In the post-financial crisis world financial institutions face a range of challenges to their business models and to their bottom lines, ranging from market risk via reputational risk to counterparty risk. Governance and compliance obligations are high on the agenda for financial institutions and mitigating operational and investment risk has become one of the top priorities. In this environment investors pay more attention to where and how assets are held and look increasingly to custodians for reassurance that those assets will be kept safe irrespective of the financial storm that might come along.
RBC Investor Services has considerable experience in this field and its position as a leading global custodian – now among the world’s top ten with $2.9 trillion of client assets under administration – was strengthened last year when Royal Bank of Canada bought out the 50% stake in Investor Services previously held by Dexia.
Olivier Laurent, Director, Alternatives Investment at RBC Investor Services, says “the choice of a custodian is more and more guided by the financial strength of the counterparty and not just about services such as securities lending, administration and collateral management.”
Since the purchase of Dexia’s stake, RBC Investor Services has become fully owned by RBC, one of the largest and most financially sound banks in the world, rated Aa3 by Moody’s and AA- by S&P. That integration under the new business segment Investor & Treasury Services has meant that the bank can offer clients not only access to traditional custodial and administrator services but also additional value-added products, such as correspondent banking and capital markets services.
Platforms for growth
To cater to its clients, who are increasingly investing in listed and OTC derivatives either as part of a traditional or alternative investment strategy, last autumn the bank launched its Global Derivatives Platform which combines vendors and in-house systems. The platform is designed to deliver middle and back-office services like trade processing and reconciliation capacities and what it calls “follow the sun” access to pricing of derivatives instruments (24 hour pricing).
The company started to process central cleared trades for its North American-based clients on the new platform in September last year; clients in Europe and Asia are moving over in the course of 2013. When the process is completed RBC Investor Services will be one of the few administrators able to offer independent valuation capacities on more than 40 derivatives instruments.
In terms of fund distribution opportunities, RBC Investor Services offers an integrated value proposition for hedge fund managers wanting to set up a UCITS fund, working with them to explain what it is that they need to take into account on alternative UCITS.
“Given our experience with hedge fund compliance we are in a good position to explain to our clients about risk management, leverage and positioning,” say Laurent.
Typically, clients new to UCITS need to understand how best to recreate a similar structure to, for example, a Cayman fund, but with daily liquidity and the appropriate operating model to eliminate any tracking errors, as well as understanding the differing roles of prime brokers and requirements around the Key Investor Information Document (KIID).
Once the fund administration is in place, RBC Investor Services is capable of assisting with the distribution process through its global fund platform, which seeks to ease the process for fund buyers and optimise fund selection by providing access to over 84,000 share classes registered with a network of 400 transfer agents. The platform also offers an online quantitative analysis tool and provides secure trading and settlement.
Fund managers can extend their fund distribution to new markets as the platform increases the visibility of their offerings to buyers, while providing full transparency and comprehensive data management oversight of the distribution network, with real time reporting, compliance monitoring and due diligence of sub-distributors.
UCITS versus AIFMD?
Dialogue and co-operation with fund managers remains crucial as the regulatory landscape keeps changing and now, with the Alternative Investment Fund Management Directive (AIFMD) about to come into force this summer, the custodian believes it is in a good position to continue to leverage its expertise in alternative investment whichever vehicle is preferred.
Although in the early days of UCITS there was initial resistance from some parts of the asset management industry to these new, more regulated, types of funds, the determination of European regulators to have functional UCITS vehicles in place has meant that the hedge fund industry now accepts UCITS as the viable option for funds being sold in Europe. UCITS funds have become the gold standard for regulated vehicles, mainly because of their strong risk management procedures, the clear emphasis on investor protection and access across the whole of the EU and beyond.
Now the same process is being repeated with AIFMD, which will have to sit alongside existing UCITS regulation, and eventually all hedge funds in Europe will have to be either UCITS or AIFMD compliant – both will affect not only managers in the EU but also fund managers from the US, Switzerland and Cayman Islands marketing to EU investors. Regulators are aiming for the two sets of regulations to eventually be fully in line with one another, but Laurent says he does not expect AIFMD and UCITS to be harmonised “until well into 2014” and there remains some uncertainty for alternatives managers in terms of what will be required. Laurent says educating and informing hedge fund and fund of hedge fund clients of the changing regulatory landscape is a priority and is now an indispensable role of custodians.
