In this edition of our Dear COO series, we explore how a universal banking model enables hedge fund managers to consolidate services across their business, helping them to reduce costs and minimize operational risk, while also boosting efficiency and freeing up resources.
Over the last five years, even casual observers of the hedge fund industry will have noticed an unprecedented level of consolidation amongst service providers, from fund administrators and prime brokers, to technology providers and even audit firms. This trend has been particularly pronounced amongst fund administrators, and comes at a time when these firms have taken on a much broader set of responsibilities – including front- and middle-office functions as well as traditional fund accounting, investor reporting, and regulatory filings. This trend of consolidation has had many consequences, but potentially none as glaring as the increasing absence of global universal banks with a strategic focus on providing these services.
Why does this matter?
Certain services will always be provided by specialist providers. It is difficult to conceive of a world in which prime brokers provide legal counsel for fund formation, or audit firms provide middle office support. However, when hedge fund managers can reduce the number of overall relationships they need to maintain, the impacts on oversight, operations and ultimately on fund performance are plentiful. Furthermore, as trading counterparties and providers of balance sheet become increasingly selective in terms of their hedge fund client base, the benefits of partnering with universal banks across a broader range of services have never been more evident.
For the hedge fund COO, operational efficiency, risk management and cost control are paramount. By partnering with a universal banking organization that can provide a broad array of services, which currently may be performed by multiple monoline providers, there are significant advantages to be gained – including increased buying power, reduced operational risk, and the integration of services across front-, middle- and back-office – in a short period of time. Moreover, a strategic relationship with a universal bank brings the added benefit of increased buying power and significance as a counterparty, which makes the provision of customized solutions for client-specific challenges significantly more likely.
Increased buying power
Basel III – and specifically the Liquidity Coverage Ratio (LCR) requirement and Risk-Weighted Assets (RWA) framework – has in recent years led to increased funding costs for banks and a far more conservative approach to the allocation of balance sheet. This has presented a challenge for hedge fund managers that rely on various forms of financing, including prime brokerage, repo lines, or derivatives trading in order to run their investment strategies successfully. By consolidating relationships with valued trading counterparties and adding revenue streams for services that are not balance sheet intensive (i.e. fund administration, custody and related services), banks are able to substantially maintain (or even increase) their balance sheet allocations while still meeting their Return on Equity (RoE) targets.
For hedge funds that rely heavily on balance sheet, fees incurred for middle- and back-office functions are far from optimized on monoline providers that provide little to no additional value beyond their core services. While historically banks have been guilty of operating in silos, and have often not viewed their client relationships holistically, a variety of factors has led to a fundamental shift in this regard, particularly for those organizations that have integrated their Global Markets and Securities Services businesses into a single franchise with a consolidated management structure.
Each additional service provider – regardless of function – brings an added level of risk to hedge fund managers, since sensitive data is shared more widely. As cyber security has become a greater concern for managers and their investors, the level of oversight required for each vendor has increased exponentially. Hedge fund managers can reduce their risk, as well as the significant time and resources required for oversight, by rationalizing the number of vendors with which they contract. Universal banking organizations are ideally placed to help facilitate this given the breadth of their capabilities across an array of functions, from core fund administration to regulatory reporting, banking, and custody services, to name a few. This is made more compelling by the robust cyber security control frameworks that banks have implemented in recent years, helping to ensure security of client data and continuity of service (tested like never before by the rapid adjustment to remote working amid the spread of Covid-19).
Furthermore, the systemic role that banks play in the global financial system requires them to maintain the highest standards when it comes to countering attempted fraud, money laundering and terrorist financing. Recent – and well publicized – issues with standalone fund administrators highlight the increased risks for hedge fund managers with a global investor base, and the ever-increasing sophistication of bad actors in the financial system. The inherent controls that global banks have in place to counter these attempts provides the COO – as well as a hedge fund’s investors – with the peace of mind that comes with knowing these are of the highest possible standard.
Consolidation of services with a single provider brings economies of scale. When universal banks view client relationships holistically, clients benefit from the effects of relationship pricing and taking all revenue streams into account when assessing profitability. For hedge funds with strategic relationships with universal banks, the COO can leverage the broader relationship to ensure the most competitive pricing across all services, ultimately reducing the drag on fund performance. The breadth of services provided by bank-owned administrators – middle office, treasury, and collateral management, in addition to core fund administration – provides COOs with the option to outsource more functions, relieving internal resources and reducing fixed costs while ensuring stability and quality of service.
In a bid to differentiate and continue to grow their businesses, many fund administrators have increasingly pushed the idea of ‘front-to-back’ services in recent years, venturing beyond fund administration and traditional middle office (e.g. trade lifecycle management and settlements) into treasury, collateral management, and even execution. This has taken various forms, with some providers building their own infrastructure, and others partnering with specialists and connecting to their environment (BNP Paribas, for instance, has taken this approach with select partners). This has undoubtedly created value for hedge fund managers looking to reduce costs and become more efficient. However, the universal banking model – which integrates extensive capabilities across Global Markets and Securities Services – takes this one significant step further. With the ability to offer a leading Global Markets franchise – including execution and financing across all asset classes – with broad capabilities across collateral management, FX and custody, universal banks have the unique ability to redefine the very meaning of front-to-back. Furthermore, this provides significant opportunities for the consolidation of data, leveraging a single ‘golden source’ data set to support multiple functions, including collateral management, margin, and fund accounting.
A final word
As we emerge from the global pandemic into a new normal, the ability of hedge funds to control costs and respond to a shifting market backdrop will be more important than ever. A universal banking model enables hedge fund managers to consolidate services across their business, leading to lower costs, a significant reduction in operational risks, and the ability to rationalize the number of service providers with whom they work. Above all, though, it enables these managers to form a true partnership with a global banking organization that not only provides a long list of services, but also able to support their clients’ businesses over the long term, in a wide array of different ways and through all market environments.