Asset Management and the challenge of the custodian
In order to avoid more Bernie Madoff-style blow-ups, asset managers must use custodians. Let’s say you give me $10000 to invest for you, how would you know I actually invested it, versus simply went out and bought a motorbike to go have fun on. This is exactly the job of the custodian. The custodian holds the money for you and you basically give them permission for me to make decisions on your behalf. Assuming you told me (the asset manager) I could do whatever I thought best with no limitations I would go out and do some research.
Let’s review a couple of typical integration patterns involved.
Think about when you want to build support for a new product. The custodian may already have connectivity to the venue where you want to trade. So you take advantage of that and now the venue is sending copies of your trades to the custodian. Quick time to market, but there are some additional reconciliations that need to be built to make sure the pipes are working. These reconciliations may take the form of emails being sent to peoples’ emails. This is a headache but once set up it’s normally just an ongoing cost of operations. We’ll cover some complexities later.
Over the counter (OTC) products are where we trade with another institution such as a bank or broker/dealer. There is no venue in the middle to force all market participants to work the same way. Each new counterparty we want to trade with may increase operational workload.
Regulatory Transaction Reporting
One complexity is that of transaction reporting. Where products are trading on an exchange, often the exchanges will do the reporting for you. However, you need to make sure that’s the case, and if they don’t report everything you’ll need to plug the gap somehow. In the happy path we have this alluringly simple pattern:
For OTC, it gets more complex! In some cases the regulators will be explicit about who has the responsibility to report a transaction. Again this becomes a co-ordination problem where we need to ensure that one, but not both of us report the transaction.
3rd party systems for trade order lifecycles
Sometimes an Asset Manager will use a third party system to manage their orders and transactions. Smaller asset managers may use a product like Bloomberg AIM instead of building it all themselves which is not cheap by any means. As with most FinTech decisions however there is a trade-off; get to market more quickly and live with more operational complexity.
Daily pricing
So remember the custodian is trying to ensure that we don’t up with a Bernie Madoff event! There is a great level of security provided by the custodian holding the assets and even just ensuring that the money is being invested as agreed is very assuring.
With all good regulations come complexities! What happens if an instrument isn’t liquid and there isn’t an obvious price discovery mechanism. This could be simple as a bond that doesn’t trade often, but could also be something like a derivative that has complicated pricing methodologies. This leads to situations where the custodian and asset manager may disagree on prices which impacts reporting of the market value of a portfolio. Generally, any pricing issues shake themselves out when money has to be transferred between counterparties but this issue becomes emotive on key calendar dates.
Quarter end and year end dates are particularly important. Performance of a portfolio will be based on valuations on these dates and published out for relevant parties to see. From an asset manager’s perspective they want to be seen to be beating the benchmark as it may impact clients’ decisions to allocate capital in the future.
Trade Events
There are many events that happen during the lifetime of a trade that aren’t sparked by the asset manager. A few examples are:
- Options exercise. An option that may have been sold could be called by the counterparty
- Callable bonds. An issuer may exercise their right to repay early, returning cash to the investor
- Margin. Exchanges may request additional cash from the investor to cover leveraged trades.
- Defaults. An issuer may not pay a coupon that the investor was expecting. Or in the case of credit default swaps, cashflows may have to be paid out.
- M&A. The legal hierarchy of an issuer may change, and those changes need to be incorporated into valuation methodologies.
Let’s talk through convertible bonds and the operational aspects of it in another article….
