coo magazine, winter 2013. issue 3

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COO Cover Story

SHOW ME MY MONEY

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Try crimson/pink and yellow lettering on the green.i.e try single and mixed colour letters.

COO / peer group network / www.cooconnect.com / issue 3 / winter 2013

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COO Cover Story

This advertisement has been approved and/or communicated by Deutsche Bank AG London. Securities and investment banking activities

Copyright © 2012 Deutsche Bank AG.

Voted No. 1 Global Prime Broker 5 Years Running Global Custodian Prime Brokerage Survey 2012, 2011, 2010, 2009, 2008

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partner for hedge funds.

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This advertisement has been approved and/or communicated by Deutsche Bank AG London. Securities and investment banking activities

Copyright © 2012 Deutsche Bank AG.

Voted No. 1 Global Prime Broker 5 Years Running Global Custodian Prime Brokerage Survey 2012, 2011, 2010, 2009, 2008

Deutsche Bank Equities

The No.1 Partner for Hedge Funds 5 consecutive years

Deutsche Bank is proud to be voted by clients as the No. 1 Global Prime Broker in the 2012 Global Custodian Prime Brokerage Survey for the 5th consecutive year. DB also earned more “Top Rated” and “Best in Class” awards than

partner for hedge funds.

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COO Connect_Prime Serv spread 6/8/11 12:07 PM Page 1

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Contents

COO EDITORIAL

8 Founder’s letter COOConnect founder Dominic Hobson looks at changes in the securities lending market.

14 Editor’s letterCOOConnect editor Charles Gubert assesses the challenges facing smaller hedge funds.

COO COLUMNS

38 How to borrow but stay in controlDavid Fletcher offers some uncompromising advice on how to borrow without losing control of your assets.

74 Time for investors to practise what they preachPierre Emmanuel Crama of Signet discusses the ongoing evolution of hedge fund transparency.

122 It should not be easyKevin Mirabile of Fordham explores an alternatives industry at a crossroads.

COO COVER STORY

16 Cash in peril at The CCPSHow confident are you that clearing brokers really know the difference between their money and yours?

COO FEATURES

44 An attempt at a definition of NewedgeDominic Hobson talked to global head of prime clearing services, Chris Topple.

58 The triumph of hopeMergers are as unlikely to work in fund management as in any other industry. So why do they keep happening?

78 What SWIFT can do for hedge fundsSince its foundation in 1973 the Brussels-based messaging co-operative has built its way into the middle and back offices of the treasury departments of the banks but what does it offer hedge funds?

100 The make-believe world of corporate governanceWhy corporate governance is doomed to failure whenever and wherever it is tried.

COO ANALYSIS

113 The biggest risk you are failing to manage Fund managers struggle to get excited about their fund administrators.

COO INTERVIEW

88 A bear for all seasonsAltana Wealth founder Lee Robinson has made a lot of money for himself and his investors by anticipating the worst that can happen.

COO PERSON

94 Out of the trenches Not many people in the hedge fund industry are prepared to put their heads above the parapet. Anthony Scaramucci gets out of the trench altogether.

COO Q&A

52 The future of hedge fund financingDominic Hobson talked to Ajay Nagpal, head of prime services at Barclays.

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

As recent events have shown,

safer markets are needed if

derivatives are to deliver their

full economic benefits.

A safer derivatives market is

transparent, to inspire trust. It’s

efficient, so processes are simple

and capital costs are lower. It ensures

investors’ positions are protected.

And above all it’s neutral, so that

counterparty risk is mitigated. Which

is exactly what Eurex Clearing helps

to provide.

Eurex Clearing is Europe’s leading

CCP clearing house for securities

and derivatives transactions. We

process gross risks valued at almost

EUR 9 trillion every month across

a wide range of asset classes – both

on-exchange and off-exchange.

At the same time, we’re the

first clearing house to deliver

real-time risk monitoring

for derivatives.

We’re also working with regulators

and participants around the world

to find ways to make markets

safer. Because the more people

have faith in the markets, the more

they’ll feel clear to trade.

www.eurexclearing.com

Eurex Clearing_CooConnect_May19 18.04.2011 10:41 Uhr Seite 1

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

As recent events have shown,

safer markets are needed if

derivatives are to deliver their

full economic benefits.

A safer derivatives market is

transparent, to inspire trust. It’s

efficient, so processes are simple

and capital costs are lower. It ensures

investors’ positions are protected.

And above all it’s neutral, so that

counterparty risk is mitigated. Which

is exactly what Eurex Clearing helps

to provide.

Eurex Clearing is Europe’s leading

CCP clearing house for securities

and derivatives transactions. We

process gross risks valued at almost

EUR 9 trillion every month across

a wide range of asset classes – both

on-exchange and off-exchange.

At the same time, we’re the

first clearing house to deliver

real-time risk monitoring

for derivatives.

We’re also working with regulators

and participants around the world

to find ways to make markets

safer. Because the more people

have faith in the markets, the more

they’ll feel clear to trade.

www.eurexclearing.com

Eurex Clearing_CooConnect_May19 18.04.2011 10:41 Uhr Seite 1

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Hedge fund returns (especially in fixed income strategies) have long depended on multiplying exposures to promising positions by borrowing money. One of the ways fund managers borrow money is by selling short and borrowing the stock to cover it. But that is not the only reason securities lending matters to the fund management industry. Prime brokers also lend securities to third parties to raise cash to on-lend to fund managers. More importantly, lending securities owned by one client to another client is one of the internal funding efficiencies that have made prime brokerage such a profitable business for the investment banks. So what is happening to securities lending is of intense interest to fund managers.

Unhappily, the securities lending markets are not in the rudest of health. The traditional drivers of borrowing activity, such as issuance (notably of convertible bonds) and corporate events (capital raisings and mergers and acquisitions) remain subdued. Dividend arbitrage trades between domestic and foreign investors - whose impending disappearance is a perennial feature of the securities lending markets - do at last seem to be dying, not least because investment banks are increasingly reluctant to incur the reputational risk of assisting with tax avoidance. Tax harmonisation could administer the coup de grace, in Europe at least, even if the proposed pan-European financial transaction tax follows the example of

FOUNDER’S LETTER

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its French and Italian precursors and exempts stock loan. Then there is that other tax: regulation. The Europeans have gone ahead with low short sale disclosure thresholds and a hard-locate rule. New rules obliging mutual fund managers to disclose securities lending revenue splits with investors, and setting restrictive portfolio lending limits and collateral reinvestment and correlation controls, are judged unhelpful by the industry. A trade repository looks certain to follow, even if a central counterparty clearing house for stock loan transactions does not. In the United States, cash collateral vehicles are being subjected to more onerous disclosure and stress-testing, and the single counterparty exposure limits of section 165 of Dodd Frank are at least as unhelpful in securities lending as they are in securities financing. The one certain outcome of these regulatory initiatives is that the cost of the indemnities offered by agent lenders to institutional investors will go up. In a business which remains marginal to investors – despite the efforts of agent lenders to dress it up as a fund management discipline – that will further reduce the already shrunken appetites of institutional lenders. Some that withdrew in 2008 have not returned. Others have quit since, grumbling about lack of opportunity to lend and low returns relative to the risk. Those that persist are fussier about where cash collateral is reinvested, and about the non-cash collateral they can accept. Prime brokers are no longer buying exclusive rights to lend portfolios on a lavish scale, reasoning that the risks outweigh the potential rewards. None of this is conducive to furnishing

COOFounding PartnerDominic [email protected]+44 (0) 207 228 3013

EditorCharles [email protected]+44 (0) 7769 276 385

Director of SalesJames [email protected]+44 (0) 7769 277 927

Content Development & Relationships ManagerDan [email protected]+44 (0) 7557 301 812

Peer Group ManagerMarta [email protected]+ 44 (0) 208 600 2359

ProductionKate [email protected]+44 (0) 7804 097 736

COO, a publication of COOConnect, the peer group network for alternative fund managers and their investors, is published four times a year. Subscription is free to authenticated fund managers and investors. The annual subscription price is £75. The entire content is copyrighted.

ISSN 2049-2510

Horatio House77-85 Fulham Palace Road London W6 8JATel: +44 (0) 208 600 2300

www.cooconnect.com

A new generation of global prime brokerage

© 2012 JPMorgan Chase & Co. All rights reserved. This is not intended for retail clients. All product names, company names and logos mentioned herein are trademarks or registered trademarks of JPMorgan Chase & Co. Access to financial products and execution services is offered through J.P. Morgan Securities LLC and J.P. Morgan Securities plc (“JPMS plc”). Clearing and financing services are provided by J.P. Morgan Clearing Corp. (“JPMCC”) and JPMS plc. Custody and collateral management services are provided through JPMorgan Chase Bank, N.A., JPMCC and JPMS plc. For additional information about these entities, please visit jpmorgan.com/primebrokerage.

At J.P. Morgan, our offering was developed with one purpose in mind — our clients’ success.

We meet your evolving needs by offering dynamic solutions for every part of your firm, from every part of ours. From financing across all asset classes to critical asset protection, we integrate world-class capabilities to help you achieve your goals.

Discover how we can meet your needs today

#1 Global Prime Broker 2012 Global Custodian Prime Brokerage Survey

Learn more: jpmorgan.com/primebrokerage

2012_005_PB_CooConnect_0907.indd 1 9/7/12 5:01 PM

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A new generation of global prime brokerage

© 2012 JPMorgan Chase & Co. All rights reserved. This is not intended for retail clients. All product names, company names and logos mentioned herein are trademarks or registered trademarks of JPMorgan Chase & Co. Access to financial products and execution services is offered through J.P. Morgan Securities LLC and J.P. Morgan Securities plc (“JPMS plc”). Clearing and financing services are provided by J.P. Morgan Clearing Corp. (“JPMCC”) and JPMS plc. Custody and collateral management services are provided through JPMorgan Chase Bank, N.A., JPMCC and JPMS plc. For additional information about these entities, please visit jpmorgan.com/primebrokerage.

At J.P. Morgan, our offering was developed with one purpose in mind — our clients’ success.

We meet your evolving needs by offering dynamic solutions for every part of your firm, from every part of ours. From financing across all asset classes to critical asset protection, we integrate world-class capabilities to help you achieve your goals.

Discover how we can meet your needs today

#1 Global Prime Broker 2012 Global Custodian Prime Brokerage Survey

Learn more: jpmorgan.com/primebrokerage

2012_005_PB_CooConnect_0907.indd 1 9/7/12 5:01 PM

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fund managers with reliable lenders and stable prices at which they can borrow stock. Managers need lenders which cover all markets in which they are active, wherever they are in the world. They want assets to be priced accurately in liquid markets, and to be available in sufficient quantities to mitigate recall risk. No fund manager welcomes a recall, especially if the lender views it as an opportunity to re-rate. Yet the rising demand for eligible collateral, driven by the growing intermediation of all financial markets by central counter-party clearing houses, is bound to increase the temptation to do exactly that. With prime brokers increasingly unable to internalise, they will have to compete with their clients to borrow stock. These challenges are not yet acute, because of markets short of conviction, and de-leveraging by fund managers. Leverage has settled at around 2½ times NAV plus borrowing throughout the last four years, which is a quarter to a third below the level immediately prior to the crisis. But if a net long bias is bad news for traditional stock lenders, it does create opportunities for managers to lend as well as borrow, since they are holding assets for longer periods. For those prepared to think creatively and take risks, some of those opportunities might well be reassuringly profitable, as many of the lenders that have stayed in the market over the last five years have discovered. It entails thinking about stock loan like a treasurer, not a fund manager. This does not entail as complete a mental revolution as that sounds. After all, fund managers are already coming to terms with the fact that they need to bring their cash borrowings into better

alignment with their assets. They used to borrow at a flat rate (typically for 90 days) from prime brokers which were sourcing at least half the cash in the overnight market. Prime brokerage, like banking in general, was a maturity transformation business. With prime brokers now obliged to cut single counterparty exposures to 10-25 per cent of capital, lift their capital and liquidity ratios, better match their assets and liabilities, forego the right to re-hypothecate and impose mandatory minimum haircuts on the collateral they accept, that yield curve play is over. With the cost of finance from prime brokers now varying by term as well as price, it makes obvious financial sense for managers to match the maturities at which they borrow with the period they hold an asset. In the same way, if they are now likely to hold assets for months or even years, managers should look to lend those assets for equally lengthy terms. For fund managers that are long the equity markets, lending securities for longer periods is a potentially profitable trade, and it will become more profitable if they are prepared to accept unusual forms of collateral. In a market increasingly infested with the risk-averse, fund managers should see plenty of opportunity. They should revel in their role as the last takers of risk in an increasingly dysfunctional financial system.

Dominic [email protected]

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Ten years ago, a hedge fund manager could start with two people, a Bloomberg screen and $5 million. This is not a nostalgic myth: I have met managers who started with no more than that. Some of the giants of the industry began with astonishingly small sums of money. Today, they would be unlikely to get started at all, let alone survive. The institutionalisation of investment, and the over-regulation of the industry, are predictable consequences of the acute phase of the financial crisis in 2007-08. It would be foolish to deny that the classic hedge fund investors (high net worth individuals) were scarred by that experience too, or that the classic investment vehicle (funds of funds) was not found wanting. But the industry is in danger of forgetting that, in any business, the genuine innovators tend to be small. It is more than coincidence that the hedge fund industry has begun to deliver beta at exactly the time consultant-advised institutional money from pension funds,

EDITOR’S LETTER: WE NEED MAMMALS, NOT DINOSAURS

sovereign wealth funds and insurance firms is shunning any opportunity below $250 million. Regulation is driving that process of institutionalisation. Frankly, it is not possible for a start-up to run money successfully and comply with AIFMD, FATCA, mandatory clearing, Form PF, CFTC registration, Solvency II, MiFID II and the FTT. A study by Citi reckons any manager running less than $250-375 million cannot cover their costs out of management fees. Indeed, the Citi study estimates that regulatory and operational costs eat 198 basis points at any fund managing less than $250 million - almost the whole of the 200 basis points funds collected in management fees in the heroic age of hedge fund investing. $5 billion-plus funds, according to Citi, pay an average of 47 basis points for the same functions. One reason that high expectations that Volcker, Vickers and Liikanen would drive proprietary trading talent into the industry are not obviously being fulfilled is the inability of talented individuals to satisfy institutional investors they can deliver institutional-quality operational processes and compliance. An industry synonymous with innovation is being crushed by unimaginative and risk-averse investors, and regulators whose constituencies are intrinsically hostile to alternative investing in general. But there is always hope. Presently, it stems from those pioneers, in California and elsewhere, that are exploring how technology can revolutionise the capital introductions.

Charles Gubert, [email protected]

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COO Cover Story

CASH IN PERIL AT THE CCPSIn 2005 the legendary hedge fund manager Jim Rogers sued Refco for allegedly shifting $362 million in assets from a segregated customer account to the insolvent capital markets arm of the firm. Seven and half years later, MF Global has gone the same way as Refco, and for the same reason. At the start of this year the proprietor of Peregrine Financial Group collected a 50 year jail term for siphoning off client cash. How confident are you that clearing brokers really know the difference between their money and yours?

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COO Cover Story

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COO Cover Story

Regulators say they are necessary to protect consumers, investors and taxpayers. Protecting the cash and securities posted by customers of clearing brokers to margin their derivatives trades was from the outset a central ambition of the regulation of the derivatives markets. With the Dodd Frank Act and the European Market Infrastructure Regulation (EMIR) now shifting a proportion of the swaps markets on to a similar trading and collateral-driven clearing infrastructure, the value of the customer assets at stake is higher than ever. Yet customer asset protection has seen some spectacular failures in the last 18 months. When MF Global collapsed on 31 October 2011, the liquidators estimated that the firm had $900 million less than it needed to make customers whole on the assets they had placed with the firm to margin their futures and options trades in the United States. The firm was short another $700 million owed to customers trading futures and options contracts in other countries. As the report of James W. Giddens - trustee to the MF Global liquidation - made clear, customer assets were being used to fund the firm as it entered its death throes. Despite the furore that followed the collapse of MF Global, just nine months later another clearing broker failed, also taking customer assets with it. In July 2012 Peregrine Financial Group collapsed after proprietor Russell Wasendorf admitted to a $215.5 million gap between the customer assets he claimed to hold and the amounts he actually held on their behalf. In January this year, Wasendorf was sentenced to 50 years in jail for misappropriating the funds. The major clearing brokers argue that

Peregrine and MF Global were exceptional, and that neither firm did much institutional business. True, Peregrine was relatively small. In its last report to the Commodity Futures Trading Commission (CFTC) before it failed, the firm claimed to be holding just under $410 million on behalf of customers trading in domestic and foreign futures markets. MF Global was holding much more. In the months before it failed, it was looking after just under $8 billion of customer assets. By that measure, MF Global was one of the ten largest clearing brokers in the United States at the time of its collapse. Even today, $8 billion is enough to put a clearing broker – or, as they are called in the United States, a Futures Commission Merchant (FCM) - in the top five nationwide. Some household names found themselves caught up in the MF Global debacle, because they used the firm as a sub-contractor to complete business in small contracts on minor exchanges, where it made no sense to purchase direct memberships. This sub-contracting of business makes the degree of concentration in the futures and options clearing business in the United States even more disturbing than the financial data reported by clearing brokers to the CFTC suggests. As Table 1 shows, just ten out of 112 firms reporting to the CFTC are responsible for three out of every four dollars held on behalf of customers. If the customer assets held separately by the clearing arms of five of those firms - Goldman Sachs, J.P. Morgan, Bank of America Merrill Lynch, Morgan Stanley and UBS – are added to the total, it rises to nearly four out of five dollars, and to more than nine out of ten dollars held against contracts traded on

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COO Cover Story

Name of the FCM Total value of cash,securities and otherproperty held on behalfof customers tradingUS domestic futuresand options contracts(segregated undersection 4d(a)(2) of theCommodity ExchangeAct, it includes excesscollateral held foradministrativeconvenience)(US dollars)

Total value of cash,securities and otherproperty theclearing broker isrequired tosegregate on behalfof customers tradingdesignated USdomestic futuresand optionscontracts (i.e. thesum of all netliquidating equities,or total accountbalances due)(US dollars)

Total value ofcash,securities andother propertyassociatedwith particularcontracts inthe US (Part30 SecuredAccountamounts ornet liquidatingequity, or totalaccountbalances due)(US dollars)

Excess ordeficiencyof customercash,securitiesand otherproperty inseparateSection 30.7accounts(less the Part30 SecuredAccountamount)(US dollars)

J.P. MorganSecurities LLC

19,936,632,507 17,886,019,785 2,858,262,936 329,737,81

Goldman Sachs & Co 19,462,434,389 18,944,697,538 7,594,258,644 536,122,712

Newedge USA LLC 16,906,169,775 16,312,998,420 3,990,091,265 400,947,833

Deutsche BankSecurities Inc.

15,468,590,079 14,876,791,368 1,180,274,320 177,406,299

UBS SecuritiesLLC 8,564,632,390 7,988,872,863 2,764,067,722 413,289,697

Citigroup GlobalMarkets Inc.

8,435,199,287 8,157,160,859 883,898,668 227,232,492

Merrill LynchPierce Fenner Smith

8,160,850,158 7,624,105,477 1,889,190,828 350,429,029

Credit SuisseSecurities (USA) LLC

7,577,439,347 6,567,351,971 1,964,799,586 588,379,333

Morgan Stanley &Co LLC

7,255,344,645 7,146,394,103 1,648,893,380 106,467,563

Barclays Capital Inc. 6,425,277,068 6,204,809,736 2,964,946,241 166,526,210

Sub-total 118,192,569,645 111,709,202,120 27,738,683,590 3,296,538,980

Others 39,355,027,036 35,429,568,970 2,269,592,443 1,046,314,111

Total 157,547,596,681 147,138,771,090 30,008,276,033 4,342,853,091

Source: CFTC, Selected FCM Financial Data as of November 30 2012, from reports filed by 2 January 2013.

Customer Assets Held by FCMs at 30 November 2012

overseas markets. Once sub-contracting is added to the mix – and it is to be hoped that the major clearing brokers have by now comprehensively revisited all their sub-contractual relationships - the risks faced by customer cash

and securities posted to collateralise derivative trades look worryingly undiversified. The total sum at risk is also substantial, and about to increase massively. The $157.5 billion of customer-owned cash

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COO Cover Story

and securities recorded in Table 1 dates back to 30 November last year (clearing brokers always report to the CFTC several weeks in arrears). Just two days earlier the CFTC had announced a series of deadlines for the clearing of fixed to floating interest rate swaps, basis swaps, forward rate agreements (FRAs), overnight index swaps and North American and European index credit default swaps (CDSs). Swap dealers and private funds were instructed to clear these swaps by 11 March this year, with third party fund managers obliged to follow suit by 9 September 2013, and all other market participants by as early as 10 June 2013. Central clearing of swaps by buy-side firms – as opposed to swap dealers – started to take off almost immediately. The notional value of client-side interest rate swaps cleared by the SwapClear service at LCH.Clearnet rose from $8,311.9 billion that day to $18,083.7 billion on 1 February – a rise of 118 per cent in just two months. In other words, the hedge fund managers, fund managers, commodity trading advisors (CTAs) and high frequency traders (HFTs) that have long used centrally cleared futures and options to express relative value in fixed income and equities are now starting in earnest to trade and clear swaps in the same way. This means that they are posting more securities (as initial margin, many for the first time) and more cash (as variation margin) to the clearing brokers that collateralise their trades at the central counter-party clearing houses (CCPs) that clear a growing proportion of over the counter (OTC) as well as exchange-traded derivatives. Estimates suggest that an additional $1-1.5 trillion in cash collateral will be posted to CCPs to margin swap trades.

Given these sums, it behoves fund managers to understand the risks to which their assets are exposed by the posting of margin to clearing brokers and CCPs. Chief among them is what happens to cash and securities belonging to customers when a clearing broker or CCP, or even a trading counterparty of a clearing broker or CCP, defaults. And what happens is a function of three principal considerations. The first is the rules and regulations governing the segregation of client assets at the level of the clearing broker and CCP on every exchange or swap trading facility and legal jurisdiction where the fund is buying and selling futures, options or swaps. The second, given that CCPs insist variation margin is always paid in cash, is to work out how cash collateral is reinvested by clearing brokers or CCPs while it is in their possession. Cash reinvested in paper issued by borrowers that fail is at risk of being totally lost. Fund managers that enter into repo trades in order to raise cash to post to a CCP also have to take into account the creditworthiness of the cash-providing counterparty to which they pledge securities, or of the CCP which intermediates the repo trade. The third consideration is the need to assess the timing and circumstances under which the initial and variation margin contributed to a CCP might actually be called upon in an event of default. The point at which a buy-side firm is at risk of losing money varies by CCP, since each has its own “risk waterfall,” or layers of capital and collateral that lie between a defaulting party and other users of the CCP. Take segregation first. The rules governing the segregation and protection

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COO Cover Story

of client assets in the derivatives markets of the United States were and are more specific than those which apply in Europe. Section 4d(a)(2) of the Commodity Exchange Act obliges clearing brokers to treat customer funds as belonging to the customer at all times, and to segregate from its own funds any cash or securities deposited by customers to margin futures and options trades. Section 4(d)(f) of the Act, added by the Dodd Frank Act, extends these protections to customer money and securities deposited to margin cleared swap contracts, while CFTC Regulations 22.2, 22.4 and 22.6 put the additional rules into practice. A longer-standing CFTC Rule – namely, 30.7 - obliges clearing brokers to segregate client monies associated with trading futures and options contracts on exchanges outside the United States. Also under Section 4(d)(a)(2), clearing brokers are obliged to retain in segregated accounts enough assets to cover the total account balances due. This figure - in the jargon, the “net liquidating equity” – is calculated daily by clearing brokers, and is reported to the CFTC if there is less cash in the segregated customer account than required to margin open positions. CFTC Regulation 1.20 requires clearing brokers to open segregated accounts at third party banks to hold customer assets in the name of the customer, and to secure a written commitment from the bank that the assets will not be used by any other customer. CFTC Regulations 1.20 and 1.22 further prohibit the clearing broker from using customer assets to margin their own trades, or those of another customer, or to secure credit, or to borrow them with a view to paying them back later.

