Panelists:
John R.: Morning, and welcome to our webinar regarding disruption and opportunity in the funds industry and banking. I have joining me today, Eamonn Greaves, global co-head of sales at SS&C Technologies, and John D’Agostino, senior advisor to Coinbase, and Colm O’Driscoll, CEO of DMS Bank & Trust in Cayman.
So, just to set a backdrop here. In 2015, JPMorgan, which provided the banking for 80 or so percent of the global funds industry, JPMorgan exited the banking of alternative investments in funds primarily because of the liquidity capital ratio under Basel III, and the exiting of those funds caused significant disruption in the subscription and redemption process for funds globally. So, now with rising interest rates leading to, I’ll say, some mismanagement at one bank that caused a cascading effect of failures of Silicon Valley Bank, First Republic Bank, and Signature Bank, I just want to ask, I’ll turn it to Eamonn, how have you been seeing the impact of these banking failures rippling through the funds industry?
The impact of banking failures on the funds industry
Eamonn: Well, thanks, John. And, you know, I appreciate being a part of this event. So, I think as far as what we’ve seen is in the past, exits from this space have been generally orderly, and there’s been some ample notice, and I think people can…and have had the time to pivot. I think the events of recent were a little bit more abrupt and unplanned. And while I think some folks had maybe an idea that that might have happened, it wasn’t necessarily the entire market view.
You know, SS&C, you know, we’ve been a pioneer in this space. We’re the first fund administrator to provide middle and back office services. So, we’ve got deep experience in our treasury management team, and we’ve got the tools to assist our clients in identifying alternative banking providers and assist with an orderly transition. So, I think the event has really been a reminder to all our clients about the importance of choosing the right partner. So, regular reviewing counterparties and service providers from a risk perspective, I think, is something that many will be very focused on as a result of the recent events.
John R.: Yeah. So, you know, I hearken back to the events with Lehman Brothers and the other prime brokers during 2008 where people really didn’t focus on who their counterparty was. They sort of saw the lead name and said, “Oh, my counterparty is Lehman Brothers,” and weren’t focused on which specific entity of Lehman Brothers it was. And I think they all found that out very abruptly when Lehman failed. So, you know, I’ll ask you now, do you see…? How do you see people focusing on counterparties? You know, what are they thinking about when they choose a partner?
Choosing counterparties
Eamonn: Yeah, I think that’s a great question, John. I think SS&C as an administrator, we have a unique sort of view of client assets and accounts given our holistic abilities to see the portfolio as a whole. And we’ve also got some unique tools like our treasury management system, which allows us to really, you know, be in a position to open up accounts with banking partners and transfer money in very short order in a fully electronic manner.
So, in general, our clients seem to have anticipated having to move assets to the providers, so we’re able to facilitate that in advance. Banking platforms, as you know, have moved to more modern technology, so we’re now able to do that via our treasury system holistically. But I think having a holistic view is the key point, and it’s important for folks to understand the risk profile so they can act pretty quickly.
I think your comments on Lehman are pretty interesting. I think, you know, that, you know, I think, was the first eye-opening experience for lots of people in the industry regarding counterparty risk. You know, I really, you know, personally remember that being a pretty nerve-wracking situation. There was not a lot of information available at the time, and I think lots of people were getting their information from the news, you know, so it was a very uncertain time, you know?
But the concept of NAV transparency, which I think was a good thing that came out of that, is it required all funds to really, you know, report the transparency of their NAV so that investors felt comfortable that the counterparty risks were known. So, that ultimately was a good thing that came out of that. I think multi-prime and multi-custody strategies have become relatively common practice as a result of the Lehman situation, but the banking partner relationships tended to not get much attention until recently.
So, I think as a result of the recent changes, that attention will be a very good thing to kind of round out the transparency, and, you know, segregation of duties, I think, will also be a big focus too. So, prime brokers doing what they do best, custodians doing what they do best, and banking partners do what they do best, and fund administrators doing what they do best. So, each having a defined role and crossover with regard to that primary role should be minimized, I think, in order to avoid risk.
