While most operational due diligence reviews focus significant attention on the procedures involving wire transfers, they often overlook those surrounding the free delivery of securities. Yet both activities involve the transfer of assets out of a fund or portfolio with nothing received in exchange.
Most purchases and sales of securities are done on an RVP / DVP basis – receive versus payment or deliver versus payment. This means that securities are received or delivered only with a simultaneous exchange for cash. Such an approach protects both buyer and seller. If the trade fails, each party still has its original asset (either a security or cash) that is, in stable markets at least, worth about the same as the other asset that should have been received in exchange.
Wire transfers, on the other hand, send money on a one-way trip out of the portfolio. Inherently these transactions represent greater operational risk because they provide greater opportunities for fraud and simple errors that could prove catastrophic. Wiring funds without proper authorization or sending them to the wrong account are two common examples of these risks.
Free delivery of securities poses the same risks as wires. A free delivery is simply the transfer of securities from one account to another in exchange for nothing – or ‘for free.’ Yet standard procedures at most custodians and prime brokerage firms are for free deliveries to be processed under the same sorts of procedures as those for settling purchases and sales on an RVP / DVP basis, despite the increased risk these transactions present. If additional procedures are imposed, such as dual signatures, investment managers and hedge funds generally need to go out of their way to put these controls in place with custodians and prime brokers. Despite the extra effort required, they should do so.
Free deliveries of securities are commonplace events. When changing prime brokers or custodians, securities are delivered free from the old account and received free into the new one. If moving securities to a counterparty as collateral, they are delivered free from the custodian or prime broker and received free at the counterparty. Likewise, when the collateral is returned, it is delivered free by the counterparty and received free at the custodian / prime broker. Some non-US markets do not settle trades on an RVP / DVP basis, thus resulting in the seller delivering securities free from the portfolio and receiving cash separately (no longer part of a simultaneous transaction).
Rarely do operational due diligence reviews even inquire about procedures for free deliveries. Due diligence firms who do not make such inquiries should ask themselves what else they have missed. Institutions and other asset owners should evaluate their own procedures for authorizing free deliveries when changing custodians. And managers (as well as their investment operations outsourcing providers) should ensure they have the right procedures in place to safeguard client assets.
Stone House Consulting, LLC 