RBC Dexia is frequently involved in the early stages of a new fund’s launch, even advising on the choice of jurisdiction and service providers. Olivier Laurent, Director of Alternative Investments (Fund Segment), says it is important that funds that want to compete in the UCITS institutional market are supported by firms that have a reputation investors will respect.
Taking a sophisticated offshore hedge fund strategy and turning it into a UCITS requires a high level of attention to detail, and RBC Dexia has worked with client funds on prospectuses and on the submissions process. Its familiarity with regulatory regimes has ensured that the approvals process, which can often be lengthy and tortuous for the fund manager, has the best possible chance of reaching the right conclusion.
Replication of hedge fund strategies via structured solutions remains a hot topic in the UCITS market. Laurent believes that 90% of offshore hedge fund strategies can be launched as UCITS. Direct replication of a fund in a UCITS consists of replacing short positions – for example short stocks – with contracts for difference or equity swaps. Synthetic replication can be employed by defining an index, for example one based on a managed account or a basket of commodities, and using a total return swap with an investment bank to receive the performance of the index.
The choice between synthetic replication and direct replication is being driven by the nature of the underlying strategy and by the requirements of the UCITS directive. Some strategies cannot be directly replicated due to leverage constraints or the use of non-compliant instruments.
Laurent points out that effective replication of a hedge fund strategy using OTC derivatives requires both scale and expertise. “As an example, contracts for difference and equity swaps that are used in long/short strategies in alternative UCITS are complicated, and non-standard products have rules such as reset, cost of funding calculation and corporate action handling which differ from one prime broker to another.”
On corporate actions, for example, custody systems have to handle the calculations and management of dividends and splits, even though custodians do not physically hold the stocks in their books. Another example is managing the volume of transactions for statistical arbitrage hedge funds, where the underlying assets must be created in advance in trading and back office systems to maintain an automated flow.
Laurent also observes that several years ago, whenever the volume of transactions was too difficult to handle on manual and ad hoc systems, administrators were forced to take a short cut in the way they managed CFDs by only taking the prime broker’s P&L and using only one accounting entry to cover the usually detailed P&L on each trade. However, this technique cannot be used under UCITS: funds need to account for their positions on a line-by-line basis, independently of the prime broker. RBC Dexia has developed systems in response to this that allow for the speedy accounting of equity swaps and CFDs.
An independent take
RBC Dexia can provide its fund clients with what Laurent believes is a useful external view of the process. Its experience with launching UCITS hedge funds to date means it has a fair idea of what will work, and what won’t. Most of the time, “funds come to us first,” says Laurent. “We are platform neutral, we have no partnerships. They ask us about the key differences between the fund platforms and their operating models.”
Once a fund is up and running, of course, the fund manager may also need to get used to the idea of higher liquidity requirements and more frequent daily NAVs (RBC Dexia estimates that 95% of UCITS compliant hedge funds offer daily NAVs). This is where the fund administrator really earns his keep, particularly in the area of collateral management and the daily processing of derivatives instruments. The RBC Dexia platform is particularly well-attuned to derivatives-based strategies, particularly CFDs, equity swaps and total return swaps. The bank works closely with hedge funds and investment banks to provide its customers with a seamless reporting process.
Because it is not possible to automate the processing of total return swaps, strategies which use these will require a bank that has close ongoing connections with prime brokerages, and can check constantly with the fund manager and investment banks to ensure that cash flows match up. RBC Dexia manages collateral management and cash flow processes, provides the middle office functions, and can also value OTC derivatives contracts. It all points to a high degree of familiarityand expertise with derivatives-based approaches to fund replication.
“OTC derivatives platforms for structuring and execution are proposed by investment banks and prime brokers,” explains Laurent. “Custodians and fund administrators are connected to these platforms and can offer settlement, repository, and valuation services. At the asset manager level, you need to have the organisational capacity to handle the requirements of OTC derivatives and interact with these platforms.”
UCITS funds are not allowed to wear counterparty risk in excess of 10% – i.e. cash or securities transferred to the prime broker cannot exceed 10%. It is a ratio that is not easy to monitor in practice, as the cash or securities transfer might be explained by the changes in the mark to market of the fund, a margin call on the book of OTC derivatives positions, or as a deposit call originating with the prime broker (for example, during periods of particularly volatile markets). In practice, not all prime brokers separate their reports between margin call and deposit call, making it hard to effectively monitor credit exposure monitoring and the overall collateral management process. Such challenges have required RBC Dexia to build tried and tested processes between the asset manager, the custodian, and the prime broker. It is a complicated challenge that can only be achieved via a step-by-step approach to the problem.
