CAPITAL MARKETS

NSIGHTS
A Domain Consulting Publication
1st October 2009 : Volume LII

E d i t
In sig h t s t e a m
Amit Kumar Choudhary
Amol Sugandhi
Ashwinikumar Maslekar
Bhargavi Hemanth
Meeta Ajit Sardesai
Praveena Sai Subramaniam
Ranajeet Dewasthalee
Rupesh Muttyal
Sanjay Moolchandani
Tony Inian Daniel
Unnikrishnan Marar
F e e d b a c k
Your feedback & suggestions
are most welcome. Please mail
your inputs to
securities-newsletter@wipro.com
CAPITAL MARKETS
NSIGHTS
o r i a l A Domain Consulting Publication
The current recession crisis engulfed the investors with huge losses, which has forced regulators (especially in USA and European
market) to enforce new regulations and supervision to assess whether the risk exposure will pose a threat to financial stability. The
fund management and administration landscape is closely contoured with more disclosure and reporting needs to help investors
in making decisions, exposing risk and potential losses.
In the recent past, investment firms and advisors have been misusing investor money and employing illegal means (window
dressing the statement of accounts for assets “under-water”, non-existent funds, and charge highly inflated fees) to avoid
scrutiny. In European fund industry, the UCITS IV is in the draft phase and is expected to be implemented in 2011. The proposed
changes include new rules and regulations to ease cross-border fund mergers and distribution, implementation of the
management company passport, robust pooling techniques to use master/feeder funds and revised regulation and
transformation in fund prospectus. Similarly, SEC proposed rules to strengthen and safeguard investor funds which are controlled
by investment advisors. The proposals include surprise yearly external audit of clients' assets managed by investment advisors
and establishing third-party monitors as independent custodian. These measures will safeguard the investors and introduce fair
investment practice and avoid advisors from preparing, maintaining and reporting false accounts. Also, such measures would
change the landscape of fund administration and increase investors' confidence.
As the fund administration and management is weathering financial turbulence, we focused on the important aspects of
outsourcing, regulations and changing landscape of fund administration and management. We addressed the importance of
outsourcing middle office operations with key business drivers, trends and challenges. Next, we highlighted FAS 157 and EITF 99-
20-1, FAS 157 addresses the problems faced by the financial institutions and if the rule really deserves to be blamed for all the
current market ills. FASB Staff Position EITF 99-20-1 highlights the challenges and measures to recognize 'Other-than-temporary
impairment' of all investment securities whose fair value is less than book value. Finally, with our advisory caps on, we projected
key strategies that a prudent investor can pursue in turbulent markets and focused on the challenges faced and options available
with fund administrators.
In this issue, we have tried to publish well researched articles that focus on the current trends and challenges in the fund
management and administration space. We hope, these articles will keep you updated on the developments and provide a
technological perspective that can potentially address the current situation in the fund management industry.
Regards Rohit Agarwal & Gudaru Anand
 CAPITAL MARKETS

