successful. Fund managers still buy nine tenths of their research using equity commissions charged to the funds they manage on behalf of their clients. As for Neil Scarth, he has followed this long dialectic from both a sell-side perspective (he worked in institutional equities at both ABN Amro and Merrill Lynch) and a buy-side vantage point
box 1: What the Myners report said about equity commisions in 2001 The fee which UK pension funds pay to their fund manager is subject to considerable scrutiny by trustees and their investment consultants. They will seek to negotiate it when hiring fund managers, and it will be a factor which they take into account when considering whether to have funds managed actively or passively. The annual fee is clearly visible. Comparisons are made between countries on the level of these fees, and the competitiveness of UK fees are cited as a success by investment consultancy firms. Pension funds using active managers will in many cases be paying a similar annual sum in commissions to sell-side investment houses, stockbrokers and so on, for providing dealing and research. This expenditure is incurred on the client’s behalf by the fund manager. Commissions are added to the cost of purchase or deducted from the proceeds of sale and settled against the pension fund’s account with its custodian. In other words, they are paid directly by the pension fund. Yet the treatment of these costs is different to that of the fund management fee in two important respects.First, although they are disclosed, this is done in a way which is far from transparent. The aggregate cost to a fund of commissions over a period is not something which must necessarily be calculated. Rather, disclosure to the client is on the note confirming the transaction, not a document of particular interest to trustees. Second, the firms which provide the services for which commission is charged are selected by the fund manager, acting as the agent for the institutional client. The client has no direct involvement in the decision, and the process by which these fees are negotiated is not transparent to the client. Some (not all) fund managers have put in place a formal assessment process for determining the quality of service they receive from the sell-side firms to whom they give business. Their incentive to target price paid as part of this process is the impact that commission levels have on fund performance. While helpful, this is not the same as more direct pressures on business costs. There is an a priori case that this system creates an artificial bias for fund managers to have services provided by the sell-side, distorting competition, since the costs for these will not be scrutinised by the client and are not a direct charge to the fund manager’s profit. In effect, the fund manager outsources a business input to the sell-side with the cost charged directly to the client. Clients’ interests would be better served if they required fund managers to absorb the cost of any commissions paid, treating these commissions as a cost of the business of fund management, as they surely are. Fund managers would of course seek to offset this additional cost through higher fees; this would be a matter for them to agree with their clients. Under this system, the incentives would be different. Institutional clients would see more clearly what they were actually paying to have their funds invested. Incentives for them to manage costs would apply equally to all costs, as opposed to acting on some more than on others, as at present. Fund managers would choose which services to buy and which to provide themselves. Under this arrangement fund managers would face a commercial tension between wishing to cut costs on the one hand, but wanting to achieve superior investment returns on the other. This is healthy.
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Issue I
(he has had spells at Deephaven Capital International, and research commissions paid to brokers. By the Symmetry Management and Trilogy Global Advisors). time Deephaven was sold to Stark Investments – the After nigh-on 30 years, he reckons the buy-side is fund was hit by a wave of redemptions at the height at last dictating the terms of the trade, thanks to the of the crisis of 2008 – Neil Scarth had already set regulatory demand that execution decisions be sepa- up Frost Consulting and Advisory to take advantage rated from the procurement of research. This stipula- of the seismic shift he had detected six years earlition originated with a passage in the 2001 review of er. “We now have a series of software and consultinstitutional investment in the United Kingdom by the ing businesses which seek to address the challenges former fund manager-turned-government-minister, which arise for many market participants as a result Paul Myners. It argued (see Box 1) that fund manag- of a variety of changes,” he explains. “But easily the most important of those changes is still ers add commissions to their management fees. Clients’ interests commission unbundling.” That did not happen would be better (see Box 2) but, as Neil served if they required fund Historically, equity commissions were Scarth sensed at the managers to absorb the cost “bundled.” In other words, the execution research components of an equity time, even the idea had of any commissions paid, and commission were inseparable, and the revolutionary potential. treating these commissions as total amount was simply passed to the a In fact, his last role at cost of the business of fund broker which executed the trade. Executmanagement ing trades generated the commissions the London office of that paid the bill from the broker. Bundling Deephaven was to manage a portfolio of European financial equities judged execution with research suited the global investment likely to be affected by the compromise that was even- banks that dominated the brokerage industry, since tually agreed between the British government and the making research contingent on execution guaranteed fund management industry over the Myners recom- them a dominant position in equity execution. In parmendation: namely, the unbundling of the execution ticular, it squeezed out independent research providers.
B
C
The pressure would be to purchase only those services which contributed to such returns, and to do so in the way which is most efficient. Fund managers would determine those services they wished to acquire from external specialists and contract on a basis that reflected the perceived value of input. Such contracts could be fixed in price for a period, linked to transaction values or on a hybrid basis. This would be a matter for the contracting parties to determine. Any organisation which could add value through the provision of efficient and effective investment services, whether fund managers or broking businesses, large or small, should succeed in this environment. Indeed, this model may attract new service providers, promoting greater diversity of input and service. To the extent that fund managers directed greater resource to developing their own research capabilities, particularly in company research, there may be a collateral gain in terms of improved governance as a result of greater contact between fund managers and corporate management. Adoption of this recommendation would mean that current inefficiencies and complexities associated with practices such as soft commission and commission recapture would be likely to cease. The review recommends that it is good practice for institutional investment management mandates to incorporate a management fee inclusive of any external research, information or transaction services acquired or used by the fund manager rather than these costs being passed on to the client. Source: Sections 5.102 to 5.113, Institutional Investment in the United Kingdom: A Review, March 2001.
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To obtain research from all of the brokers that produced it, a fund manager had to maintain an execution relationship with the same firm. The average long-only fund manager had to maintain as many as 100 brokers to execute trades on its behalf. Though even traders could be found to argue that was far too many, maintaining multiple relationships created tension with the in-house dealers, who would always prefer fewer but better relationships and disliked the multiplication of counterparty risk. On top of that, research was the principal sales tool for brokers, so fund managers were bombarded with material from brokers wanting a slice of their execution business. Yet bundling also worked for fund managers, because they could use clients’ money rather than their own to buy an important input to their work. Truly independent research from non-brokers could be purchased by fund managers only with their own money, which they were understandably reluctant to do, even if the work was of superior quality. Inevitably, information-gathering by fund managers became inefficient. Just to manage the complexity of multiple relationships, they had cut themselves off from sources of potentially valuable information. Inevitably, research was tainted by the interests of the investment banks, which always have securities to sell, notably in IPOs. From the point of view of the neutral obsever, this system was potentially corrupt and certainly inefficient, and it was to put an end in 2001 when the Myners report argued that fund managers should include equity commissions inside their management fee (see BOX 1). This was a predictably unpopular idea with fund managers, since portfolio turnover usually guaranteed that commissions exceeded the value of the management fee. “If you were going to put commissions into the management fee, you would have to double or even triple the management fee,” explains Scarth. “UK fund managers reckoned that might make them uncompetitive internationally, because their foreign competitors did not have to do the same. They also argued that only the larger managers would survive and that was bad for consumer choice and competition.” The eventual trade-off between the fund management industry and the regulators was the “unbundling” of commissions. In the United Kingdom, the Financial Services Authority (FSA) introduced unbundling via CP-176 in 2003, by which fund managers and brokers enter into 32
a “commission sharing agreement” (CSA) through which some of the commission can be spent on third party research. In 2006 the Securities and Exchange Commission (SEC) followed suit with its “client commission agreement” (CCA) structure under Section 28(e) of the Securities Exchange Act of 1934. CCAs – the different term reflects the fact that the SEC forbids brokers from sharing commissions with non-brokers – allow brokers to create pools of research dollars in accounts they manage, but funded by commissions and directed by fund managers, not unlike CSAs in the United Kingdom. In France, the Autorité des marchés financiers (AMF) has encouraged commission sharing, and so has the regulator in Sweden. By these compromises, fund managers could still use commissions to buy execution and research as a package, but the two purchasing decisions had to be made separately in order to guarantee “best execution,” or execution for clients at the best price available in the market at the time of the trade. Best execution was then being formally enforced in the United States via Reg NMS (established in 2007) and throughout Europe by the first Market in Financial Instruments Directive (MiFID), which was launched in 2004 and became effective from 1 November 2007. CSAs and CCAs are now the fastest growing category of equity commission. CSAs alone now account for 70% of equity commissions in the United Kingdom and, although the proportions are lower in continental Europe (50%) and the United States (40%) both markets are catching up, not least because of the popularity of commission sharing with larger managers. “Once asset managers get used to commission sharing they love it, because the ability to retroactively reallocate commissions is a truly wonderful thing,” explains Scarth. “A fund manager may care about molybdenum once every 15 years, but when they do, the fact they can commission a $2 million study of it when they have got huge portfolios riding on it, and pay for it out of commissions, is hugely valuable.” He reckons CSAs are now used exclusively by nine out of ten large long-only managers in the United Kingdom, four out of five in the United States, and two out of three in Europe. This rising popularity reflects intensifying competition between fund managers to gather assets, giving them Issue I
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an interest in freeing up commission monies to access sources of information that give them an edge. With sell-side research budgets being cut, the best sources are increasingly other than the executing brokers. This is gradually prising apart the longstanding connection between research and execution. In practice, “unbundled” trades via CSAs and CCAs see fund managers allocate a portion of the commissions paid to the executing broker to independent sources of research. The cost of a typical “unbundled” trade usually splits two thirds research (say, eight basis points) and one third execution (say, four basis points). The execution portion of the commission goes to the broker that executes the trade, and the balance to an account maintained by the broker on behalf of the asset manager, which can then allocate the money in that account to buy research from third parties. In reality, about half of the research commission pot still goes to the executing broker anyway, provided the firm produces research of some kind. There are of course plenty of execution-only brokers, such as Instinet, ITG, Knight Capital (now owned by Getco) and ConvergEx, but most research still tends to comes from the global investment banks. When Neil Scarth polled a group of European CIOs in the spring of last year, he found that nine out of ten relied on the global investment banks for at least 60% of their research, and that one in twelve got their research from nowhere else. He finds this puzzling, since there is a lengthy array of alternative sources of research, and ample competitive advantage in using them. Regulations insist that all research published by the global investment banks is distributed simultaneously to every client, conferring no competitive advantage on anyone. Yet genuine alpha-generating studies can be commissioned from consultants, academics, business schools, publishing houses and databases which are entirely proprietary, and can still be purchased using commissions. “There are thousands of potential sources,” explains Scarth. “A fund manager has the ability to hire a consultant to do a proprietary study of Chinese copper demand for his or her firm alone, and to use commission dollars to pay for it. If a manager pays a university professor in Malmo to research nickel deposits in Kazakhstan, that research is theirs alone. It is a real potential source of alpha, which belongs to the manager. One reason it is a source of alpha is that, unlike investment bank research, it is not immediately distributed to every competitor.” 34
Some fund managers are already buying research this way. Scarth says he knows of one London-based long-only manager that makes use of over 300 research producers, of which fewer than 40 are brokers. However, thinking in such radical terms requires a revolutionary mind-set which many managers have yet to adopt. Most, as that CIO survey underlined, are still getting all of their research from the usual sources. Equally, potential producers are finding it hard to penetrate the fund management industry (see “The truth hurts your wallet”, pag. 60-62). “The challenge for research providers is how they get through asset manager firewalls, because fund managers are used to preventing information getting out, not bringing it in,” says Scarth. Yet there is a great deal of money to play for. Frost Consulting estimates that $22 billion a year is currently spent by fund managers globally on non-execution commissions – the majority of which is research. That pot of money (another $11 billion is going to execution only) is steadily being liberated for third party research. Scarth predicts that the number of execution counterparties used by the average fund manager will fall by half over the next five years. This will not in itself free up pools of equity commissions to spend on third-party research – that is the role of CSAs – but it will loosen the investment banking stranglehold over research expenditure. “The global investment bank monopoly over research spending is coming to an end,” he says. “We are actively seeing the number of execution counterparties fall. The whole small and mid-cap brokerage sector in the UK has imploded already, because they started getting CSA cheques instead of execution commissions for taking counterparty risk. They started getting very few execution orders, while research is expensive to produce, and the CSA payments were not enough to maintain profitability.” If the number of executing brokers continues to fall, there is likely to be a commensurate increase in the number of research providers used by fund managers. In the US, the settlement negotiated by former New York attorney general Elliott Spitzer with the fund management industry, following his investigation into the tainted research produced by investment banks at the height of the Dot Com boom, included provisions to subsidise for a limited period the development of independent research. Issue I
box 2: What happened to equity commissions after the Myners report After publication of the Myners report (see Table 1), the Financial Services Authority (FSA), the financial markets regulator in the United Kingdom, considered whether it should require fund managers to rebate the non-execution part of broking commission to clients. However, it decided that a disclosure-based regime would be more efficient. On 26 March 2004, it announced that it would give the industry the opportunity to develop a rigorous transparency regime for disclosure of such costs, on pain of regulatory enforcement. The FSA did specify that the services that can be paid for through trading commission should be limited to research and execution services only and, through CP176 in 2003, that the decisions be separated, or “unbundled.” Though the regulator has never explicitly endorsed commission sharing arrangements (CSAs), it has described them as “part of the market-led solution.” On 10 November 2004, the FSA did define research as “value-added analysis with clear intellectual content” and execution services as those “demonstrably linked to the arranging and conclusion of a transaction.”
banks and brokers that wish to sell research-plus-execution, but many more independent research firms (around 1,500), academic journals (300), management consultants (250), strategic research institutes (75), expert networks (120), primary research firms (250), forensic accountancy shops (150), quantitative or technical laboratories (125) and trade publications (1,500), none of which want to get paid for executing equity trades.
