May 2011

ASSET SERVICING: New kids on the bloc

DubrovnikCountries such as Poland and Hungary are promising places for asset servicing firms to do business, both to satisfy local demand for fund services, and to locate low-cost processing centres. George Mitton asks if the Aifm directive could shake up the network of sub-custodians in the region Eastern Europe offers an important opportunity for asset servicing firms. On the one hand there is an increasing local demand for investment products; on the other, many businesses are finding that a skilled workforce with low salary expectations means the region is a compelling area to establish administration centres. Poland is a shining example. BNY Mellon, BNP Paribas and State Street all operate out of the country. In 2008, when State Street announced its first Polish operations centre in Krakow, it praised the city for having “a highly educated workforce… with the broad range of language and technical skills that we’re looking for”. Historically, one important way to expand in central and eastern Europe (CEE) has been through acquisitions. BNY Mellon bought Germany’s BHF Asset Servicing last year to enhance its coverage of the region. But even those that have not bought big in the past recognise the importance of a local presence. Russia, the Czech Republic and Hungary are also considered important areas to base operations. Along with Poland, these are “the major capital markets of the region where we see the beginning of the next cycle in diversification outside of domestic market investing”, according to Matthew Grabois, who heads sales and relationship management in the region for BNP Paribas Securities Services. Hungary makes the grade despite having turned to the International Montary Fund for assistance in 2008. However, Grabois adds: “Markets like Slovenia and Croatia are evolving in their use of global custodian services, bringing a strong share of world market knowledge to allow for a better cross-distribution network.” Of course, it is expensive to establish operating centres everywhere and for those countries where an asset servicing firm lacks a presence, local banks must act as sub-custodians. The question of which banks to choose raises issues such as risk, compliance and control. Eastern Europe is an emerging market and faces many of the challenges other emerging countries face, such as inconsistent regulation and a potentially unstable political landscape. Grabois says: “It’s obviously important to select the right providers in each country to match our risk appetite to that of our shareholders and clients. The most important aspects today are risk, compliance and control mechanisms. This is felt throughout the network.” Because of the risks involved, BNP Paribas has “a very advanced methodology in the selection of our local agents in each market”, he says. Choosing partners
The question of which sub-custodians to pick could become even more charged when the European Union’s Alternative Investment Fund Managers (Aifm) directive comes into force as this could dramatically increase custodian banks’ liability for the investments they oversee, including those outside the EU. The original version of the directive, proposed in 2009, set potentially unlimited liability on custodian banks for failures on transactions. This foretold a radical shake-up of the asset servicing industry.
The directive has now been refined allowing for a limited liability assuming the custodian takes reasonable care in doing its due diligence. However, this raises the question of what is reasonable care. One likely consequence is that custodians will be forced to demonstrate that their due diligence processes are working and well-documented, and that they understand and can list their relevant exposures. Gary Goldberg, director at London consultancy Capco, says: “In the emerging market space – eastern Europe as well as Asia and Latin America – due diligence is ever more important. Part of what will be happening is custodian banks relying much more on local expertise and potentially on sub-custodians to provide that level of due diligence.” This could lead to consolidation in eastern Europe. “There’s going to be a need for the custodian banks to scale and manage the potential liabilities and have strong controls over that due diligence process,” he adds. “There’ll be closer partnerships with local banks and I think the larger players will be looking at potentially consolidating.” As well as potential buyouts – Goldberg says acquisitions of local sub-custodians are “certainly in the offing” – custodian banks may seek closer relationships with brokers and administrators. “One of the things that’s happened is a greater prominence of prime custody alongside prime brokerage, and I expect that to continue,” he says. Paul Francis-Grey, head of Mergermarket Group’s financial sector coverage for Emea (Europe, the Middle East and Africa) agrees there is a  likelihood of more acquisition activity in the region. “In general, across Europe in the financial services sector we’re going to see a growing amount of M&A [mergers and acquisitions]. I don’t think Central and eastern Europe is going to escape that. “It will be busy. A lot of these regions could be seen as undervalued at the moment. A lot of them dipped, possibly more heavily than in other parts of Europe. Banks with cash and capital will be looking to grow in those regions.” Qualified expansion
Though there is a great deal of interest in eastern Europe, it is unlikely that all the main players will commit to setting up operating centres there. Despite the looming threat of a shake-up caused by the Aifm directive, some firms will continue to pursue indirect custody. Others say they maintain an interest in the region but are not planning to expand there in the near future. Philippe Huerre, deputy head of emerging markets for Société Générale Securities Services (SGSS) says: “Our strategy is to leverage the group’s strong presence in Emea to serve our clients wherever they are. We take advantage of our central hub as well as of our local services. In eastern Europe, SGSS already covers all relevant countries.” Huerre says it has no further plan to set up new operating centres in eastern Europe, though it remains open to opportunities. “It could make sense if we had specific business requests from the local players.” Of course, eastern Europe is not the only region where educated, English-speaking workers can be employed at lower cost than in Western Europe and the United States. Outsourcing planners will continue to look to Asia, especially as growth within the European Union starts to erase the cost benefit associated with setting up in eastern Europe. However, the facts remain that eastern Europe is an attractive market for the asset servicing industry, though the different countries within the region have different advantages. Poland, for instance, is the second-biggest economy in Central and eastern Europe after Russia and was the only EU state to avoid recession in 2009. It has been described as a beacon of stability. A key perk is that foreign investors can benefit from EU structural funds which, together with government funds, will be worth more than €100bn until 2013. These can reward foreign investors for reducing unemployment or retraining Polish workers. Other countries are keen to prove they are worthy of foreign investment. The National Bank of Hungary recently said the Hungarian financial system is stable and claimed its ability to withstand adverse shocks is adequate, while the Russian government has said it aims to turn Moscow into an international financial hub. Some states have not fared so well. Ukraine attracted a great deal of foreign investment following the Orange revolution in late 2004, but many have failed to see the returns they hoped for. And, of course, the region still contains many countries which are potentially politically unstable, such as Georgia and Kosovo. But despite the risks and question marks over some of the less developed states, eastern Europe remains fertile for asset servicing companies. The prospect of low-cost administration centres is ever more appealing as the big companies aim to squeeze out profits in an environment which continues to exert down pressure on rates. This impulse will also push the trend for consolidation as companies pursue scale as a means of driving profits. Eastern Europe is not the only region on the radar. Countries such as India will continue to occupy the thoughts of asset servicing firms. But in the meantime, Poland, Hungary and the rest will be studied carefully as these companies seek to expand. ©2011 funds europe

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