Counterparty risk is defined by the UK’s Financial Services Authority (FSA) as the risk that a counterparty to a transaction could default before the final settlement of the transaction’s cash flows. An economic loss would occur if the transaction or portfolio of transactions with the counterparty has a positive economic value at the time of the default.
Looking at the example of a homeowner hiring a contractor, it is considered good practice to obtain references and otherwise complete due diligence as a natural part of the decision making process, to reduce the chance of default risk by the contractor. However when we approach a large bank often this step might not be considered necessary, as we may trust that this entity adheres to regulatory requirements which are designed to ensure the stability of such institutions. As there is no real-time way to monitor the balance sheets of key counterparties, hedge fund managers are often left with finding other alternatives to protect themselves from the fallout when one of their financial counterparties has a meltdown or otherwise does not live up to its contractual obligations.
Learning from Failure
Counterparty risk is a challenge faced by all players in the financial industry. Pre-2008, banks believed that hedge funds were one of the greatest sources of counterparty risk. However, in 2008 when Bear Sterns was rescued by JP Morgan and then Lehman Brothers Holdings Corp (‘Lehman’s’) collapsed, it became clear that the risk could be reversed, and banks have the potential to pose a major risk to hedge funds. When Lehman’s folded in September 2008, many funds were frozen with trades they couldn’t close and therefore resorted to invoking side pocket and gate provisions in order to manage liquidity. In the four years since then, managing counterparty risk has become a critical component of hedge fund operations.
Lehman’s was not necessarily an isolated case; demonstrated by the recent downfall of US brokerage firm MF Global in late 2011, which has been attributed to exposure to Eurozone debt, as well as the common industry practice of re-hypothecation. Hypothecation is the use of collateral to back a debt, and brokers often use collateral which has been deposited by clients to back their own proprietary trades and borrowings (re-hypothecation), a practice which is perfectly legal in the US and UK. According to an article by leading US law firm Crow & Associates, legislation in these jurisdictions also appears to allow this collateral to be re-hypothecated more than once, and often brokers end up re-hypothecating assets several times, known as ‘churning’ .
In the MF Global case, an estimated $1.2billion in customer funds disappeared, and the firm’s CEO Jon Corzine testified that he did not know what happened to these funds. Speculators have suggested that the fact that MF Global used re-hypothecated collateral to invest in repurchase agreements in large sums of Eurozone debt resulted in this loss of funds. Hedge funds once again took a hit when this happened, despite the major efforts by global governments to control the risks taken by financial institutions. As a consequence, whether it’s a Wall Street investment bank, or a Canary Wharf prime broker, alternative asset managers need to limit their counterparty risk effectively.
Worldwide, governments are currently attempting to address the systemic risk posed within financial markets. There have been calls for the separation of investment and commercial banking, after the Glass-Steagall Act was repealed in 1999. (Glass-Steagall was enacted in 1933 as a reaction to the Great Depression in the 1930s.) There are arguments which suggest that the risks taken in securities lending should be completely separated from commercial bank customers’ funds. US law currently requires a financial institution to limit its exposure to a single entity to less than 25%. However as the US ushers in regulation to prevent another financial crisis through the Dodd-Frank act, the Federal Reserve now proposes that large, important institutions limit their exposure to single entities to 10%.
The FSA in the UK has also recently issued guidelines including frameworks and procedures to mitigate counterparty risk which apply to smaller financial entities as well as large institutions. Specifically, these guidelines are aimed at central counterparties (an entity that interposes itself between the two counterparties to a transaction, becoming the buyer to every seller and the seller to every buyer i.e. prime brokers). For fund managers, it is important to understand if their prime brokers adhere to these, or similar, guidelines.
