New world of regulation prompts reassessment

The participants Operations and technology round table, June 2007, Grand Duchy of Luxembourg

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  Pablo Alvarez, head of operations, Allfunds Bank, Madrid
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  Jean-François Fortemps, CEO, Fortis Investments, Luxembourg
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  Gary Janaway, head of operations, Schroders Fund Services, Luxembourg
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  Ivan Nicora, head of investment fund product management, Euroclear, Brussels
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  Frédéric Pérard, head of global fund services, BNP Paribas Securities Services, Luxembourg

Panel Moderator: Yuri Bender, editor-in-chief, Professional Wealth Management, London

Yuri Bender: Our aim is to examine changes for transfer agents, distributors, fund houses and central securities depositories triggered by the new regulatory environment. We will ask how a more open architecture affects technology solutions at banks and fund houses, how transaction processing is responding to demand for more specialised products, and whether we are any nearer to the eventual goal of the mythical, straight-through processing (STP), infrastructural solution. The Ucits III legislation allows use of derivatives in funds, allocations to currency and commodities, plus a new breed of products which includes 130/30 funds. Has the process to register funds and transform product ranges been a smooth one, and how has it changed relationships between fund houses and service providers? Jean-François Fortemps: At the start, we thought the Ucits III story was very good news, with new products, many based on our hedge funds, translated into absolute return products in the Ucits III range. As we distribute products all over Europe, we wanted international registration. At first, we were surprised because normally the rules are clear: you register your fund in Luxembourg; ask for international registration in other countries; then have two months to obtain authorisation to start sales. The reality has been different, since in several countries we had people from the regulatory bodies coming back to us and asking us to explain our product offering. This should not have happened, so it surprised us. So we went to the Luxembourg Commission to ask why. They said this was not normal, but we had two choices: we could take the legal route or the soft route. We took the soft route and discussed with country regulators what we wanted to do, and they explained what they wanted to achieve, which was the protection of the saver. Finally they understood our products were well managed, thought-out and tested, and agreed with what we were trying to do. There has been a round of observation in the industry with these new products, but confidence has now been built. On the commercial side, as we were becoming more international, we had to think about how our client would be welcomed at our transfer agent desk, so we needed to make sure we could speak the languages of our customers, understand their culture and they way they were used to trading in their countries. This has been achieved through training, new hires and a new organisational structure. Regarding the custodian and also the central administration, we needed to increase the technical abilities and professionalism of those teams, because managing long-only funds is plain vanilla to the industry right now. The hedge funds arena is still not plain vanilla and not available everywhere, so we needed to test to verify that they were at the level we wanted. They had a lot of experience in this business since we were already working with them in other, non-Ucits III structures, so it was not that complicated to get to the level we wanted. I can imagine, for other companies not active in hedge funds before Ucits III who wanted to go there, it could have been more complicated. Gary Janaway: Ucits III has changed what we do in a few aspects. Looking at the registration process for EU-wide funds, we were experiencing difficulties in registering new products through prospectus updates. There was confusion in various markets; some were knocking them back with referrals; some were registering them, but very slowly. We got to the stage, perhaps 18 months after the introduction of Ucits III in Luxembourg, where we started to have various versions of our prospectuses with the same product registered in different jurisdictions. A prospectus stamped and certified in June 2005 might have been in force in one of the jurisdictions whereas, actually, faster jurisdictions would have adopted and allowed us to register the prospectus for the same fund, but a September version. Somewhere in between we had the longest delays between the most and least efficient markets at about 9-12 months, which meant we had various versions of documents being registered, records to keep track of what fund could be launched where, what you can promote and what marketing materials you can run off the back of that. It was quite a torrid time; it took a lot of resources, control and put a lot of pressure on communication. That is quite difficult for all the components and players involved in the fund – our administration, servicing and distribution. But there has been considerable improvement since. Across Europe, many regulators have made vast improvements and the timeline is actually much shorter and more effective now. We have got where we want to, with maybe a little further to go, but it feels much better than where we were a year or two back. Frédéric Pérard: Fund groups domicile their Ucits funds in Luxembourg, with the objective of distributing them in as many countries as they can. So Ucits III still requires a global and local operating model, in which we support Spain out of Spain, France out of France and Italy out of Italy, either for regulatory or client servicing reasons, but with global reporting and a global view of the assets for the promoter or distributors. The second aspect is the use