Value added is core

Value-added is a much-used term in the securities services business, but it is a definition that quickly becomes redundant as clients come to expect more from their providers. It doesn’t take long for a value-added service to become a core part of a custodian’s standard offerings.

Now, custodians provide a range of services incorporating fund administration and accounting, performance measurement, securities lending, risk analytics and corporate actions processing.

The definition of value added depends not only on the client but also on the provider. The changing definitions reflect the change in the behaviour of custodians’ clients. Institutional investors have become increasingly sophisticated in terms of the investment vehicles they use, and the more sophisticated the instrument, the more complex the servicing of those assets.

The main competition in the custody business is around derivatives processing and pricing, says Daron Pearce, head of relationship management, EMEA, at BNY Mellon Asset Servicing, the recently merged entity of The Bank of New York and Mellon Corporation. “UCITS III allows for greater use of derivatives within portfolios,” he says. “Most of the investment we are making is in this area. In order to price complex instruments, we must pull in data from various sources that are independent of the asset manager and calculate the prices. We are using some very sophisticated technology that we have either bought in or built ourselves.”

Derivatives administration is one of the additional services the bank will provide to Denmark’s largest pension fund ATP, which awarded its mandate to BNY in May this year. Other services in addition to global custody will include trade support and data
management.

The problem with many derivatives is that they are illiquid - they are either not traded very often or are over the counter instruments and therefore it is difficult to fix a price for them in order to properly calculate the net asset value (NAV) of the fund. Derivatives pricing has been targeted by Standard & Poor’s, which is offering valuation services to custodians. “We have done a lot of work with large custodians, many of which don’t have the inhouse expertise in modelling and valuing complex illiquid securities,” says Peter Jones, director of European securities evaluations at Standard & Poor’s Securities Evaluations (SPSE).

Pricing illiquid securities has become a hot topic, says Jones, particularly following the recent problems in the sub-prime mortgage securities in the US.

SPSE provides independent daily valuations for more than 1.1 million global structured finance securities. Valuations are provided across the capital structure, including prices for tranches rated down to BB. SPSE’s methodology combines cash flow analysis and modelling with daily observable market information to deliver valuations for illiquid structured finance
securities.

SPSE has also increased its coverage of US CDOs (collateralised debt obligations), pricing more than 2,200 securities daily. Other areas for growth are US sub-prime issues, where SPSE values over 20,000, as well as UK and European non-conforming deals.

In addition to the 1.1 million global structured finance securities, SPSE offers timely and independent valuations for other asset classes, including high yield, syndicated loans, swaps/swaptions, corporates, governments and US municipals. Five intra-day pricing snapshots for European corporates are also available. In total, SPSE prices more than 2.9 million instruments.

Jones says during the first half of 2007, trade bodies and regulators placed increased scrutiny on how firms, and in particular hedge funds, are valuing the assets they hold. “It is more important than ever that institutions can demonstrate that the OTC and more illiquid securities they employ are being valued in a transparent and frequent manner,” he says.

The S&P valuations are available through a data feed, SPSE MasterFeed, which also includes OTC content from other third-party pricing providers, including Complex Security Valuations and ICAP. The valuations are also distributed through third party distributors such as Thomson ISS, Independent Valuation & Risk Services and Principia.

“Fund administrators have to calculate the NAV, but this is becoming increasingly difficult for illiquid stocks as there is no process in the market to do so. They are struggling to keep up to speed with the market. In the sub prime market you could have valuations that varied widely for the same security. During the past few weeks we have seen several funds wrapped up because the NAV had dropped,” says Jones.

It is too difficult for custodians, which have highly competitive business models, to strike NAVs for every asset class a pension fund will trade, says Jones, so it makes sense for custodians to tap into S&P’s expertise. “We have brought a lot of focus to how to value securities and the different methodologies there are. We’ve built this expertise up over the past 30 years.”

The holy grail of derivatives pricing, says Pearce, is full automation. But that is a long way off. “No one has yet achieved this for the most complex instruments and there is still a degree of manual oversight and review to check for consistency and to spot moves that cannot be justified.”

