The global custody market is at a crossroads in its development, beset by thin margins in a difficult economic climate, but also on the verge of technological developments that could bring substantial efficiency savings and regulatory changes that could open up new opportunities.
“There is a large volume of confirmed or potential regulatory initiatives which will influence custody banks’ business models over the coming years,” says William Slattery, executive vice president of State Street Corporation, head of the global services business in the UK, Middle East and Africa.
These initiatives include the Alternative Investment Fund Managers (AIFM) directive, Target2-Securities (T2S), Ucits V and new client money and securities rules in the UK – to name but a few.
“In many cases, they impose increased obligations on custody banks – perhaps the most important being the provisions around strict liability for depositaries stemming from the AIFM directive and potentially Ucits V,” says Slattery.
In addition, T2S will completely change the settlement landscape in Europe by enabling participants to operate centralised securities settlement and cash pooling, with implications for global custodians, their custody networks and central securities depositories (CSDs).
Some of these rules will require custody banks to examine the business case for further self-custody. They also encourage custodians to fundamentally re-examine their contractual obligations and oversight models applicable to the more than €9trn ($11.9trn) held in Europe-regulated fund structures.
By applying a common depositary model across all European jurisdictions for the first time – including those markets not previously requiring a depositary – these new regulations allow opportunities for economies of scale.
“But given the level of responsibility demanded, a very detailed understanding of local regulations and clients’ operations is required to carry out the contracted services effectively.”
The AIFM directive, which came into force for new funds in July, and will take effect for existing funds from next July, establishes a framework for supervising unregulated funds, and the requirement for a depositary for the post-trade work, including position recordkeeping, cash monitoring, and asset oversight for each investment fund. It also sets out provision for the restitution of assets.
“If you want to offer depositary services, you had better be a custodian bank given the liability on the assets,” says Florence Fontan, head of client segment, asset managers for BNP Paribas Securities Services.
“We believe that AIFs should choose a depositary that has experience, has the backing of a Global SIFI, is well rated, and hence will still exist when the investor comes looking for their funds.”
The second element is the question of the custody chain.
“The global custodian will want to ensure it has control of the chain of custody because it will be responsible for any asset loss. All custodians have undertaken a full review of their network in the light of the AIFM directive, and BNP Paribas currently holds an average of 90% of clients’ assets in its proprietary network.”
A new era
The current raft of regulations is primarily focussed on risk, compared with previous eras when regulation centred on harmonisation and level playing fields. It means new obligations to undertake functions that reduce risk, ultimately creating opportunities for custody firms to grow their businesses by monetising these additional functions.
“The AIFM directive requires a lot more transparency and information about where assets are held, and trustees have to have a greater oversight, so custodians can play a bigger role in helping hedge funds or prime brokers meet their obligations,” says Samir Pandiri, CEO of asset servicing at BNY Mellon.
“There are more things we can do in regulatory oversight and risk reporting. However Dodd-Frank is the bigger and more far-reaching piece, and while some of the detail is yet to be crafted, the potential for providing a different service is going to be greater in the US where markets are much bigger.”
Major initiatives designed to increase the stability of the over-the-counter derivative markets, Dodd-Frank and the EU equivalent of the European Market Infrastructure Regulation (Emir), bring huge operational obligations.
The use of central counterparties (CCPs) shifts the model away from bilateral arrangements to one where both parties are required to post margin into a CCP. All derivative contracts are cleared with initial margins and variation margins based on mark-to-market daily fluctuations, just like exchange-traded derivatives, with collateral demanded and returned on a daily basis.
Emir is not expected to be implemented in Europe until 2014 but, even so, there is already a spike in collateral volumes, and it is a trend that plays into outsourcing, with one party running both the middle and back office.
“Emir results in operational obligations around client classification, timely confirmations, trade reporting, enhanced collateral requirements, collateral dispute tracking, portfolio reconciliation and compression, among other things,” says Crispian Lord, regulation partner at PwC.
“There are arguments that clients should be looking at outsourcing as this is all very detailed and we have seen an uptick in firms interested in the outsourcing conversation who are talking to classic custodian middle offices.”
Re-engineering back office architecture is a key priority for firms because over time they typically tend to spawn enormous complexity. Simplifying systems onto one common platform reduces fixed costs, and also allows quicker adaptation to regulatory change.
“With regards to the AIFM directive, risk management and due diligence have been ratcheted up to a significantly higher level,” says Marcus Austin, Emea head of intermediaries, Citi Securities and Fund Services.
“Our clients are demanding more disclosure about processes, systems and procedures – something that plays to Citi’s specific strengths given our common operating platform across markets. While fees and reciprocity will continue to be a major consideration for banks, the safety, soundness and consistency of the network now seem to be the primary consideration.”
The emphasis on risk has led clients to disaggregate and look for best in class, making it harder for custodians to automatically cross-sell their services. Custodians are responding by focussing on margin management rather than market share.
Tony Child, director of independent custodian monitoring service Amaces says that custodians are still chasing the big RFPs (request for proposals) and smaller pension funds in particular have experienced rate hikes.
Pressure on fees
For core custody services, fees have been slim for several years. But now the ‘gouging’ cases – where firms have been taken through the courts for alleged overcharging – have also curtailed fees for non-core services such as FX, transition management and securities lending.
