Following the collapse of Lehman Brothers (in September 2008) and the knock-on effects of the subsequent liquidity crisis, analysts predicted that power would shift in two ways:

– investors would be able to demand better terms from
investment funds; and
– investment funds would be able to demand better terms from financial services providers like brokers and custodians.

MF Global's recent bankruptcy presents an opportunity to review these predictions.

The main issue with brokerage and custodian arrangements surrounds the segregation of assets. Brokers and custodians prefer to have their clients' assets registered in the institution's own name because, amongst other things, it simplifies administration.

The result though is that the institution owns the assets and has only a contractual duty to the fund to return an equivalent asset. If the institution collapses, the fund becomes a creditor and needs to stand in line like any other creditor.

Funds generally prefer the assets to be held in an account registered in their own names with an independent provider and the custodian or broker operating the account under power of attorney.

It is easy to see why the broker's preference is more dangerous for the fund than the managed account.

Between these two scenarios are a number of different arrangements that purport to offer segregation. Most institutions do not offer full managed account services except to extremely large clients. However, they will sometimes offer other forms of segregation such as separate accounting.

After the collapse of Lehman, regulators took steps to enforce segregation in certain circumstances, including the typical broker / custodian situation. The UK branch of MF Global was required to comply with various legislation, including the EU Markets in Financial Instruments Directive (MIFID), which required segregation for many of its clients.

However, these regulations are not a panacea and the MF Global case has revealed systemic delays inherent in the new regulations which for many funds will be as devastating as the lack of regulation was in the Lehman scenario.

Before the administrators will allow any segregated assets to be transferred to their owners, they need to firstly verify that the assets are not in fact MF Global's and secondly finalise the administration costs and make sure that they are deducted from the affected assets. The administrators of MF Global say that this process will take about five months to complete. During this time, the affected funds will have no access to their assets which will obviously have a devastating impact on the affected funds' performance and their businesses generally.

The truth is that the post-Lehman events initially had both of the predicted outcomes. Not only did terms improve for funds and their investors, but regulations were introduced which protected them.

However, judging by the difficulty funds are having in finding providers that offer truly segregated accounts, it seems that the shift in the balance of power in the fund / institution relationship was short-lived.

Today, as prior to Lehman, the message is invariably, "Those are our standard terms. Take them or leave them." Furthermore, while the systemic protections funds benefit from today, are enhanced in comparison to the pre-Lehman era, funds cannot afford to be complacent.

The effects of a failure of a service provider can still be devastating and the MF Global meltdown serves as a reminder to all investment funds to review their brokerage and custodian arrangements.

Contact:
Shayne Krige, Director
Direct line: +27 (0)21 405 5161
Email: skrige@werksmans.com