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Risk and Regulation

Summer 2011

2 J.P. Morgan thought / Summer 2011

Thinking Out LoudWith mid-year’s approach, several issues linger on the minds of

clients everywhere. One topic in particular – the global regulatory

landscape – continues to present challenges. Complex changes are

underway which may affect front, middle and back office operations

for some and create opportunities for others. Hence, this issue

of Thought is devoted to the transformative nature of risk and

regulatory affairs.

Inside you’ll find insight into the policy debate underway in

the European pensions industry as well as an overview of OTC

derivatives in the midst of changes mandated by the Dodd-Frank

Act. We take a look at the potential for various regional integration

initiatives underway in Asia. We also review what custody clients

may expect from their service provider in the midst of a crisis

situation. We examine the requirements for transparency faced by

private equity real estate fund sponsors and, finally, oversight as it

relates to securities lending.

As ever, J.P. Morgan stands committed to servicing the evolving

needs of our clients worldwide. Thank you for reading and, as

always, your questions and comments are welcome and may be sent

to [email protected].

Thomas ChristoffersonGlobal Sales and Client ExecutiveWorldwide Securities Services

Thomas Christofferson

Global Sales and Client Executive

Worldwide Securities Services

As ever, J.P. Morgan stands

committed to servicing

the evolving needs of our

clients worldwide.

Summer 2011 / J.P. Morgan thought 3

Summer 2011

J.P. MorganWorldwide Securities Services

Tom ChristoffersonGlobal Sales and Client Executive+1 [email protected]

mark KelleyAmericasMarket Executive+1 [email protected]

Laurence BaileyAsia-PacificMarket Executive+852 [email protected]

Francis JacksonEMEAMarket Executive+44 [email protected]

About J.P. Morgan Worldwide Securities Services

J.P. Morgan Worldwide Securities Services (WSS) is a premier securi-ties servicing provider that helps institutional investors, alternative asset managers, broker dealers and equity issuers optimize efficiency, mitigate risk and enhance revenue. A division of JPMorgan Chase & Co., WSS leverages the firm’s unparal-leled scale, leading technology and deep industry expertise to service investments around the world. It has $16.6 trillion in assets under custody and $7.5 trillion in assets under administration.

For more information, go to www.jpmorgan.com/wss.

4 10 1818 Strategic Challenges and

Opportunities for Corporate Sponsors of multinational Pension Funds

A follow-up to J.P. Morgan’s first forum for corporate sponsors of multinational pension funds.

20 How Technology is Changing the Face of Operations for Asset managers

Asset managers expected their service providers’ operations to be reliable, secure and timely. That’s no longer enough.

24 Is Your real estate Fund Team ready for Transparency?

As the world returns to a growth phase, private equity real estate fund sponsors are faced with new challenges.

28 Securities Lending Defined A comprehensive introduction to

proper securities lending oversight: education, monitoring and goals.

32 New markets – Assess / Access Global institutions constantly evaluate

the options and arenas for investment available to them.

4 europe’s Future: Pensions Policy and its Impact on Investment management

A major focus for governments and policymakers around the world is the crucial issue of pensions policy.

6 Dodd-Frank and Derivatives: Preparing for Transformative Change in the OTC market

A panel of in-house experts discusses how to prepare for pending changes in the OTC market.

10 Is Asia Taking Steps Towards Harmonization or is It Fragmenting Further?

An examination of initiatives that could provide impetus for growth and the development of Asian financial markets.

12 markets in Turmoil An interview with two J.P. Morgan

experts reveals how custody clients may best prepare for crisis situations.

16 From the Inside Out: A View of u.S. Tri-Party repo market Infrastructure reform

The U.S. tri-party repo market came under significant scrutiny following the market crisis – from the participants themselves.


political fray, is to introduce an automatic adjustment related to changes in longevity. This approach is something the UK Government has embraced as announced by its Chancellor of the Exchequer in his recent Budget.

J.P. Morgan responded to the Green Paper, pointing out that national pension systems are complex, vary significantly, and that homogeneity is neither feasible nor desirable. In summary, our response urges the EU to, inter alia:• Encourage measures to increase retirement ages and

efficient private saving• Promote financial literacy• Extend the opportunity to sponsor IORPS to

investment managers and banks• Acknowledge that responsibility, e.g., for funding,

regulation and supervision, should be retained at Member State level

However, the Green Paper discusses many other aspects of the fragmented European pension landscape and it is clear that there are many obstacles ahead.

Back in 2003, the Institutions for Occupational Retirements Provision Directive (IORPS) was agreed. Whilst it was a laudable first attempt to provide a European framework for cross-border pension provision, its success has been muted at best: as at June 2008, of 140,000 eligible schemes in the EU only seventy-eight had availed of the Directive’s provisions.4 The general view is that IORPS, a Directive that required minimum harmonisation, has not been a success and that given the economic and demographic challenges, adjustments must be made to try to dismantle barriers that prevent pension funds from embracing IORPS. IORPS 2 should therefore address the regulatory differences and legal uncertainties that hinder adoption of cross-border IORPS.

There is naturally a role for European Institutions regarding pension provision given the importance of pensions both economically and socially to the region; sustainable public finances are critical, inter alia, to the integrity of the European Union. The Commission gives as one of its key social policy objectives: to ensure adequate retirement incomes for all and access to pensions which allow people to maintain, to a reasonable degree, their living standard after retirement, in the spirit of solidarity and fairness between and within generations.5

The issue of pensions is a major focus for governments and policymakers around the world. In Europe, modification of generous pay-as-you-go and benefits systems, and adjustments to retirement ages are elements of the solution to what is, or is rapidly, becoming a crisis for many Member States. A crisis predicated on fragile prospects for growth and a worsening demographic profile for most European countries.1

In Greece last year, the government was forced into a radical reform of its pension system to avert bankruptcy. The European Commission had forecast that Greece’s pension obligations would be the highest in the Eurozone by 2050, at 24% of GDP.2 The situation in France may be less precipitous, but last year too, there was widespread unrest as the Government struggled to lift the retirement age from sixty to sixty-two. The French Government succeeded, but many would think that this can only be an interim step and that a more aggressive adjustment may be required before long. The reality for several beleaguered European countries is that reform may be unpopular but deferral of the issue can be a more costly option in the long term.

In Europe, the variation In provision is marked It is against this backdrop that the European Commission seeks to move the policy spotlight to pensions. Some countries have well-developed and mature funded arrangements (for example, the UK and the Netherlands) while several others rely principally on a ‘pay-as-you-go’ approach. Given a difficult economic backdrop, there is an urgency to the debate that the European Commission has prompted with its Green Paper on the Future of European Pensions,3 which acknowledges the demographic challenge and examines a number of ideas for change. This Green Paper, together with the European Parliament’s own report on pensions, will provide a framework with which Member States and the Commission can establish priorities for the future.

The Green Paper is wide-ranging. It discusses pensionable age – many countries struggle to increase the age of entitlement even as longevity clearly strains public finances. One possible solution cited by the Commission, that has the estimable merit of removing the issue from the

SheenaghGordon-Hart

Industry and Client Research

Executive

Europe’s Future: Pensions Policy and its Impact on Investment ManagementThe pension debate is underway and it is crucial for us all


The real challenges are that Member States retain responsibility, for example, for their social security systems (which have a critical interface with state pensions) and fiscal matters, and that each Member State has a completely unique array of methods for retirement provision. Hence the Commission may set out a wish list but its ability to intervene is limited; in time it may obtain wider powers but this is likely to come at a very high price in terms of sovereignty and diversity across the European Union.

Given that the Commission has limited room for manoeuvre, what should it do?

Key issues that should be tackled in the next round of change include portability. This was recognised when the original IORPS Directive was conceived; the issue gained little traction then. Successful IORPS should, in the Commission’s view, assist in promoting labour mobility. However, I would argue that absence of portability of pension rights is not a critical obstacle to labour mobility and that securing portability will not magically change things. Labour mobility is likely to be attractive to those with occupations that suit mobility, for example, those with easily transferable skills, with a wanderlust, with an aptitude for language – usually mobile workers are young and single – and pensions is not a significant feature in their thinking. That being said, there is every reason to think that for some a lack of portability could be an obstacle to free movement within Europe, and that the obstacle should be removed. The big questions are: how, and how much of a priority should it be?

The Commission considers that setting minimum standards on acquisition and preservation of pension rights may be a starting point and that this could be supplemented by an EU-wide tracking service. The idea of common minimum standards for acquisition and preservation of rights seems to be widely accepted. It could be though that a tracking service would become an unwieldy and possibly expensive data repository, and one wonders what useful purpose it would serve. In terms of priority, if there is widespread agreement on the objectives, and on the face of it, implementation should not be particularly challenging, then this should be an early action point on the priority list.

Whilst the picture of European pension provision is marked by severe fragmentation, IORPS as it currently stands has failed to make any substantial difference. Certainly in the current environment there is no evidence of an emergent pan-European pension product. This issue was referenced in the Monti report6 and echoed, if weakly, in the Green Paper. To accomplish a pan-European pension vehicle would be a significant achievement. How to move beyond the fragmentation of current arrangements towards this goal is the big question. European asset managers and banks are effectively unable to compete with insurers in the IORPS business; it may be that if a scalable investment fund-type vehicle, similar to UCITS in having mutual recognition and common construct, were created it could be a means of promoting a level playing field. This is something that has been proposed by EFAMA7 in a report that called for the creation of ‘Officially Certified European Retirement Plan’ or OCERP. It is precisely here that the asset management

industry’s voice must be heard, urging the Commission to include this on its list of priorities. The use of mutual funds for defined contribution pension plans in the U.S. has been a great success:8 their transparency and simplicity is attractive to investors, and for the industry, 401(k) plans are the lifeblood.

Of course, no matter what is devised as a construct for pan-European pensions, the issue of promoting retirement savings remains; whatever the solution, it must be scalable, affordable, simple to understand and transparent.

One area where the Commission looks set to act is solvency. Currently, Solvency II which lands for European insurers on 1 January 2013, will not apply to pension funds, although insurers argued strongly that it should. This element of reform for pension funds is highly contentious and most national pension fund associations and the European Federation for Retirement Provision have argued that Solvency II is inappropriate. Certainly, given the fragmentation of types of provision across Europe a one-type-fits-all approach would potentially be unworkable if not damaging. The Commission asked respondents to its Green Paper for their views on what form of solvency rules would be appropriate and has indicated that the status quo is not an option. Perhaps this issue should be set aside until Solvency II for insurers is implemented: its costs and its market implications have given rise to concerns. This seems unlikely though as it has been raised in the Commission’s Call for Advice from EIOPA.

It is clear that as we look ahead, whether as asset managers, pension funds, insurers or service providers, pension provision will be a key policy priority for Europe. For all of us, whether providing data for solvency calculations or account information for investors, the overriding challenge will be to ensure we can deliver on the value that the pensioners of tomorrow need. n

1 Peter McDonald of the Australian Demographic and Social Research Institute estimates that if Italy’s recent fertility levels remain as they are, bar mass immigration, it will lose 86 percent of its population by the end of the century. His estimates for population drops for Spain, Germany and Greece are similarly worrying at 85%, 83% and 74% respectively.