As Child of Amaces, which benchmarks FX services, says: “They have all been overcharging clients for many years.”
This has led to custodians negotiating more realistic fees on their core business, parting company with existing clients in some cases if an agreement cannot be reached.
Heightened regulatory focus on uncommitted credit lines has also materially changed the business model of custody banks and transaction services providers generally, and the provision of intra-day liquidity is difficult to justify within custody banks without a charging structure to recoup the underlying cost of capital.
“Emir will impact liquidity and collateral,” says Austin. “Collateral pools will be stretched due to growing requirements resulting in a collateral scarcity. Over time, this will add to already increased operating costs and begin to be reflected in updated charging models. The days of de facto free intraday liquidity are limited.”
The new European settlement system, T2S, should ultimately deliver some welcome cost savings by eradicating some of the duplication in settlement processing. The settlement landscape across Europe is highly fragmented; T2S should be a game-changer in opening up the opportunity to access multiple markets electronically.
While smaller custody banks and CSDs are threatened, the big custodians see it as an opportunity to reinvent their relationships with major clients by unbundling core services.
Through their direct connection to T2S, they can remain both a primary infrastructure provider to the industry through the conventional agent bank model or provide account operator or asset servicing-only solutions, a model that is expected to gain considerable traction.
Research by Clearstream and PwC has calculated that by facilitating the management of capital, liquidity and collateral, T2S could help European banks deal with the costs of regulation such as future Basel III capital requirements.
Two respondents in their survey predicted T2S could help banks make up 11% or €33bn ($44bn) of the €300bn capital the OECD estimates that they will need to meet Basel III Tier 1 capital requirements by 2019.
“Preparation for T2S is pushing many market participants to re-evaluate their operating models which are already under intense cost pressures due to adverse market conditions,” says Austin.
“Participants need to find both internal efficiencies as well as value for scale from their global suppliers of custody services. Notably, infrastructures need to achieve operating efficiencies while banks and broker-dealers need to implement new technologies, from making messaging format improvements to upgrading their platform capabilities and refining their operating models.
"We are continuing to see off-shoring, near-shoring and outsourcing being used to centralise processes and to lower costs.”
Dealing with all these moving parts is not easy. Lord likens the task to trying to slot together a “veritable Rubik’s cube of regulation”, with leaders in custody businesses having to simultaneously think through innumerable strategic, operational and technological implications.
“Further consolidation can be expected in the European custody space as the cost of maintaining global custody networks amid enhanced liabilities will become significant for smaller or single-country custodians,” says Slattery.
“T2S and other regulatory initiatives will further drive this development, as the complexity and cost for providers may increase. There’s likely to be an increase in self-custody among larger global players. We may also see the emergence of some specialist, low-capitalised players offering services in the depositary space.
"Overall, the successful organisations will be those that can navigate the regulatory and other trends that are reshaping the environment, while being able to deliver on their clients’ increasing need for specialist solutions.”
There has been a lot of talk about vertical integration in the market to take advantage of these challenges, and of continued consolidation in the sub-custody space.
For example, Citi recently acquired the ING custody business in Central and Eastern European which takes its custody network coverage to over 95 markets.
“Vertical integration is starting to take place on a limited basis,” says Austin. “The rush to establish a proprietary sub-custody network will however be tempered by the significant costs and management bandwidth that invariably accompanies this strategy.
"This is seen to be indicative of an ongoing industry trend, whereby smaller players will exit the market due to a mixture of cost and regulatory pressures.”
BNY Mellon, the first to set up its own central securities depository (CSD), has realigned many of its businesses such as asset servicing, its new Global Collateral Services business, Corporate Trust, BNY Mellon Clearing and Pershing under the umbrella of Investment Services.
The bank has observed that the boundaries between traditional businesses and areas of expertise are becoming more nebulous as its clients move towards broader, more multi-faceted solutions – basically asking to do more for them in a more seamless fashion.
By pulling businesses together under investor services, BNY Mellon says it is better able to service clients in a joined up fashion across all points across the investment lifecycle, from the creation of assets through the trading, clearing, settlement, servicing, management, distribution and restructuring of those assets.
JPMorgan has forged an alliance with The London Stock Exchange Group that is establishing a CSD in Luxembourg built on LSE's Italian CSD, Monte Titoli, and aims to provide a full range of custody and settlement services in the first half of 2014.
As global custodians move down the value chain, there is also speculation that CSDs will move up the value chain, but as Lord says, “this has been the subject of speculation for many moons, and there are few signs yet”.
“For smaller CSDs, it could be difficult,” says Alexandre de Schaetzen, director, product management at Euroclear. “CSDs are already having to cope with the heavy investment in infrastructure required for accessing T2S, which for a large CSD could be in the region of €100m although over the long term there is an opportunity for sharing costs and risks.”
Pandiri highlights that patents are a critical component of the fiercely competitive exchange traded fund industry and BNY Mellon recently received long-anticipated patents for transforming physical commodities into exchange traded funds (ETFs) and acts as trustee for all these grantor trusts such as the $63bn SPDR Gold Trust, cementing its position as a major servicer of the US ETF business.
“There is much innovation going on behind the scenes,” Pandiri says, “and the patents are a visible extension of that."