Since the demise of Lehman in September, 2008, there are two big questions business heads in the FO sector have most ask themselves. Many such leaders now consider a suitable answer to these to be the proper bedrock of all their subsequent business activities. Firstly: “Are assets genuinely segregated off balance sheet?”
Then; “How secure as a corporate entity is my custodian?”
Clearly the respective answers need to be ‘yes’ and ‘very.’ If this is not the case then the fundamental security and organisation of the family assets entrusted to an adviser’s care is not what it should, and could, be.
Master Global Custody (MGC) involves having a single custodian for all assets, even though such a custodian will in turn use the services of sub-custodians in various countries where laws and regulations may not make sense for them to operate directly.
The essential significance to consider is that of balance sheet risk. Client assets and securities should always be segregated from the assets of a MGC and from those of the custodian’s other clients. This ensures that creditors of a custodian don’t have any rights to the securities in such client accounts.
There was an example in this writer’s firm, on a Friday in early 2009 when the chairman of a large commercial MFO asked for full legal title with regards to balance sheet risk, saying: “a year ago my COO would have told me once a year that this was in order and in practice probably had someone two reporting layers below him actually doing the due diligence every few years. That’s not good enough, now I need to know for myself.” He read 87 pages from our legal department over that weekend.
In looking at the FO benefits of asset servicing and information management with a consolidated reporting platform, there are four main areas to discuss: security, efficiencies, reduced administrative functions and economies of scale.
Security
As mentioned, post Lehman, there are two prime questions: are assets segregated off balance sheet and what is the corporate strength, stability and credit rating of a MGC? Security here should be understood in several senses: safety of assets (i.e. off balance sheet), confidentiality and privacy of platform and strong processes for monitoring corporate actions and receiving dividend and interest payments which are due to the client family. Robust state-of-the-art systems are crucial given the content of private client details being held and processed. Each client requires the analytical tools necessary to effectively administer, evaluate and report on individual or consolidated portfolios. A client access system should provide highly secure Internet access with advanced encryption technology to ensure absolute security and confidentiality of client data. Within the MGC, firewalls should ensure only authorised employees have access to client accounts and information. No more employees, no fewer. Reporting platforms should also be available to clients’ investment managers and other third party intermediaries and advisers approved by the client, with access limited to only those portfolios within the family wealth universe that clients wish their third parties to view. In summary, systems need to be robust, connected, accurate, timely and customisable for fully integrated information management.
Efficiencies
Efficiencies lie in interconnected and integrated systems and repositories of
data and information. There will be daily interfaces to all major advisers and while not all of them will wish such regularity, a sophisticated consolidated reporting platform represents the favourable utilisation of technology for a FO. Efficiencies flow from the categorisation of assets in a consistent format for reporting and accounting. There is tremendous benefit in offering the combination of a simple summary screen of all holdings with the ability to deliver very sophisticated performance and risk analytics through the same portal - in essence the joining of the simple and complex. By way of example, two particular financial risks sometimes underappreciated are treasury risk and currency exposure: MGC consolidated reporting can produce the data to enable these to be correctly assessed and managed.
Reduces administrative functions
One central benefit is to categorise assets in a standard format for reporting and accounting. MGCs usually offer a multi-currency platform that fully integrates core systems of custody, full double entry accounting, performance and risk analytics. Of particular significance will be the provision of year-end tax information in a suitable format for the actual tax adviser to use. This is an example of a MGC’s administrative efficiency rather than actual offering, since the custodian should provide the information but not be the actual tax adviser. The direct custodial link and resultant automation, sharply reduces the factor of human error in regards to inputs and reconciling. Such systems also naturally lend themselves, through the ability to store detailed information, to becoming the FO’s ‘book of record’ and repository of historic data.
Spreadsheets are arguably no longer acceptable as the primary tool for consolidated reporting for a FO. They are sometimes created by people who are unfamiliar with financial investments
and can be subject to much human error and consumption of that most valuable
of resources, time. At the SFO where this writer previously was, it sometimes took two weeks after quarter-end of working with spreadsheets to have a fair view on assets and positions. In such an environment risk management and governance are seriously impeded. Senior FO staff should have their time freed up for more value-added work.