Accessing such a large universe of potential research providers is a research task in itself. Frost Consulting is offering to solve that via the research aggregation arm of As a result of regulatory pressure, discussions between the a related company. “Research agInvestment Management Association (IMA) and the National gregators are a bit like TravelociAssociation of Pension Funds (NAPF) led to the adoption of a ty,” explains Scarth. “What current Pension Fund Disclosure Code in May 2002, by which fund managers disclosed charges and costs to pension fund clients in a aggregators do in effect is manstandardised format. The Code was amended in March 2005 to age all the brokerage websites on incorporate dealing commissions following the passage of new behalf of fund managers, because rules by the FSA. The third version of the Code, designed to fund managers cannot be expectbring it into line with the first European Union Markets in Finaned to remember 50 passwords, cial Instruments Directive (MiFID I), was agreed in September and which broker covers which 2007. Fund managers now disclose in a standardised format stock. They serve up brokerage the amount of commissions paid to brokers, and the division of those commissions between full service (i.e. including research) documents to fund managers in and execution-only services. The reports also include informaa convenient way. Ideally, in the tion enabling pension funds to compare their commission costs future, they would bring a vastly with those of other clients of the same fund manager that are enhanced search capability to a invested in the same asset classes. This data underlies the equimuch wider corpus of informaty execution cost chart prepared by Investor Data Services (IDS) tion to help asset managers find in charts 10 to 12 on pages 56-58 of this issue. alpha-generating data points and other relevant sources of information.” Research aggregators such as those related to Frost are now extending their reach beyond brokers to third party sources of information. Since The European Association of Independent Research aggregator are paid out of commotion dollars as Providers now boasts over 40 members. But Frost well, Scarth is not a disinterested observer of curConsulting draws the potential universe much more rent market developments. But it is hard to fault the widely than the conventional analysts that are now accuracy as well as the enthusiasm of his case for running boutiques independently from the execuunbundling, and the potent new sources of valuable tion arms of major financial institutions. The firm information that it opens up. estimates that there are about 750 investment myInvestorCircle
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Scarth also points to a looming operational challenge, as the number of CSA brokers used by large asset managers in the United Kingdom has climbed from an average of seven in 2007 to 25 in 2011, and the number is still rising. One large asset management firm known to this publication has 81 CSAs in place. Each one of those brokers is delivering a commission report back to the fund manager, usually in a non-standardised spreadsheet format. This is manageable for small funds, but not large ones with multiple counterparties. The complexity is multiplied by the number of markets to which a global CSA applies (it can be dozens), the split in the sub-accounts between bundled and execution-only CSAs and between CSA and non-CSA agreements in each of those markets, the number of currencies involved, and the number of third party research providers paid out of the total commission pot. “The average CSA broker pays about ten third party research providers every quarter, on behalf of each of their CSA clients,” says Scarth. “So you can imagine that, as the number of CSA brokers you use goes up, the complexity increases ten-fold. There are hundreds of thousands of trades. At present the resulting complexity is managed by what I call bi-lateral spreadsheet chaos. There is no central matching mechanism in this market. The market has grown so quickly it has outpaced the administrative solutions available. It represents a substantial fiduciary and operational risk.” A typical fund manager might have to reconcile data from 1,000 sub-accounts in 50 equity markets and 30 currencies. Inevitably, some do not bother, and rely on their brokers to do the work for them. This is worrying, since the sums at issue are not trivial. Frost Consulting estimates that, on a global scale, about $10 trillion of equity trades are going through 11,200 bi-lateral CSAs (see Table 1), generating around $6.6 billion in distributable CSA commissions. Mistakes are inevitable. Frost estimates that around $800 million a year is inadvertently left with executing brokers through inaccurate or incompetent management of commission allocations by fund managers. Understandably, fund managers are now pushing for commission-sharing to be made available in every equity market where they are active, and not only because of the operational convenience. Commission sharing also frees up millions of dollars to spend on research, with no ties to execution, and without having to subtract the cost from management fees. But what is really making the global trend to CSAs and CCAs gen36
uinely unstoppable is end-investor demands for fuller disclosure of how their commissions are being spent. After all, it is their money. Until now, they have effectively left the allocation of commissions to brokerage houses and their research to fund managers. As anyone familiar with the allocation process adopted by fund managers in the days of yore could attest, the traditional approach to the problem was determinedly unscientific, with portfolio managers and dealers voting for their favourites in annual beauty parades which owed as much to the quality of the golf day or the frequency of tickets to games as the value of the research or the efficiency of the execution. The research came “free” in return for commission sums whose price was determined entirely by the volume of execution. In effect, the investment banks and broker-dealers were betting that they would make more money by not putting a price on the value of their research. When buying from third party sources without execution attached, the decision is about value and price alone. Buying on price requires the development of a more sophisticated allocation mechanism than dividing the commission pie between the brokers that service the firm – especially since end-investors are now probing the commission allocation procedure. “The risk for the clients of the asset managers, including pension funds, is that there has been a radical change in the market structure, which has made the research environment much more complex and fragmented,” explains Scarth. “The issue for end-investors is, ‘How are my fund managers dealing with this?’ The opportunity is that a lot of alpha can be generated by diversifying sources of research. Conversely, if an asset manager does not change the way it procures research, and insists on continuing to buy it from an investment banking sector in secular decline, that creates the risk of under-performance. The key question is, ‘Can my fund managers articulate and justify how they spent the research money on behalf of the beneficiaries of my fund?’ End-investors need to force their fund managers to do a much better job of understanding what value investment bank research is really adding. They know the research budgets are being cut at the investment banks. They should be asking their fund managers, if they are dependent on investment bank research, what they are planning to do about it. Because the performance of their fund is dependent on how the managers spend their money to make investment decisions on their behalf.” Issue I
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Scarth estimates that aggregate research expenditure with global investment banks is poised to fall by two fifths from its peak in 2007. Declining budgets will force fund managers to look at alternative sources of research. An obvious corollary is that those who continue to buy from investment banks may find they are purchasing an inferior product. Yet there may be no escape from this. Quality is bound to be hard to sustain, since expenditure is being diverted elsewhere, yet users of investment bank research run the risk of having to ensure that research remains sufficiently profitable for the investment banks to carry on producing it. In other words, managers are likely to be trapped into buying a research product which is bound eventually to disappear. Once it does disappear, taking the bundled commissions-for-research business model with it, the cost of replacing it with in-house research will fall on fund managers. Frost Consulting estimates that if investment banks stopped producing research altogether, a cost of $5 billion a year would have to shift from the P&L accounts of the investment banks to the P&L accounts of fund managers, cutting their operating margins in half. That is one reason end-investors need to put the research buying habits of their fund managers under pressure, since they might be pursuing an unstable business model. But the fact investors are now asking managers about how they source and pay for research reflects a much larger concern. This is that research expenditure has far greater impact on investment performance than the efficiency or inefficiency with which trades are executed. “If I buy a stock that moves from $60 to $8 it does not matter how good my execution was,” explains Scarth. He reckons sloppy execution might cost investors up to 200 basis points in a bad year, while poor investment decisions can cost thousands of
basis points. Yet even regulators, through Reg NMS and MiFID I, became fixated on best execution. Belatedly, those same regulators are now waking up to the importance of research procurement to investment performance. In 2010 the Department of Labor in the United States laid a duty on American pension funds and their underlying asset managers to justify their expenditure on research in an annual report to departmental officials. Those reports must include an account of dealings with every counterparty on which a fund or its fund managers have spent $5,000 or more. That low threshold covers almost every commission-based relationship between fund managers and brokers, and the report must go on to explain why the sums incurred were “reasonable.” In November last year the FSA published a similar document, entitled Conflicts of interest between asset managers and their customers: Identifying and mitigating the risks (see Box 3), following a review of practices in the fund management industry between June 2011 and February 2012. It looked at the use of presents and entertainment, access to investment opportunities, personal dealings by staff and the allocation of the cost of errors as well as how fund managers buy research and execution. It did not paint a flattering picture of the industry. “We identified that many firms had failed to establish an adequate framework for identifying and managing conflicts of interests,” reads the report. “We also identified breaches of our detailed rules governing the use of customers’ commissions and the fair allocation of trades between customers. We concluded that most of the firms visited could not demonstrate that customers avoid inappropriate costs and have fair access to all suitable investment opportunities ... In most cases senior management failed to show us they understood and communicated a sense of duty to cus-
table 1: The CSA operational complexity challenge Region
Number of asset managers
Europe United States United Kingdom Other Global total
Number of bilateral CSAs
Annual value of equity trades
900 300 400 100
4,500 1,500 4,800 400
$1,300 billion $4,425 billion $3,300 billion $850 billion
1,700
11,200
$9,875 trillion
Source: Frost Consulting and Advisory
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Issue I
box 3: What the FSA said about commission management by UK fund managers in 2012 1. “Too few firms adequately controlled spending on research and execution service. Firms regularly spend millions of pounds of their customers’ money buying research and execution services from brokers. Only a few firms we visited exercised the same standards of control over these payments that they exercised over payments made from the firms’ own resources. One firm had carefully considered which services represented valuable inputs to its investment process and challenged brokers about why it should pay for other services. Other firm sets a maximum spend on research services and, once these limits were reached, switched commission rates for the brokers concerned to execution-only rates for the remainder of the commission period. These firms could show us that they were both acting in their customers’ best interests and putting customers’ interests before their own. Poor practice we identified included no central organisation of commission payments where individual fund managers paid for research services by directing business to particular brokers on a trade-by-trade basis. It was unclear to us how firms using this approach monitored whether they were acting in customers’ best interests.” 2. “Firms did not regularly review whether services were eligible to be paid for using customers’ commission … In particular, various firms were using commissions to pay for market data services and were unable to demonstrate how these met all of our evidential standards for research services.” 3. “Firms were also unable to demonstrate how brokers arranging for access to company management or providing preferential access to IPOs, constituted research or execution services. Access to company management (sometimes also referred to as ‘corporate access’) means, in this context, the practice of third parties (typically investment banks) arranging for asset managers to meet with the senior management of corporations in which the asset manager invests, or might subsequently invest, on behalf of customers. It does not refer to any research services that might be provided by the third party alongside providing access to company management.” 4. “Firms with poor controls over how they spend customers’ commission put at risk their ability to execute transactions by directing them to counterparties or venues that might not provide best execution. We found that firms with the strongest controls over commissions also tended to have the best monitoring over execution. Good practice we observed in this area included a designated management committee, using transaction cost analysis to assess and challenge the performance of dealing desks.” 5. “Some firms did not observe our requirements to disclose to customers details of commission payments. We found one firm that claimed to comply with the Investment Management Association’s (IMA) Pension Fund Disclosure Code (the Code) regarding commissions when, in fact, it was not fully compliant. The firm was not able to explain to our satisfaction why it had chosen not to comply with the Code, nor how it believed it had met our commission disclosure rules through other means.” 6. “We found that the highest standards resulted from reviews performed by a governance committee or working group involving independent business staff, rather than by compliance staff in isolation. An example of such an approach working well is the review of broker usage and brokerage commissions.”