NSIGHTS
A Domain Consulting Publication
A r t i c l e s o f t h e M o n t h
The complexities
involved with middle
office functions have
Rise in Middle Office Outsourcing deterred fund managers
The middle office outsourcing market has evolved to consider them as a
Abhinav Khandka significantly since the initial few landmark deals which the
industry witnessed in the initial years of this decade. The candidate for
Introduction service providers have also evolved and offer a greater outsourcing while back
Outsourcing in the fund management industry has traversed degree of customization with lesser time to market. office functions were
a long way since the early 80s when firms realized the benefit Geographically the asset managers in Europe have taken a
lead to offload their middle office followed by North
their favorite to be
in paying vendors to do the non-core back office functions.
Initially functions outsourced were limited to custody of America and Asia Pacific. outsourced. However
assets and settlement of trade and gradually encompassed Key Players
the maturity of
activities like daily NAV price calculation. Today back office The middle office outsourcing market is dotted with three outsourcing service
outsourcing has reached maturity and the middle office
functions which can be mapped to activities from post trade
different types of service providers. They include traditional providers, increasing
outsourcing service providers such as Software Engineering
execution to pre-settlement phase of the trade lifecycle have margin pressures have
Institute (SEI), Citisoft and Investment technology pioneers
become a hot candidate for outsourcing as the fund manager like Sungard and Thomson financial and custodians like Bank forced fund managers
strives to achieve low cost alpha. of New York Mellon, Northern Trust and State Street. to have a re-look at
Trends Custodians enjoy an advantage as they are already providing
Middle Office Back Office Tr a d i t i o n a l l y, a n y their approach towards
services like custody, cash management, securities lending
Trade Matching economic downturn and hence are in a position to offer a bundled package of outsourcing.
Trade Settlement Custody has witnessed a surge in middle office function along with other offerings. The table
Reconciliation Fund Accounting outsourcing deals as below lists some of the key deals in the space.
Post-Trade Compliance Fund Administration outsourcing is viewed as
a way to reduce bottom Key Drivers Abhinav Khandka is a
Figure : Key functions in middle office and back office
NEED Business Analyst in the
line costs for fund Outsourcing Quotient: Due to their repetitive and objective
PHOTO Portfolio
managers. This argument holds true in the current market nature, middle office functions are good candidates for
scenario. However, the complexity involved in middle office automation with some manual checks to be successfully Management- Domain
outsourcing is forcing fund managers to critically evaluate performed. The economy of scale is easy to achieve as it is Focus Group within the
their options. relatively simple to devise methods to measure and identify Securities & Capital Markets
Fund managers are more inclined towards component transactions with exception in capturing, processing and Domain Consulting Group and has
outsourcing rather than lift out deals where the outsourcing reporting. These characteristics associated with middle office varied experience in Business
vendor takes control of entire middle-office and/or back allow the fund managers to reduce cost without increasing Analysis across collateral
office functions including the technology infrastructure and the operational risk by outsourcing these functions management tri-party repo
the employee. Component based outsourcing provides the Changing Market and Regulatory landscape: The recent transactions and middle office
fund managers immediate benefits and access to best of the financial turmoil calls for an overhaul of the regulatory reporting functions. He is based in
breed services as opposed to that in liftoffs. environment. It is expected that it will call for new reporting Bangalore India.
 CAPITAL MARKETS

3 NSIGHTS
A Domain Consulting Publication

Fund Manager Service Provider Deal Details expressed the need to have a control on these functions to maintain the competitive
Frost for its $24.2bn in trust
SEI Full service fund operations outsourcing for its mutual fund edge. Middle office outsourcing is a sizable project and the loss of control on time to
assets
Lazard Asset Management
Lift Out deal for middle office includes trade settlement, portfolio
market is a key deterrent factor to outsource it for the fund managers.
(LAM) for its $134.1bn in State Street
Assets Under Management
administration, reconciliation, performance and data and client reporting. Service quality problems: The inability of service provider to offer the expected
Hermes Fund Managers for
its £23bn in assets under Northern Trust
Lift out deal for Middle and back office functions including level of service levels has been another important factor that has led to
operations, fund accounting and custody
management. termination of contracts. Complexity of various middle office functions and
Back office functions like Fund Administration, fund
Axa Investment Managers State Street accounting and Middle office functions like Performance absence of standard interfaces with front and back office are the prime reasons
measurement, investment operations support contributing to the inability of service providers to maintain the desired service
Deal Includes middle office functions like Securities pricing, account
Allianz Dresdner Asset performance calculations, record retention, levels along with the timelines. Service providers are required to invest
State Street reporting, daily position reconciliation and back office functions like
Management significantly in time and resources in order to ensure smooth transition from
Custody and fund accounting
legacy systems to new plug in infrastructure.
Table : Key back-office and middle-office outsourcing deals
Implicit costs: Many of the fund managers have not been able to derive the
requirements, along with the change in measurement of capital requirements. In return on investment they expected. Middle office typically needs significant
addition, the demand for greater transparency resulting from regulations like FASB investment in customization of interfaces and system to be outsourcing ready, this
Statement No. 157 has created numerous challenges. This has mandated limits the potential cost savings. The implicit costs associated with middle office
enhancements in the processes and systems across the middle office functions. The outsourcing are hard to predict and result in underestimation of overall costs.
impact of regulations like UCITS III (Undertakings for Collective Investments in
Conclusion
Transferable Securities) which bring alternative investments like OTC derivatives in to
Although the middle office shares the same set of drivers that support outsourcing
mainstream for fund managers, brings in complexity. Fund managers prefer to
with the back office, the complexities involved in the middle office like extensive
outsource middle office functions supporting these asset classes. Outsourcing the
customization, absence of standard in the interfaces that middle office shares with
middle office functions saves the fund manager from some of these unavoidable costs.
front and back office tones down these drivers. This would make the middle office
Cost Dynamics: Industry experts' claim that the expenses are at 2008 level
outsourcing never match the rapid growth that back office witnessed. However
whereas revenue has gone down to 2001-2003 levels. Redemptions, withdrawals
the middle office outsourcing is driven by its own set of growth drivers which
and market depreciation have caused a sharp drop in assets under management,
include strain on the margin of fund managers, negative growth in assets under
and hence the profits from fees based on those assets. The shrinking margins
management and inability of legacy systems to cope with regulatory changes.
forces the asset managers to look for every possible opportunity to switch from
These drivers are fueling the growth of middle office outsourcing and positioning it
fixed cost to variable cost model, they are trying to refrain from large ticket capital
as the next hot spot of outsourcing world.
expenditure in technology or infrastructure. Outsourcing helps fund managers
achieve these objectives. It is estimated that middle and back office costs Source
represent roughly 18-23 percent of the industry's total expenses2 1. A New Bread, October 2008; International Custody and Fund Administration Magazine
2. Regroup, restructure, recover; August 2008; Buy Side Technology
Deterring Factors
Loss of strategic control: Some of the leading fund managers have decided to
terminate their outsourcing contracts and bring back major set of outsourced
functions citing the loss of control over strategically important functions. They have
 CAPITAL MARKETS

