By Peter Marcus

Global custodians may do a great job of safekeeping, accounting and performance reporting, but they have not been on the cutting edge of the evolution in risk measurement. Traditionally, their function has been to report on what was in a client’s portfolio and how much it was worth, usually on a monthly basis. Although they were frequently asked to be master record keepers, and even to do risk attribution on certain asset classes, total fund risk reporting was not high on the service menus they offered clients.

Now things are changing. The shock waves resulting from any number of crises—the Barings failure, the Malaysian repatriation laws, the collapse of the Russian ruble—have forced investors to take a closer lookrepatriation laws, the collapse of the Russian ruble—have forced investors to take a closer look at the risks they are exposed to as they venture overseas.

The GOAL is not just delivering DATA, but delivering them in a form that is USABLE. Ralph Vitale State Street Corp.

As a result, investors are asking their custodians for reporting that is more timely, more relevant and that includes more sophisticated analysis of the risks they are exposed to. “Clients tell me, ‘The custody business has changed. Anybody can settle a trade. Now it is information delivery that we expect,’” says Singapore-based Rob Edwards, head of custodial services in emerging markets at Standard Chartered Equitor. “Clients want more analysis—not just details of what is happening in a market, or dangerous scenarios, but what has happened.”

While custodians say they have been talking about risk reporting perhaps as much as or more than any other single service they provide, they are clearly scrambling to improve their reporting on the risks that affect clearance and settlement issues. They now offer a range of services that, while hardly cutting-edge, give their clients more of what they need.

Multiple headaches

The job before custodians is formidable. Risk comes in many flavors in the arcane world of clearance and settlement: the risk of a flood that prevents a courier from delivering paper shares to a registrar; the risk of a government that changes currency repatriation laws (as in Malaysia), making it difficult for investors to get their money out once trades have settled; the risk of a market participant failing and causing a domino effect through the market; and so on.

Then there is the risk of sudden and unwarranted market inflation. Edwards points to Dhaka, Bangladesh, in 1996, when average daily turnover increased by an astounding 1,000 percent and market capitalization jumped by 265 percent over the span of several months. When the price bubble burst late in the year, the market seized, and the local currency, the taka, began to depreciate, causing what Edwards calls a double jeopardy situation: Clients could not sell their shares, the value of which was dropping like a stone, and at the same time, the U.S. dollar value of the shares was also falling rapidly as a result of the depreciation.

Another big headache involves settlement cycles. The longer a trade goes unsettled, the higher the risk on both sides of default. In physical markets, where traded shares are represented by pieces of paper, a settlement is neither electronic nor guaranteed. Shares may be counterfeit, or may not be delivered in time.

In markets such as Jakarta, moreover, there is often a discrepancy between the settlement date and the day on which the clearing house, KSEI in Jakarta’s case, actually releases the shares to the buying broker. In Jakarta, settlement is officially T+4, but the shares are not made available until 9 a.m. on T+5. Trade failures tend to be higher in these markets, and outside market participants must be able to stomach quirky market and regulatory conditions. To make matters worse, central securities depositories, often seen as a panacea for these types of problems, have markedly different ownership and membership profiles, and handle securities quite differently.

The year 2000 bug promises to engender its own share of clearance and settlement problems. It has already forced custodians to look beyond their counterparties to others up and down the trade cycle. A failure in any link of the chain could reverberate through the entire trade cycle and cause repeated trade failures. Implementation of the euro and the ways nonmember markets handle the new currency have also fueled problems in developed and emerging markets.

Single numbers

In an ideal world, all these operational and market risks would be quantified into a single unit and then neatly applied to an investment objective. But reality is nowhere close to that idealized goal. In the world of international investing, for example, one emerging market is typically benchmarked against another, with little attention paid to risks between them. That raises an important question: Do clients have enough information to make investment decisions wisely?

Comparing one market to another becomes a way for clients to understand and consider markets using established benchmarks. How strong, for example, is Pakistan compared with India? While the answer used to depend on specific factors and the characteristics of each market, custodians hope to rate global markets in a way their clients can understand and can work into their investment decisions. Both clients and custodians, however, have continued to struggle with a question: Is there a way to aggregate disparate markets and their unique risks across the entire trade cycle, rate them numerically and then match up countries by rating?

Aggregating the results

Barclays’ answer is the delivery of what Andrea Zulberti, chief fiduciary officer and global risk adviser at Barclays Global Investors calls the “enterprise-wide view of risk: looking at every possible risk across the services Barclays offers its clients.” The goal is to build and refine a holistic risk model that takes into account “everything from the beginning research to the final settlement of a trade.” She notes that while Barclays is working to bring market and operational risks together to create a unified picture of each non-U.S. market a client might be interested in, “clients are still spotty in understanding risk on a holistic basis.”

