Technology to shake-up custody business

Technology to shake-up custody business

The rapid pace of technological change across financial services has led to some bold predictions about the future of cus­­­­­­­­todian banks. Some hold the view that the current crop of providers will be disintermediated out of the market. Others believe new technology will put custodians even closer to the core of the financial system. 

It’s safe to say every serious asset servicing firm that holds securities and facilitates transactions remains heavily focused on developing technology across cybersecurity, robotics, artificial intelligence, cloud computing, advanced data analytics and blockchain.  The latter, also known as distributed ledger technology (DLT), is often top of the mind.

“DLT allows individuals and companies to make financial transactions directly between each other. There is no need for settlement, reconciliation, securing assets or providing proof of ownership, all key aspects of the custodial function,” Feriz Hasani, head of custody advisory at UBS Switzerland, wrote in a recent paper.

Even so, Hasani believes while blockchain is indeed disrupting the world of asset custody, as it is so much else, it is a bit too early to count custodians out. “Custodians have a role to play in developing this kind of architecture and helping ‘onboard’ assets onto chains, for example by verifying their provenance,” he added.

Last year John van Verre, head of global custody at HSBC, set out his vision of how the custody industry will develop in response to regulatory and technological changes, market infrastructure developments and enhanced risk.

Among the many predictions made in his paper, titled ‘Custody in 2025’, van Verre said DLT would eventually create a golden source of data across the entire value chain resulting in brokers, custodians, central securities depositories and clients having access to a single book of records.

Benefits to clients, he added, would include shorter settlement cycles, cost reduction; full straight-through processing (STP); the removal of reconciliation processes and fewer settlement failures.  Van Verre listed an even bigger potential upside - the entire matching process can take place within this closed community, turning settlements into an internal book transfer. As a result, the arguably artificial split between global and direct custody will no longer exist.

“In theory, that could be true,” said Axel Pierron, managing director of research and consulting firm Opimas. “However, I believe this would indeed be a long-term scenario. As long as national specificities remain in asset servicing and tax regime, sub-custody is likely to remain a relevant value proposition.”  

Moreover, Pierron said a change to a single book of record would require all markets to change in sync, which is very unlikely. “One could argue that with the development of robotics and artificial intelligence (AI) solutions, the local expertise of local custodians will eventually be automated, which is very likely but will require AI technologies to mature and the relevant knowledge to train the AI that is currently held by sub-custodians.”

Mathieu Maurier, head of coverage at Societe General Securities Services (SGSS), said that for buy-side clients, the difference between global and direct custody has never really existed as they purchase trustee and custody services from a single provider for the assets held within the range of funds they manage.

“An individual fund may invest predominately in financial instruments in one market, but across the range of funds the assets are typically global,” Maurier explains.  “It is true to say, however, that we a trend among our sell-side clients – other custodians, investment banks, brokers – to look to simplify i.e., reduce the number of providers with whom they interact. This may involve direct relationships with several operational units/booking locations in a given custodian’s proprietary network or, as is increasingly the case, the selection of a single provider in each major geographical zone for a regional offer.”

Maurier, however, does not see in the near future the ‘death’ of direct custody least of all in the less mature markets where there is generally a lack of regional post-trade infrastructure and various market specifics including regulatory constraints that make it difficult to operate in the market without a local presence. “Whilst the technology may exist to support a ‘one book of records’ concept, such tools can only be used within the limits of the prevailing market conditions and regulation,” he adds.

Chris Rowland, JP Morgan’s, global head of custody, said that new digital technologies such as DLT offer the potential to extend the scope of custodial services beyond regular securities to other digital assets, held on shared industry ledgers. Rowland added: “In addition to today’s centralized post-trade infrastructures, there is a real need to ensure robustness of these ledgers, exercise control over access rights, and ensure confidentiality of data. Given their expertise in this domain, custodians are well placed to assume the role of access provider and exercise oversight and control on behalf of investors, which could include managing digital keys and identities.”

Cryptocurrencies

Another prediction made by HSBC’s van Verre is that custodians will eventually act as the consolidated data source for all asset classes, and even for crypto currencies, digital keys and digital identities.  

Pete Cherecwich, president of corporate & institutional Services at Northern Trust, reckons this is a given. “Northern Trust already reports on cryptocurrency positions and treats this as another type of non-custodied asset class," he explains. "We also hold the “keys” for our private equity blockchain application. The real question is not whether custodians hold these as assets but rather, what happens to the custodian’s business model if transactions are executed digitally? What happens if there is no longer interest earned on operational cash?”