However, the details of the rules do contain gaps which are open to exploitation. Clearing brokers are free (ostensibly as a matter of administrative convenience) to commingle in a single account the funds of one futures or swaps customer with funds belonging to other futures or swaps customers. Since most users of derivatives over-collateralise their margin accounts – to reduce the administrative hassle of repeated margin calls, and the risk of positions being liquidated if a margin call is not met in a timely fashion – this enables clearing brokers to maintain sizeable amounts of non-segregated client margin. On top of that, clearing brokers inject significant amounts of their own capital into client accounts, in case a client fails to meet a margin call on time and so creates risk for other customers. These “excess segregated funds” can be substantial. At the end of November last year, for example, the difference between the total amount of collateral held on behalf of customers by the 112 clearing brokers reporting to the CFTC, and the amount needed to cover “net liquidating equity” was nearly $10½ billion (see Table 1). Inevitably, the temptation to make use of these funds for purposes other than margining derivatives contracts is strong. Rule 30.7 creates another temptation. Under it, only initial margin has to be segregated, allowing the clearing broker to do what it likes with the variation margin, even to the extent of using it to fund the proprietary business of the firm. Though the majority of clearing brokers run Rule 30.7 accounts on the same terms as they run 4(d) accounts - even though that is not strictly required - the temptation to use the funds is ever-present. It was one

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to which the management of MF Global succumbed. According to the Giddens Report, customer assets available to MF Global during its last (increasingly desperate) weeks averaged $1 billion. In deciding whether to borrow these assets to fund the firm, it helped that CFTC end-of-day accounting rules appeared to permit borrowing of customer funds intra-day, and to allow a clearing broker to use its own money to make up any shortfall either intra-day or at the end of the day. According to Giddens, by the summer of 2011 it had become a matter of routine at MF Global for the New York operation to request a “loan” (actually a transfer of funds between different parts of the same entity) from the treasury department responsible for the segregation of customer funds. These sums were used to fund proprietary trading and other non-clearing broker business, with management arguing that there was no regulatory breach provided the funds were returned before the end of the trading day. Funds were borrowed overnight, with borrowings initially limited to sums equivalent to its own “excess segregated funds.” By July 2011, it took the MF Global CFO to resist a senior management plan to borrow $250 million overnight on a regular basis from customer accounts, irrespective of whether it was money belonging to customers or the “excess” funds. Later in 2011, according to the Giddens Report, MF Global started to use the funds of some customers to meet the requests of other customers to withdraw funds from their accounts. By October 2011, these payments were running at up to $60 million a week. This threatened a breach securities firms to segregate

sufficient assets to cover the net credit balances of customers at all times. However, MF Global management reasoned that, by performing the Rule 15c3-3 calculation on Monday using data from close-of-business on Friday, the requirement would be reduced sufficiently by the withdrawals to permit the release of funds and still stay within the Rule. What drove sophistry of this kind was mounting desperation. “Events during the final week of MF Global’s operations increased the demands to use FCM funds to meet liquidity needs elsewhere in the enterprise,” is the verdict of the Giddens Report. On 26 October, just five days before it declared bankruptcy, MF Global transferred $615 million of funds from customer accounts at its clearing brokerage arm to fund proprietary trading activity, chiefly in European sovereign bonds. A day later a further $175 million of customer funds were transferred to MF Global in London to clear an overdraft at J.P. Morgan. These moves meant the firm was in serious breach of its duty to segregate customer assets and invest them in line with CFTC Rule 1.25. Yet these last desperate measures were the culmination of a long debate within the firm over the appropriateness of tapping customer assets. As the Giddens Report puts it: “Some confusion and differences of opinion existed within MF Global regarding the extent to which excess funds might be available to meet liquidity needs across the MF Global enterprise ... Some at MF Global considered the Regulatory Excess to be a potential source of funds for intra-day, or even overnight, transfers to fund the non-FCM activities of MF Global, although others

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were of the view that the Regulatory Excess would still have to be `locked up’ for the benefit of customers.” What resolved the debate was the withdrawal of other sources of funding. By the second half of October 2011, creditors had stopped lending to MF Global, or demanded increased margin to do so, until the firm was left with nothing but collateral it could not finance at any price. This reflected a loss of confidence in the viability of a thinly capitalised firm following a change of strategy which sought to profit from the euro crisis, but which had also vastly inflated the daily borrowing needs of the firm. By October 2011 MF Global had a net $7 billion invested in euro bonds. These securities were purchased by the American arm of MF Global, and repoed to its London affiliate at a term which matched the maturity date of the bond. This enabled MF Global to book the repos as sales in the profit and loss account, with the assurance of proceeds to re-pay the cash borrowed through the repo when the bonds paid out. One problem was that the repo transaction between the London affiliate and LCH.Clearnet as the CCP was two days shorter than the maturity date of the bonds, so the UK affiliate had to finance the bonds for the missing two days – further increasing the demands on the firm for cash to fund its portfolio. It was to cover that funding gap that the firm began to tap customer assets. It is a reminder that, when a crisis becomes existential, events will always overwhelm any rules regulators care to devise. The new and amended regulations published by the CFTC to “enhance protections for customers and customer funds” held by clearing brokers and

CCPs must be viewed in this light. In December 2011 the CFTC amended Regulation 1.25 to narrow the range of instruments in which customer collateral can be invested. This was an attempt to correct the steady erosion of restrictions over the reinvestment of customer cash collateral, as clearing brokers pressed for liberalisation, to diversify risk and enhance yield. Treasuries, repos, foreign sovereign debt, money market funds, bank deposits, municipal bonds and some varieties of corporate debt all became permissible investments, as did money market mutual funds regulated under Rule 2a-7 of the 1940 Investment Company Act, and approved by the derivatives exchanges. Money market mutual funds were the perfect form of collateral for clearing brokers, because they counted as margin at the exchanges without the cash having to be withdrawn, earned interest from the first day of deposit, and yet could be liquidated into cash without notice. Accepting money market funds as collateral also boosted net interest margin, enabling clearing brokers to collect LIBOR while paying customers, say, treasury bills less 25 basis points. As the financial crisis set in during 2007-08, the spread between treasury bills and LIBOR climbed from the historical norm of around 25 basis points to 200 basis points or more. Until the Reserve Fund “broke the buck” in 2008, and credit departments started to shun money market funds again, the spread enabled clearing brokers to effectively print dollars. Net interest margin, once of equal value to execution and clearing commissions as a source of revenue, rose steadily to half or more of the revenue of the average clearing broker. With commissions squeezed by

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electronic trading anyway, the return from exploiting the customer “float” became a source of positive feedback, intensifying the hunt for yield in cash collateral reinvestment in the derivatives markets just as it did elsewhere. So it was no surprise that the December 2011 revisions by the CFTC to Regulation 1.25 focused on restricting investment in money market mutual funds, chiefly by imposing concentration limits. It was even less surprising that the revisions precluded investment in foreign sovereign debt (of the kind MF Global had bought) and repos with affiliated entities (of the kind MF Global used to finance its portfolio of foreign sovereign debt). Repos with third parties are still allowed, but subject to a 25 per cent counterparty concentration limit. This additional protection for customer assets was reinforced in October last year, when the CFTC published a series of further new and amended regulations for public comment. If approved, the revised rules will require clearing brokers to hold sufficient customer cash in segregated accounts to cover their daily margin obligations (as measured by “net liquidating equity”) on foreign as well as US domestic derivatives exchanges. Clearing brokers can hold nothing else in these accounts, and must ensure that there is sufficient assets to cover all open positions at all times, if necessary by topping the accounts up with proprietary funds. This brings Rule 30 accounts into line with 4d(a)(2) accounts. Any withdrawal of 25 per cent or more of “excess segregated funds” will now be subject to management approval if it is not for the benefit of clients. Clearing brokers will have to draw up written policies to govern the management of

customer segregated accounts, inform clients about the firm-specific as well as market and other risks they run in leaving assets with them, and adopt formal internal procedures on the supervision of the accounts. Clearing brokers will also have to report daily to the CFTC on the value of the assets held in customer segregated accounts, and twice a month on the whereabouts of the assets and the investments in which client cash is held. Both clearing brokers and CCPs will also have to grant the CFTC direct (albeit read-only) access to the bank accounts to verify these reports. While these measures represent a significant tightening of the regulation of customer assets, their detail is more alarming than reassuring, since it provides a vivid reminder of the inadequacies of the previous regime. On the other hand, European regulators have faced criticism for lacking detailed rules over the protection of customer assets posted against derivative contracts. The European Market Infrastructure Regulation (EMIR), which makes the clearing of standardised swaps in Europe mandatory, specifies that CCPs must segregate in their books and records the collateral that belongs to customers from their own resources so that they can be distinguished “at any time and without delay” (Article 37, paragraph 1). EMIR lays an equivalent obligation on clearing brokers to distinguish clearly between proprietary and customer assets. The Regulation further obliges CCPs and clearing brokers to offer customers “at least” a choice of holding their collateral in an individually segregated or omnibus account. Omnibus accounts are “legally segregated but operationally

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commingled” (LSOC), matching Part 22 of the regulations issued by the CFTC under Dodd Frank, by which customer collateral posted to CCPs enjoys “legal segregation with operational comingling.” That operational convenience, and ability for clearing brokers to profit from reinvesting the cash collateral, means LSOC accounts are cheaper for clients to buy than individual accounts. Where EMIR differs from Dodd Frank and the CFTC regulations is in offering users of CCPs the option of an individual, fully segregated account, or what the Regulation calls “individual client segregation.” Clients that opt for individual segregation have the reassurance that only the collateral necessary to cover their net existing positions will be exposed to the risk of default by another member of the CCP, with any excess margin clearly earmarked as unconnected to the positions of other users. It is the clear intent to give clients with individually segregated accounts a higher degree of protection than those using omnibus accounts. For example, EMIR does not specify whether omnibus accounts should be margined on a net (across all client positions in the account) or a gross (gross per client after netting all positions of that particular client) basis. This gap creates an opportunity for clearing brokers to be gross margin to the client, but net margin to the CCP, with surplus margin held by the clearing broker. That, as it happens, is how clearing brokers have traditionally liked it. In old-fashioned derivatives clearing, they would collect margin gross from the client that is long, say, 20 and from the client that is short, say, 10 but have to

deliver to the CCP only the net amount of 10. The 20 left at the clearing broker could then be reinvested in bank deposits or money market instruments, and a spread collected. The 10 posted to the CCP would be pooled in an omnibus account. The risks to the client in this structure are obvious. The client posts gross amounts to the clearing broker, but the clearing broker posts net to the CCP, and the customer does not know where the difference between the net and the gross is invested. If their clearing broker defaults or fails, and there is a shortfall after emptying the omnibus account at the CCP, the clients of the failed clearing broker have to share pro rata the cost of the loss. In other words, in this structure all customers have risk on all other customers. Understandably, EMIR seeks to alter the distribution of these risks. Instead of a single omnibus account at the CCP which the clearing brokers fund on behalf of their clients on a net basis, the clearing brokers must under EMIR offer clients a choice of omnibus or individually segregated accounts, and in either case maintain a record of what belongs to the clients and what belongs to the firm. Worse, the accounts at the CCP have to be margined gross so, in the example above, the collateral from the client which is 20 long and the collateral from the client which is short 10 has to be posted to the CCP. In other words, the full 30 is held in either an omnibus account at the CCP, or in two individually segregated accounts at the CCP, and the CCP gets to reinvest the cash. True, clearing brokers can still insist clients over-margin their positions and reinvest the consequent surplus, but only in the case of omnibus accounts. In the case of individually segregated

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accounts, EMIR insists the CCP capture and control even this “excess” collateral posted by clients. If the client defaults, the clearing broker has to retrieve the excess margin from the CCP. It is not hard to see why individual segregation makes sense for clients in terms of risk management. In an omnibus account, they still run the risk of sharing pro rata in any shortfall if a clearing broker fails. But that extra protection has a cost: clients earn less from the reinvestment of their cash collateral, because their clearing brokers earn less as well. There is also a risk that individually segregated accounts are not as individual or as segregated as they sound. Client cash and securities might be segregated only by means of “value protection” or a “legal construct,” rather than being in an actual individual, segregated account. This type of artificial construct is a predictable consequence of a conflict of interest between the clearing broker and the CCP. In case the clearing broker defaults, the CCP understandably wants first charge over any collateral. The clearing brokers want the same thing, in case a customer defaults. Using complex legal constructions to obtain the semblance of individual segregation is a solution to this conflict. The customer passes ownership of the money to the clearing broker, who passes it up to the CCP, which either takes full ownership, or a security interest in it. All the customer gets is a legal right to the return of his assets if the clearing broker defaults. How exactly that legal right is achieved is likely to vary between jurisdictions, which is not reassuring in a business where possession is nine tenths of the law. When the Financial Services Authority

(FSA), the United Kingdom regulator, set about amending what it calls its “client assets sourcebook” (CASS) to take account of the client money protections stipulated by EMIR, it came under pressure from clearing brokers to permit “gross omnibus accounts” as well as omnibus accounts and individually segregated accounts. It was precisely because EMIR does not specify whether omnibus accounts should be margined on a net or a gross basis that brokers saw an opportunity to propose this. It effectively retains, on a smaller scale, their old habit of being gross margin to the client but net margin to the CCP, and the FSA went along with the idea. It amended its rules, as it put it in policy statement PS12/23, to treat omnibus accounts that are “functionally equivalent to a collection of individual client accounts in the same way as an individual client account.” A solution to this challenge for fund managers is to hold their assets at neither the clearing broker nor the CCP but at a third party custodian, with the CCP being given a lien over the assets in third party custody. This idea is being discussed but has yet to take off. It is intrinsically difficult to insert a tri-party agent into a derivatives relationship because the clearing broker is the intermediary between the client and the clearing house. Unless a client is willing to become a member of the CCP, and post collateral directly to it, the clearing broker has to have possession of the collateral and a perfectible security interest in it. This is because the clearing broker is liable to collateralise the clearing house, and is understandably reluctant to use its own money to meet margin calls. A large fund manager with a

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Collatoral Segregation at CCPs

CME Legal segregation with operational commingling (LSOC), in which the collateral of customers of a clearing broker in default is not pooled but allocated to particular customers, and used only for their benefit, reducing the risk that client monies are used to meet the obligations of other clients.

CME Clearing Europe Omnibus or individually segregated accounts with optional full segregation of individual client collateral, governed by English law.

Eurex Clearing Full legal and operational segregation to secure client positions and collateral assets to achieve timely portability in the event of a clearing member default via a choice of individual clearing accounts or net omnibus accounts.

ICE Clear Credit Legal segregation with operational commingling (LSOC), in which the collateral of customers of a clearing broker in default is not pooled but allocated to particular customers, and used only for their benefit, reducing the risk that client monies are used to meet the obligations of other clients.

ICE Clear Europe Swaps customers of Futures Commission Merchants (FCMs) benefit from legal segregation with operational commingling (LSOC), in which the collateral of customers of a clearing broker in default is not pooled but allocated to particular customers, and used only for their benefit, reducing the risk that client monies are used to meet the obligations of other clients. Futures customers have gross omnibus accounts governed by the US bankruptcy code. Clients of European Clearing Members can access clearing with full legal and operational segregation via a choice of EMIR-compliant individual client accounts or net omnibus accounts, governed by the law of England and Wales. There is full separation of house and client accounts.

SIX x-clear Two collateral groups (i.e. cash accounts and safe custody accounts) are maintained for each clearing member. The house account is maintained as a net omnibus account, and may include house business as well as unsegregated accounts, while the client account is segregated from the house clearing account, and the clearing member is free to decide if margin is posted to it net or gross. SIX x-clear will be implementing a new option, which will allow clients to choose omnibus accounts or individual accounts for each and every NCM (Non-direct Clearing Member). This solution will be in line with EMIR and the CPSS-IOSCO Recommendations. The implementation date is currently foreseen as November 2013.

LCH.Clearnet SwapClear US customer accounts are protected under the legally segregated, operationally commingled (LSOC) model of the CFTC. Under LSOC, collateral owned by a customer is segregated from house assets and used only to collateralize the obligations of that customer. This is designed to eliminate “fellow customer risk.” European clients have a choice between individual segregated accounts (ISAs), which are similar to the LSOC model, and omnibus net segregated accounts (OSAs). In both models the collateral belonging to a customer is segregated from collateral supporting proprietary risk positions of their clearing member, and is portable to an alternative clearing member of their choosing upon the default of their first.

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COO Cover Story

CC & G Waterfall

CCP Risk Assessments: A service from Thomas Murray

lot of sub-accounts would also have to open hundreds of accounts at the CCP, because the adviser to a client is not allowed to be a member of a CCP on behalf of its clients. Becoming a clearing member costs money too - between $ 5 and $10 million, depending on the CCP - and members are not only subject to

onerous regulatory supervision, but run the risk of getting caught in complicated default waterfalls when another member fails. Fortunately, EMIR has a different solution for clients if a clearing broker defaults. This is “porting,” or the transfer of all the outstanding client positions of the failed clearing broker to another, solvent clearing broker. Importantly, EMIR adds that any surplus margin over and above that required to cover the net positions be returned directly to the client as soon as the “porting” process is complete. “Porting” is obviously

attractive, because it allows positions and their associated margin to survive the death of a clearing broker, enabling the clients to either carry on trading or see their positions closed and money returned. However, critics have pointed out that returning collateral directly to customers is not only unduly

favourable to clients (where an account was pre-funded by a clearing broker for operational convenience, clients would enjoy a windfall) but that the ability of a CCP to do this is limited by the insolvency laws that apply in its jurisdiction. EMIR, undeterred, insists member-states of the European Union adapt their insolvency regimes to its requirements. In the United Kingdom, the consequent FSA amendments to CASS - which were published in December last year and came into force in January this year - have inadvertently occasioned a radical

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CME Waterfall


revision of the entire treatment of client assets. In introducing its proposals in September last year, the FSA described the creation of what it called “multiple client money pools” as “the most radical change that has been made to the client money regime in over 20 years.” This is because the changes replace the single pool that was industry standard

in events of default up to the passage of EMIR. Prior to EMIR, the FSA rules in CASS simply pooled all client money for distribution when a clearing broker failed, turning all potential beneficiaries into claimants on a single pool of money, with any shortfall being borne pro rata by the members of the pool. This was obviously incompatible with the EMIR stipulations that client monies be segregated, and that positions and collateral held by a failed clearing broker be “portable” to another, solvent clearing broker. Client margin held in a segregated account obviously cannot be pooled if it

is also to be “ported.” Client margin held in omnibus accounts, on the other hand, can still be pooled, though even in this area the FSA has formulated complex rules that allow “excess” client margin held by the clearing broker rather than at the CCP to be returned directly to clients rather than retained for pooling. Importantly, the new client

money protection rules apply not just to margin posted to CCPs, but to all client money held by investment banks and broker-dealers, including in the prime brokerage business more generally. The intention is to overcome the complaints which will be forever associated with the bankruptcy of Lehman Brothers International: outright loss and/or loss of control of assets which were in no defensible way part of the assets of the failed investment bank, an unconscionably prolonged bankruptcy process that trapped those assets in liquidation proceedings for years, and

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ICE Clear Credit Waterfall


limited pay-outs from the residual assets. In essence, the new FSA rulebook aims to ensure client assets are kept separately, identified immediately when a broker fails, and returned to their owners quickly. In this sense, the measures are part of a wider effort by the British authorities to overcome the long-running embarrassment of the Lehman Brothers

International liquidation. The Investment Bank Special Administration Regulations 2011, a set of streamlined bank winding-up tools introduced under the Banking Act 2009, were used for the first time at the British end of the MF Global bankruptcy. They saw a proportion of assets – and a low one too - returned to their owners within ten months. Though that was impressive by comparison with the Lehman case, where assets were still trapped in the aftermath of an event that occurred four years earlier, the timescale was still embarrassing by comparison with the American end of the MF Global bankruptcy: it returned two thirds of unencumbered assets to their owners

inside a month. Getting assets back quickly is not just a matter of selecting the right account-holding and “porting” structures. Since variation margin is payable in cash, where it is reinvested is also material. In the United States, CFTC Regulation 1.25 lists permitted investments, and requires clearing brokers to ensure that any

assets purchased with customer money are “consistent with the objectives of preserving principal and maintaining liquidity.” In the United Kingdom, there is no equivalent of the detailed client money protection rules laid down by the CFTC. Instead, cash held on behalf of clients is subject to FSA Principle 10, which holds that “a firm must arrange adequate protection for clients’ assets when it is responsible for them.” There were no concentration limits on reinvestment in the United Kingdom until last year, when the rules were tightened to oblige clearing brokers to invest cash collateral in bank deposits only, and no- more than 20 per cent of the total with

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ICE Clear Europe Waterfall


any one bank. If a client posts securities instead of cash, British law stipulates that the clearing broker takes title to the assets. The truth is that, until MF Global exposed the inadequacy of existing protections, clients assumed that their collateral was protected by the

CCP, and that they had no exposure to clearing brokers. Even the collapse of Lehman in 2008 did not alter that perception. Typically, clients did not seek to exert any degree of control over the reinvestment process. Though a small number of sovereign wealth funds and larger fund managers have always banned re-hypothecation of their collateral, even they were more concerned to eliminate replacement risk than reinvestment or counterparty risk. It was MF Global that changed attitudes, and forced the FSA and CFTC to act. Even now, clearing brokers are understandably cautious about full disclosure of cash reinvestment to

clients and regulators. Though few oppose private disclosure to clients, no clearing broker is eager to get into detailed discussions about the weighted average maturity of the portfolio, or to be forced to take steps that inhibit their ability to make a decent spread on the cash while remaining liquid.

But collateral is not of course posted to help clearing brokers make a spread. It is there to protect the CCP against the risk of default by one of the clearing brokers that belongs to it. When a counterparty defaults, the CCP manages and fulfils the obligations of the defaulting party, and will call upon the collateral in doing so. Which is why the circumstances under which a CCP is likely to have to call upon the collateral posted by its members ought to be of intense interest to any fund manager active in the cleared futures and swaps markets. If a client defaults on a margin call from the CCP – and CCP margin calls have to be met immediately, in cash

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LCH. ClearNET Ltd Waterfall


- the clearing broker is liable to make the CCP whole. Liquidating the variation margin (calculated on a trade by trade basis) and the initial margin (calculated on a portfolio basis) posted by a clearing broker on behalf of a defaulting party is the first recourse in the so-called

“default risk waterfall.” It is followed by the liquidation of the contribution of the defaulting party to the loss-sharing pool, usually known as the default fund. After that, losses start to be shared by other participants in the CCP, including the capital of the CCP itself. The exact sequence varies by clearing house, but the basic structure is always the same. The clearing broker, as a member of a clearing house, contributes to the default fund in proportion to the volume of business it clears (measured by the value of the open interest, or risk,

it presents to the clearing house). This sum tends to fall between $50 million and $200 million. Clearing houses can then levy a further “assessment” based on the size of the contribution to the default fund. The CCP will next add some money of its own, taken from

its equity and retained earnings. The waterfalls vary in the size of the layers, and in the sequence in which different layers are at risk, and this affects where non-defaulting members fall in the queue. Charts 1 to 7 are graphic illustrations of the default risk waterfalls of the seven leading CCPs. The point at which non-defaulting parties are at risk is measured from the top of the blue arrow labelled “survivor pays.” Neither LSOC nor net omnibus accounts nor individually segregated accounts can eliminate the risk of loss at that point.

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SGX-DC Waterfall


What they can do is move a client further back in the default risk waterfall queue by ensuring that the collateral of the defaulting party is exhausted first. In the case of MF Global there was no defaulting party but the clearing broker had lost client monies funding

its proprietary trading business, so the clients ended up sharing the losses on a pro rata basis from the outset. Which is a reminder that risks are intrinsically hard to predict, and do not always manifest themselves in the orthodox or anticipated manner. Indeed, in their rush to insert CCPs into every conceivable market, the regulators have ignored the possibility that CCPs can add to risk as well as mitigate it. They do not eliminate risk. How could they? No

institution devised by fallible human minds can ever guarantee that both parties to a trade will always get what they want or expect or deserve. CCPs merely concentrate risk, and then redistribute it to their clearing members and their clients. The sums involved are

non-trivial. CME Clearing processes a billion futures and options trades a year, valued at $1,000 trillion. Yet CCPs run on remarkably low levels of capital. At the end of 2011, LCH.Clearnet held liabilities valued at €541 billion on an equity capital base of €333.1 million, or just 0.06 per cent of its liabilities. Of course, CCPs run matched books – what one member owes is offset exactly by what another members owes to them – but this is still a worryingly thin capital base.

