10/08/2020 by Dominic Hobson 0 Comments
Fund accounting might not be safe from technological disruption
A SUMMARY AND FULL REVIEW OF THE DISCUSSION AT THE WEBINAR ON 29 JULY 2020 Part I
As an accounting technology that solves problems of trust, reconciliation and verification, blockchain threatens fund accountants with disintermediation.
However, adoption of blockchain by the fund accounting industry is inhibited by reputational issues stemming from the ICO bubble and limited knowledge of its capabilities.
Blockchain use-cases are nevertheless being found in the fund administration industry.
One is automation of the KYC AML, CFT and sanctions-screening checks conducted on investors as they are on-boarded to a fund.
A second is to hash data about illiquid assets such as real estate to a blockchain, where it can be used to drive fairer and more frequent valuations, which improves liquidity and reduces capital cost.
In the long term, better data about assets can in theory increase liquidity in previously illiquid assets, by assuring buyers that data posted by sellers is trustworthy.
Another technology, artificial intelligence (AI), is being used to automate documentation searches by fund accountants, bank account-opening and data validation.
Technology makes more frequent valuation points possible, but fund managers are not yet willing to offer investors more frequent liquidity opportunities, and investors are not yet pressing for them.
Digitisation of assets through the issue of tokens on blockchain or other networks has yet to take off, so fund accountants are not yet under pressure to value tokenised assets at scale.
Technology has yet to disrupt funds as an investment vehicle.
Managed accounts have become a popular alternative for institutional investors, but the opportunity this creates is being exploited by conventional rather than disruptive technologies.
So far, the impact of digital technologies on fund accounting has proved evolutionary rather than revolutionary and, with the probable exception of quantum computing, is likely to remain that way.
In theory, nothing could disrupt fund accounting more completely than blockchain, and for the same reason that it could disrupt the accounting profession as a whole. It is, after all, an accounting technology, which creates an immutable record of all transactions – in the case of funds, that means subscriptions, redemptions, switches, income payments, fees and charges – that can be shared with all the parties to a fund: the manager, the distributor, the custodian bank and the fund accountant.
Theoretically, blockchain is an existential threat to fund accounting
Blockchain also creates the possibility of triple entry accounting, in which entries to the ledger by the various parties to a transaction can be cryptographically sealed by a third party, which checks the entries match and then hashes them to a blockchain. By eliminating the possibility of tampering with the entries, hashing eliminates the need for the fund accountant to verify and reconcile the different accounts of the same transaction held by the manager, the distributor and the custodian bank.
In short, blockchain can in principle allow the funds industry to dispense with fund accountants as the trusted intermediaries which prepare trustworthy valuations of funds and report them to investors. However, the technology has yet to win the trust of either fund accountants or their clients. Neither is ready yet to believe that blockchain eliminates the obligation to maintain physical double entry book-keeping records. They continue to worry that the information in a digital ledger cannot be verified.
Yet the hashing of double-entry book-keeping entries to a blockchain ought to overcome this scepticism. It allows any changes to an entry – right down to the level of an individual bit - to be identified immediately. In this way, it helps fund accountants fulfil the primary duty of any accountant: to ensure that the records of the transactions, which govern the value of the assets held by the fund, were not tampered with. It does not of course eliminate the risk that the original entries were false, and that remains an argument against endorsement of the technology, so blockchain has some way to go before it wins the trust of the fund accountancy profession.
Blockchain faces reputational, operational and educational barriers to adoption
In doing so, it is handicapped by the fact blockchain originated in the crypto-currency markets, where a number of initial coin offerings (ICOs) were reminiscent of the South Sea Bubble and assets belonging to investors were stolen regularly. These problems were facilitated not only by the lack of an independent custodian to hold the assets – established custodians are still deterred by the technical difficulties of safekeeping the private keys which remain the sole guarantor of entitlement to crypto-assets – but by the lack of an independent valuation agent to attest to the value of the assets.
Beyond blockchain enthusiasts, knowledge levels in the funds industry are also surprisingly low. Understanding of how the technology could work with mutual and alternative funds remains superficial. The obvious solution to this knowledge gap is to standardise blockchain coding and create more blockchain coding courses for developers, and to develop educational courses for fund accountants as well, but there is a more fundamental need to be met. This is for blockchain to prove that it can add value in fund accounting.
Blockchain is automating KYC, AML, CFT and sanctions screening checks at on-boarding
Use-cases are being found. For example, fund administrators have to collect large quantities of data about the funds they service. The list of items includes private placement memorandums, investment management agreements, prime brokerage agreements, administration agreements, constitutional documents, broker statements, daily trade blotters, and information about investors obtained in Know Your Client (KYC), anti-money laundering (AML), countering the financing of terrorism (CFT) and sanctions screening checks when they are on-boarded.
KYC, AML, CFT and sanctions screening checks are one field in which Apex Group has found blockchain technology useful in terms of making a manual and paper-based process more efficient. The firm is working with Triple Point Liquidity in New York on a Blockchain-based investor on-boarding tool that makes use of a digital identity for each limited partner (LP) without compromising the KYC, AML, CFT and sanctions screening compliance obligations of the firm.