In June, Northern Trust expanded its services for OTC derivatives trading to include independent valuation of an array of derivatives for its custody, fund administration and investment operations outsourcing clients. An automated solution, it links to third party specialist providers of OTC derivatives valuations and uses a system of tolerance checks to arrive at optimum pricing and performance measurement.

“Independent valuation has become a crucial piece of the derivatives puzzle as institutional investors seek portfolio transparency to meet internal risk and compliance goals, as well as emerging regulation and industry best practices,” says Judson Baker, product manager for derivatives processing related services at Northern Trust. “For our ‘best of breed’ approach, Northern Trust has selected independent pricing firms specialising in a range of swaps and options. Each provider has an extensive history in running market-standard valuation models, and Northern Trust brings them together in a cost-effective solution with coverage across broad product types.”

In addition to independent valuation, Northern Trust’s derivatives processing initiative includes automated collateral management for OTC derivatives trades under International Swaps and Derivatives Association (ISDA) master agreements. The suite of services, integrated with Northern Trust’s global infrastructure, provides end-to-end processing including calculation of exposures, making and receiving of collateral calls, managing collateral according to the terms of the credit support agreement, legal agreement documentation management, reconciliation and settlement.

The provision of value added services is a technology-hungry business and custodians have invested significantly in their platforms. Neeraj Sahai, global head of securities and fund services at Citi, says value added services should be seen in the context of an operational architecture that can incorporate best of breed solutions over a period of time. “One size does not fit all in this industry and we are able to offer solutions that are a good blend of customisation and existing systems, depending on what suits the particular client,” he says.

Sahai points to Citi’s managed accounts service, launched last year, as a good example of a “plug and play” service from a third party provider that was integrated into Citi’s platform. Citi partnered with US securities depository The Depository Trust & Clearing Corporation (DTCC) to introduce the service, which centralises and streamlines the processing of managed accounts - an area that has been growing dramatically in the US and is projected to reach a value of $1.5trn in assets under management by 2011. In addition to investing in new technology and plugging in third party services, Citi has also acquired capabilities where necessary. Its acquisition in May this year of Bisys, a US-based outsourcing service provider for $1.45bn in cash will improve Citi’s fund of fund and mutual fund servicing capabilities as well as its private equity fund
services.

Fund servicing capabilities were also sought by JP Morgan Chase when it acquired Paloma Partners, a US-based, privately-owned investment management group in February last year. The resulting entity, JPMorgan Hedge Fund Services very soon won a mandate to provide middle and back office services for the hedge funds of London-based global asset manager Henderson Global Investors, which comprise 14 hedge funds representing around $2bn of assets.

In June this year, State Street launched an upgraded real estate servicing capability, which includes a range of online performance analytics and risk assessment tools to enable institutional investors to monitor their entire real estate investment portfolios. State Street says real estate investing requires comprehensive monitoring of key assets and portfolios to evaluate risk and make more informed investment decisions.

Citi’s Sahai says the ability to service emerging asset classes is very important for custodians, but attention also should be paid to the underlying architecture. “Customers want us to provide value added services at a cost that is relevant to them. They are seeking out new assets and instruments and want us to service these across the globe. But what they want most of all is a platform that can evolve with them and will not be constrained by being closed ended, leading to any changes taking a long time. Securities services providers must find a balance between providing the features and functions required today in an architecture that can evolve rapidly and meet the changing needs of clients.”

For Pearce at BNY Mellon Asset Servicing, scale is an important factor in the ability to provide value added solutions that are robust and can work across many different clients. He says for pension funds, investment accounting and performance data were once considered value added but are now becoming a standard service. “We are investing to take performance attribution analytics and risk analysis to the next level,” he says. “That will then enable us to compete with more specialist providers.”

It’s not only technology that is needed, however. People are also important and Pearce says it is difficult to find staff, particularly in competitive cities such as London. “People who understand the complex fund accounting issues are in great demand,” he says.