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SIX x-clear Waterfall


Yet far from arguing that they need more equity capital, CCPs maintain a stronger capital base would create moral hazard, encouraging clients to trade recklessly on grounds that the CCP will cover the counterparty risk. When the European Securities and Markets

Authority (ESMA) suggested European CCPs hold in the default risk waterfall a sum equivalent to 50 per cent of the value of the guarantee fund before survivors were put at risk, the CCPs insisted it was cut to 25 per cent. The CPSS-IOSCO Principles for Financial Market Infrastructures reckons that forcing CCPs to hold liquid net assets equivalent to six months net operating expenses should be enough to cover defaults by their two largest members. That is an optimistic assumption, given the systemic risk CCPs are now creating. That systemic risk is being created in the markets for collateral. CCPs devour collateral – and, in terms of variation margin, cash collateral, a large proportion of which will have to be raised against securities collateral in the repo markets. In effect, CCPs are not even

mitigating risk. They are simply re-packaging it as liquidity risk in the market for collateral. That market for collateral is one in which the CCPs themselves are massively inflating demand, leading to inevitable corner-cutting in the shape of risk-enhancing

rides down the collateral eligibility curve and collateralisation economy measures such as portfolio margining. In a system dominated by clearing brokers with a less-than-impeccable record for keeping their hands off client assets, more Refcos, MF Globals and Peregrines are a near-certainty. Even regulators are compromised in this field, as their central banking cousins allow banks to repo anything short of the office furniture. Already, central banks are warning CCPs in private that an excessive commitment to the highest quality collateral might be unhelpful to current monetary policy. Expect clearing brokers to fail. In fact, expect CCPs to fail too.

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COO Columns

how the standard form of lending to hedge fund managers actually works. Some managers borrowing from Lehman Brothers against pledged assets actually lost the surplus of value over borrowings in exactly this way. The risk of a bank failure to depositors is well understood – if rarely observed – but no-one conceives of a risk to borrowers. Perhaps if that risk had been understood by fund managers prior to the collapse of Lehman Brothers in 2008, prime brokerage would not have flourished in the way that it did between 2003 and 2007.

HOW TO BORROW BUT STAY IN CONTROLAs a former CEO of Leopold Joseph, David Fletcher is a trained banker who retains a strong belief in the value of something rather unfashionable in the fund management industry over the last two or three decades: managing the counterparty risk of lenders, and especially prime brokers. Here, he offers some uncompromising advice on how to borrow without losing control of your assets.

Imagine ten years ago you took out a £500,000 mortgage with a bank to buy a house for £650,000. Today, with the property worth something over £2 million, you hear that the bank is in trouble, and you decide to repay the mortgage. But whilst arranging the paperwork, the bank finally goes under, and you discover that, even if you repay the loan, you may have lost your house – and your equity of £1.5 million. In the home mortgage market, such an outcome is unthinkable, but in the prime brokerage industry, that is exactly

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The risk was not well understood, partly because many fund managers were outsourced versions of the proprietary trading desks of the investment banks and prime brokerage mimicked the support they were used to. Other boutique fund managers lacked the skills or appetite to set up large middle offices. After all, fledgling fund managers consisted of two investors, one secretary and someone to runoperations, and they needed prime brokers to intermediate the borrowings of cash and securities they required. However risky it seems in retrospect, at the time cash-rich banks and asset-rich investors preferred to lend money and securities to investment banks, whilst hedge fund managers were seen as too great a credit risk to take on unadorned. Agent lenders – mostly the global custodian banks – made no serious attempt to disabuse investors of that idea. But prime brokerage is much more than financing and stock borrowing. It is a bundle of services tailored to the needs of small financial services firms with limited infrastructure. As well as access to cash and stock, fund managers enjoy a host of attractive ancillary services. These include custody, settlement, accounting, IT, portfolio analytics, and investor introduction – and at an unobjectionable cost. On the other hand, the concomitant legal agreements, often wrongly dismissed as “formalities,” tend to be complicated, badly explained and to put prime brokers in an extraordinarily powerful position over the assets in the portfolio of the fund manager. At first glance this appears reasonable in the light of the banking role being performed.

Most bank loan documents look fairly terrifying to a borrower, but are considered reasonable as the protection required by the party on risk. What no fund manager considered was that they would be on risk if the lender failed. When that actually happened, in 2007-08, the prime brokerage model was called into question. In defence of the fund manager, the idea that borrowers can incur a risk from their lenders is more than counterintuitive. It is astonishing,and this is where it gets technical. You can divide loans from banks into three: unsecured, secured, and re-hypothecated. In the first case, the bank has rights against you, but no direct link with, or control over, your assets. In the second case, the bank has rights and a degree of control over your assets which he may use to repay your loan if you fail to meet your obligations. He may even be the legal owner of your assets, but he is not the beneficial owner – they are still yours. In the third case, the bank owns your assets and may use them as it wishes. He normally has an obligation to return the same or similar assets to you, but if he goes bust he may fail to do this, and your assets will be lost. An essential element of UK lending law is “the equity of redemption.” This concept originated to protect borrowers against malicious foreclosure, allowing them always to reclaim their pledged property by repaying any loans it secures. Re-hypothecation trumps this. When a lender such as Lehman Brothers fails, the initial owners of re-hypothecated assets are reduced to the status of

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less tightly controlled. But customers of failed financial institutions do not face the shock of re-hypothecated assets only. Assets do not have to be re-hypothecated to be frozen in a liquidation. They can be frozen in a custody account. Under a standard custody agreement, as many hedge funds discovered in 2008, banks enjoy rights over the assets of clients until all of their own claims and costs are discharged. True, some custodial clients may beable to negotiate these rights away. But it would be prudent to review the law on this point, since it gives banks even in a purely fiduciary role an extraordinary degree of discretion over the disposal of the assets of their customers. Inevitably, in any crisis, possession proves to be nine tenths of the law. As a result, assets are withheld for purely precautionary reasons. In the case of Lehman Brothers International, the charge over client assets empowered the liquidator to freeze assets being held on trust in custody accounts until (often many months later) he was able to establish that they were not available to discharge costs or callable as collateral for some other purpose or person. As managers have found to their cost, even if no losses are involved, freezing the assets of a fund can quickly lead to its closure. If a manager places assets with a bank as fiduciary, and cannot retrieve them at will after discharging all of his obligations, custody is badly broken. If the assets cannot be retrieved in a crisis, the relationship is broken irretrievably. The purity of third party custody is utterly compromised. Explanations are offered, of course.

unsecured creditors, and must queue up for the return of their property. Usually, they will be able to offset any borrowings from the failed institution, which limits their loss to the excess of the pledged collateral over the borrowings - the margin or “haircut.” However, this margin is typically substantial, at 25 to 60 per cent over the value of the loan. In the United States (US), regulations limit the margin excess to 40 per cent, but in the United Kingdom there is no limit. The London hedge fund industry was unfamiliar with this type of financing, which was largely imported by American broker-dealers, and they failed to appreciate the significance of the re-hypothecation wording amongst the thick legal agreements. Post-Lehman Brothers, the scales began to fall from the eyes of prime brokerage clients. The real cost of those excellent services and facilities became more apparent. Broker-dealers do not lend you their money. They pledge your assets to other financial institutions and lend you the proceeds. It is the lending equivalent of the old joke about management consultants: in exchange for a large fee, they will borrow your watch to tell you the time. The International Monetary Fund (IMF) calculates that, by 2007, the seven largest US brokers were getting about $4,500 billion of funding from re-hypothecation, most of which was not recorded in their accounts or in the flow of fund data prepared by the US government. The cynicism of prime brokerage clients increases with indications that a disproportionate share of the assets re-hypothecated originated in London, where re-hypothecation was

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Andrew Thornhill Managing [email protected]

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One argues that securities cannot be segregated properly because, in many markets, custodians hold them in omnibus accounts in their own name, and not in a segregated account in the name of the client, thereby conferring rights of ownership on the bank. This blurs the line between having a safe custody account and a principal relationship and, in the case of cash, it eliminates it altogether. Because cash is fully fungible, custodians argue that it is re-payable only to those clients whose entitlement to it can properly be established through the books and records of the deposit-taking bank. In the case of Lehman Brothers International, it took litigation through the higher courts to establish that, if Lehman had accepted cash as an off balance sheet client deposit account, it did not matter whether or not the firm had earmarked it as client account cash in its own books and records. In other words, it took litigation to establish that evidence of a deposit by a client was sufficient proof of ownership by that client. That outcome of that court judgment was scarcely satisfactory. By widening the size of the group entitled to repayment, it ensured that every creditor received less. A useful test for funds is, ‘How easily would you recover your assets from the liquidator of a failed institution?’ At Odey Asset Management, the fund assets with the prime broker are segregated into those held as collateral and unencumbered assets. A daily report describes exactly where each asset is held and confirms explicitly that any unencumbered assets are available for immediate withdrawal. However, even under this arrangement

the assets are still within the control of the prime broker. We remain concerned by the $8 billion in cash transferred from London offices of Lehman Brothers to New York on the eve of the bankruptcy of the firm. We have also witnessed the MF Global debacle, which took place in a jurisdiction replete with intricate laws and rules and regulations designed to protect client assets. So we retain the option to place most of our cash and other unencumbered assets at third party banks with which we have no borrowing relationship. This eliminates any possible doubt that the assets belong to us absolutely. A liquidator would find it hard to justify holding on to them. This approach is untested in law, but still seems a sensible precaution to take. With re-hypothecation, a prudent manager should minimise the excess collateral at a prime broker. Any excess over the liability exposes the fund to the prime broker to the extent of that excess. With more assets than liabilities at a prime broker, the fund manager will, if the prime broker fails, rank no higher than any general creditor. In a normal world some excess margin might be acceptable to reflect the relative creditworthiness of the prime broker and the fund. The problem is that today the fund is almost certainly more creditworthy than the prime broker, especially as broker-dealers become regulatory pariahs, classified as non-systemic risks. It follows that, as both parties are on risk, zero haircut lending ought perhaps to become the norm. If that was the case, the exposure of the fund to the prime broker and the prime broker to the fund would be offset, with collateral

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posted to balance the difference. However, mutual offsetting of this kind would lead to a breakdown of the re-hypothecation model of prime brokerage, as the prime brokers also need to post excess margin in the market to fund their own balance sheets. Ultimately, unless prime brokers can attain satisfactory credit status, their position will be under threat. With recent reports of fund managers asking banks for security before they will lend to them, why would anyone take an unrewarded credit risk with a prime broker whose CDS spread exceeds 500 basis points? The alternative is to revert to traditional secured banking facilities, in which the fund manager can borrow up to a certain percentage of the value of a portfolio. Under these arrangements, the assets never cease to belong to the fund, unless and until the lender exercises the right to seize them in order to extinguish an unmet liability. This is a palpably different arrangement from traditional prime brokerage, and one which is much more comfortable for fund managers borrowing money, since it honours the “equity of redemption.” However, depending on the exact regulatory categorisation, this may be considerably more expensive than conventional re-hypothecation arrangements. In addition, traditional lenders prepared to advance money to fund managers on these terms will not necessarily be able to meet the ancillary needs of fund managers, which prime brokers presently fulfill with a range of services that stretch far beyond mere financing. That said, the vulnerability of prime brokers is an obvious opportunity for the commercialbanks to exploit. Losses on loans

to hedge funds are so far minimal. Now that fund managers have woken up to the risks of gaining access to borrowed money and stock through the re-hypothecation of their assets, the commercial banks could pick up a large share of the business, via traditional secured lending. Custodian banks are particularly well placed. So far, however, not one with a demonstrable interest in the fund management industry has developed an alternative form of secured lending to fund managers. Those that have entered the industry have generally adopted the traditional re-hypothecation model. For fund managers, it is worth noting that the implicit government guarantee of the liabilities of the banking industry is given to banks, not broker-dealers. Perhaps the Basel III capital adequacy regime ought not to penalise a bank which lends against a portfolio as security, as opposed to lending against the right to re-hypothecate that portfolio. Ultimately, who and how hedge funds are serviced will depend on a combination of the level of service available, the price, and the extent to which the (newly discovered) risks to fund managers can be mitigated. Funds which are less leveraged may be more inclined to trade higher security for higher borrowing costs. Whatever the exact outcome, we can all learn from an important mistake too many of us made in the years before 2008.

David Fletcher is chairman of Odey Asset Management.

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NEWEDGE: AN ATTEMPT AT A DEFINITIONNewedge is a listed derivatives specialist with an agency model that is no longer old-fashioned but ideally suited to the regulatory and commercial environment of today. It has also developed an appetite for new asset classes, investment strategies and distribution plays. Dominic Hobson talked to global head of prime clearing services, Chris Topple.

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Most of us categorise by analogy. But five-year-old Newedge is so unlike any other prime broker that the usual method is quite useless. For a start, it is an agency broker, not an integrated investment bank with proprietary traders, equity analysts and corporate financiers. Fimat and Calyon, its two French predecessors, were always best understood not as investment banks but as listed derivative brokers. So learning that Newedge clears more futures and options trades than Bank of America Merrill Lynch, Credit Suisse, Deutsche Bank and UBS is the least surprising fact of all. The bank (and it is a separately capitalised bank) is a direct member of 85 derivatives exchanges, and claims a listed financial derivatives market share of 12 per cent in execution and 11.5 per cent in clearing. The share of global commodities derivatives trading it claims is even higher, at over 15

per cent. In the

United States, only Goldman Sachs is bigger than Newedge in futures and options both inside and outside that enormous market. Globally, the bank earned

two out of every three of its €913 million of revenue in 2011 from the financial and commodities derivatives markets, and three out of four if the related revenues from broking OTC fixed income, currencies and commodities derivatives are added to the total. In other words, prime brokerage – broadly construed as the servicing of fund managers that describe themselves as hedge funds - accounts for somewhere between one fifth and one quarter of the income of Newedge. So it is reasonable to ask whether Newedge is accurately described as a prime broker at all. The answer is affirmative, but it is a complicated

affirmation. Prime Clearing Services (PCS) is one of three business

divisions, but in reality one of four large streams of revenue,

the others being futures and options and equities

execution, futures and options and equities

clearing, and fixed income,

currencies and

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commodities. However, the share of PCS in the total revenue of the bank was over 40 per cent in 2011, which is twice as large as the share generated by the Futures and Options and Equities Execution (FFOE) division and the Fixed Income, Currencies and Commodities (FICC) business lines. FICC is not a prime brokerage business in any recognisable sense at all. Its core business is servicing corporates that hedge their currency exposure and commodity production, storage, distribution and purchases in the futures and options markets, and the sell-side trading houses active in metals, energy, soft commodities and grains via the London Metal Exchange, Nymex and other commodity exchanges. It is complicated and unusual, but Chris Topple, a senior managing director at Newedge and global head of PCS, explains that it makes no sense to look for a traditional equity finance business at an organisation which has always specialised in servicing commodity trading advisors (CTAs) and managed futures funds. “We have grown up clearing trades for large, institutional CTAs,” he says. “Listed derivatives are at the heart of what we do, and how we aim to generate revenue. They are the core around which our prime brokerage business was built. We have an expertise in futures and options which is unrivalled among our competitors. But as our clients have become more sophisticated, and traded more asset classes, we have grown with them. We do now service all the other asset classes. In fact, it is the diversity of our client base and business that has helped us to maintain our performance and profitability.” Newedge originally grew into cash

markets as the only alternative to losing revenue as its managed futures and CTA clients diversified their counter-party and market risks. The recent MF Global and Peregrine debacles have raised consciousness about counterparty risk in futures and options clearing, and about the treatment of cash collateral posted to clearing houses in particular, but futures clearing has a tendency to scale in ways that accentuate counter-party, concentration and collateral risks. In 2011, Newedge processed 3½ billion contracts, which is twice as many as its nearest competitor. At that scale, it is frankly imprudent for COOs not to diversify their counter-party risks. Topple says Newedge compensates for the inevitable loss of business by expanding its product set. “Futures clearing is about the ability to process a very large volume of business at a very low cost,” he explains. “As our core clients have grown and expanded their trading strategies, so we have followed our clients by diversifying our products and services beyond purely listed derivatives.” Supporting CTAs took Newedge into foreign exchange – the foreign exchange prime brokerage platform was refurbished and re-launched in 2012 - as well as equity and fixed income, purely as a result of quantitative strategies evolving away from straightforward futures and options. “FX is now a huge part of our business,” says Topple. “CTA managers are also FX managers.” Winton Capital, which began as a CTA running a managed futures fund, is the classic example of the steady transition to multiple strategies and asset classes that Newedge evolves to match. Today, the 2,700 people working at Newedge in Europe (1,000 of them), the United

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States (another 1,000) and Asia (700 so far) can support equities, fixed income and swaps as well as listed derivatives and commodities, from every one of their 21 offices in 16 countries. Importantly, Newedge is now fully entrenched in Asia, with its regional headquarters in Hong Kong and offices in Singapore, Seoul, Mumbai, Sydney and Tokyo plus a joint venture in place with Citic in China. In fact, the Newedge of today is not just global, but diversified: it belongs to 50 equity exchanges as well as 85 derivatives exchanges. This globalisation and diversification is not indiscriminate. Newedge does not seek to mimic the corporate access, equity research and IPO allocations offered by the major investment banks to equity-based funds, or to chase emerging market or corporate bond strategies “We obviously need the ability to service other asset classes as our clients expand, but we are never going to be able to service a large global macro fund or a multi-billion equity long/short fund that now has huge capital implications for its provider,” adds Topple. “We simply do not have the dedicated repo desk or the stock loan capability or the access to the inventories to service that type of fund. We focus on the market-neutral or liquid strategies that have a significant bias towards futures and options. We are much better at serving the clients that have an element of listed derivatives in their strategies, such as volatility funds that use index options and futures. We also like high frequency traders. The balances run by high frequency trading strategies are relatively small, so the requirement for inventory on the stock loan side is lower.” As it happens,

managed futures and CTAs and high frequency trading strategies (HFTs) have boomed in recent years, as the success of Winton Capital attests. Activity in physical commodities soared just as financial futures and options volumes shrank, in line with the deliberate distortion of interest rates. Commodities have also provided ample volatility in the less–than-thrilling monetary conditions of today. “You can almost track our revenues to a volatility index,” notes Topple. “For an agency broker, volatility-driven transactions are the biggest driver of volume.” That volume reflects the fact that volatility is creating value for investors too. As a result, CTAs and managed futures have become conspicuous among new fund launches in the last four years. But chance favours the prepared mind, and Topple claims no bank began with a sounder grasp of the products and services CTAs and managed futures funds require than Newedge, and that none can match its understanding of what he calls the “intricate web” between managers, trading and distribution platforms and investors. “The ten to 15 years we have spent doing the research, mapping the universe of CTAs, knowing which investors invest in which type of strategy, takes a lot of time,” says Topple. “We have a dedicated capital introductions team, and huge amounts of data on performance, which enables us to identify the underlying strengths of managers, and work with them to market them to investors that are looking for specific types of returns.” Increasingly, Newedge finds itself working with pension funds and insurance companies (Solvency II notwithstanding) as potential sources of capital for the managed

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futures strategies in which its research teams and indices specialise. Institutional investors like managed accounts, which Newedge supports. Likewise, the UCITS fund distribution business at Newedge has grown out of investor appetite for investment strategies based on listed derivatives. “We have a UCITS platform, which is of particular interest to US managers looking to access European investors,” explains Topple. “We have had great growth in that business over the last two years, but the majority of the UCITS funds we distribute are run by CTA managers. For investors, we provide a UCITS vehicle for accessing that type of manager.” The UCITS fund launched in 2011 by Aspect Capital, in which investors gain exposure to a flagship managed futures fund through a total return swap provided by Newedge, is a perfect exemplar of exactly that brand of client-led growth. HFTs are another. As intense, technology-based competition shifted sell-side traders away from trading millions of lots of eurodollar futures and options into exploiting spreads between markets and asset classes by arbitraging indices, bonds and futures and options, Newedge saw a looming buy-side opportunity. “One of the reasons we brought the high frequency business closer to our prime brokerage business was the fact that hedge funds can use the high frequency trading infrastructure we had developed for proprietary trading desks at other firms,” explains Topple, a former head of the HFT business whose own elevation to leadership of PCS was part of the union of the HFT and prime brokerage client bases. “We have had a core franchise within the proprietary

trading groups for ten or 15 years, and it was all ultra-low latency, high frequency trading, so we had an infrastructure that was easy to leverage. The high frequency fund managers now count on us to aggregate the risk and provide a Value at Risk (VaR)-based margin solution, and extract the value across the asset classes.” Being thinly capitalised relative to banks or even large funds – the typical Newedge high frequency client will manage anywhere from $10 million to $250 million - HFTs rely on the efficient use of collateral to raise the finance they need. An obvious way to achieve valuable collateral efficiency is to work with a prime-cum-clearing broker prepared to offset long positions at one exchange against short positions at another. According to Topple, Newedge has developed sophisticated risk engines that enable the firm to calculate financing risk across the entire portfolio of a client, and to charge clients accordingly. A portfolio margining capability is one reason why, although Newedge is not a traditional swap dealer and runs no prop trading business line, Topple nevertheless sees swap clearing as “a very significant opportunity” for the firm. A large part of his reasoning is that smaller users of swaps will seek to escape the greater capital and regulatory burden of OTC derivatives by using more listed products instead. The deliverable interest rate swap futures contract now available at the Chicago Mercantile Exchange (CME) is an obvious example of the derivative-on-derivative opportunities that are opening up. Inevitably, structured and esoteric swaps are not susceptible to being re-engineered in that way, and are likely to continue to be traded and cleared

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bi-laterally. But Newedge is building swap clearing capabilities to handle the commonplace interest rate and FX swaps that are set to shift to being traded on swap execution facilities (SEFs) and cleared in central counterparty clearing houses (CCPs). Topple points out that Newedge is already a leader in the short-dated interest rate derivatives market, which furnishes market participants with hedges of underlying swaps. “With aggressive cross-margining, we believe we are in a good spot to be dealing with large swap market participants,” he says. “The ability to offset margin between a listed and an OTC portfolio can have some material impact on the capital that is required to be posted. Over the last few years, we have developed real skill in looking at all asset classes, and rolling them into single margin calls.” In autumn 2012, Newedge introduced a clearing brokerage service for interest rate swaps cleared through CME. Extension to LCH.Clearnet Europe was completed by the end of the year, and a service to support clients clearing at LCH.Clearnet in the United States was scheduled for launch in March 2013. The development of these clearing services provides the best example of why Newedge finds it helpful to be owned 50:50 by two single A-rated French deposit-taking banks. Because Newedge has no swap dealing capabilities of its own, and a balance sheet whose size is geared to agency rather than principal business, the capital requirements and default risk associated with its memberships of CME and LCH.Clearnet are being borne by its parent banks, Credit Agricole and Société Générale. “It reiterates the support

of our shareholders for our business model, and our support of them,” explains Topple. “Société Générale has a significant OTC derivative business and, without an FCM model in the US, you cannot clear swaps. So we are integral to their future as well as them to our future.” The advantages do not end there. Banks with large retail franchises offer stable funding, especially by comparison with the stand-alone investment banks, which are finding it hard to sustain even their equity finance franchises as the right tore-hypothecate client assets is truncated. Yet the chronic travails of the euro do mean that French universal banks are still treated with circumspection, especially beyond Europe. Though Newedge currently trades at a CDS spread comparable to that of its main competitors, it is subject to political factors affecting the euro-zone. The immortality of the parent banks is taken for granted in Europe, but political considerations can be an obstacle to doing business in North America, even for a firm that avoids principal risk. In fact, that agency model, which was considered by some in the pre-crisis years as a potential source of disadvantage, has proved extremely well-adapted to current market conditions. “The key point that differentiates us from every single one of our competitors is that we do just operate on a pure agency model,” explains Topple. “There are absolutely no proprietary trading business operations within the firm.” The mounting evidence of the permeability of the Chinese Walls within the integrated investment banks and the universal banks - to say nothing of their vulnerability to expensive accidents of the kind that have overtaken

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increasing its share of exchange-traded derivative execution and clearing, even in a shrinking market, precisely because clients are veering away from the counterparty, credit, asset safety and reputational risks of working with integrated broker-dealers. A firm that does no proprietary trading is less likely to use client cash to fund its balance sheet. But even an agency broker active in the exchange-traded derivatives markets has to take cash collateral from its clients to post to the clearing houses. In the United KIngdom, Newedge spreads customer cash over ten highly rated banks, and discloses to clients both the amounts and the names of the banks. Those banks can include Credit Agricole and Société Générale, but Topple insists transparency and regulations restricting the percentage held at related institutions provide sufficient reassurance. “We produce for clients reports on all the banks, and all of the instruments, in which their cash is invested,” he explains. “Client cash is invested in US treasuries and UK gilts with very short dated maturities. That is the beauty of our agency only model. We can provide complete transparency, and that is the key - literally, showing clients where their funds are deposited. Our model allows us to give clients complete transparency into where their assets are sitting and what they are invested in. It gives clients the security they are looking for.” He says transparency, and the absence of conflicts of interest, is proving especially persuasive with the institutional fund managers that Newedge has traditionally struggled to attract. In less anxious markets, institutional managers struggled to grasp the logic of separating execution,

Barclays, J.P. Morgan and UBS in the last year - ought to make this un-conflicted character valuable to clients of all kinds. In light of the Volcker Rule, the Vickers Report and the Liikanen Report, it is not surprising to learn from Topple that Newedge has received a welcome reception from regulators anxious to reduce systemic risk as well as from clients concerned about conflicts of interest, lack of transparency and re-hypothecation. Of course, the same regulatory endorsement means that the agency-only approach will not remain distinctive for long. “We really want to be out there selling our model, because we believe it is so pertinent to the current regulatory climate, as well as the business environment,” says Topple. “All the regulations are pointing towards the agency model we operate already. And it is of even more value to our clients now. Between 2005 and 2008 the primary criterion for choosing a broker, on both the futures and the prime brokerage side, was price. Now clients look at financial stability and the treatment of customer assets, as well as scale and operational stability. Agency-only is a powerful story, and it is working well across the different client segments that we deal with, including hedge funds. After all, it is much easier for the COO of a hedge fund to explain to a pension fund that his clearing arrangements are completely segregated, and carried out by an institution that does no proprietary trading. Compare that with explaining why your trades are cleared by a firm where, you have just read in the newspapers, a proprietary trader or financing desk has lost millions of dollars, including client assets.” Topple adds that Newedge is

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research and clearing. “Now, with regulators asking fund managers to identify clearly where they are paying revenue to service providers, the ability to connect research with execution is more closely delineated,” says Topple. “It gives us a far greater opportunity to be relevant to institutional fund managers.” But there is another reason, beyond disbursement of the commission pot, that traditional managers are looking afresh at Newedge. This is the convergence between traditional and alternative investment strategies. It is making previously long-only managers potential buyers of prime brokerage products. In fact, it is the pursuit of these large, institutionalised and increasingly convergent buy-side clients that sparked the organisational changes in October 2011. Philippe Teilhard de Chardin, the former global head of prime brokerage, left. On his departure, prime brokerage and prime clearing were merged into the new PCS division under the leadership of Chris Topple, a J.P. Morgan-trained former prime brokerage sales director at Lehman Brothers and its successor, Nomura. He joined the French bank three years ago as global head of institutional clearing and high frequency trading. “What we saw – and Philippe and I discussed this on many occasions – were the synergies between the two groups,” explains Topple. “Fundamentally, we were servicing similar financial institutions, which required many of the same services, in terms of the core, multi-asset class execution and clearing. We were seeing similar services being requested by the institutional asset managers, which were allocating to alternative managers, so

it made perfect sense to bring the two businesses together.” In a sense, the merger marked the completion of the slow merger of the two brokerage houses that made up Newedge Version 1.0, and its replacement by a new, global client servicing model. “Ultimately, all we do is service clients, because we are an agency broker,” explains Topple. “Our clients are our lifeblood. We have no other source of revenue as a firm. Everything has to be client-focused.” If that sounds trite, it should not. In an investment banking industry which has, rightly or wrongly, acquired a reputation for treating clients not as ends but as means, it represents a cultural revolution.

