Screen your investors and monitor your custodians and administrators

Categories: 
Regulation
18 Nov, 2013

The Financial Conduct Authority (FCA), the United Kingdom securities market regulator, is warming to its role as the scourge of the fund management industry. In a keynote speech at his own asset management conference on 30 October the FCA chief executive Martin Wheatley warned asset managers that their failure to clean up the way they use client commissions to buy research and other services, and especially corporate access, means “wider reform is now required.”

The inherent conflict of interest in managers spending clients’ money, which was reopened by the predecessor body to the FCA, the Financial Services Authority, in its paper of November 2012, Conflicts of interest between asset managers and their customers: Identifying and mitigating the risks, opens a much wider debate about transaction costs incurred by managers, as a lively COO Connect event in London last month indicated (members can read the transcript and watch the video here).

The dread term “commissions” even found its way into Anti-Money Laundering and Anti-Bribery and Corruption Systems and Controls: Asset Management and Platform Firms (TR13/9), a further broadside unleashed by the FCA a day after its asset management conference. “One firm which used a number of brokers,” reads an approving story included by the regulator in the document, “detailed commission amounts paid and the rationale for broker relationships in a report to its board in 2012.” Here, the concern was commissions paid to intermediaries to introduce investors.

A fund manager does not have to be paranoid to worry that including a reward for successful capital introductions in the calculation of the value paid to a prime broker will be seen by the FCA as ethically problematic.  The infantilisation of business relationships has already proceeded so far that TR13/9 proposes that managers put any gift or entertainment worth more than £50 to a senior manager for approval. It even wants firms to include adherence to “compliance-related objectives” in bonus calculations.

The paper, based on a survey of anti-money laundering (AML) and anti-bribery and corruption (ABC) policies and procedures at 22 firms based in the United Kingdom, accuses asset managers of failing to pay sufficient attention to the risk that they are receiving and managing money which was either laundered or originated in a bribe. It deplores haphazard systems and procedures to monitor AML and ABC, inadequate and incomplete documentation, and palpable lack of interest on the part of senior management (who can blame them?).

But it would be a mistake to ignore TR13/9 as a case of the school creeps, Lear-like, threatening to do such things that they know not yet what they are. A telling anecdote can be found on page 10. “At one firm, a customer due diligence file for a long-standing customer from the Cayman Islands indicated that relevant identification and verification information for two of its trustees had been sought and refreshed one week before our visit,” it reads. “Prior to that, it had not been refreshed for over ten years.”  The story has a serious intent. You have been warned, it implies.

One of the findings – and this applies a fortiori to hedge fund managers – is that  many firms rely on their fund administrators to run AML and ABC checks on investors. But the FCA warns in TR13/9 that checking how well your administrator is doing the job every three years is no longer good enough. “Firms generally need to do more to ensure these arrangements are adequately monitored and controlled,” reads the paper. It advises firms to ensure customer due diligence records are readily available, and to be ready to prove that the work of the outsourcing firm can be relied upon.

In fact, the FCA has something of a downer on outsourcing generally. In December last year the FSA declared itself concerned that fund managers had outsourced so many back and middle office functions that, if their service provider failed, investors’ assets would be put at risk. It issued one of its infamous “Dear CEO” letters asking how fund managers were dealing with that risk. The industry trade body, the Investment Management Association (IMA), published a white paper in May this year listing 11 “ideas” that might help mitigate the outsourcing risk.

The IMA also set up an Outsourcing Working Group of fund managers and custodians to improve “portability” between service providers - in much the same way that derivative positions are ported when a clearing broker fails- through greater standardisation of service level agreements (SLAs), less “sticky” contractual relationships between managers and custodians (which have endeavoured always to trap clients, notably through proprietary technology), the formulation of detailed exit plans and preliminary understandings with back-up providers.

The FCA applauds this work in yet another paper, published last week, entitled Outsourcing in the asset management industry: thematic project findings report. The report, based on an analysis of the outsourcing arrangements of 17 asset managers, reiterates the concern expressed a year ago that managers are not prepared for the failure of their custodian bank. Switching provider, it estimates, could take anywhere from three to 24 months.

The FCA is not convinced managers have retained the people, data and technology to bring operations back in-house. It names reconciliation of assets with custodians, calculation of NAVs by third party fund administrators, collection of entitlements from corporate actions and trade clearing and settlement as areas of particular concern, since errors and omissions in any of these could see investors lose money.

The good news is that the FCA thinks hedge fund managers are not at risk. Those it reviewed “fully replicate the majority of outsourced activities in order to ensure their service provider operates effectively. This would allow those hedge funds to continue servicing their customers uninterrupted should their service provider fail.” Multi-prime brokerage and shadow fund accounting clearly have their uses.

On the other hand, the average hedge fund manager is organisationally simpler than the average institutional money manager. And the gradual extension of custodian bank relationships beyond the safekeeping of unencumbered assets, partly at the behest of institutional investors, is making hedge fund managers more like their institutional cousins. So this issue is likely to rise up the agenda at alternative managers, especially as the depositary requirements of the Alternative Investment Fund Managers Directive (AIFMD) bed down and mature. For now, however, hedge fund managers have quite enough compliance work to be getting on with: regulators never sleep.

Nor do they have a sense of irony. But that should not prevent the rest of us enjoying a joke. The FCA frets in TR13/9 that fund managers are not doing enough to screen investments made by “politically exposed persons” (PEPs). This term is bureaucratic jargon for individuals holding a public office in which they might be tempted to take an emolument in exchange for doing someone a favour. In other words, the public officials that lambast asset managers for a lackadaisical approach to taking tainted money are in some cases a source of that tainted money. Are we missing an invitation here? Perhaps asset managers should consider paying regulators to leave them alone.

 

Dominic Hobson
 

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FCAIMA

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