To trust or not to trust? That is the big question which many firms responsible for investment accounting operations face today. I’m referring to the important issue of the dependability of custodial data. Can you rely on it? Should you rely on it? After all, it is, ultimately, your data and it is your organization – not the custodian’s – that will be impacted.

Though greatly separated by time and subject, I’m reminded of the sage advice handed down from my old-country, immigrant grandfather. He, speaking in fractured English, once asked my teen-aged sister about a particular boy who was taking her to a dance. Grandpa’s concerned tone and raised bushy eyebrows spoke volumes.

“Oh, grandpa, he’s a nice boy and, besides, this is America. It’s different here. You have to learn to trust people. Trust is a good thing!”

His head, covered with a dense jungle of snow white hair, nodded in a less than convincing, placating manner, and I knew he wasn’t really buying my sister’s reply. His answer confirmed my suspicion. “Yes, yes, to trust is good---but to not trust---is better!”

My grandfather, now long deceased, wouldn’t have known a custodian if it hit him over the head with a corporate action, but his wisdom is good advice that should be heeded by today’s asset management industry. So, how reliable is your custodial data? What forces contribute to the accuracy or inaccuracy of that data? And, what can an organization do to protect its interests?

The Problem

At the risk of alienating many of the fine, hard-working professionals within the custodial services community – some of them good, personal friends of mine for many years running – I am just going to come right out and lay it on the line: Custodial data is often far from reliable. There. I’ve said it, and I can’t take it back!

Sure, most of the data is accurate, but from a small number of inaccuracies large problems result. Security valuations sometimes cannot be relied upon. Valuations are always important, but in today’s troubled financial times, very serious repercussions can, and do, result from inaccuracies. Entitlements can be missed. This has a hard dollar affect on investment performance (not just the reporting but the actual investment return itself, if, for example, a dividend entitlement is missed. Corporate actions can be improperly processed. Foreign taxes might not be reclaimed. And the list goes on.

What’s Going On?

To understand the reasons behind these problems you have to look back at the evolution of the custody business itself. Originally, custodians provided only basic safekeeping services to their clients. Customers had to do their own coupon clipping and dividend collection. They even had to take their own securities out of safekeeping for trade settlement or for bond maturities. Settlement services were a later optional service that came about as a result of the custodian banks having had to perform these same processes for their own accounts, so it was a natural extension to leverage their own securities processing operations as an optional service to their clients. From that point on, additional services were eventually added – securities lending, global custody, performance reporting, and so forth. Now, a client can contract for as little or as much as they desire. Some custodians will even offer a complete outsourcing of back-office operations to their clients.

But here’s the dark side. As stated by the Comptroller of Currency in its Custody Services, Comptroller’s Handbook, “---Custody is a volume-driven, transaction-processing business, and much of the risk associated with it is operational in nature”. At the same time, the core custody business has become a commodity business, and with that comes very low profit margins. So, consequently, the key to success for the custodians lies in technology and associated automation of all forms of securities processing. Over the years the major custodians have built, expanded on, and patched-up an impressive array of custody systems. All of them are legacy systems, often monolithic in their architecture – but they do process the high volume, straightforward transactions efficiently and accurately. This is not the problem. The real challenge, as suggested by the Comptroller’s Handbook, is the manual operations – those things that must be done outside of their core systems, often (due to the low margins of this business) by entry-level staff that, if not overloaded, is surely not looking for extra work.

A Day In The Life

When things are going well everyone’s happy. The custody system chugs along and there is ample staffing to handle the exceptions. But, often, and especially at period endings (monthly, quarterly, yearly) things can, and do, get dicey. With the added volumes of processing it become more difficult to handhold the exceptions and other transactions requiring manual intervention. Transactions not of a plain vanilla flavor, such as interest-only mortgages, Treasury Inflation-Protected Securities (“TIPS”), and many others, often require a good deal of handholding, contributing to that operational risk the comptroller speaks of.