NSIGHTS
A Domain Consulting Publication
4
The article takes a look
at the problems that are
faced by the financial
Will the FAS 157 Rule for Mark to Market be Abolished? institutions on account
Ameet Fanse of FAS157 also know as
their current fair market value. The rationale behind the the mark-to-market
Introduction
mark to market rule is to create a greater transparency when rule and if the rule really
it comes to valuing and reporting the current market value of
The FAS rule 157 also commonly known as the mark to
a portfolio held by the financial institutions.
deserves to be blamed
market rule provides standard guidelines to financial for all the current ills
The FAS 157 has established a three level hierarchy for
institutions for determining the market value or fair value for
the various securities held by them. Though the FAS 157 rule
measuring fair value of securities based on which the facing the market.
financial institutions classify the securities held by them.
has been around for some time and there were some early
The levels are:
adopters of the rule, for majority of the companies, FAS 157
came into effect from the fiscal years beginning after Level 1 Security
November 2007 or basically from the fiscal year of 2008. • Level 1 Security is one whose price is readily available
Recently the rule has been in news almost on a daily basis in active markets on a given date.
and has been blamed and hammered by many for the recent Level 2 Security
collapse of the once mighty institutions of Wall Street. Many • Level 2 Security is one whose price is not readily
market men have gone to the extent of blaming the rule for available as a quote in the market but can easily be
all of the current problems being faced by the derived from other observable market data like
banks/brokerages/financial institutions and have interest rates, yield curve and so on.
vociferously called for its roll-back. The SEC does not seem to Level 3 Security
be open to the idea of rolling it back, although it is reviewing • Level 3 Security is one whose price is not readily
the rule and making certain amendments when it comes to Ameet Fanse is a
observable in the market.
valuing alternative investments. Senior Business
Let us now look at how the rule has changed the Analyst in the
The rule 157 states that the single criterion for valuing any
standards being followed by the institutions for valuing a Portfolio
security is to value it using its exit price – either observable
security and why it is such a disliked rule in the market. Management &
or unobservable using certain fair assumptions/
Accounting - Domain Focus Group
guesstimates.
Background within the Securities & Capital
This rule causes major heartburn for the institutions
On September 15, 2006, the Statement of Financial Markets Domain Consulting
when it comes to valuing the level 3 securities. These
Accounting Standards, number 157 pertaining to “Fair Value Group and has experience in
securities can be classified as alternative investments and
Measurement” was issued by the Financial Accounting areas like Custodial Services,
are composed primarily of mortgage backed securities/
Standards Board (FASB).The FAS 157 was proposed to prevent Securities lending, Fund
holdings in unlisted firms etc. The problem here is that the
the recurrence of Enron like scams. The rule makes it Accounting and Cash
trades in the above type of securities are very infrequent
mandatory for Banks/Brokerages/Financial institutions to Management. He is currently
and over the counter – the price is not readily available or
value the securities that they hold in their trading account at based out of New York, USA.
observable.
 CAPITAL MARKETS