In Europe, a legislative proposal has also been submitted by the European Commission on derivative transactions and central counterparties (CCPs). The European Market Infrastructure Regulation (EMIR) states that ‘a CCP’s main purpose is to manage the risk that could arise if one counterparty is not able to make the required payments when they are due i.e. defaults on the deal’. EMIR’s proposed legislation aims to render the OTC derivatives market more transparent in order to facilitate credit and operational risk management. The proposal states that there will be thresholds which will exempt some CCPs from the legislation but details are yet to be released.
Additionally, the Committee on Payment and Settlement Systems and Technical Committee of the International Organisation of Securities Commissions (CPSS-IOSCO) issued a report in early June 2012 which outlines high international standards for derivatives market intermediaries. These standards relate to prime brokers, enabling them to manage counterparty risk, limit the risk of fraudulent behaviour, and mitigate systemic risk in the OTC derivatives market.
Implications for Fund Managers
The monitoring of counterparty risk is an on-going process with a growing field of service providers offering various solutions, and choosing the right broker and service providers are key steps to managing risk exposure. Best practices for proactively managing counterparty risk include ensuring robust internal procedures relating to portfolio and risk assessment, formalizing outsourcing procedures and the use of portfolio management systems, separating banking services from the brokerage relationship and using a recognised and regulated third party which is independent from the financial counterparty for the fund’s administration. In much the same way that independent directors provide confidence and oversight of the fund, an arm’s length third party administrator can help to ensure the accuracy of reporting for the manager by offering independent daily trade reconciliation, monitoring and review of the processes during the period,
as well as independent calculation of the fund’s Net Asset Value (NAV), thus reducing risk and increasing shareholder comfort and confidence.
The fact that institutional investors now dominate the hedge fund market means that investor demands are becoming increasingly sophisticated. This is a global trend seen in developed nations as well as emerging economy regions such as Latin America and the Middle East. The various media reports on the risk of fraud as a result of lack of financial transparency have urged investors to look for information on where assets are held, thus the fund manager needs to be able to provide clear information on the fund’s custodian, sub-custodian, brokers and bankers. The agreements with these counterparties will outline this information, as well as procedures in the event of a credit default and therefore should be scrutinised carefully before such contracts are executed.
When choosing a custodian or a prime broker, it is extremely helpful to take advantage of an experienced industry service provider who can assist with introductions to the relevant providers, as well as provide input with regard to which providers are strong in a particular area or in relation to a particular investment strategy. Third party independent administrators with no ties to a financial institution can assist in this regard. They will have experience with a wide array of global financial firms, and are generally happy to work with any institution that a client brings to the table. Equally, they can provide introductions to a choice of industry service providers with whom they work on an on-going basis. Likewise introductions/references from industry peers can be very useful and should be utilised.
Employing more than one broker and banker is an effective way to diversify and minimize exposure to any one institution; however one’s fund size may limit one’s ability to undertake multiple relationships and with fewer creditworthy institutions to choose from, the overall risk remains an issue. If a manager’s fund is large enough, they can use such a multi-prime model, contracting more than one prime broker, although they must be aware that this will increase the complexity of the middle and back office operations of a fund. In order to help manage this complexity efficiently, a third party fund administrator can provide a high level of experience, automated processes and coordination of the disparate data repositories. This is provided while helping to monitor exposures from a risk management perspective and ensuring cost efficient service, as well as accurate real-time reporting.
One operational mechanism which can be used to protect a fund manager’s assets is the use of segregated accounts. Subject to size the of Assets under Management etc, the manager may be in a position to negotiate terms whereby the fund’s assets are held in accounts which are segregated from the general assets of the relevant institution and thus not available for re-hypothecation. An alternative, but related tactic that fund managers have been using to manage counterparty risk in a prime broker is the use of ‘amber terms’. These terms state that if a broker’s credit default swap (CDS) spread goes beyond a certain point, the unaffected assets are moved to a separate account as a precaution. Amber terms should be written into a prime broker agreement, and a fund manager can formulate the terms by carrying out due diligence on a prime broker and evaluating its exposure to various markets, industries and regions.
