The mutual fund industry is in the midst of a massive technology and operations push to comply with the Securities and Exchange Commission’s new redemption fee regulation, which takes effect on October 16 -- unless the fund industry can wangle an extension.
Rule 22-c-2 requires mutual fund companies to enter into agreements to obtain trading information from so-called omnibus account holders: financial intermediaries such as banks, brokerages and 401(k) administrators that aggregate their clients’ orders for a given fund into one all-encompassing account. The point of this expensive exercise? So that fund companies can better monitor trading in their funds and enforce their redemption policies -- levying stiff penalties when necessary -- to discourage such investors as hedge funds from darting in and out of their funds to capture short-term price movements to the detriment of the funds’ long-term investors.
The rule comes, of course, in the wake of the 2003 mutual fund market-timing scandals. It will raise the hood on omnibus accounts and give fund companies a peek at shareholders whose identities are now known only to the financial intermediaries where they maintain accounts. Consulting firm Deloitte & Touche estimates that 35 percent of mutual fund assets are held in omnibus accounts, representing 145 million separate accounts.
The aim of Rule 22-c-2 is laudable, but making it technologically feasible for intermediaries to share trading data with fund companies is turning out to be no small feat. Nor is it cheap. The fund industry’s ongoing compliance bill could be more than $160 million a year, by one consultant’s estimate. Indeed, the job looks to be so large that a number of trade groups and large fund complexes have begged the SEC to extend the October deadline by at least six months.
Tim O’Sullivan, a senior manager at Deloitte’s investment regulation consulting practice, contends that before the rule can work, fund companies and brokerages must build “pipelines” to send and receive data. Fund companies, he says, will have to determine how often they want to receive the data, a decision that will dictate the cost of the technology effort. After analyzing the data for market-timing activity, fund companies also will have to determine whether they will store it and, if so, for how long. The rule doesn’t specify a holding time.
“Some funds are saying that they want to keep the data received to prove they’ve done what the rule requires,” O’Sullivan says. “Others say they don’t want the overhead that storage entails and will just show the regulators records of their due diligence.” Fund companies that opt to store the information will have to build or buy a data warehouse, the consultant says. Some, though, may get by with enhancing their existing sales reporting systems.
Laura Chasney, the attorney at T. Rowe Price Associates who is responsible for the Baltimore-based fund company’s in-house transfer agency, says T. Rowe intends to use the National Securities Clearing Corp.'s Networking system as a hub for requesting and receiving data from intermediaries. Networking is an automated, centralized mutual fund recordkeeping system. The fund firm is evaluating vendors, including DST Systems and SunGard Data Systems, that it may employ to handle the data flow if the incoming traffic turns out to be heavy. The NSCC’s operator, the Depository Trust and Clearing Corp., says that Networking has been upgraded to accommodate the redemption fee rule.
Chasney notes that T. Rowe Price will use a system it developed in-house to track market timers. If it finds any, she envisions employing the NSCC hub to send notices to intermediaries to restrict the offending shareholders from further trading. NSCC is only now considering adding such a feature, however.
“One of the current unknowns is whether intermediaries will be able to handle ad hoc data requests from fund companies or whether the intermediaries will want to send batched information daily as a simpler alternative,” Chasney says. She notes that her firm is taking a risk-based approach to monitoring omnibus accounts: It will ask for detailed feeds only when it sees suspicious activity.
T. Rowe Price, which has identified 311 financial intermediaries with which it conducts omnibus business, reckons that compliance costs will be manageable, provided it can stick to ad hoc requests for data, using its risk-based approach. Chasney worries, however, that the costs -- specifically, for data storage and staff -- could escalate quickly if T. Rowe discovers that it needs the information daily.
Ann Bergin, who heads distribution services at DTCC, says her utility’s upgrade of Networking -- which was undertaken with input from the Investment Company Institute, the fund industry trade group -- is designed to ease the cost burden on participants while addressing the privacy issues that accompany the transfer of so much personal data. Networking’s standard format for data transmission minimizes the chance of error, and the system’s security is constantly being monitored, says Bergin.
“Networking is already used by a majority of large broker-dealers and large third-party administrators, but it’s a new technology for small TPAs in the 401(k) world,” the DTCC executive notes. To encourage redemption-rule compliance, while being mindful of costs, DTCC will allow small third-party administrators, trust companies and others in the retirement sector to join the utility for data services only. Bergin says the utility is considering allowing participants without dedicated communications pipelines to use DTCC’s Web services.
Craig Kolzow, who heads financial products operations at San Franciscobased Charles Schwab & Co., says his firm is trying to decide whether to use the DTCC pipeline or to enhance the Schwab Trade Activity Portal. Designed to provide details about large orders and other events, the three-year-old portal can tell fund companies whether activity is coming from Schwab’s 401(k) business or its retail, correspondent clearing or registered investment advisory channels. Kolzow says that if Schwab goes ahead and enhances the portal system, it could automatically send Rule 22-c-2 data to fund companies.
