The hidden dangers of custody

For pension funds, their huge and apparently invulnerable global custodians may look like elegant swans serenely swimming along with no apparent effort. 

But while a swan may seem to move effortlessly, beneath the surface it could be paddling furiously against a prevailing current. In the same way, pension funds may not be aware of what is going on at their custodians most of the time and this can have its dangers.

One danger is that certain custody issues may not be receiving sufficient attention. Another is that custody risk as a whole is not being managed, although the recent shocks to the financial system have caused some pension funds to look again at the security of all the institutions they have dealings with.

On the first point, the issue of failed trades is one potential below the surface disturbance that pension funds may be unaware of. Software and systems vendor Claimatrix's senior consultant Richard Cato said that pension funds may be missing a problem with failed trades. "Many custodians offer contractual settlement to their buy-side clients. Unless a trade fails for a significant period of time, this contractual settlement is not reversed by the custodian," he said "This seemingly incubates the buy-side firm from the cost of carry on a failed trade caused by the end broker. Custodians are not charitable organisations so it is not unreasonable to conclude they have built in the cost of carry into their tariff, a market inefficiency that ultimately impacts the end investor." 

Trading transparency

According to research by Claimatrix, there is a lack of transparency over successful trade settlement rates. "People don't tend to publish their fail rates. Crest used to but no longer does so and neither does the Central Securities Depositary in the US," Cato commented.

In most established markets, settlement rates of up to 99% are claimed by participants, but this masks a less impressive picture under the surface. For example, 2008 statistics from Euroclear showed that settlement rates for some categories of securities are frequently below this. In other, less regulated markets, such as foreign exchange or over the counter derivatives, getting settlement rates is very difficult, making it impossible to judge market efficiency accurately. 

Looking at all markets, Claimatrix conservatively estimated that the average trade fail rate is 5%. Cato said these inefficiencies are not transparent, meaning fund managers and custodians have little incentive to improve their processes and this is costing pension funds. 

However, not everyone shares the view that failed trades are being swept under the carpet. Sonja Spinner, a senior associate at Mercer Sentinel, part of Mercer Investment Consulting said: "We look at the number and value of failed trades when monitoring portfolios and work with clients to resolve any problems quite frequently."

As alluded to earlier, one complication is that pension funds may not have direct exposure to failed trades if their custodians use contractual settlement, something that most global custodians offer and is the norm in major markets. Under contractual settlement, if a custodian sells a bundle of equities on behalf of a client, the trade will be credited to the client's account before settlement actually occurs. Then, if the trade fails in the market for any reason, the trade will still be shown as having occurred as far as the pension fund is concerned, while behind the scenes, the back office staff frantically try to sort out any problems.

But if the trade has not succeeded in, say, three weeks, then it may reverse, which does create a problem for the end investor, because they may no longer have a security which they thought was in their portfolio.

Spinner commented: "You need to understand why trades are failing. Is it because a fund manager can't be bothered to complete an instruction? If so, by using the custody data, we can go and have a conversation with the manager. They might not be as diligent as they could be."

When trades fail persistently, Spinner said that it should ring alarm bells. "I personally think it does matter. It is an operational risk that you are running and at some fund managers, the front office traders are not really interested in what's happening in the back office."

Tim Reucroft, director of research at custody consultants Thomas Murray is less convinced that failed trades are an issue. "It isn't so much of a problem in a lot of markets because of contractual settlement. If a trade fails for two or three days, the custodian will cover the cost of it. If it fails for 60 days, they will tend to unwind it and other mechanisms will kick in. It is not something that should keep pension funds awake at night."

If trades cannot be settled over time, then Reucroft said the custodian should look at whose fault it is. "If the other party is at fault, the custodian should claim against them for the cost of the failure. If it is the custodian's fault, they should pay for it."

However, Cato said that in practice, failed trades may not be adequately policed. He said: "To research events that led to a loss [from a failed trade] is often manually laborious and time-consuming, leading to many questionable stalling tactics. As this process remains almost totally unsupervised by any regulator, industry participants have effectively agreed to ignore these errors in some cases by agreeing cash thresholds beneath which the loss is written off." This means that pension funds could be paying for failed trades that are not the fault of their custodian, but merely because it is too embarrassing for participants to admit to their clients that they have a problem.

He added that a failed trade associated with a corporate event will mean further remedial work is needed, with the end investor eventually picking up the tab in their fees.

Reucroft agreed that in some cases, even individual failed trades could carry a significant cost. "If the cost is just notional interest, it is not likely to be large. But the biggest cost is on proxy voting. If there is a take-over and the vote on it is marginal, if you want your securities back from someone who borrowed them to vote on them, and that trade fails and the take-over doesn't go through, then the cost of compensating for that could be enormous."

Cato added that there are signs that the regulators are starting to wake up to the problem of failed trades, citing the US Treasury Market Practice Group which has introduced a voluntary fine against selling parties in US government bonds that fail to deliver. Similar fines have been called for in the UK, leading Cato to comment: "Perhaps the final investor will be afforded some additional protection from costly incompetence."

While failed trades may be a nasty that pension funds need to address, a more fundamental issue could be custody risk as whole. This has shot up the agenda since the collapse of Lehman Brothers and other scares at major institutions; for pension funds, the idea of the custody bank going down is the stuff of nightmares.

Reucroft said that Thomas Murray has been talking to clients about action points for any future crisis involving a custodian. "There are three levels of trouble. One is if a global custodian is in trouble, another is if one of the sub-custodians in its network got into trouble and a third is if the market itself is in trouble."

Global issues

If the global custodian is in trouble, Reucroft said clients should ensure any cash held at the custodian is withdrawn, any contractual settlements cancelled and any segregated assets moved away, in that order. While segregated assets should be secure, there could be a liquidity problem and recovery may take time, whereas for pooled assets, a pension fund could become an unsecured creditor, which could mean a loss. 

In order to assess the risk levels, Reucroft said trigger points, such as a falling share price should be used, with action taken against them. He added: "You can use the credit default swaps markets as substitute for the rating agencies, as they are completely unreliable these days."

At the sub-custodian level, Reucroft warned that in some markets there may only be a small number of banks acting as sub-custodians, so if they suffered problems, there could be a rush for the door, making it important to have contingency arrangements in place. On the question of whether a global custodian would indemnify clients for any losses at a sub-custodian, Spinner commented: "If the sub-custodian is not an affiliate, then unless the global custodian breached its standard terms of care, it would not be liable for any losses at the sub-custodian."

She added that quite a few clients were asking questions as a result of this, such as where their assets were held and what sort of vehicle they are in, and if it gave any protection. "A lot of clients want to understand how secure their assets are and how the custodian's monitoring its sub-custodian network", Spinner said.

The final level of failure is at the market as a whole and Reucroft said there is not much that can be done in this event. "You want to get your assets out if you can, or try to net off debits and credits. If you are with a big player, they would become a de facto central securities depositary and would net off asset internally with the custodians in the market", he commented.

For pension funds, failed trades and custody risk are two ends of the same spectrum. Both show the importance of keeping an eye on what is happening at a custodian, to ensure that scheme assets are in good hands. Then, like an unruffled swan on a summer's day, the pension fund can glide smoothly forward, because the necessary work is being done out of sight.