Source: FSA, Conflicts of interest between asset managers and their customers: Identifying and mitigating the risks, November 2012, paragraphs 3.1 to 3.4
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tomers or even that they had reviewed or updated their arrangements for conflicts management since 2007. In these firms, employees too often lacked awareness of situations where short-term business goals conflicted with the long-term interests of customers.”
certify that their commission practices are compliant with the rules of the FSA, but it effectively specifies that it is best practice for asset managers to move to execution-only commissions with a broker once the research commission allocation target is reached (see point 1 in Box 3). If pursued – and not every fund manager has formal allocations to particular brokers – and especially if enforced, it will further reduce the commission revenue of
The paper threatened enforcement actions and follow-up visits, and obliged the board and CEO of every asset management firm in the United Kingdom to complete and return to the FSA by 23 February 2013 an “attestation” that the procedures adopted by the firm are “sufficient to ensure that the firm manages conflicts of interest effectively Fund managers, especially of the alternative variety, and in compliance with FSA rules.” The are already buying research in unorthodox ways. LondonFSA paper constitutes a major regbased Titan Advisers has worked mainly for large corporations ulatory alert for the fund maninvesting directly in overseas markets, but its workload increasingly agement industry. It not only consists of hedge funds, private equity funds and long-only managers obliges fund managers to that need in-depth, bespoke research into particular industries, sectors
Titan
Advisers
or countries or regions, and which work to tight deadlines. Deadlines are of course the principal motivation of a journalist. Titan Advisers CEO Daniel Costello is a former Wall Street Journal and Los Angeles Times reporter who set up Titan Advisers at the start of 2011 after l15 years reporting about business across the world and completing his MBA. His journalistic career has given him access to an informal network of upwards of 75 journalists, financial analysts, management consultants and political risk analysts all over the world. Titan have conducted on-the-ground research studies into a variety of industrial or commercial sectors commissioned by clients, including health care (Costello was a correspondent in the sector), energy (one recent report was a detailed study of fracking in the United States), pharmaceuticals (Titan reported recently on the politics of accessing the Ghanaian market) and technology (Titan helped a private equity firm decide on an investment in aviation), defence (assessment of failed business pitches) and media as well as financial services work. It is the kind of work that pits Titan against the business intelligence agencies (such as Kroll), security consultants (such as Aegis Group) and even management consultancies (such as Bain & Company) which undertake similar work. “Our model makes more sense than the fixed cost model of the consulting firms if you need to reach someone quickly in a particular sector, or an emerging market,” explains Costello. “Our approach is just more flexible. Give me 24 hours, and I can find someone who knows something about anything you care to name, in any country in the world.” But he emphasises the investigative reporting skills of his network are the true distinction . “Someone with those skills is in a good position to determine whether the apparently fast-growing hospital chain in second tier cities in China is actually doing most of its deals with family members, simply by talking to customers and suppliers,” says Costello. “Investigative reporting skills are essential in markets where you cannot always trust the official information.” It is no longer uncommon for journalists to join fund management houses and consultancies, because they can gain insights which are just as valuable as those provided by the usual numbercrunchers, if not more so. In China, Muddy Waters Research exists primarily to help fund managers penetrate the natural opacity of Chinese capitalism.
the major global investment banks, accelerating the trend towards alternative sources of information. Tellingly, the FSA paper also strongly discouraged the use of commissions to buy “corporate access” (see point 3 in Box 3), or the purchase by asset managers from investment banks of meetings with the senior management of companies in which they are invested or in which they are considering an investment. “That is a big deal, because hedge fund managers in particular can be quite specific with brokers about how much they will pay for each management the firm brings to them,” argues Scarth. “Long-only managers have a more demure approach, but there is sometimes “Joura price tag attached nalists and
to corporate access, so a ban on using client money to pay for it is unwelcome.” Corporate access is now the front line in the long running battle between fund managers and regulators over what they can use client money to purchase. The importance of corporate access to investment performance is obvious, and guesstimates suggest that some managers are prepared to spend up to a third of their commission pots on it. $25,000 a meeting is not uncommon, especially for the hedge fund managers that are often shunned by corporate leaders who believe they do nothing but short stocks.
But there is next to no data that could tell a fund manager whether it is over-paying or under-paying for corporate access. At a time when end-investors are asking searching questions about commission expenditure, ex-journalists can the information vacuum is a worrying one. It is time for deliver alpha-producing benchmarking services that enable end-investors, let research,” says Costello. alone managers, to benchmark more than the gross The value to fund managers of commission payments their managers make to brokers. on-the-ground business intelligence They need to understand which brokers generate the is obvious. In fact, it can be worryingly most commissions, and why. They need to be told exactvaluable, and not only to the businesses ly what managers are spending commissions on. And and officials who would prefer the truth to they need to be able to benchmark their fund manbe contained. Earlier this year, there were agers against the fund managers used by other reports that the Securities and Exchange end-investors. “Fund managers want to know Commission (SEC) in the United States had subwhat their research expenditure looks like poenaed a political intelligence firm, allegedly for relative to a peer group,” says Scarth. “And supplying hedge fund managers with non-public but their clients – the end-investors and asmaterial information that the Food and Drug Adminset-owners – are going to be increasingly istration was going to delay regulatory approval for a interested in how their money is spent.” therapeutic drug. It is the sort of development that has alerted chief compliance officers to the risks (as opposed to the benefits) of unorthodox sources of research. Indeed, the fear of being collared for alleged insider trading has prompted some managers to cut spending on independent research. Titan likes to get paid by monthly retainer, whose value is geared to the likely length of the project and the number of people involved. “Our model is more like the consultancy model, and rightly so, because we are often advising on the strategy as well as doing the actual research work,” explains Costello. “What starts as a one–off project can often mutate into a fullblown research project into new technologies or expansion into new markets.” That entails assessing political and regulatory risks as well as evaluating investment options, assessing customers and competitors, and understanding market and industry opportunities. A premium price is usually charged for completing a project to a tight deadline.
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Chris Freeman, a partner at investment technology consultants DBFS, located in London, was previously head of operations at a large asset manager. Experience tells him that fund managers are at serious risk from the banks to which they have outsourced custody, investment accounting, asset and fund valuation, transfer agency, securities lending, collateral management, derivative pricing and processing and other operational services...
rc W Outsourcing: The unmanaged risk
... At least one regulator agrees with him. On 11 December last year the Financial Services Authority (FSA), the outgoing regulator of the financial markets in the United Kingdom, asked the CEOs of the major fund management firms how they managed this risk. Frankly, reasons Freeman, investors ought to be a lot more worried about this issue than the regulators. He also has some advice for fund managers.
Fund managers are enthusiastic outsourcers. Because their service providers tend to be banks, that has exposed them to risks other than the operational. If the bank to which a fund manager outsources got into difficulties, operations would be severely disrupted. That could cost the investors who rely on the manager to look after their assets tens of millions. Yet fund managers have made no plans to switch their operations to an alternative provider if a supplier is distressed. Nor is in-sourcing operations a viable back-up plan. The knowledge and systems that once resided in the back office of every fund manager were long since exported to specialist banks with operations anywhere but in a major financial centre, making it impossible to re-recruit the relevant staff locally. So what can actually be done to mitigate this risk? A first step is standardisation of operational processes and communication protocols. Banks have tailored their outsourcing services to the needs of particular clients, so every client has outsourced a different portfolio of services, and is sending and receiving data in bespoke 42
formats. This makes switching assets and services promptly from a distressed bank to a solvent one impossible. It already takes between four and six weeks to accomplish the relatively simple task of moving assets from one custodian bank to another. In markets that are distressed, that is tantamount to saying that transitioning business of any kind to a new supplier is impossible. Yet estimates suggest that it would take between 18 months and two years to switch a full outsourcing contract from one bank to another, and cost the three parties somewhere between ÂŁ30 and ÂŁ50 million, with no guarantee that existing business would not be disrupted. If operational processes and data feeds were standardised, on the other hand, fund managers could switch their business between banks cheaply and easily. It would also reduce the investment banks currently make in tailoring systems and processes to their clients. This duplicates the investment needed to keep pace with the widening range of assets and markets fund managers trade in, without creating any serious competitive advantage for one in-sourcing bank over another. Issue I
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A second step is unbundling of services and fees. By outsourcing multiple services to a bank, fund managers have increased the reliance of one service (say, collateral management) on another (say, asset valuation). For every ten services outsourced, 90 service dependencies are created. This degree of inter-connectedness between services and data makes it impossible to divide the operational staff and technology that support different functions into discrete groups that can be moved conveniently to provide the equivalent service at a new supplier. Employment contracts and ownership of technology would have to be re-negotiated case by case. Worse, by emphasising the importance of price in outsourcing arrangements, fund managers have rewarded bundled pricing by the banks, in which marginal or even unprofitable services are cross-subsidised by more profitable tasks. If banks provided only the services which made economic sense, they would have an incentive to invest in the people and systems needed to support those activities only. It would also enable them to price their liability for operational errors more accurately, and escape growing regulatory distaste for cross-subsidised fees, which regulators see as disadvantaging some clients. A third step is simplification of contracts. Outsourcing arrangements are bedevilled by contractual complexities, in which multiple entities assume liabilities and obligations to each other as banks provide different services to fund managers and their underlying clients. Investment accounting, for example, is the subject of a contract between the in-sourcing bank and the fund manager. Securities lending, on the other hand, is the subject of a contract between an underlying investor in the fund and the in-sourcing bank. This multiplicity of bi-lateral and multi-lateral contracts
“Our concern is that if an outsource provider were to face financial distress or severe operational disruption, UK asset managers would not be able to perform critical and important regulated activities, thereby causing detriment to customers. Based on our findings so far we are not confident that across the industry, effective recovery and resolution plans are in place for the asset management sector as a whole.” Clive Adamson Director of Supervision Conduct Business Unit Financial Services Authority 11 December 2012
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greatly complicates the task of assigning contracts to a new supplier. The fourth step is to adopt the radical solution of a user-owned and user-governed utility. This would operate on the same lines as SWIFT, the Brussels-based financial messaging co-operative. At present, dozens of banks compete to produce net asset values (NAVs) for fund managers on a daily basis. They could instead subscribe to a single, standardised valuation process designed and maintained by an entity owned and controlled by the banks. It would eliminate the counterparty credit risk of relying on one bank, since all member-banks would support the entity if one bank failed, not least by porting the valuation responsibility to another member. Economies of scale would also reduce the costs of providing valuation services. There will be those who argue that this is unrealistic, and even undesirable, on grounds that competition even between identical services is both intense and useful. My own view is that, if the fund management industry does not take ownership of the operational infrastructure that supports its core function of investment, the regulators will force individual fund managers to put in place contingency plans which are likely to prove far more expensive and cumbersome – namely, the appointment of duplicate suppliers, or the in-sourcing of operational functions currently performed by third party banks. In short, the co-operative approach would eliminate the regulatory risk of doing nothing. But escaping regulatory prescription is not the only reason fund managers should look to join forces with each other and with the banks to create a simpler, standardised, unbundled and utility service model. It would mitigate the operational risk of being unable to switch activity away from a failing service provider. Such a model would also retain the benefits of outsourcing – fixed infrastructural costs, automatic technology upgrades, and the ability to concentrate resources on the core business – without the disadvantages of the fragmented approach of today. Component services could be priced and benchmarked on a like-for-like basis and investors as well as managers could see exactly what they were paying. Last but not least, it would also reassure investors their assets were safe.
s Issue I
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MIC | analysis
taming the invisible gorilla The Invisible Gorilla is a more dangerous animal than the Elephant in the Room. If there is an Elephant in the Room, everybody knows it is there. They have just decided to ignore it. But if there is an Invisible Gorilla in the room, nobody knows it is there. The extraction of transaction charges from institutional funds is often mistaken for an Elephant in the Room. In reality, it is an Invisible Gorilla. A new study from Investor Data Services show just what that invisibility is costing funds.