of derivatives, where you can see, for example in the UK, a big change. Where you once had equity fund managers, they are now using contracts for difference (CFDs) extensively to support a fund, with large volumes costing a fortune operationally and bringing a fortune back to the asset manager. There is now a limited capacity to support these funds in the industry, not only from our side but also from the counterparty side, because even the investment banking business has difficulties in supporting that development, especially in the UK, where there has been a dramatic change to the industry over the past 18 months. To get there, we need very powerful platforms that were more available to the investment banking business than the securities services business. The key battlefield today is over-the-counter (OTC) derivative capability. The third angle with Ucits III is that open architecture is supporting the distribution side. Originally our clients were fund promoters, whom we were supporting on the distribution side, country by country, according to their own distribution network. Now, more and more, the power is in the hands of distributors, who select their promoters and want global reporting and a global capability to manage commissions, with a global quasi-real time view of what they are distributing. It is the same on the promoters’ side; they want to know in real time who is buying their funds. This has seen a strong adaptation of our services as support for distributors is creating more risk because, instead of receiving very small orders from retail, UK or German investors, we are now receiving bulk orders from distributors, creating more market risk for some firms that nobody is ready to take care of. Some distributors are not well recognised by our risk department; some distributors still have a prehistoric way of doing business. Ultimately, even if you try to bring them into the modern world, they will just take money from promoters without feeling any push to be more modern. Yuri Bender: You talked about what the market needs, but is it also about profitability? If you somehow shift your clientele towards private banks, wealth managers, financial advisers and distributors who want to outsource their services, is that a lot more profitable than working with fund manufacturers? Frédéric Pérard: Private banks are very interesting from two angles. First, they are asking for institutional services and you can cross-sell most of your services to private banks, starting with account holding to execution on funds, equities, derivatives and potentially other types of instruments. They also leave balances, and the custody business is about non-interest expense (NIE) and foreign exchange (FX) more than the transaction business. This is a very nice animal, but is not optimised in terms of processing today. In the countries where retail banks are very strong, nobody knows today who is going to win the battle between independent financial advisers (IFAs) and retail banks. There is a strong view that, for the UK IFA market, you need to be there to support the risk-adjusted performance concept. In other countries, like France for example, IFAs are developing as well. Investors will want to see direct portfolios with investment into pension funds, life insurance contracts and have a consolidated view of their portfolio. That is why they are very interesting clients for us in the future. Yuri Bender: With groups such as Schroders moving from an institutional asset management to a distribution model, what has this meant from an operational point of view, with greater volumes in pooled funds? Gary Janaway: Year-on-year it is not unusual to see growth above 30 per cent, or even 40 per cent plus. We generally have a requirement to build something volume-insensitive that can also work with the different kinds of products coming on board. Even some of our long-only funds almost look like an alternative, with the types of derivatives they have within them, the different instruments they use, the nature by which they are hedged and the offering in various currencies. It is quite a complex beast. The complication comes in the product; the volume is the marketplace. Probably in all markets, there is such a growth in funds, particularly in the brand and the funds that come from Luxembourg, that it is necessary to have consolidation in one form or another in the distribution chain, be it IFAs or private banks. Everybody is looking for service in one form or another and, if you try to service everyone, from the end beneficial owner all the way through a line to the product manager, the demands and the complexity of that would be far too high. We will continue to see consolidation through people and platforms that are distributing, and that will increase growth. We have also moved to a closer relationship with the investment division. With huge amounts of money coming in, the investment managers need to be well informed as and when the flows are is occurring. The relationship between our distribution and investment arms is also much closer, particularly when working on a new product. In the funds world, working in Schroders, we have an infrastructure with funds processing teams sitting very close by the distribution arm on one side and the investment arm on the other. I see that change continuing to get stronger and closer. That is probably the biggest change that I have seen anywhere in the industry over the last 10 years. Yuri Bender: Does this closer co-operation mean the operations team can influence the investment side in areas such as the choice of sub-advisors? They may have a choice of sub-advisors, and think: ‘This lot might have good performance but their processes might not be right. Can we work with those people efficiently?’ Would you then come in and say: ‘We can work with these people but not with those’? Gary Janaway: There might be an element of that. If they wish to do something sub-advisory, they would want to ensure we can do it safely, well and correctly, but they would probably ask us to make that happen and to ensure everything was safe. We would do due diligence on them; we would ensure trading could happen, was properly controlled and monitored; and the risk would be evaluated. They will ask us this as much more of a partnership. When we are working with product teams and investment managers and they are designing a fund, they would give us an idea of what they wish to invest in. You then need to go through the whole process of how you are going to evaluate, price and transact it, with whom, what agreements you have to put in place and what markets it will be distributed in. Some of that takes quite a lot of doing, particularly the design around timing. We will get very close and involved there. It is about getting ready from an operational point of view and saying: “We can support it; you can sell it; and we can distribute it on the other side.” The further you move into different asset classes with complex instruments – the derivative range on exchanges is relatively difficult – like the OTC market, the more you are talking about laborious targets, the more difficult it is to manage. It is very bilateral and the agreements sitting behind the structured deals are quite complex. The life of an instrument, moving away from the transfer agency side where you are looking at accounting or maintaining it, you find that the agreement is that, at a certain point in time, you will either be receiving or paying money. How do you do that with a legal agreement? How do you set this up when it is not a very normal instrument? How are you going to get the right amount of money, value what is coming, make it paid on time and understand what it is for? It is quite a complex world. If you do not get it right, the product will not do what it is meant to do. There is a lot of research and preparation time that needs to go in but, to do that well, you need to have access to the people who are designing it and, ultimately, are going to run it. That close relationship is making it happen and is doing it well, and it cannot happen without that. The whole industry will move that way. Yuri Bender: Frédéric, in your relationships with, for instance, FundQuest at BNP Paribas, would you have any influence on the selection of sub-advisors on the securities services side? Frédéric Pérard: I would say ‘no’ before the fact, and ‘yes’ after the fact. When you select sub-advisors from an asset management perspective, you have to ensure that, by asset class or strategy, you find the right partner with the right track record. On top of that, I am not sure that people on the asset management side so far have been forced into doing it. What is going to change this approach tomorrow is MiFID, because an asset manager needs to be justified and is ultimately responsible for the counterparties he selects or the sub-advisor he selects. That will be part of the due diligence they will do moving forward. When I say ‘after the fact’, that is because it is part of the service review we carry out on a quarterly basis. We do franking of the counterparts we work with. Asset managers do the same with the custodians they use, and we do the same with the sub-advisors we use. Yuri Bender: If we look at the broader move to a more automated, paperless system, should the transformation to STP come from the distributors rather than the fund manufacturers, or from the service and infrastructure providers? Pablo Alvarez: Allfunds is a platform in the middle between distributors and transfer agencies. We are willing to have a very strong relationship with the transfer agency, and of course with distributors, and we are always very focused on STP. In Allfunds Bank, we have a standard protocol we use with many transfer agencies; it is very simple. We selected this protocol because, when we started, there was no standard communication method between distributors and transfer agencies. We decided not to work with faxes because of manual intervention and risk and are now seeing that there are entities creating standards like Swift and ISO 20022 to assist orders without compromising prices. From our point of view, we consider that is not going to cover all the flows needed in the funds market, and does not cover lost of information like corporate actions, legal information, market information and other kinds of information that will not be supported by Swift. Yuri Bender: Is your funds platform competing with FundSettle at Euroclear and the Vestima model? What are the similarities and differences? Pablo Alvarez: We give our distributors custody, settlement services, and orders processing. In this way we are competitive with them. Our business model differs from these kinds of order platforms, because it is based on the distribution side, which means we sign agreements with the fund providers for all clients, give them more services in that sense, because they only have to sign one agreement with Allfunds Bank. When we enter a country, we take care of the needs of distributors who want to adopt our platform and we build a local team to give administration services, like calculation of taxes, reporting to official authorities and so on. As well as IT and operative solutions, Allfunds has a specialist investment consulting team, which studies the funds in a very objective model to give advice to our clients. Often they select funds where we haven’t got rebates or even are not in the platform, so we need to rush to include them. Ivan Nicora: We do indeed need to distinguish between the two approaches. Euroclear’s FundSettle and Vestima are trying to position themselves more as part of the infrastructure for the funds market, focusing on the processing side. The name of the game here is critical mass – offering economies of scale by consolidating volumes. Models like Allfunds, which I consider to be more of a hybrid animal, are completely different in that they include commission negotiation with processing services. The key question the market needs to ask itself is: does it want to go with models that co-mingle the distribution side through the negotiation of commissions with processing – and in effect use distribution to subsidise processing – or