A host of difficulties confront investors and their global custodians participating in non-U.S. markets, particularly emerging markets.
These issues include the difficulty of investing in certain markets, valuation (i.e security pricing) problems, liquidity, operational risk assessment, corporate governance and securities lending.
"Investors must be aware of two main issues when participating in today's foreign markets," said one respondent. "The first concerns the various local regulations which affect foreign investment in a given country or market. Foreign investors must ask the question, 'Can I invest in a market? And, if so, what restrictions exist concerning the desired investment activity?'
"The second involves the lack of common operating procedures from one foreign market to the next. Not all countries, the United States included, have adopted the G30 recommendations in their entirety. Investors must be cognizant of the differing operational environments when investing in any market."
The global custodians pointed out that in some countries, the difficulties begin even before an investment is made.
In many markets, non-domestic investors cannot invest until "approved" by the local authorities. Poor preparation can lead to deals being made that cannot be settled because the documentation is yet to be completed and a delay of four to eight weeks for local authorities to approve the deal, said David Bilbe, managing director, Chemical Bank Global Securities Services.
This is a classic problem caused by lack of close contact with custodians in advance of investing, he said.
Investors can experience problems in markets requiring some form of registration prior to investing, such as Chile, Colombia, India, Korea and Taiwan.
While foreign investment is allowed in these countries, there are various regulations concerning which foreigners may register for investment and how the registration may be accomplished.
In Taiwan, regulations list those entities/investors eligible to apply for foreign investment registration. In Chile, foreigners must choose a method for foreign investment registration. Any method that is used will result in a high dollar cost to enter the market.
Valuation problems
Problematic issues face U.S. investors in the collection of uniform pricing and valuation methodology from performance measurement providers, custodian banks and investment managers, said Patti L. Smith, vice president at Bankers Trust Co., New York.
For monthly valuation purposes, one custodian uses more than 80 different pricing sources to provide comprehensive and accurate information on a worldwide basis.
This issue becomes more critical when expanding to emerging markets, where less market data is provided via electronic services. More than one provider at any time may reflect "accurate" market pricing, yet material differences are continually experienced by the different parties' methodologies of interpreting the price (e.g. selecting bid vs. ask price or last-traded pricing), identifying an appropriate pricing vendor and producing the valuation and performance calculations consistent to the other parties of interest (such as settlement basis, traded basis or cash basis accounting), Ms. Smith said.
While most U.S. securities can be priced accurately at the close of business every day by any custodian, foreign securities are very different. Even the world's best international data vendors cannot accurately price all securities in all markets, as coverage may be as low as 50%. The custodian is left with the problem, said Mr. Bilbe.
Data maintenance to the highest quality is expensive. Investors should review custodian-priced securities carefully and not assume the pricing will be correct just because a reputable source is being used. The efficiency of data maintenance also determines how soon after month-end or quarter-end a valuation can be provided, Mr. Bilbe said.
International securities prices
Determining the market value of securities is fraught with difficulties in the emerging markets and for particular securities types, for example international derivatives, the survey showed.
All global custodians use one or more primary vendors and one or more secondary vendors to determine the most accurate and timely price, according to the survey. They also use other price sources - local brokers, agent banks and local branches.
The most frequently mentioned vendors for international securities prices were EXTEL, Reuters and Telekurs. Prices for derivative products are provided by either Bloomberg or Reuters.
Most global custodians use an extensive network of primary and secondary sources to ensure securities are priced accurately daily. Review procedures focus closely on the identification of stale or missing prices. Should a stale price be identified, the secondary sources for alternative pricing are used.
The global custodians mentioned certain security types and markets that are especially difficult. Among the security types: unlisted rights that have arisen from a corporate action but are not officially listed on a major exchange; unlisted foreign securities, especially fixed income, which typically requires broker quotes; derivative and structured asset products in all currencies; and new instruments with non-traditional cash flow features.
Among the countries that presented problems were:
Canada, with securities issued for short periods, such as Canadian government bonds; Ontario Hydro coupons, bonds and strips; and Province of Ontario bonds and strips.
Korea, where foreign investment limits imposed on equity shares have created a separate foreign registered market where all trading is done on an over-the-counter basis. Pricing data cannot be obtained from either vendors or brokers. Bankers Trust introduced a sophisticated internal price estimate system for foreign registered Korean shares, where broker estimates of premiums applicable to these shares are used to produce estimates on a daily basis.
Thailand/Indonesia, because foreign investment limits create a separate market, although price information for Thailand foreign registered stocks is available from vendors. According to Bankers Trust, prices typically become stale if no trades are effected for a period of time. Some custodians use an internal system to manufacture estimates when required.