5 NSIGHTS
A Domain Consulting Publication

Let us take the example of a venture capitalist that has made an investment in a financial institution itself. By forcing the institutions to mark the securities at the
company that is still unlisted. Before the FAS 157 rule came into effect, the venture current market price rather than at historical prices, which might reflect a very
capitalist would carry the investment in his books at cost till the company (in which different scenario compared to the current market reality; the rule has forced the
the venture capitalist has invested) received additional funding by a third party or institutions to come clean on the health of the portfolios held by them.
was sold off. Then the venture capitalist would mark up or down the investment Abolishing Rule 157 is not going to be the answer for the current crisis, but
based on the valuation received at that time. Since the rule 157 states that the making amendments to remove some of the drawbacks would go a long way in
investments should be valued at market value, the venture capitalists now have to ensuring the overall health of the market.
spend an inordinate amount of time in developing complex theoretical models to The Financial Accounting Standards Board is taking a step in the right direction
derive the price of the investments in privately held companies – price which may by reviewing and amending the Rule for valuing alternative instruments. The
not be the actual price that he might receive in the market and the time that is message is loud and clear that the rule is here to stay, while the Board tries to iron
required to be spent on the activity could have been spent by the venture capitalist out some of the genuine problems that the Rule 157 may cause.
on ensuring the health of his portfolios.
Let us now look at another problem for mortgage backed securities. When the References
current financial crisis started with the mortgage defaults, some of the market 1. A FAS 157 Primer – WSJ.com's inside look at the markets by David Reilley, November 15 2007.
2. FAS 157 is stupid by Jason Mendelson, January 15 2009.
participants holding MBSs panicked and started offloading the securities –
3. Seeking Alpha - FAS 157 and Other Regulatory Actions: Good Intentions, Unintended
sometimes at artificially deflated prices. The mark to market rule caused the other Consequences by Frank Holmes, March 3 2009
institutions to mark their investments (which, most of the time they had no
intention of selling) against the new low prices, causing them to write off millions
on instruments that were paying interests regularly. The millions in write offs
caused the banks to raise additional capital or sell off the written down securities
at further deflated prices, causing a catch-22 situation for the holders of mortgage
backed securities.
The FAS 157 rule has been blamed by many for most of the Wall Street banks
going insolvent. While it would be incorrect to blame the FAS 157 rule for all the
problems facing the street, the rule may have played an unintended role in
exacerbating the situation.

Conclusion
Though some of the market participants might like to believe that abolishing the
article FAS 157 would be a cure-all for all of the ailments facing the street, the truth
is that the rule has not created the problems facing the economy and the financial
institutions. It might have accentuated the problems, albeit unintentionally, but
not created the problems. There is no doubt that FAS 157 rule has increased
transparency for the investor community at large in determining the health of the
portfolios held by the financial institutions thereby judging the health of the
 CAPITAL MARKETS

NSIGHTS
A Domain Consulting Publication
6
Article highlights the
strategies a prudent
investor can pursue in
Volatile Markets – Portfolio Management turbulent markets.
Remya Parameshwaran Asset allocation based
green in the graph given here) are considered as less volatile on Monte Carlo
Investor sentiment has turned from fear to greed and this has compared to periods when they are wide apart. If the Simulation should be
resulted in markets being driven by speculation, leading to Bollinger bands stay narrower for a long period of time, it
indicates that there would be a sudden price movement in
executed discretely in
volatility as witnessed in the last two years. However, when
investors believe and invest based on a corporation's the near future. normal and volatile
fundamentals; the markets witness stability and growth. periods. Rebalancing
Both turbulence and stability can be witnessed in every era. the portfolio
So far, the 21st century has been earmarked by
unprecedented turbulence beginning from early 2000 when
considering the
the stock markets were hit by dot-com bust evaporating 50% turbulent optimal asset
of the S&P 500 index. allocation at the
Market turbulence is a product of many forces. First is culmination of volatile
“institutionalization” of the stock market, which grew from
10% to 75% in the last 50 years. These institutions have not period will benefit the
adhered to the time-tested principles of long-term investor considerably by
fundamental investing and have resorted to short-term reducing the relative
speculative tendencies to increase profits and create alphas.
Second major reason behind this volatility can be attributed
risk exposure.
Chart courtesy of StockCharts.com
to “innovation”. Though this is a blessing to the financial
world; in some cases it has turned out to be one that is There are many strategies investors can follow to
complex and expensive. Innovative products like Collaterized manage their portfolios in volatile markets. Remya
debt obligations (CDOs) are one of the main culprits of the Quest for Quality: A simple and easily executable Parameshwaran is a
sub-prime crisis and have made financial institutions take a strategy would be to go long on quality assets for example, Business Analyst with
write down of more than $250 billion in assets. Derivatives to go long on S&P 500 index and short on Russell 2000 index. the Securities Domain
market currently is estimated to be $500 trillion in value The justification of this strategy will be that the small cap in Wipro Technologies presently
which is ten times compared to the world's GDP. stocks have seen extreme growth in the past years through located in Boston. She has over 4
There are various measures to predict market volatility speculation and would now return back to their years experience in Capital
and the usage of Bollinger Bands is considered as one fundamental value. Markets which includes work
amongst the best measures. Bollinger bands are generally Straddling a Stock Portfolio: Another strategy that may related to Indexing, Research on
based on 20 day moving averages and standard deviation. benefit an investor who has knowledge of derivatives is to European Small & Mid Cap
These bands serve as an indicator to decide when to buy/sell hold both call and put options with the same expiration date Equities, Trade
a stock. Periods where these bands narrow down (circled in and strike price. If the investor is confident that his stock Processing/Accounting systems.
 CAPITAL MARKETS

