The NAV Crash: Mess at BNY Raises New Questions For Big Funds, Custodians Alike

When I first started writing about financial technology way back in 2012, Inside Market Data's editor, Max Bowie, sat just across from me and taught me much about how to cover the space — especially what was a juicy tech story, and what was not.

For example, I once got needlessly excited about some exchange-traded fund news. And Max was there to tell me: actually, ETFs just aren't that exciting from a tech angle. They're listed like commons stocks; get reported like mutual funds on the back end. Get over it.

Well, now Max has twins to look after (rather than me) and I'm here to delight in officially telling him, after three and a half years, that he's wrong.

After all, in the maelstrom of market turbulence and news that came out of trading last week, it wasn't lost on anyone — including the financial broadsheets and broadcasts — that one of the world's largest custodians, BNY Mellon, had suddenly stopped reporting NAV calculations for some three score of funds, many of them structured as ETFs.

And better yet, it wasn't market volatility that caused the outage, so much as a software refresh from one the Street's biggest tech giants, SunGard.

Perhaps most interesting, and returning back to a question that has been raised for years about the SunGards of the industry: if this isn't proof of their systemic importance, what is? ... One thing is sure: CEO Gerald Hassell's conference call to clients made very clear his firm's stern discontent around the vendor's slow and unsure response to the incident. Should some of those major ETFs start hopping to new custodians, watch out.

I won't go so far as to call this personal vindication, but I think we can finally say it for certain: the basic functioning of ETFs is very much reliant on the tech underneath.

When It Rains ...

This all comes at an extremely interesting time for both custodians and ETFs. You could say of this situation "when it rains, it pours." And not just because of the poor timing with the markets rocking last week.

Let's hit the latter first: ETFs are far more complex than they used to be with the advent of liquid alternatives and — as my colleague Anthony Malakian has covered with aplomb throughout the year — fixed income ETF flavors.

Sure, you still buy them on exchange like an equity, but the valuation and pricing of them is entirely different story. And that has had the SEC already taking a very close look at whether these newer products are suitable for average investors and — assuming they are — whether the funds themselves are doing enough to provide transparency into how they are performing.

As for custodians, well that's usually a fairly sleepy business. But it's one that has gotten more interesting in the last year or so as fund managers — from mutual funds to alternative investors — have begun to more closely look at their chain of back-office providers; the quality of technology those providers are working with; and indeed, after a period of consolidation, whether any conflicts of interest could now leave them exposed.

That goes first and foremost for fund admins, particularly given SS&C's purchase of Advent and, more recently, Citi's AIS business, but it likewise goes for custodians. Indeed, one good point I've heard is that several of the larger fund managers — Fidelity, among others — and combined manager-plus-custodian shops like State Street had no problem during the BNY outage, because both calculate their NAV internally.

This surely will have managers of comparable and, especially, smaller size thinking long and hard about how they deal with NAV — a relatively simple but legally and operationally crucial calculation.

Fuel to the Fire

Of course, they may need to do more than just thinking if the SEC decides this situation warrants stronger action. Should funds be required to calculate their own NAV?

Many already do, or at least keep a running tally internally to compare relative to the custodian's number — though almost of them rely on that custodian partner to determine the final value; those that don't, in most cases, are big enough to be a custodian on their own. The mid-sized and smaller funds surely won't appreciate such a move.

As an alternative, a middle ground could be found where managers are required to have alternative agreements in place if NAV calcs are down for a certain number of days (again, I'm guessing many do ... and others now surely will).

Though perhaps most interesting, and returning back to a question that has been raised for years about the SunGards of the industry: if this isn't proof of their systemic importance, what is? How should major vendors be evaluated going forward and, well beyond sevice-level agreements (SLAs), how should they be treated when a tech failure of this magnitude arises?

One thing is sure: CEO Gerald Hassell's conference call to clients made very clear his firm's stern discontent around the vendor's slow and unsure response to the incident. Should some of those major ETFs start hopping to new custodians, watch out.

Equal Numbers

In a way, SunGard and BNY have the Chinese government to thank, providing a good bit of cover during a week-long moment that was far from their proudest, but also rife with market chaos.

But put it another way: about 1,200 US stocks were reportedly affected by circuit breakers last Monday, for minutes at a time. Amazingly, a nearly equal number of fund structures were affected by this software glitch, some of them for several days.

Which is worse?