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COO Q&A

THE FUTURE OF HEDGE FUND FINANCING

In September 2012 Barclays Prime Services published a special report on how investment banks source the funding they pass on to their hedge fund clients. Despite its innocuous-sounding title,

Evolution of the Hedge Fund Financing Model is probably the single most important piece of research into the future of the hedge fund industry to be published since the crisis. COO Connect founder Dominic Hobson talked to Ajay Nagpal, head of prime services at Barclays, about the profound implications for the industry of the changing ways in which prime brokers fund themselves.

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COO Q&A

Hobson: Regulators are focused on the “shadow banking” industry. What are the implications for prime brokers and, by extension, their hedge fund clients?

Nagpal: Since the onset of the financial crisis, central banks and regulators have focused on reducing the level of systemic risk within the financial system. The effort is still on-going, and many rules are still under development, but we are already seeing enforcement of some prescriptions related to liquidity, leverage and capital requirements that directly affect prime brokers. Specifically, prime brokers are being asked to do five things. First, better match the duration of their assets and liabilities. Secondly, shift their funding mix toward more diversified and longer-term sources of secured financing, while minimising their reliance on liquidity sources that are more susceptible to “runs” such as money market funds. Thirdly, perform stress tests and maintain appropriate liquidity buffers to mitigate contingent liquidity risks specific to prime broker activities. Fourthly, manage intra-day credit requirements just as intensely as other contingent liquidity risks, particularly when embedded in certain financing and settlement structures, such as tri-party repo. Fifthly, limit the extent of re-hypothecation of client collateral across repo and security lending activities. The main implication of all five of these developments is that the average cost of funding has been going up for prime brokers. This increase in cost is likely to be passed along to hedge fund clients because banks and broker-dealers do not have the ability to absorb this increase in costs over the long term due

to the pressure they are under to improve their return on assets. A related implication for hedge funds is that pricing will increasingly have a term structure. For example, six month financing will be more expensive than three month financing. This will likely force hedge funds to re-examine the extent to which they need term financing, based on the composition of their portfolios.

Nagpal: Regulators - for example, the UK Financial Services Authority (FSA) through its Client Asset Sourcebook (CASS) requirements - have addressed this topic explicitly through their rules regarding haircuts and re-hypothecation of client assets. As a general rule, regulators want prime brokers to use re-hypothecation to fund their clients’ activities, and not their own. Additionally, prime brokers need to disclose to their clients the extent to which their assets are being re-hypothecated, and finally, they need to allow clients to place a cap on the extent of re-hypothecation allowed. While these requirements are fairly onerous for prime brokers, most hedge funds have already taken steps to reduce the exposure of excess cash and fully paid-for securities held by their prime brokers, by sweeping out excess cash on an overnight basis to their custodial accounts. Finally, while

Hobson: The “internal funding efficiencies” to which the paper refers can be seen as a polite term for unlimited re-hypothecation, which investors now resist. What changes in behaviour have you seen so far, and what do you expect long term?

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not yet explicitly mandated by regulators through caps – or at least caps beyond SEC rule 15c3.3 - I do feel that the extent of internal efficiencies employed by prime brokers may be reduced over time.

Hobson: The prime broker-hedge fund financing problem can be reduced to a mismatch of funding and lending terms – as your report notes, 50 per cent of funding is overnight but 50 per cent of assets mature in more than three months - which regulators wish to close. What do you expect to happen?

Nagpal: As I mentioned before, duration mismatch limit frameworks and stress testing have, together, already reduced that mismatch relative to what existed across the prime brokerage industry before the financial crisis. As the recent survey by the FSA found, the mismatch between the tenor of prime brokers’ assets and liabilities has come down significantly. Weighted average maturities of liabilities have risen and weighted average maturities of assets have declined. There was a considerable reduction in the overall mismatch from 2011 to 2012, and we expect this trend to continue for the foreseeable future.

Hobson: This is something of an under-arm ball, but is it your expectation that stand-alone prime brokers will be more affected by the changes you have described than prime brokers that belong to universal banking groups with more diverse funding sources?

Nagpal: I am definitely of the view that

larger, better capitalised banks will have better and cheaper access to a diversified set of funding sources, both secured and unsecured, going forward. It is true that several of the banks seen to have better credit health - at least by the rating agencies, if not CDS spreads - are universal banks.

Hobson: In the new era, will some hedge fund strategies become non-viable? If so, which will be affected most?

Nagpal: I would not go as far as to suggest some strategies will become non-viable. However, some strategies will be more susceptible to the pain of the rising cost of financing. At the most basic level, if and when leverage starts to become more expensive, those strategies that rely on high leverage and use less liquid assets - the financing of which is a primary target of recent regulatory actions - to generate returns will find their returns getting compressed. Another thing to keep in mind is that some hedge fund strategies may have a better ability to absorb a 50-80 basis point increase in the cost of funding, assuming they can continue to generate higher than average annualised returns consistent with their historical performance.

Hobson: Will the impact of change vary by the size of the fund, as measured by assets under management?

Nagpal: Larger funds naturally have a better ability to negotiate with their prime brokers. Additionally, bear in mind that leverage in the hedge fund industry has

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COO Q&A

remained flat for several years now. If financing capacity were to ever become a constraint due to rising leverage, prime brokers might be forced to choose to make it available to larger, more profitable clients rather than smaller ones. Finally, larger hedge funds tend to be more diverse in the types of strategies they employ and assets they trade. This gives them a natural ability to cross-finance assets to an extent which, in turn, could potentially reduce their reliance on prime broker financing for their least liquid assets.

Hobson: Will the future model of hedge fund financing see an increase or a decrease in the use of synthetic financing tools? Can the prime broker of the future offer synthetic financing more or less efficiently in balance sheet terms?

Nagpal: Synthetic financing adds to the breadth of sources of liquidity for prime brokers as well as the financing arrangements that prime brokers can offer to clients. The impact of hedge funds’ potentially greater reliance on synthetic financing on prime brokers’ balance sheets will vary depending on a number of factors, including the need to access certain restricted markets where traditional repo markets have yet to develop. And, yes, synthetic financing may offer additional balance sheet synergies, but the actual impact will vary, depending on a number of factors.

Hobson: Financing has been a major earner for prime brokers. What will the changes in prospect do to the attractiveness of prime brokerage as a business overall?

Nagpal: I do not expect any of the major prime brokers to be impacted by these changes in a way that would make them reconsider whether they should be in the business. That said, if the cost of doing business is going up for everyone, some of these costs will need to be passed along to clients to maintain the fundamental viability of the prime broker business model. Prime brokerage has always been a scale business with significant entry barriers and some of these recent developments may result in marginal players exiting the business altogether.

Hobson: Has the still incomplete structural reform of the tri-party market in the United States (US) had any consequences, minor or profound, for the funding of American investment banks? If not yet, do you expect the consequences to be or to become more profound?

Nagpal: The reform efforts in the US tri-party repo market have had and will continue to have a profound effect on secured funding. In addition to enforcing change in areas such as liquidity risk management, which I alluded to earlier, there is considerable focus on operational changes to reduce the systemic risk of the tri-party platforms, such as the introduction of three-way deal matching. Probably the most important recommendation from the Tri-Party Repo Infrastructure Reform Task Force was the “practical” elimination of intra-day credit, provided historically by the two clearing banks on an unlimited, discretionary and cost-free basis. This credit was a source of considerable systemic risk, given that the US tri-party

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COO Q&A

repo market is, by far, the largest, and the terms offered by the clearing banks were uncommitted. Major market participants continue to change their behaviour both operationally and in the marketplace to reduce their reliance on this daily, intra-day credit, and it seems the industry is finally making meaningful progress towards meeting this goal. Remember that one consequence of the trade-off for a reduction in systemic risk is higher costs for end-users, such as hedge funds and other borrowers. What the levels of those final costs will be is still evolving, as even current costs are not yet being passed on in full.

Hobson: Money market funds, which were a major source of funding in the repo markets of the pre-crisis era, are also being reformed. How will changes to their permissible liquidity ratios affect the funding of prime brokers?

Nagpal: Some of the changes in regulations governing money market funds have already had an impact on the extent and type of financing available to prime brokers. New portfolio maturity limits, liquidity requirements, and explicit mandates on portfolio credit quality have led to a shortening of the maturity of money market fund lending. In fact, many funds are already running well within the guidelines on several of these regulatory requirements. Some of the other regulations that have been debated in recent months, such as a floating net asset value (NAV), creation of a reserve, or the putting in place of redemption gates, are potentially more likely to impact the behaviour of lenders to money market funds, rather than

borrowers like prime brokers. In my view, the goal of any further reforms should be to make the sources of liquidity such as money market funds less susceptible to potential “runs,” and the prime broker community is in principle quite supportive of that goal.

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COO FeatureCoo Feature

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THE TRIUMPH OF HOPEMergers are as unlikely to work in fund management as in any other industry. So why do they keep happening?

Coo Feature

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Mergers are a characteristic feature of finance-capitalism. They are, like the credit that fuels the financial system, an attempt to fast-forward to the future by skipping the tiresome and time-consuming demands of organic growth. Despite their dismal track-record in all industries and every era, they offer enough to managerial egos and fee-grubbing M&A lawyers and investment bankers to remain an evergreen feature of the corporate scene. Think only of the acquisition of ABN Amro, which destroyed or disabled several major banks, for a recent example of how much can go wrong when egos and exuberance coincide. Fund management, where dismay about the fragmentation of the industry and the proliferation of copycat investment strategies is frequently expressed by those with little interest in how competition works, is exempt from none of the temptations.

performance-linked deal worth up to £53.6 million. A few weeks later Man acquired GLG, creating an organisation of exceptional size in the alternative asset management industry: it had $70 billion in assets under management (AuM) at the outset, though this was down to less than $60 billion by the end of last year. Less than six months after the Man-GLG deal, RBC paid $1.5 billion for BlueBay Asset Management. But those deals were initiated during the crisis, and in train even as markets picked up in 2010. 2012 has also seen its fair share of activity. Switzerland-based Gottex recently acquired Penjing Asset Management in order to bolster its Asian presence while UBP purchased Nexar in March. Meanwhile, EIM, the $7 billion fund of funds run by the flamboyant Arpad Bussan, announced it was for sale having seen its AuM decline by half since the crisis. David Nissenbaum, a partner at Schulte, Roth & Zabel (SRZ), says less all-or-nothing transactions are now favoured. “There was a lot of M&A activity after the crisis as managers tended not to generate great returns,” he says. “However, we are now seeing more strategic partnerships or investments than out-and-out M&A.” Strategic partnerships take many forms, ranging from pension funds working with fund managers to teams spinning out of larger fund management houses, but all aim to lock together capital and talent in less risky and expensive ways than outright mergers and acquisitions. However, like acquisitions, they are still rooted in the extraordinarily resilient belief among investors in scale as the key to making allocations. “Alpha is hard to find and a lot of managers are experiencing

MERGERS ARE AN ATTEMPT TO FAST-FORWARD TO THE FUTURE BY SKIPPING THE TIRESOME DEMANDS OF ORGANIC GROWTH.

The market uplift of 2010 (almost certainly the first of many unsustainable rallies to come) provided an occasion to indulge. In April 2010, F&C agreed to purchase Thames River in a

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of commission to distributors, restrictions on `complex’ UCITS sales, on-exchange swap trading in Europe); UCITS IV/V (standardised key investor information documents, or KIIDs, tax problems for master-feeder structures, and extra custody costs); European Union PRIPs (distribution complexity plus tougher investor protection rules), and the Retail Distribution Review in the UK (an end to commission payments in the UK from 2013). Compliance with all of this regulation will cost real money. The Alternative Investment Management Association (AIMA), the international hedge fund industry association, has estimated that AIFMD alone could cost the industry up to $6 billion. The micro-sums that make up that larger magnitude will be hard to find out of 2 per cent or less on a relatively modest AuM. But, as Jeremy Charles, former COO of Thames River, points out, cutting regulatory costs would be a poor rationale for a merger anyway. The F&C acquisition of Thames River, he says, was ultimately driven by the strategic fit. “Thames River has a lot of wholesale investors putting capital into its funds while F&C comprises generally institutional money such as pension funds and insurance companies,” he says. “F&C wanted to move more into the absolute return arena and have distribution to higher margin products. The merger was designed to give both companies access to each others’ distribution networks.” In the same way, accessing the distribution power of Man in Asia and Switzerland as well as Europe was what appealed to the founders of GLG, which had experienced the challenge of rapid and significant redemptions by investors

INSTITUTIONAL MONEY LIKES ITS MANAGERS TO BE BIG. Another factor behind the urge tomerge (or at least pool expertise and assets) is regulation. The direct and indirect regulatory costs borne by fund managers now include the Dodd Frank Act (SEC registration, Form PF, swap clearing and on-exchange swap trading); the Volcker Rule (loss of market-making, spin-off of proprietary trading desks); FATCA (potential liability to tax authorities on behalf of investors); AIFMD (distribution restrictions in Europe, plus extra reporting and custody costs); Basel III (deleveraging of the banking industry); EMIR (increased margin payments, swap clearing in Europe); MiFID II (termination

decreased capital inflows,” says Daniel de Faro Adamson, CEO of Lincoln Square Advisors, a New York-based consultancy. “If a manager is running a sub-$500 million fund, it is a challenge. Investors are allocating to managers with substantial assets so more people are joining forces to create economies of scale.” If this is counterintuitive in a hedge fund industry that has long understood the inverse correlation between size and performance – even now, many of the most successful investment managers cap the size of the funds they manage – institutional money likes its managers to be big. A Citi Prime Finance survey found just 13 per cent of managers, all with more than $1 billion in AuM, now account for the bulk of the $2 trillion invested in hedge funds.

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7COO

COO Cover Story

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in 2008. In return, Man, like F&C, got access to the supposedly superior investment performance of GLG, plus diversification away from its reliance on funds of funds. “This will be a transformational deal,” Manny Roman of GLG told the newspapers at the time of the sale of the firm to Man. “We have been very close to the abyss and we got things wrong. But this is an incredible deal and one year from now that will be very clear.” Two years on, the promised transformation is not yet apparent. With neither Man nor GLG performing especially well - the Man long-only funds lost $3.7 billion (including a single redemption of $1 billion) during the third quarter of 2011. The total AuM of the firm fell to $58.4 billion at year-end 2011, 17 per cent down on the starting point of the merger in May 2010. There was a slight recovery in the early part of 2012 to $59.5 billion, but it reflected better investment performance – net redemptions continued.

The flagship $17 billion AHL Fund,normally a metronomic profit generator for Man, finished 2011 down 6.4 per cent and struggled noticeably last year. “There has been a significant decline in AuM, and inward flows of capital have noticeably decreased,” says one former GLG employee. “AHL, which is one of Man’s largest and historically successful funds, has generally not performed. The alternative funds on offer are generally first-rate and are run by exceptional people, but they are not performing as well as they would hope in these volatile markets.” Nevertheless, he remains optimistic, arguing that the rationale of the deal remains intact. “GLG wanted to get onto Man’s established distribution platform and, so far, it is working reasonably well,” he says. “Additionally, there is now a complementary pool of products there. I believe the GLG-Man merger will ultimately reap dividends. I am personally still long my own Man equity and my fund is long Man corporate debt.”He is also equally buoyant about the prospects of Man’s funds of funds business latest acquisition – the $8 billion fund of funds Financial Risk Management (FRM). The deal, which was announced on May 21, lead to a combined entity managing $19 billion in AuM. The JV is now the largest fund of funds outside the US. According to a statement, Man paid $82.8 million for FRM, which was valued at $600 million pre-crisis. Furthermore this is contingent on whether FRM can retain assets for three years – something of a challenge given that FRM has seen its AuM fall by 60% since the crisis. He argues the deal will give Man access to FRM’s sovereign wealth fund and pension fund client base, although

“THIS WILL BE A TRANSFORMATIONAL DEAL. WE HAVE BEEN VERY CLOSE TO THE ABYSS AND WE GOT THINGS WRONG. BUT THIS IS AN INCREDIBLE DEAL AND ONE YEAR FROM NOW THAT WILL BE VERY CLEAR.”Manny Roman, 2010, on selling GLG to Man

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rejects claims the JV was a cynical ploy to appease Man’s frustrated

shareholders. Others attribute the sale to

pressure from Sumitomo in Japan, FRM’s biggest investor. The deal, should it

succeed, could mark the end of

the nadir for Man, having been kicked

out of the FTSE 250 following its

significant share price drop.

But it is easier to argue that

the original rationales for the Man-GLG/ FRM deals were flawed. What Man required (diversification and high performance) and

what GLG/FRM expected (stable and growing sources

of capital to manage) reflected their respective weaknesses, which were exposed by the events of 2007-08, and are now in all likelihood being exposed again. Considered soberly, it is not obvious that weaknesses can ever be remedied by pooling strengths, however complementary strengths appear to be. The wider market environment, which argued for the merger, has also made it harder to make a success of the transaction. Making two companies work together effectively to generate alpha is not easy in any environment, but it is harder still in the relatively directionless markets of today.

Acquisitions can also be staggeringly expensive. In 2011 Man reported acquisition costs of $35 million on the purchase of GLG. Henderson Global Investors paid £365.4 million for £15.3 billion in AuM, or 2.4 per cent of the total, when it acquired Gartmore. The acquisition was in trouble, with its share price down by half on its 220p listing price in December 2009, but this did not prevent Henderson having to dole out another £33.2 million in share allocations to persuade former Gartmore staff to stay on. On top of that, it paid “integration costs” of another £69.7 million. Once those costs are added back in, the cost rises to 3.1 per cent of AuM. And Henderson did not even get to keep all of the Gartmore assets anyway. Henderson says it managed to retain 86 per cent of the AuM it expected to retain – that is to say, net of market movements and notified redemptions at the time the deal was announced – but that still amounts to a post-acquisition attrition rate of 14 per cent. In fact, during the whole of 2011, Henderson suffered

MAKING TWO COMPANIES WORK TOGETHER EFFECTIVELY IS NOT EASY IN ANY ENVIRONMENT, BUT IT IS HARDER STILL IN THE RELATIVELY DIRECTIONLESS MARKETS OF TODAY.

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significant net outflows. They totalled £6.4 billion. True, there were inflows in 2011 into the AlphaGen funds previously managed by Gartmore, and of course the acquisition increased management, transaction and even performance fees, boosting earnings at Henderson. Yet Henderson attributed only half of the underlying increase in earnings to the acquisition of Gartmore. The rest came from cutting costs. In theory, the growth lies in the longer term, the purchase having given Henderson increased exposure to higher margin hedge fund strategies and the even higher margin retail funds market. But it has also massively increased the reliance of the firm on a rise in equity markets, where nine out ten pounds managed by Gartmore were invested. That is the real long run story. One former employee, who says Gartmore would have collapsed had Henderson not rescued it, remains staunchly optimistic. “Gartmore was a very successful manager which sadly ran into difficulty,” he says. “The Henderson acquisition was a lifeline and now we are seeing a lot of talent emerging through the ranks. I am very confident about the firm’s future.” Talent is what the denizens of the fund management industry believe they possess in abundance, and if it is not recognised they can cause damage in the aftermath of an acquisition. It was the unexpected departure of star manager Guillaume Rambourg (who has since started a hedge fund of his own, Verrazzano Capital, in Paris) and his colleague Roger Guy that torpedoed the Gartmore share price in 2010. In 2012, Morningstar downgraded the Henderson Gartmore Global Focus fund after its manager, head of global equities Neil

TALENT IS WHAT THE DENIZENS OF THE FUND MANAGEMENT INDUSTRY BELIEVE THEY POSSESS IN ABUNDANCE, AND IF IT IS NOT RECOGNISED THEY CAN CAUSE DAMAGE IN THE AFTERMATH OF AN ACQUISITION.

environment they will find appealing. This is not easy, or at least not easy without displacement, as the aftermath of the Man-GLG merger shows. “The personalities and culture at GLG are very different to that at Man,” muses the former GLG employee, as he compares

Rogan, left the firm to spend more time with his family. “Quite frequently, this type of business comprises of successful stakeholders with egos, and they have to be managed accordingly and encouraged about the benefits a merger will bring,” says Sunil Chadda, an independent consultant. “Alternative investments do have a higher rate of staff litigation.” The risk, of course, is that investor capital will follow the exiting stars. So acquirers are not just willing to pay them to stay (witness the £33.2 million paid by Henderson) but work hard to create or preserve a cultural

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the merger to a comprehensive school absorbing a public school. “At GLG, the employee base is typically dynamic, aggressive and hugely intelligent, whereas at Man it is more relaxed, and an institutional and long-only culture prevails. In many ways GLG is very Goldman-esque. Arguably it has been a reverse acquisition. Many senior GLG personnel such as Pierre La Grange and Luke Ellis have been given very senior roles within Man while Manny Roman is now CEO.” Man has also opted not to force the two cultures together by making them share an office. GLG remains in Curzon Street, while Man remains in Lower Thames Street (although FRM has moved to Man’s offices in Lower Thames Street). Ken Fry, COO of Aberdeen Asset Management, a company which in the last decade has acquired the asset management businesses of Deutsche Bank, Credit Suisse and the fund of hedge funds platform of RBS, thinks this is a mistake. “It is a key part of our strategy to move staff into one building to cement an acquisition,” he says. “It is just the same as consolidating on one operating model, and it goes a long way to breaking down cultural differences. It also helps to start the alignment of investment processes, as this takes longer and cannot happen overnight. It is essential to convince the market that you are a unified, single organisation.” Though F&C has also elected to leave Thames River in Berkeley Square, Jeremy Charles thinks it works well. “The Thames River investment teams are very independent from F&C,” he says. “With our Chinese walls, we do not even share the office with each other, and F&C’s policy is not to dominate us.