Decentralization of the custodian’s organization can create efficiencies but can also cause problems. For example, by passing a security back and forth to specialized departments, such as for corporate actions processing, a position will often be finalized with critical data fields still missing. Another significant problem occurs when the custodian does not update a security position in the chronological order of the related transactions themselves, but rather (as is sometimes the case) in the order in which the custodian receives the transactions. Thus, transactions can be processed out of their logical sequence and not-so-little things like an entitlement and the associated dividend can be missed. Only by rolling back the system and reprocessing the transactions in the correct sequence will this be corrected – but that often isn’t done. As a result your clients can be leaving money on the table, never to be seen again. Isn’t it tough enough to beat the indices without making it even more difficult?

Things I’ve Seen

Still need convincing? Well, how about the experiences of a very large pension plan that uses the services of a major custodian – a household name that you’d recognize, were I to identify them. While working with this pension organization I have personally seen the very clear handprint of two different employees of the custodian who have processed identical securities transactions in very different ways (each was in a different account, hence the work by two employees of the custodian). This wasn’t just an isolated incident but was repeated over time to the point where you could pretty much predict that the two individuals would treat the transactions differently. One was always correct, the other was always incorrect. Always! Ms. Right and Mr. Wrong. It got to the point where, knowing them so well, you began to feel a personal attachment to these two. Ok, maybe I’m exaggerating just a bit – but it’s no exaggeration to say that the data provided by the custodian was unreliable – and that’s really the point, isn’t it?

Regulatory Considerations

Regulations like FASB 157, “Fair Value Measurements”, effective since late 2007, are placing an ever-increasing emphasis on accurate investment accounting. This particular FASB Statement refines the definition of fair value and goes on to state disclosure responsibilities related to fair value and the methods used to measure it. Sarbanes-Oxley is another legislative initiative that puts added focus on financial and accounting disclosures. Are you comfortable that your custodian is as diligent in complying with these directives as you would be, were you responsible for them (which, by the way, you actually may be!)?

The net of all this is that valuations, especially for esoteric derivatives, and other challenging security types are seldom straightforward, and even a well-run custody operation may require input from you, the customer.

The Solution: A Separate Accounting Basis

Increasingly, we are seeing organizations deciding they cannot afford to rely solely upon their custodians in this all-important responsibility of accurate investment accounting. The stakes are too high and the opportunities to make serious mistakes are too many. Whether their assets are managed internally or externally or both, these organizations are using technology that is totally separate from that of their custodians to track all investment transactions and perform all of the related investment accounting. They will take data feeds from external managers, if they use them, and data feeds from the custodians and perform a complete reconciliation – often on a daily basis. The number of differences – each a candidate for accounting error – is often eye-opening. Rather than relying solely on the valuations performed by the custodian, they will often pull in securities pricing data from other third party sources such as Interactive Data Corporation and calculate valuations within their own accounting system. Ditto for corporate actions.

Sure, there is additional expense associated with keeping a separate accounting basis but, with billions of dollars at risk, can you really trust that your custodian will get it right? This is something that each organization must answer for themselves. As for me, I think that grandpa was a visionary - though he wouldn’t have known that word either.

About QED Financial Systems

Based in Marlton New Jersey, QED Financial Systems is a unique provider of a totally integrated portfolio accounting system solution to the public and private sectors. A small, privately owned company, QED carefully selects the organizations they choose to partner with and then provides an extraordinary degree of initial and ongoing service. As a result of this, QED has a 100% referenceable client base that is the envy of its industry. QED's clients account for approximately $1 Trillion in assets managed, with its largest single client managing approximately $180 Billion.

About Matt Mille

About the Author Matt Mille is a Senior Account Executive with QED. Over the past twenty-five years he has held senior account management and marketing positions with other financial services companies such as SunGard, SEI Investments, SS&C Technologies, Financial Models Company, Netik LLC, and Premier Solutions.