Clients 101: Low-Tech Risk Reporting

Malaysia stands out as a global investor’s worst nightmare in 1998. “It was a crisis situation that developed from one day to the next,” explains Gillian Van Schaick of Chase Global Investor Services. To keep clients informed, Chase sent a daily report on the state of the market to clients by fax, e-mail or mail every day as events necessitated. But to back up the written reports with a personal touch, it also gave clients access to updates on a daily conference call. Although that hardly ranks as cutting-edge risk reporting, Chase believed that the personal touch of reaching out to clients was critical. “We wanted to offer perspective,” Van Schaick explains, “so we first told our clients what had happened since yesterday’s call, what we thought it meant and what implications it might have on them. Then we allowed our clients to ask questions.” Responses to clients’ questions were provided at the beginning of the next day’s call. Van Schaick says that these calls attracted an average of 75 to 140 clients, and the bank realized this was a successful strategy of information delivery. “In the beginning,” she says, “people thought ‘I’ve got to get my money out.’ But in reality the stock market was continuing.” —P.M.

To make the information her firm provides truly useful, she says, clients need to be able to aggregate information from different custodial accounts in a meaningful way. Most, however, are unable to do so. Gillian Van Schaick, product manager for network management at Chase Global Investor Services, notes that her bank also tries to find out whether clients are capable of doing their own stress-testing on portfolios, and whether they are capable of consolidating aggregate exposures when they use multiple custodian banks. But Van Schaick concedes that when it comes to overall risk, “some clients focus on it more than others.”

Clients are still SPOTTY in understanding risk on a HOLISTIC basis. Andrea Zulberti Barclays Global Investors

Maarten Nederlof, managing director at Deutsche Bank Securities, explains that the problem becomes particularly acute when one considers that funds typically employ numerous external money managers. “Given that those managers are frequently the most knowledgeable about the risks they are taking, they become the obvious sources for risk reports. Reconciling the patchwork of reports with the risk view provided by the custodian is a real challenge.”

Ralph Vitale, executive vice president and head of global securities lending at State Street Corp., notes another important issue: there is no agreed-upon definition of timeliness. Monthly might be too late for one client, while hourly might be too late for another. By the time the client gathers information from several sources, compiles it in complex software programs and then generates reports against those compilations, a market opportunity may have been lost. “Clients have a great thirst for usable information, but the goal is not just delivering those data to them, but delivering them in a form that is usable,” says Vitale.

How should large pension funds, for example, reconcile risk reports from their network of custodian banks with reports from investment managers and custodians? That responsibility falls squarely on the client, not the custodian bank delivering the information.

One successful model is State Street’s acquisition of Askari Software to handle securities lending risk. Peter Davies, president of Askari, notes that while clients are “keen to have something,” it is still murky “what the specific risks are that we are trying to measure, let alone who is doing it.” He says that Askari and State Street are taking the approach that the problem is bigger than a single custodian. Askari is developing risk measurement reporting systems for State Street clients that use available State Street data but also allow the client to integrate other information on holdings, valuations, liabilities and so on. “By working with State Street, Askari can provide a significant up-front solution for the client that justifies adding the other information sources. We can provide fast results from one of the world’s largest custodians while keeping an open platform—the best of both worlds.”

Elisa Spain, president of Chicago-based EKS Consulting, sees a fragmented marketplace in which custodians offer a variety of different risk measurement and reporting services. As a result, she explains, performing risk analysis is not easy. One solution, however, may lie in the growing trend toward treating portfolios as businesses: Risk analysis tools can be a way to understand a business better since they see deeper into and across portfolios. She offers the example of a money manager who had a mandate to hedge the Standard & Poor’s 500. When the client ran risk tests against the hedge, the mandate was rescinded. The hedging strategy changed the entire portfolio when it was tested against risk-reporting tools. “Clients need to use total risk analysis to understand their own portfolios better—not just market risk, but operational, credit, accounting and every other risk a smart business would constantly monitor,” she says.

We want CLIENTS to be able to compare every ASPECT of every MARKET, whether it’s foreign exchange, payment, registration or settlement. Gillian Van Schaick Chase Global Investor Services

Chase’s Van Schaick hopes to take this approach one step further. “We intend to continue to benchmark best and worst practices everywhere around the world,” she says. “We want clients to be able to compare every aspect of every market, whether it’s foreign exchange, payment, registration or settlement. We want our clients to be able to compare countries across a spectrum, so they can see Morocco vs. the United Kingdom, for example.”

That may well be the Holy Grail of risk analysis. But will custodians adopt it, and will their clients accept the rethinking that would accompany it? Thus far, investors have been content with a fragmented view of the risks in their portfolios. That places them far from the enormous efforts of the major dealers to consolidate enterprise-wide risk.

Making risk as intuitive as other parts of the investment decision is a part of the “educational hurdle,” explains Guy Coughlin, head of portfolio research at JP Morgan. Coughlin says that investment managers have an “intuitive feel for the return side of a business decision,” but not so for risk.

“Right now, education is the answer, but there are not enough dedicated forums” on the subject, concludes Deutsche Bank’s Nederlof. “Improving one’s ability to attach risk information to the investment decision is the key. Over time, I think the whole process will get easier and easier.”

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