The Funds Europe custody survey finds a greater presence of custodial banks in Europe and emerging markets, and highlights the challenges surrounding the implentation of new regulation, writes Fiona Rintoul
A glance at the European office network table for Europe’s custodian banks offers a fairly shrewd picture of which markets have historically been most important to custody providers. Virtually every bank is present in Germany, Italy, the Netherlands and the UK.
What is perhaps more surprising is the number of banks that now have a presence in Poland. This reflects both the increasing importance of the Central and Eastern European markets, which are cited by many respondents to the Funds Europe European Custody Survey 2007 as a key growth area, and a renewed focus on cost considerations.
For many groups, setting up in a market such as Poland offers an opportunity to access well qualified back office staff at a lower cost than in the traditional Western European centres.
Cost is becoming a key consideration for custodian banks, with greater transparency putting pressure on fees. A common solution is to cut core custody fees then attempt to garner additional revenue from value added services, though not everyone favours this option.
“We are not advocates of the subsidy approach,” says Jeff Holland, partner at Brown Brothers Harriman Investor Services. “We are more transparent about how we price the business. The more open you are, the more successful you are.”
Whatever approach custodian banks take to fees, there can be little doubt that the services they are being asked to provide by clients are becoming more complex.
The expansion of third-party distribution means coverage of more markets is required, reflected in an expanding presence on the ground by many banks, with European offices being opened in markets as diverse as Denmark and Bulgaria. A typical sub-custody network now includes banks in markets such as the Ukraine and Serbia. There is also expansion outside Europe to consider – China and India are cited as key markets – and sectoral developments, such as increased use of fund platforms.
At the same time, the products that clients run are becoming more diverse and more sophisticated. Many respondents report increased demand for custody support for hedge funds and fund of hedge funds, real estate funds, and pooling solutions.
Many of these developments are driven or supported by regulation. Ucits III has been key to expansion of derivates use, for example, and supporting derivatives and the related convergence of long-only and alternative strategies are cited as key challenges for the future by many respondents.
There is some frustration surrounding some of the new regulation, particularly Mifid. “The most significant challenge currently facing Europe’s fund managers is the issue of changing market regulations and inconsistencies across markets,” says one custodian bank CEO. “This process, which is wholly inefficient for the funds, fund sponsors, and investors, has slowed the growth of funds, discouraged the introduction of new products, and detered companies from entering new markets.”
European regulation moves at a majestic pace and there is no quick fix for these kind of problems. It falls to custodian banks both to institute new products to deal with the new paradigm and to keep abreast of developments through dialogue.
Investment in infrastructure
“With regard to regulation, in order to help their funds’ clients, securities services providers need to deliver highly specialised tools, such as sophisticated compliance systems, and at the same time engage in on-going discussions with regulators,” says Francis Jackson, senior vice president of JPMorgan Worldwide Securities Services.
This means greater investment in infrastrucutre, particularly IT infrastructure, and handling this in an environment of declining fees is cited as a key challenge by many survey respondents. A way of remaining competitive is to standardise as many core services as possible, while developing in key new or expanding areas, such as performance attribution, customised securities lending and OTC derivatives pricing.
Development in new areas is often made more complex by a lack of standardisation. This is particularly the case in the funds of hedge funds and derivatives space. Nonetheless, several respondents report that they are introducing automation of the fund of hedge fund transactional process and reporting cycle.
Benefits of regulatory change
In the alternative investment space generally, the biggest challenge, according to one respondent, is that the custodian must rely upon the investment manager to value the alternative investment securities accurately and in a timely fashion. Another challenge is obtaining historical information for new clients.
Custodian banks work in a market that is becoming increasingly complex and demanding and there is some sense of fatigue with the constant round of regulatory change, in particular. At the same time, regulation and increased transparency ultimately may bring benefits for custodians.
“The transparency under Mifid will lead to better pricing disclosure,” says BBH’s Holland. “I would expect people to pay more for derivatives than for equities because they are more expensive to service. Mifid will allow asset managers to understand more about what they are paying for. But it will also help custodians as it will show how much we are paying to support derivatives.”
© fe September 2007