The expectation is that this will reduce on-boarding costs and improve the investor experience, not least by allowing the information used to complete one on-boarding check to be re-used when the same investor invests in another fund administered by the same fund administrator. However, automation of this kind cannot extend that benefit to funds administered by third parties. Nor can it re-write the requirements of the process itself. The same documents must be obtained and verified.
Although the efficiency of the blockchain-based on-boarding process is likely to improve over time, as experience yields insights into common risk factors, there are limits to the ability of any technology to transform the process. This is partly because no firm is prepared to rely entirely on the checks completed by another firm. But it is also because automation of on-boarding demands new process controls to ensure the KYC, AML, CFT and sanctions screening checks are thorough and independent, and guarantee the protection of sensitive information submitted by investors.
AI is automating and accelerating documentation searches and account opening
Another laborious process which technology is transforming is data searches. The sheer quantity of information administrators now collect on behalf of every fund they administer makes it hard to find the data they need, let alone filter, analyse and use it across multiple applications. But by using artificial intelligence (AI), Apex Group has found tasks that used to take weeks – for example, preparing a list of the funds for which it acts as a valuation agent – can now be completed in minutes.
Apex Group has also used AI to reduce the time taken to open a bank account for a client from weeks to days, by using the technology to verify documents obtained from multiple sources through application programme interfaces (APIs).
The process of opening a bank account has demanded a surprisingly heavy volume of documentation since the passage of the Foreign Account Tax Compliance Act (FATCA) by the United States in 2010. The principle behind FATCA, which forced fund administrators to assist the Internal Revenue Service (IRS) with tax compliance by American citizens, has since spread to nearly 100 other countries via adoption of the Common Reporting Standard (CRS).
Technology has had a limited impact on fund valuations
Such applications are peripheral to the work of fund accountants. Technology has yet to have a substantial impact on their core responsibility: valuations. This is largely because fund managers have yet to put fund accountants under sustained pressure by investing in unusual assets. They also tend to give fund accountants considerable latitude in the valuation process itself., especially when it comes to valuing liquid assets.
Valuation techniques are not a staple of fund documentation, which tends to stick to broad principles which managers then turn into specific policies for approval by the management company board. This endows valuation policies with the flexibility managers need to adopt new pricing sources and methods and, where funds are invested in liquid assets with readily verifiable prices, poses no technical difficulties for fund accountants in satisfying investors.
Investors are less sanguine about funds invested in less liquid assets, such a real estate, private credit and private equity. In these cases, they take a close interest in valuation policies to make sure they understand any mark-to-model techniques, the degree of independence of valuation agents, the level of discretion asset managers have over pricing assets and any deviations from valuation norms in a particular asset class.
This is an area in which technology can make comparisons easier, as Inveniam Capital is demonstrating with its application of blockchain technology to data gathering and verification. Obviously, valuations change when data inputs change.
It follows that, if technology can increase the variety of data inputs used by fund accountants, and the speed at which they are incorporated, it becomes possible for valuations to be become fairer and more frequent – which can, by increasing liquidity, reduce the capital cost to banks of holding the associated financial instruments.
Data can be used to create better-informed and fairer valuations
This is what Inveniam Capital is doing in real estate valuations. The firm creates a digital representation of ownership of all the various financial instruments that fund a commercial property (such as equity, mezzanine debt or senior debt) and attaches to it all the information that governs its performance and value.
The data includes accounting and operational information, legal agreements and inspection certificates, but also “experiential” data. This last category includes footfall in a building, entry key swipes, mobile telephone activity within a particular area (what is known as “geofencing”) and data collected by Internet of Things (IoT) sensors.
Instead of attaching such vast quantities of data directly to the asset, each piece is instead hashed to an Ethereum blockchain, creating a certified and immutable record of it which can then be accessed by permissioned users in much the same way that a private equity firm makes use of a deal room. The data is indexed (so it is searchable) and validated using AI (ensuring it remains within two standard deviations of comparable assets). This allows it to be used for monthly fair market valuations.
The short-term ambition of Inveniam Capital is to use the data to drive weekly valuations, and eventually daily or even – if data about an asset class changes often enough to warrant it – more frequently. But trustworthy, updated information about an asset offers more than better or more frequent pricing. It also facilitates credit analysis and underwriting of assets and compresses the premium investors demand to compensate them for the illiquidity of the asset.
In the long term, better data has truly revolutionary potential. If the buyer of a commercial building has access to the full set of data hashed to the blockchain by the seller, and has complete confidence in it, there is no reason why at least daily liquidity at fair market prices cannot be achieved even in real estate investment.
More frequent valuation points can deliver more frequent liquidity opportunities
This is an intriguing prospect in an industry in which even mutual funds invested in listed equities offer no more than daily liquidity at a single valuation point. As it happens, fund accountants have for many years discussed the prospect of continuously updated, or at least intra-day, net asset valuations (NAVs). In theory, technology can retrieve from stock exchanges the prices of liquid instruments held by funds continuously, creating room for frequent valuation points throughout the trading day.