John R.: Good points. And, you know, I’ll focus in on one of them, which I think a lot of people say, “Well, a bank is a bank with little differentiation between the offerings.” I think people have now realized that as a depositor of a bank, you are, in fact, a general unsecured creditor of the bank. So now I’ll turn it to Colm. Colm, as CEO of DMS Bank & Trust that operates as a trust bank, what have you been seeing as far as client flow, client commentary as a result of what’s gone on with Silicon Valley, First Republic, Signature?
Client commentary on the banking crisis
Colm: Yeah. Thanks, John. Well, firstly to note that, you know, hopefully, people are watching…the people that are watching are aware that DMS Bank operates exclusively within the asset management space. So, I think we’ve got a pretty good viewpoint on this. The first point is a salient one in that while there’s been some uncomfortable echoes of the 2008 GFC, that this is sector stress and it’s not a crisis, and that, you know, it is quite localized, firstly localized in terms of the U.S., and secondly localized in terms of size.
I mean, U.S. national champion banks are in no way exposed. They’re better diversified and more stable sources of funding and, you know, frankly, more disciplined risk management. But what we are hearing is that, you know, it doesn’t mean the managers, you know, can necessarily access those counterparties for some of the reasons that were elucidated earlier.
What we are seeing is that, you know, this is… Like, we’re back in the scenario where there’s somewhat of a vacuum in terms of offering banking services to the fund industry. But regardless who fills this void, this cycle will likely repeat until the fundamental approach changes. And it’ll repeat because the regulatory mathematics of the liquidity coverage ratio of Basel III still exists. And it’ll repeat because the fundamental liquidity and volatility characteristics of alternative investment funds, they don’t align with the commercial bank’s requirement for a stable deposit base to manage their asset books.
So, this is why I think trust bank structures, you know, that being where client assets are held off-balance sheet in a diversified portfolio of, you know, either cash at top-tier financial institutions and/or high-quality liquid assets is kind of the ideal solution for the sector of the banking industry. You know, it removes credit risk, it removes duration risk, and, you know, fundamentally it also makes investment managers’ counterparty risk management function much more simple.
John R.: Yeah, because I think that it’s well known that the largest financial institutions, those over $250 billion in assets that are subject to the liquidity capital ratio, find the deposits from financial firms to be unappealing to them. And because they have to keep high-quality liquid assets behind them, can’t use the deposits for lending or other things, and because of their volatility and how they’re disrupting to the balance sheet, yet lots of funds want to go with the banks like that that are perceived to be too big to fail. And then the smaller banks, of course, don’t have the balance sheets, or perhaps the expertise to work with alternative investment funds. So, you know, do you think that the market understands the difference now between sort of the trust structure and the traditional commercial banking structure?
Trust structures vs. commercial banking structures
Colm: I think that difference is beginning to be understood by the industry. I think it ties in with an increase in creep of diversion…divergence within the financial industry where effectively credited and deposit functions of a bank, you know, they’re somewhat segregating. So, you know, we see it in the credit space with non-bank financial institutions and private equity. You know, over the last couple of decades, they’ve been kind of replacing banks and providing credits. And this form of financial intermediation, it kind of makes sense.
You know, I mean, bank runs like we saw with SVB and First Republic, they were strange phenomena. Like, they’re driven as much by psychology as financial fundamentals. But they’ve been happening like ever since the Venetians found ways to circumvent usury laws, you know? The converse of that is, you know, I think we’ll see…
So, this divergence, I think we’re gonna see more of, and I think we’re gonna see more players that are operating exclusively within the deposits and payments arena with ancillary services being offered potentially including credit, but with an operating model where it can be done in partnership with a more concentrated pool of systemically large banks, or with more focused non-bank financial institutions. So, I think these different banking operating models will be a lot more prevalent, and I think we’re at the starting point of it being understood the impact that can have on the funds industry.
John R.: Thanks, Colm. And John, now I’ll turn to you because you focus on a very specific segment of the alternative investment funds business, specifically digital assets, also known as cryptocurrencies. How have you seen this, I’ll say, turmoil in the banking sector impacting the digital asset business and funds that work in the digital asset space?
Is the crisis in the banking sector impacting the digital asset business?