Thieves have long understood the value of a distraction. And large parts of the financial services industry are based on a similar understanding of human behaviour. Custodian bankers, fund managers, administrators, agent lenders, cash managers and foreign exchange traders can all rely on customers to look at the wrong things. It is so much a part of human nature that psychologists Christopher Chabris and Daniel Simons have popularised the idea that all humans miss more than they see through their book, The Invisible Gorilla. It is named after a cognitive test in which half the viewers of a video are so heavily invested in counting the number of times players wearing white shirts pass a basketball that they fail
to spot a man in a gorilla suit passing through the players – even though he pauses at one point to beat his chest. First among the distractions diverting the attention of institutional investors is the cost of institutional custody services. In the year to the end of the third quarter of 2012, the total safekeeping and asset-servicing fees earned by the three major independent global custodian banks – BNY Mellon, Northern Trust and State Street – amounted to $11.1 billion. It sounds a lot of money, but as a proportion of the $49 trillion of assets in custody with the three banks it is tantamount to an average of just 2 basis points.
It is an extraordinarily low percentage charge to pay for the safekeeping of the assets of a fund, especially at time when institutional investors – let alone regulators, notably via the AIFMD and UCITS V directives in Europe – are simultaneously demanding that custodian banks ensure their assets are completely safe and, if they are damaged, that the banks make good any of the losses. It is one twentieth of the 40 basis points the average person pays for household contents insurance. This is not a reason for complacency. After all, 2 basis points is just an average. Some funds are paying more, and some are paying less. As Chart 1 shows, the differences can be large. Funds of the same size can be paying less than half a basis point or ten times as much. This can reflect the size and complexity of a portfolio – the chart shows there are definite returns to scale, with the bigger funds paying less for custody than smaller ones – but is more likely to reflect a failure to manage the cost aggressively.
Information is now disclosed, so prices can be monitored, managed and massaged in a downwards direction. As a result, the overwhelming majority of funds in the Investor Data Ser vices (IDS) data set are indeed paying just 1 or 2 basis points. But custody is unusual. There is no other ser vice provided by the financial ser vices industry which is as cheap as custody. But even custody is not as cheap as it looks. As regulators never tire of pointing out, if something looks too good to be true, that is generally because it is too good to be true. The right question to ask about custody at 2 basis points is, “How can custodians sell custody for such a low price?” The answer is that they get paid in other ways, or at least used to (see “Amazing grace star ts work on foreign exchange dealers”, page 72).
Chart 1
Source: Investor Data Services
Yet the really striking feature of Char t 1 is actually the narrowness of the spread. The number of funds over-paying for custody is not large. Consultants have demonstrably done an excellent job in reducing the costs of safekeeping. 48
The extraction of spreads on foreign exchange bargains is the best-understood of these ways, thanks to the notoriety created by a number of high profile law suits against custodian banks in the United States (US). Issue I
ids
INVESTOR DATA SERVICES
Helping investors benchmark and monitor the costs of the safekeeping, management and administration of their invested assets In the current low-yield environment the importance of managing costs eectively has never been more signiďŹ cant. By benchmarking fees and costs against a global peer group and analysing them through a series of key metrics, Cost Explorer can help investors build a clear and objective picture of the cost of their investments and help them identify potential savings.
Asset Servicing & Custody Fees
FX Transaction Costs
Investment Management Fees
Cash Interest Opportunity Costs
Administration Costs
Brokerage & Transaction Costs
cost e x p l o r e r
Lewis Brown + 44 (0) 20 3011 1720 lbrown@investordataservices.com www.investordataservices.com
The legal and reputational risk this has created has forced custodian banks to share data and agree fixed spreads, which has had some effect on their profits from the business. As Chart 2 shows, custodian bank earnings from foreign exchange have been
under severe downward pressure for several years. Foreign exchange revenues at the two largest pure play global custodian banks are down by half on the peak in 2008. But, unlike custody, this decline has had little to do with better management of the cost.
Chart 2
Source: Annual reports
Chart 3
Source: Investor Data Services 50
Issue I
Unlike safekeeping fees, the cost of buying foreign exchange from your custodian is not ‘transparent’ (to use the cant phrase), so the data is not readily available to manage and monitor behaviour. Indeed, as Chart 3 shows, foreign exchange trades of the same size can be charged at vastly different amounts.
There is another generous spread that banks collect. This is on the cash that institutional clients deposit with them, while it is awaiting reinvestment. Like all banks, custodian banks live in part off the difference between the price they pay for money and the price at which they on-lend that money. Most of that money comes from clients. At a specialist custodian bank such as BNY Mellon or State Street it is between three out of four and four out of five dollars on the liability side of the balance sheet. But as it happens, the utterly distorted structure of current monetary policies means that getting a decent return on cash is almost as much of a problem for the custodian banks as it is for their clients. As Chart 4 shows, the top two pure play global custodians hold 50 to 90% more cash on deposit now than they did five years ago. But Chart 5 shows that they are earning the same amount of interest on it now as they were then.
There is some evidence of economies of scale in the chart, but it is not as pronounced as a market which never loses an opportunity to boast of its size and liquidity ought to achieve. It is not hard to work out what is going on. According to the Bank for International Settlements, average daily turnover in the global foreign exchange markets in 2010 was $4 trillion a day. In a year, that is 56 times the annual value of world exports of merchandise. So for every dollar that is traded because someone wants to buy goods manufactured in another country, $56 are traded because someone thinks a currency will fall against another, while someone else thinks it will rise. The sum of all those speculative trades is, ultimately, zero. They do nothing but redistribute money from unsuccessful trades to “average daily turnover successful ones, minus the costs of the trans- in the global foreign exactions, collected by the banks in the middle. In- change markets in 2010 vestors are somewhere inside that $56, paying was $4 trillion a day. in a spreads to banks. In other words, unlike safe- year, That is 56 times the keeping fees, the savings to be made in foreign annual value of world exexchange transactions are still substantial. ports of merchandise.” Chart 4
Source: Annual reports myInvestorCircle
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Net interest margin – the difference between the price banks pay for money and the price they lend it out again - is down 30 to 40% from its peak in 2008. If cash deposits are up, but cash revenues are down, returns paid to clients on deposits must follow suit. At present, investors cannot do better elsewhere. The difference between the rates paid by custodian banks on cash deposits and the rates paid by a AAA money market fund is infinitesimal. The spread ranges from less than 0.1 basis points to 0.6 basis points. To be exact, the difference is measured in hundredths of a hundredth of a per cent. Monetary conditions are so distorted that in
monitoring will increase as interest rates rise. With banks facing higher liquidity ratios under the Basel III regime, custodians will inevitably have to pay more for cash, and institutional clients should not be shy of exploiting that need. The third way custodians have traditionally profited from safekeeping services is by lending the securities for a fee to investment banks, which then on-lend them to hedge fund managers to cover their short positions. The reduction in leverage throughout the banking industry (and diminishing conviction about the direction of equity prices)
Chart 5
Source: Annual reports
the summer of 2011 BNY Mellon actually started to charge clients to place large deposits with the bank. But even at vanishingly small spreads, the interest earned from a deposit can make a difference. For a fund with an average balance of £10 million on deposit with a custodian bank, at present rates the difference between custodian bank and money market rates of interest is £57,000 a year. If interest rates went up by just a quarter of a per cent – 25 basis points – that cost would rise to £82,000 a year. If every quarter per cent rise in rates costs £25,000, a rise of just 5% will cost a fund half a million pounds. Certainly rates paid on cash are worth monitoring, and the value of that 52
has cut the number and value of short positions. As a result, there is less borrowing of securities. There is less lending too. Many institutional lenders, spooked by the loss of control of assets in the Lehman Brothers International bankruptcy and losses on the reinvestment of cash collateral they received in return for stock loans when it was invested in short term securities, have withdrawn from the market. In the IDS data set, the proportion of funds not lending stock at all rose from 12% in 2003-04 to 50% in 2010-11. As Chart 6 shows, securities lending revenues at two of the major agent lending banks are down 80% on the peak in 2008. Issue I
Again, the volume of data available from the agent lenders – and data vendors such as Data Explorers – needs to be expanded. After analysing 586 local authority pension fund reports in the United Kingdom, IDS discovered that one fund in twelve did not know and were unable to establish whether they were actually lending stock – chiefly because they are invested through pooled funds. More worryingly, the return on stocks lent varied from 3 basis points to 404 basis points. Though the wide variation must have owed a great deal to the composition of the various portfolios, the truth is obscured by the lack of data. In short, securities lending is an area in which greater disclosure is not just a nice-to-have: it is an urgent necessity. Another area where it would be helpful for investors to know more is the cost of administering a pension plan. Chart 7 (see page 54), based on the IDS study of local authority pension fund reports between 2007 and 2011, shows that there are obvious returns to scale in administration (the left to right curve of the costs along the asset size on the X axis is textbook). That larger funds incur lower administration costs is an indisputable finding. But the massive cluster of data points on the left hand side of the chart also shows that there is huge variability in the cost of administration at the lower end of the size spectrum.
The cost of running a fund of roughly the same size varies from less than 5 basis points at the bottom end to nearly 40 basis points at the top end. In the note that accompanies Chart 7, IDS has estimated the notional annual savings in administration costs that could be achieved if the five most expensive local authority pension funds in the United Kingdom cut their costs of administration to the mean. It adds up to nearly £11 million. But the mean should just be the starting point. As Andrew Hilton pointed out in an editorial in the London Evening Standard in July last year, it is not unusual for administration to cost a small British pension fund £1,000 per member per year. In the Netherlands, the average charge per member for administration is around €7. In other words, some British funds are paying 170 times as much as their Dutch counterparts. But the most significant - and least understood cost of all is investment management. While funds worry about the 2 basis points they pay for custody, investment managers pocket dozens of basis points for a service which often delivers a lot less value. Chart 8, again based on the IDS study of local authority pension funds, shows that funds of the same size can pay ten times as much as their peers for investment management.
Chart 6
Source: Annual reports myInvestorCircle
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Chart 7
Source: Investor Data Services NOTE: The implied annual savings for the five most expensive plans to achieve the administration expense mean are (2011 figures) £4 million (Fund A), £2.7million (Fund B), £1.6 million (Fund C), £1.5 million (Fund D), £ 1 million (Fund E), or £10.8 million in total for the five funds.
That is worrying, but tolerable if the investment managers are delivering outstanding returns for the money. Unfortunately, hardly any of them are. Most are delivering nothing but beta.
Chart 9 (see Boom, Bust, Recovery, page 55) plots the returns achieved by fund managers managing money for funds in the IDS study against the investment management fees paid.
Chart 8
Source: Investor Data Services 54
Issue I
Chart 9
Source: Investor Data Services
The ease with which a line can be drawn through the data points delivers a very simple message: paying higher fees does not generate higher returns. When the market is booming, investment management returns go up. When the market is busting, investment management returns go down. When the market is recovering, investment management returns recover. Through Boom, Bust and Recovery, whether you pay 5 basis points or 50, fund managers deliver nothing but some variant of beta. This dismal performance in exchange for lavish fees is not the end of the story. The pièce de rÊsistance of the IDS study is its study of the costs of trading: the tax which buying and selling securities imposes on an equity portfolio. This data, which has become available only since the Myners report of 2001 proposed that fund managers disclose to institutional clients the amounts they are paying in commissions to brokers, is so far available on a large scale for public sector funds only. The three separate charts which make up Charts 10 to 12 are based on a study of the commissions paid to brokers by the equity investment managers of 120 local authority pension funds between 2004 and 2009.
Chart 10 measures equity portfolio turnover against the cost of that turnover. The fact that it is possible to draw a 45 degree line through the data points indicates a very strong correlation between turnover and costs charged to the fund. Which is scarcely surprising. The less predictable discovery lies in the data points in Chart 11 (see page 58), which measures commission costs against investment returns. It is impossible to draw a 45 degree line through this set of data points. Over five years between 2004 and 2009, the returns are all over the map, from minus 40% to plus 40%. One unfortunate fund was paying 80 basis points in commissions for a return of minus 30%. Finally, Chart 12 measures equity commission costs against portfolio size. Again, there is no correlation between the size of a portfolio and its propensity to be churned. Average equity commissions range from almost 50 basis points to just a handful. That gap is vast. It means that funds are paying millions of pounds every year in transaction costs for the privilege of buying and selling equity stocks.
Chart 10
Source: Investor Data Services NOTE: Limited to 5% Churn and 50 bp Commissions
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Issue I
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Chart 11
Source: Investor Data Services NOTE: Minus 8 Largest Fee Outliers
The data prepared by IDS is more than suggestive. It is also embarrassing, as much for the individual running the funds as for the intermediaries exploit-
ing them. Nobody enjoys being told that they have failed to manage their suppliers, let alone that their failure has cost their fund many millions of pounds.