In a world where counterparty risk is widespread and seemingly, increasing by the day, fund managers have some options available in order to limit counterparty risk. These include diversification of counterparties
(where possible), industry referrals and references, service provider due diligence and defined risk avoidance procedures.
There is no panacea from counterparty risk in today’s world. A recent example is the story of PFG Best, the US futures broker which was revealed to be holding $5million in a bank account which it had stated held $225million. This missing $200million was concealed, whereby the broker forged documents which it sent to the National Futures Association. PFG Best holds less than a tenth in assets of what MF Global held but it serves as reinforcement that counterparty risk continues to be an issue. What serves as an even greater warning was when credit ratings agency Moody’s downgraded 15 of the world largest banks in June. Moody’s has effectively downgraded the credit worthiness of the entire financial industry, highlighting the risky times we live in. The old approach of ‘banks are safe as houses’ is no longer acceptable and duly diligent monitoring of all relevant counterparties is unfortunately a sign of the times and an issue that all fund managers need to address.
COVID-19 and PCL property – a market on the rise?
By Alpa Bhakta, CEO of Butterfield Mortgages Limited
Over the last five years, demand for prime central London (PCL) property has been fairly inconsistent. Sudden peaks in interest from buyers could be followed by periods of stagnate price growth. Nonetheless, the advantages of PCL property investment, particularly by international investors, has remained well known.
Well-funded development and neighbourhood re-generation schemes, alongside an influx of overseas investment, has resulted in a vibrant market with a diverse range of opportunities for prospective buyers.
Nonetheless, the PCL market has not been immune to the impact of the COVID-19 pandemic. During the first half of the year, the lockdown meant physical valuations and onsite inspections could not take place. People in the UK were also discouraged from moving properties unless they found themselves in extreme circumstances.
However, as we now enter the final weeks of 2020, I believe there’re plenty of reasons to be optimistic about the future prospects of the PCL property market. Buyer demand has resulted in a new wave of activity, and this is resulting in significant house price growth. Indeed, it was recently revealed by Halifax that the average rate of house price growth in November was at a four-year high.
Obviously, there are multiple factors that have helped sustain this strong level of house price growth. Most notably, the Stamp Duty Land Tax (SDLT) holiday has succeeded in coaxing buyers back to the property market––be they seasoned buy-to-let (BTL) investors or first-time buyers––by offering up to £15,000 in tax savings on any given property purchase.
However, it’s worth considering the other factors underway in London’s property market. With the UK in a second national lockdown, many investors will be keen on hedging against future COVID-imbued market uncertainty through acquiring safe-haven assets like British property. As you’ll read below, this is having a positive impact on the PCL market.
Investors are flocking to PCL opportunities
The PCL property market has managed to be one of the most active areas of the UK’s real estate market during the whole of 2020. When discussing why this is so, we must first begin by understanding the behaviours of overseas buyers.
Given that international investors represented over half (55%) of all the PCL property purchases recorded in the second half of 2019, anything to further incentivise or dissuade such foreign actors would hugely impact PCL property transaction figures.
Earlier in the year, alongside the announcement of the aforementioned SDLT holiday, UK Chancellor Rishi Sunak indeed announced that he would be implementing 2% SDLT surcharge for non-UK based buyers of British property from April 2021 onwards.
So, for those seeking properties worth over £5 million in the UK capital, a 2% additional cost may represent a substantial amount of wealth. To avoid this, many overseas buyers who may have been contemplating a PCL property acquisition have rushed to buy such properties before this surcharge is applicable. This trend will undoubtedly continue until 1 April, 2021.
Remote working and PCL
On the topic of the PCL market’s future, many property speculators were concerned earlier this year that London’s property market would potentially collapse entirely as a result of remote working. With homeworking set to remain the norm for the foreseeable future, commentators predicted that professionals would escape the capital en-masse in favour of roomier, cheaper properties farther from their London employer’s offices.