Investors are still happy with the set-up.” But he adds that it works precisely because there is no political conflict to be managed. “If there is overlap or jockeying for power, problems will follow,” he explains. “I respect F&C, as there is very little politics, which is why the changes have not been substantial. But mergers can be pushed apart when cultures are different. The best example of this is when various retail banks purchased broking houses. The cultures were so different that they were not really strategic fits and many of them disintegrated.” Charles is referring to the acquisitions of London brokers and jobbers ahead of the Big Bang in October 1986, when half of the estimated £3 billion expended by banks went to the individual partners of the firms being purchased, creating hundreds of lucky millionaires (then a comparative rarity) who felt little loyalty to the new owners. That feeding frenzy, in which every bank felt they had to purchase securities market expertise, afforded little time for proper due diligence. But few mergers or acquisitions do. “It is remarkable how little opportunity you have for in-depth operational due diligence in advance of an acquisition, so you have to focus on what is important,” says Ken Fry. “You need to understand the characteristics of the business you are acquiring, the profile of the clients, the type of assets and instruments in the portfolios. You also need an understanding of existing investment processes and how they compare with your own, as you will need to support them. It is easy to fall into the trap of focusing on detail during operational due diligence when what you need is a high-level gap analysis.

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You can get bogged down comparing technology platforms, as everyone typically wants to retain their own platforms.” Aberdeen Asset Management solves that problem by shifting every acquisition on to its own platform. “For us, it is about what enhancements our platforms need to support the new business,” says Fry. “We do not typically carry out a full analysis on the acquired platforms as our strategy is to consolidate on our existing global operating model. It is the only way to complete the integration in a reasonable time frame and significantly cut overheads.” Stuart Martin, a partner at Dechert, has a more nuanced approach. “Implementing integration is important if it makes sense to the way the merger group wants to operate but it is not the be all and end all,” he says. “It is ill advised to integrate systems if it smothers the individuality of the business. It is possible to run acquired companies as ‘boutiques’ if strategies genuinely do not overlap, but you have to be sure the real motive is not to avoid the pain of integration. Either way, you need global platforms for functions like risk management, so a degree of integration is inevitable in order to gain from any synergies.” Fry acknowledges that integrating the technology of an alternatives manager with that of a long-only manager is challenging, as Aberdeen found after acquiring the RBS funds of funds unit. “Moving from a traditional asset management business into alternatives did involve considerable system

development as we did not support those asset classes,” he recalls. “It took the best part of two years to fully integrate RBS’s fund of hedge funds business into our platforms. It is human nature to want what you are familiar with and it is no different with systems. It is our job is to convince users that our systems can support their requirements, and we have fought many battles on exactly this point. The trick with fund management is to integrate the front office first, even if it means implementing a transitional operating model, and running two back offices during the integration. The only danger is that it can look like you have completed the integration, when in fact the bulk of the work is still to be done.” Sunil Chadda agrees that integrating technology systems well is essential. “It is so important to have an understanding of the new business plan and overall requirements so that a gap analysis can be performed on the technology infrastructure of the existing firms versus the new enlarged business,” he says. “The sooner managers integrate core systems the better as only then will the planned synergies and cost savings be experienced.” Which is a reminder that acquisitions are about subtraction as well as addition. In fact, post-acquisition, the managers of the integration process

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are best advised to focus on the one aspect of the deal they can control after the investment stars have extracted their bounty. Without careful management, any acquisition is liable to create an increase in expenditure, even without taking management contract and goodwill write-offs into consideration, though these inevitably leave their mark for years to come. As a result of the acquisition of Gartmore, for example, Henderson is amortising over the next four to six years goodwill of £238.3 million and investment management contracts valued at £220.9 million. Acquisitions can deposit time-bombs of a less predictable nature too. “It is so important to review any liability issues,” advises Nissenbaum. Investors will certainly not look kindly on an acquisition if there are pre-existing litigation complaints against the firm that is being acquired. But it is even more important to analyse the stickiness of the investors and the complexity of the assets managed by the acquisition. “It is imperative people do not find out a company they are about to acquire is full of hard-to-value, illiquid assets,” says Peter Hughes, CEO of fund administrator Apex Fund Services. Fund of hedge funds contemplating mergers also need to look at each others’ underlying investments, and not only for signs of illiquidity. “This is to ensure there are no Madoffs or frauds in the portfolio,” says James Abbott, partner at Seward & Kissel in New York. “It is basic security against potential fraud as well as a chance to see how the portfolios of the two funds will mesh. While fraud is uncommon, it does happen, and post-closing discovery of problems is a sure-fire way to scare off existing or potential

investors and to become embroiled in regulatory and legal proceedings.” But then there are so many ways to alienate investors. A deal specifically designed to allow managers to meet high-water marks and claim their performance fee, or simply as an alternative to closing the fund, is an automatic red-flag for many investors. “Investors have to be kept informed about the whole process otherwise they will redeem and take back their money,” says Abbott. “It is essential to be transparent and send a well-crafted notice letter to investors outlining that major changes are underway in the business and explaining how the transaction strengthens the manager to the benefit of all. It is also useful if managers inform investors of the transition plan and time-frame, with direct personal communications or meetings with the biggest investors and, most importantly, managers have to show how the deal will benefit the investors.” During the F&C-Thames River merger, for example, planned changes in service providers were explained to investors as part of the process. “Thames River did outsource a lot and they moved fund administration and custody to State Street,” says Jeremy Charles. “Investors did want to be involved in the whole process and we kept them up-to-date with developments. But having a name like State Street is certainly a boost.” Choosing a new service provider for the merged businesses rather than sticking with the one used by the dominant partner can be the best course of action. “When two organisations merge, it often comes down to operational professionals looking at

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what service providers are offering and whether or not they can work effectively with the new business,” says Stuart Martin. “A change of service providers rarely spooks investors.” But even reassuring investors, though undeniably the most important part of any merger in the fund management industry, is a relatively easy challenge by comparison with the multifarious political and cultural obstacles presented by melding multiple groups of human beings together. “You always need a plan or you will lose the initiative,” says Fry. “It is essential to have a clear strategy and the political backing to implement it, or you will find yourself with a project that keeps getting bigger the closer you get to it.” But even the best-laid plan is, at bottom, an exercise in hope. This is not a bad foundation for success if the individuals involved subscribe as well. After all, hope - as the persistence of religious faith into the modern age constantly reminds us - is the most powerful expression of the human spirit. It is also what keeps investors coming back for more. Fund managers can count on it to retain the capital of investors even as they destroy its value. But in the long run, out-performance must revert to the mean. And as long as performance ultimately remains correlated with the markets, the two-plus-two-equals-five rationale of mergers and acquisitions will always be found out in the end.

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COO Columns

Mention the words “hedge fund transparency” to a due diligence professional of the 2006-07 vintage, and they would probably describe it as an oxymoron. Put bluntly, telling investors what was being done with their money was not at the top of the agenda of managers in those days, or investors for that matter. Provided the returns were maintained, most investors were content with a monthly factsheet, replete with meaningless verbiage to conceal the absence of meaningful detail. Fast forward to 2012, and the landscape could scarcely be more different. Investors scarred by their experiences of 2007-08 – gating, side-pockets crammed with illiquid assets, NAV suspensions, even fraud - are no longer taking managers at their word. Funds of funds in particular have become much more demanding in what they ask of hedge funds before they invest, and while they are invested. A survey by Preqin in 2011 found 84 per cent of institutional investors reject funds unwilling to meet their transparency requirements. Of that large majority, funds of funds

were the most vocal. This is scarcely a surprise, given the exposure of some to the Madoff fraud. But hedge funds, which evolve rapidly at times of crisis, have certainly responded to the challenge. The same Preqin survey found 96 per cent of investors had noticed improvements to the level of hedge fund transparency, more than twice the proportion reporting to the survey in 2010. A joint survey by KPMG and the Alternative Investment Management Association (AIMA) identified a similar pattern: 84 per cent of managers had increased transparency to investors since 2008. Respondents also told that survey they had increased headcount significantly to cope with increased investor demands. These huge majorities in favour of transparency, and investment to deliver it, are predictable. In a post-crisis, post-Madoff world, transparency is a non-negotiable criterion for securing investment. But what exactly are investors looking for? When I visit a fund, I expect disclosure across the entire organisation, and not just the portfolio

TIME FOR INVESTORS TO PRACTISE WHAT THEY PREACH

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management side of the business. I expect to see portfolio positions, core-risk analytics, stress test analysis, plus details of reconciliation breaks and counterparty exposures, which are of particular importance in volatile markets. As investors we want regular reports from service providers, as well as managers. We seek reassurance that non-executive directors are effectively monitoring a fund and have investors’ interests at heart. In fact, corporate governance is one area where the hedge fund industry has generated more media coverage than genuine progress. What nobody can deny is that managers have, under prompting from investors, made serious improvements to investor transparency over the last four years. Even those managers pursuing quantitative investment strategies, in which the so-called “black box” or magic algorithms are guarded fiercely, have recognised a need to disclose more information if they are to recruit and retain investors. Whilst these managers will never share with us the secret formulae of their success, they are giving us unparalleled access to their proprietary systems. This is something which was unthinkable prior to 2008. But it is not just investor pressure that has led to greater transparency. Industry bodies such as AIMA, the Managed Funds Association and the Hedge Funds Standard Board have also encouraged managers to increase transparency by publishing papers and best practice guidelines. This has assisted the investor drive for increased disclosure. So have some of the regulatory requirements. Indeed, one of the few benefits of the worldwide zeal for re-regulation in the wake of the financial crisis is the

increased onus on managers to be more open. Form PF, to take the most obvious for example, requires managers to provide the Securities and Exchange Commission (SEC) with, inter alia, details of counterparty risk, asset class exposures, liquidity, leverage and geographical concentration. In Europe, MiFID II obliges managers pursuing high frequency trading strategies to disclose details to regulators on an annual basis. Investors are already securing access to the information disclosed in Form PF (see “What investors want from Form PF, COO, Spring 2012). While not every manager will be willing to share it, allocators should not be afraid to ask for it. At the least, managers should be willing to provide a “Form PF-lite,” which omits sensitive data. As investors, we accept the need for this constraint. While investors need to be diligent about transparency, they must not be over-zealous. Making unreasonable demands inevitably distracts managers from their principal task: generating high and dependable investment returns. Besides, an excess of transparency can lead to information over-load, creating problems for investors that lack the people, knowledge, technology and expertise to assess a mass of data on a regular basis. The SEC is already running into this problem, as it takes delivery of Form PF submissions. Finally, it is vital that transparency does not become a one-way street in which investors demand and managers disclose. Investors need to be more transparent themselves. Managers often complain they receive inadequate feedback when they fail due diligence tests. This is unhelpful. If we want

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the hedge fund industry to become more institutional, investors must offer feedback to managers on why they were rejected. That way, managers can fix their problems, improving their chances of securing an investment in the future, while raising industry standards overall.

Pierre Emmanuel Crama is head of ODD at Signet Group. He is writing in a personal capacity and the views expressed here do not represent the views of the Signet Group, its employees, partners or any of its affiliates.

Mention the words “hedge fund transparency”

to a due diligence professional

of the 2006-07 vintage, and they

would probably describe it

as an oxymoron.

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WHAT SWIFT CAN DO FOR HEDGE FUNDS

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SWIFT used to be synonymous with big, fat, boring payments between big, fat boring banks. But since its foundation in 1973 the Brussels-based messaging co-operative has built its way into the middle and back offices of the treasury departments of the banks, and over

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the last two decades it has repeated the feat in the middle and back offices of broker-dealers and fund managers. Now, in its fortieth anniversary year, SWIFT can boast a string of standardised messages covering not just everything that happens between execution and settlement, but asset-servicing and fund administration as well. Even now it is moving into securities financing and collateral management, where regulators are stoking demand for standardised messaging. SWIFT is now the network that links networks of cash payments and custodian banks, broker-dealers, fund managers, fund distributors, fund administrators, stock exchanges, and central securities depositories. Hedge fund managers are an integral part of this eco-system. The question is: why are they not making more and better use of an industry utility that could solve an awful lot of their operational problems through a single window on the world? Dominic Hobson asked SWIFT why they think that is.

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Hedge fund managers are no longer just the firms to which investment banks outsource the asset management function. Many are now large and sophisticated businesses in their own right, and managing institutional money which holds them to the highest standards in risk management, asset protection and corporate governance. The result is that hedge funds are no longer trapped in a marsupial relationship with a single prime broker that caters to their every need. Instead, they have multiple prime brokers to which – unlike the pre-crisis years - they allocate meaningful amounts of business. The post-MiFID I and post-Reg NMS equity markets of Europe and North America are also arenas in which managers interact with multiple brokers and trading platforms, often at high frequency and in small amounts. Executing brokers have retained a large share of hedge fund business, and are actually increasing it as hedge funds move into emerging markets. Hedge funds now also use third party custodians on a major scale. A straw poll of 40 sizeable hedge funds by COOConnect found slightly more than half had appointed a separate custodian for unencumbered assets. Even in the United States, where outsourcing of fund accounting and investor services was long thought a waste of money, investors now insist their hedge fund managers make use of independent fund administrators. In short, the number of third party relationships managed by a hedge fund has inflated. To deal with the consequent complexity, hedge funds have a number of choices. One is to increase the size of their own middle and back offices. A second is to invest in technology. A third is to outsource more

back and middle office functions to a global custodian, in the manner of a major long-only fund manager. A fourth is to do a bit of all of these things. And one way to piece them all together is to start using SWIFT messages to communicate with the enlarged number of counterparties, service providers and clients in a visible, standardised and automated way. “We have had an increased number of pro-active calls from hedge fund managers over the past 18 months, inquiring about the options to join SWIFT,” says Arun Aggarwal, managing director, UK and Ireland, and head of post-trade services, EMEA, at SWIFT in London. “The drivers are two-fold. They want to automate their existing prime broker and/or executing broker allocation and confirmation processes, to reduce costs and increase efficiency. And they want to move away from multiple file and fax communications with their various custodian, cash and fund administrator service providers. The use of third party custodians has been an important trigger, as this community is highly committed to helping customers find alternatives to faxes and spreadsheets. And, with so many counterparties these days, no hedge fund wants to have to use five or six proprietary portals.” This degree of openness to hedge fund managers is of relatively recent provenance for SWIFT. As recently as seven years ago, a hedge fund manager was not permitted to join SWIFT. Both the SWIFT board of directors and the owner-users at the annual general meeting (AGM) have now approved admission of all regulated financial institutions. Even some unregulated institutions, provided they are

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sponsored by a bank, are now eligible for membership. This is a happy side-effect of an unrelated adjustment to the membership criteria agreed by the (exclusively bank) owners of SWIFT at their AGM in June 2010. Of course, bank-owned asset managers have long belonged to SWIFT, joining as soon as the payments network recognised the self-defeating nature of the strategy of excluding the buy-side in 1992 (one of whose long term consequences was the creation of the trade matching utility Omgeo, which many hedge fund managers use). Today, SWIFT fully understands the network effects of broadening its membership. Equally, its members understand how greater message volumes translate into lower costs, because SWIFT operates as a not-for-profit utility. More than 900 fund managers now enjoy membership of SWIFT, either directly or via a preferred service provider. The messages and network offers them access not just to custodians and broker-dealers but also a host of other counterparties: insurance companies, pension funds, wrap platforms, fund distributors, fund administrators, clearing houses and proxy voting agencies. “In 2012, as a member of SWIFT, a hedge fund manager can now standardise its end-to-end connectivity and communication with its entire financial ecosystem,” says Aggarwal. “This enables the hedge fund community to take advantage of a truly global, standardised, secure and scalable business model. Levelling the playing field – transparently – allows this community to make the best choices about executing their investment and distribution businesses in a cost-

effective, compliant way.” Plenty of hedge fund managers are already unwittingly – or, in a post-Lehman environment obsessed with counter-party identification, wittingly - users of SWIFT through prime brokers that have added them to their own cluster of accounts, achieved by the simple device of adding three further digits to their own bank identifier code (a BiC-8) to register the fund separately as a “branch” of the bank entitled to use the SWIFT network (a BiC-11). This reflects the fact that, even though fund managers can now join SWIFT directly, the cost and complexity (SWIFT has nine message types: FIN, InterAct, FileAct, FINCopy, FINInform, Accord, CLS, Funds and RMA) of joining and using the services has remained an inhibitor to all but the largest and richest fund management groups. While major bank-owned fund managers, and huge firms such as BlackRock, Legal & General and Schroders were early members of SWIFT, hedge funds were deterred by the assumed cost of buying, maintaining and using an interface designed for major banks. An important consideration is whether that perception of the cost is still correct. Aggarwal says it is out of date. In 2008, SWIFT launched Alliance Lite, a browser-based form of access, which has attracted more than 500 new and smaller volume firms to SWIFT. In 2012 SWIFT built on the popularity of this tool by launching Alliance Lite2, a cloud-based form of access through the Internet which aims to cover all SWIFT message types and a significant volume of messages whilst remaining both low cost and highly secure. “It is now possible for hedge fund managers not only to access the network indirectly through a range

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of service bureaux but also via the Internet to a low-cost, secure interface - Alliance Lite2 – and to take advantage of standardised communication with the entire financial ecosystem for as little as €375 per month,” says Aggarwal. That amounts to just €4,500 a year. Unfortunately, SWIFT is unable to provide meaningful information that would enable fund managers to comparethat cost with the costs of accessing the network directly, through a prime broker or custodian bank, or via a service bureau (such as BBH Infomediary or Bloomberg or FundTech). The pricing schedules are volume-related, which complicates the calculation. But if the price is more attractive than it once was, there may still be other inhibitions. SWIFT does insist on higher levels of security and greater levels of automation in data transfer than the e-mailed Excel spreadsheets and FTP uploads and downloads that hedge funds have traditionally preferred to use when communicating with their prime brokers. The other members of SWIFT, and notably the custodian banks, also like to receive data in the highly structured SWIFT message formats: they do not want file dumps or Excel spreadsheets or e-mail messages or faxes (though they still get plenty of them, especially from fund managers). But SWIFT argues it is not difficult or expensive to acquire the necessary technology to speak SWIFT. Every vendor of an order management system has a SWIFT engine built into its offering as a matter of course these days. They are invariably available on an installed or a hosted basis, so the technological costs of substituting SWIFT messages for the fax machine and e-mail are not

high. However, if connecting to SWIFT is not expensive, the obligations of membership (such as maintaining the infrastructure and being open to receive messages) can be burdensome. Aggarwal counters that hedge funds should consider the costs of their present modus operandi. “Once you add up the costs in terms of personnel, non-automated communications technologies, and manual processing, they are significant,” he says. “You have to look at the total cost of ownership relative to your existing operating model. The gains you will get from managing your existing relationships more efficiently will on their own more than cover the costs and obligations of SWIFT membership.” Whether membership is worthwhile, however, depends on what hedge funds can actually get done by using SWIFT (see Table). Matching, clearing and settling trades, sending and receiving swap payments, and bi-lateral cash and collateral exchanges with repo and reverse repo counterparties, can all be carried in SWIFT message formats. So can cash and portfolio reconciliation information exchanged with prime brokers. Traditional fund managers have also found SWIFT a useful tool for automating fund subscriptions and redemptions, and this will appeal to hedge funds running regulated `40 Act or UCITS funds. SWIFT messages might even appeal in traditional hedge fund capital-raising, since the messages enable managers to keep subscription deadlines tighter. Asset servicing tasks are another obvious use of a SWIFT membership. SWIFT messages offer the ability to track dividend payments, allowing hedge funds to make more

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accurate cash projections. Aggarwal says corporate actions notifications and instructions are now the fastest growing traffic segment at SWIFT, with messages between global custodians, sub-custodians, investment banks and CSDs surging as flat-lining stock markets have intensified interest in sources of income that seemed less important in a bull market. By using SWIFT messages, a hedge fund can also elect to trade closer to the cut-off times of corporate actions. These are among the benefits of the 2010-12 collaboration between seven global fund managers, their global

Things hedge funds can do via SWIFT:

custodians and SWIFT to standardise corporate actions communications on the International Standards Organisation (ISO) 20022 standard. A similar project to standardise proxy voting notifications and instructions between issuers and their registrars, fund managers and global custodians – on a global scale - is now under way. SWIFT has also published a new set of ISO messages for the posting of cash and securities collateral to and from central counterparty clearing houses (CCPs), which are currently being tested, though these will of course be more valuable

Match trades with counterparties across equity, fixed income, money markets, swaps, FX

Match trades with prime brokers (and their executing brokers)

Send settlement instructions to prime brokers

Receive settlement confirmations from prime brokers

Allocate trade proceeds between funds

Send delivery instructions to prime brokers

Receive corporate action notifications

Issue corporate action instructions

Trade closer to corporate action cut-off times

Receive proxy voting forms

Issue proxy voting instructions

Move cash from prime brokers to third party banks

Move assets between prime brokerage and third party custody accounts

Receive fund subscriptions

Pay fund redemptions

Receive net asset valuations (NAVs) from administrators

Communicate with managed account platform

Communicate with regulated fund platform

Post margin/collateral to a prime broker

Post collateral to repo and reverse repo counterparties

Post margin/collateral to a CCP

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Accord foreign exchange trade matchingengine to the task – and connect to three CCPs shortly after that, it did much to eliminate doubts about the ability of the messaging co-operative to adapt to the fast-paced world of hedge fund trade processing. The service has so far matched 12 million trades. The reason Accord for trade matching works for hedge fund managers is in large part because they do not need to have anything to do with the process: it is all handled by the prime broker and the executing broker. But using SWIFT to match the trade also means SWIFT can be used to settle and report the trade. Matching trades via SWIFT is, unlike using Omgeo or a local matching service, an automated window into not only the rest of the clearing and settlement sequence, but asset-servicing and fund distribution and administration and collateral management as well. “Hedge funds using SWIFT have realised that they do not have to be locked into one provider for any post-trade process or asset-servicing function at all,” says Aggarwal. “SWIFT liberates hedge funds to inter-operate with whoever they like, but in a coherent, structured, transparent and cost-effective way.” He adds that, in addition to centralised trade matching on Accord, a growing number of hedge fund managers are joining long-only managers and broker-dealers in using SWIFT for electronic trade confirmation. The Global Electronic Trade Confirmation (GETC) service offered by SWIFT automates allocation-only or block allocation confirmations using ISO-standard messaging. “It is an ever-more popular option for confirmation matching for firms looking to reduce the costs of this process, to preserve their investment

to clearing brokers than hedge funds themselves. At present all of these tasks are being completed by hedge funds largely through a mixture of telephone, fax, e-mail and spreadsheet, with a heavy reliance on the prime brokers to insulate managers from the operational consequences of a low level of automation. With the number of prime brokers and custodians multiplying, that reliance is unsustainable, or rectifiable only through work-arounds such as hearsay reporting. Aggarwal says adopting SWIFT is an obvious solution, and points to an existing service in the trade matching area as proof positive that SWIFT can help what he calls “the hedge fund ecosystem” to shift to a cheaper and more efficient way of doing business. SWIFT has since May 2009 offered a securities trade matching service that enables hedge funds’ prime brokers to pre-match and then net transactions through CCPs that managers have executed with third party executing brokers. There was considerable surprise in the marketplace in 2008 when SWIFT pipped trade matching specialists Omgeo and the London Stock Exchange to win from a group of prime brokers the contract to develop the service. In retrospect, awarding the contract to SWIFT was another sign of acceptance by prime brokers that they could no longer monopolise the business of their hedge fund clients. Instead, they are now looking to cut the costs of servicing multiple counterparties by encouraging hedge fund clients to adopt the leading industry standard methods of communication. When SWIFT was able to deliver the service from a standing start in just nine months - by adapting its

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business, fund managers of all kinds tend to use the FIX protocol. In the derivatives markets, they use FpML. Now both these protocols can not only be used across the SWIFT network – they can also be couched in SWIFT language via the ISO 20022 message standard. The war between messaging protocols is now history, says Aggarwal, who points out that all messages types are now converging on ISO 20022 as a single operating standard that will eventually make participants in the payments, money, fixed income, futures and options and OTC derivatives markets indifferent as to what messaging protocol their counterparties choose to use. “By joining SWIFT, a hedge fund can enhance its distribution, improve its operating model, and increase the efficiency with which it collects income and other entitlements,” adds Aggarwal. “It can trade closer to cut-off time. It can even fulfill its corporate governance obligations more easily. And a hedge fund can do all of this securely, and in a fully automated fashion, without worrying about an inability to make themselves understood to their counterparties.” Aggarwal even argues that the apparently heavy-handed SWIFT insistence on counter-party identification helps hedge fund managers, because it improves their management of asset safety, collateral and counter-party credit risks. As the implementation agent of ISO for the securities industry, SWIFT could become a major distribution channel for the new 20 digit alphanumeric codes known as a legal entity identifiers (LEIs). These are being pushed by regulators and central bankers as the means of tagging counterparties down to the entity level,

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in existing workflows and indeed those looking to automate for the first time,” explains Aggarwal. “The number of investment managers – including major players such as Legal & General and DWS – and broker-dealers using SWIFT GETC is growing steadily. Some are seeing savings in excess of 50 per cent on their confirmation matching costs in comparison to using other providers, and the option to connect to SWIFT using Alliance Lite2 makes this solution highly cost-effective for lower volume players and those firms looking to eliminate fax, email and telephone-based communications and to automate for the first time.” Another useful application of SWIFT, according to Aggarwal, lies in fund administration. SWIFT ISO messages can be used to automate information flows stemming from fund subscriptions, fund redemptions and reconciliations of account holdings between custodians, fund administrators and transfer agents. Much of this activity is at present manual or poorly automated, especially in the alternative fund management industry. “Hedge funds are pioneering in terms of investment strategy, but the administration and processing procedures that underpin their business have been far less cutting-edge,” says Aggarwal. “Extensive use of manual processes to complete hedge fund transactions adds greatly to cost and risk. Deployment of standardised messaging over SWIFT minimises both, and is another aspect of the automation achievable via SWIFT for the hedge fund community.” Importantly, using SWIFT does not mean using nothing but SWIFT messages. In their cash markets

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reducing systemic risk by making it easier for banks, investment banks and their fund management clients to know exactly which entity owes them cash or securities, or is owed cash or securities by them, or is in possession of their cash or securities. “Knowing who you are doing business with, and who your service providers are doing business with, is a lot more important now,” explains Aggarwal. “LEIs may sound boring, but they are pretty important if you want to know at any point in time which entity exactly has control of your assets, and whether you are engaging in transactions in those assets with counterparties that are at risk of default.” In September 2008, for example, LEIs would have enabled hedge fund managers and their prime brokers to identify immediately which assets were at Lehman Brothers in New York and which were at Lehman Brothers International in London, and even the identity of counterparties to whom those assets were re-hypothecated. Of course, it will not be easy to ensure that LEIs apply at every point in the extended chains of intermediaries and counterparties that characterise an industry which lends and borrows the same cash and securities multiple times. But couching information exchanges in the SWIFT messaging protocol will certainly facilitate it. In fact, SWIFT is finding that its insistence on the highest levels of security in transaction processing is no longer viewed cynically, as an excuse to charge more. Asset safety, and the minimisation of collateral and counterparty risks, are fashionable even. The unanswered questions are how SWIFT can capitalise on its reputation for

security in an industry more interested to extend its reach into all parts of an industry as fragmented as hedge funds. Its task is made harder by the relatively limited penetration by SWIFT of the securities markets of the United States, where three quarters of the hedge fund industry is still based. The technology vendors (which incorporate SWIFT engines in order management systems) and the service bureaux (which transform the economics of SWIFT membership by acting as message aggregators) are the obvious channels of distribution. But SWIFT could do a lot worse than simply change its idiom when speaking to the hedge fund industry. It took an important first step in that direction by joining the Alternative Investment Management Association (AIMA) in 2011. The danger is that the SWIFT appetite for forming or contributing to working groups will so delight the AIMA management that it keeps the messaging co-operative in its comfort zone. Rather than publish papers on how it can help hedge funds transform their operational processes, SWIFT needs to tell hedge funds what back office duties it can cover, what it charges to cover them, and which counterparties and asset classes are already members of its network. Aggarawl is well aware of the need to talk to hedge funds in a language they understand. “Ultimately, what we offer hedge funds is the ability to access all of their service providers through a single channel,” he says. “They can join our network, and communicate with everybody they do business with in a secure, reliable and standardised way.”