Chart 12
Source: Investor Data Services NOTE: Limited to 50bp Commission Charge and 600 EuM
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Issue I
Which explains why the reaction of those funds which have seen this data already is often one of denial. Their own management of their own fund, they argue, is infinitely superior to these averages. But the IDS data set has an excellent riposte even to that. Chart 13 depicts two local authority pension funds. They are the same size; invested in the same asset classes; and enjoy similar returns. Yet the costs they are paying their fund managers and for administration are radically different. The data, which is drawn from the years between 2003-04 and 201011, shows that Fund B paid on average £3.9 million more than Fund A in investment management fees, every year. Over the whole eight year period, that means Fund B paid a premium over Fund A of £31.43 million. In administration charges, through the same period, Fund B paid on average £850,000 more than Fund A. Over the whole eight year period, that means Fund B paid a premium of £6.81 million. In total, for the entire period, with the same assets and for the same period, Fund B paid £38.2 million more than Fund A. These are significant sums. In fact, when IDS calculated the total value to a pension fund of moving from the fourth quartile of its data set to the first quartile, the annual savings were worth £15.5 million a year.
Now, any fund may well be in that the first quartile already. The problem is, without obtaining the data and benchmarking itself against its peers at home and abroad, how will it ever know?
“The data prepared by IDS is more than suggestive. It is also embarrassing, as much for the individual running the funds as for the intermediaries exploiting them. Nobody enjoys being told that they have failed to manage their suppliers, let alone that their failure has cost their fund many millions of pounds.”
Chart 13
Source: Investor Data Services myInvestorCircle
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Thurts
MIC | interview
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he truth
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(your wallet)
T The research used by fund managers is almost always paid for by investors, through the commissions they generate when executing trades with investment banks. The sums involved are substantial. One estimate is that investors are paying $20 billion a year for research. Yet the conflicts of interest at investment banks are obvious. They have every incentive to publish research which suits their corporate finance business or trading positions or which generates further transactional activity. Fund managers themselves have an interest in placing execution business with investment banks that offer them stock allocations or corporate access as well as research. Which may or may not be valuable. This was why the global settlement negotiated by New York forme attorney general Elliott Spitzer in the wake of the deflation of the TMT bubble in 2001 included provisions to subsidise the development of independent research. It was also why the Myners Review, published in the United Kingdom in the same year, favoured the “unbundling� of research from the payment of commissions for equity execution. This environment has made it hard for independent research providers to compete, since they have to charge for their work and cannot cross-subsidise their research from other activities. The net result is a worrying level of distortion in investment allocation and stock selection. Yet investors are a lot less concerned about this than they should be, according to Peter Allen, Managing Director at the European Association of Independent Research Providers (Euro IRP).
MIC: How can your members compete with the resources and access of the investment banks? Peter Allen: To put it simply, independent research needs to be better than the free bank offerings if it is to survive. The challenges lie in making it work as a business. Setting up in the first place, and sustaining the business long enough for revenues to grow is the 60
biggest. Attracting and retaining the talent - in sales as well as research - in a world where the buy-side and sell-side will always pay better is not easy. That is why many independent research firms are partnerships, or are owned by the senior analysts. In fact, some of the most successful independent research houses have been set up by top banking analysts that became fed up with the constraints, conflicts and stresses of working in investment banks. Issue I
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MIC: How lonely can it get when an independent research house challenges the findings of analysts at major houses?
PA: For passionate, experienced analysts this is not a difficulty. It is their mission. You need to be certain of your facts and analysis - and then courageous in presenting your findings – but independent houses tend to attract this sort of person.
MIC: How hard is it for independent research houses to get a hearing? PA: All investors, in particular the top institutions, are drowning in information. They need our help to think through and debate our ideas and their concerns. This trusted advisor role, which is unique to independent research, because we have no vested interest to sell them a security, is an important part of the value that independent research firms bring. MIC: An important source of the power of the investment banks is “corporate access.” How can your members compete with that? PA: It is a common misconception that only big banks have “access” to leading companies. Many independents enjoy the same or even better access, since companies need not be concerned with how they are managing conflicts of interest between research and banking or trading. Most companies realise they need to engage with firms that influence market opinion with solid reasoned arguments and deep fundamental research. That is something independent firms need to offer to survive.
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MIC: Regulators have shown interest of late in both corporate access and expert networks. Are regulatory moves helpful to independent research houses? PA: Corporate access should be more tightly regulated. Sometimes, firms covered by an independent research provider appear at conferences organised by large investment banks, and the independent research house is not granted access. This can limit the ability of independent providers to provide accurate information to clients. In the credit markets, prices are not publicly available. Any regulatory change that would lead to a more timely publication of market prices would help independent research providers to better follow the price moves happening in the markets. MIC: How are fund managers paying for independent research? PA: There are multiple mechanisms that institutions can use to pay, from simply writing a cheque, through Commission Sharing Agreements (CSAs), to Directed Commissions. Access to CSAs has been a major driver of the take-up of independent research. There is a clear acceptance among equity investors in the United States, Canada and the United Kingdom that receipt of idea-generating research, and in particular incoming analyst calls or visits, is a valuable service that must be paid for. The CSA concept is less used in some countries of continental Europe. The Germans are the most advanced. In Asia payment is more often by directed commissions than by CSA. One might call this the old-fashioned way, akin to soft dollars. MIC: Are your members selling mainly to larger fund managers? PA: The bigger firms lap up a lot of independent research, because they have greater internal bandwidth. The smaller,
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long-only players have more limited resources. Some content themselves with broker research, precisely because it offers them the “comfort” of knowing that they will be told what security to buy. It makes their lives easier.
(research from industry consultants, expert networks and channel checking, or researching stocks by examining their distribution channels) and orthodox stock research based on financial analysis and talking to management.
MIC: Are some types of manager and some types of investment strategy more interested in independent research than others?
MIC: How hard is it for independent research houses to survive?
PA: The simple answer must be “yes.” Hedge funds have very different requirements to conventional long-only managers or pension funds. Some hedge funds are trading or quant-based. Long-only players tend to be stock-pickers – or bond or credit pickers – with varying time horizons, but mostly rather longer than hedge funds. In the major centres such as the United States and the United Kingdom – and Canada, for that matter – we come across the whole spectrum of styles. In fact, the growth at pension funds in the United Kingdom and Canada of tactical asset allocation teams that act more like hedge funds – looking, for example, for poorly correlated trades - has increased their appetite for idea generation through independent research. Funds of that kind in the United States have a greater tendency to employ industry analysts in-house. In Asia the number of styles is growing as more and more sophisticated managers move in, but it is still a much simpler world than the United States.
PA: Relationships are critical. If your main client is fired, or they close down the team, or a credit crunch or fiscal cliff intervenes, your business is vulnerable. Sometimes it is possible to follow an individual client from one firm to another. Mostly however we fan out from our point of entry and try to build a broader base of support in the client firm. Once you have built the relationships you can still face a battle to get their middle or back office to pay you. So it is important to get on a plane and go and see people, and persuade hard-to-meet institutions that it is worth them taking on yet another provider of research. But the What is real secret of success EURO IRP? is delivering an excellent Euro IRP represents the interproduct.
ests of the European independent investment research industry. It was set up in 2005 with the twin goals of enhancing awareness of independent MIC: Does that relative lack of sophistication in research, and strengthening its reputaAsia make Asian managers less interested in tion. Its founders wanted to change the perindependent research? ception that research is always free, and to work with regulators and investors to promote PA: In Asia the focus is on Asian stocks of course. acceptance of paying for research directly or via There is a bit of “not invented here” in Hong commission-based payment structures. Since 2005 Kong. But investors in Shanghai think the new forms of alternative research, using non-tradiHong Kong people are too far from the actional methods, have come into widespread use. These tion to make sound judgments. In the Unitinclude expert network firms and consumer channel ed States and Europe there is a greater checkers. Euro IRP has adapted its membership criteria openness to independent research, to allow new types of firm to join, but sought to maintain which stems from an admission that “we sufficient rigour to ensure the reputation of the industry know enough to know that we do not is protected and that members remain free from conflicts know.” When it comes to their research of interest. To become a Certified Provider Member of Euro needs, institutional fund managers in the IRP an organization must attest that they derive their revUnited States and the United Kingdom enue primarily from investors, and not from investment have a strong world view. They absorb banking, underwriting or corporate broking, propriemultiple feeds in order to better inform tary trading or market making, advisory or consultantheir investment process. These feeds are cy services for clients other than investors, or from at several levels, including fundamental (for companies that were the subject of research. example, macro- economic research), primary
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Issue I
myInvestorCircle
MIC | features
ThE selection of fund managers is one of the most unreconstructed processes in the entire financial services industry.
Now a startup headquartered in San Francisco is bringing mathematics,, psychology,, behavioural economics,, data analysis,, raw processing power and a heavy dose of Silicon Valley attitude to bear on a business that remains virtually untouched by science.
how to
revolutionise
investment
management
Think about the last time your fund made an allocation to a hedge fund manager. It almost certainly involved a great deal of manual work to source suitable funds through industry contacts, consultants, databases, prime brokers and industry publications. Screening funds for the right characteristics, setting evaluation metrics and testing the performance record will have involved even more work, though rather less than the background checks, performance data analysis and operational due diligence occasioned by the short list. Today, the process of investing in hedge funds is prodigal of time as well as money. In fact, it is now commonplace for a relatively modest investment to take two years or more from start to finish, by which time the original rationale for investing in a particular strategy may be a lot less convincing. Such an inexact and protracted process is equally frustrating for fund managers, which lose investment opportunities as the due diligence machine eats its way through the piles of paperwork. These days, many do not get any allocations at all. If there is one prime brokerage service which hedge fund managers find consistently disappointing, it is capital introduction. Yet even the prime brokers share the sense of disappointment, and not only because their capital introduction efforts fail more often than they succeed. The real problem for prime brokers is that the costs of providing the service are real, but capital introductions are not a service they can ever get paid directly for providing. It was the palpable inefficiency of this process that prompted Sam Hocking to ask himself if there was not a better way to match end-investors with fund managers. At the time, Hocking was global head of prime brokerage at BNP Paribas and was also in charge of Capital Introduction at BNP Paribas Prime Brokerage, which he joined when the French
bank bought the prime brokerage business of Bank of America in 2008. “The plan we implemented for Cap Intro was way too labour-intensive, involving a long process of search, discovery and analysis,” Hocking recalls. “Matches all had to be done manually. I quickly realised it was ridiculously inefficient and needed to be better optimised by using technology to screen funds and match them with investors.” The Capital Introductions group at BNP Paribas was eventually shifted out of Prime Brokerage into Relationship Management in late 2012. By then, Hocking was already long gone. He resigned from the bank in May 2012, his family having made clear to him that the weekly commute from his home in San Francisco to his principal office in New York was putting something precious at risk. The summer of 2012 turned out to be more than a prolonged family reunion. Even before he left BNP Paribas, Hocking had got to know some creative academics at the Harvard Business School, where he had attended a senior management course.