While there have been some signs of shifting demand from urban London neighbourhoods to suburban ones, according to Rightmove statistics, there has been no recordable effect on the UK’s property market as a result.
Conversely, property specialists Savills have actually discovered that over half of all transactions including properties worth more than £5 million in the UK this year were all located in just five central London postcodes.
A busy few months
Given the performance of the PCL property sector in 2020, I only foresee this market growing stronger and stronger in the years ahead. Recent developments in the production of COVID-19 vaccine have many hoping that we may return to normality by Spring 2021, which would represent fantastic news for those involved in bricks and mortar, should it transpire.
In the coming months, I anticipate a surge in activity across the PCL market as buyers look to take advantage of the tax breaks on offer. As such, it will be important that these buyers have access to the financing needed to complete these transactions quickly. If not, there is a risk any purchase they attempt might be concluded in April 2021 when the current tax breaks in place are removed.
Overall, I cannot help but be impressed by the performance of the property market more generally during the pandemic. Having experienced slow growth in the years following the EU referendum in June 2016, it is clear that buyers are eager to take advantage of the opportunities on offer. This is particularly true when it comes to PCL property.
An outlook on equities and bonds
By Rupert Thompson, Chief Investment Officer at Kingswood
The equity market rally paused last week with global equities little changed in local currency terms. Even so, this still leaves markets up a hefty 10% so far this month with UK equities gaining as much as 14%.
The November rally started with the US election results but gathered momentum with the recent very encouraging vaccine news. This continued today with the AstraZeneca/Oxford vaccine proving to be up to 90% effective in preventing Covid infections. This is slightly below the 95% efficacy of the Pfizer and Moderna vaccines already reported but this one has the advantage of not needing to be stored at ultra-cold temperatures. One or more of these vaccines now looks very likely to start being rolled out within a few weeks.
Of course, these vaccines will do little to halt the current surge in infections. Cases may now be starting to moderate in the UK and some countries in Europe but the trend remains sharply upwards in the US. The damage lockdowns are doing to the recovery was highlighted today with the news that business confidence in the UK and Europe fell back into recessionary territory in November.
Markets, however, are likely to continue to look through this weakness to the prospect of a strong global recovery next year. While equities may have little additional upside near term, they should see further significant gains next year. Their current high valuations should be supported by the very low level of interest rates, leaving a rebound in earnings to drive markets higher.
Prospective returns over the coming year look markedly higher for equities than for bonds, where return prospects are very limited. As for the downside risks for equities, they appear much reduced with the recent vaccine news and central banks making it clear they are still intent on doing all they can to support growth.
Both factors mean we have taken the decision to increase our equity exposure. While our portfolios already have significant allocations to equities and have benefited from the rally in recent months, we are now moving our allocations into line with the levels we would expect to hold over the long term.
Our new equity allocations will be focused on the ‘value’ areas of the market. The last few weeks have seen a significant rotation out of expensive high ‘growth’ sectors such as technology into cheaper and more cyclical areas such as financials, materials and industrials. Similarly, countries and regions, such as the UK which look particularly cheap, have fared well just recently.
We think this rotation has further to run and will be adding to our UK exposure. This does not mean we have suddenly become converts to Boris’s rose-tinted post-Brexit view of the UK’s economic prospects. Instead, this more favourable backdrop for cheap markets is likely to favour the UK.
We will also be adding to US equities. Again, this does not represent a change in our longstanding caution on the US market overall due to its high valuation. Rather, we will be investing in the cheaper areas of the US which have significant catch-up potential.
We are also making a change to our Asia ex Japan equity holdings. We will be focusing some of this exposure on China which we believe deserves a specific allocation due to the strong performance of late of that economy and the sheer size of the Chinese equity market.
