Your prime broker may be the biggest risk you are failing to manage
“Counterparty risk is not just Lehman risk," says Chris Caruso, a principal in Thomas Murray Pangaea Hedge Fund Services (TMP HFS). "Of course fund managers must take insolvency risk seriously, but what really matters is what we call 'continuum risk.' We review on behalf of managers a broad range issues that can disrupt the business of a hedge fund, including issues that are specific to the bi-lateral relationship between the fund and the prime broker. What you do not know can hurt you, especially in this environment, when regulation is having a massive effect on prime brokers. Just like you should know your investors, because they are providing capital to your firm, you should know your prime brokers, how you stand with them, and how they operate, because they are providing finance and other services to your firm.”
TMP HFS, the product of a partnership between post-trade consultants Thomas Murray Investor Data Services (TM IDS) and Pangaea Business Solutions (Pangaea), aims to help fund managers do exactly that. Their joint product uses TM IDS technology to develop the standardized reviews of prime brokers as counterparties that Chris Caruso set up Pangaea to provide after leaving the prime services group at Deutsche Bank in 2012. “In the wake of a financial crisis, we saw a number of clients – particularly the larger firms – come in to review the bank as a financing and a risk counterparty, but the process was not standardized,” recalls Caruso. “They just asked a large number of questions across a broad range of topics. I launched Pangaea because I saw it was a process that could benefit from structure and standardization.”
The Pangaea process did focus on standardized rather than customer-specific or prime broker-specific questions. They covered funding, asset protection, risk management, regulation, client profitability, technology, data security and derivatives clearing. The methodology has not changed much since becoming part of TM HFS. In fact, the real changes is the substitution of a manual process based on narrative answers in a Word document to a rigorous on-line process based on a Thomas Murray request for proposal technology called RFX Hub. It swaps narrative answers for structured questions that permit analysis and comparison. "With RFX Hub, we are able to encourage the respondent to answer the question the way we want it answered," explains Caruso.
He adds that the technology make it easier to refresh the information gleaned in the prime broker review process. "Prime broker reviews, like any counterparty review, only really work if you carry on doing it," explains Caruso. "You need an annual refresh of all the data. We think we know the answer to a lot of the questions we ask, but we need to update the information regularly." Doing that manually is an onerous process, but the RFX Hub technology made it easy to automate. Thomas Murray uses RFX Hub for a variety of purposes but, as luck would have it, last year developed a service for its existing custodian bank client base to collect data from prime brokers.
The reason was regulatory. Thomas Murray has limited penetration of the hedge fund industry, but strong relationships with custodian banks. As they were appointed as depositary banks by fund managers under the Alternative Investment Managers Directive (AIFMD), the custodians needed reassurance on encumbered assets held by prime brokers, which act in effect as sub-custodians to the depositary banks. So Thomas Murray had already developed a questionnaire for prime brokers which addressed the consequent asset safety issues.
The fit with what Pangaea was doing became obvious as soon as Chris Caruso met Janet Wynn, director of business development at Thomas Murray Investor Data Services in New York. "It immediately became apparent to me that this was a much more powerful way to administer the reviews," says Caruso. "With RFX Hub, there is a lot more opportunity to ask questions in a structured fashion that would be more efficient for the prime brokers and allow us to do more with the responses in the review process as well. The earlier version took a much more narrative approach. The increased capacity enables us to scale the product, and reach more of the prime brokers."
Scalability applies only to the data-gathering stage of a review – the analysis and reporting back to the fund managers can only be conducted by knowledgeable individuals, whose time costs money – but RFX Hub does mean the overall price of the product is affordable for small to medium sized managers which lack in-house capacity. This reflects the fact that the complexity of the analysis and report is a function of the number of questions and the number of prime brokers, and smaller firms need to ask fewer questions of a smaller number of prime brokers.