Back in California, he naturally ran into the technology thinkers and entrepreneurs that populate Silicon Valley. When Hocking explained to them how the hedge fund investment process worked, they immediately sensed another opportunity to use data science and data-processing technology to transform a market, with potentially dramatic effects on its efficiency, which could in turn significantly lower transaction costs. But an industry as densely populated with rent-seeking intermediaries as institutional fund management is less interested in using big data and technology to transform itself than in using them to reinforce or enhance existing practice. So it has helped that circumstances are conspiring in favour of radical change. In the immediate aftermath of 2008 – when investors discovered that hedge fund investments could be gated as well as lost, and funds of funds failed spectacularly to deliver on their promise of diversification and liquidity – hedge fund allocators retreated to the safety of size. Large hedge fund managers got larger. Smaller funds merged, or closed, or failed to raise capital. To maintain institutional quality operations and compliance functions takes real money now. A recent survey by Citi estimated that a hedge fund needs minimum assets under management of $250 million to live off its management fees alone. In short, institutional investors are driving the hedge fund industry towards fewer but bigger managers. Nearly four dollars out of every five invested in the industry are now managed by funds looking after at least $1 billion. The recent Ernst & Young hedge fund and investor survey found that investors allocate just 5-6% of their assets to emerging or start-up managers. The most enthusiastic are not conventional end-investors, but funds of funds managers desperate to reinvent a broken business model. But this trend towards ever greater size is almost certainly the wrong direction in which to
travel. Already, bigger funds are failing to deliver. In fact, the performance of most hedge funds is now so unimpressive that few would contest the claim by Hocking that the trend towards greater scale is a serious mistake. “In most segments of any industry it is fairly well attested that innovation comes from the smaller and mid-size companies,” he says. “In the hedge fund industry it is no different. Hedge funds consistently make better returns when they are smaller and more innovative than the really large funds who get burdened with overhead, social constraints, and too many people and decision-makers.” The post-crisis performance of the bulkier hedge fund managers certainly supports this view. The increased burden of payroll and compliance is further damaging performance by increasing operational costs. Hocking reckons this dismal combination of high costs and low performance argues definitively for a massive reallocation of assets to smaller and mid-sized managers. “I have a fundamental thesis that this is going to change,” he says. “It will change because allocators are not going to stand for the current combination of low returns and high fees.” Other factors argue in favour of a switch by end-investors to smaller managers. An important one is the passage in April last year of the JOBS Act by the United States Congress. This will in theory lift the 80 year ban on general solicitation, allowing fund managers to more freely market and advertise themselves in order to raise money. The JOBS Act creates an opportunity for start-up managers to attract investors but is also likely to result in a sharp incline in the volumes of information cascading through the industry. The altX platform aims to democratise the Cap Intro market, manage the information and create an appetite for a centralised marketplace or clearing house where investors and managers can meet each other.
An industry as densely populated with rent seeking intermediaries as institutional fund management is less interested in using big data and technology to transform itself than in using them to reinforce or enhance existing practice.
... and climbing.
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The somewhat clumsily (but vectorially) titled altX, the platform Hocking is now bringing to market under the umbrella of his new company iMATCHATIVE, was inspired by his introduction to the Lead Innovation team at Harvard Business School. Later Hocking found the work of Al Roth helped to validate the use of matching algorithms as a mechanism to provide new ways to work. Roth is the Harvard economist who last year collected a Nobel Prize in economics for his work on the theory of stable allocations and the practice of market design. This pair of obscure phrases refers to a set of game theory-based algorithms for matching buyers and sellers in markets where price alone is insufficient to match supply and demand. Classic applications of the Roth algorithm include dating and marriage, job searches and university admissions. In all of these cases, “buyers” and “sellers” have to be chosen as well as to choose. Marrying up investment managers with investors is a problem of exactly the same kind. Both sides have preferences they are happy to state, and the ideal solution for matching them is a two-sided market or centralised clearing house which is so efficient that neither fund managers nor investors can achieve a better outcome by transacting in any other way. That is what “stable allocations” means. And that stability is achieved by ensuring that all participants come to the same market at the same time, and that it is safe for them to state their true preferences by ensuring that their second preferences are not even considered until their first choice becomes impossible, and third choices until their second choices have become impossible, and so on. Preferences (or choices) of this kind are of course exactly what investors express when making allocations to strategies or asset classes within an investment portfolio. Those preferences will always reflect a wide array of considerations, including the size and maturity of the fund, the nature of its liabilities, and the risks it is prepared to run. Matching investors with fund managers efficiently requires access to large volumes of quantitative data on the fund managers and strategies available, an understanding of the investment goals of a fund, the strategic and tactical asset allocations 68
made in pursuit of them, the organizational capabilities of the fund, the risks being run by the fund and the appetite of the fund for other risks, based on behavioural and psychological assessments as well as liabilities. So designing a market to match investors with fund managers – and especially smaller fund managers – is a complex assignment. But it is one Sam Hocking is eager to take on. “The applicability of the Roth methodology to the complex and highly manual courtship of fund managers and investors was obvious,” he says. “Selecting appropriate hedge fund investments is complicated, even for sophisticated institutional private investors. Which is why I saw an opportunity to use a combination of Roth algorithms and data processing technology to make the matching process more efficient. In essence, our altX platform aims to find the optimum fit between the preferences investors have expressed, and the investment strategies that are on offer.” Putting together a technology-cum-data platform that achieves these ambitions is a complicated piece of engineering that depends on mathematics, data-gathering and big data processing power. Hocking recognised that appointing himself as CEO was not enough. He knew he needed help from smart people – and he seems to have got it. The iMATCHATIVE COO is John Attwell, a friend of Hocking from their days together serving on the Rollins College board of trustees, but also a former commodities trader, private equity GP and founder of a futures trading and risk management company. The Senior Vice President of Technology slot is filled by Peter Paribas, the former Chief Architect for SCI Solutions. The Chief Science Officer (CSO) is Thomas Oberlechner, professor of psychology in Vienna, Austria, with two books to his credit on the psychology of financial markets. He is joined by Chief Data Scientist Cas Milner, a ‘big data’ analyst and former quantitative analyst and consultant for several hedge funds; Carla Borsoi as Vice President Customer Experience, Former VP Consumer Insights, AOL; Nils Senvalds, VP of Business Intelligence, former Senior Manager of Tax Technology at Ernst and Young; Dr. Gerlinde Berghofer, Measurement and Quality Assurance, Former Clinical psychologist and Researcher, Ph.D. Psychology, from Vienna. Issue I
Marketing and Strategy is the responsibility of Pam van der Lee, a 25 year marketing and branding veteran, having worked at Nickelodeon and parent company Viacom for 14 years, along with Abigail Rizor, a member of the portfolio management team at R.W. Baird. As for the advisors to altX, they read like a brains trust. They include a physics Ph.D. and professor in the technology and operations unit at the Harvard Business School (Marco Iansiti); a management Ph.D. and assistant professor in the same unit at Harvard (Karim Lakhani); a Ph.D. in management at MIT and a professor at Harvard Business School and London Business School (Kevin Boudreau); a mathematics Ph.D. who is also a professor of economic decision-making and leading game theorist and market design expert at the Kellogg School of Management (Rakesh Vohra); and another physics Ph.D., economics Ph.D. and Deputy of Finance in Lebanon (Alain Bifani).
"Everybody understands that it is good to have more data but it is not always clear what you Can do with it"
Much of this formidable intellectual capital is now being poured into the development of altX. The platform is already processing information about the performance of 8,000 funds over the last ten years, drawn from industry-accepted databases, as well as other information that has only recently become available and Hocking bets is almost certainly not being integrated elsewhere. “The myInvestorCircle
effectiveness of a matching engine depends on the data,” says Hocking. “Once you have the data, you can mine it to refine your algorithms, so they do a better job at finding the best matches.” This is a lesson he learned from Match.com, the on-line dating service, which has developed sophisticated algorithms for matching people with their preferences. Of course, Amazon, Google and even supermarkets are all using similar technologies to identify preferences and drive people towards products and services (and people) that can satisfy them, but this is the first time the methodology is being applied to marrying up investors and fund managers. “The technology adds a degree of efficiency to the matching process that is unattainable if you rely only on manual processes or random encounters,” explains Hocking. “Everybody understands that it is good to have more data, but it is not always clear what you can do with it. We are here to help investors do something with their data that yields them greater efficiency and matches them with funds that best suit their unique investment goals, styles and preferences.” Public data published by the Securities and Exchange Commission (SEC), including infractions of SEC rules, is being added to altX (sadly, the information submitted by hedge funds to the SEC via Form PF is not being made available to the public). In fact, the platform is scouring the internet for any information that may be relevant to an investment decision, from planning applications to a divorce petition against a fund manager. The firm is also in discussions with strategic partners to secure permission to include key information and reliable news about managers and investors into the platform as well. “We want to offer informed views on the big trends in the investment markets,” says Hocking. “If inflation is rising, for example, how will that affect credit strategies? Knowing how a class of credit managers and investors in credit strategies are reacting to the issue of inflation is an important part of the analytical tool set we are building. We are not seeking information for its own sake. We are seeking information that has specific applications for specific users of our matching engines.” 69
The firm is even exploring how to make use of qualitative data on thousands of individual portfolio managers and analysts assembled by a recruitment consultant. “Who are these people?’ is a good question to ask of a fund manager,” explains Hocking. “Is there a pattern of behaviour that clusters around certain types of people? If so, does that mean those types of people will help you reach your investment objectives? You may well find you are investing sequentially in exactly the same types of people, and that might well explain the returns you are achieving.” On the investor side, iMATCHATIVE’s CSO Thomas Oberlechner has prepared a proprietary investor profile designed to tease out decision-making processes, and work out if the claims investors make about their investment preferences and decisions accord with the reality, as measured by behavioural science. The idea is to identify unconscious as well as conscious investment biases, so these can be taken into account. But at the heart of altX is a belief in big data – the ability to assemble and analyse and interpret large quantities of information as an aid to decision-making. “Investors want to run every conceivable kind of analysis,” explains Hocking. “By using innovative algorithms, psychometric data and advanced quantitative analytics, we will have the capability to run analyses that match investors and managers much more exactly than they can manage with existing processes.” Hocking is aware that “existing processes” are also income streams, and he is careful to emphasise that altX aims to broaden and enhance, rather than replace, existing manager selection procedures. He even argues that funds of funds, which are on the face of it most threatened by a more efficient manage selection process, are natural adopters. Having spent the last five years reinventing themselves as informed and intelligent finders of emerging managers, who also know enough to conduct a rigorous operational due diligence, they might well find altX a cost-and time-saving tool of exactly the kind they need to stay in business. “We offer them a platform which enhances the search and discovery process through greater transparency into what managers can actually do,” he says. “Funds of funds are also a potentially valuable source of in70
telligence for the platform, about managers looking for investors and, through their operational due diligence activities, of the non-investment capabilities of managers too.” It is an astute bargain to strike. After all, the pace of adoption will be governed by the speed at which investors are prepared to try altX. If it works for them, they will become evangelists, and then agents of revolutionary change in the fund manager search and discovery business. In fact, the long term success of altX depends on investor engagement. The commercial model includes a fee for accessing the data and tools on the platform, but Hocking would prefer to get paid as and when capital actually flows from investors to fund managers. “We do not want to offer a service in exchange for a consulting or retention fee, but to get paid when we help managers get investors and investors find managers that make them and save them money,” he explains. “For me, the best outcome would be an improvement in the performance of the portfolios run by our early adopters of 50 to 100 basis points. If we can improve the way investors make decisions, so they achieve a measurable improvement in performance, they ought to be willing to pay us a sum commensurate with the value we have added. That is not only how we would like to get paid. It is where we deserve to get paid.” Hocking accepts the pricing model of taking a percentage of capital raised may have to change once the business gets beyond the start-up stage, especially if altX succeeds in breaking into the crowd funding or retail sector, but payment-for-success is certainly the right place to begin. It is an established model of business in hedge fund capital raising, which reduces the inevitable resistance to novelty, whose fierceness will be intensified if it makes previous purchasing patterns look negligent by comparison. The principal obstacle is probably inertia rather than price. In Silicon Valley innovations such as altX are an intuitive aspect of the business culture, but in a financial markets sector rooted in the east coast, rent-seeking is more common than solution-seeking. “There is high degree of disbelief that we can do this,” says Hocking. “That is no different from anything new and different in any industry. It takes time to overcome disbelief, but clearly we have got to do that, and we will.” Issue I
SEEKING GROWTH
WITH PASSION,
INVESTING
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MIC | analysis
A string of high profile law suits launched against custodian banks by pension plans in the United States has created a strong impression among investors everywhere that custodian banks have exploited information asymmetries to profit from foreign exchange transactions at their expense. Four years after the first cases came to public attention in 2009, what have investors gained and what have custodian banks changed?
on foreign exchange costs, or at least use foreign exchange costs as a lever to squeeze them on custody fees. Household names, including BNY Mellon and State Street, have faced litigation from institutional clients bereft of returns from any other quarter. To say a political environment hostile to banks and bankers was favourable to such manoeuvring is to badly under-estimate press interest in anti-bank stories and its value to plaintiffs. The aboriginal law suit, launched against State Street in October 2009 by California attorney general Jerry Brown on behalf of the California Public Employees Retirement System (CalPERS) and the California State Teachers Retirement System (CalSTRS), was seen even at the time as part of his (ultimately successful) bid for election as Governor One change is almost palpable. If investors have of the Golden State. In 2011, the Boston-based learned anything since 2009, it is that they can custodian retained the custody business of CalPalmost certainly squeeze their custodian banks ERS, but allegedly at a price.