7 NSIGHTS
A Domain Consulting Publication

portfolio will be volatile and is not sure about the direction of the move, he can
hedge the risk by entering into a straddle.
Hedge the Portfolio: This strategy involves minimizing downside risk without
compromising growth prospects e.g. buying insurance via buying put option against
an index/ETF that closely mimics the investor portfolio. So even if the market falls,
investor would profit from the put option despite losing out on the portfolio. 2 Copyright 2009, CFA Institute.
Reproduced and republished
Turbulent Optimal Asset Allocation: The fundamental objective of modern from Optimal Portfolios in
portfolio theory as defined by Harry Markowitz is “to optimally allocate the Good and Bad Times with
permission from CFA Institute.
investor's portfolio into different asset classes considering trade-off between risk All rights reserved.
and return.” This is often referred to as a single period mean variance optimization.
The efficient frontier is plotted for each investor which would list the set of portfolios A tolerance or boundary circle is drawn separating the returns of normal vs.
that have the highest return for a given risk or lesser risk than any other with same or volatile periods. Other circles are drawn for each observation with the center same
greater return. Three inputs are required for defining the efficient frontier: as the tolerance or boundary circle. Radius of each circle is compared with the
1. Expected return (mean return) radius of the boundary circle. If the radius is greater than the boundary circle, the
2. Risk (standard deviation) observation will be classified as one in volatile periods. When the asset classes
3. Correlation between asset classes have different variances the circle turns to be an ellipse or ellipsoid.
A turbulence index can also be arrived at by comparing the distance from the
For estimating expected return, we first need to estimate the beta center of the ellipse for various global assets. This index will be considered as
(investment's relative volatility or systematic risk measure) of the asset class superior to the volatility index (VIX) since it is based on multiple asset classes and
compared to the broad market portfolio such as S&P 500. We also need to identify also portrays the interactions between asset classes.
the excess return or risk premium that is required to invest in the asset class. Based on historical data, a standard deviation and asset allocation of normal vs.
While estimating risk, traditional risk parameters such as standard deviation turbulent period is given in the table here. We can observe that volatility during
and correlation based on complete set of data for a given period in time in the past turbulent periods is significantly higher than in normal periods. Both asset
will not be reflective in volatile markets allocations yield an expected return of 7.1%; however, the standard deviation of
Asset Class Beta (ß) Expected Return since they attribute equal importance to the normal optimal portfolio during turbulent times is 11.3% vs. 10.3% for the
US Stocks 1.62 8.9% volatile and non-volatile periods. turbulent optimal portfolio. Therefore, investors will be able to surprisingly reduce
Foreign Stocks 1.78 9.4%
Hence, it becomes very important to their risk by 1% and earn the same expected return by rebalancing their portfolios
REITs 0.77 6.3%
Commodities 1.23 7.7% partition the historical returns into efficiently in turbulent times.
Foreign Bonds 0.46 5.4% returns that are for volatile periods
Standard Deviation Asset Allocation
US Bonds 0.03 4.1% (similar to the one observed now) and Asset Class Normal Period Turbulent Period Normal Optimal Turbulent Optimal
US Stocks 16.2% 23.2% 19% 8%
1 Copyright 2009, CFA Institute. Reproduced returns for periods where there are no Foreign Stocks 16.3% 19.4% 26% 37%
and republished from the CFA Proceedings
Quarterly with permission from CFA Institute. significant events. REITs 18.0% 25.7% 4% 6%
Commodities 27.1% 35.4% 8% 12%
All rights reserved.” Consider two primary asset classes Foreign Bonds 9.7% 16.1% 29% 7%
US Bonds 3.7% 6.0% 14% 30%
stocks and bonds, and draw a scatter
1 Copyright 2009, CFA Institute. Reproduced and republished from the CFA Proceedings Quarterly
plot of returns. with permission from CFA Institute. All rights reserved.
 CAPITAL MARKETS

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A Domain Consulting Publication
8

Conclusion
Market turbulence can be witnessed in each era and when markets turn volatile
they are bound to stay the same for a longer period of time; as can be witnessed
from the consistency in volatility index measures during turbulent days. It is
prudent to pursue strategies to combat volatility so as to maximize returns or
maintain the returns while reducing the risk.
Risk and returns experienced in quiet periods may not be reflective of volatile
periods and hence must be discarded while performing asset allocation in
turbulent markets.