While it complements UCITS regulation by including alternative investment managers, AIFMD is more stringent than the UCITS regulation requirements for depositories to perform the two key functions of asset safe keeping and oversight over the management company. AIFMD also specifies clear rules on depository eligibility and provides a detailed definition of safe keeping duties split between custody and record keeping with stricter demands in terms of clients’ account segregation and the monitoring of fund cash flows.
In relation to custodians and depositories, one of the key changes in the upcoming UCITS V is that a UCITS will have to appoint a single custodian to be entrusted with the safekeeping of all the assets of a UCITS. Under the MiFiD directive only EU-authorised financial firms will be able act as such custodians and will be liable for any loss suffered by a UCITS or its investors.
Also, at present EU countries can prescribe the types of entities that can be UCITS depositaries at a national level, which has led to countries imposing different levels of capital requirements on each depositary. Given that UCITS funds are sold on a cross-border basis, this situation may create uneven levels of investor protection in different jurisdictions where claims against the depositary are made. To combat these issues, UCITS V will introduce a list of entities that it considers eligible to act as a UCITS depositary.
In this new business environment and amidst increasing demand for alternative UCITS invested in high yield, low rating investments, effective portfolio valuation is one of the key aspects of the level of support provided by depositaries. Accurate pricing, particularly when it comes to less liquid assets, is imperative, as are specific reports to investment managers on credit strategies. RBC Investor Services will typically provide specific reports for managers on higher risk strategies such as high yield on a weekly basis, as opposed to bi-monthly reports for more traditional strategies, Laurent says.
Another upshot of the more stringent rules and increased liability will be an enhanced requirement for cash management, collateral management and more transparency. For example, collateral management agreements will become much more detailed to take account of counterparty positions and monitoring the repatriation of excess collateral. As AIFMD requires the use of a single sub-custodian, and increasing liability for deposits, relationships with prime brokers will need to be examined and “In practical terms [it] will mean that the custodians might end up working closely with only two or three selected prime brokers to be sure that they can provide the necessary rigour and due diligence,” says Laurent.
Between continued use of alternative UCITS and widespread adoption of AIFMD, the company is “agnostic” in terms of the type of alternative funds or fund strategy its caters to, says Laurent.
However, he does believe that alternative UCITS funds will continue to show faster growth this year compared with AIFMD or Cayman-registered funds. UCITS still make up a relatively small portion of the overall hedge fund sector– about 10%, with another 10% consisting of AIFMD compliant funds and the remainder mostly of Cayman-based funds – yet the UCITS segment has grown at about 20% per year over the last five years compared with growth of about 7% for Cayman-registered hedge funds. “I believe we will see a similar rate of growth for UCITS this year,” says Laurent
The service provider expects that, apart from regulation, the growth of emerging markets and technology development will drive cross-border distribution trends over the next five years and says that it will become crucial for alternative fund managers and their distributors to build robust partnerships and expand geographical reach to enhance their cross-border capabilities. Emerging markets, in particular in Asia, are becoming one of the key targets for the distribution of alternative UCITS funds.
Asia does not have a common regulatory framework for the distribution of domestic funds and as a result UCITS dominate the market there, while Asian firms are also creating their own UCITS funds to sell domestically and in Europe. China is beginning to play a bigger role in fund management and Chinese fund managers are also starting to set up UCITS funds as a vehicle to distribute their products to European investors.
Trading strategies are changing this year as the equities markets begin to recover and commodities no longer deliver the returns of the past. Instead credit strategies and distressed debt are becoming the flavour of the month as alternative investors shift their focus to higher yielding assets. Private equity firms are increasingly looking at diversifying in this way and RBC Investor Services will look to support them with the launch of credit funds and integration of distressed assets into the UCITS framework.
Further regulatory change in Europe is going to place far more emphasis and scrutiny on the financial institutions providing mission-critical operational support like custody. Managers of UCITS funds and their investors will be paying more attention to issues like expertise, operational effectiveness and the stability of parent groups. The value of the UCITS structure and brand seems to be more sought after than ever. As a service provider that has chosen to make servicing these funds a key service specialisation, RBC Investor Services is well-positioned to meet UCITS fund manager needs in a new and more demanding arena.