Why custodians may not be aware of the risks they are running when acting as brokers for investors in hedge funds.

Liquidity emerged as a major risk for hedge fund investors during the 2008 credit crisis, but it remains a major source of risk for custodians of alternative assets. Again, it is worth comparing the risks posed by alternative assets against those of more traditional securities.

In the world of normal trading, a broker who makes an error can usually rectify it quite speedily. This is because he is trading in a continuous market – the period during which the broker is exposed to his mistake is limited. He might only be at the mercy of price movements for an hour or less. And because systems between counterparties in conventional securities markets are automated, brokers can limit financial losses caused by errors with relative confidence.

Within the alternative investment market, where custodians are acting as brokers for investors in funds, potential errors are magnified because of the time it takes to confirm a trade. Mistakes in orders are uncovered in the reconciliation process, but it can take days before a counterparty will issue a trade confirmation.

Consider then the situation a custodian faces once an error in an order is discovered, for example when a sell order is confused as a buy order. Because shares in hedge funds are so illiquid, it can prove very difficult to have a mistake resolved, particularly as the custodian bank is dealing in a principal market – i.e. the fund is creating the security for the investor.

Funds have very little leeway to address errors, particularly since corporate governance might prohibit them from favouring a specific investor. Redemption terms can mean a trade will not be resolved for six or even 12 months, during which time the price of a fund will change with little or no scope to hedge it.

Custodians participating in the market for alternative funds are not being rewarded for the liquidity risks they are taking on a daily basis. Once such risks are fully understood, many banks may decide that it is not worth the slim rewards they earn. Custodians have improved the language used in agreements with clients as they have started to wake up to the liabilities they face, but another solution would be the introduction of electronic execution, speeding up the trade confirmation process and radically reducing manual errors.

On the other side of the coin, investors may want to use their alternative investments as collateral when raising cash. However, due to the lack of hedge funds’ liquidity, it can often be difficult to discover an accurate price. There is no readily available market data source, requiring significant proprietary effort to procure a recent net asset value (NAV).

Investors will often want to raise cash more quickly than shares in a hedge fund can be redeemed, and the lack of daily or weekly market prices means the lending bank can create significant risk for itself by lending against hard to value assets or assets than themselves can take some time to liquidate (frequently three months or more in the case of many hedge funds). Again, investment in electronic pricing interfaces can ensure more accurate and speedy pricing and support faster decision making.

A detailed liquidity report of an underlying portfolio of hedge funds, one that could be dynamically updated, was the Holy Grail for many funds of funds in the dark days of 2008. Proper liquidity reporting is underpinned by effective data and tools. It requires a degree of investment in technology that can be proactive, agile and responsive.

One of the real tests of any portfolio management system occurs when things go wrong: in the world of money management, operational failures, for instance on the part of a business further down the service provider chain, can force the portfolio manager to re-evaluate retrospectively. Can he be sure that such revaluations are being consistently applied, especially if multiple individuals within the same firm are juggling dozens of spread sheets? Once mistakes creep into the historical portfolio picture, they can be difficult to track down and correct, and they can continue to have an unforeseen impact on reporting further down the line.

Beyond the problems of effective performance tracking, investors in hedge fund portfolios today want to feel they have a better grip on what is happening in underlying hedge funds. This means being able to view a more complete operational picture. Their questions cover key issues relating to fund liquidity, including whether funds have the ability to gate withdrawals, whether gates have been initiated, the expiry of each tranche lock up, and what the options are to reduce lock ups and when. Better information on the liquidity scenario can deliver important additional advantages to the portfolio manager.

It all comes down to a question of confidence: can an investor feel confident that a trade has been properly executed? Has it been confirmed by the relevant custodian and underlying transfer agent? How long does it take to receive the estimated and real NAVs? Do they always come in on time? Are communications with relevant parties secure and dynamic enough to process real-time information flows?

With a more detailed picture comes a higher degree of confidence in the underlying investment and a superior level of reporting to end investors when required. This also helps the portfolio manager to allocate further funds more efficiently.