References
1. Optimal Portfolios in Good and Bad Times, Financial Analysts Journal, May/June 1999
2. Managing Portfolio in Turbulence, CFA Institute Conference Proceedings Quarterly, March 2009
 CAPITAL MARKETS

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A Domain Consulting Publication

The article highlights

the challenges and
measures to recognize
Investment Impairment Analysis: 'Other-than-temporary
Recognition and Evaluation issues impairment' of all
this write down impacts the current earning as realized loss, investment securities
Gudaru Anand Rao therefore any subsequent recovery in fair value is not whose fair value is less
recognized in earnings until the security is sold. The entities than book value.
In the recent times, it is very important for the asset don't consider their investments/holdings underwater
management industry in general and fund industry in (even beyond the threshold limit of 12 months), if an upward
Entities should evaluate
particular to justify the impairment analysis with decline in swing in the market for the recovery of fair value is impairment of
investment portfolio values. Can impairment analysis depict anticipated. Also, there is a probable risk to report an investment securities
the accurate disclosure of investment securities that are inflated portfolio valuation, which can help the portfolio
underwater (securities whose fair value is less than book managers to retain existing clients and attract new clients in
quarterly and apply a
value)? Let's focus on evaluating the concept of temporary worst financial conditions. systematic and rational
and 'other than temporary' impairment of securities, which is The reference point for determining the initial methodology to identify
subjective in nature. impairment as temporary is not only restricted to track the
This article highlights the impairment issues, risk and and document the
unrealized losses position for less than 12 months, but also
assessment of securities with respect to FASB Statement no. to disclose additional information (as notes to financial factors considered for
157 (Fair Value Measurements), no. 115 (Accounting for statement) with respect to the following points: analysis and conclusion.
Certain Investments in Debt and Equity Securities) and most a) Nature and objective of investments
importantly the effects of the recently issued FASB Staff b) Probable cause of impairments
Position no. EITF 99-20-1 (as amendments to the impairment c) Investment in unrealized loss position
guidance of EITF issue no 99-20). d) Severity and duration of impairments (decline in
As per FASB Statement no. 115, investment securities are fair value) and other evidence to conclude that the Gudaru Anand Rao is
classified into three categories upon acquisition: 'Held-to- investment is temporary in nature. a Business Analyst
Maturity (HTM)', 'Trading' and 'Available-for-sale (AFS). For
with the Securities
each reporting period, the investment entities are required The impairment analysis is based on the following steps: domain in Wipro
to assess their HTM and AFS securities. This assessment is Step 1: Determine whether an investment is impaired, Technologies. He has
important to determine whether the decline in fair value Step 2: Evaluate whether impairment is 'Other-Than- worked on Asset and Wealth
below book value is 'other than temporary' and to arrive at Temporary', Management (Investment & Fund
the true and fair financial position. The disclosure Step 3: Recognition of an 'Other-Than-Temporary- Management and Accounting
requirements suggest that if the asset is underwater for more Impairment', operations), Securities and Capital
than 12 months, then such asset should be considered as Step 4: Accounting for debt and equity securities after an Markets, Application Architecture
'other-than-temporary' impaired asset. The holder must 'Other-Than-Temporary Impairment' and has an overall service delivery
write down the cost basis for the impaired security to its fair Step 5: 'Other-Than-Temporary-Impairment' financial experience in the financial sector
value, if impairment is considered other than temporary. As presentation and disclosures. in USA, UK and Austria.
 CAPITAL MARKETS
NSIGHTS
A Domain Consulting Publication
When the market value of investments is less than cost, the impairment
indicators include, but not limited to the following:
(1) The earnings potential of the investments or the discontinuance of a
segment of the business that may trigger impairment, provided, the
regulatory, economic, or technological environment of the issuer or
investee has changed significantly;
(2) Apart from regulatory, economic or technological environment of the
issuer, the earnings performance, credit rating, asset quality, or business
prospects of the issuer or investee ( company in which an investment is
held) has deteriorated significantly;
(3) The adverse change in the industry or general market condition in which
the issuer or investee operates;
(4) An offer to sell or a completed auction process by the issuer or investee
for the same or similar security for an amount less than the amortized
cost basis of the investment; or
(5) The going concern principle is tested for issuer or investee's ability to
continue with respect to negative cash flows from operations, working
capital deficiencies, or noncompliance with statutory capital
requirements or debt covenants are some of the factors that should be
considered.
As a rule of thumb, to conclude whether impairment is other than temporary
can be simple. For instance, if the issuer of a corporate debt instrument defaults on
scheduled payments (interest or principal), then there is strong evidence of
impairment (other than temporary). Therefore, the reporting entities should place
greater weight on evidence that is objective and verifiable, rather than on
subjective assessments. But it is difficult to assess the impairment status of
equities, if contractual cash flows don't exist (where different evaluation is
required) and periodicity of dividend payment is not consistent.
The jargon 'other than temporary impairment' may not be recognized, as long
as the decline in fair value is not attributable to the credit deterioration of the
issuer. The assertion is placed on the holder's intent and ability to continue holding
the security for a sufficient period to allow an anticipated market value recovery.
Conclusion: In order to avoid scrutiny from investors and regulatory authorities of
10
impairment, the “intent and ability” of the holder should be justified to retain its
investment (when fair value is below its amortized cost) in the issuer for a period of
time sufficient to allow for any anticipated recovery in market value. Impairment
decisions are debatable during economic downturns and as there is no 'thumb
rule' for making impairment decisions, therefore scrutiny from investors and/or
regulatory authorities is based on investment entities' prudence and judgment. A
meaningful disclosure is required for the market participants to assess the entities
rationale to ensure that impairment analysis is applied consistently, well
documented and concluded. Finally, entities should place greater weight on all
available evidence that is objective and verifiable, rather than subjective
assumptions. It is not appropriate to apply any rule of thumb; can technology help
to decide whether investments are temporary or other than temporary
impairment? Yes, indeed the continuous tracking of fair and amortized value,
analysis of cash flows and issuer's financial condition at securities level should help
the entities to determine whether other-than-temporary charge is to be
recognized.
References
1. Defining Issues by KPMG, Vol No: 09-16, April 2009: FASB to Issue Guidance on Fair-Value
Measurements, Other-than-Temporary Impairments, and Interim Disclosures of Fair Value.
2. Defining Issues by KPMG, Vol No: 09-04, January 2009: Changes in Impairment Accounting for some
financial instruments.
3. FASB Staff Position EITF 99-20-1, Amendments to the Impairment Guidance of EITF Issue N0. 99-20.
4. Financial Staff Position FAS 115-1 and FAS 124-1, The Meaning of Other-than-Temporary
Impairment and its application to certain investments.
5. FASB Standards 2009

