How KYC data can lend a fund manager an informational advantage

13 May, 2014

Fund managers tend to be more interested in running money than in working out where it came from. Pecunia non olet, as the Romans put it. But accepting investments from anybody who cares to write a cheque is an increasingly imprudent practice in a regulatory environment obsessed with making sure every citizen pays taxes (FATCA), let alone one surrounded by   Know Your Client (KYC) and Anti Money Laundering (AML) procedures that ensure no dollar is invested whose provenance cannot be proved.

The Patriot Act, which made customer due diligence a legal obligation, dates back to 2001. In Europe, the AML Directive was agreed in 2005. A large part of the raison d’etre of the Financial Action Task Force is to tackle AML. Both the Dodd Frank Act and the European Market Infrastructure Regulation (EMIR) insist that derivatives users know their trading counterparts.

The International Organisation of Securities Commissions (IOSCO) first published principles on client identification and beneficial ownership in the securities industry a decade ago in May 2004. The immediate drivers included suppressing terrorist financing in the wake of 9.11, but KYC and AML procedures have since expanded to include motherhood-and-apple-pie issues such as investor protection, fraud prevention and sanctions observance.

The IOSCO principles include using sufficient information from independent sources to be sure of the identity of a client, untangling the beneficial owners hidden in omnibus accounts, quizzing clients and their transactions on a regular basis, keeping records for at least five years, and preparing written policies outlining what will happen when a client fails a KYC investigation. It is a lot of work. So it is just as well that the IOSCO principles also permit outsourcing of KYC duties to third parties.

Most fund managers are content to outsource their KYC needs to their fund administrators, whose transfer agency (mutual funds) or investor relations (alternative funds) duties naturally include vetting the investors. However, administrators are struggling to do the job well, and to get paid properly for it too, especially in relation to the risk of getting it wrong. The fines levied for KYC breaches are increasingly material. Recent victims include Clearstream, HSBC and Standard Chartered.

Unsurprisingly, fund administrators have joined banks in arguing openly for the creation of a KYC utility for the securities industry akin to the one which SWIFT has launched in the payments sector. The argument is that there is no competitive advantage to be derived from multiple service providers running exactly the same checks on the same individuals.  The Depositary Trust & Clearing Corporation (DTCC), the American central securities depositary, is already working on an investor documentation utility for the United States domestic market.

But until that becomes available, and equivalent services are developed elsewhere, there is no alternative for service providers but to tackle the problem in-house. The most expensive option is to hire the consultants, such as Control Risks, but that rarely makes sense in fund investing. Like a lot of operational functions, investor due diligence is at bottom a Big Data sourcing, categorisation, management and analysis exercise. And there are several providers who can help fund managers and their administrators navigate their way through the morass of information.

The major markets are covered by Factiva and World Check, which offer public information about individuals and firms. The increasingly important emerging markets are now covered by Arachnys, which was founded by former Control Risks investigator David Buxton. Its software trawls multiple sources of public information - newspapers, court records, corporate registries, directories, NGOs, even blogs – in the original languages, and then makes the findings  available to researchers, in both the original language and English, via proprietary databases and sophisticated filtering tools.

On-line informational tools of this kind are impressive feats of engineering, let alone data management. They can obviously help shorten the process of checking the background of investors and verifying asset ownership. Efficiency in performing an onerous and non-remunerative task imposed by regulators obviously counts for something. But there is a more positive reason to make use of services such as those provided by Arachnys.

The Arachnys service is focused on the emerging markets, which have enjoyed something of a comeback this year. Fund managers investing in emerging markets should find the information Arachnys sources and presents extremely useful for portfolio management purposes rather than KYC, especially in the emerging markets. After all, it is in the emerging markets that the paucity of reliable conventional research makes informal analysis essential.

Dominic Hobson

FATCAIOSCOKYCHSBCClearstreamStandard CharteredDTCC