A continuously updated NAV is pointless if the fund manager insists that investors can only buy or sell shares in the fund once a day or, in the case of alternative funds, once a week or once a month or once a quarter. In the absence of more frequent dealing rights for investors, continuously updated NAVs are of more value to portfolio managers than investors.
In fact, fund accountants are producing gross valuations and daily profit and loss statements and risk analyses for managers already. These are proving valuable to managers looking to reassure investors in volatile markets or make portfolio adjustment decisions. That said, the production of intra-day valuations does indicate that there is no fund accounting obstacle to managers offering investors more frequent liquidity.
If intra-day NAVs became available to some investors, the likelihood is that others would press for more frequent liquidity opportunities than the monthly or quarterly subscription and redemption rights currently accorded to investors in hedge funds.
Fund accountants are already supporting managers under pressure from investors for more frequent portfolio valuations and, if managers are willing to share the information with their investors, fund accountants are already able to support its translation into more frequent liquidity opportunities.
Not everybody wants more frequent liquidity opportunities
On the other hand, some investors will resist increased liquidity rights, because more frequent comings and goings to and from a fund are liable to undermine its performance. The portfolio manager must maintain a pool of liquid assets to meet redemption calls, vitiating his or her ability to place buy-and-hold bets or maintain short positions in line with their convictions. Equally, he or she may not be able to offer performance to an excessive number of subscribers.
Managers will also argue that more frequent NAVs – and, ultimately, it is the manager who is answerable to the regulator for the accuracy of the NAV – increase the risk of errors. Even straightforward equity funds can have multiple share classes, or complicated performance fee calculations, that require flesh-and-blood fund accountants to make judgements and check their decisions against the offering documentation. If an error is not picked up quickly, the mistake will be repeated in several NAVs, increasing the liability of the manager.
Technology has yet to transform the instruments fund accountants must value
This is one reason why managers are comfortable with a cautious approach to technological change in the fund accounting industry. Nor are they putting fund accountants under pressure to value novel instruments. It is striking that neither mutual nor alternative fund managers are creating innovations comparable to the credit default swaps (CSDs) and collateralised debt obligations (CDOs) that contributed to the financial crisis of 2007-09.
Even the tokenisation of securities has made limited progress in the face of the discouraging experience of many ICOs, in which it proved impossible to value and custody assets safely. The comparison may be unfair - established firms are prepared to take the private keys to a digital asset such as a security token into custody while continuing to refuse to do the same for crypto-currency – but it remains a deterrent to investment in digital assets.
The slow pace of adoption also reflects regulatory barriers. Regulators, with their preference for retail funds in particular to be run by regulated managers which invest in regulated instruments traded on regulated exchanges only, may not have discouraged digitisation, tokenisation and (in the case of alternative assets such as real estate or fine art) fractionalisation, but nor have they encouraged it. In fact, in several major jurisdictions the regulation of digitised assets such as security, payment and utility tokens has yet to be settled.
Technology has yet to spawn innovative alternatives to funds as investment vehicles
That said, funds are investing in digital assets, and fund accountants have developed the price sources and techniques – such as averaging prices from several on-line exchanges - to value them in line with the valuation policies stipulated in the offering documents.
Where digitisation has made no progress whatsoever is in challenging the idea of a fund itself, as a pool of money collected from multiple investors to invest in financial assets. Fund managers like to manage single pools of assets, as their distaste for managed accounts – in which an investor holds assets in a separate account, increasing their control over their portion of the fund but creating an additional administrative and re-balancing burden for the manager – demonstrates.
Managed accounts have nevertheless become the preferred investment structure for institutional investors in hedge funds. This has created an opportunity to offer hedge fund managers a technology which reduced the burden of managing a series of managed accounts. Existing systems providers are looking to seize it. But making managed accounts easier to administer falls a long way short of a technological revolution.
This is emblematic of the impact of digital technologies on fund accounting so far: increased efficiency rather than total transformation. This effect can be traced back a long way. From the calculator, through the spreadsheet, to the API, technology has increased the efficiency of NAV production in numerous ways. But, in the absence of quantum computing - which would disrupt blockchain and AI, let alone fund accounting – fund accountants are likely to continue to do what they have always done, just ever more efficiently.
Questions to be addressed for the next fund accounting discussion
Is concern about the veracity of entries to ledgers hashed to blockchains a valid obstacle to the adoption of blockchain by fund accounting firms?
Are there any other valid objections to the use of blockchain in fund accounting?
How can lack of knowledge about the application of blockchain to fund accounting best be overcome?
Digital identities have an obvious part to play in making transfer agency/investor relations more efficient. Do they have useful applications in fund accounting as well?
Do the advantages of more frequent valuation and liquidity points outweigh the disadvantages?
Is fund accounting equipped to cope with widespread tokenisation of securities?
Why has technology failed to create an alternative to funds as investment vehicles?
The Future of Finance is always open to hold further meetings to answer these and other questions and to continue the conversation. If you would like to sponsor such a meeting please contact Wendy Gallagher at the number or email address below. Also view our upcoming meetings elsewhere on www.futureoffinance.
Tel: + 44 (0)7725 160903