2 12.5% 2010, and, following reform, 15.5% in 20603 COM 920109 365 final 7 July 20104 European Commission Roadmap October 20105 http://epp.eurostat.ec.europa.eu/portal/page/portal/employment_social _policy_equality/omc_social_inclu-

sion_and_social_protection/pension_strand6 A New Strategy for the Single Market: At the Service of Europe’s Economy and Society, 9 May 20107 European Fund and Asset Management Association8 DC plan assets are a significant component of American retirement assets, representing more than one

quarter of the total retirement market, totalling US$ 4.3 trillion as at 31 December 2010, of which US$ 3.1 trillion was held in 401(k) plans. Mutual funds managed 54% of all DC plan assets at 31 December 2010. SOURCE: www.ici.org

120%

100%

80%

60%

40%

20%

0%Netherlands Switzerland United

StatesUnited

KingdomGermany France

Pre-Funded Pension Assets: GDP 2009

Source: Towers Watson


Dodd-Frank and Derivatives: Preparing for Transformative Change in the OTC Market


Signed into law in July 2010, the so-called Dodd-Frank financial reform legislation established the framework for a sweeping series of reforms to the financial markets, with particularly strong measures targeted at OTC derivatives trading. The bill established a one-year timeframe for literally hundreds of new rules and regulations to be drafted, reviewed and enacted. With the July 16, 2011 deadline rapidly approaching, key issues are yet to be resolved, and the implementation timetable is yet to be set. It’s also important to note that rules are not final and could change before they are finalized. What is clear is that massive change is coming to the OTC derivatives markets and that every market participant should be taking proactive measures to prepare themselves as best they can.

What we know right nowDodd-Frank will create a series of revolutionary changes that will fundamentally transform how participants enter into derivatives

J.P. Morgan recently convened a panel of in-house experts to discuss the implications of Dodd-Frank financial reforms on the OTC derivatives market. The goal of the panel was to assess the current state of the rules-making process and identify measures that J.P. Morgan clients should be taking right now to prepare for the post-Dodd-Frank trading environment. The participants included:

mArY BeTH CAmPAu, Western Hemisphere Product Head, Derivatives Collateral Management ALeSSANDrO COCCO, Managing Director and Associate General Counsel mArK DemO, Global Collateral Operations Change Management SHeeNAGH GOrDON-HArT, Client and Industry Research Executive DAVe OLSeN, Head of OTC Clearing JASON OrBeN, Global Product Head, Derivatives Collateral Management JOe WILLING, Investment Bank Regulatory Risks and Controls DArreN W. WOOLFOrD, Head of Global Derivative Services, Americas

Significant reform efforts are also under way in Europe and, to a lesser extent, Asia. While the panel stressed the vital importance of proper coordination among international regulatory authorities, the following article focuses on reform in the United States.

transactions, where those transactions will take place, and how they will be reported upon after the fact. Margin requirements will change, and this will likely have an effect on margin, capital and transaction expenses.

Most reforms will fall into one of three areas: clearing, trade execution and transparency.

CLeArINGMany swaps that are currently traded on a bilateral basis will soon be cleared through a Central Clearing Party (CCP). Standardized swaps will be subject to mandatory execution and clearing through a registered entity, unless an exemption applies. A bilateral OTC market will also remain, consisting of pre-existing grandfathered trades and new trades that are not suitable for clearing or where one of the parties is an end-user not subject to the clearing requirement. Notably, The U.S. Treasury Department has proposed that some foreign exchange transactions will not be subject to clearing mandates.

Regulation proposed under Dodd-Frank will introduce significant changes in

the bilateral OTC market, requiring in some cases that collateral securing OTC transactions be held at a third-party custodian. If finalized, this would present a number of challenges for participants who will have to maintain parallel transaction processes and optimize collateral across cleared and non-cleared trades.

TrADe eXeCuTIONMost OTC derivatives trading is now initiated over the phone. In the post-reform market some trade instructions will be communicated using a swap execution facility. Many participants will be required to invest in automated trading systems or incur the costs of engaging outside providers for those services.

TrANSPAreNCYWhile the full extent of the rules has not been codified, there will be substantial new reporting requirements for OTC derivatives trade that will govern what must be disclosed to both the public and regulators, and when the reports must be submitted. Cleared or not, trading desks will have to process post-execution trades through their middle and back offices. They will then have to consolidate and report this information within a short timeframe to meet the new requirements for market transparency.

What is still to be determinedWhile it is understood that much of the OTC derivatives market will migrate towards CCPs, many of the details concerning how that will happen are not yet in place. These concern the specific definitions of which transactions and participants will be exempt from clearing mandates, what the exact reporting requirements will be for both cleared and non-cleared trades, what the accepted collateral and margins will be, and what the cost will be to market participants and the end investor. Broader questions also persist.


Until the final rules are released, it is difficult to assess how challenging it will be to operate in the new environment. We do know that clients must negotiate a new world replete with multiple vendors and processes…making more choices and processing more information.

The key open questions include:

Exactly which swap transactions will be exempt from clearing?

Final rules defining “swaps” and “security-based swaps” have not been put forward, and there is some uncertainty surrounding when a counterparty will qualify for an exemption as a “commercial end-user” (i.e., one that uses swaps to mitigate a commercial risk).

Are we diminishing risk, or concentrating it?

Beyond concerns about clearing regulations and requirements to clear, there are open issues regarding what the construct is for the clearinghouse rules themselves. As CCPs receive such concentrated financial system risk, how will regulations make sure that clearinghouses have the right governance, risk controls and balance between their for-profit status and the central role they will play in the derivatives markets?

What will margin requirements be?

Initial and variation margin requirements, and the capital treatment for both cleared and non-cleared derivatives trades, have yet to be finalized. The stated preference for high-grade government securities and cash is likely to place a considerable strain on the markets and drive demand for collateral transformation services. At this point, there is considerable uncertainty surrounding collateral and financing costs.

adding new infrastructure, collateral and capital expenses. How much more expensive is far from certain. Better projections are needed concerning the true cost to the market, and who will bear those costs. It is not yet clear whether increased costs will force many participants, particularly smaller participants, to exit the derivatives market.

How will regulation be coordinated with Europe and Asia?

Dodd-Frank is thought to be at least a year ahead of European reform legislation and even further ahead of Asian reforms (except for Japan which has already mandated clearing).

What you can do to be preparedWith many market participants taking a wait-and-see attitude, there will be an inevitable rush to implement new systems and initiate new relationships as soon as the final regulations are issued. By taking concrete actions now, it may be possible to affect a smoother transition to the post-reform world:

Determine your regulatory status.

If you have not already done so, the first order of business is to make sure you understand which category of participant you will fall into under Dodd-Frank regulations. Larger clients should ascertain whether they are likely to be classified as swaps dealers, or securities-based swaps dealers. This determination will help you understand how you will be trading in the post-reform environment and what your future reporting requirements are likely to be.

Identify, and establish links with, clearing members.

You should identify which clearing members / CCPs are best suited to the products you trade and begin to establish relationships with and connections to them. Participants who are certain they will not receive an exemption may want to conduct test trades to identify

How many Requests for Quotations (RFQs) will I need?

Different rules are currently being discussed for swaps and security-based swaps. Current indications are that a minimum of one to five quotes will be required, raising concern about higher costs for clients.

How will transactions and counterparties be identified?

The regulators are mandating a “Legal Entity Identifier” (LEI) which will be associated with each trade over its life, and a “Universal Client Identifier” (UCI) which will identify each counterparty trading in the derivative markets. The industry is debating with the regulators, clearing organizations and swap execution facilities, who is to take responsibility for creating such identifiers, where in the transaction process LEIs will be created, and how LEIs and UCIs will be propagated through the various derivative infrastructures (SEFs, DCOs, and SDRs) and in the case of LEIs, what happens in various life cycle events such as trade allocation, compression, etc.

What happens if a clearinghouse defaults?

More clarity is needed about what might happen should a clearing member go into default. Given the mutualized risk structure of a clearinghouse, what will the impact be on other clearing members if one defaults? Will one default cause others? Will clearing members have limited or unlimited liability to a CCP for defaults of other clearing members? For clients who access a CCP through a clearing member who defaults, can they transfer their positions to another clearing member?

How much will this cost?

Dodd-Frank reforms are likely to make derivative trading more expensive,

At the threshold of a great transformation in derivatives trading, there

are still many important questions to be answered.


potential areas of difficulty in the transition to cleared trades.

Consider liquidity management issues.

If you are not used to posting up-front collateral against derivative contracts, expect a big change in the amount and type of capital you have to put behind your strategies. Consider how you will manage your liquidity so that you have enough cash or high-grade government securities on hand to post collateral to the CCPs. Recognize that posts change day-to-day, either based on the risk profile of the counterparty, valuation or pricing data, or other inputs used by the clearinghouses in their existing models. Understand the financing or collateral transformation strategies that might be available to meet margin requirements.

Examine your swap positions.

Assess the regulatory impact on your current swap positions across business lines, and make sure you will be in a position to report the purpose of entering each swap under the new regulations. This should be part of a larger effort to assess the economics of your trading strategies in the post-reform market from a liquidity and capital standpoint.

Assess your trading infrastructure to identify current weaknesses.

Any challenges in today’s bilateral world will only be exacerbated in the post-reform environment. Clean up any concerns now, so you will be free to focus on the tracking and reporting demands of the cleared trades once the regulations are finalized.

Review your current collateral requirements and collateral management systems.

It will be far more difficult to manage and optimize collateral in the post-reform, bifurcated environment. Collateral requirements will be different across multiple clearinghouses, and the collateral demands of bilateral trading will still be in force, at least through a

transition phase. Make sure your collateral management systems are up to the task, or consider outsourcing them to a third-party collateral agent.

To the greatest extent possible, keep up with the regulations and assumptions.

There will be multiple iterations and changes in regulation up to, and well beyond, July 16th. Many of these changes will have a substantive impact on your infrastructure and technology requirements.

How J.P. morgan is preparing to helpAt the threshold of a great transformation in derivatives trading, there are still many important questions to be answered.

As the world’s leading derivatives house, one of the leading collateral agents, and the provider of other market-leading services for OTC derivatives, J.P. Morgan is uniquely positioned to understand both the importance of derivatives to the world economy and the potential impact of upcoming legislation on market participants. As part of our commitment to helping reduce systemic risk, we closely monitor the progress of each regulatory body, and regularly contribute comments to help refine proposed rules.

We provide clients with the most current insight and analysis, working closely with other J.P. Morgan partners to support our clients throughout this multi-year transition. We are clearing derivatives trades for many clients today, and helping many more prepare themselves for clearing as soon as they are required to do so. We will continue to make the substantial investments needed to provide comprehensive end-to-end capabilities in derivatives trading, clearing, lifecycle management, valuation and collateral management – and to expand the scope of services we offer to support the markets as they evolve. n

Not Just What, But When?