According to SocGen’s Maurier said the time at which custodians were only safekeeping equities and fixed income for their clients is somewhat behind us. “Indeed the notion of safekeeping is also largely outdated as physical stocks become an increasing rarity – although the ability to act as the guardian of ‘asset safety’ is, inversely, developing to be a key criteria in the custodian selection process. Custodians are thus yes increasingly acting as a ‘position keepers’ for an ever wider range of asset classes. This extends of course to cash in whatever currency it may be although crypto currencies remain somewhat on the fringe of the asset classes considered acceptable.”

Maurier has also observed that banks in general and in particular those seen as having solid foundations are still today very much seen as ‘trusted third parties’. “Whereas yesterday this may have meant trusting the custody of a family heirloom or fine art in a safe box at the bank, today this trust extends to the digital world.”

Opimas’ Pierron said acting as the consolidated data source for all asset classes is clearly how custodians would like to position their services in the future, but there are a number of factors that could change that.

“We’ll have to watch how the regulatory framework evolves, and if a third party is still legally required to hold assets on behalf of investors,” he adds. “Secondly, there are a number of FinTech companies that are developing solutions to compete in this market, from Nivaura, which is creating a permission-less blockchain infrastructure with the aim of removing all intermediaries, to ledger, which has created blockchain applications safeguarding crypto assets for individuals and companies. There is a lot of uncertainty currently in future market structure, and we’ll have to watch closely how blockchain initiatives are adopted in each market. For example, initiatives like Iznes, which is a pan-European record-keeping platform for funds, could have a profound impact on the market.”

Data

There is also a growing view that custodians will be data consolidators, taking information feeds from different sources. This information will go beyond traditional transaction and holding data requirements.

“Clients already look to their custodians to aggregate information coming from multiple sources - scrub, structure and validate it,” said JP Morgan’s Rowland. “Increased digitization boosts the ability to streamline, enhance and enrich the flow of information, to generate deeper insight for clients and unlock economic value. It will be a key differentiator going forward, though it is still up to investors to decide how best to use these tools for their investments.”

Pierron suggests custody banks will be more than data consolidators. “I believe that custodians are well positioned to be data creators, as they hold a vast lake of data that can help their clients improve their trading strategy, distribution (with data around local market structure and investors’ appetite), efficiency (data to identify operational inefficiencies), client relationships and regulatory reporting.”

Northern Trust’s Cherecwich said custodians already compete as data consolidators. He suggests the next frontier is enabling a client to get an alert. “For example, noticing that x event happened which could impact a portfolio by y. In other words, move from answering the question to providing insight.”

Rowland has a similar view to Cherecwich in that he believes custodians will be knowledge providers to their clients, leveraging local insight and their connections with market infrastructures, industry organisations and regulators. “As digital technologies allow us to move away from pure processing services, the value of information, insight and analytics will become ever more important. As such, we are focused on providing our clients with up to date insight into market activity, regulatory updates, financial market infrastructures and how each impacts clients. The quality of these services is becoming a key differentiator when selecting the right custodian.”

Cybersecurity

Other industry experts, including HSBC’s van Verre, believe custodians will play a key role in protecting clients from cyber threats. Asset safety will no longer just be about safekeeping. It will also include data protection against cybercrime.  “This is certainly a major area of concern/opportunity for custodians, and they will clearly beef up their game regarding cyber threats,” adds Opimas’ Pierron.

For SocGen’s Maurier, it’s important to remember that custodians are not child minders. “What clients do in the privacy of their own home or office is somewhat out of our control,” he says. “Nor are we pure tech players that go and install anti-virus software, firewalls or the suchlike. However, we can and do provide protection for cyber threats for the assets – including data – that clients confide to the banks and we can and do ensure the security of the communication channels – be it in application to application or user to application situations – used to perform transactions and provide reporting.”

When looking through the client portfolio from individual investors to institutional clients, Maurier adds that more and more solutions are being developed either to facilitate safe storage of digital information or provided heightened contractual coverage against breaches or loss of data.

For Pierron, it’s been clear for some time that good old days are over for custodians and if they do not address swiftly their operational inefficiencies, they will eventually become obsolete. “While the business has traditionally relied on human intelligence for processes and market expertise to cater to diverse clients, help is at hand from technology,” he wrote in a previous study. “Artificial intelligence, through its ability to analyse to vast amounts of data and identify patterns and potential resolutions, has the potential to profoundly improve custodians’ operations. By allowing staff to achieve more with less, AI, by Opimas’ estimates can potentially generate over US$5 billion of cost savings to the custodian industry.”

 

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