Thriving in adversity: Withstanding operational challenges during Covid-19

Covid-19’s sudden escalation has not only exposed the fragility of financial markets, but it has forced asset management companies to think carefully about their business continuity planning (BCP) and operational resiliency to a level that few would have ever imagined.

While investment firms’ BCPs have been tested in the past by technology outages (i.e. cyber-attacks) or extreme weather events (e.g. typhoons in Hong Kong, Hurricane Sandy in New York, to name just a few examples), Covid-19 presents an altogether different challenge insofar as it is a global crisis with no clear resolution in sight. Despite the extreme market conditions and unprecedented levels of disruption, INDOS Financial believes that fund depositaries can play an important role in helping asset managers weather the storm.

The role of depositaries in protecting investors

Conscious of the rising Covid-19-induced volatility, the UK’s Financial Conduct Authority (FCA) recently sent a memo instructing depositaries and their UK authorised fund manager clients to provide more detailed information in the event of their funds running into trouble.

According to the memo, depositaries must issue an alert to the FCA with a full explanation if a fund is about to suspend shareholder dealing. Depositaries will also be obliged to inform the FCA if a fund incurs a NAV (net asset value) drop of more than 10% on any single day, caused either by volatility, client redemptions or other factors. Simultaneously, depositaries must notify the FCA when a fund suffers a disproportionate number of failed trades or if it is struggling to meet its margin calls. As a result, depositaries will play a significant role in ensuring that investor interests are fully safeguarded during this crisis.

Although the new reporting requirements are targeted at UK retail funds, many alternative fund managers will face similar challenges. It is crucial that any issues are managed carefully so investor interests can be protected.

Valuation and fund oversight

Regulators including the FCA and Central Bank of Ireland had made it clear that liquidity risk management ought to be a priority for asset managers after a series of high-profile fund suspensions in 2019. Elsewhere, new ESMA measures will soon require depositaries to affirm that UCITS and AIFMs have well-documented liquidity risk management processes in place. These rules were primarily introduced to stop daily dealing managers accumulating exposures to illiquid assets, potentially preventing them from meeting redemption requests.

However, the volatility is creating new, unexpected problems for regulators. In many cases, equity securities considered to be highly liquid and revenue generating at the beginning of the year – such as airlines, travel companies and hospitality services – are facing panicked, mass sell-offs and potential defaults. Given the uncertainty about how long the pandemic will last, the valuation of once vanilla assets is expected to become more difficult.

As we head into the March month end NAV cycle  which is also incidentally the financial year end for many UK fund structures, depositaries will play an important role and must perform their NAV and general fund oversight responsibilities as thoroughly as possible.

Facilitating BCP and a leaner operating model

 Covid-19’s disruption is making life particularly tough for smaller asset managers, many of whom will often only have a handful of key operational staff carrying out core back office activities. If one or more member of the operations team falls ill or is unable to access the relevant IT system, this could cause serious problems for small to medium sized (SME) firms.

Larger managers are also needing to adapt to a leaner operating model. During such critical times, it is essential the industry collaborates so that it can emerge from this crisis stronger and more resilient. Depositaries and other fund service providers should support clients experiencing any operational issues. INDOS, for example, stands ready to perform its usual detailed independent NAV reviews for clients who are unable to conduct their own checks.

Once the Covid-19 situation has passed, many firms are likely to re-think their operational processes moving forward. There are already suggestions that home working will become more commonplace, enabling firms to make cost savings by reducing their office space. If service providers such as depositaries are able to fulfil their obligations effectively and independently during these challenging circumstances, and demonstrate the value of the oversight they perform, then managers may also consider placing more reliance on this oversight thereby generating operational efficiencies.

Strong fund governance

Robust and independent fund governance during this critical time is more important than ever. Boards need to be assertive with managers if they are to fulfil their fiduciary obligations. This means probing managers about their BCP initiatives,  service provider resilience and risk management processes. Boards should also be evaluating the quality and level of management information being provided to them in a timely manner too.

Given these testing circumstances, boards should be meeting more frequently than on a quarterly basis as is the norm now. Despite today’s significant challenges, boards cannot afford to let standards slip or to take short-cuts. Right now, directors have a duty of care to investors to perform their governance commitments to the highest of standards.

Monitoring and review of service providers

Post-financial crisis, hedge funds learned some stark lessons about being overly reliant on a single prime broker relationship. Faced with the prospect of being unable to access their assets, hedge funds began to multi-prime in response and took a more vigilant approach towards regularly monitoring the creditworthiness of their counterparties. It is essential that fund managers continue to conduct thorough oversight of their providers.

It is equally important that managers have a clear oversight of what is happening at their fund administrators and other providers such as depositaries and IT suppliers. If one of these vendors were to suffer a credit or business continuity event, then it could put managers in an awkward position. It would therefore be wise for managers to engage with their providers about their operational resilience.

Even before Covid-19, a lot of managers adopted the multi-service provider model as they did not want to be over-exposed to any one entity. However, it is very probable more firms will now shift towards the multi-provider model as they look to mitigate their operational risk.