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Reacting to new risk challenges

Risk has always been a concern in the business of custody, but what is perceived as ‘risky’ has changed. The evolution of risk lies not only in our ability to tackle various forms of risk—hence making them no longer “risks”—but often is a direct result of a change in behaviour or getting more comfortable with a new way of looking at things.
Formerly, risk for investors was largely defined by ‘globalisation’. As investors sought higher returns, they were willing to risk a little more in newly opened, less developed markets. A direct result was the push for custodians to ‘open’ every market they could in support of their clients’ strategies. Most large global custodians now offer services in 90 markets and upward.
The ironic bit of this behaviour is that the majority of investments are conducted in a quarter of those markets. The trend to push, push, push global had its day, and now investors, while still active across the globe , are seeking new ways to make money. And, what they are focusing on is not so much where they invest, but in what.
In part, this is as a result of the economic internet boom experienced up until the latter half of 2000, when the investment arena of venture capital and private equity blossomed. Other investments, like hedge funds and derivatives which were dallied with a few years back, but dropped then because of the risk factor, have also made a big return. And, while the boom burst, the appetite for this type of investment has remained, wih still great IPO technology opportunities.
Outside the eager opportunists, mainstream corporations invest in this type of security for two reasons:
a) as a supplement to traditional R&D, wherein the investment provides them with a “window” on interesting new technology as it relates to their core competency; and
b) as a strategic investment, to smooth earnings.
These more “traditional” venture capital investors are still around, and they are in need of risk management to stay around. These types of investments require much more administrative work than classic investments, services which the investor can do in-house – but usually using a high cost, low efficiency model.
Where’s the risk? From a regulatory perspective, the risk is associated with the premature selling or lending of a security during its restricted period. If a security is sold, lent or otherwise disposed of, changing the beneficial owner of the security during a required holding period in error, the portfolio must re-purchase the security on the open market. Typically, these securities are highly volatile, thus re-purchasing could be affected by large market swings.
To service their investments, these investors need assistance in the clearing process of restricted securities, which entails facilitating, between the issuer and transfer agent, to expedite the removal of a restriction from a holding. As well, they need to adjust their standard portfolio monitoring and reporting to target these special issues of concern, such as types of restrictions applied to each security and the date the security eventually enters the public market through IPO.
There was a time in the not-so-distant past when derivatives were seen as a blight on an otherwise healthy balance sheet. Derivatives and hedges were being tried out – and bringing home bad press. However, as our appetite for return keeps growing – especially for the pension funds, our attraction to various risks subsides, and these strategies are also now in vogue.
As evidence, hedge funds’ assets have quadrupled during the past six years. Tass Investment Research quoted growth from $50bn to $205bn between January 1994 and June 2000. This trend is notable in that it is attracting investors of every type: from the more progressive management house to the most conservative custodian bank. In addition, pension fund organisations and consultancies, in an attempt to introduce alternative investments into the pensions landscape, are educating their constituents on the merits of hedge funds.
One reason for the ‘re-boom’ of derivative and hedge fund investment seems to be the real fear that retirement plans are not sowing what will need to be reaped. As the Myners report in the UK stated and other words of warning in countries throughout Europe are heralding, pensioners’ demand will exceed savings if investors stay on the current track. The mode of thinking seems to be that, properly educated and approached, derivatives and hedge funds are a respectable, and indeed key, element of a well diversified portfolio.
That is not to say there is no longer risk, but the risk is perhaps more understood now, and more acceptable. As a general proposition, enormous strides have been made in the area of information management and monitoring. We have immediate access to data via the internet, we can monitor our holdings daily, automatically and we can do all of this reporting on a global basis. In fact, information management provides enough control to make the risk associated with derivatives, for many investors, more assumable.
As trends fade – becoming either obsolete or routine – risk once again will be redefined to match the situation and the times.
Lucille Knapp is responsible for European business development for global custody at Northern Trust in London

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