Due to the enormity of the task, and the limited resources to accomplish it, it is unlikely that the full extent of the new regulations will be ready for release by the July 16, 2011 deadline. Both the CFTC and SEC have indicated that new regulations under Dodd-Frank are more likely to be phased in than launched with a big bang. A three-wave schedule is among the options being discussed:

• Late spring: Key terms will be defined, notably those that clarify which entities will qualify for end-user exemptions. Further details are expected on new processing mandates, along with more guidance on clearinghouses and swap execution facilities.

• mid summer: Rules should be released pertaining to clearinghouses, risk management facilities, eligibility, conduct of swap dealers, portfolio reconciliation, swaps data repositories and swap execution facilities.

• Fall/winter: Rules concerning caps and margining requirements for centrally cleared and uncleared (i.e., bilaterally traded) derivatives will be released.

It should be noted that different teams are drafting different rules at the various regulatory agencies, and the tight deadlines leave little opportunity to coordinate these efforts. Once the full set is released, there will be a need to look at the full body of the legislation holistically, as it would not be prudent to finalize any one rule without being able to assess the impact of all rules on the market. So, those rules that are phased in earlier may well be subject to revision as subsequent rules and regulations are released.

In addition, clients that have global operations will be required to devote significant resources to make sure they comply with regulations in the U.S. (Dodd-Frank and related rulemaking activity), Europe (EMIR and MiFID 2), and other regions (e.g., Japan’s clearing requirements for credit derivatives and interest rates). The timing of implementation of these requirements in each region is still being determined.


Is Asia Taking Steps Towards Harmonization or is It Fragmenting Further?

As global regulatory reform enters the rules-writing and implementation phase, there is little

doubt that 2011 will be a year of historic change in financial markets across the U.S. and E.U.

While Asia is not producing its own regional set of new rules, largely as a result of the absence

of a pan-regional legislative and regulatory framework, there are various initiatives which could

provide impetus for growth and the further development of the financial markets in the region.

Is Asia as fragmented as it is perceived?Some observers see no collective consensus across Asia but rather a collection of countries and regions all developing in their own right. Financial markets are largely confined within their national borders and financial market infrastructure is significantly influenced by national priorities.

However, as individual markets seek to attract international issuers and investors from within the Asian region and beyond, some important signs of cross border linkage of financial markets and harmonization became evident in 2010.

Furthermore, during the course of 2011, we expect to see greater clarity in a number of key areas, including the public sector’s involvement; the potential emergence of

a new currency regime; harmonization within the local bond markets; linkages between equity exchanges and contributions from the OTC derivatives markets.

emerging regional public institutionsFinancial markets in Asia do not have a regional legislator or regulator. However, we note two examples of regional public sector activities in 2010 as a sign of increasing public sector cooperation. One is the Chiang Mai Initiative Multilateralisation (CMIM) and the other is the ASEAN+3 Macroeconomic Research Office (AMRO).

The CMIM is a multilateral currency swap arrangement agreed to by the Finance Ministers and Central Bank


masayuki TagaiExecutive Director, Global Market Infrastructures

Governors of the member countries of the ASEAN+3 (the 10 ASEAN countries plus China, South Korea and Japan) and the Hong Kong Monetary Authority. It will allow participating central banks to draw on a pool of foreign exchange reserves that would help manage a regional financial crisis.

AMRO is a newly established regional monitoring body in Singapore tasked with assessing regional macro-economic stability and financial vulnerability. Its role is to support the decision-making process for CMIM.

While these are not financial market infrastructures or regulators, one can easily imagine that it aspires for an IMF-like entity dedicated to Asian stability.

emerging rmB currency regime When a mountain moves, it starts with a slight shudder. The series of measures announced during the course of 2010 regarding the internationalization of the RMB were certainly the shudder that awoke markets to the fact that a new currency regime is in the making. Currency fluctuation was reintroduced, the RMB international trade settlement pilot scheme was expanded, the mainland inter-bank bond market was opened up and Hong Kong took center stage as the off-shore RMB market. Amidst this backdrop, it will be important to monitor China’s contribution to the development of global standards.

Local currency bond marketsThe Asian currency crisis in the late 1990s resulted in the birth of the Asian Bond Market Initiative (ABMI) in 2003. The ABMI itself covers a broad range of public sector cooperative initiatives aimed at growing the local currency bond markets, and it has been widely lauded as a success given the double-digit growth rates in those markets. Most recently, it has initiated a public-private sector joint forum called the ASEAN+3 Bond Market Forum (ABMF) where public sector and private sector participants, including J.P. Morgan, have started ground-breaking exercises that may lead to some harmonization in the clearing and settlement of bonds in the region.

The current exercise by the ABMF is seen as laying the basis for more efficient markets regardless of the existence of a common regional clearing infrastructure.

Proposed linkages of exchanges Asian exchanges have often been seen as trading venues with an integrated clearing platform (or a CCP) and settlement platform (CSD). In order to increase market share and volume from outside their domestic markets, the Asian exchanges

developed issuer strategies such as foreign listings and incentives, attempts to develop common listing standards and common disclosure requirements.

Further to these activities, we have seen increasingly direct methods to cross over to each others platforms, including the proposed but unsuccessful SGX-ASX merger and the linking of the Thailand, Malaysia, Singapore and the Philippines stock exchanges expected to begin in early 2012. It will be interesting to see if these linkages precede mergers between clearing platforms or settlement platforms.

OTC derivatives CCP developmentWhile the vast majority of the OTC derivatives markets center on the U.S. and the E.U., some Asian markets with significant domestic derivatives activity have announced their intention to capture activities in a central manner. For example, the Singapore Exchange started to clear U.S. Dollar and Singapore Dollar Interest Rate Swaps (IRS) in November 2010. Japan announced their intention to centrally clear some Japanese Yen products by the end of 2012. Hong Kong will launch a public consultation by Q3 2011 regarding the establishment of a Central Counterparty (CCP) and trade repository also for domestic use.

The preliminary conclusion seems to be that some domestic markets are introducing or considering central clearing of OTC derivatives but not in a harmonized way. Fragmented markets may well remain for the time being.

Can outside moves help Asia integrate? Asian integration will require a different path from that of Europe, but this does not mean that Asia cannot learn from Europe from its decades of experience. Europe is in the process of identifying and removing barriers (the Giovannini Barriers), and the E.U. is making progress in marrying approaches from both the public and private sectors.

Indeed, this collaboration between the public and private sector through the formation of industry groups and public sector sponsored working groups is a pattern that can be replicated in Asia.

The opportunity for Asia is significant. While Europe is focused on regional harmonization, Asia has an opportunity to position itself as a major influencer in the formation of true global standards and market practice. But only once regional goals and ambitions can be agreed upon. n

cture changes • geopolitical crises • environmental disasters • major market infrastructure changes • Geopolitical crises • environmental disasters • major market infrastructure changes • geopolitical crises • environmental disasters • major market infrastructure changes • geopolitical crises • environmental disasters • major market infrastructure changes


cture changes • geopolitical crises • environmental disasters • major market infrastructure changes • Geopolitical crises • environmental disasters • major market infrastructure changes • geopolitical crises • environmental disasters • major market infrastructure changes • geopolitical crises • environmental disasters • major market infrastructure changes

THOuGHT: In a crisis situation, what are clients most worried about?

KM: Clients seem to have three main concerns:

1. The need for real-time information and access to their assets, cash and securities – to know where their assets are.

2. The ability to instruct their service provider on their accounts – to be sure that their provider has clear and accurate designation of their accounts.

3. Quick and direct access to their client service and relationship coverage – to reach the people that know their business and are their partners.

THOuGHT: And what should a client be thinking during a large-scale emergency?

KM: Number one, the client should be hopefully confirming that they’ve made the right choice of service provider, because that provider is operating with

World turmoil can mean risk and risk mitigation choices for the custody client operating on

the global stage. Recently, Thought magazine sat down with two J.P. Morgan experts, Kelly

mathieson and Beth Fortier, to discuss the topic of international crises and how clients may

best prepare for unforeseen events.

Markets in Turmoil

first-hand information and a depth of knowledge that is beyond what they can get anywhere else.

Clients want to be thinking about clear lines of ownership of their cash and securities in a country. Because in a time of crisis, if something actually does go awry, and access to either securities or cash becomes impaired for a period of time, I think that clients want to make sure that they have confidence that their positions are uniquely defined and uniquely owned, and that it’s unencumbered if they needed to get access to it.

BF: I was talking with one of our clients shortly after the first wave of events in Egypt, who asked for insight on how they could improve their response to a market crisis. We leveraged our own protocol and compiled a list of questions that we thought clients should ask at the onset of an issue. For example, what global custodians and sub-custodians support their business? Are they holding assets? Are the positions debt or equity? Do they have cash balances? Are there

upcoming maturities or corporate events? What about special processes or market nuances? The ability to quickly gather intelligence and data is critical in my opinion, because they can’t start thinking about how to mitigate their risks if they don’t have a clear view of what their exposures are.

THOuGHT: What other questions should clients ask themselves to prepare for a crisis?

BF: Do you have a formal crisis response plan? How does it work during weekends? Do you know how to pull every part of your exposure across every one of your funds? Does your plan include key dependencies like infrastructures and service providers?

THOuGHT: What do you advise a client look for in a service provider?

KM: Real strength of local market presence, either directly or through a very deep and rich agent relationship. Deep and rich, meaning we really take partnership to the ultimate level, and



capabilities. What’s become critically important since the global financial crisis in 2008 is a thorough sub-custodian selection and monitoring process and the ability to respond effectively in a crisis situation. That’s one area that we’ve demonstrated very well across multitudes of situations where we have reacted quickly and contained risk. We’ve set up a contingent provider structure across a number of markets, which provides us with the ability to transition client assets to an alternate provider in response to a concern with a bank at risk of failing. This is a unique approach and is not our obligation – this is something that we believe is prudent in order to protect the liquidity of our clients’ assets.

You want a service provider who knows the markets and knows how to get information quickly, assess it and

“ The service provider has a duty to be diligent in monitoring

sub-custodians and providing information.” BETH FORTIER

we use agents only to the degree that they act as an extension of ourselves. And that allows clients to make good business decisions. Flexibility of operating models to be able to accommodate unique hours, unique structures, or unique arrangements that are needed for a temporary period of time to manage through the crisis.

Leadership that is directly engaged. I think that helps bring sensitivity to certain client scenarios and an understanding of the total business implications.

An organization that has a demonstrable expertise and understanding of market or country risk in a way that is objective for clients to be able to rely on as information for their own decisions.

BF: In today’s environment, a provider must have solid global custody

communicate quickly. The other part of it is you also want a provider who knows the client. During Egypt’s crisis, for example, we had clients who were absolutely concerned about buttoning down risk and either doing nothing or getting out quickly because they were concerned. We had other clients who saw this as a buying opportunity. Knowing your clients, you need to make sure that you’re providing information in a way that’s meaningful to them, that helps them to execute their own goals, whether it’s risk containment or investment opportunity.