Likewise, just over a year after the attorney general of Virginia sued the Bank of New York Mellon (BNY Mellon) for $120 million in damages for allegedly over-charging state pension funds on foreign exchange bargains, the Virginia Retirement System (VRS) renewed its custody contract with the bank. VRS let it be known the funds considered the renewal terms favourable. Better for BNY Mellon was the fact that in May 2012 the case was dismissed, and in November last year the state – not the bank – ended up making a payment to the whistle-blower who had launched the initial complaint. Yet at the time the law suit was launched in August 2011 almost everybody was prepared to believe that a global bank was making huge profits at the expense of the beneficiaries of taxpayer-funded public retirement funds in the middle of the worst, bank-induced recession in decades. Unsurprisingly, amid the political cacophony, custodians promising robustly to defend themselves against allegations they considered unfair found it hard to convince anyone of the justice of their case.
“It was through collecting spreads not only on foreign exchange bargains, but also on cash awaiting investment, and a share of revenue from lending client securities to broker-dealers that custodian banks could offer custody services as a loss leader. That is what banks do: they live off the assets of their customers. A client would have to be extremely naïve not to grasp that this was the economics of the arrangement.” One reason why is that the litigation was built on more than a grain of truth, though not necessarily the truth the plaintiffs chose to see. The fees paid by the Virginia pension funds to BNY Mellon for keeping $54.3 billion in custody on behalf of the VRS, for example, was 74
$4.7 million in in 2010 and $4.4 million in 2011. That is less than one basis point. In seeking, in the original filing of August 2011, damages of $120 million and a further $811.6 million in civil penalties ($11,000 for each of 73,784 “falsely reported foreign currency trades”) Virginia Attorney General Kenneth Cuccinelli was seeking to recoup a sum that was 207 times as large as the annual fee paid to BNY Mellon for custody services. So it was clear even from the claim that Virginia was not paying a commercially viable fee for custody services. The money to pay for the services had to come from somewhere else. In a somewhat sensational sense, the initial suit filed by Cuccinelli in August 2011 explained where. It alleged that BNY Mellon charged the VRS funds the most expensive foreign currency prices of the trading day – or something very close to it – rather than the actual interbank rate at which the currencies were purchased. When the currencies were sold, on the other hand, it paid the least expensive price of the trading day. In both cases, according to Cuccinelli, BNY Mellon kept the difference. Whatever really went on, some variant of this toll on foreign exchange transactions was the implicit – and sometimes explicit – basis on which global custodian banks agreed to cut custody fees to nugatory levels. It was through collecting spreads not only on foreign exchange bargains, but also on cash awaiting investment, and a share of revenue from lending client securities to broker-dealers that custodian banks could offer custody services as a loss leader. That is what banks do: they live off the assets of their customers. A client would have to be extremely naïve not to grasp that this was the economics of the arrangement. So custodians were understandably dismayed at the disingenuous behaviour of clients that claimed not to have understood the nature of the bargain being struck. But at a time of weak investment returns, and widespread hostility to bankers, there was much to gain and little to lose for State lawyers to pretend otherwise. In October 2011 the New York Attorney filed an action against BNY Mellon seeking $2 billion in damages as compensation for alleged over-charging on foreign exchange transactions. Such lavish sums proved hard to justify and collect, but plaintiffs which chose to settle were still able to use the opportunity to negotiate more favourable terms for renewing a custody contract. Issue I
In December 2011 the Louisiana Municipal Police Employees Retirement System (LAMPERS) actually joined a class action against BNY Mellon even though the bank was not its custodian. LAMPERS argued instead that it had suffered losses on its shareholdings in BNY Mellon when the bank was exposed to litigation over foreign exchange following the whistle blower revelations. “Throughout the Class Period, and unbeknownst to its investors, BNY Mellon and certain of its executive officers issued a series of false and misleading statements, and omitted to disclose material information, regarding the Company’s use of fraudulent practices to artificially inflate BNY Mellon’s reported financial results, including by artificially increasing BNY Mellon’s FX revenue, and misled investors regarding the sustainability and reasons behind the profitability of this critical line of business,” read the class action complaint. “As a result of these disclosures, BNY Mellon’s common stock has declined over 37% from the date the first qui tam action became public through the end of the Class Period. The decline is directly attributable to the market absorbing previously undisclosed information about the Company’s fraudulent FX practices.” Even those custodian banks whose brands were not emblazoned across the newspapers found themselves being drawn into behind-the-scenes discussions with clients who reasoned they too might have suffered from adverse foreign exchange rates. Those close to the industry suggest that many banks moved quickly to placate clients in order to avoid the reputational risk of litigation and the accompanying headlines. More than three years on from the Jerry Brown case that sparked the imbroglio, institutional investors are extremely alert to the pricing mechanisms custodians apply to the servicing of their assets, and not just in foreign exchange. The litigation has brought to the surface how banks exploit information asymmetries – access to information about prices not available to their clients – to generate profits. It has also created an opportunity for consultants to sell services that promise investors some combination of transparency into the prices they are paying and discipline to keep their service providers honest. Though firms such as Record Currency Management have long audited foreign exchange trades on behalf of institutional investors, in addition to offering them advice on foreign currency hedging and return, a new class of independent advisers has now emerged. myInvestorCircle
FX Transparency, for example, was founded with the explicit goal of helping “the institutional buy-side narrow the significant variance in currency execution quality across investors” by measuring, monitoring and managing their FX costs. Likewise, Klarity FX describes foreign exchange as a classic “buyer beware” market, and promises to help buy-side clients “achieve competitive pricing and proper execution of currency related transactions.” In London, Investor Data Services (IDS) provides similar foreign exchange execution analysis services to institutional investors.
“More than three years on from the Jerry Brown case that sparked the imbroglio, institutional investors are extremely alert to the pricing mechanisms custodians apply to the servicing their assets, and not just in foreign exchange. The litigation has brought to the surface how banks exploit information asymmetries – access to information about prices not available to their clients – to generate profits.” According to Jimmy McGeehan, co-founder and CEO of FX Transparency, the spread paid by pension funds to execute foreign exchange bargains through their custodian has fallen substantially since Jerry Brown and the whistle-blower changed the environment. He also points out that trades which are large enough to be negotiated tend to enjoy finer spreads than those executed by standing order. “After looking at millions of negotiated and standing instruction trades, 30 plus basis points spread was typically being charged on standing instruction FX trades executed by custodian banks on behalf of clients,” he says. “When trades are negotiated it tends to be from fractions of a basis point to closer to 3 basis points depending on currencies traded.” 75
Interestingly, this was also chief among the findings of the only academic analysis of the performance of an unnamed custodian bank in the foreign exchange markets. In a 2011 study of transactions executed in 2006 in 27 different currencies against the US dollar, entitled Asymmetric Information and the Foreign-Exchange Trades of Global Custody Banks, Carol Osler and Thang Nguyen of Brandeis International Business School and Tanseli Savaser of Williams College found that the average spread – the difference in the price received by the bank and that charged to the client – was 20.4 basis points. The average was higher (22.4 basis points) for non-negotiated trades such as those executed as part of a standing instruction service but significantly lower for negotiated trades, at just 3.4 basis points.
does say that IDS has succeeded in trimming foreign exchange costs for those clients that monitor them actively. As Chart 1 shows, IDS clients that monitor their costs have achieved quite sharp reductions. The implication of this finding is disconcerting, but plain. Custodians which are not under continuous scrutiny do charge higher prices. A less obvious conclusion is that some custodians provide better rates than others, and the worse performance may owe everything to incompetence and nothing to a desire to exploit information asymmetries. Chart 2 illustrates how widely the costs of a similar transaction in the same currency pair can vary between banks. One global custodian in particular can clearly be seen to be applying a significantly higher spread than its rivals, resulting in significantly poorer execution quality for its clients.
Brian Ward, who as head of foreign exchange execution cost analysis at IDS runs regular analyses of foreign exchange bargains executed by custodians on behalf of institutional clients, reckons the 30 basis points identified by Jimmy McGeehan is closer to the mark, though he cautions it varies by currency pair. Ward adds that this average price is still being paid years after the whistle-blower litigation began to change perceptions, whereas Osler, Nguyen and Savaser were measuring trades (albeit against the US dollar only) at the height of the pre-crisis markets in 2006. He
As Chart 2 on page 50 of this issue shows, the profits generated by the two leading pure play custodian banks from foreign exchange execution were significant until 2009, and have fallen sharply since, partly because of lower levels of activity and less volatile markets (which reduce arbitrage opportunities) but also because clients are more alert to rates charged, so the business they are transacting is less profitable than it once was. 2009 was, more than coincidentally, the year Jerry Brown launched his law suit against State Street on behalf of CalPERS and CalSTRS.
Chart 1
Source: Investor Data Services
76
Issue I
US Securities and Exchange Commission (SEC) filings on the FX litigation State Street
G In October 2009, the Attorney General of the State of California commenced an action under the California False Claims Act and California Business and Professional Code related to services State Street provides to California state pension plans. The California Attorney General asserts that the pricing of certain foreign exchange transactions for these pension plans was governed by the custody contracts for these plans and that pricing was not consistent with the terms of those contracts and related disclosures to the plans, and that, as a result, State Street made false claims and engaged in unfair competition. The Attorney General asserts actual damages of approximately $100 million for periods from 2001 to 2009 and seeks additional penalties, including treble damages. This action is in the discovery phase. G In October 2010, State Street entered into a $12 million settlement with the State of Washington. This settlement resolves a contract dispute related to the manner in which State Street priced some foreign exchange transactions during a ten-year relationship with the State of Washington. G In February 2011, a putative class action was filed in federal court in Boston seeking unspecified damages, including treble damages, on behalf of all custodial clients that executed certain foreign exchange transactions with State Street from 1998 to 2009. The putative class action alleges, among other things, that the rates at which State Street executed foreign currency trades constituted an unfair and deceptive practice under Massachusetts law and a breach of the duty of loyalty. G Two other putative class actions are currently pending in federal court in Boston alleging various violations of ERISA on behalf of all ERISA plans custodied with State Street that executed indirect foreign exchange transactions from 1998 onward. The complaints allege that State Street caused class members to pay unfair and unreasonable rates for indirect foreign exchange transactions with State Street. The complaints seek unspecified damages, disgorgement of profits, and other equitable relief.
BNY Mellon G In early 2011 the Virginia Attorney General’s Office and the Florida Attorney General’s Office each intervened in a qui tam lawsuit pending in its jurisdiction, and, on Aug. 11, 2011, filed superseding complaints. On Nov. 9, 2012, the Virginia court, which had previously dismissed all of the claims against BNYMellon, dismissed the lawsuit with prejudice by agreement of the parties. G On October 4, 2011, the United States Department of Justice (“DOJ”) filed a civil lawsuit seeking civil penalties under 12 U.S.C. Section 1833a and injunctive relief under 18 U.S.C. Section 1345 based on alleged on-going violations of 18 U.S.C. Sections 1341 and 1343 (mail and wire fraud). On Jan. 17, 2012, the court approved a partial settlement resolving the DOJ’s claim for injunctive relief. In October 2011, several political subdivisions of the state of California intervened in a qui tam lawsuit that was removed to federal district court in California. On March 30, 2012, the court dismissed certain of plaintiffs’ claims, including all claims under the California False Claims Act. Certain plaintiffs have since filed an amended complaint. G BNY Mellon has also been named as a defendant in several putative class action federal lawsuits filed on various dates in 2011 and 2012. The complaints, which assert claims including breach of contract and ERISA violations, all allege that the prices BNY Mellon charged for standing instruction foreign exchange transactions executed in connection with custody services provided by BNY Mellon were improper. Source: Bank of New York Mellon Corporation, Q1 10-Q 2013 and 2012 Annual Report. State Street Corporation Q1 10-Q 2013
myInvestorCircle
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Importantly, foreign exchange is a business which generates flat rate execution fees plus variable spreads while devouring little or nothing of the balance sheet of the bank. In executing trades on behalf of institutional clients, custodians bank rarely take principal risk. Instead, they pay whatever price the market demands, and mark it up before passing it on to the clients. Some custodians now guarantee to give clients the rate at which the bank executed the transaction, but this entails no risk for the bank. What would entail risk is guaranteeing the rate at a certain time of day, with the bank assuming the risk of an adverse price movement between that rate and the actual time of execution. How best to execute foreign exchange bargains is now being actively discussed for, if the whistle-blower litigation has proved anything, it is that institutional clients have historically paid insufficient attention to the wording of their custody contracts on the issue of foreign exchange. Custodians are now offering clients ways to achieve greater certainty on price, such as fixing points during the trading day, at which users of standing instruction services are guaranteed to receive the price at that time. Chief among them is BNY Mellon (see Sidebar at page 81).