11
Hedge Fund Administration – Changing Landscape
Vijaya Nishu
Fund managers, often outsource the back-office operations
to specialists called fund administrators, so that they can
focus on core activities like execution of investment
strategies.
NAV
Hedge Fund
Fund Administrator
Trades
Prime
Investment Manager Cash & Assets Broker/Counterparty
Trades
Source: www.rbcdexia-is.com
In a post-Lehman, post-Madoff world, generating alpha is
no longer the primary investment criterion for hedge funds
and investors alike. The funds are under intense scrutiny to
meet market and regulatory demands, which re-affirms the
significance of risk management, transparency and
compliance from point of view of all the stakeholders. The
volatile market triggered a decline in Assets under
Management (AUM) and Assets under Administration (AUA)
and made the climate for fund administrators extremely
challenging with fewer funds and more regulation. The
diverse forces redefining the fund administration process
are:
(i) Enhanced valuation and risk management capabilities
The diverse nature of investing by hedge funds, especially in
complex and illiquid financial instruments makes valuation a
key issue for fund administrators. The lack of an adequate
CAPITAL MARKETS
NSIGHTS
A Domain Consulting Publication
The cataclysmic impact
of credit crisis has made
the climate for fund
administrators
extremely challenging
valuation structure thwarts the fund's ability to properly with fewer funds and
measure the valuation risk inherent in such illiquid products. more regulation. The
As part of valuation of illiquid securities, fund
administrators are using the prices recommended by
article briefly deals with
myriad forces that can
external specialist pricing vendors. The administrators play a
pivotal role in verification of prices of illiquid instruments by redefine the hedge fund
helping managers to develop and follow clear valuation industry and enhance
policies as per industry best practices. Also, valuations
should be governed by valuation committee within each the scope of services
fund and escalation process should be clearly outlined to provided by fund
resolve pricing and valuation issues. Based on growth in administrators.
demand for independent price calculations by stakeholders,
administrators have to work towards building in-house
pricing expertise to quantify portfolio's exposure to complex
products.
The traditional risk management measure – VaR (Value
at Risk) is falling short of hedge fund's demand for improved
credit and market risk analysis. Thus, many fund
administrators are providing risk analytics engines that
facilitate what-if analysis, scenario analysis, and stress
testing to enhance the risk management capabilities. Vijaya Nishu is a
Business Analyst in
(ii) Automation - Efficiency and process control the Portfolio
As an aftermath of credit crisis, multiple stakeholders are Management &
demanding greater reporting diligence and transparency Accounting - Domain Focus Group
from fund administrators. Meeting these demands in a within the Securities & Capital
timely and efficient manner will place new burdens on fund Markets Domain Consulting
administrators and require unprecedented flexibility and Group and has varied experience
control in the back office. Disparate systems and error- across Securities Operation,
prone, labor intensive manual processes can no longer live Reference Data & Fund
up to the task. Fund administrators must consider how Accounting functions. She is
technology and automation can improve their reporting based in Bangalore, India.
 CAPITAL MARKETS