THOuGHT: And what happens if your service provider doesn’t react quickly in a crisis situation?

BF: The service provider has a duty to be diligent in monitoring sub-custodians and providing information. In our view, we have an opportunity to help our clients by providing as much information as quickly as possible so that they can feel well equipped to react.

KM: Clients need to rely on their service provider for accurate, real-time

The Sub-Custodian relationship

J.P. Morgan has a well-established process for selecting sub-custodians that seeks to ensure they have the proven

expertise and experience to deliver a premier service. The process extends beyond the review of core capabilities

and financial strength to include a clear understanding of their business continuity plans, their recovery sites for

operations and technology and how they might react to crisis situations. To the extent that there is a developing

concern, the firm quickly performs outreach with sub-custodians to revisit their plans and learn how they intend to

adapt them to a real-life crisis scenario. This process has been tested on many occasions during natural disasters,

pandemic threats, civil unrest and other circumstances.

The expectation is that if the market can function at any level, the sub-custodian should be able to function,

either in their core location or from an alternate location. In the event of a crisis, J.P. Morgan expects a report

from the sub-custodian immediately on their status, the status of the market and what is expected to occur. Each

sub-custodian is selected on the basis that it is expected to perform as well as, if not better than, the rest of the

market, no matter what the issue is.


information that reflects the impact of any of the market or crisis conditions in a way that helps them remain informed as to the execution choices they can make about their positions.

THOuGHT: In a crisis scenario, what are the common challenges?

KM: One of the common challenges is an ability to get timely and clear information on the nature of the crisis. Notice I didn’t say detailed or complete, because you also have to accept that it’s going to come out in bits and pieces. That’s understandable in any crisis. Another of the biggest challenges that anyone faces in dealing with a crisis is having access to people and organizations who know what’s going on in a particular market scenario.

BF: We constantly deal in crisis situations. We have a very well-tested approach for how to act in a situation. J.P. Morgan has leveraged this protocol for currency devaluations, major regulatory changes that caused huge upheavals for our clients, earthquakes, economic issues like the implosion in Iceland, the Lehman bankruptcy, the instability in Europe, etc.

Every day can be a challenging situation. However, our goal is always to react quickly, assemble a team and communicate as much and as soon as possible.

THOuGHT: What’s the first thing that happens?

KM: The probability of J.P. Morgan having direct information on the ground in a country is high, simply

because of the depth and breadth of our organization. We also have experts who are constantly monitoring the country and credit risk of the major organizations we deal with. For us the biggest focus is getting information, local, accurate information on which we can act.

BF: There are a variety of places where information is going to come from. If it’s an economic issue, it’s going to come in through J.P. Morgan’s credit organization where they are monitoring country risk issues and economic situations. In other cases, it’s driven by market events. If it’s a major regulatory change, that creates a completely different situation for our clients than one with political unrest disrupting stock exchanges and sub-custodian banks, etc. – that’s going to come in through J.P. Morgan Network Management.

As information comes in, there’s a group that gathers together to evaluate and assess the potential implications and ask, what do we need to do about it and what other information do we need to quickly gather in order for us to have the full set of facts to start making informed decisions?

THOuGHT: What does J.P. morgan offer clients in terms of risk mitigation?

BF: We have a Market Intelligence portal that is part of JPMorgan ACCESSsm [the firm’s web-based platform for securities applications]. It produces extensive information about each market and about regulatory requirements, risks associated with settlement, counterparty risk in that market, etc. We provide detailed

information about every market regarding the risks that exist within the market just as part of the market infrastructure. We cover that for all 100 markets where we offer custody services today.

We also monitor the markets on a continuing basis. To the extent that there’s any type of development, whether it’s a change in a regulation, a currency devaluation, a market infrastructure issue that creates any type of impact, we issue NewsFlash bulletins to our clients. Those happen throughout the global workday. We’re constantly communicating with clients. The information comes out in a form that explains the issue and the potential impact. It’s detailed and directly relevant. Where beneficial, we also host Client Dial in Forums where we walk clients through an issue and host a Q&A with the experts to provide direct access to our team.

KM: In coming to us as a service provider for global custody, particularly at a time of crisis, we’re going to call out to all the different areas of J.P. Morgan that may be operating or have some degree of activity in a country, whether it’s treasury services for cash, the investment bank because of proprietary activities, the global corporate bank because of relationship activities, etc. It’s sort of one-stop shopping, if you will.

We always say, for our businesses we bring the whole of J.P. Morgan to you. If I were a client, I would be thinking, when I’m using someone as an agent, let me think for a moment about that agent and the degree to which that agent is going to bring me information and perspective in a timely and a comprehensive way, and what resources do they have available in one fell swoop that I might not get anywhere else. n

Kelly mathiesonGlobal Custody & Clearance Business Executive

Beth FortierHead of Network Client Consulting

“ Leadership that is directly engaged. I think that helps bring

sensitivity to certain client scenarios and an understanding of

the total business implications.”KELLy MATHIESON


As chairs of the Operational Arrangements Working Group and

Settlements Policy Working Group, and a leading tri-party agent

serving the U.S. clearance and collateral market, J.P. Morgan shares

its unique perspective on the reform process.

by substituting those assets with other eligible securities, continuously scanning loans for assets that meet the delivery criteria and automatically replacing them with eligible securities or cash.

• Repo AccessSM promotes greater transparency for cash lenders, for the first time providing a real-time view of repo status and cash balances. Lenders can access detailed collateral reporting, either online or for download. Repo Access also delivers online trade confirmation capabilities, well in advance of the August 2011 deadline.

• As the three-way trade matching and confirmation deadline approaches, J.P. Morgan’s flexible operating model allows clients to select the option that best suits their needs. Lenders can confirm using Repo Access, request J.P. Morgan to perform a match internally, or use a third-party vendor to match the trade. The matched instruction can then be sent to J.P. Morgan for processing.

• A Repo Maturation Facility offers dealers clearing their tri-party repos through J.P. Morgan a pre-negotiated, committed, secured financing facility that will support and facilitate the maturation of tri-party repos and the intraday collateral substitution process.

J.P. Morgan will soon introduce Global Longbox to broker-dealers. Global Longbox provides a first-ever view of securities collateral obligations across regions, asset classes, and platforms – particularly valuable to global institutions seeking to

reform from the inside outFollowing the market crisis, the U.S. tri-party repo market came under significant scrutiny – not just from the various regulatory bodies, but interestingly, from the participants themselves. Sponsored by the Federal Reserve Bank of NY, a Task Force composed of the agent banks, broker dealers, cash lenders and the Securities and Exchange Commission took a hard look at market practices that had been in place for decades. The consensus? The time was ripe for reform, and the most effective reform would come from the inside out, driven by those who navigated these markets on a daily basis.

According to Kelly Mathieson, Head of Global Custody and Clearing at J.P. Morgan, “This process differed from other reforms which are often handed down by governments or regulatory bodies. We held ourselves to a very high standard, working collaboratively and with full disclosure on infrastructure and daily practices.” Mathieson believes the results speak for themselves: the comprehensive market reforms recommended last May by the Tri-Party

Repo Market Infrastructure Task Force are already being implemented, and December saw the publication of a detailed implementation timeline.

market leadership through strategic solutionsAs a market leader, J.P. Morgan has been at the forefront of identifying opportunities, defining solutions, and educating the market on the proposed reforms and their likely impact. Based on the firm’s own internal assessments, J.P. Morgan has independently undertaken a set of strategic actions that largely anticipate the scheduled reform targets and directly address key Task Force recommendations:

• To reduce intraday clearing agent exposure and the daily unwind, J.P. Morgan introduced Auto Substitution in May 2010, even as the market reforms were first shared. This advanced, patent-pending capability has now been rolled out to all dealers, enabling them to lock up their term repos well in advance of the June 2011 deadline. Auto Substitution allows the release of assets held in tri-party repo loans

A View of U.S. Tri-Party Repo Market Infrastructure Reform

From the Inside Out


Gain Control with Global Longbox

For any global organization, one of the greatest challenges can be keeping track of assets and obligations across multiple entities, regions and portfolios. This is particularly true for banks and broker-dealers seeking to manage their collateral on an enterprise-wide basis. J.P. Morgan’s new Global Longbox service will simplify the task of effectively allocating, monitoring and managing collateral.

The Global Longbox is designed to provide a fully global, integrated view of collateral positions and obligations, for the first time giving clients access to information aggregated across platforms, legal entities and underlying accounts.

Using Global Longbox, clients will be able to quickly access a snapshot of their obligations, including current and projected positions, at any time. A hierarchical view extends from the global portfolio, where positions can be viewed at a corporate or ‘parent’ level, through to specific legal entities or each individual account. This will provide a single point of reference for decision-making, asset utilization and allocation, enhancing the client’s ability to fully leverage and optimize their combined global collateral inventory. According to John Rivett, Global Product Executive for Collateral Management at J.P. Morgan, “With Global Longbox, clients

will have the information they need to better manage their intraday financing and monitor liquidity across their enterprise.”

The initial rollout of Global Longbox will support clients trading in the U.S. domestic and international tri-party repo markets. Aggregated asset inventory will enhance the ability to manage exposure with a clear view of pending, cleared and settled trades. This will facilitate rapid assessment of the impact of those trades on available collateral. At the same time, portfolio managers will have access to in-depth breakdowns that show available, obligated and encumbered positions,* plus the security details behind each position. Drill down capabilities will provide access to more than 100 data elements on nearly two million securities, with search and filter options that include concentration by index, asset class, currency and more. Rivett notes that the service will be extended to deliver more information and encompass other security classes, such as derivatives, in the future.

The Global Longbox will give banks and broker-dealers greater control, with data and intelligence to support informed decision-making at every level – from the individual account manager to the global CFO.

*Position and pricing data reflects currently available information as dictated by market practices and time zone considerations.

manage their collateral on an enterprise-wide basis.

Finally, J.P. Morgan is working closely with its clients to discuss the ramifications of the Single Settlement Window proposed by the Task Force. According to Mark Trivedi, Senior Product Manager – Clearing and Custody, the Single Settlement Window would further reduce intraday credit exposure but also creates significant operational and infrastructure complexity. “Given our in-depth understanding of our clients and these markets, we are leading the development of industry-wide solutions. As always, the challenge is to take the model from concept to implementation,” comments Trivedi.