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A BEAR FOR ALL SEASONSAltana Wealth founder Lee Robinson has made a lot of money for himself and his investors by anticipating the worst that can happen. And right now he is more bearish than ever.

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default could have on Portugal, Italy, Ireland and Spain, which in turn will hit the biggest economies, like the United States, Britain and Japan.” Views of this kind are treated as lese-majeste in anyone working at a European bank, and are of the kind that prompt European politicians, regulators and central banks to retreat into a belief (last held with any real conviction in the 1920s) that any currency problem is an Anglo-Saxon plot. But Robinson has form. As co-founder of Trafalgar Asset Managers, the fund management firm founded in 2001 that has now bifurcated itself into CapeView Capital (headed by fellow co-founder Theo Phanos) as well as Altana, he predicted the credit crisis and successfully navigated his investors through the threats and opportunities it presented in the sovereign debt markets. “If one does not read and learn from history, one is doomed to fail,” says Robinson. “History has shown us repeatedly that credit is the most important factor in the global economy. 90 per cent of the world economy is about credit and borrowing. Credit is the engine of the car. Without it, the car will not work. Everything else that makes up global markets, like derivatives, equities or commodities, are just spoilers on the car.” This attentiveness to history is complemented by a commonsensical approach to markets. “You did not need to be a rocket scientist to figure out there would be a sovereign debt crisis three or four years ago,” says Robinson. “Likewise, when Ireland bailed out its banking system, which was three times larger than its GDP, it did not take a rocket scientist to figure out there would be problems down the line either.

“I am more nervous today than I ever was in 2008,” says Lee Robinson. This is an alarming statement, for Robinson is the founder of Altana Wealth, a London and Monaco-based hedge fund which aims to insulate its investors from the inflationary consequences of looming sovereign debt defaults, bank failures and currency collapses. “It is common sense mathematics,” continues Robinson. “We are heading into a credit crisis far worse than what we have endured over the last few years. Take the United States. It has a national debt of $15 trillion and over $100 trillion in Medicare and pension commitments on top of that. And the United States is not alone in its debt. There is no resolution to solve this debt mountain other than to default.” Which is worrying enough from a leading expert on distressed assets, and he has not even begun to discuss the euro-zone. “That,” he says, ominously, “is another problem altogether.” His own prediction is that the euro-zone will at some point enter a period of exquisite danger, characterised by some variant of the hyper-inflation, incessant debt negotiation and re-negotiation and breakdown of civil society that characterised the Germany of the 1920s, and which ended in a vicious dictatorship and war. “If Greece exits the euro and closes its borders, there is a very high risk we will see civil unrest and a potential return to military rule,” says Robinson. “Shops will run out of food and pharmaceuticals and there will be a capital flight out of the country’s banks. We are already seeing Greek money being deposited in German and British banks. We have not even begun to discuss the contagion effect a Greek

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Even a child could have added up those numbers. Common sense went out the window in the run up to the crisis.” He cites Iceland as another example of a country in which lenders as well as borrowers lost touch with the most obtrusive aspects of reality. “How can a country with 300,000 inhabitants be rated AA by the major credit rating agencies?” he asks. It was to encourage others to ask equally commonsensical questions that Robinson teamed up with Patrick L. Young (author of Capital Market Revolution) and others in the industry to produce The Gathering Storm, a collection of essays designed to help investors manage their way through current and coming financial crises. The book, the proceeds of which are being given to a variety of charities, points to the ineradicable tendency of political leaders to postpone a reckoning. “The solutions to escape the on-going debt crisis, both in Europe and the United States, are simple but politically unpalatable,” explains Robinson. “Politicians are going to have to raise retirement ages, reduce benefits and lower spending. The Keynesian approach of spending your way out of debt is unsustainable, but simultaneously no politician will ever get re-elected if they carried out all of the aforementioned policies.” But if Robinson is as realistic about politics as he is about the financial markets, there is nothing modish about his current bearishness. He first learned about finance covering a market which many believe offers Europe and North America their best sighting of the future: Japan. It was the Nikkei he covered when he joined the BNP Paribas equity derivatives desk in London in 1991, armed with little but a degree in

mathematics from Cambridge, the Japanese economy was in the early years of its two decades (and counting) bear market. Robinson attributes his career-long awareness of the steepness of the downside to that experience. “It was rare for traders in their twenties to be working on a book in a bear market but I believe in the long-term it stood me in good stead,” he says. “I was not brainwashed with that bull market mentality.” Two years trading equity, rates and credit derivatives at BNP Paribas also taught Robinson the importance of energy. “My biggest achievement at Paribas was not learning about derivatives, stock markets and making money, but getting through the day,” he recalls. “Leaving home for university is not a big deal, but leaving university and starting work, especially at an investment bank, is a huge transition. I recall feeling exhausted after six hours of straight exams at Cambridge, but working a full 12 hour day five days a week on a trading desk is something no university can ever prepare you for.” Clearly, the culture was not hard enough to drive him out of the industry, because by 1992 Robinson was already mapping out his career. Having noticed that almost every member of the senior echelon at BNP Paribas had a fixed income background, he decided it was vital to move away from equities. “I heard there was a job opening on the bond derivatives desk at Bankers Trust, which was then one of the top three derivatives houses,” he says. “It was 1993-94. Virtually nothing went wrong, and 1994 was a great career year. I was made the youngest ever vice president at Bankers Trust.” By 1996, he had moved on to the credit derivatives

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desk at Deutsche Bank, which in 1998 acquired his erstwhile employers, Bankers Trust. He chose not to stay. “I spoke to an old mentor at Bankers Trust, who was then at Tudor Investment Company,” explains Robinson. “We talked about life and work at a hedge fund, and I was promptly offered a position as a portfolio manager.” Established by Paul Tudor Jones II in 1980, Tudor was already an iconic name in hedge fund investing by the time Robinson arrived to run a global event-driven strategy. He warmed immediately to work and life at the then-$11 billion firm, not least because it was mercifully free of the politics and inertia of investment banking. “There is a lack of meetings and red tape at hedge funds in comparison to investment banks,” says Robinson. “The ultimate aim at a hedge fund is to go in every morning and make money. You are not there to build an empire or a political base. I often find at investment banks, mediocre employees who are decent politicians rise up the ranks. At hedge funds, if you are not a performer, you get found out very quickly, much like in a boxing match. A hedge fund is also a more personal environment. At banks, if you are down on the month, you do not feel it as much and the loss is not as personal. However, if you are trading your own books at a hedge fund and take a hit, you feel it.” It was at Tudor that Robinson developed his famous risk system, which he says has helped him survive every crisis since 1999. It was designed, as he puts it, to calculate the “Armageddon scenario” in any given trade. Orthodox opinion thinks that is what Value at Risk (VaR) is meant to do, but Robinson says the conventional wisdom is wrong.

“VaR is a measure of risk, but it is not a measure of worst case risk, but ordinary risk,” he says. Predictably, the Robinson risk management system has a lot less to say about the upside, and he argues that was the key to positioning the Trafalgar funds for the catastrophe which struck in 2007-08. “It is essential to have a defined downside and not just focus on the upside,” he warns. “Our system identified the defined downside at a time when many traders just focused on the upside, which at the time made it hard to manage risk properly.” Demonstrably, Lee Robinson is never afraid to re-state the gods of the Copybook Headings. He even admonishes traders who fall in love with their positions. “Hedge funds and traders have to be neutral about their trades,” he says. “If you are in a long position and you are wrong, cut it. One of the best traits I learned at Tudor was never to be married to a trade and to be completely indifferent about being long and short.” Where Robinson did have definite preferences was a desire to be his own boss. That was the ultimate catalyst behind his exit from Tudor in 2001, and the foundation of Trafalgar Asset Managers. An event-driven hedge fund, Trafalgar at its peak managed $3 billion. Adding money to manage was facilitated by an exceptional performance in the Dot Com bust, which coincided with the foundation of the firm. Trafalgar was one of the few event-driven managers to make money in 2002, which was not a year notable for potentially lucrative events. “2002 was a dreadful year for most event-driven managers, but we made decent returns and we stood out, which helped us attract more investors,” recalls Robinson. “I am glad we were

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operating in a bearish environment, because if we had been making money in a bull market, nobody would have noticed us.” The Trafalgar returns also attracted the interest of the Petershill Fund, the Goldman Sachs-controlled private equity vehicle for investing in third party hedge fund managers run by Jonathan Sorrell, one of the three sons of Sir Martin to work at the investment bank. It acquired a 20 per cent stake in Trafalgar in 2008. That, as it happens, was the annus mirabilis for Lee Robinson and his risk management system. As the average hedge fund was losing 20 per cent of its investors’ money, the Trafalgar Catalyst Fund was up 5 per cent. “As early as 2007, the money markets were shutting down and the red flag just got higher and higher,” is how Robinson now remembers his thought process. “Even when Bear Stearns was sold to J.P. Morgan, people just did not get the crisis we were facing. Bankers were the last people to figure out how serious the crisis would be.” Even the Robinson risk management system could not insulate Trafalgar completely from the events of 2008-09. “While we moved money into money market funds and had no exposure to Lehman Brothers, Bear Stearns or Merrill Lynch, we did have exposure to Morgan Stanley and Goldman Sachs,” says Robinson. “During the crisis, returns were secondary to actually getting money back from counterparties.” The near-failure of Morgan Stanley and Goldman Sachs during the critical phase of the crisis in September 2008 is etched on his memory as the most stressful experience of his career. “I would never want to live through that experience again,” he says. “Had Goldman gone, the impact on

Trafalgar would not have been terminal but it would have been a big hit. I lost a lot of sleep during that September.” Predictably, as the crisis continued into 2009, uneasy and cash-hungry investors ensured that even good returns in 2008 did not prevent Trafalgar suffering redemptions in early 2009. The Trafalgar Catalyst Fund was eventually closed in April 2011, by which time its assets under management had declined to $450 million. By then, Altana Wealth, the family office set up by Lee Robinson with $25 million of his own money, was already two years’ old. It currently runs three funds: one investing in distressed assets, another in hard currencies, and a third which aims to protect investors from inflation by investing in commodity and financial futures. The Petershill Fund became a minority investor in this latest venture early last year, and he would welcome other investors who share his bearish outlook. “The quality of staff we hired are top tier and the infrastructure build-out comprehensive,” says Robinson. “Coupled with the Petershill investment, it has made the first year an incredible success. The next phase of gathering investors to participate in the funds is the harder part, especially in the current climate. I established Altana because I want to protect my own net worth and take advantage of what is going to be an incredibly tough market to work in. I genuinely believe the game is up for many market participants and sovereigns, and I think we are going to see a lot of countries defaulting via inflation or via genuine default. There is just too much debt at the moment, and it is unsustainable.”

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“Where on earth did Anthony Scaramucci come from?” asks a fund of funds manager. “One minute he is unheard of, and the next he is everywhere. He just exploded onto the scene after the crisis.” The man in question, whose aliases include “The Mooch” and “Gucci Mucci” (the latter coined by that master of the spoken word, former US President George W. Bush), is founder of SkyBridge Capital, a $7.1 billion New York-based fund of funds, and the brains behind the

SkyBridge Alternatives Conference. The event is better known as SALT, an abbreviation redolent of the age of Détente. Hosted at the Bellagio Hotel in Las Vegas every year since 2009, SALT has already become the premier hedge fund conference, and last autumn launched its first Asian conference in Singapore. The inventor of these prestigious conferences can seem scarily successful. Not only does he control a large fund of funds house, and a

Not many people in the hedge fund industry are prepared to put their heads above the parapet. Anthony Scaramucci gets out of the trench altogether. And charges the enemy lines.

OUT OF THE TRENCHES

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staggeringly successful event. He is also a published author. Goodbye Gordon Gekko, in which Scaramucci offered advice on how to make money and still feel good about yourself, was published in 2010. Its character is evident in Wall Street 2: Money Never Sleeps, a movie in which he acted as a consultant to Oliver Stone, and secured a cameo for himself and his SkyBridge logo. The Little Book of Hedge Funds (a user-friendly guide to the industry) followed last summer. None of which is bad for a man who failed the Harvard Law School bar exam at the first hurdle, and lost a job at Goldman Sachs before he turned 30. “After deciding law was not for me at the old age of 23, I started work in the real estate investment banking unit at Goldman Sachs,” recalls Scaramucci, a Tufts as well as Harvard graduate whose contemporaries included Barack Obama. “But I was terrible at the job. I had just left law school so I had absolutely no expertise in analytical trading or spreadsheets. It went from bad to worse because in 1990 we had a recession and I was fired. I took the job in real estate because it was the hot job to be in but it was not what I was best at. It is a cautionary tale – do not take a hot job just to impress your friends.” The experience has left a lasting impression on Scaramucci. “At the time, it felt like a massacre,” he says. “I was 27, burdened with school debt and feeling insecure and vulnerable.” Despite that salutary experience, Scaramucci does not hold any grudges. “I have fond memories of Goldman Sachs,” he says. “I thoroughly enjoyed my training there and the man who fired me – Mike Fascitelli– is one of my best

friends now. In hindsight, getting fired from the real estate division was the best thing that ever happened to me.” By which he means that, although it led initially to a spell in the wilderness, he was eventually re-hired by Goldman Sachs into its institutional salesdepartment. “It was absolutely ideal for me,” he says. For that period at Goldman in the early 1990s, Scaramucci has nothing but praise, and not a little scorn for what came after. “I was at Goldman during the golden age when people were long term greedy rather than short term greedy,” he says. “It was a great place to learn the business. Goldman Sachs was the best brand in financial services.” Even then Scaramucci was an entrepreneur trapped in the role of an investment banker. He knew he wanted to run his own business, unconstrained by the politics of a large organisation. Scaramucci left Goldman for the last time in 1996. “I have always wanted to run my own business,” he explains. “If you had interviewed me at 13, I would said even then I wanted my own business. I was 32 when I left Goldman, and I had paid off my school debt, so I felt that the time was right. I left Goldman on good terms with my business partner Andrew Boszhardt to form Oscar Capital Management in 1996.” This was a hedge fund-cum-wealth management business advising high-net worth individuals on stock and bond selections. Like any start-up, it was an uphill struggle initially. “It was a cold, brutal harsh awakening,” recalls Scaramucci now. “If you ask me now whether at 32 it was a good move to leave Goldman and go at it alone, I would have said it was crazy. We found it very hard to attract assets and talent.

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Everybody knew Goldman but they did not know Oscar Capital Management.” Money did eventually start to flow in. At its zenith, Oscar Capital Management ran $800 million. As Scaramucci admits, “ultimately, we set up in a bull market and we got very lucky.” But the journey was not without stern tests. The toughest was 1998, when the Russian default, a tumbling rouble and the consequent collapse of LTCM shook confidence in investment banking and fund management. “The financial system was on the brink of havoc and we lost a lot of money at Oscar,” recalls Scaramucci. “Honestly speaking, we were over-leveraged and inexperienced. In hindsight, I should have forecast there would be massive problems in our stock selection. We were levered long private equity, low stock, and short high private equity stocks – all of the low private equity stocks went down while the Internet stock in our portfolio shot up to the moon. It was all very strange but we found ourselves caught on the wrong side of the trades, and we lost a lot of cash.” The firm never really recovered from that flirtation with disaster. Oscar Capital Management was eventually sold in 2001 to Neuberger Berman. Scaramucci stayed on until 2003, when Neuberger Berman was acquired by the soon-to-fail Lehman Brothers. Working for an investment bank again certainly did not appeal to Scaramucci. “I am a small company person and I did not feel comfortable working at a big bank,” he says. “I wanted to get my hands dirty again and set up my own business, which is what I did with SkyBridge.” In 2005, Scaramucci set up Skybridge with no assets to manage but three

permanent staff. However, by combining funds of funds with advisory services and customised portfolios, investors had soon entrusted the firm with $300 million. The ascent was rapid, but Scaramucci admits the descent could easily have proved just as steep. “What happened during 2008 was one of the worst business environments for 80 years,” he says. “It took about 50 years off my life.” Funds of funds in particular, whose promise to trade higher fees for lower risk was exposed as empty, took a serious battering in 2008. Many were proved to have exposed investors to illiquid or highly correlated investments. By December that year, Madoff was synonymous with the hedge fund industry, even though the fraud was perpetrated by a man who ran neither a hedge fund nor a fund of funds. SkyBridge, which had no exposure to Madoff, was not immune to the wider effects. The assets under management by the firm fell by one fifth as jittery investors pulled their capital out of anything associated with fund management. For Scaramucci and SkyBridge, which might easily have failed to survive the annus horribilis of 2009, the episode was highly instructive: something, the founder reasoned, had to be done. “We were hit by redemptions and the crisis was taking its toll, and the business genuinely could have folded,” explains Scaramucci. “We ultimately took the decision to raise our profile, to alert the world we were still alive. We were aggressive and creative.” It was this new-found recognition of the value of profile which led to the creation of SALT. While there are those who question the wisdom of the hedge fund industry

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hosting a lavish conference amid the most sustained bear market since the 1930s, Scaramucci is unapologetic about the benefits that accrued to Skybridge. “We ultimately established the SALT conference at a time when people were quieting down,” he says. “It increased our national and international profile, and it was one of the key factors that saved our business.” It achieved more than that. Four years on from the first event, SALT has become, as one attendee puts it, “the Superbowl hedge fund conference.” It has arrived at hat heady status by refusing to economise. Keynote speakers at SALT have included household names in the hedge fund industry, political heavyweights such as Gordon Brown, Robert Gates and Bill Clinton, and even the odd ex-President (George W. Bush), prime minister (Tony Blair) and vice-presidential candidate (Sarah Palin). The public profile of Anthony Scaramucci is certainly a beneficiary of this razzmatazz. He even got the opportunity to spar with President Obama in a live television spectacular on CNBC over the persistent vilification of Wall Street. That won plaudits in the industry, even if it made him some predictable enemies elsewhere. But Skybridge has not waxed on the back of publicity alone. The firm acquired the Citi fund of hedge funds unit in 2010, securing the management of approximately $4.2 billion in discretionary assets and another $2.3 billion in advisory accounts. At the time, Citi was under visible pressure from the US government to shrink, de-risk and re-build its balance sheet, and SkyBridge secured the business at an attractive price. The acquisition also gave

Skybridge access to a wider group of institutional investors, plus roughly 6,000 high net worth individuals invested in the funds. “The Citi deal was an amazing outcome,” says Scaramucci. “More than two years since the acquisition, we have raised about $2 billion. The growth in the business has been a resounding success.” But personal and corporate success has not reduced Scaramucci to a facile optimism about the future of the hedge fund industry. “If you want to be a success, you have to embrace change and show adaptability,” he says. One way hedge funds can burnish their battered image, he says, is by embracing transparency and educating the broader public about why hedge funds are a good thing. “A lot of managers out there want to keep a low profile because they are afraid of being a target of a media frenzy,” explains Scaramucci. “The problem is the industry cannot keep a low profile. The media is focused on us because there is a lot of money out there. A lot of managers are opaque and not transparent and they are vilified because of it. We try to be as accessible as possible and we firmly believe the industry has to open up and face the public.” Openness is not a complete answer, he admits. Reinvention is also necessary, especially for funds of funds managers. “Institutional investment into funds of funds went off the cliff in 2008 and 2009,” he says. “The old model of funds of funds is dying, and rightly so – it will follow a path treaded by the Dot Com businesses in the late 1990s and early 2000s. Funds of funds nowadays have to create a 2.0 version of themselves and reinvent themselves and their

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businesses.” One way they are already reinventing themselves is by focusing on emerging managers and niche or under-developed strategies. Unfortunately, large investors are still playing it safe and allocating to the biggest funds, many of which are delivering correlated returns. “Right now, the momentum is going to the brand name managers but such trends do not last forever,” predicts Scaramucci. “In 1998-99, investors believed the Internet was booming and would go on forever, but tech stocks collapsed in the Dot Com bubble. Smaller managers will make a comeback.” There is realism as well as optimism. “A lot of regulation is being imposed which could stifle innovation in the financial sector going forward,” warns Scaramucci. “Furthermore, the media focus on hedge funds has been overwhelmingly negative and this does not help our cause. I also believe the class warfare is doing irreparable damage to our society. We have political leaders who make a habit of bashing the 1 per cent, when these individuals create numerous jobs for the economy. Such talk can only hurt the

nation and the economy.” Nevertheless, even Anthony Scaramucci believes that hedge fund managers are at least part-authors of their predicament. “People with a lot of money sometimes act stupid and do stupid, nouveaux riches things, such as holding lavish parties or making opulent, grandiose investments,” he says. “This all gets picked up in the

media and damages our image.”

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THE MAKE-BELIEVE WORLD OF CORPORATE GOVENANCELike temperance or chastity, corporate governance is doomed to failure whenever and wherever it is tried. The reason for this is obvious. Corporate governance aims not to alter the nature of the problem, but merely its appearance. It has all the force of painting black and white stripes on a horse and calling it zebra. Unfortunately, this pointless ideology is now running amok in the fund management industry, raising costs and damaging performance without doing anything to improve investor protection.