Alien shares (held by foreigners) from Thailand and Indonesia are officially listed and traded. But, infrequent trading creates stale prices.
India, with Bombay being the main exchange and the only one supported by most data vendors. Bankers Trust says pricing is very infrequent, and prices for any stock trading on any of the other Indian exchanges are difficult to get.
Brazil and Venezuela, whose government bonds are on temporary Sedol numbers. Subcustodians were reported slow to respond to requests. One custodian successfully bypassed existing vendors to set up price supplies with brokers based in, or specializing in, the area concerned.
Closing pricing data from the South American marketplaces varies among vendors. Prices are provided by a global custodian's subcustodian network as opposed to a vendor.
Mexico, whose securities are difficult to price because quotation and par value haven't been properly set up.
Normally there are too many issued to fax out regularly for prices and set-up changes. Examples of securities difficult to price are Mexican Cetes, Tesobono, Adjustabonds.
The global custodians report continuous enhancement of their pricing systems. They report clients continue to demand a higher standard for pricing securities in a complex and ever-changing environment. Some of the more frequently mentioned requests by clients are:
Change the timing of updates for European and Far East clients. Clients require end-of-day portfolio pricing in their own time zones, rather than New York time.
Give historical pricing, which often involves faxing out to the respective subcustodians.
Expand into emerging markets on an ever more frequent basis.
Give daily pricing and portfolio valuations, especially for the larger more sophisticated clients. More pension funds and large institutional investors are requesting this service, as opposed to the traditional mutual fund client.
Add instruments such as index certificates, Brady bonds and sinking funds.
Give a price source or methodology for pricing derivative securities.
Liquidity problems
The conditions imposed on the ownership of securities and the related cash movements are, in a number of less mature and emerging markets, severely regulated by local authorities, the global custodians noted. These regulations often create operational issues for investors if they are unaware of either the requirements at the time of the security purchase or the implications of non-compliance.
For example, in certain markets, investors are not able to repatriate sales proceeds or income unless they can produce documentation proving prior purchase of the related security with hard currency. This can be a daunting task. The investor must first produce documentation showing the foreign exchange transaction by which the local currency was purchased. If the foreign exchange was transacted with a third party and not the investor's custodian or the custodian's local agent, the investor also must prove the cash was moved to the custodian and used for purchase of the security in question.
The countries where investments are most problematic are those where restrictions are plentiful and the mechanisms to exchange securities for cash and vice versa are not well suited for non-resident investors. The restrictions vary depending on such factors as the market infrastructure and central bank regulations controlling flows into and out of the market. Examples of such restrictions include the appointment of local administrators prior to regulatory approval to begin trading in Brazil, application for a trade identification, and deposits of funds in advance in Korea.
Custodians say the foreign exchange controls in Latin America are a problem because of requirements to pre-fund the trade and repatriation restrictions.
In addition, the growing impact of derivative instruments in marketplaces not ready to handle them is a problem for global investors and their custodians. For example, China is attempting to slow the creation of a derivative marketplace in Hong Kong.
Risk assessment
Investors need to be clear about the risks they are taking when they invest overseas. The danger that market or currency risk may eliminate a large part of the initial allocation should not be the only factor to be considered, said Chemical's Mr. Bilbe.
Many investors ask about political risk, and the associated danger of not being able to repatriate funds, but few go any further. Additional risk considerations should be systemic risk, counterparty (credit) risk and settlement or custodian risk, he said.
Custodians often provide some sort of indemnity that covers fraud, negligence, default and other risks. Many do so on behalf of their subcustodians, but a custodian will not offer a blanket indemnity and certainly very little, if anything at all, for the newly emerging markets, Mr. Bilbe said.
Determining the financial impact and risk associated with changes in certain markets is a difficulty facing many foreign investors. Examples of some recent events that have caused much discussion include:
Korea early this year introduced rules requiring foreign investors to pay 20% of the value of the investment on trade date and the remaining 80% on settlement date.
In Brazil, the introduction of an economic program designed to combat inflation, and the introduction of a new currency (the real) in July brought new uncertainty to that market, compounded by the presidential elections scheduled for October.
Also, early this year, Venezuela introduced a tax of 0.75% on certain transactions.
The Securities and Exchange Commission has ruled institutions cannot buy Eurobonds prime, or at any time within the first 90 days of issue. This ruling occasionally is overlooked by money managers, and so investors should ensure their custodian checks before settling Eurobond deals.