Mathieson agrees, noting that even as market participants work collaboratively to define the mechanisms and requirements for reform, including orderly liquidation and default, J.P. Morgan remains committed to driving industry development – leveraging the full strength of its franchise to continually deliver on its history of service and innovation. n

FeBruArY• Clearing banks to implement auto substitution• Clearing banks to begin supplying committed credit facility

term sheets to dealer clients

JuLY• All dealers and all large lenders participate

in 3-way trade confirm/matching• Initial changes to single settlement window

APrIL• Clearing banks to

introduce 3-way trade confirm/matching

SePTemBer• Dealers continue to

subscribe to committed credit lines

OCTOBer• Clearing banks to stop

providing uncommitted intraday credit

AuGuST• All dealers and lenders participate in 3-way trade confirm/matching• Additional moves towards single settlement window• Dealers subscribe to capped committed credit lines with the clearing banks

Key 2011 Task Force Deliverables

• • • • • • • • • • • •


Multinational corporations create employment for hundreds of thousands of individuals and

secure the retirement for hundreds of thousands more. In fact, approximately 65 of the largest

global 300 pension funds have a multinational corporate sponsor. These 65 multinational

pension funds have combined assets of $1.3 trillion.1

Benjie FraserWSS EMEA – Practice Lead

Pensions

Strategic Challenges and Opportunities for Corporate Sponsors of Multinational Pension Funds

Managing costs is another key driver for a multinational approach. Pension plans in multiple jurisdictions each with their own service provider (custodian, asset manager, administrator) incur additional costs and demands on resources required to manage these various functions. Streamlining processes and using the same service provider across multiple locations can arguably help reduce costs.

Longevity is an ongoing challenge and widely underestimated. Multinationals in particular, given their size, are exposed to longevity risks. However, the issue is not simply that life expectancy has increased, it is the uncertainty about the degree and predictability of that increase which impacts longevity risk. For multinationals, longevity risk will require greater provision to be made for pension liabilities, which in turn will reduce available cash within the organisation that would otherwise be directed towards capital investment, dividend payment to shareholders or protective measures to avoid insolvency.

Consequently, for some multinationals, the strategy is no longer to add money to the pot, but to focus on managing the liabilities. A challenge here is the difference in opinions on how to match and measure liabilities, which is often the result of using different investment consultants in different countries. Therefore, not only does the corporate sponsor need to ‘convince’ trustees to take a multinational approach, but also the consultants advising those trustees.

The multinational pensions journey There is what might be called a pensions ‘journey;’ a spectrum of available routes to take, with increasing levels of standardisation and centralisation. The corporate sponsor chooses where they ideally want to be on that spectrum, whilst taking into account the challenges they will face, be

In October 2010, J.P. Morgan held its first forum for corporate sponsors of multinational pension funds entitled, ‘Strategic Challenges and Opportunities for Corporate Sponsors.’

The audience included some of the world’s leading multinationals and their advisors. Two multinationals – Shell Asset Management Company (SAMCo) and Philips – gave their perspectives on the challenges they are facing.

Why take a multinational approach?The structure of a multinational pension fund may be complex. It will typically include a network of schemes of different sizes, with mixed DC and DB assets, held in different jurisdictions, with varying reporting requirements, allocation strategies, and governance models, including local trustees with a strong local market culture. This structure generally reflects the historical development of the firm.

The corporate sponsor, usually acting through the Chief Financial Officer, requires sufficient visibility into this network, to better understand the inherent risks involved and potential efficiencies to be gained. The natural preference is to have a centre of expertise, which can manage the risk holistically across this network. However, there is a balance to be struck between the urge to centralise and standardise on the part of the corporate sponsor, and the need for autonomy on the part of local trustees, seeking to serve the best interests of their pensioners.

The CFO is protector of the balance sheet of the pension plan. She or he needs a clear understanding of the asset portfolio risks, asset concentration levels and liabilities at a global level. To understand these, the corporate sponsor needs transparency and consistency in reporting.


they legal, tax, regulatory or cultural. There are incremental potential steps on this journey captured in the matrix below.

Simplified governance structure – a process to simplify the demands of governance of service provider relationships, streamlining these with the goal of achieving economies of scale by using fewer providers (such as asset managers, administrators and custodians) and thereby leveraging buying power.

Global / consolidated service provider – the provision of data to the corporate sponsor through multiple data sources is one of the main impediments to transparency. A single data source (most effectively achieved through one or maximum two service providers) enables standardisation and reduces operational risk. This was the approach taken by SAMCo, who reduced the number of custodians they were using from 10 to 1. The global custodian route is a priority for numerous multinationals, given that dealing with different custodians across jurisdictions is time-consuming and introduces risk.

Global consolidated reporting – consolidated reporting for the corporate sponsor covering custody, fund accounting, performance, and risk and compliance reporting.

Cross-border asset pooling – asset pooling allows multiple pension plans to pool their assets into a common fund with the purpose of investing these on behalf of the underlying

plans. In recent years, pooling has helped multinationals improve the management of their global pension plan assets and benefit from cost efficiencies, including tax savings.

Pursuit of these solutions does not mean that trustees will lose their independence. However, the corporate sponsor will need to engage trustees and communicate the bigger picture. If trustees do not have a full understanding of the issues and solutions, they may feel they are being pushed down a road they do not understand and which is not aligned with the interests they represent.

Above all, experience from the forum suggests there is no one ideal solution for multinational pension provision. The right solution will critically depend on each organisation’s specific situation and business goals.

The 2011 Forum for corporate sponsors of multinational pension funds takes place in Paris on 29th/30th September. For further information please contact:

Benjie Fraser, WSS EMEA - Practice Lead Pensions [email protected] or

Kate Spencer, Consultant Relations, [email protected]. n

1 Towers Watson, Top 300 Pension Funds, 2010. The top 300 pension funds represent $11.3 trillion in pension assets.

Solutions and Benefits Matrix

Leveraging Buying Power

√

√

√

√

managing Costs

√

√

√

√

Solidarity Among

Smaller Funds

√

Greater risk management &

Governance

√

√

√

Tax Savings

√

Reporting Requirements

√

√

√

Solution

Simplified Governance Structure

Global / Consolidated Provider

Global / Consolidated Reporting

Cross-Border Asset Pooling

How Technology is Changing the Face of Operations for Asset Managers



Over the years, technology has made the industry more

automated, responsive and effective. Until recently asset

managers expected their service providers’ operations to

be reliable, secure and timely. That’s no longer enough –

expectations are raised.

canvas to create the “perfect” technology platform and solution, because it would be too disruptive to day-to-day business. Fund managers need to ensure their existing operating architectures, which may have come together piecemeal over a number of years, work together to provide transparency to each of their stakeholders.

Risk managers, regulators, investors, and front-office managers are increasingly focused on the data they need on a regular, usually daily, basis. Market volatility only exacerbates this challenge. Asset managers need a solution that will allow their data to be viewed in a number of ways, in order to meet the requirements of their multiple stakeholders. And asset servicing providers need to provide solutions to manage multiple data sources and formats.

The meta data repository solutionA meta data repository addresses the way data flows through fund managers’ systems architecture. It describes and defines data elements that are the essential building blocks of an asset manager’s business. By defining all data, the repository creates a standard format so data elements can be used, reused, manipulated or recycled through an asset manager’s entire architecture.

The diverse hardware and software that many firms utilise can include mainframes, rules engines, databases and reporting frameworks. By using a meta data repository, fund managers

can label different data in the same way, ensuring stakeholders and anyone in the organisation can see the data in a way that makes sense to them, to meet their specific needs.

This works by creating a common business glossary to give data a common meaning across these disparate systems within one firm. For example, the meta data repository is able to reference the variations of data formats through all of the different systems and have the data fully reconstituted and normalised by the time it is used in a post-trade report at the back-end of the transaction lifecycle. Proprietary information that used to exist only in an individual’s head may now be translated to a fully automated system, thus increasing productivity and ensuring the process is embedded in the organisation, and doesn’t depend on one person.

If used by fund managers, this methodology would enable them to be more agile in how they cope with changes to their technology systems, reducing development costs and improving the understanding of business requirements. If an asset manager adds a new instrument or fund type, operations can move very quickly to update their back and middle offices.

A meta data repository also improves the collaborative process between business and an operations provider on a global basis and creates an easier experience for all users. It establishes the single “golden record” and uses a common language that forms the basis of any communication between business and technology users both internally and externally.

Testing: the heart of stability and managing changeThe process of change is a complex one, and testing is critical to ensure it is successful.

Today, there are new imperatives – flexibility, transparency, keeping up with the speed of change and interoperability – to enable asset managers to interact with an increasing number of stakeholders and infrastructures, including investors, brokers and exchanges. These requirements are equally as important as reliability, security and timeliness. They bring with them new challenges, and new thinking is required when asset managers look for solutions to support the day-to-day issues.

There are four important ways the new named imperatives are being met:

• Transparency, supported by data storage and management

• Speed of change, managed through testing

• Flexibility, delivered via communications, and

• Interoperability, advanced through component-based outsourcing.

Data: the foundation of transparencyFor asset managers, data is an essential and fundamental component of any operating and business model.

The search for one platform to provide end-to-end processing is over; it doesn’t exist. An asset manager’s business model isn’t homogenous, and the majority of asset managers have grown by adding processes and infrastructure as their businesses developed. It is not normally feasible to start with a blank


One of the most intense communications between business and technology is testing. The testing phases and life cycle can be the most complex and time-consuming part of any change process.

This process is now easier: the use of automated end-to-end testing ensures any system defects are identified early in a change process, which makes testing smoother than before.

Pre-launch testing is crucial. Traditional technology projects often leave testing until the end, once the number of users involved and the ways they would use it is fully defined. This process created long tails in the development process, with the testing procedure dragging on. By carrying out testing during the life of a project and bringing as many data-related processes into the technology sphere, it is no longer just the systems infrastructure that benefits from full testing, but also the less tech-heavy business users. This means testing can be completed in a much shorter time,

The interaction between managers and clients is one area to look at for such opportunities. Video conferencing has made huge advances in both functionality and cost. For example, there is a more effective way of installing video conferencing technology that leaves a more indelible footprint so there can be a continued dialogue rather than a series of one-off and unrelated exchanges. It is possible to use video to create a business-to-business backbone for communication that can bring in other stakeholders. Video is now embraced by the business community in the way personal technology users have done for years. One example is the excitement over the iPad 2’s addition of a high definition multimedia interface (HDMI) facility to enable a richer video-conferencing experience – and more of this technology is being made available on office desktops. There is also a dramatic increase in the use of social media, collaboration suites and the social mining of data to enrich the process

and what used to take months can now be completed in days.

As asset managers’ structures become more global, a service provider’s focus on one region for the development of products is limited. Fund managers need platforms that are flexible enough to work across global and multiple business segments in any location and for a variety of purposes, the meta data repository makes this easier to achieve.

Communications: the delivery mechanism for flexibilityTechnology is advancing at a rapid pace in all parts of our lives: personal entertainment, video and home entertainment (streaming and web-enabled TV), social interaction and business (faster and more resilient networks, BlackBerries). These new technologies are allowing for flexibility and transparency, two very sought-after attributes for businesses.

• Portfolio Management

• Marketing & Client Service

• Provider Management

• New Business Support

• Performance Attribution

• Client Reporting

• Cash Management/Collateral Management

• Data Management

• Asset Servicing

• Transaction Processing

• Transfer Agency

• Custody & Clearance

• Risk Management

• New Product Development

• Trade Execution

• Client Billing

• Performance Returns

• Complex Securities Processing

• Cash Administration

• Investment Accounting/Recordkeeping

• Securities Lending

• Reconciliation

• Fund Administration

• Fund Accounting

Identifying Functions for Outsourcing

INVe

STm

eNT

mAN

AGer

VArI

eS

BY m

ANAG

erSe

rVIC

e Pr

OVI

Der

LOW

Scalability

HIGH

HIGH

Investment Manager

Differentiators

LOW


ellen m. BishopManaging Director, WSS Technology

of engaging with B2B customers but within a secure and authenticated environment. Using social media to build groups of client relationships and discussion forums is an innovative approach from a global custodian.

