Changing regulatory and legal requirements within the United States and abroad have put investment managers, brokerages, banks and plan sponsors under increasing pressure to improve their compliance capabilities. While many firms may opt to ramp up internal compliance facilities, developing an effective process can be a complex undertaking - one that is beyond the capabilities of many financial-services firms' technology organizations. As a result, many companies are outsourcing part of the compliance function to their back-office providers, custodian banks.
"Organizations may gravitate toward their custodians for compliance because they do not have the IT infrastructure - or they have the systems but do not have the data - to do the compliance," says Tom Driscoll, vice president, Charles River Development, a portfolio management vendor that also offers a compliance solution. "So the custodian becomes appealing because it already holds this information."
Custodian compliance services comprise two categories. In the first arrangement, the client outsources all primary compliance monitoring to its custodian, allowing the firm to reduce headcount and IT infrastructure investment and improve risk management. The alternative is for the client to maintain an in-house compliance department and for the custodian to provide a secondary check.
For custodians, adding compliance monitoring to their value-added services has its appeal. According to Driscoll, "The custodians' margins are being squeezed constantly. In many cases, custody itself is a loss-leader business, and they make their profits by offering other types of services, which might include FX, securities lending, and fund administration and fund accounting, a natural extension to which would be compliance monitoring."
The level of service custodians can offer their clients varies. One variable is the frequency of monitoring - monthly, weekly, daily or in real time. A second variable is the comprehensiveness of monitoring - does it involve a handful of broad guidelines that act as a safety net, or is it more extensive? Additionally, there is the issue of how monitoring information is delivered, whether by hard copy, via e-mail, through a real-time browser or through a complete front end.
Brown Brothers Harriman (BBH) is one of five custody providers, including The Bank of New York, that use Charles River's system to support their compliance operations. BBH's compliance service is part of its modular fund administration product suite, through which it supports an array of commingled investment vehicles, including mutual funds.
BBH takes a three-pronged approach to compliance monitoring: First, it tests SE Commission and Sub-Chapter M. Internal Revenue Service requirements for U.S.-based 40-Act funds. Second, it tests for local regulations, such as those required for Dublin and Luxembourg fund ranges. And finally, it monitors self-imposed compliance rules with regard to portfolio-specific investment policy and the prospectus, explains Roland Caron, managing director and head of fund administration and fund accounting at BBH.
BBH offers its clients a range of service options. "Clients choose certain reporting and compliance testing to be done based on the level of service they require and what they do in-house," Caron says. "We then write those rules into our compliance system, and run the tests on a daily, weekly or monthly basis." The flexibility of the Charles River system allows BBH to quickly change its testing or reporting to incorporate industry or portfolio-specific developments, he adds.