A fund administrator shudders as he recalls a telephone call with a non-executive director of a Cayman-domiciled fund. The director was angry about an alleged NAV miscalculation. The first problem was that his interlocutor was not the administrator to the fund. The second was that the manager had liquidated the fund two years beforehand. Synthetic anger and a paint-by-numbers approach to

directorships was not uncommon in the bad old days, when offshore directors sat on dozens of boards, and naturally struggled to keep up with the paperwork. One regulator, concerned about the number of directorships held by some individuals, insisted that any individual holding more than 30 directorships disclose the fact to boards of funds proposing them as director. What contribution lax corporate governance

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of this kind made to the financial crisis is more questionable than debatable (the real issue between funds and investors was gating of redemptions without any means of redress at board level). But that has not stopped institutional investors and regulators arguing that sub-standard corporate governance, especially in offshore jurisdictions, was unhelpful when it came to mitigating and managing risk in the financial system. Since every regulatory initiative creates a business opportunity for someone, it is not surprising to find industry conferences packed with consultants warning fund managers of the dire consequences of persisting with corporate governance-lite. Industry associations, whose real clientele inevitably includes public officials as well as paying members, were not slow to respond to the siren call for better corporate governance. The Alternative Investment Management Association (AIMA) Guide to Institutional Investors’ Views and Preferences Regarding Hedge Fund Operational Infrastructures was downloaded a record 5,000 times. It opens with a discussion of “governance” by Luke Dixon, senior investment manager for hedge funds at the Universities Superannuation Scheme (USS), whose underlying robustness was scarcely concealed by some ingenious editing. It warned managers of their “fiduciary” obligations to investors, and declared corporate governance a “make or break” issue for investors considering allocations to fund managers. On this, Dixon is almost certainly correct. A survey of institutional investors managing $600 billion in assets by Carne Group found 91 per cent of allocators would shun a fund with poor governance even

if the manager met other operational and performance criteria. Furthermore, 76 per cent of investors polled had already failed a fund at least once because of governance concerns. In his AIMA essay, Dixon went on to offer detailed guidance on how to specify in offering memoranda and articles of association, corporate structures, the appointment, number and powers of conflict-free independent directors, votes for shareholders, the role and responsibilities of directors, investment objectives and restrictions, investment and redemption terms, risk parameters, responsibility for net asset valuations and the right to hire and fire service providers. AIMA has worked with USS and Hermes BPK on an industry-standard due diligence questionnaire (DDQ) aimed at hedge fund directors. “Having an AIMA stamp of approval on the DDQ is good,” says John Donohoe, chief executive of the Carne Group. “However, there are still going to be directors out there who refuse to answer questions on the DDQ.” But there is pressure from within the hedge fund industry too. The Hedge Fund Standards Board (HFSB), which cites the work of AIMA with approval, lists “good governance” among its objectives. Its standards advise fund managers to establish governance “mechanisms” that manage conflicts of interest with investors. The HSFB is clear that its own preference is for boards that have a majority of independent directors, who know what they are doing, and which meet at least quarterly. Failing that, the HSFB favours articles of association make certain decisions – such as changes in fee structures, and alterations to investment strategies or legal

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structure or, presumably, redemption terms - subject to the consent of investors. All of this is more disruptive than it sounds. “It is imperative,” as Luke Dixon put it in his essay in the AIMA paper, “that the fund’s directors do not recognise the investment manager as their `client.’” In the hedge fund industry in particular – where even the administrator which calculates the NAV reported to investors is really controlled by the manager - that idea is a revolutionary one. Historically, managers of funds based offshore needed directors to comply with local company law requirements and to skirt onshore taxes, so income can be distributed without being taxed inside the fund first. As a result, investors tended not to be overly fussy about conflicts of interest, or the knowledge and time directors had available. “A decade ago, many investors did not really give much thought to the quality of hedge fund directors or whether they were independent or not,” says James Newman, head of operational due diligence at Barclays Wealth. “It was only in the late 1990s that professional services firms started offering directors who had various skill sets in fields such as law, auditing, administration and custody.” Perhaps the best-known of these firms is DMS. Established by former Cayman Islands Monetary Authority (CIMA) regulator Don Seymour,

the organisation has become one of the largest professional director services firms in the world. “During the 1990s, Cayman attracted a lot of very good hedge funds but simultaneously attracted a lot of bad ones which lacked proper controls and fund governance,” explains Seymour. “This encouraged me

to set up DMS.” As the investors in the

hedge fund industry have institutionalised,

“bad” hedge funds have become rarer and – whether or not there is any connection between

the two phenomena - the appetite for

more intrusive forms of corporate governance

has increased exponentially. Many institutional investors were

surprised to find, as the upswing of the credit cycle gave way to a downswing in 2008, that the boards of directors of funds did not necessarily place their interests first or act decisively to protect their assets. Countless investors are still scarred by the experience of being gated, suffering NAV suspensions, or having telephone calls to directors go unanswered. Five years on, more than a few investors have still not recovered assets that went AWOL in 2008. It has not helped that institutional investors are still running into problems establishing exactly what managers are doing with their money. More than half of investors polled by Carne (55 per cent) said they had experienced problems when requesting information. “About half of the hedge funds we invest in give us investor-friendly minutes,” says Vincent

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Vandenbroucke, head of operational due diligence and partner at Hermes BPK, a $2.3 billion fund of hedge funds. “We sometimes struggle to get the minutes and the agenda. We understand a lot of the discussions at board meetings are confidential, which is why we ask for investor-friendly minutes which omit sensitive information about other investors or strategies. But we are entitled to a certain level of transparency which is why I believe a standardised format should be created for boards to communicate with shareholders. It is unbelievable that in this day and age, we get monthly letters from our managers, capital statements from administrators and absolutely nothing from directors, the only body supposed to represent our best interests.” Accessing board minutes is still a difficult issue for managers. “A lot of the discussions during board meetings can be sensitive,” says Richard Grant, director at Veritas Asset Management, a hedge fund. “Directors could be discussing marketing, trading positions or even recalcitrant investors. It is quite understandable that certain investors will not want information leaked to their competitors. However, I do believe a compromise can be met by holding more public AGM meetings which will enable investors to see how the board interacts.” Despite that faith in the power of compromise, distrust between managers and investors remains

surprisingly high. An Ernst & Young survey published in November 2011, for example, found 36 per cent of investors believed the directors of funds were more accountable to the fund manager than to them. Predictably, the same survey found 75 per cent of

managers reckon directors are more accountable to their

investors. In other words, managers and

investors are still at odds over the issue of corporate governance. The fact that Luke Dixon

believes corporate governance can

avert hedge fund failures is a reminder

of how deep the fissure remains. “Corporate governance

was not on the radar until 2008,” he explains. “Investors were shocked when assets were being locked up and could not comprehend why many of the protections they thought they were entitled to were not enforced. Investors believed directors would stand up for their interests but more often than not this did not happen. Some hedge funds have even continued to charge fees on assets which have not been redeemed as they are considered too illiquid to unwind.” Exposure to illiquid assets, adds Dixon, was a consequence of style drift that independent directors could and would or should have noticed. “Directors need to look at the balance sheets and ask the manager what they are doing with the capital,” says Dixon. “When the tide went out in 2008, there were shocking revelations about the

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assets in some funds, a lot of which were illiquid. I saw luxury homes, yachts, cars, and even a golf course masquerading as private funds in a portfolio. Investors are certainly paying more attention now to the quality of directors and the specific activities the directors undertake to supervise activities that they have delegated to third parties.” The principal governance tool for preventing escapades of this kind is the independent director. After all, many of the directors in situ prior to 2008 fell a long way short of independence. Five years on, the Carne survey that found nine out of ten investors would shun a fund without effective corporate governance found almost as many (87 per cent, to be exact) would also like the majority of board directors to be independent. A large majority (80 per cent) reckoned an independent chairman was necessary too “Having a truly independent director is absolutely essential,” says Vandenbroucke. “It is best practice nowadays, given the recent scandals. Independence allows directors to operate in the best interests of the shareholders without being conflicted.” This view is echoed by Per-Johan West, partner and chief financial officer at Norway-based hedge fund Estlander & Partners, but he also stresses the need for relevant knowledge and experience. “It is essential the director is not compromised by their relationship with the manager,” he says. “The board needs to have diverse skill sets. Ideally, there will be one lawyer, an accountant and another service provider who can take an active role and ask the right questions of the manager.” Diversity obviously matters. Fund administrators are well-placed to

question valuation judgments. Custodian bankers know enough to question asset segregation procedures. Lawyers can address legal challenges. But who will query unusual investment decisions? Preventing style drift let alone rank bad investments, requires directors with investment management experience of the kind that almost guarantees an awkward relationship with the chief portfolio manager of a fund. Luke Dixon counters that professionals accredited with Chartered Alternative Investment Analyst (CAIA) or Chartered Financial Analyst (CFA) qualifications would have adequate knowledge to fulfil the role. “There are people out there who want to work in fund governance,” he argues. “If you have been relatively successful in finance but do not have a whopping great pension to live off, a directorship can be a nice, steady source of income and a good way to remain intellectually active and apply one’s many years of valuable experience in retirement. It is important to stress that investment management experience does not refer exclusively to trading or front office roles but could apply to someone in the middle or back office, risk management or credit risk assessment with a good understanding of capital markets and securities financing.” Emlyn Palmer, chief operating officer at fund of funds Saguenay Strathmore Capital, is less convinced. “It is good to have a spread of skills on the hedge fund board,” he says, “However, I do not believe you need to be an ex-investment manager to have a solid grasp of finance and markets. A lack of actual investment management experience is not necessarily a weakness on a board but a lack of understanding finance is

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a massive flaw.” Dermot Butler, himself an independent director in addition to his role as chairman of Custom House Group, agrees. “The USS is very pro-investment personnel sitting on boards but how many experienced people are there to do that?” he asks. “Surely, those people who were successful investment managers have better things to do. I also disagree with the USS requirement that there be CIAIs on the board of hedge funds. Many CIAIs cannot even spell hedge.” A larger obstacle is the sheer lack of ex-investment managers willing to take on a directorship, given the wide-ranging fiduciary responsibilities and unlimited liability it entails. So the Luke Dixon-USS approach may struggle to gain traction. There are natural limits to boardroom diversity anyway, set by the possibility of a conflict of interest. An accountant employed by the auditors to the management company, or a fund accountant who works for the administrator to the fund, could scarcely be described as independent even if they are knowledgeable and experienced. Even recommendations by service providers to a fund would be tainted. After all, a principal responsibility of the board of directors – specified in the AIMA and HSFB documents – is to review the performance of service providers to the fund. As it happens, Vandenbroucke thinks the conflicts are manageable. “If the administrator is on the board, one way to deal with the potential conflict is for that director to excuse himself from the discussion,” he explains. “It is about applying good judgement and common sense.” Surprisingly, other investors appear to be content with this compromise as well.

According to the Carne survey, directors that have a relationship with the administrator, accountant or lawyer to the fund or the management company is problematic only if those directors are the only “independent” people on a board. But independence, knowledge and experience are not the only criteria by which investors such as USS judge a director. The amount of time a director can devote to the job is equally important. Institutional investors were alarmed by the number of boards which some hedge fund management company directors sat. While there is no hard and fast cap on the number of directorships an individual can assume (although CIMA is contemplating reform of corporate governance) investors are convinced that no director sitting on more than 50 boards can perform his or her duties effectively. “There are directors sitting on several hundred funds with some even rumoured to be on over a thousand boards,” says Emlyn Palmer. “Assume a director sits on a thousand boards. There are 365 days in a year, which in turn means there are, give or take, 260 working days. Assuming a director works 10 hours a day, this would mean they dedicate about two and a half hours per year to each fund. If a fund has $300 million, 40 investors and a complex strategy, I doubt any investor would be comfortable with having just two and half hours of a director’s time dedicated to overseeing that fund. James Newman of Barclays Wealth agrees, arguing that a director sitting on hundreds of boards would be challenged if a bear market started or a black swan event occurred. DMS is one organisation which has

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had to respond to arguments of this kind. The firm contends that it is an institutional business with systems, people and technology to handle all eventualities. “The debate should be about quality and not quantity,” argues Seymour. “We have a strong infrastructure which supports our directors incredibly well. 2008 was probably the single most challenging year for hedge funds yet we managed everything carefully and effectively. Some of our critics expected us not to cope with the demand but our model proved them wrong.” While DMS says it handled the liquidations and wind-downs of 2008 with aplomb, its critics believe the technology and systems available cannot compensate for the sheer number of boards some directors sit on. “Some directors’ services firms may highlight technology as a substitute for a quality professional services model but at the end of the day they are just promoting a document management system,” says John Donohoe. “Document management systems cannot replace a competent director being involved. If a hedge fund came to me for advice, I would not delegate to a junior staff member and wait for them to spot a problem before I dealt with the situation. If an auditor takes on hundreds of clients and just signs what his underlings put in front of him, and he makes a mistake, he would find it difficult to defend his practices. Some services firms are just hired signatures that amount to rubber-stamping directors. These directors are not discharging their fiduciary duties or looking after the best interests of the funds’ investors. During the crisis, many investors were furious about gates and criticised certain directors. In fact, some

directors are on investor blacklists now.” Certainly the number of directorships held by some individuals can be astonishingly high. In November 2011, the Financial Times published a study that estimated how many boards senior DMS executives sat on. According to the study, Don Seymour sat on 567 boards in 2006, while David Bree, another director, was involved at more than 240 separate hedge funds. The article also identified 19 individuals holding more than 50 directorships. “The Financial Times article was fantastic and timely,” says Luke Dixon. “However, I suspect the analysis underestimated the number of boards by a factor of two or maybe three. Anecdotal data suggests that some of the most prominent directors at these professional services firms sit on upwards of a thousand boards, but it is very difficult to obtain the data confirming this, principally because the directors themselves refuse to disclose it.” The analysis by the Financial Times entailed analysing thousands of Form D filings made to the Securities and Exchange Commission (SEC) in the United States. This worked well, because any capital allocation to a Cayman-domiciled fund based in the United States triggers submission of Form D if the manager wants to secure exemption from regulation as a mutual fund under the 1940 Investment Companies Act. It worked less well in the sense that many Cayman-domiciled funds offer US-domiciled versions to onshore investors, making it uncommon for Cayman-domiciled funds to trigger Form D submissions. The obvious conclusion to draw is that the directors counted by the Financial Times actually sat on far more boards than Form D alone indicated.

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Which is one reason there are now calls for full disclosure by directors of the number of board seats they occupy. “A lot of directors refuse to tell us how many boards they serve on,” says Luke Dixon. “Some even refuse to answer the most basic questions about the service they provide.” At DMS, Seymour says the information is disclosed privately.“While DMS does not disclose this information publicly, the firm does share it privately to any stakeholder who asks – be it hedge fund managers, investors or service providers,” he says. “We are fully transparent and accountable to our stakeholders.” Others think the only meaningful solution is a formal limitation. Kevin Ryan, founder of HedgeDirector, a professional services outfit, says his firm limits its directors to 15 boards. “It simply is not possible to be on the boards of hundreds of funds and provide adequate protection to investors,” he explains. “Even with support staff and IT systems to help manage diaries and processes, the jumbo directors can only ever react to problems after they arise, which, as we have seen with previous blow-ups, is usually too late. To do the job properly, the directors need to be familiar with the fund manager, their team and all aspects of the business. They should know each fund individually, be aware of its strengths and limitations and be in a position to head off problems before they become critical. If you are on the boards of hundreds of funds, you cannot even name all of the fund managers, let alone claim to have any working knowledge of the business.” His view is supported by the nine out of ten respondents to the Carne survey who endorse the view that directors sit on too many boards. This has led to calls for

formal caps on the number of directorships one individual can hold. Seymour protests that such notions are entirely self-interested. “Our competitors, particularly in Europe, are the only ones calling for caps and for obvious reasons,” he says. “Caps may be acceptable for the European industry but the Cayman industry is very large and advanced, comparatively speaking. As the European industry grows, it is inevitable that it too will demand more sophisticated fund governance and more professional governance models will evolve.” Nevertheless, some jurisdictions have unwritten caps on directorships. Jersey has an unspoken limit of 25 boards, according to Charlotte Valuer, chairman of the board of the Brevan Howard Credit Catalysts Fund, and co-founder of the Global Governance Group. “I have eight board relationships,” she says. “I spend about 20 hours per week on these eight relationships and the board appointments within them. As part of being authorised and regulated by the Jersey Financial Services Commission (JFSC) as a director, I annually submit an overview of my appointments, co-directors, D&O insurance, administrators and fees. The JFSC requires a high level of best practice from the regulated board directors and rightfully so. They conduct individual visits to regulated entities including regulated directors where discrepancies would be picked up on. I am sure they would also take an interest in a high number of individual directorships by a director, especially in terms of time commitment to each appointment. A board cannot just meet for 15 minutes once a year as that is poor corporate governance.”

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For managers, a cap of any kind means higher costs. A director from a professional services firm will typically charge between $5,000 and $10,000 per fund per year. It is such an insignificant sum that it alone explains why some directors have to sit on so many boards to make a decent living. Indeed, Seymour says the demands of the moreaggressive investors will erect another barrier to entry to talented managers. “One investor believes a directorship should be a full-time job, performed by someone with 15 years’ experience, sitting on no more than ten boards,” he says. “That would be costly. Someone of that calibre commands at least $500 per hour, so requiring that person to spend 200 hours annually on a fund would cost $100,000 per fund director. That is very expensive, particularly for start-ups.” Some investors are prepared to pay that. “As in life, you get what you pay for,” says Vandenbroucke. “We are willing to pay for good directors.” But there are ways to keep costs below such inflated levels. Many directors are flexible on fees, and could be convinced to accept a fee waiver until a fund reaches an agreed threshold. Alternatively, hedge funds can share directors. Director-sharing and fee-waiving apart, any form of limitation on the number of board seats an individual should occupy is bound to have unexpected consequences, since no rule can take full account of the complexity of the industry. Sitting on the board of a straightforward European or North American-focused equity long/short fund probably requires fewer man-hours than sitting on the board of a complex, esoteric hedge fund running a large

number of bespoke swap transactions. Should a director be free to sit on both, or specialise in one? The answer is not obvious. “Every hedge fund is different and it is difficult to specify a fixed cap for all directors,” says Ingrid Pierce of Walkers. But the most persuasive argument for a self-imposed cap is that regulators will impose one if the industry refuses to select its own. “There does need to be a limit to ensure that directors can meet quarterly at least,” argues Luke Dixon. “But I do not believe it is necessary to regulate if industry participants can come together and give the issue thoughtful consideration. There are often unintended consequences of regulation, so if regulatory or political intervention can be avoided, it should be. The industry ought to be capable of devising a solution that satisfies most stakeholders.” One such “solution” mooted by investors is an online database identifying which boards directors sit on, and it is something CIMA is considering. In 2010, the $14.1 billion Chicago-based fund of funds Mesirow Advanced Strategies sent a letter to CIMA urgingthe organisation to make public all of the data it collects from FAR and MF-1 forms on directors. In January 2011, USS and nine other global pension funds, managing just under $1 trillion, also demanded an on-line database of directors. A centralised database would certainly simplify the corporate governance aspect of operational due diligence. “Investors can comb news databases or the Internet, or even request all the offering memoranda out there and construct their own database but that is extremely time-consuming,” explains Luke Dixon. “A searchable

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database can and should be set up to make the process simpler because the data is hardly secret – it is just difficult to obtain it all”. But Charlotte Valuer thinks publication might not work. “An on-line database pooling all of the directors together would help investors,” she says. “However, some hedge funds are private companies and do not want to be on a public web site.” A more extreme proposal is investor-nominated directors. Rajiv Jaitly, now an independent consultant but formerly chief operating officer at Axa Investment Managers, argues this could prevent the incipient conflict between independent directors and fund managers getting worse. But such a proposal is unlikely to be endorsed by managers, who will not hesitate to argue that being second-guessed by directors answerable to investors will inhibit alpha generation. There are also practical obstacles, according to James Newman of Barclays Wealth. “If a director is engaged by a single investor then the conflict may have moved from the manager to the single investor,” he explains. “More specifically, how can other investors be sure that the single investor is not receiving advantageous information and that the director is acting on behalf of the fund and not one investor, and should that investor redeem, would that director just resign and follow the investor when it pulls out of the hedge fund? These are questions that would need to be answered.” Another challenge to the Jaitly proposal is that it could simply replicate the over-commitment problem. “Investor-nominated directors would be a challenging proposition for investors,” says Emlyn Palmer. “One issue is that,

if investors discover a good director, they will want them on the boards of the funds they invest in. This could mean the director might find it difficult to say no to certain investors, which would create the same problem via a different route. It is essential to strike a balance. Excessive intrusion is always a problem by a director, but we know all too well what too little intrusion feels like. It is imperative to stick to the middle ground.” In other words, investor-nominated directors could lead to a tyranny of the richest investors. Furthermore, if a fund failed, investors might find themselves arraigned alongside the other directors as partly culpable. One investor notes that, in any disaster, “all options would be explored.” It is reflections of this kind that has persuaded some industry figures that corporate governance is being hijacked by investors whose demands are unrealistic. “The Weavering case was a shocking development and it was a much needed wake-up call for the industry,” says Dermot Butler. “However, many people are going overboard and are jumping on the populist bandwagon. There has always been guidance on corporate governance for directors. The first edition of AIMA’s Offshore Alternative Fund Directors’ Guide, which was published in June 2005, said everything highlighted in the Weavering Judgement in 2011. I know because Custom House sponsored it with Simmons & Simmons, and I helped write it.” Ratan Engineer, global leader of Ernst & Young’s asset management practice in London, agrees. “Investor expectations are far too high for the present state of maturity of corporate governance in the hedge fund market,” he says. Others

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take a more practical view. “Ten years ago, people were indifferent about corporate governance,” says James Newman. “The industry has become institutionalised and it always takes time to get up to speed with what investors expect.” Investors are also far from blameless when it comes to sub-standard corporate corporate governance. Many investors are still not interested in corporate governance or, if they are, are happy to let USS, UBP, Barclays Wealth, CalPERS, CalSTERS and Hermes BPK make the running. “We are working together to bolster interest and we have hosted a series of conferences on corporate governance, and we speak at whatever opportunity we get to raise awareness,” says Luke Dixon. “However, I have spoken to some investors, who are important brand-names, who have said they could not care less about governance.” Investors can also be Janus-faced, demanding transparency without offering it themselves. Managers often complain that investors do not explain why they failed an operational due diligence test, even if the problem was corporate governance. “Investors have not been clear on their fund governance expectations,” says Seymour. “There is a clear and growing gap between investors and managers about proper fund governance practices.” Emlyn Palmer acknowledges that investor feedback can be too time-consuming to deliver, but argues it is not worthwhile unless it leads to meaningful changes. “I do not want to tell a manager how I want them to look just so they can tick the boxes and game the process,” he says. “If a fund has a weak governing body, it sometimes gives you an insight

of the culture at the manager.” Others believe the situation can be remedied in a much more straightforward way. “The only way of avoiding future scandals is by improving the culture of the managers themselves and making sure that they are doing the right thing,” says Tony Solway, an experienced chairman and independent fund director. “This means more than ticking boxes on DDQs, it means seeing how seriously the manager takes compliance and fiduciary duties, and whether there are effective non-executive directors at the level of the manager controlling behaviour. I would say that the general level of focus on governance, risk and compliance issues at Board level could be much improved. At a time when there is a need to rebuild trust with investors, and when there is a welter of regulatory change and greater competition, I am surprised that there are not more senior industry figures working with hedge fund managers at board level to get these aspects right. Sorting out fund governance is important: clearing out the rent-a-mob, and professionalising management services to ensure things are properly run and so on are all important steps in the right direction. However, these reforms do not get to the root of the problem and will not prevent a recurrence of something like the Weavering case. Fund governance happens well downstream. Even if the fund board pressed the ‘nuclear button’ at the first indication of wrongdoing and fired the manager, the damage would be done. Further, investors bought the manager – absent the manager, that leaves both investors and the fund in a really odd position, probably with investors in a queue for the exit anyway. “

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Weavering Capital is the gift to the corporate governance movement which just keeps giving. It has done more than any other disaster in the hedge fund industry to put corporate governance in the limelight. In March 2009, Weavering Capital went into administration after it failed to meet redemption requests. Given the extreme market turbulence at the time – it was the month Citi almost failed, and the nadir of the immediate aftermath of the failure of Lehman Brothers – the collapse of another hedge fund did not attract much attention. It was only when an investigation found that the sole asset of the Weavering Macro Fixed Income Fund was a $637 million swap agreement with a company that was controlled by Weavering itself that suspicions started to mount. It was not just this fraud that the directors failed to spot. Weavering investors were equally surprised to discover they owned the legacy rights to a sexually explicit rock musical called Spring Awakening (although the Financial Times reported it was “critically acclaimed”) and a documentary entitled Lobos Girls (a documentary hypothesising Hitler’s escape from a defeated Germany in a U-boat). The value of both of these unusual investments was inflated by the manager, without being noticed by the directors. So it was no surprise when in 2011 a Cayman Islands court fined the two directors of the fund $111 million each for “wilful neglect” and “default of duties.” This ruling turned an everyday fraud into a landmark case in corporate governance. One investor argues that Weavering Capital is for corporate governance what Lehman Brothers’ default is for

counterparty risk. The two directors were blood relatives working on a pro bono basis, who signed off the minutes of non-existent board meetings in complete disregard of their fiduciary responsibilities. “The Weavering Capital case is very important,” says Luke Dixon of USS. “People are focusing on governance much, much more because of it. The Cayman Court’s judgement was excellent and explicit and it is a benchmark case setting legal precedent on incompetent directors. There are now 111 million reasons for directors to do the job responsibly.” Ingrid Pierce, a partner at Walkers in Cayman, agrees. “The facts were pretty horrific in the Weavering Capital case and it shows what can go wrong when corporate governance standards are non-existent,” she says. “This was reflected in the damages.” But is what happened at Weavering Capital exceptional? Luke Dixon thinks it was, but argues it has helped the cause of better corporate governance no end. “The judge did not dwell on these directors being relatives of the manager, which is useful,” he says. “The judge mainly criticised the amount of time and effort these directors committed to the fund. This is important.” On the other hand, a London-based lawyer reckons the directors were probably representative of the bottom quartile of boards in Cayman. “I believe the Weavering Capital case is somewhere between the extreme and the norm,” adds Charlotte Valuer. “Governance in the hedge fund world is generally substandard and directors must change the way they act and not just see their position on a board as merely rubber-stamping the investment managers’ decisions.”