Like many smaller mutual fund companies that have decided against managing the data flow themselves, Milwaukee-based Heartland Advisors, which has $2.9 billion in assets, plans to use its transfer agent, Bisys Fund Services, to help screen data for market timers on the omnibus level, as well as to gather data from intermediaries and generate reports. Bisys is one of the few vendors whose outsourcing solution provides staffing in addition to technology.
“Using Bisys is so much less expensive than buying the technology or developing it internally,” says Heartland’s chief compliance officer, Nicole Best. She notes that the Columbus, Ohiobased transfer agent’s Rule 22-c-2 efforts will yield an unintended dividend: ensuring that intermediaries accurately calculate redemption fees.
DST Systems, the Kansas City, Missouri, transfer agent and mutual fund recordkeeper, is encouraging mutual fund clients to use a new product that it dubs an “accountlet” -- account information that is a scaled-down version of the data DST takes from intermediaries in fully disclosed arrangements, those in which a fund holds shareholder records itself. The accountlets, which provide customer identity and trading activity, are a reasonably priced solution to the data needs of fund companies, says DST executive Jonathan Boehm. For marketing purposes, “it would be better if the fund knew all of its customer demographic information, but this solves 90 percent of the problem,” he notes.
PFPC, the transfer agency and technological support arm of PNC Financial Services Group, is taking a different approach. Christine Gill, senior director of global product development, says Wilmington, Delawarebased PFPC has developed a Web-based tool to help fund companies analyze exceptions at both the omnibus and the underlying-account-data levels. Gill says her firm could develop the tool because its SuRPAS service is the most widely used subaccounting system at intermediaries that control omnibus accounts. PFPC is forming an alliance with Hinsdale, Illinoisbased SunGard Financial Networks Group to offer PFPC clients access to SunGard data from its 50 million broker-dealer subaccounts and from retirement plan providers and bank trusts overseeing 43 million retirement accounts.
Martin Burns, a product manager at SunGard Transaction Network, the company’s automated trade routing and communications unit, says that even some large fund companies are looking into using third parties.
“A system’s cost will depend on how often a firm retrieves data and how long that data is stored,” Burns points out, noting that many fund companies are reluctant to receive daily data feeds because they are concerned about compromising shareholders’ privacy rights. They worry about glitches and about storing huge amounts of personal information; they are uncertain about what the SEC would do should the fund company fail to spot a problem in the data.
Such concerns, says Burns, have spawned a cottage industry devoted to developing analytics that detect anomalies in trading data. SunGard is completing work on its own trading analytics and is talking with consultants about using their proprietary screens.
The cost of compliance, one way or another, promises to be steep. The SEC estimates the fund industry will have to spend $47 million up front to equip itself to receive and analyze trade data, and an additional $21.5 million annually to monitor transaction activity. Needham, Massachusettsbased consulting firm TowerGroup contends that the agency underestimates the expense. Tower senior analyst Peter Delano projects the up-front outlay at a more modest $35.1 million but says annual expenses will be almost four times as steep as the SEC supposes: $81.6 million, including the cost of taking corrective action if irregularities are found. Adding the costs on the intermediary side for extracting the data, transmitting it and customizing it for thousands of fund companies doubles those estimates, Delano says.
By way of compensation, Rule 22-c-2 may produce some good beyond discouraging fast trading of funds. Charles Miller, co-founder and senior vice president of Pittsburgh-based financial software company Access Data Corp., says most of his company’s fund clients are interested in using the data for other purposes, such as learning more about the advisers and brokers who are most successful at selling their funds. Access Data had a law firm confirm that such use of the information was within the legal framework of both the redemption fee rule and the SEC’s privacy rule, Reg SP.
Although fund firms are barred from using an investor’s name, address, tax identification number or account number gleaned from omnibus account data for any purpose other than to check for trading anomalies, they can employ aggregated information, such as data on a wholesaler’s territory, to determine a salesperson’s effectiveness, according to Access Data’s attorneys.
“It would be good if fund companies could get a better sense of where sales are coming from,” agrees PFPC’s Gill, yet she acknowledges that “privacy is the primary consideration.” Several fund companies now prevent intermediaries from sending them an investor’s name and Social Security number in the same file, to avoid mistakenly revealing a shareholder’s identity. But Social Security or tax identification numbers will be critical in tracking market timers across multiple brokerage firms.
At the same time, fund companies are concerned about liability and suitability issues if they receive too much data, Gill says. Brokerage firms currently are responsible for whether an investment is suitable and appropriate for a customer, and fund companies worry that greater responsibility could fall on them if they receive additional data, she says.
T. Rowe’s Chasney and others in the fund industry wonder whether, with so much client data being revealed, omnibus accounts may be on the road to extinction. Tower’s Delano thinks not.
“The complex recordkeeping that goes along with omnibus accounts is as much a political issue as it is a systems issue,” he says. “The intermediary world makes a lot of money on omnibus accounting -- about $145 million a year in servicing fees if one assumes an average of $15 per account.”
That may be too much money to automate away.