Economies of scale
In addition to consolidated reporting, a MGC should deliver other services such as performance & risk analytics, cash management including overnight sweeping and forecasting and aggregating commissions paid to individual brokers to allow clients to negotiate more favourable charges. Economies of scale are about effective management of information flows. Many costs, especially that of compliance are becoming overwhelming, so third party administrators with the resources derived from scale to keep their system up-to-date, are increasingly seen as a potentially welcome solution.
Timely and efficient management of information is one of biggest challenges
for FOs and that now includes a dependence on technology. As risk measurement and management becomes more complex and diversified there is an ever-present demand for instantaneous access to financial information.
Similarly there are cash sweep benefits.
A MGC should offer the ability to automatically sweep all uninvested cash from accounts on a daily basis into a choice of multi-currency cash sweep vehicles to ensure a client’s entire investment portfolio is working on their behalf at all times and earning a competitive rate of interest. A MGC platform can also potentially allow a family to position itself for better value lines of credit from its bankers, principally by presenting a whole net worth view and associated financial details to a credit committee.
The essence of a MGC’s economies of scale benefits are a single asset servicing platform for clients to hold, process, monitor, and measure all investment data from investment administration through to aggregated reporting.
Working together
The FO might be seen as a hub: organising, liaising with and consolidating information from numerous different sources.
Mark Haynes Daniell has termed this the ‘Family eco-system.’ The FO is also the only entity that can fulfill these functions but is not just a general administrative hub - it is also potentially positioned to be the overall risk manager. Risk management should not be mistaken for risk measurement:
the capacity to properly measure risk is a necessary, though insufficient condition,
to ensure proper risk management. This can only be done with suitable information.
It is now a ‘must’ in financial discussions to talk about risk but much harder to deliver on executing effective risk governance and management. In the UHNWI sphere where clients are of sufficient scale, an independent and professional FO can take up the mantle as manager of the family’s counterparty risk. However, it can only do so if it is provided with timely and accurate information. This is where the link to family governance comes, and in a sense returns back again, since effective family governance is, in essence, about risk mitigation.
And the role of effective family governance is to mitigate the biggest business risk a family faces, namely family disharmony.
The last few years of the financial crisis has resulted in FO leaders returning to the basics; the fundamentals of how assets should be held and reported on. If such matters are established well, then these back and mid office functions can be largely behind the scenes, while focus is put on the front office and alpha generation side. But these important investment decisions must not be based on faulty information. If they are, then the toil of the greatest asset allocator or investment manager may be in vain. A tiny movement in the muzzle a rifle aimed at a target some distance away will translate to a very wide difference at the other end.
The connection between back and front office functions and administrative efficiency is an essential one. The MGC/ FO relationship not only provides a single point of contact but also, when working smoothly, frees up talented senior staffers from the burden and tedium of process to create active value and in turn retain their interest and commitment, a key theme. A recent survey by a custodian reported that some FO staff were spending as much as 60% of their time on back office administration, principally on complex investment accounting, data consolidation, standardised aggregated reporting and management information. FOs should be appointing a MGC to address such problems of managing the information that comes with substantial and diversified holdings and ordering it into a timely, accurate and flexible format.
One of the most valuable outputs of a MGC is a reporting platform providing an efficient, consistent and immediate snapshot of total family wealth, through bespoke on-line information delivery. This should include the reporting of line items (non-custodisable and physical assets) alongside investible assets to deliver a whole net worth view. The utility of this is widespread for beneficiaries and advisers alike.
The role of the MGC is to safe-keep investments, value and record changes
in assets and provide accounting and reporting on total wealth. Having a single custodian is the most effective way to avoid the administrative limitations that can delay or inhibit the ability of a FO to perform investment execution and oversight functions. Technology is a key enabler in allowing FOs to achieve their financial goals: as the saying goes, ‘information is power.’
What attributes matter?
So what should a FO look for in a MGC and how should such a provider be evaluated? Scale might seem a daring factor to stress, especially since the rightful long-term trend is for FOs to use experts and specialists for most of their financial needs. The simple fact is that custody is a scale business: the larger the business, the greater a firm’s ‘investment power’ to commit to technological projects and ongoing development, so there is tangible client benefit to being serviced by very large custodians. Gregory Curtis argued in Creative Capital: Managing Private Wealth in a Complex World:
“Asset custody is an extremely capital intensive business, requiring massive and on-going investments in technology and personnel merely to stay even with the competition.” Since it is also low margin, only a few institutions can compete. The idea of a boutique custodian is literally ridiculous.
