One of the surprises of the run-up to the derivative trade reporting deadline of 12 February 2014 was the lack of preparedness of the global custodian banks to help their buy-side clients meet their obligations. After all, many of the largest fund managers outsourced their back and middle offices to global custodians years ago, so it was natural for them to expect assistance.
At the turn of the century, operational outsourcing was seen as an important part of the future of the fund management industry. Global custodians such as BNY Mellon, Citi, J.P. Morgan and State Street vied to “lift out” the back and middle office staff and systems of major fund management houses, ostensibly to provide the platform to grow their in-sourcing business ever more deeply into the buy-side of the securities industry.
None of those deals lived up to their exuberant expectations, but they did denude some major fund managers of any back and middle office capabilities. So, when it came to working out how to report their exchange-traded and OTC derivative transactions to multiple trade repositories, they lacked the in house expertise and experience to do it. But when they turned to their global custodians for help, they did not always receive a reassuring reply.
Custodians argued that they were under no obligation to report derivatives on behalf of fund management clients, though they were prepared to consider doing it. “We are discussing the new reporting requirements with our clients in order to better understand the exact nature, scope and level of interest that clients may have in leveraging our capabilities to potentially provide a transaction reporting service,” said HSBC in a statement shortly before the deadline of 12 February 2014. “Once we have established the level of interest we will consider the feasibility and timeframe for introducing a service of this nature.”
State Street was more advanced, offering full and partially delegated reporting to clients in exchange for a fee. Managers that opt for full delegation can count on the bank to collate and blend external as well as internal data, and to enrich and validate it before passing it on to the trade repository. The partial delegation service, on the other hand, sees the bank share the data in its possession with the client or the third party trade reporting agent chosen by the client.
Of course, the chaotic prelude to the introduction of trade reporting, characterised by the fluidity of the regulatory advice on Unique Trade Identifiers (UTIs) and Unique Product Identifiers (UPIs) in particular, provided cover for custodians that had manifestly failed to prepare on time. “At present, most of these global custodians have no workable solution for reporting to trade repositories or adding UTIs and UPIs to those reports for their buy-side clients,” noted one observer in January 2014. The continuing chaos in the aftermath of 12 February 2014 bought custodians further time.
It was certainly curious for custodian banks to argue that regulatory reporting was the responsibility of the manager. After all, they were well-prepared to service end-investor clients that use OTC derivatives. “BNY Mellon places all of our FX transactions for us and will also handle the reporting of these trades to a trade repository,” said one large pension fund shortly before the deadline passed on 12 February 2014. In this case, the total value of the derivative contracts handled by BNY exceeded £1 billion a year, indicating custodians had no choice but to support a high volume client.
Equally, even the most complete outsourcing to a global custodian could not absolve the custodian and the fund manager from some degree of interaction on derivative trades – and both parties were scarcely unaware of the looming deadline, and of the ultimate responsibility of the fund manager for ensuring that the data reported is accurate.
“Even if you have outsourced your back office to a custodian bank, you are probably sharing 20 fields of information with that bank every time you confirm and settle something as simple as an FX trade,” explains Joe Halberstadt, head of FX and derivatives markets at SWIFT. “The European Securities and Markets Authority (ESMA) is asking you for 60 or 80 fields, and the custodian bank cannot report for you without that additional data. Your communication channels with your custodian potentially need to be changed. It is your legal responsibility. You have to reconcile it.”
The truth is that, for all their talk of developing fee-generating regulatory reporting services that span Annex IV of the Alternative Investment Fund Managers Directive (AIFMD) as well as EMIR, most custodians are struggling to convince themselves that they can get paid properly for undertaking this work. Fund managers say the prices they are being quoted by custodians indicate they are not interested in doing the work.
But that may not apply to every manager, not only because some relationships are more valuable than others, but because doing regulatory reporting well entails choosing clients well, since much of the data must come from them.