Is Splitting the ABOR from Custody a Fiduciary Duty?

Among an asset manager’s books of record (i.e., investment book, performance book, accounting book) the accounting book of record (ABOR) is the most important. ABOR is the only book of record that is clearly governed by legal and professional standard setting institutions (FASB, GASB, SEC) and is the foundation of an asset manager’s publicly disclosed records.

Who is Working for Whom?

Reconciliation (cashflows, trades, and positions) between custodial records and accounting is a daily process for most asset managers. A good internal control system provides a mechanism to verify that transactions and activity are for the correct purpose and amount, and allowable. Errors and discrepancies should be detected, investigated, and resolved in a timely fashion.

Is the accounting service at your custodian actively involved in the reconciliation process and doing its job as the controller of the most important book of record? Shouldn’t the accounting function act as an independent check on custody? Or, to phrase it another way, is your custodian accounting service simply taking information from in-house custody and leaving it to you to find inaccuracies and make corrections?

Simply taking data feeds from custody and applying one-size-fits-all accounting amortization and accretion calculations is not especially taxing. Separating two functions within an organization can create a false sense of security that there is a check between the two functions. In fact, a robust accounting service overlays sophisticated investment modeling with accretion/amortization methods to properly apply income and expenses over an investment’s life. No, the true work is in the process of properly identifying and reconciling cashflows and in appropriately identifying and modeling investments.

Time spent manually gathering, reconciling, and generating investment data and manipulating it into usable formats often adds up to weeks and even months over the course of a year. Market volatility exacerbates delays, further reducing staffs’ and oversight bodies’ ability to rely on reports to make sound, timely, and strategic decisions. The effects compound in lost opportunities and staff resources, adding up to not-insignificant dollars over time. An ABOR provider should independently monitor and reconcile investment data in a timely fashion.

Handcuffing

The thought of changing custodial service providers sends shivers through many public asset managers (i.e., state treasuries and pensions). Why is it that custody is the source of so much angst?

At Clearwater, we have asset manager clients across multiple private sector industries, including the insurance sector with clients whose operations and assets are truly global and highly complex. These private sector asset managers widely view custodial services as a commodity service for which providers can be easily switched. Fear of the custodian seems unique to the public sector.

Public investment managers can be broadly grouped into pensions, treasuries, agencies, and local governments. But look a little closer and significant differences emerge within each group. Each public entities’ operating, accounting, investment, and reporting needs and processes differ (often significantly) because of each one’s statutory and regulatory construct and history. In many cases, it is a testament to public employee ingenuity that processes have been fashioned to track public funds across a disparate array of mandates, jurisdictions, and systems. One can almost sympathize with service providers that offload aggregation and reconciliation responsibility back onto their public entity clients.

Given the highly discreet nature of many investments and the labyrinth of processes and spreadsheets behind daily cash reconciliation, adding perceived operational risk of splitting accounting and custody is abhorred. As research in behavioral economics has shown, aversion to regret is a powerful force influencing sub-optimal decisions. It is better to be safe and allow the fairly hidden administrative costs to survive and subtract from net returns over time (which only grows with the compounding of opportunity cost returns) than to face the responsibility of a noticeable missed cashflow or wrongly recorded investment while implementing a split of ABOR and custody.

Public asset managers are seemingly handcuffed to their custodian by side-services such as accounting and performance and unfortunately feel compelled to accept poor customer service. It is difficult to hold custodial services to exacting standards when the custodian is providing the ABOR. Thus, asset managers are fettered to poor custodial services and poor customer service. Asset managers should be empowered to choose among custody providers and allow competition to improve both costs and service. Where is the incentive for the custodian to offer better service at lower costs if the barriers to competition are so high? By splitting ABOR and custody, the asset manager obtains greater leverage with both services.

Multi-Function or Specialization

Nirvana for asset managers is supposedly a single, real-time system providing sufficient support for the front, middle, and back offices. But could the single provider solution be self-defeating? A one-system-does-all service requires a significant investment of time, effort, and expense. The expense and difficulty implementing the all-in-one system creates a high hurdle.

With ever increasing complexity in strategies, investments, and structures, providing excellence in every aspect of the asset management process is a dubious promise. The benefit to the service provider of course is that this creates deep tie-in and significant barriers for change, reducing the power of the client. To my knowledge, history is not replete with examples of product excellence in noncompetitive environments.

The availability of data has increased exponentially in recent decades and with Moore’s Law pushing technological advancement, our struggle as humans to keep up and use it efficiently will continue. The complexity of financial information will become ever more nuanced. Consequently, investment accounting will also become more nuanced and complex. Public asset managers have unique transparency and reporting burdens, unlike the private sector. In addition to regular statutorily mandated public disclosures, public asset managers must often report to multiple oversight bodies, all of which operate on different calendar schedules and have varying levels of investment management backgrounds.

Providing reconciled and accurate financial data drawn from multiple books of record (ABOR, IBOR, PBOR) with appropriate levels of context and detail for various audiences is a heavy and time-consuming burden. Data aggregation and verification result in a cleaner data set and consistency in the data. Accurate, uniform data allows specialized system or service providers such as risk analytics, order management, and custodial to perform their respective functions with efficiency while allowing the client leverage and flexibility to better manage vendors and assets from a holistic perspective.

The Verdict

Clean, timely investment data plus improved vendor leverage reduces explicit and hidden expenses while improving decision-making.

Clearwater Analytics’ unique construct and customer service model make public investment managers natural clients. Clearwater comes to the relationship prepared for unique client needs; Clearwater’s service model provides a dedicated account manager and team to each client. The extreme flexibility of the Clearwater solution allows it to adapt to complicated processes. The modern ABOR should only be entrusted to a service provider whose core competencies are accounting and aggregating, verifying, and reconciling investment data.

Clearwater reconciles your data daily, ensuring that effects of incorrect data do not compound. It is critical to have a precise view of the portfolio at any point in time. A modern ABOR should record all assets within the multi-asset class framework, including hedge funds and private equity investments. Clearwater accesses and aggregates data from internal and external systems to provide robust financial reporting capabilities across a multi-asset class framework with highly customizable reporting. Managing investment complexity and operational risk, while increasing efficiency and agility, are critical to asset manager success.

If you’d like to learn more about Clearwater, or discuss my experiences from a career in the public sector, don’t hesitate to get in touch.