Bernard Hanratty: There are direct parallels between OTCs and the loans business. Traditionally, loans have been provided by a centralised centre of expertise in the structured product sell-side of the investment banks. Now that institutional investors are coming in, they are looking for independence – independence of processing, independence of pricing.
Moreover, there are very few loan administration systems or people who actually understand how these systems work.
If you, as a hedge fund, want your administrator to provide a NAV [net asset valuation], there is an expectation that you will be able to price the loan independently of the loan issuer. For administrators entering the field of OTCs, this is a significant learning curve that can eventually be overcome with the right partnerships. As David says, it is a revolving door of complexity.
David Wright: It is wave after wave.
Russell Hart: We see many banks that are not willing to do this [wrap the loan up into an SPV]. Wrapping up is good because the banks provide the valuation, and it also provides some leverage. However in the current climate, many banks want to migrate from that business or are reticent to do it. However, when they do wrap it up, it is probably easier from the point of view of the administrator. The wrapped up entity has a valuation.
Bernard Hanratty: Interestingly, the Dutch market has quite a mature loan industry and there are some examples of administrators and systems there that we have looked at. There are also some US based systems, which are well structured to be able to deal with some of these issues.
Sunil Chadda: However, some of them are very US-centric and do not necessarily cover the European or UK way of doing things. That is an issue. It is a technology lag.
The fund managers are looking for alpha, and constantly looking for new asset classes and investments. We then have the service providers and software providers lagging six months to two years behind, depending on the complexity of the asset class.
Peter Guest:I think it is safe to assume that people such as Markit will look to get into that space.
Russell Hart: They have got in there already with Loan-X. You may not want to guarantee any of your calculations based on their figures, however. They are based on broker quotes and the market is not very liquid compared to CDS. There are not as many broker quotes coming in, therefore it could be skewed by one or two banks’ prop positions on that.
David Wright: You used to be able to buy loans through total return swaps, but since the credit crunch, the banks want their balance sheets back and they are trying to unwind the swaps. You would be lucky if you could find someone to do that with.
Peter Guest: You would almost think that a fund manager would be actively discouraged from going into the instruments, but it does not seem to be the case.
Russell Hart: As Bernard began by saying, the principal concern is performance. If that is how they achieve the performance, then they will do it. They will tell their middle office operation staff first, and it will then flow down to their administrator, with their prime broker being involved somewhere along the way. It is a secondary concern for many managers.
Peter Guest: So all the operational due diligence that we have heard about is not taking place?
Russell Hart: I disagree. As soon as the performance hits a hurdle, many of our investors take notice and will spend two half days working on the operational DD. Typically, unless anything out of the ordinary is happening, they do not really delve into the process, and many still rely on simple questionnaires that they follow.
Peter Guest: We have focused on administration almost exclusively as a back office function, but to a degree, some of the value-added services are not in the traditional space.
Bernard Hanratty: The value-added services are in the middle office. A mind shift is required of traditional NAV producers. NAVs are the basic ‘widget’ that administrators provide.
However, increasingly there is other data, related to a portfolio of bonds such as modified duration, which we are providing and on which investment managers are making hedging decisions and stratifying their portfolio. Suddenly you cannot simply assume the data provider you use has the correct modified duration or that you have calculated modified duration correctly. It is important that you have a process by which you validate this before you let it out the door. If you let it out the door and a wrong decision is made based on this data, then you will face an unpleasant discussion.
So, typically the primary data element produced by the administrator was the NAV. Now, there is much more information coming through that does not affect the NAV. Moreover, the traditional controls of an administration shop were not designed to fix or ensure the integrity of this new information.
