This is the second in a series of articles from Comada on the subject of custody risk.
The challenge for custodians in safekeeping alternative assets like hedge funds is that there is no Central Securities Depository they can rely on. For conventional securities, CSDs exist to help investors and custodians by providing an easily accessible record of securities owned. Historically, the CSD would take delivery of physical share certificates – today an electronic registry is maintained which allows investors and company registrars to keep track of who owns what.
For the vast bulk of hedge funds, which are not actively traded on stock exchanges, there is no CSD. Nor is there a broker to broker network like the Depository Trust Company’s National Securities Clearing Corporation. Custodians are therefore forced on a monthly basis to request statements of hedge fund holdings from the transfer agents who maintain funds’ registers of shareholders. The problem with this is that there is a large universe of TAs in the market, each acting for only a small portion of the total universe of hedge funds.
This problem does not exist in the long only funds universe where there are effective CSDs in the cross-border funds market, like Clearstream and Euroclear, or in the North American market the NSCC’s Fund/SERV network. But for hedge fund investors, to obtain a regular proof of ownership is much harder.
In this series we often refer back to emerging share markets as an example of the problems faced in early stages securities processing. In Russia in the 1990s, for example, there was no CSD and no facility to verify share ownership electronically. Custodians had to send representatives to the offices of the company issuing the shares to physically inspect the shareholders’ register. Hedge fund custodians have similar problems today – they have to check in with each individual transfer agent acting for every fund they hold on behalf of their clients.
There is currently still no effective central repository of data that can be used as a statement of ownership for even 20% of the hedge funds universe. While some TAs have explored electronic connectivity with custodians, there is no uniform transport mechanism, no way to achieve reconciliations in a consistent format. Most TAs are still not using SWIFT, for example.
Consequently, when custodians have to report to clients on their hedge fund holdings it is not only harder to confirm positions, but a great deal of internal data processing has to still be carried out manually.
The above just covers the problems arising from putting out a monthly statement – what of corporate actions? How does the custodian establish how investors want to vote at AGMs or EGMs for hedge funds? How are voluntary or involuntary corporate actions communicated effectively? How can custodians manage the issuance of equalisation shares or the establishment of side pockets? There is no automated method of managing this, creating yet more manual processing and a wider margin for costly errors. The custodian is left accumulating reams of non-standard information from TAs, often delivered in fax or email format. While traditional securities are processed via rules that have been established in global capital markets, no such standards exist for hedge fund investments.
Ultimately, this remains a key area of risk for custodians – investments are issued and redeemed at NAV. If errors occur here, they can be costly ones. Similarly, corporate actions in themselves can require delicate management as they often include a decision making component.
Custodians will need to find a way to manage their investor reporting for hedge funds with fewer manual processes, as errors can bring significant reputational damage with them.
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