“You have to reconcile all your positions with the prime brokers,” explains Laurent. “Then you have to independently value all these positions and then, with a very quick turnaround of between four and six hours, you have to agree the collateral management valuation with the various investment banks involved before processing the margin call.”
Independent valuation of OTC contracts has come to the fore in the post-credit crunch investing world, and RBC Dexia’s role of providing an independent third party valuation is considered essential by hedge funds and investors. In some cases, it is providing the second independent valuation. “Investors expect a certain level of control,” says Laurent. “They need to see that some external parties have been involved.”
Tracking error between onshore and offshore versions of the same strategy stole the headlines earlier this year. As an administrator, RBC Dexia has been focused on ensuring that there is no daily mismatch in the NAVs of the funds it is responsible for. This means making sure it adheres religiously to its valuation rules, and that it takes time to define the rules for pricing.
Laurent is confident that his bank is playing a key role in helping to reduce operational risk in the hedge funds industry. He recognises that there remain concerns in the investor community that funds not ‘in the spirit of UCITS’ are being allowed into the market via esoteric structuring processes. “If we look at the overall hedge fund industry, are we improving the level of security and reducing the level of operational risk by progressively moving from the offshore Cayman or BVI structure to UCITS? If you look at the different risks in a UCITS fund compared to a Cayman fund, due to the level of regulation, as well as the fact that you have more actors involved, responsible and accountable for the overall process of controls, most of the time the balance is in favour of the UCITS funds.”
Individually and collectively, operational risk is lower under UCITS. Yes, the use of OTC derivatives in the replication process is adding a layer of operational risk that does not exist for Cayman funds, but firms like RBC Dexia can help to reduce this significantly by taking the industry away from the culture of ‘lite’ NAVs towards a more robust system of controls and reconciliation.
“The UCITS model represents a significant reduction in counterparty risk,” says Laurent. “This is limited to 10%, thereby representing a good way to limit investor risk and systemic risk. The same goesfor liquidity.”
Hedge fund managers need to ensure that they can apply their strategy effectively under the UCITS banner by respecting all the regulatory ratios permanently. This is a key principle that needs to be applied when the fund is being established, and which is why the role of the custodian/administrator is so critical at this early stage.
The added scope for fund distribution has been one of the major attractions of the UCITS option for offshore fund managers. The success of a good distribution strategy partly depends on having a solid platform partner with the capabilities to support this, including via share class and shareholder services. RBC Dexia is fully acquainted with the flexible models available to fund managers and what is being offered by the various UCITS platforms. It is well-positioned to support funds from a platform-neutral perspective, as well as advise on distribution issues that might spring up, for example taking Asian investors into a Luxembourg UCITS fund.
On top of this, however, RBC Dexia is also part of the Royal Bank of Canada group, which includes a sizeable global wealth management network. It can help to open doors to this network for fund managers seeking distribution via the private banking route. “We are agnostic between Dublin and Luxembourg when it comes to choice of jurisdiction,” explains Laurent. “We have equal capacities in both locations.” The bank has also been doing some work with onshore launches, for example with French UCITS. Laurent notes that the collateral management restrictions in Dublin are tighter than in Luxembourg, and is also finding that US and UK managers are leaning towards the Irish option for their UCITS launches, while Nordic and German managers opt for Luxembourg.
To continue to maintain its position as the leading UCITS hedge fund custodian, RBC Dexia knows it has to keep a neutral posture, not only in relation to the favoured jurisdictions for UCITS funds, but also between platforms. Part of its strength as a service provider is derived from its capacity to offer fund managers objective advice, and to match the fund and its manager to the right service providers that will also support its distribution plans. All this requires plenty of homework be done at a very early stage in the fund’s life.
Looking ahead, the bank is planning to expand its marketing activities in North America this year as interest in UCITS options gathers pace amongst US-based fund managers. “We recently helped a family office there to launch an alternative UCITS,” says Laurent. “They had to demonstrate a high level of security, and we were able to provide that for them. We are seeing a lot of interest in the UCITS model in the US, and a preference for direct replication.”
The bank is also continuing the development of its collateral management capabilities and its overall competency in this area, particularly with UCITS IV on the horizon. It is also contributing actively to the debate in this respect, for example as part of the working group set up by ALFI.