Why custodians may not be aware of the risks they are running when acting as brokers for investors in hedge funds.
Liquidity emerged as a major risk for hedge fund investors during the 2008 credit crisis, but it remains a major source of risk for custodians of alternative assets. Again, it is worth comparing the risks posed by alternative assets against those of more traditional securities.
In the world of normal trading, a broker who makes an error can usually rectify it quite speedily. This is because he is trading in a continuous market – the period during which the broker is exposed to his mistake is limited. He might only be at the mercy of price movements for an hour or less. And because systems between counterparties in conventional securities markets are automated, brokers can limit financial losses caused by errors with relative confidence.
Within the alternative investment market, where custodians are acting as brokers for investors in funds, potential errors are magnified because of the time it takes to confirm a trade. Mistakes in orders are uncovered in the reconciliation process, but it can take days before a counterparty will issue a trade confirmation.
Consider then the situation a custodian faces once an error in an order is discovered, for example when a sell order is confused as a buy order. Because shares in hedge funds are so illiquid, it can prove very difficult to have a mistake resolved, particularly as the custodian bank is dealing in a principal market – i.e. the fund is creating the security for the investor.
Funds have very little leeway to address errors, particularly since corporate governance might prohibit them from favouring a specific investor. Redemption terms can mean a trade will not be resolved for six or even 12 months, during which time the price of a fund will change with little or no scope to hedge it.
Custodians participating in the market for alternative funds are not being rewarded for the liquidity risks they are taking on a daily basis. Once such risks are fully understood, many banks may decide that it is not worth the slim rewards they earn. Custodians have improved the language used in agreements with clients as they have started to wake up to the liabilities they face, but another solution would be the introduction of electronic execution, speeding up the trade confirmation process and radically reducing manual errors.
On the other side of the coin, investors may want to use their alternative investments as collateral when raising cash. However, due to the lack of hedge funds’ liquidity, it can often be difficult to discover an accurate price. There is no readily available market data source, requiring significant proprietary effort to procure a recent net asset value (NAV).
Investors will often want to raise cash more quickly than shares in a hedge fund can be redeemed, and the lack of daily or weekly market prices means the lending bank can create significant risk for itself by lending against hard to value assets or assets than themselves can take some time to liquidate (frequently three months or more in the case of many hedge funds). Again, investment in electronic pricing interfaces can ensure more accurate and speedy pricing and support faster decision making.