Time to think about sub-custody risk
Among the many risks fund managers are too busy to monitor is sub-custody risk. Yet any manager who trades or invests in foreign securities markets is dependent on the financial stability as well as the operational calibre of the sub-custodian banks used by their prime broker to clear, settle and safe-keep securities in those markets. The average network of sub-custodian banks will usually run to at least 100 countries. In some of those countries, the choice of banks will not be wide or reassuring, and investment banks are unlikely to advise a buy-side client against a transaction on grounds of operational or counter-party risk.
This worrying thought recurred as I perused a list of markets, prepared by Thomas Murray Data Services, in which local regulation allow banks to operate omnibus accounts. According to the list, 70 out of the 101 markets listed allow the use of omnibus accounts. Since the exceptions – oddly enough – are all emerging markets, it follows that the vast majority of the assets held in foreign jurisdictions by value are held in omnibus accounts. These allow banks to commingle assets in a single account, in the name of the bank rather than the client. Greatly favoured by banks as operationally convenient, they are also rich in temptation.
A manager trading government bonds in a market where omnibus accounts are permitted will be long and short. Under the prime brokerage agreement, the prime broker will hold the long assets as collateral for funding the short positions. Since even now the majority of prime brokerage agreements give the prime broker full rights of re-hypothecation, it is not unthinkable that the better class of assets will be pledged to fund the prime broker, and be replaced by lower quality assets that cannot be funded at the finest rates or even at all. After all, amid predictions of a global collateral shortage, a rising appetite for collateral can certainly be satisfied by this means.
Indeed, multi-market collateral management services of the type agreed between Clearstream and Euroclear and BNP Paribas and Citi – two of the largest sub-custodian networks in the world – are designed precisely to make it easier for banks to use assets held in local markets in tri-party securities financing transactions. It is a longstanding gripe of the investment banks that they could not mobilise collateral trapped in local markets because of infrastructural shortcomings.
Most fund managers will not know which sub-custodian banks their prime broker is using in every market where the fund is active. Indeed, one of the many purposes of our proposed COOConnect RFI database – if you have not completed our petition in favour of the prime brokers and hedge fund administrators completing the questionnaire yet please do so by clicking here - is to correct that lack of knowledge. Yet if the sub-custodian fails, fund managers are not indemnified against the loss of their assets by the prime broker, as some were dismayed to find in a case as close to home as Iceland. If and when it happens, assets are likely to fall into a winding up process in a local jurisdiction that may make the Lehman International default look tame and rapid by comparison.
So what is a fund manager to do? Asking the right questions of the prime broker is the starting point. First, establish whether assets in custody with the prime broker are held at the sub-custodian level in an omnibus account or a segregated account in the name of the client (just because omnibus accounts are permitted does not mean they have to be used). Secondly, assess what limitations the prime brokerage agreement places on the right of the prime broker to re-hypothecate client assets. Thirdly, if the prime broker is empowered to use client assets for its own purposes, stipulate – or at least find out - what forms of collateral the prime broker posts against the borrowing of the assets of the fund.