The time-stamping of every trade is proving harder to obtain. Indeed, custodians have mounted effective defences to legal actions, arguing that their agreements empowered them to act as they did. They have not hesitated to point out that the image of well-informed bankers exploiting uninformed – even naïve – institutional clients is a travesty. Institutional investors openly accepted that foreign exchange profits, like securities lending revenue splits, were a way of paying for custody services. Custodians have furnished clients with reports about foreign execution for years, albeit rarely with the relevant comparisons, and almost never with the time-stamps that would enable clients to measure spreads. Lack of time-stamping was a frequent complaint in the litigation, but it has certainly proved arguable that institutions were given enough information to raise inquiries about how their costs compared to the market rate or the prices given to their peers long before tanking markets encouraged them to do so. Even if they have not litigated, investors have certainly understood the lessons of recent experience. Monitoring foreign exchange execution rates is now regarded by pension fund trustees, for example, as a standard fiduciary responsibility. The work, however, is being done largely by third party consultants
Chart 2
Source: Investor Data Services
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Issue I
who are paid to pore over the data from the custodians. “It is essential to identify and then manage potential conflicts of interest in any relationship,” explains Troy Rieck, Managing Director of QIC Capital Markets, the Australian investment firm that operates an agent-only foreign exchange execution model. “To quote former President Ronald Reagan, you need to ‘trust, but verify’.
“Certainly the commercial model that has developed in the custody industry over the last 20 years – essentially, giving custody away for free in order to exploit the assets in custody in the cash, securities lending and foreign exchange markets – is effectively broken, but no custodian bank is willing to pioneer the raising of custody fees.”
The simple process of monitoring outcomes and comparing them to expectations sends a strong signal to service providers that you care about the outcome. That alone will improve their performance, and build trust and confidence in the relationship.” Others worry that cutting custodian bank profitability in foreign exchange will undermine the quality of the service. A more immediate concern is that, if the foreign exchange subsidy is withdrawn, prices will have to rise elsewhere. IDS, for example, is now monitoring actively for signs that custodians are compensating for lost foreign exchange revenues by increasing prices elsewhere. “Custodians will look at the balance sheet and see two key figures: margin and revenue,” explains Brian Ward of IDS. “It makes little or no difference how the figures above that change around. Some areas can become more or less profitable but it does not matter provided the end-calculations result in those two bottom-line figures at least staying the same or, ideally, growing.” myInvestorCircle
Certainly the commercial model that has developed in the custody industry over the last 20 years – essentially, giving custody away for free in order to exploit the assets in custody in the cash, securities lending and foreign exchange markets – is effectively broken, but no custodian bank is willing to pioneer the raising of custody fees. “At present the custody business is under significant pressure because, although clients are negotiating down on costs in areas like foreign exchange, they are not in a position at present to maintain their revenues by increasing those costs elsewhere,” says one industry observer. Reick of QIC argues that this reluctance to act is not sustainable. “At one point, custody fees were being squeezed so hard that it could have tbeen seen as a loss-leading business, and cost recovery and profitability came from undertaking a range of ancillary services, like foreign exchange trading,” he says. “To the extent that funds really believe that quality custodian services could be provided for less than cost, they are part of the problem here. Custody is a serious activity that needs to be done properly, and as such, a transparent and reliable fee needs to be arranged and paid for services rendered. Having said that, custodians should be in a fiduciary relationship with their clients, and to act in a way that is inconsistent with that intention is fundamentally damaging to the relationship.” The conventional solution to this conundrum is “unbundling,” by which custodians would dispose of hidden cross-subsidies by itemising what they charge for each component of the services they provide. Brian Ward of IDS reports that, in contract negotiations, an increasing number of clients are isolating individual costs such as custody, foreign exchange, cash, corporate actions and other aspects of the service. “The trend we are seeing is definitely toward an unbundling of services provided by custodians,” says Ward of his clients. Custodian banks are increasingly willing to adapt to that demand. However, even “unbundling” ultimately requires clients brave enough to trade an undisclosed spread for an explicit increase in fees, and disclose it to trustees which might well accuse officials of dereliction of duty at an earlier stage. “An unbundling would allow you to see the true cost of all the services included within your custody arrangement,” according to Ross McLellan, president of Harbor Analytics LLC, a transaction cost analytics and consulting firm focused on measuring transition management. 79
“Inevitably that would mean that servicing fees would go up if the services were unbundled, undisclosed costs were clear and cross-subsidies were eliminated. It would be difficult for any client to take that leap of faith and ask for a fully unbundled service and a larger service fee.” McLellan certainly knows what he is talking about, having set up the consultancy after leaving the portfolio solutions group at State Street which found itself at the centre of an inquiry into fixed-income trading costs charged by the bank during the transition of a portfolio to a new fund manager. At the heart of that inquiry was allegations of undisclosed spreads on fixed income trades executed for the Royal Mail Pension Fund. One transition manager at the bank, dismissed by State Street after the bank admitted in a letter to clients that it had evidence of overcharging a client on transitions, took the bank to a London employment tribunal, alleging that mark-ups were approved at the highest level of the bank. The tribunal found that the employee was unfairly dismissed because a fair procedure had not been followed. However, it found no evidence that the mark-ups were sanctioned at the highest levels within the bank. “The dismissal was caused (100%) by the conduct of the claimant,” according to judgement of the tribunal. Although Reick of QIC also favours unbundling, he argues that – in the absence of transparency – investors should continue to monitor costs aggressively across all of their service providers. “Whether services are unbundled or not – and I am a fan of doing so – transparency, monitoring and benchmarking are an essential part of the mix,” he says. “Third party providers can help funds to independently verify and analyse their trade data, and thereby better discharge their own set of fiduciary obligations to their members.” He highlights the importance of gaining access to the data that facilitates effective monitoring of custodians. “Funds need their custodians to extract and supply data at a more granular level. For example, foreign exchange trades should have a time stamp attached to them. Where this is not the case, the analysis cannot be as rigorous, but it is still possible to look at the open, high, low and closing price 80
of the day, and to calculate some form of average price over the day.” The findings provide the information needed to re-negotiate costs in a downward direction. If satisfaction cannot be obtained on that score, the radical option is to take business elsewhere. Naturally, QIC would like to attract business to its own execution platform. However, shifting to execution-only agents is no guarantee of improved performance in foreign exchange costs. As Brian Ward of IDS notes, not all providers are equal, and some have more sophisticated trading desks than others, with greater experience of how and when to execute trades to achieve an optimal price. Indeed, he argues that the issue with certain custodian banks was not that they achieved poor rates but that the benefits of their excellent execution were not always shared with their clients, or even disclosed to them in reports. In fact, Ward warns that agency-only execution platforms are open to exactly the same forms of analysis as traditional standing instruction trades carried out by a custodian bank. As it happens, custodians are also raising the price of moving business to third party providers. They are applying ticket fees each time cash is transferred into or out of a custody account. That is one measure of the continuing power of the banks in the foreign exchange industry. Another is the triennial survey of the foreign exchange markets by the Bank for International Settlements (BIS). Its most recently published survey (from 2010) found that three quarters of spot, outright forward and swap trading in US dollars, sterling, Japanese yen and Singapore dollars was conducted by no more than ten banks - half as many as in 1998. In an industry as consolidated as that, competition on rates is understandably muted, especially as banks control the digital trading platforms too.1 The custody industry has consolidated even further, with three quarters of assets in custody controlled by just four banks. This makes threats to move business elsewhere empty. “The custody industry is essentially an oligopoly in which it is difficult to see that the major competitors are going to be giving you any better service than you are already getting,” explains Ross McLellan of Harbor Analytics. “Around two thirds of trades are still executed with custodian banks. However, a lot less business is taking place on standing instruction.” Issue I
That modest alteration in modus operandi is only the beginning of a tectonic shift in the foreign exchange markets, which have for too long traded on their reputation for deep liquidity and low barriers to entry, while providing banks with informational advantages which they have understandably sought to exploit. After all, prices are the signalling mechanisms by which markets work efficiently. In markets where prices are distorted, resources will be misallocated. At present, it is clear only that institutional savings are being diverted needlessly into the profits of the banking
industry. Now that is understood, the pressure for greater transparency and competition – especially from non-banks – will do the rest. Investors must maintain the pressure the pioneers have exerted, even if that pressure was sometimes applied by disingenuous as well as litigious means.
1 See “Why foreign exchange is not a market” at http://myin-
vestorcircle.com/opinions/why-foreign-exchangenot-market
BNY Mellon maps the future of its foreign exchange business
jim cecere
In response to the litigation the bank experienced, and increased scrutiny of the foreign exchange markets by consultants and journalists, BNY Mellon set up an internal “Enterprise FX Group.” It brings together the client-facing side of its custody business and the foreign exchange execution desk, with the aim of developing a model of business better adapted to client needs. bob ne a “The group is focussed on understanding the on-going foreign exchange needs of today’s clients, identifying opportunities to grow our FX business, and developing market driven FX solutions that will allow us to capitalise on these opportunities,” say Jim Cecere and Bob Near, co-heads of the group.
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They are robust about the fact that foreign exchange execution must remain a profitable business for the bank if it is to continue to provide a service. But they also say that BNY Mellon has made conspicuous moves to introduce more transparent pricing models. It offers a set range of prices at the start of the trading day. It is also open to fixing execution prices at a point in the day agreed with a client. This does mean the bank takes on some of the risk of intra-day price fluctuations. This protects clients from sharp movements in the market, though it can also profit the bank if the market moves in a favourable way. Most importantly, BNY Mellon is embracing increased client demand for unbundling of services. “Both clients and BNY Mellon want a clear understanding of what services are being used and the corresponding cost for the services being provided,” say Near and Cecere. “There are instances where BNY Mellon, and others in the industry, have bundled solutions. However, there has always been a preference for a clear understanding of costs and fees, especially when considering the value of the service. This is increasingly leading us towards the unbundling of services and assigning individual fee structures. While there still may be room for bundling, the trend we are seeing is toward unbundling.” myInvestorCircle
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MIC | Editorial
How tnew methods
of
social networking n can guide investors into a
brighter futureć Asset owners can harness peer group networks for their own benefit, as well as the benefit of the industry and society as a whole. Only by sharing with each other what they know can investors work out if they are paying too much to their service providers, or failing to follow best practice.
Social media platforms are rebuilding economies, bringing down governments, revolutionising business models, creating new sources of data, and altering how we acquire and share information. Using networks to exchange information and ideas with peers in the industry is an effective way to increase output, enhance transparency and cut costs. Online peer-to-peer networks such as myInvestorCircle gather an audience, and engage the interest of their members by producing and hosting compelling content. Membership of the network is free to registered end-investors, including pension funds, sovereign wealth funds, charities and endowments, family offices and insurance companies. Membership of the network is closed to banks, brokers, fund managers, consultants, IT vendors and other service providers, who might want to sell a product – except on those occasion when they are willing to take the risk of sharing with members what they know through our expert networks.
In networks like myInvestorCircle, it does not pay to be precious about so-called “intellectual property.” The backbone of the network is a range of tools designed to stimulate and facilitate dialogue between members, in which they share knowledge, ideas and experience, benchmark service providers, keep their suppliers honest and cut their costs. That dialogue is stimulated by the provision of engaging content, created by our own staff as well as our sponsors and resident experts, and distributed online. That information-sharing creates tremendous value for members. By sharing data with each other, members can create benchmarking services covering fund management, administration, execution and asset-servicing costs. As the network grows, members will also be able to exert their collective force directly, securing better disclosure of information by service providers and keener pricing of the products and services they buy. It will take time for these benefits to be realised. How long depends on how quickly the network grows, and the effects kick in. The growth of the network in turn depends on our ability to win the trust of members. That means giving members control over who they share information with, and who can access their profile. We offer that assurance by restricting membership only to asset-owners. But in the end myInvestorCircle will become whatever its members want it to be. Indeed, as a motto puts it, we ask not that our members move with the times, but that they help define what the times are. To join our network, contact me, Frances Doherty, at frances.doherty@myinvestorcircle.com
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