Back Office: Tail Or Dog?

Fund custodians and administrators are no longer in the back seat, it appears.

My fascinating excursion this week into the world of fund administration and custody reached a climax with a visit to yesterday’s ISJ European Custody Summit in Canary Wharf.

I’m a novice in the area of global custody, securities finance and fund administration, although the more I learn about it, the more I’m intrigued. I even half-wish I had gone into this area of the business 20 years ago, rather than into front office fund management. For those of us then who saw our job as predicting where markets might be heading and staking our clients’ money on it, fund administration and custody seemed a subsidiary, almost unimportant business, confined to providing accurate monthly fund valuations. Now I realise that view was arrogant and uninformed.

Several comments from the high-level group of fund management professionals speaking at yesterday’s event (the COO of fund manager Schroders, my first employer in the City, and the London or Dublin heads of securities finance for BNY Mellon, Citi, HSBC, Northern Trust and State Street, all the key players in this area of the business) caught my attention.

For example, Paul Stillabower, head of business development for HSBC’s London securities operation, talked about how his desk is currently overflowing with CVs from former proprietary traders – a comment that rather neatly answers Michael Lewis’s latest Bloomberg piece (“The Mystery of Disappearing Prop Traders”).

Stillabower noted, tongue in cheek, that he might even employ some of them, though they’d need to be “re-educated” in fund accounting. But, whatever you might think of prop traders, they’re usually a fairly bright bunch, and their current interest in back and middle office roles tells you a lot, not just about where the regulatory wind is blowing, but also about the complexities involved in administering and running funds, which now requires a real variety of skills.

Other speakers yesterday, such as Roger Fishwick, former fund manager and now a consultant at Thomas Murray, a global custody ratings and research firm, and Phil Brown, head of client relations at Clearstream, mentioned the increasing trend towards collateralisation. “In five years’ time, everything will be collateralised,” said Fishwick.

This rings true for those of us following the ETF market, as we’ve already seen issuers starting to overcollateralise swap exposure in their funds (i.e., they’re competing to do better than the 90% minimum required under UCITS), as well as the collateralisation of products that previously operated with raw credit exposure to the issuer (many ETCs, for example).

How funds are collateralised (within the scope of the UCITS rules that regulate the use of derivatives and the use of securities lending in ETFs) and the interplay between the quality of collateral and the cost of index replication (which, in turn, means tracking error) are crucial questions that have up to now not been analysed as much as they deserve.

With swap-based ETF providers now starting to provide much greater transparency regarding their use of collateral (though collateral policy in securities lending remains opaque), we can expect more and more attention to be paid to these issues.

Finally, the importance of questions that relate specifically to the custodial part of a fund’s operation – the size of the custodian’s balance sheet, the scale of subcustody networks, and even the legal liability of custodians when things go wrong (there’s been a different assessment of this liability by French and Luxembourg regulators in the Madoff case, several speakers yesterday pointed out) – means that a true assessment of the quality of a passive fund like an ETF cannot be made without a detailed look at these areas. Isn’t the custodial business too concentrated, asked Fishwick, and shouldn’t regulators worry more about systemic risk in this area?

And operational risks are rising across the board, noted Markus Ruetimann, Schroders’s COO, meaning that fund management houses are having to pay much closer attention to questions of settlement, custody and clearing, as well as the interplay of different trading platforms. Flash crash, anyone?

All this makes me think that we probably all focus too much on the front office part of an ETF, the fund manager or issuer (and aren’t ETFs all managed to formula, anyway?) and not enough on the bits that go on behind the scenes. Forget the star stock picker: think systems engineer and IT expert. Does the fund manager dog really wag the back office tail, or is it the other way around?

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