are these two completely different aspects? Is that creating value or adding costs? From my perspective, I think it creates more costs than savings as the net result of consolidating business on a platform like Allfunds allows negotiated commissions to surpass operational savings for which the market will pay. The second consideration is connectivity between dist�ributors and manufacturers. I see, day after day at Euroclear, the need for increased transparency for promoters as to who is buying their funds and the other way round. Any model that does not facilitate transparency or visibility will be, over time, a bottleneck or obstacle to growth for the market. That is why a model like Allfunds is creating an issue, because it does not encourage transparency. Allfunds stands in the middle. Pablo Alvarez: When we say we are in the middle, it does not mean we do not give any transparency to the fund providers, because we need to be authorised, by each distributor. In our platform, there is a single access point, but distinguished perfectly well for the distributor and the different countries. The asset manager normally has to ask for information because some transfer agencies do not give them information regarding the clients. In this way we separate different distributors, and give information to each distributor, which is the reason we have hundreds of accounts with different transfer agencies. Otherwise, from an operational point of view, for me it would be great to have a single account in every transfer agency, but we know we are offering services and not selling funds. Every fund promoter sells their own funds. They do marketing activities directly to the client; they know perfectly well who the distributor is and who the key people are within the different distributors, because sometimes we give them that information in order to sell their products. We are offering operational and settlement solutions, as well as a single access point, to simplify the process. We are not creating any costs increase. Our business model is based on volumes, and retrocession of the asset management fees we are not incurring any more costs in the market; it is probably costing less because of efficiency and a single access point. We are guiding operations and they only have one counterparty for very big distributors all over Europe. It is easy to support the client from the client services team, and it is easy to identify what a product can be. We are reducing risks and reducing costs as well. It is not the same receiving thousands of faxes all over Europe and receiving just one file from only one centre. Frédéric Pérard: This industry needs – and the US market has demonstrated this – an infrastructure to connect distributors, promoters and service providers together in the right way. If you take the example of the Luxembourg market, Luxembourg has such a big influence on this that you should start with Luxembourg and other domestic markets, where it is volume- and standards-driven. When you say that Swift cannot support this industry, I am very surprised, because Allfunds is part of the working group at the Swift level. Swift has been doing corporate action mechanisms forever. We need to be careful that we all push in a single direction, which is the point of having distributors around the table, to make this industry commoditised. Commoditisation will bring lower costs. Euroclear is supporting and working on this as well. Ultimately, if it is transaction-driven, it makes the investment worth it. Tomorrow, with MiFID, I will be surprised to see how MiFID looks at the capacity to take a piece of the commission rebate in the middle, which most fund supermarkets are also doing. Most markets are now looking at listing funds on stock exchanges to avoid these kinds of platforms, and basically saying to people: “Forget these complex mechanisms where many people sit in the middle.” Tomorrow, people will want to list funds in the Netherlands and in Germany. Deutsche Bank is buying funds from the transfer agencies and selling them back to the original banks to put them on the stock exchange. In France, the regulators want to push for the listing of funds and execution on the stock exchange as well. Ultimately, it is nothing against Allfunds, but this is pushing for a model that I am not sure fund promoters and distributors would be happy about in the end. We need to be careful about the way it is going. Ivan Nicora: Let’s not look at the issue in isolation. On the surface, models such as Allfunds look great. What Allfunds tells distributors is that it has much stronger commission negotiation power and can squeeze the promoter for more remuneration, which allows distributors to maintain their level of commissions without having to negotiate further. And they get processing for free. Not many fund promoters are happy with this model, as there is serious leveraging taking place to generate massive commissions. That cost is ultimately passed on to the fund, one way or the other. When you take the total costs – the savings that are made on one side from distribution – plus the extra costs that are paid by the fund houses, the equation is negative, which is what I referred to as additional costs. Who pays for that? The distributor has the impression he is benefiting by reducing his costs but, ultimately, the extra costs have an impact on the performance of the fund, forcing the investor to absorb the cost. That is why I think a fundamental question the market should ask itself is whether this model is the right one to ensure future growth. Jean-François Fortemps: As a promoter of funds, what the promoter is ready to pay for is the distribution. He will never pay for the settlement of the funds. He can accept a contribution, but only a small amount, because the real value added is in the distribution model. We are very happy to work with Allfunds and others, because we know they are distributing our funds, because they have selected them, have been active sellers and have brought information to the final clients, who will pay for it. As you know, the distributors are kings of