Inalytics' Ben Murphy takes stock of an industry under fire from both regulators and the press, and explains how schemes can make sure they protect members' assets in transit, in the latest Technical Comment.
Transition managers in the UK and the US have been fined for taking undisclosed remuneration from clients. In the wake of these scandals, and the subsequent increased regulatory scrutiny and tightening margins, several providers have withdrawn from the market.
Three simple steps
Before transition: Undertake proper and thorough due diligence.
During transition: Ensure that a good governance structure is in place and adhered to.
After transition: Make clear who has responsibility for verifying the transition manager’s implementation shortfall calculation.
An institution seeking to appoint a transition manager is faced with a daunting task.
Transition events can be very difficult to follow, particularly when they often occur several years apart. They are short, intensive, and highly complex, often involving complicated trading strategies and unfamiliar derivatives.
Despite this there are three relatively straightforward steps that can be taken to increase the chance of executing a successful transition (see box).
Appointing a good manager is critical to securing a successful outcome and as such it is very important to undertake thorough and proper due diligence before appointment. This should be at least as comprehensive as when appointing a new asset manager.
One of the most important things is the transition manager’s performance track record. This allows the client to examine the costs incurred by similar transitions and to assess how accurate pre-trade cost estimates supplied by the transition manager tend to be.
Other benefits of the due diligence process include determining that the transition manager has appropriate levels of internal governance, oversight, and control. The due diligence process helps the client gain familiarity with the transition manager’s procedures, processes, and reporting, making it easier to follow the actual event.
The governance structure
In addition to thorough due diligence, a good governance structure must be in place during a transition event. The typical governance structure for a transition is inherently weak. Transition managers are often appointed without sufficient due diligence: they set their own benchmarks and calculate their own performance.
This does not deliver an appropriate “level of oversight, governance and control”, something the Financial Conduct Authority highlighted in its 2014 thematic review.
Best practice requires clients to have a greater understanding of, and exert greater control over their projects, and to ensure there is always a proper governance structure in place to oversee the transition manager.
The implementation shortfall
Objective and independent verification of the implementation shortfall is a necessary part of good governance post-execution. Recent revelations over undisclosed mark-ups applied by two transition managers were only possible because the implementation shortfall was independently verified.
Transition managers can also make mistakes. Despite the large numbers of checks in place, human error in trading and reporting can happen. Independent verification of costs is the only way to guarantee protection from this.
By not verifying costs, the power to assess whether the transition was successful moves from the client to the manager. If transition managers are calculating their own performance and writing the final report, it is easy for unscrupulous managers to embellish performance, conceal error or facilitate additional, undisclosed remuneration.
While there are complexities involved in transition management, the service, as explained by the FCA’s review, plays an important role in securing value for clients.
By undertaking these three steps institutions can maximise the chance of obtaining a successful outcome:
Institutions must undertake thorough due diligence to appoint the right manager and to understand the costs involved.
Constructing a governance system, which locates power firmly with the client and not the manager, is critical.
Independent verification of the implementation must occur to protect from error and malpractice.
Ben Murphy is a transitions analyst for Inalytics