NSIGHTS
A Domain Consulting Publication
12

processes in order to provide the speed, control and flexibility needed to weather
this new era of regulatory and accounting compliance.
(iii) Global Accounting Standard – Impact on fund administrators
Adopting a unified, global accounting standard in US and internationally was the
mandate of FASB and IASB committee working towards convergence of UA GAAP
and IFRS by 2014.1
Advisers in the process of launching new funds are faced with the decision
regarding the set of accounting standards to follow: US GAAP or IFRS. Since hedge
funds do not require regulatory filing, so decision to adhere to either of the two
accounting standards depends on investor's requirement or investment strategy
for the fund. Also, there is a strong possibility that hedge funds will have to adhere
to IFRS (global accounting standard) in the near future and deal with complexities
involved during transition from US GAAP to IFRS. Thus, the administrator will need
to be competent in both US GAAP and IFRS and have controlled processes and
systems in place to lead a smooth conversion to IFRS.
(iv) Changing relationship with prime brokers
The collapse of Bear Stearns & Lehman Brothers has forced the hedge funds to
review its relationship with prime-brokers in a new light.
Hedge funds have become susceptible to re-hypothecation2 by prime brokers
which enable them to use client assets even when the hedge fund is not borrowing
or using leverage in the portfolio. Post Lehman collapse, hedge funds have become
aware of therisks associated with re-hypothecated assets, if a prime broker
declares bankruptcy (all the fund cash can get trapped). Thus, hedge funds are
moving towards multi prime-brokers model to mitigate counterparty risk. Fund
administrators have to work towards building a technology platform that would
act as a bridge between funds and prime brokers with least operational
complexity.
Conclusion
The role of hedge fund administrator is constantly evolving owing to the rapid
growth in the hedge fund industry and the scope of the product 'fund
administration' is expanding. As competition heats up, hedge funds have opted to
unload the burden of maintaining a back office and focus more on core activities.
Thus, fund administration space has become a battle ground for many players who
want to capitalize on this hedge fund outsourcing trend.
The hedge fund industry turmoil, owing to volatile market conditions has made
hedge fund managers biased towards administrators providing a host of value
added services like enhanced valuation capabilities, risk reporting, collateral
management and compliance services etc. Besides the traditional fund
administration services, these value added services act as product differentiators
and help the administrators to gain competitive advantage in present market
condition and emerge as future winners.
References:
1. Jose'R Santamaria – RBC Dexia Investor Services (April 2009) - The changing landscape of valuation
services for alternative investments.
2. Neill Ebers (2008), Changing Relationship – FT Mandate, November 2008
3. Hedge Fund Review (February 2009): Global administration round table – Confronting a
challenging environment.
4. PWC Advisory Services (2009): IFRS is on the horizon – Are your systems ready.
5. Definition of re-hypothecation (http://www.businessdictionary.com)

1. The US Securities and Exchange Commission (SEC) announced in April 2007 a series of actions it
intends to take relating to the use of global accounting standards that are high quality,
comprehensive and rigorously applied i.e. acceptance of IFRS globally.
2. US practice in securities trading whereby (under certain circumstances) a broker may use securities
in his or her possession (but owned by a customer) as collateral to raise a loan to cover a short
position.
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