John D.: Well, thanks, John. So, I think I can broaden that a little bit beyond just crypto. I’d say any investment pool that trades in a volatile underlying asset class or a higher volatility underlying asset class, whether that’s derivatives, cryptocurrencies, anything of that nature, I think it’s commonly agreed upon that we are in, from a banking perspective and probably from a margin lending perspective, we are in a risk-off environment. I think the concerns around the banking crisis were not so much that innovative firms would not be able to find banks to house their checking accounts, but that they would no longer, with the demise of SVB, you wouldn’t have banks that were lending into that innovation sector.
And so, I think that’s probably the biggest problem that I see now is that if you’re a startup or you’re a hedge fund or a private equity firm, and you’re investing in asset classes that are perceived to be more volatile, because generally in risk-off environments, the number one thing that people tend to reduce is volatility, volatility is perceived as being akin to risk even though we now know that the banking crisis was really caused by duration mismatch, not necessarily investment in volatile underlying assets, the easy thing to do is just take off risk, take off volatility, and that means lessening your exposure to volatile underlying asset classes. And that, again, that could include crypto, that could include startup lending, or startup banking.
And so, I think what we’re seeing now is a cycle we’ve seen before. This is not new. This tends to happen once every 5 to 7 to 15 years. We’re in a risk-off environment, and it’s much, much harder for entities engaged in these volatile underlying assets, particularly on the smaller side. And so, you have this sort of self-replicating cycle where the smaller, and that tends to be, not always, that tends to be where clusters of innovation occur. It’s more difficult for those smaller entities to get off…you know, to get off up and running.
You know, I got a call yesterday for fund of funds. This is even a crypto hedge fund. This is a crypto fund of funds. They’re holding LP interests in funds struggling to find an auditor to work with, you know, and they’re on the smaller side. Whereas I’d say a year ago, I would know four or five, maybe not the big four, but four or five smaller auditors that would certainly have worked with a startup fund of funds. It tends to be low risk. It tends to be easy money, easy business, and they’re struggling to find someone to take on that audit business. So, I think there’s no question that from banking and then on down or laterally, it’s a harder environment for anyone engaged in a asset class or an industry sector that’s perceived to be higher volatility.
John R.: So, Eamonn, I’ll turn to you. Is this something that you see across your portfolio of clients where, let’s say banks that weren’t necessarily all in on the alternative investment fund space have now sort of pushed back, are they shying away from this business not just for regular alternative funds, but also for crypto funds?
Changes in views on alternative investment funds
Eamonn: Yeah, John, I don’t think we’re seeing any fundamental change in that. I think it depends on the opportunity, you know? And I think back to Colm’s point on, you know, the differences between potentially commercial bank and a trust bank, you know, my opinion, it’s really two different risk profiles. You know, I would say a commercial bank, you know, generally leverages deposits to generate revenue or returns for the bank via corporate lending or mortgage loans, or consumer loans. And whereas a trust bank is more capital preservation and safekeeping and, you know, at times mostly using instruments that are backed by the government.
So, to my earlier point and comment, it’s really about the importance of choosing the right partner and understanding the risk profile, which I think is gonna be more important than it’s ever been. But I think, you know, the question around the trend, I think it’s still too early to understand, you know, where folks are gonna be concentrated on the crypto space. I think lots of folks are interested in the space. I think they are watching it very closely. I think some of the technology around the space is pretty impressive. And I think, you know, adapting to that technology and integrating with that technology is obviously going to be very important. But as far as, you know, diving deep into that asset class, I think that there’s still a ways to go for people to feel pretty comfortable there.
John R.: Thank you very much for that, Eamonn. I think we’ve gone to our desired time limit here. So, if there’s no other comments that anyone else would like to add, I will thank Eamonn, John, and Colm very kindly for their participation in this webinar. And I’d also like to note that, Colm, congratulations on DMS Bank & Trust and their rebranding to FundBank, which will continue to be focused exclusively on the alternative investment funds business. So, everyone, thank you very much.
John D.: I’ll throw one more comment out there. I wanna thank Colm as well and John. You guys have been…DMS Trust Bank has been…I’m sorry, FundBank, apologies, FundBank has been a really, really great partner soaking up some of the clients that are struggling to find banks to work with, particularly in Cayman. And I know your announcement about New York. So, I think you guys have been a great partner and I think I highly recommend that these folks look to you.
John R.: Well, thank you very much, John. Everybody, thank you very much for joining, and hope to see you on the next webinar that we do.