the market and we pay a lot of money to them. The money they are receiving is not for their settlement capabilities. Gary Janaway: The issue we need to address as a whole is how everyone can have access to the industry systems and the automation that provides great service and reduces costs. If we can agree on what we are doing, take out confusion and agree to protocols for how we work, we can reduce the cost of settlement and clearing. There are many areas where money is lost in that world, through inefficiencies, not being bulked, bank charges and lack of clarity around where you are holding cash when it might not be earning interest. All of these are just the leakage of cost and inefficiency that hits the markets and the funds. If you ask anyone how they price their transfer agency services, commercial or internal, there is a fixed cost to doing that. If your running costs operationally are not just driven by your technology spend but your transactional spend, they will be passed on and consumed by whoever is paying for those services. In the Luxembourg model, most of that ultimately goes to and is charged to the fund. If it is someone providing services to a promoter, they are paying but the promoter will have the right to recharge to funds. What we have been trying to do is get as much automation as we can, reduce the costs of the unit price across the spectrum of distribution, from distribution to intermediary, to transfer agent or the fund – whoever is playing in that space – and, at the same time, try to work on the services. The services are the foundation of bringing the information along. If there are some things I like about Allfunds’ model is the advice service for funds, which is very strong; most people would recognise that. In terms of messages at the moment, we talk about deals, confirmations, reconciliations or holdings. They are the first world; the next world will be about more information, and the information that begins to carry will be information on funds – factsheets and performance. If you can use the same carrier, you will reduce the cost again. In a similar manner to how we use the internet, you pay as you go; if you pick it up you reduce the base cost and encourage more and more people on. Then the world will separate between the distribution and the investment worlds, where people will pay for what they are doing rather than trying to make money that is unreasonable in returns for transaction. In between commercial entities and market infrastructures, the biggest problem I am still left with is that I cannot access everyone I want to. No one who has been able to provide those services would be able to do so if it was too costly to get there. The bigger critical mass we get, the less we can change for processing, the more we can reinvest back to open access up to more players, increasing the market as a whole. That is the reason for doing it: we get some benefits from it as an asset manager but, operationally, one of the things I am judged on is greater productivity and managed costs. How do you get there? You have to do that in partnership with a lot of people, and you have to be able to encourage it and put some time in to do so. We are getting a long way already. Europe is emerging well and Asia is now coming on board rapidly. If we are going to have a look at this type of topic in three years’ time, the improvement will be immense. Our eyes should be on where we are going next, and how we are going to use the same infrastructure we have to make it a powerful industry. I include the unit costs of everything we are doing. Ultimately, we can reduce costs even at a fund level, take those management fees down, get a better return for investors, encourage more and become virtuous. Perhaps I’m dreaming, but that is generally why we put the effort into working with other people to make that happen. Yuri Bender: We are all, broadly, of a similar age. Will we see, in our working lifetime, this US Depository Trust and Clearing Corporation (DTCC)-style solution in Europe? Gary Janaway: We will see something similar, but it will not look the same. It will not be one platform owned by one owner; what we will have are common protocols that link them. You might be running through several systems, but you will be doing the same thing, and talking and communicating in the same manner. Your connectivity will probably be the same, but they will be shared by a number of entities. I do not think that we will get some very developed markets that have invested in established clearing and settlement systems to change to look like someone else; therefore, it will be connectivity, use of protocols and communication that will bind them together. Ivan Nicora: This is a high-investment business. The only way for this industry to reach the ‘dream world’ will be through incentives and concentration, with fewer players, because the investment costs are way too high for fragmentation to continue. Connectivity is important because we probably will not end up with just one provider – there will be two or three. As long as there are 10, as there are today, Europe will not excel. Frédéric Pérard: We are about to see the evolution of domestic markets versus the market in Luxembourg. In addition, we are about to see the evolution of another situation in terms of the targeting of securities. If you listen to the European Central Bank, it would be a unique platform. If this happens in the planned timeframe, it should be there. My view is that the Luxembourg market will be important in coming years. If tax harmonisation happens, you may have several positions, but you will have a stronger platform. I think Europe will still be Europe, but it depends on how you define it, since it may be 30 countries in 10 years’ time. I agree with Gary that, for 10 countries, a unique platform might be feasible. If Clearstream merges with Euroclear, it would become a single de facto. However, there is eastern Europe, Asia and the Middle East, so that is the end of it. Within given parameters, yes, we can have have a single system, but taking into account different factors.