Weavering

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THE BIGGEST RISK YOU ARE FAILING TO MANAGE

calculate the daily or weekly or monthly or quarterly net asset value (NAV) at which investors buy into a fund, and at which they exit from it, and have to produce that valuation even in the most extreme market conditions, when asset prices are hard to verify. They distribute reports and valuations and accounts of transactions to investors, tailored to their domicile and tax status, and list what fees and expenses they have paid to the manager. They monitor and report inflows and outflows of capital to and from the fund. They check investors for money laundering, blacklisting, eligibility and (even before FATCA raised the temperature) tax status. Administrators deliver the information auditors need to prepare financial statements for investors as well as management company boards and tax advisers. They reconcile trades and positions and cash and security prices with managers and prime brokers. In fact, it is not hyperbolic to say that the ability of an administrator to reassure investors that their investments will be visible at all times, kept safely, valued accurately, serviced correctly, charged the correct amounts and held in compliance with all regulatory and fiscal obligations is an essential prerequisite to securing capital to manage in the first

Fund managers struggle to get excited about their fund administrators, seeing them merely as agents which provide valuation and investor services in exchange for modest fees. In fact, they pose a number of potentially existential risks that are well worth examining and managing.

COO Analysis

Fund administration is not glamorous work. Yet, at a time when managers need investors more than investors need managers and regulators add constantly to the burden of compliance, it is increasingly important. The administrator is, after all, the principal link between a fund and its investors. Administrators

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place (and not only during initial due diligence but throughout the life of the investment). It follows that conspicuous failure by an administrator in any one of its tasks would be enough to break the confidence of investors in a fund, sparking a wave of redemptions. This alone explains that constant chagrin of the aspirant administrator - the preference of managers for brand-name and bank-owned administrators, even if they provide an inferior service - because they tend to have deeper pockets as well as nobody-ever-got-fired-for-buying-IBM credibility. Yet the work is not well-remunerated. There are providers that charge flat fees. But typically an administrator charges between 2 and 10 basis points on the NAV, according to a sliding scale governed by the size and complexity of the fund, and subject to minimum fees which can range as low as $4,000 a month. This persistent under-valuation of the importance of the administrator creates a number of obvious risks. One is a temptation to under-invest in process, people and technology. A second is a lack of resources to make investors whole if a mistake is made. A third is that, because administration revenues are linked to the value of assets under management, a wave of redemptions can do as much damage to the viability of the administrator as the manager. Phillip Chapple, an executive director at boutique consultancy KB Associates in London, says several fund administrators flirted with failure in 2008 as their clients lost assets. “A fund administrator default during the crisis was a genuine fear,” he says. “But it appears to have slipped off the radar of a lot of hedge funds and

investors since.” It is not surprising. The fund administrator as a counter-party risk is counter-intuitive. They rarely lend more than bridging finance, and then only if they are owned by a bank. They hold no cash or assets directly. “In comparison to a custodian bank or trading counterparty, a fund administrator is not systemically important,” says Hans Hufschmid, founder and formerly CEO at GlobeOp, which was acquired by SS&C last summer. “When Lehman went under, hedge funds had exposure to Lehman and did not get their money back. A fund administrator does not hold assets, so while it may be an inconvenience to managers, it would not destroy their businesses. While a default is very unlikely, we do have contingency plans and data centres, which hold all of the information. We spend a lot of time working on back-up systems and these could be used in a worst case scenario of a fund admin failure.” William Keunen, global director of fund services at Citco, agrees. “Hedge fund administrators are service providers and, provided business continuity is planned properly, any handover should be feasible,” he says. Chris Adams, head of hedge fund solutions at BNP Paribas Securities Services, also downplays the importance of the role of the administrator. “The most important thing for a fund administrator which has run into trouble is to wind the business down in an orderly fashion,” he says. “Management and systems should still be operational, thereby enabling an orderly transition of hedge funds’ books and records to another administrator. I doubt a fund administrator default would be a sudden event but a long-drawn out process.”

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Others take the point, but are less sanguine. “I doubt a hedge fund manager will wake up one day and discover their administrator is gone but by no means would a fund administrator default be a straightforward exercise,” warns Phillip Chapple. “The challenge for the fund would be to keep the business running. I doubt a fund administrator default would be an ‘end of days’ scenario but it would be difficult for a fund to calculate the NAV or process investor redemptions.” In other words, investors might find liquidity lacking at just the moment they want to redeem. “Without the production of a NAV, investors cannot be paid their redemption monies on a timely basis,” warns Ian Stephenson, global head of fund services at HSBC Securities Services. Carolyn Burke, chief financial officer at Mesirow Advanced Strategies, a $14.1 billion hedge fund managed out of Chicago, agrees that losing an administrator would create significant problems for managers and their investors. “If an administrator goes down, would a hedge fund lose money?” she asks. “I doubt they would lose a significant amount of assets because the administrator does not have custody of any of the assets. However, it would be an operational nightmare and a giant inconvenience to the manager and their underlying investors.” The scale of the inconvenience will vary by investment strategy. “If the hedge fund is a long/short equity or CTA carrying out a couple of trades every week, then the disruption would be minimal and the manager could survive some time without trading,” explains John McCann, managing director of Dublin-headquartered Trinity Fund Administration. “However, if the

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manager happens to be a high frequency trader and the administrator buckles, the problem would be magnified.” But an administrator does not have to fail to cause managers and investors significant operational problems. A mistake can be eye-wateringly expensive, and not every administrator has the resources to eat the cost. “A fund administrator is like any business in that it can run into difficulty either through bad management or if it is undercapitalised, or if it fails to react in good time to a disruptive market event,” says Chris Adams. Administrators with a limited client base are naturally more vulnerable, even to the risk of the failure of a single large client or a particular investment strategy they support falling out of favour. There is no shortage of firms with one, two or at most three dozen clients. “Smaller fund administrators, certainly those with asset or strategy-specific client bases or those with clients using a great deal of leverage, or those supported by a few large clients are a risk,” says Phil Niles, a director at Butterfield Fulcrum, an independent administrator with $110 billion in assets under administration (AuA). “Any fund administrator with large exposures to Europe right now would also be considered dangerous.” Niles adds that his firm is regularly probed by operational due diligence teams on its financial strength and ownership structure. “Investors carry out a lot of due diligence on fund administrators,” he explains. “For example, they will look at whether there are annual audits carried out on the fund administrator, and by whom, and whether the administrator has a SAS 70 or another accreditation. Investors will also review whether the

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was sued for $465 million by Archeus Capital Management, a manager which closed after its Animi feeder funds suffered a wave of redemptions between 2005 and their closure in October 2006. The suit centred on alleged shortcomings in reconciling cash and positions with prime brokers, but the complaint issued by the lawyers to Archeus provides graphic insights into what can happen when administrative problems undermine investor confidence. The document alleged that, after the problems were discovered, Archeus incurred millions of dollars in fees to consultants and auditors, and had to pay $7 million into its master fund to make investors whole. Ultimately, delays in preparing audited accounts prompted a wave of redemptions by existing investors and deterred prospective fresh investors. Thousands of positions had to be liquidated prematurely to meet the redemptions. Assets under management fell by three quarters from $3 billion to $700 million in just 18 months to October 2006, slashing management and incentive fees. That steep decline was extremely painful to the Archeus managers. After all, 2 per cent of $3 billion is $60 million, while 2 per cent of $700 million is just $14 million, to say nothing of the 20 per cent incentive fees that were gone forever. Yet, for the risky work it performed over the life of the contract with Archeus, GlobeOp was paid a mere $9 million in fees. Indeed, Archeus alleged in its law suit that the reconciliation problems arose chiefly because GlobeOp employees were under-paid, under-trained, over-worked and demoralised. Staff turnover in the hedge fund administration industry

business has continuity planning and sound risk management.” He accepts that some privately owned administrators are more willing to share their financial statements than others but argues that, by asking the right questions, it is always possible to get comfortable with the stability of a firm. Unsurprisingly, Mark Mannion, head of client relationship management and sales, for BNY Mellon Alternative Investment Services, disagrees. He points out that smaller administrators present a greater counterparty risk for reasons quite unrelated to the quality of their work or business continuity planning or the thoroughness of the due diligence process. “Smaller administrators tend to have smaller to medium sized clients who may experience greater redemption activity in turbulent markets,” he explains. “The loss of a key client could have a devastating impact on a smaller administrator’s business.” Administrators can also be sued. Most litigation does not reach the public prints but two episodes experienced by the once publicly listed GlobeOp give an indication of the sums which are at stake if administrators do not get everything right. In 2009 GlobeOp settled for $43.5 million a suit brought by Regents Park Capital Management, a hedge fund which went out of business in 2006. According to the London regulator, the Financial Services Authority (FSA), the chief executive presided over “a discrepancy between the realisable value of certain investments and those valuations provided by Regents Park.” Yet reliance on managers to value illiquid assets was not uncommon in 2005, and is not yet banished from the industry even now. Two years earlier, GlobeOp

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is a perennial complaint by clients. Even now, long after the boom in hedge fund investing has subsided, turnover rates of 15-20 per cent a year are not uncommon, even at major administrators, so the alleged source of the difficulties encountered by Archeus is still very much alive. If the risks are realised, the first meaningful recourse managers and investors have is to the insurance cover. Operational due diligence questionnaires issued on behalf of investors now query the value of the insurance cover of administrators as a matter of routine. However, like most forms of insurance, the cover purchased by administrators is rich in clauses inhibiting pay-outs in all but the most exceptional circumstances, which are best defined as (hard to prove) gross negligence. Certainly, the vivid prose of the Archeus complaint strove for that effect. Claims inevitably take years to settle too. Three years elapsed between the closure of Regents Park Capital Management in 2006 and the settlement with GlobeOp in 2009. “A multi-million dollar lawsuit, which might be out of the remit of insurance cover, could prove fatal for some of the smaller and mid-sized administrators,” admits John McCann. At bottom, insurance cover is a lot more remote than the balance sheet of a bank with a reputation to maintain. Custodian banks, all of which double as fund administrators, are discovering exactly how expensive that deep-pockets responsibility can be, as the aftermaths of the

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Lehman Brothers failure and the Madoff fraud take their toll. In 2010 the Autorité des Marchés Financiers (AMF), the French regulator, ordered Société Générale and RBC Dexia, which were acting as depositaries for hedge funds that used Lehman Brothers as prime broker, to make whole investors which lost assets held in custody by Lehman Brothers. This decision was taken despite the fact the managers had signed agreements allowing Lehman Brothers to re-hypothecate the assets they managed, and the custodian banks were powerless to control their fate. As custodians to various feeder funds to Madoff, both UBS and HSBC have found themselves drawn into litigation launched by investors that lost money in the fraud. In June 2011 HSBC agreed to pay $62.5 million to settle a legal action brought by victims of the Thema fund, which invested in Madoff. In November last year, the bank settled a second case

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with the Kalix Fund, which had sought $35.6 million from the bank as custodian to the Thema fund. Risks of this magnitude are an effective form of negative marketing against smaller and especially non-bank administrators. The AMF decision was, incidentally, confirmed by the highest court of appeal in France, where depositary responsibility for investor losses was written into the law years ago. Now the European regulators are writing that same responsibility into law in both the alternative (via the Alternative Investment Fund Manager Directive, or AIFMD) and retail (via the UCITS V Directive) fund management industries on a pan-European scale. Under AIFMD, hedge fund managers are required to employ a depositary (or custodian bank) to hold assets, monitor cash and oversee fund operations. Large custodian banks can already do these jobs, while stand-alone fund administrators without banking licences are pondering an unenviable choice between selling to a bank and forming a partnership with a bank. The choice may be illusory. As Chris Adams of BNP Paribas points out, banks are unlikely to agree to act as depositary partners to competitors, particularly when they are investing in the necessary infrastructure and carrying effectively the entire risk of making investors whole if losses arise. Ian Stephenson of HSBC agrees. “Depositaries will wish to control as much of the process as possible to mitigate the additional liability they have to take on under AIFMD and UCITS V,” he says. “So it is difficult to see a depositary taking on a liability whilst allowing revenues to go to providers of other services, particularly if the

depositary has to do oversight and due diligence on the provider.” It would be surprising if bank-owned administrators passed up an opportunity to portray non-bank administrators as vulnerable, but they have a point. Small administrators lack a large parental balance sheet to turn to in times of stress. Even a bank which failed is now (in the post-Lehman world) subject to an orderly winding-up process which would allow services to be maintained in the event of catastrophe. But it would be imprudent for any manager or investor to work on the assumption that every bank-backed fund administrator is immune to catastrophic failure. Goldman Sachs sold its hedge fund administration business to State Street last year but, when the firm came close to failure in 2008, it had assets in administration of well over $200 billion. Morgan Stanley, which also came close to failure in 2008, still administers assets for 89 hedge fund managers via the fund services business the firm started in 2004. Even universal banks with well-diversified funding sources (including retail depositors) such as BNP Paribas, Citi, Deutsche Bank and HSBC are still vulnerable to the closure of the wholesale money markets. European banks with exposure to Portugal, Ireland, Italy, Greece, Spain and the possible disorderly collapse of the euro still represent, despite disclosures, unquantifiable risks in a global liquidity crisis. “If the hedge fund administrator is part of a bank that fails, then presumably the administration business will end up in default,” argues William Keunen, which has itself faced the marketing challenge of being part of an international conglomerate of banks, trust companies

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and fund services companies. “Imagine if either Lehman or Bear Stearns had had fund administration arms, and think of the runs on some of the prime brokers that have administrators. In this environment, a bank-owned failure seems more likely than the failure of an independent administrator.” If the source of these observations makes them predictable, it would nevertheless be imprudent, given what happened at Lehman Brothers in 2008 and at MF Global in 2011, for a hedge fund manager to assume that a bank would not place its own survival above the continuing segregation of client cash and collateral. Mark Mannion counters that banks are subject to strict capital requirements and closer regulatory oversight than stand-alone administrators. Indeed, all of the major banks that own hedge fund administrators enjoy the dubious privilege of being globally systemically important financial institutions (G-SIFIs) in the eyes of the Financial Stability Board (FSB) of central bankers. Which means the greatest risk their hedge fund administration clients face from them is a low return on risk-weighted capital, prompting the bank to exit the fund administration business. Mark Mannion thinks this is not a serious risk. “Bank-owned administration businesses tend to generate higher margins from the same business as their administration-only competition,” he says, because they offer “a broader range of services to hedge funds than pure administration, often incorporating cash management, foreign exchange, collateral management and custody services.” Yet bundled services of this kind present risks of their own. A great many

managers currently purchase custody in combination with fund administration, either at their prime broker or via third party custodian banks, such as BNY Mellon or State Street. A purist would argue that it is always a mistake to buy custody from the same source as administration, since every asset is potentially a piece of collateral available to a bank to finance its own balance sheet. If a manager got into trouble, let alone its custodian bank or prime broker, possession of the assets would inevitably turn out to be nine tenths of the law. As Carolyn Burke of Mesirow points out, an administrator-only failure is easier to recover from. “Managers would be able to continue trading – a luxury that was not afforded to them when Lehman went down,” she says. “A lot of managers multi-prime, and the primes will have their positions so they could reconcile all the data from their primes. Most hedge funds also have quality portfolio management tools, so, while they might not be able to identify the NAV precisely, they would not be in a terminal position.” Certainly these are risk assessments of the kind operational due diligence experts are now being paid to consider. One possibility is to adopt a solution fast becoming the conventional wisdom in the custody industry: appoint a back-up service provider. “We have two administrators, which was an investor-driven decision and we started using multiple administrators in 2009,” explains Carolyn Burke. “The business is split roughly 60:40 between them. However, I do believe we are the exception rather than the rule in this case. When our funds of funds operations teams review prospective investments, having

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multiple administrators is certainly not a prerequisite and it could be very costly.” Bridgewater recently announced it had appointed Northern Trust to shadow the fund administration and accounting work undertaken by BNY Mellon, which the $140 billion Connecticut hedge fund outsourced its middle and back office to in 2011. The decision has been described as “insane” and “expensive” although Northern Trust says the decision is cost neutral, albeit without disclosing fees Bridgewater is paying. Nonetheless, the deal will certainly give Bridgewater’s investors an additional safety net albeit at quite some cost. Phillip Chapple thinks multiple administrators preferable to a reversion to self-administration. “Managers would be responsible for calculating the management and performance fee,” he points out. “Ever since Bernard Madoff, who self-administered his funds, investors have been wary of letting managers self-administer. I suspect many would attempt to redeem if a manager announced they were self-administering.” Carolyn Burke, who is also responsible for a funds of funds business at Mesirow, agrees that self-administration can never be more than an emergency stop-gap. “The manager would have to do something immediately and acquire a third party administrator in good time,” she says. “If a manager did administration-lite internally, this would not be acceptable to us.” Changing administrators in a swift and timely fashion is harder than it sounds, even outside the constraints of a crisis. “Switching administrators is a difficult process,” says Peter Sanchez, CEO of the hedge fund services business at Northern Trust. “In normal market

conditions, a mid-sized hedge fund could take several months to be on-boarded by a fund administrator, while a large fund could take more than six months.” The time-line might easily extend beyond that date if a major administrator failed, and hundreds of clients and hundreds of billions of dollars suddenly had to find a new home. Consolidation within the hedge fund administration industry is creating dangerous giants of exactly that kind. State Street, the largest hedge fund administrator in the world, had $877 billion of alternative assets in administration at the time of the Goldman Sachs acquisition. Citco has $650 billion, and SS&C GlobeOp $430 billion. Were any one of them to fail, thousands of NAVs would not be calculated. Investors would be unable to redeem. Panic would ensue. “If one of the larger stand-alone fund administrators went out of business, thousands of clients would be stuck,” warns Phillip Chapple. “It is not an overnight process to set up a new administrator and providing all of the information to new administrators, as well as setting up new bank accounts. This is a time consuming task. In normal market conditions, a quick on-boarding takes three months, or eight weeks at an absolute push. This is not a ten minute job, and at a time of market stress with hundreds or even thousands of hedge funds clamouring for an administrator, it will take longer. I also suspect the smaller hedge funds will be pushed to the back of the queue. During the crisis, hedge funds signed first draft prime brokerage agreements, often without reading the fine print, just so they could continue business. Prime brokerage

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agreements always require negotiation and compromise, and I could see something similar happening in fund administration.” Ian Stephenson of HSBC agrees that smaller funds would be at a disadvantage in the aftermath of the failure of a major administrator, and adds that complex or esoteric strategies would also find it harder to find a new home. “Large complex funds are likely to be impacted purely due to complexity and the reduced number of administrators likely to be able to support their investment structures and activity,” he says. Mass redemptions as NAV calculations falter or disappear. Regulators seeking deep pockets to make investors whole whatever the cause of their losses. Administrators sued into extinction. Panic-stricken aftermaths, with no-room-at-the-in risk attached. These add up to a strong case for ending the complacency about fund administrator risk, and taking it seriously enough to manage and mitigate it properly. Unfortunately, the options are scarce and unattractive. Appointing multiple administrators, other than on a contingency basis, is prohibitively expensive for the majority of managers. It is also potentially chaotic unless data is reproduced exactly at all administrators. “Operationally it would prove to be too expensive and difficult to divide between the different administrators,” says Ian Stephenson, and Mark Mannion and William Keunen concur on grounds of cost. A cheaper alternative is shadow fund accounting, in which a second administrator merely “shadows” the work of the principal administrator. This is not unlike the Franco-German approach to mutual fund accounting, but it

also adds costs, which managers would pin on the fund. “A lot of managers have the ability to run shadow P&L but very few can afford to use a full-on shadow accounting system,” explains Chapple. “The issue often lies with debate on who pays for it – it is not cheap and investors might not be too happy to foot the bill.” This is confirmed by a recent Ernst & Young survey, which found most investors thought shadow accounting a good idea, but barely half agreed the additional cost was worthwhile. Chris Adams of BNP Paribas is more dismissive. “Shadow accounting is merely NAV-lite,” he says. “Managers should either replicate all of their administrators’ work entirely, if that is their preference, or solely rely on a third party.” Which is why the more feasible option for most managers is to mimic what global custodians do in the sub-custody industry: put a fund administration agreement in place with a third party administrator, so assets can be transferred quickly and conveniently if the need arises, but without any money changing hands until it happens. “This gives managers protection,” says Chapple. “If managers have pre-negotiated terms and conditions with a second administrator in case the first administrator fails, it would give adequate protection. The second administrator would be on stand-by and would not charge fees for this service.” If it costs nothing but time, and could insulate a fund from mass redemptions or even loss of assets, it is certainly worth thinking about.

With thanks to Martin Beney for film stills from The Convention of the Dead.

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IT SHOULD NOT BE EASY Hedge fund AuM grew every year until 2007. Odd years apart (1998 and 2002) performance was positive, ahead of beta or non-correlated, or all three. To start a fund, all you needed was pedigree, process, and a few months of money-making, and prime brokers, cap intro teams and FoFs would beat a path to your door. Unfortunately, it seems investment skill and business acumen grew at a slower rate than AuM. As a result, the industry now finds itself at a crossroads. The big are getting bigger. The likes of Bridgewater Associates, Brevan Howard, AQR and Och Ziff are pulling away from the field in terms of scale and scope as well as AuM, in some cases with returns to match. Costs are rising, none faster than compliance. More funds are closing than launching. Extraordinary mergers are occurring: witness $10.2 billion Mariner Investment Group absorbing the $1 billion Concordia Advisors. Many funds are mired below 2008 high-water marks. According to the recent Citi business expense survey, a manager needs $250 million to just to break even without incentive fees. Capital is available, but obtaining it takes time and money. The demands of institutional investors are outrunning the ability of managers to meet them. Many if not most hedge funds still have a back to front office headcount ratio close to 1:1. Yet scale is both elusive, and often detrimental to performance. So what should investors do? Investing successfully in an industry adapting to a

hostile environment entails deep and critical analysis of how firms are responding to a changing world. That costs time and money, especially in an industry where data is cheap but information is not. Interrogating a commercial database to screen funds for risks and returns is merely a starting-point. To access talented managers with sustainable franchises and high returns worthy of the fees charged needs site visits, in-depth conversations and background checks. Effective due diligence will uncover managers who are investing in themselves as well as their funds; which have institutional quality compliance and legal functions; and which have a workable plan to stay in business for at least a year or two without any incentive fee, working capital of GP reinvestment. The good news is that hard work will bring rewards. There undoubtedly are a lot of talented managers out there, making smart business decisions and generating attractive returns, based on sound business models. They are just waiting to be discovered. The challenge is finding them, especially in a market where half the participants are running less than $100 million. No one says it is easy. In fact, the mistake we made prior to 2007 was to think that it was easy.

Kevin Mirabile, Professor finance at Fordham University Professor Mirabile’s new book, Hedge Fund Investing, was published by Wiley in February 2013.

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