Price matters because, unlike sub-custodian risk under AIFMD, there is no clear regulatory driver behind prime broker reviews. Although the growing official focus on cyber-security in the United States is not unhelpful - the Securities and Exchange Commission (SEC) is running spot checks on fund managers on the adequacy of their cyber-security policies and controls, prompting managers to press prime brokers on the issue – there is no obligation to run formal tests. “Managers are naturally consumed by the things they have to do,” says Caruso. “While every manager we speak to agrees that it is good thing to do, they do not have to do a prime broker review. If they can do it at 5 per cent of the cost they could do it themselves, it make sense.”
A further advantage of RFX Hub is that it allows fund managers to store and re-use their answers with investors. The same will I theory apply to prime brokers. Naturally, such a novel service has yet to become an integral part of the relationship between the firm and the prime brokers –prime brokers currently use the system only when a client or potential client triggers a review – but TMP HFS has demonstrated the system to every prime broker in the market and secured a favourable response. It is tempered only by occasional questions about where the data they submit will be held, and how securely. "We were keen to brief the prime brokers before doing our first review with them on the system," says Caruso. "It was a sound strategy. It means we are unlikely to encounter resistance when we have a live client."
In fact, at least one prime broker has already proposed using RFX Hub to pre-load and store its data so that it is readily available whenever a client asks to see it. "Some prime brokers already have their own databases," says Janet Wynn. "One idea is to create a data repository that the prime brokers would undertake to update and maintain. Some of the information is financial, and so it has to be updated quarterly anyway." Caruso adds that “when prime brokers see the product, they can think of a lot of other uses for the information.”
Pangaea has data about prime brokers already, of course, buts its unstructured narrative format makes it difficult to key the existing data into RFX Hub. TM is using the system to capture data for current clients, and the firm is also talking to prime brokers about loading the information from their most recent Pangaea reviews into RFX Hub. Some of the data is only six to nine months old, and would save prime brokers work entering unchanged information when the next review takes place. "But generally we will be loading data when we get clients going to review," says Caruso.
As data accumulates, there is one obvious use to which it can be turned: benchmarking prime brokers. Chris Caruso says a number of prime brokers have declared an interest in a benchmarking service, which would enable them to compare their stance on counterparty management issues with their competitors. They might even be prepared to pay for it, if it enabled them to benchmark expenditure in areas such as technology and headcount.
Another obvious application of the service is investor due diligence. “Investors want to see best practice in all areas of the managers they invest in,” says Chris Caruso. “Checking, on a regular basis, all of your service providers across broad range of topics, is a best practice. Of course, managers think they know the answers to most of the questions they ask, but they need to refresh he information on regular basis.”
When he launched Pangaea, this was being done by the largest managers only, because only they had the budgets and the staff to do it, and even they were doing it inconsistently. TMP HFS reckons it provides a commercially viable means of spreading the practice to mid-sized and smaller managers, and doing it in standardized way. “To do something like this yourself would take weeks and, if you ever got around to doing it, you probably would not do it next year,” says Caruso. “There are capacity issue at mid-sized firms. We are selling capacity, on an outsourced basis, to help managers do something they should be doing.”
An investor due diligence service of this kind can help prime brokers as well as fund managers. At present, investors in hedge funds are inundating prime brokers with due diligence questionnaires from their investors. “Investors want to see an institutional firm, that is operating to best practice in the industry, and I know from my own experience that these due diligence requests come in multiple times a week,” says Caruso. “Answering them is a potential use of the product once we are up and running and have a sufficient mass of data.”
In the end, however, the success of TMP HFS will hinge not on the data it accumulates from the questionnaires it distributes, but on the quality of its analysis and advice and its ability to create time for its clients. Guides to best practice in prime broker selection, and even RFP templates, are available from both the Managed Funds Association (MFA) and the Alternative Investment Management Association (AIMA). Fund managers already know what questions to ask, and lack only the time and capacity to ask them. “My original plan was to write a book, and keep selling the book,” says Caruso. “Then I realized that I was completely missing the point."