Component-based outsourcing: the reality of interoperabilityThe burden of investment and the need for speed are re-igniting outsourcing discussions. It now takes on a different form. The classic model is one where the provider performs the bulk of the middle and back-office tasks including custody, accounting and administration, allowing the asset manager to focus on the front-office activities that make up their core competencies – such as stock picking, asset allocation and investment strategy.

Prior to the financial crisis, the objective for most service providers was to develop an outsourcing model that would benefit from economies of scale, because back and middle-office tasks are complex and involve a great deal of resources. By developing technology based on reliability, scalability and straight-through-processing, the asset servicing provider can offer a service that promises increasing value for both the outsourcer and its client.

In the current environment the focus for fund managers and their securities services providers has changed. Margins and returns in the investment market have been challenged and the search for growth has led many investment managers to pursue more exotic strategies. There are a broad range of strategies such as fund of funds, alternative UCITS and exchange traded funds moving into new markets to increase distribution capability, and new asset types, as key drivers of business growth. Complexity is seen as the greater use of derivatives and the increased involvement in emerging markets.

Coupled within this, there has been a convergence between the traditional and alternative ends of the industry, best illustrated by the growth of alternative UCITS funds which has led to new challenges and interoperability. These funds enable investment managers to use alternative strategies such as synthetic shorting and OTC derivatives but within the regulated environment of UCITS – a popular structure that saw inflows increase 70% in 2010. These strategies are increasingly adopted by all managers. A service provider must be focused on the differences between these converged funds and traditional funds, because they have different needs.

Despite their differences, these new UCITS can benefit from outsourcing the same way traditional funds can, with third-party providers performing more client-facing tasks, like client reporting, asset valuations and performance measurement.

This trend is likely to be reinforced as a result of the changes in UCITS IV which comes into effect in July 2011. The new framework, with its focus on master-feeder structures and management company passports, means fund managers can benefit from the economies of scale asset servicing providers have built up, to take advantage of services that operate across domiciles.

The new regulation is also likely to enable asset servicing providers to offer an expanded range of services, such as the production of the Key Investor Information Documentation (KIID), either by supplying clients with the necessary fund data or assuming the full production of these investor reports.

Component-based modelClients’ data needs are increasingly sophisticated. Data previously sent overnight to be used in the back-office is now being fed to the front-office on

an intra-day basis and is increasingly used for investment decision-making and to actively manage positions rather than for basic record-keeping and compliance purposes. As managers’ investment strategies become more global, they are adopting a ‘follow-the-sun,’ 24 hours a day model for reconciling their positions.

The key to ensuring that this component-based, securities services model is able to satisfy all clients’ requirements is based on an efficient and consistent flow of data between service providers and the client, as well as bearing the responsibility for this data flow. Standard message formats make this task considerably easier, but not every manager has implemented the latest Swift ISO format and many still have proprietary data formats.

Unfortunately there is no convenient rule governing the extent of standardisation – it is not as simple as saying the large asset managers are highly standardised and the smaller hedge funds tend to be proprietary. Any asset servicing provider has to develop a model that can cater for non-standard message formats and undergo the normalisation process and ensure that this model works for all fund strategies, traditional and complex.

This is not a commoditised business. No two asset managers are the same. However, there is commonality in processing approach.

J.P. Morgan’s response to these challenges has been the creation of a component-based architecture that allows for any or all processes within an operational life cycle to be outsourced. We are in the business of managing data on behalf of clients and continue to develop new solutions to ensure our technology is responsive and effective. n


As the world of real asset investing returns to a growth phase, private equity real estate fund

sponsors are faced with new challenges. Most fund sponsors face new, expanded reporting

demands from their investors plus a new level of exposure to the Securities and Exchange

Commission (SEC), the regulatory agency assigned to enforce new Dodd-Frank1 rules.

These new rules are designed in part to deliver transparency into funds, investment activities and investments as well as reduce risk. Given these factors, the word “transparency” is often introduced very early in a conversation with potential investors, and fund sponsors must be prepared to discuss it.

The definition of transparency is evolving – among both the SEC and investors. Investor reporting requirements vary widely with different levels of detail about the fund, assets in the portfolio and deals. A General Partner’s (GP) team must be available to respond to ad-hoc requests and potentially provide real-time, online access to data and reports. To the SEC, transparency may mean that fund sponsors must provide detailed information about not only fund books, but also deal activities, fee calculations and literally any area of the operation that exposes fund investors to risk.

The common thread throughout most discussions about transparency is the need to have highly organized books and records and the ability to easily open them for review. With this as the basis, a fund sponsor can move to the detailed process of examining each investor’s individual reporting needs and transparency definitions with the goal of preemptive preparation for compliance.

The challenges and the opportunityThis new environment of increased investor requirements and regulation creates a business challenge for GPs – but also creates an opportunity for fund differentiation. Funds that organize exemplary books and records as well as demonstrate responsive reporting skills will stand out in the eyes of LPs and regulators.

Is Your Real Estate Fund Team Ready for Transparency?

The challenge to a GP’s operation is clear: expanded transparency translates to more time researching asset data and compiling investor reports. Collectively, GPs want to be responsive to investor needs but are grappling with the increased burden on their resources. Ideally, most GPs want their team lean and focused on value-added endeavors such as finding quality assets, executing superior asset management, timing dispositions carefully, and servicing investor needs. While the back office supports core competencies, any growth of non-core personnel that results from expanded transparency needs is a direct cost to a GP.

Even with this challenge, some GPs see a window of opportunity in meeting investors’ new transparency needs – and the market is taking notice. Several large institutional investors have recently observed that those GPs who do fulfill investors’ expanded information requests are successfully differentiating themselves from their competitors. The happiest LP investment officer is one who receives pro-actively delivered, comprehensive investor reporting that shows improving property indicators and portfolio strength. Since LPs are typically limited on staff themselves, they look for partners who understand their investment committee needs and deliver investment transparency.

The GP opportunity is not merely for differentiation through better transparency – it is also one of winning more capital commitments. Institutional investors are shifting more investment dollars to real estate and alternatives as an asset class2 and many new real estate funds have emerged as a result. To win more of those expanding commitments, some GPs are adopting new software solutions and hiring,


while others are turning to third-party fund administrators to alleviate burdens associated with the books and records.

True transparency starts with granular property dataDuring a fund-raising period, fund managers today must sell their fund strategy to their prospective investor and demonstrate their ability to meet investor reporting needs. As a result, a GP’s back office operations — the people, process and technology — become part of an overall discussion about meeting transparency demands. A fund manager who demonstrates superior operations, including transparent reporting, may even win a commitment deal over another GP.

GPs should proactively address investor reporting expectations early in the process, especially now that most institutional investors wish to allocate capital in ways easier to monitor. Fund sponsors should consider

how they collect, store, calculate and report on portfolio data. Ideally, property, fund and investor data is stored in an audited, controlled and single database system, which streamlines transaction processing and reporting events.

The granularity of the asset data is important as well: investors want detailed views into portfolio risk and performance. Data must be collected from property operators, organized into a property database, and fed up to the fund entities to produce the relevant trending reports. This database would ideally be a single, unified database from property and asset data up to fund and investor data.

The GP’s Asset Manager and CFO – who some refer to as the “middle office” – are both active consumers of this detailed property data. Typically it is these individuals who follow property cash flow and occupancy trending. As risk appetites remain low, LPs may even require the GP to explain methods of calculating loan-to-value ratios, property forecasts, market lease assumptions and other important portfolio


Bonnie NovellaExecutive Director, Private Equity and Real Estate Services

metrics. For this middle office analysis to occur, the data collection process must be efficient and accurate and subject to similar transparency.

Questions for a fund team All of this may well prompt a self-assessment of the fund sponsor’s internal operations and systems. A CFO should examine what systems are used to calculate capital calls, calculate management fees, track fund performance, and prepare investor returns. This should include an examination of how complex calculations like preferred returns and waterfalls are handled. If the scrutiny uncovers heavy reliance on spreadsheets or generic quick-book accounting systems, these are likely to be insufficient to meet today’s transparency standards. Ideally, investor reporting is a by-product of the fund sponsor’s controlled, audited system and consolidated database. At some point, investors or regulators may demand a complete audit trail and outright reject reports which have been created offline.

To remove reliance on spreadsheets, a fund sponsor could consider licensing a software system designed for fund

accounting, or as an alternative, hiring a third-party administrator already leveraging such systems. Either option will yield a strong audit trail and reporting methodology supported by underlying transactions.

The impact of regulatory changesThe Dodd-Frank1 bill will have the first impact on private equity funds in July 2011 when regulators expect transparent views into fund books. Strong internal governance, well-documented events and internal controls are now critical to any GP who is now or will be a Registered Investment Adviser Firm.3 These GPs need to be prepared for an SEC review of their fund books and records, including a narrative analysis of deal activities and other functions that expose investors to risk.

There are many resources available to fund sponsors on Dodd-Frank from audit firms, attorneys and other industry resources. From a broad perspective, many GPs preparing for July 2011 are already beefing up their internal governance, people and systems, in some cases working with an audit partner or law firm toward that goal.

While hiring and buying technology is an option, an alternative is to hire a third-party fund administrator. A reputable fund administration firm should not only provide transparent report solutions, auditable systems and expertise, but should also remove the reporting burden from a fund sponsor. A third-party administration model should be delivered without sacrificing the GP’s control over the information or their relationship with their investors. A high-quality fund administration service supports the partnership in its goals of transparent reporting, while allowing the GP to fully control the messaging, content and timing of delivery.

Regardless of whether a firm expands their in-house systems or hires a third-party administrator, fund sponsors who can allow regulators and auditors to scrutinize books easily will have less disruptive fund reviews.

Transparency: a win for all stakeholdersIn summary, the real goal of transparency is to help the GP fulfill their fiduciary responsibility to all fund investors. With a streamlined operation brought on by this new focus on transparency, a GP can effectively allocate capital, manage the assets, maximize fund performance and return capital to investors. Investors can expect this transparency to foster improved return and minimized risk. It is a true win-win for fund sponsors and their investors. n

1 The Dodd-Frank Wall Street Reform and Consumer Protection Act, or HR 4173, passed in 2010 to amend the Advisers Act of 1940. Source: http://www.sec.gov/about/laws/wallstreetreform-cpa.pdf

2 Source: PERENEWS.COM by PEI Media. March 2, 2011 article “LPs look to deploy larger amounts of capital in RE in 2011.”

3 A Registered Investment Adviser Firm is a fiduciary registered with the SEC and subject to annual filing of Form 1A of Form ADV. Source: http://www.sec.gov/divisions/investment/advoverview.htm

A Fund Sponsor Benefits from Firm-Wide Optimization to Efficiently Deliver Transparency

Key questions for a Fund Sponsor include:

• Howmuchreportingisdoneofflinewithspreadsheets?

