What is the relationship between the administrator and custodian and how will this change over the medium to long term?

Typically the prime broker/custodian is involved with the day-to-day, ‘real-time’ trading activities of a fund and the administrator comes into the picture after the fact or post-trade to book all transactions and reconcile cash and positions, explains Akshaya Bhargava at Butterfield Fulcrum.

“This is changing because administrators are increasingly moving into the middle office, and even the front office in terms of facilitating the daily operations of a hedge fund,” says Bhargava. “There will likely be some overlap in functions provided by prime brokers/custodians and administrators, for example, provision of detailed risk and portfolio attribution reporting to fund managers,” he adds.

For John McCann at Trinity Fund Administration there has been considerable change in this area for some time. “Many investment and traditional banks have ventured into fund administration, thereby increasing the number of contact points that they have with a client outside of the areas of banking, trading and prime broking,” he points out.

“Generally, these units will be ring-fenced into separate companies or departments with ‘Chinese walls’ but, as has been seen over the past two years with many poster child meltdowns, the interests of the ultimate shareholders can be at increased risk if the principal services are all from the same financial family, for example, Lehman Brothers, Bear Stearns and others,” notes McCann.

“We feel adamantly that there is a greater drive for independence and checks and balances between these two core services which is client driven. It is even possible that the regulatory bodies may consider it mandatory, like in South Africa where these two parties must be from different financial families,” he says.

“One will start to see the custodians return to their knitting and prime brokerage and fund administration hived off as separate businesses all together,” predicts McCann.

“The relationship between administrators and custodian is key, especially for funds of hedge funds,” says Richard Ernesti at Citi.

“The ability to aggregate, disseminate and report on client data is essential. The most-effective scenario is one in which the fund administrator and custodian work in concert to maintain the fund database, process trades, provide automated reconciliation between custody and admin accounting systems, share centralised pricing, provide equalisation adjustments, produce net asset value (NAV) calculations and provide transfer agency services,” says Ernesti.

He also notes that clients demand their administrator possess the capability to liaise with and manger multiple counterparty relationships.

“Often there is no relationship between the administrator and custodian as they can be the same party in many cases,” notes Peter Hughes at Apex. “As the regulatory system evolves it will encourage the segregation of these duties over the medium term,” he adds.

Hughes believes there is no advantage to the investors in having these functions with one party as this increases counterparty risk and often incurs higher fees. “If these are segregated, the administrator will add another layer of control by checking the prices the custodian provides. When they are the same party with one pricing source, do the administrators always independently check the prices?” questions Hughes.

“This is a relationship that continues to evolve, especially with the number of administrators owned by large custodians,” says Oliver Scully at Citco Fund Services. He believes the EU’s alternative investment fund managers directive and the growth of Ucits and more regulated domiciles will necessitate a closer relationship between administrators and custodians. “The consequence of this is less competition and independence,” he concludes.

“As long as the prime broker is able to provide the administrator with data promptly and cleanly, by some electronic link, then there is no reason for the administrator not to be entirely happy with the prime broker,” believes Dermot Butler at Custom House.

“Similarly, there should not be any problems with regard to the relationship between the administrator and the custodian, although many custodians still use legacy systems and this can cause delays,” he says.

“Hopefully the custodians will upgrade their systems – it is usually the custodian who is running on old systems – in which case most of the problems should disappear. It is an area that is likely to need greater effort, given the demand for Ucits funds and the requirement under Ucits regulations that the custodian has to be seen to have control of the assets, even if they are held by the prime broker in a futures account,” concludes Butler.

For Stephen Castree at Equinoxe Alternative Investment Services, the relationship with the custodian/prime broker has shifted as many of the traditional prime brokers have reduced their consulting groups. “This often requires the administrator to act in a consulting manner as well as a purely administrative manner in assisting the manager in the launch process, however the level of this need varies manager to manager and between the custodians/prime brokers,” he says.

Independence between custodian and administrator will become a much more important requirement for many investors, believes Hans Hufschmid at GlobeOp. “The more checks and balances, the better,” he adds.

“We see current regulatory pressure having the potential to require independent fund administration, for example where the administration is done in house,” says Paul Stillabower at HSBC Securities Services. Although the custody of assets has historically been the domain of the prime broker, over the medium to long term, “we feel that the custody and administration will become bundled services, since it will be difficult for any supplier to fully discharge their fiduciary responsibilities without performing both services,” predicts Stillabower.

“The custody is important to service providers to enable them to provide credit/leverage. The administration, on the other hand, is critical to see the total picture of the fund and detect early warning signs of problems with the fund.

“In the long term in particular, it is difficult to see a space for either independent administrators or monoline custodians, neither of which have the balance sheets to participate fully in this business,” he notes.

For Joseph Truelove at Kleinwort Benson the relationship between administrator and custodian needs to be a strong one. “At Kleinwort Benson we can offer both services,” he notes, adding that the company is also happy to work with other administrators and custodians where the client wants separate legal entities performing these roles. This is a requirement of many South African fund promoters, he says.

Many of the alternative funds under administration, except, for example, funds of hedge funds and long/short equity funds, do not require a formal custodian, says Martin Tolcher at Legis Fund Services. “Increasingly, clients look for the administrator to manage the relationship with the custodian, and the administrator may well be involved in selecting the custodian, thus enhancing the importance of such relationships,” he adds.

At Omnium, John Buckley says administrators and prime brokers must work closely together to ensure that trades are properly received and reconciled on a regular basis. “As more hedge funds have moved to a multi-prime environment, administrators must ensure their processes and systems support this paradigm,” he points out.

Hedge funds are now relying less on single prime brokerage and are appointing a number of custodians in order to reduce counterparty risk, notes Liam McNiffe at Bank of Ireland Securities Services. “Data exchange for ease of automated trade interfaces and reconciliation will be the key driver in the development of this relationship,” he says.

“Experience has shown in events like Madoff that relationships between administrators and custodians will change,” advises Jonathan White at Viteos Fund Services. “Fund administrators will be much more wary of working with custodians that have sub-custody agreements, making the reconciliation of assets and cash more difficult due to the quality of information that is being received by the administrator,” he predicts.

“The administrator is relying on custodian reports where they are being passed data by the sub-custodian; in this case there is potential risk that that data could be inaccurate,” he adds.