The ‘scale argument’ must be counterbalanced by a stated requirement for a MGC to have in place permanent and dedicated FO teams, to avoid even the most substantial SFOs being lost in the huge institutional pools that large custodians hold.
Intellectual capital and scale can actually be linked strongly. For example, BNY Mellon, the world’s largest custodian, has $24.4 trillion in assets under custody. Given this concentration of assets, such a firm and other scale players, have a ‘ringside seat’ to the financial world, not j ust being close to the markets but actually part of them. They should take advantage of this position by accumulating ‘know-how’ and developing the ‘plumbing’ which will enable their services to be broad but tailored to client need.
The summary of the offering from a FO client perspective is robust information management, reporting and delivery, reporting tools that are adaptable to each client’s needs, with both customisable and standardised reports available, as well as access to client statements and documents online.
Evaluation
In considering how a FO should evaluate their MGC, they might perhaps begin with considering if their provider genuinely unites the strengths of a global technology and custody leader with world-class information management and reporting capabilities. Actual methods to evaluate an offering, either in the run-up to making a choice or as part of a periodic review of an existing solution provider, might include asking others in one’s peer group whom they are using and what their views are. This accords with the growing theme of peer-group networking, discussion, information and ideas sharing. There is an increasing use of ‘request for proposals’ (RFPs) in Europe, though it is still far from usual. And despite earlier remarks on scale, technology and coverage, all business relationships are still driven and directed by the human element, especially in ‘FO world’. Therefore, it is important to meet both senior management, together with actual account officers to gain a clear idea for the genuine nature and character of a business. In terms of cycles in evaluating MGC there is a wide range
in answers as to how often this should be. For example in London this might typically be every two to five years.
Two final points deserve emphasis.
Firstly, commitment to the business line. This is actually the most critical message for any business to transmit to its target market. Failure is likely to follow if this is not heard and believed by prospects and clients alike. Looking into the eyes of business heads explaining their model has even been suggested as potentially offering an insight into this: not everyone has a poker face.
The second is a significant consideration for MGCs as to how they form their business model. If they wish to be truly collaborative then the CIO function of SFOs or a family’s general asset allocation or investment consultant element, should see the custodian as a supporting partner, a possible introducer of best ideas when they have top quality active management within their group, but not a competitor.
Reporting results
Having addressed the ideal and desirable, what happens when arrangements go wrong? When custody and financial security, together with information accuracy is not exact and as it should be? Potentially all the clever efforts of the front office may be futile. Luqman Arnold was a former President of UBS and a well known activist investor who founded Olivant Advisers Limited. Olivant’s entire shareholding in UBS was held in accounts managed by Lehman
\- in other words, not segregated off balance sheet. When Lehman failed in September 2008, Olivant tried to recover its 2.78% stake in UBS, worth about SFr1.4bn.
However, despite intensive discussions with Lehman and administrators PwC, it was unable to locate the shares. Because of the uncertainty over its shareholding, Olivant, which had been pushing for significant management and strategy change at UBS, was not be able to
exercise its votes at UBS’s EGM in October 2008, the ultimate horror for an activist investor, and a salutary lesson for all.
FO Services in the form of the MGC model with its attendant output of consolidated reporting is not just fundamental to the security of it family but also of tremendous benefit to the efficient running of its FO and advisers. Well managed custodians seek to assist the work of advisers, as well as adding value to the end family and this view of the supporting role of advisers is instructive.
Advice and support is crucial: General George Washington is a good example of an able man, who optimised his impact by being very ably advised, principally by Alexander Hamilton, a far-sighted financier (who in 1784 founded The Bank of New York, America’s oldest bank). George Washington observed: “To form a new Government requires infinite care and unbounded attention; for if the foundation is badly laid, the superstructure must be bad. Too much time, therefore, cannot be bestowed in weighing and digesting matters well.”
This could equally have been remarked of a FOs custody and reporting arrangements.