• Doallreportsandinvestorcalculationsderivefromatransaction-based, audited system?

• Whichpeople,processesandmethodsarerequiredtoproducenewreport formats?

• Howdoesyourteampackageanddeliverinvestorreportseachperiod?Are portals and electronic conduits used? Are those portals secure?

• Howefficientistheprocesstocollectpropertydata?


The process of lending out these securities affords an investor the opportunity to produce alpha by generating income that can be used to increase portfolio returns or reduce portfolio expenses all while accepting a manageable level of risk. For the global markets, securities lending provides critically needed liquidity in the financial markets, supports a variety of trading strategies, facilitates trade settlements and supports general financing techniques.

mechanics of a transactionIn a traditional securities lending transaction, securities are lent short-term after provisions such as loan length, collateral type (cash or securities) and rebate rate or fee are agreed to by a lending agent and borrower. When transactions are collateralized with cash, a rebate rate will be negotiated between the lending agent and the borrower. This rebate rate, stated as an interest rate, represents the interest on the borrower’s cash collateral that the lending agent agrees to pay back to them at the termination of the loan. In order to generate a yield, the lending agent will invest the cash via a commingled fund or a separate account in short-term fixed income instruments in order to generate a spread above the rebate rate. The difference between the yield on the cash collateral and the rebate rate is the revenue that will be shared between the lender and their lending agent. Consequently, lenders should be aware of the market risk they assume with the investment of the cash collateral.

If securities (e.g., fixed income or equities) are accepted as collateral, or there is no cash to invest, a borrowing fee is charged. The fee will be applied against the market value of the securities on-loan and is shared between the lender and their lending agent.

Oversight and monitoring – overviewLenders should monitor their securities lending programs to ensure that they are achieving their objectives while staying within the expected risk profile. This monitoring should encompass three areas: lending, collateral and performance. Within each area, various metrics should be reviewed on a periodic basis by individuals whose training is in line with the appropriate oversight task. Oversight can be conducted through reporting, due diligence reviews, and on-going communication with the lending agent.

Oversight – lendingThe first area of oversight, lending, focuses on the loan side of the transaction. Specific metrics should be reviewed daily, while others can be done monthly. Lenders should be aware of the counterparties (i.e., borrowers) involved in their program, review the market value of securities on-loan to each, and the proportionate share that each borrower has to their overall program. Lenders may want to avoid concentration risk by requiring their lending agent to use a diverse universe of borrowers. Since lenders are typically indemnified by their lending agent against borrower default, they need to be comfortable that their lending agent has the capital resources available to stand behind the indemnification, and therefore, it’s important for lenders to be aware of their lending agent’s financial condition. Finally, lenders may find it prudent to aggregate their securities lending borrower exposures with that of other transactional activity (e.g., swaps) to determine their overall firm-wide exposure to various counterparties.

At its core, securities lending is an investment overlay strategy. It’s an investment product that

complements existing investment strategies allowing investors the ability to take a portfolio of

idle securities and monetize their intrinsic lending value.

Securities Lending Defined


The vast majority of loans are for an overnight (i.e., open) period, meaning they can be terminated on any day and the rebate rate can be negotiated daily, when the transaction is secured by cash collateral. When loan transactions are collateralized by cash, lenders should compare the yield earned on the cash collateral against their loans’ overall rebate rate in order to gauge the profitability of their program.

Generally speaking, loans are overcollateralized at either 102% for same currency transactions or 105% for cross currency transactions. As such, lending agents mark-to-market the collateral daily after the financial markets close to determine if additional collateral is required from the borrowers or if collateral needs to be returned.

To further gain an understanding of the supply/demand dynamics of their lendable assets, lenders should periodically evaluate their utilization rates (e.g., program-wide and security type) to determine how much of their portfolio is out on-loan. With this information, lenders can assess the overall risk/reward profile of their lending program. For example, fewer loans with higher fees or wider spreads imply a high degree of “specials” (i.e., high borrowing demand) allowing for a lower risk/higher return program or a very efficient loan distribution.

Lending securities should be largely transparent to the lender’s portfolio management process and it should not impede an investment manager’s trading ability. On occasion however, a security that was out on loan and subsequently sold by the lender may fail to be delivered on settlement date. Failure to return securities on time may be caused by a combination of lower liquidity and high borrowing demand or a sale instruction received past an agreed upon deadline. Under most circumstances, large securities lending agents may be

able to execute a loan swap thereby substituting the loan with another lender to avoid the fail. If this option is not possible when sale instructions were received on-time and the lending agent provides contractual settlement, lenders will be advanced the sale proceeds on settlement date. The borrower will be penalized by not being entitled to share in the earnings from the investment of the cash collateral from the fail date forward. In those cases where a security sale fails as a result of lending, the lending agent should provide a detailed analysis of the underlying cause and propose a resolution strategy. Actively reviewing the metrics of securities on-loan provides a lender with the necessary tools to adequately assess exposures to various counterparties, borrower demand, and the overall intrinsic value of their portfolio.

Oversight – collateralThe second area of oversight involves the review of the collateral. As previously mentioned, securities lending transactions are either collateralized with cash or securities. In either case, it’s incumbent upon lenders to know whether their lending agent indemnifies them in the event of a borrower default to protect against the risk that the value of the securities or cash collateral delivered to the lending agent is not sufficient to cover the return of the collateral to the borrowers at the end of the loan, or in the unlikely event of a borrower default.

Market events that can affect your securities lending program when cash collateral is accepted:• Federal Reserve eases or tightens rates • Credit spreads widen or contract• The yield curve inverts, flattens or steepens • Short term interest rates such as LIBOR rise or fall

Cash which is typically used to collateralize a loan transaction in the United States is invested in short-term fixed income securities, adding a layer of investment risk to the lender. Therefore, it’s prudent to have an individual with fixed income investment experience involved in the monitoring process. In addition, it’s imperative that lenders have documented, well defined and transparent cash collateral investment guidelines. Overseeing the cash collateral in a securities lending program should encompass a similar process to that of any short duration fixed income mandate. Essentially, when cash collateral is involved, a lender takes on the risks from the investments such as interest rate, credit, duration and liquidity risk, and therefore having input from individuals familiar with such risks is recommended.

As financial market conditions change, lenders should work closely with their lending agent to be aware of the effect of these changes on their program and anticipate the impact


of market events. An understanding of how these events or actions can affect or influence a program’s profitability and performance is critical in order to assess whether a mandate is positioned appropriately to be in-line with its expected risk and return.

At the very least, lenders and their lending agent should discuss on a periodic basis the cash collateral investment strategy, investments held and overall program philosophy. As a starting point, a lending agent should provide an indication or estimate of the expected return from the investment of the cash collateral versus the demand to borrow securities while lenders should assess whether this estimate is in line with their risk/return profile. Lenders need to have a clear understanding of their program’s cash collateral investment guidelines with respect to such attributes as security types, duration, sectors, issuer concentration, liquidity levels, proportionate share of fixed versus floating rate securities, and credit ratings.

When securities (i.e., not cash) are used to collateralize a loan transaction, if the lending agent does indemnify against borrower default, then a lender’s exposure to their lending agent is increased. Knowing the types of securities utilized to collateralize their loans and whether or not indemnification is provided against a short fall in the value of the collateral, will help lenders discern how much if any of their lendable portfolio’s risk profile has been altered and therefore, how their portfolio might be impacted by market movements or events. Effectively, if one security type is loaned out to a borrower and collateralized with another security type, a mismatch scenario would ensue and the risk profile of the lender’s portfolio could be altered. Consequently, it’s important to be aware of any correlations between security types.

Oversight – program performanceThe last area of oversight involves the assessment of the overall program’s performance with respect to investment return, core drivers, and the associated risks taken. It’s not enough to focus solely on earnings; a lender should seek a clear understanding of how those earnings were achieved.

Program performance focuses on reviewing:• Investment return• Core drivers• Risk taken

Earnings can be derived from two places – the demand to borrow securities and the investment of the cash collateral. Assessing the performance of a program that accepts cash collateral encompasses a variety of metrics. First, lenders need to be aware of three types of spreads – gross, demand and investment. The investment spread is the yield the lender earns on the invested cash collateral less a risk free rate (generally viewed as the overnight Fed Funds rate) and the demand spread is the difference between the risk free rate and the rebate paid back to the borrower. The combination of the two spreads equates to the gross spread. Wider investment spreads may indicate a greater assumption of investment risk, and similar to any other investment strategy, this risk is borne by the lender. Therefore investment guidelines should reflect the lender’s risk/return profile.

An important metric that lenders should understand is the maturity gap. The maturity gap measures the difference in duration between a lender’s assets (i.e., cash collateral investment portfolio) and liabilities (i.e., loan portfolio).

Tips for Better Oversight

To facilitate oversight, lenders should obtain information on a variety of metrics including:• Borrowerexposures• On-loanamounts• Collateralizationlevels• Rebaterates• Spreads• Investmentportfolioorsecuritiescollateralholdings• Earnings

Lending Oversight Tips

In managing your lending, monitor the following:• Counterpartyexposure• Lendingagent’sfinancialstrength• Yieldoncashcollateralversusrebaterate• Openversustermloans• Factorsthataffectrebaterates• Marketvalueofcollateralversusmarketvalueofthe

securities on loan• Securitiesthataretrading“special”• Utilizationrates• Securitysalefailsasaresultoflending


Joshua m. LavenderExecutive Director, Securities Lending

Generally speaking, a wider maturity gap increases a lender’s interest and duration risks but can lead to greater earnings as one moves further out on an upward sloping yield curve allowing a lender to take advantage of higher interest rates. Familiarity with the projected direction of interest rates, expected changes to the slope of the yield curve and an understanding of the proportionate share of fixed versus floating rate investments will help a lender ascertain the level of risk their securities lending agent is taking in managing the maturity gap risk.

Looking at trends and discovering the core drivers behind a program’s results is an important oversight tool for lenders. Reviewing results and trends of various metrics such as earnings, utilization rates, spreads, and the maturity gap will allow lenders to ask questions about their program’s performance. Lenders will gain a better understanding of how changes in borrower demand and interest rates along with market activity affect their results and will help set future expectations.

Depending on a lender’s resources and the overall sophistication of their program, more extensive due diligence reviews should be conducted with their lending agent on a quarterly or semi-annual basis to discuss in greater detail the market environment, performance results and attribution and the agent’s overall program as well.

Summary Proper oversight is about education, monitoring and goals. Having a thorough understanding of securities lending, performing on-going monitoring of the key metrics behind your program and having a defined set of goals with respect

Tips for Monitoring your Program

As a lender you should work with your lending agent to understand the factors that affect rebate rates and be aware of the proportionate share of open versus term loans to determine how interest rate changes will impact your program’s return.