On the fixed income side, we will be reducing our allocation to short maturity high quality UK corporate bonds, where return prospects look particularly limited. We are also taking the opportunity to add an allocation to inflation-linked bonds in our lower risk, fixed income heavy, portfolios. These have little protection against a rise in inflation unlike our higher risk portfolios, which are protected through their equity holdings.
Optimising tax reclaim through tech: What wealth managers need to know in trying times
By Christophe Lapaire, Head Advanced Tax Services, Swiss Stock Exchange
This has been a year of trials: first, a global pandemic and, now, many countries facing the very real possibility of a recession. For investors, private banks, and wealth managers, these tumultuous times have manifested largely in asset price volatility, ultra-low interest rates and uncertainty about when things may level out, as well as questions about what can be done to safeguard portfolio performance.
The answer here lies within identifying and creating efficiencies to maximise performance and minimise cost, and while there is a slew of options as to how to do this, they are often siloed or have a single USP. Tax optimisation, on the other hand, provides benefits to all, not just in increasing returns for investors, but also in creating economies of scale across stakeholders, creating millions – if not billions – in savings for banks.
Evolving tax reclaim
The tax reclaim process used to be a tedious one banks had to manage themselves, and required detailed, industry and country-specific knowledge to stay on top of constantly shifting requirements and regulations. And when we consider that many countries – such as the UK – allow for capital gains exemptions, tax optimisation may not seem like an integral part of the process. However, this isn’t the case for all countries, and can lead to severe after-tax implications on global portfolios.
Furthermore, even if you’re able to avoid double taxation, getting the money back is not always as simple as it sounds. This, combined with the fact that countries often have contradictory taxation rules or requirements, makes navigating the tax reclaim space a challenge even for those with the right expertise and experience.
Ultimately, providing tax optimisation to investors ends up being a heavy lift for private banks and wealth managers, who often don’t have the right solutions, are relying on outdated technology and manual processes. While this is generally fine for business, it is no longer fit for the purpose when it comes to tax optimisation. To date, knowledge and expertise have been the key to protecting and maintaining profitable investments and avoiding tax leakage. However, through tax optimisation services starting to emerge, portfolio managers can now manage and reinvest easily.
Today, technology has evolved the process so that banks are able to access and submit tax reclaim – and the relevant documentation – online, leaving the tech provider to coordinate next steps with custodians and tax authorities behind the scenes. In essence, taking the legwork out of the process while assuring consistency and completeness in execution.
Simplifying tax through tech
While tax optimisation may seem like an easy choice in theory, it is not always the go-to for every private bank or wealth manager. Without the right supports and setup, including innovative technologies and automation, tax reporting must be done manually, leading to labour intensive processes and huge time wastage. Changing these processes can be overwhelming for those used to a certain way of operating.
By making tax reclaim digital, banks will be more able to optimise returns and gain efficiencies while reducing redundancies and unnecessary complexities. Cloud based solutions or platforms can offer a safe and secure solution for banks, wealth managers, and investors to access and submit any information required, processing the data automatically for conformity and completeness.
It is critical that providers who intend to offer tax services are able to do so efficiently with the right software and data processing capabilities. Not only does this drive continuity in service and efficiencies in process, but it is the only sustainable way to handle such a complex landscape sustainably without wasting time or money.
End-to-end, technologically driven tax services offer a huge number of advantages to private banks and wealth managers, the most important of which is the ability to provide continuity through tumultuous times. As we move through the end of 2020 into 2021 this will only be increasingly important as banks, managers and investors look to provide new services to clients and strengthen existing relationships in a difficult market.
As investors seek to find returns amid the global economic downturn, the demand for innovative solutions will only increase. Technology like cloud-based software, AI, and data optimisation can all serve to improve not just the tax reclaim processes, but the overall client experience within capital markets. Private banks and wealth managers are suitably equipped to provide these innovative solutions, but those who do not prepare themselves effectively and keep ahead of trends will run the risk of losing current and new clients to someone who can offer more for less.
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