Monitor the market value of the collateral versus the market value of the securities on-loan on a daily basis to make certain that the collateralization of the loaned securities remains at a sufficiently protective level.

On a daily basis, inform your investment managers of securities that are trading “special” since it may provide them with additional market color.

Collateral Tips

Review the following in managing your collateral: • Cashcollateralinvestmentstrategy• Securitiespurchasedwithcashcollateral• Programphilosophy• Investmentguidelines• Securitiescollateral

to lending motives and risk/return parameters will provide the framework for proper oversight.

Today, securities lending continues to present an attractive opportunity for investors to generate additional alpha or income within a risk controlled environment. Utilizing a disciplined oversight approach, this investment strategy allows lenders to benefit from enhanced portfolio returns and lower operational expenses while remaining transparent to the portfolio management process. On-going oversight by an appropriate set of professionals enables lenders to gain a better understanding and appreciation of the risk/return dynamics in their program. n

Performance Metrics

In assessing the performance of a program that accepts cash collateral the lender must understand the following metrics: • Grossspread• Demandspread

• Investmentspread• Maturitygap

Core Drivers of Program Results

As lenders assess their program’s various metrics, they should be aware of the core drivers behind these results. Examples include: • ChangesintheFedFundsrate• Fluctuationsinborrowing

demand• Increased/decreasedmarket

volatility• Highnumberof“specials”

securities

• Increased/decreasedlendingof less liquid securities such as small cap equities and high yield bonds

• Lendinginternationaldividendpaying equities during a specific time of year

New

Mar

kets

– Assess/Access



GLOBAL CuSTODY Identifying the right markets and the right optionsWith a global custody market that is fairly saturated – for example, J.P. Morgan alone offers global custody in over 100 markets – the markets yet to be accessed are likely to be smaller and/or may be complex. Gaining a clear view of the opportunities and challenges that await a foreign investor is the key to deciding whether a market will be opened. According to Kelly Mathieson, Global Custody and Clearing Executive at J.P. Morgan, “The genesis for evaluating a new market may vary – either we may believe it is of broad interest to our client base, or a client might ask us to explore it. Regardless, our approach is the same. The fundamental question is whether this is a good fit for us and for our clients.”

An initial market review focuses on five key areas:

• The market and financial infrastructure – from the cash and securities landscape, to the role of a central bank or central securities depository, to an understanding of the structure of local exchanges.

• The regulatory landscape – the regulations that would govern the agent, laws or limitations which might be in place today and affect cash and securities transactions locally, and forthcoming changes.

• Legal precedents – the contractual expression of market practices and policies, and what they mean to the agent and to foreign investors from both a practical and commercial point of view. How are foreign investors treated under local law?

• The provider landscape – what local options are available and how do they operate?

• Specific market risks – the risks and nuances in the market and their impact on the agent and on foreign investors.

As Beth Fortier, Network Management Executive at J.P. Morgan, states, “With that foundation, we can determine whether a market is a good fit, as we recently did in Uganda and Costa Rica. Next we enter an active market opening phase, where we gather market intelligence to gain a deeper understanding.”

Market opening requires a comprehensive evaluation that explores the risks and issues a foreign investor might face when entering that market. Factors to be considered include an analysis of trading and settlement practices, cut-off times, corporate action policies, the mechanics of foreign exchange, unique market issues or restrictions, and more. End-to-end processes are thoroughly scrutinized to assure a clear understanding of all key aspects,

As global institutions increasingly seek to expand their operations to take

advantage of worldwide business opportunities, they constantly evaluate the

options and arenas for investment available to them. These institutions rely

on their agents to help them assess the viability of new markets for foreign

investment, with an in-depth, risk-focused look at clearing, settlement and

custody practices.

Taking a Direct Approach

In October 2010, J.P. Morgan announced an expansion of its direct custody and clearing capabilities, in conjunction with its plans for international growth. For each of the firm’s priority markets – aligned to its international expansion strategy – the firm may choose to create a tailored direct custody model to offer local custody and clearing services, as well as service for cross-border investment flows.

The decision to custody assets directly or employ a local sub-custodian is

based on market expertise, the local J.P. Morgan footprint, market complexity, an assessment of the best option for our clients, and other factors. In many markets, J.P. Morgan can best mitigate custodian risk by becoming its own sub-custodian.

J.P. Morgan currently provides direct custody in Australia, India, Ireland, New Zealand, Taiwan, Russia, the UK and the US. The most recent transition occurred in December 2010 in Ireland, with Brazil targeted for early third quarter 2011.


including market liquidity, exposure levels, documentation requirements, settlement processes, and investor requirements and obligations. Understanding the investment process is not enough; the foreign investor needs to understand its investment exposure to a market and the duration and extent of that exposure.

For a global custodian, identifying a local provider is another critical step. There are two options: either using a third party sub-custodian or a direct agent in the market. According to Rowena Romulo, Direct Custody Executive at J.P. Morgan, “We have a flexible model that can provide support in-country, in-region or globally; use either a direct or sub-custody approach; and combine core custody solutions with value-added securities servicing options. The key question is ‘which provider can best meet our clients needs and live up to our standards?’ Often, that provider is J.P. Morgan.”

Any potential sub-custodian must be a provider that is well-prepared to support its foreign investors regardless of extraordinary events that may take place (see page 14 for more information on sub-custodians). The right provider must demonstrate that readiness along with a thorough understanding of the regulations, settlement requirements and risks associated with that market. These include market factors such as liquidity risk, or harder-to-control factors such as geopolitical or natural

risk. Either way, the sub-custodian must be prepared to support foreign investors during both normal and unusual circumstances.

Once a new market is open, interested global institutions need access to market intelligence so they can decide if the market fits their investment strategy. To help clients make those decisions, Fortier notes that J.P. Morgan provides a comprehensive suite of information products containing everything necessary to get started – from detailed documentation requirements to key market information. The Network team she manages provides ongoing support to clients, including regular updates on market changes and nuances.

GLOBAL CLeArANCe Navigating the proliferation of exchanges and opportunitiesFor the sell-side, the ability to access a broad range of markets for both OTC and on-exchange (OEX) clearing that match their trading activity is increasingly critical.

• Making new OTC markets accessible to global institutions requires in-depth market knowledge, due diligence, and the appropriate legal agreements that span the products and services being offered. The nuances of a particular market are critical as they can have a significant impact on client activity. For example, back-to-back activity in a particular market may require different account structures and service from a buy-and-hold activity, and both activities may differ from one market to the next.

• OEX market expansion is currently driven by competition between the trading venues and the increased adoption of Central Counterparty (CCP) clearing as the market structure of choice. The trading community will look for connectivity

to most venues where the liquidity corresponds to their strategy. However, the rate at which new venues are being launched poses an ongoing, and increasing, challenge for them. As Jenny Furmidge, Senior Product Manager for Globeclear in EMEA, explains, “Our strategy is to keep up with the pace of market expansion by developing a broad footprint, either by becoming a General Clearing Member (GCM) or by accessing a CCP via a third-party GCM. Once the initial link to a CCP is established, the process of adding new OEX trading venues is greatly simplified.”

Increasing market fragmentation and the overall pressure on all-in execution and clearing costs just adds to the complexity of deciding how to access markets. For its clients, Furmidge notes, “J.P. Morgan provides a welcome service – the option of simplifying access to new markets with a single agreement, instruction window, and view of activities across the 60 OTC and 50 on-exchange markets we currently support in conjunction with the ability to provide direct service.”

This provides clients with substantial flexibility as they seek to manage their activities – either in multiple markets, or in a single market where they have high trading volumes and thus require ongoing visibility directly into that market, its processes and reporting sources.

J.P. Morgan’s unique approach blends direct and/or global access for clearance, settlement and custody activities and gives clients the flexibility to construct the solution that best meets their needs. Across the board they also benefit from J.P. Morgan’s disciplined approach to risk management combined with market-leading tools and expertise – designed to manage risk while expanding global opportunities to new markets. n

More Clearance Options – With More to Come

In the last 18 months, J.P. Morgan has expanded its clearance footprint to 20 new OEX trading venues and 4 CCPs.

With 15 OTC markets scheduled to open in the coming year, sell-side investors can look forward to an increasingly wide array of options in which to execute their trading strategies.


editor Michael Normandy

Contributors Jessica ConradBeth MeadJames MurphySara NortonAdele SmallKate SpencerRebecca StaimanPeter van DijkSharon Weise-Nesbeth

FPO

About JPmorgan Chase & Co.

JPMorgan Chase & Co. (NYSE: JPM) is a leading global financial services firm with assets of $2.2 trillion and operations in more than 60 countries. The Firm is a leader in investment banking, financial services for consumers, small-business and commercial banking, financial transaction processing, asset management and private equity. A component of the Dow Jones Industrial Average, JPMorgan Chase & Co. serves millions of consumers in the United States and many of the world’s most prominent corporate, institutional and government clients under its J.P. Morgan and Chase brands. Information about JPMorgan Chase & Co. is available at www.jpmorganchase.com.

J.P. Morgan is the marketing name for the Worldwide Securities Services businesses of JPMorgan Chase & Co. and its subsidiaries worldwide. JPMorgan Chase Bank, N.A. is a member of the FDIC.

We believe the information contained in this publication to be reliable but do not warrant its accuracy or completeness. The opinions, estimates, strategies and views expressed in this publication constitute our judgment as of the date of this publication and are subject to change without notice. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. J.P. Morgan Securities Inc. (JPMSI) or its broker-dealer affiliates may hold a position, trade on a principal basis or act as market maker in the financial instruments of any issuer discussed herein or act as an underwriter, placement agent, advisor or lender to such issuer.

In the United Kingdom (UK) and European Economic Area: Issued and approved for distribution in the U.K. and the European Economic Area by J. P. Morgan Europe Limited. In the UK, JPMorgan Chase Bank, N.A., London branch and J. P. Morgan Europe Limited are authorized and regulated by the Financial Services Authority.

For more information, visit: www.jpmorgan.com/wss

©2011 JPMorgan Chase & Co. All rights reserved.Approved by the Forest Stewardship Council.Printed in the U.S.A.

J.P. Morgan ACCESSsm is a powerful, fully integrated, browser-based

platform. It easily provides applications for all of your information,

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J.P. Morgan ACCESS – it’s a secure information solution for securities

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To learn more, please contact your relationship manager, or visit us at jpmorgan.com/wss.

The products and services featured above are offered by JPMorgan Chase Bank, N.A., a subsidiary of JPMorgan Chase & Co. JPMorgan Chase Bank, N.A. is registered by the FSA for investment business in the U.K. J.P. Morgan is a marketing name for Worldwide Securities Services businesses of JPMorgan Chase & Co. and its subsidiaries worldwide. © 2011 JPMorgan Chase & Co. All rights reserved.

Risk and Regulation - J.P. Morgan Home | J.P. MorganA follow-up to J.P. Morgan’s first forum for...

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Transcript of Risk and Regulation - J.P. Morgan Home | J.P. MorganA follow-up to J.P. Morgan’s first forum for...