Soc Gen’s global head of securities services, Alain Closier, tells Nick Fitzpatrick how the firm has derisked the business following the collapse of Lehman BrothersThere is one way in which Alain Closier, global head of Société Générale Securities Services (SGSS), the sixth largest custody bank in the world, will never do business again.
“We have organised our business so that we are not exposed to this risk and we will not accept sub-depot banks that have not been selected by us,” he says.
He is referring to when a French court held SGSS liable for the loss of assets belonging to a client even though those assets were not in SGSS’s custody at the time, but in the custody of Lehman Brothers when it collapsed. Making matters worse, SGSS had not had a choice in where the assets were custodised. It was the client’s decision.
When the French court told SGSS, along with RBC Dexia Investor Services, the other custody bank involved in a similar case, to return those lost assets, SGSS was obliged to do so even with no guarantee that it could claim equivalent sums back from Lehman’s own insolvency administrator.
The court case revealed the true risks of counterparty exposure and served to shake the world of custody banking.
Counterparty risk, which brought markets to their knees when the extent of those risks became starkly obvious after the Lehman Brothers failure, looks so simple in hindsight. Financial transactions, such as stock lending or the the purchasing of complex derivatives, involve multiple parties that become reliant on each other to stay afloat until the contracts binding those transactions expire.
Closier confirms: “We are no longer in a situation such as the one that led to the court case... We are not in that position in any contract that we hold with a client.”
He adds: “We are not the only ones to refuse to work like that and prime brokers will have difficulty establishing that kind of set up because I expect this stance we have taken will be seen more and more in the industry.
“Inevitably it will affect the way prime brokers or asset managers set up their business.”
He said the case did not have a big financial impact on SGSS – which has over €3 trillion of assets under custody – or its parent, the French bank Société Générale.
“We wanted to be clear about the contractual terms. It did not have a big financial impact for us, but the principle was important.
“Unfortunately, the danger is that there may be different terms in different contracts, so custodians have to be careful.
“It is particularly important to be aware of this in France, where the courts have been very clear where liability lies and, therefore, the risks.”
SGSS is clearly being pickier about its counterparty arrangements. If this approach pervades the industry it could lead in worst cases to a refusal by custodians to provide custody in certain markets, particularly emerging markets, where there is no strong sub-custody network and no clear laws about how assets are segregated from failed counterparties. But Closier says SGSS has not had this problem.
“No, we have not [pulled out of a market]. It has not been an important consideration yet. In Africa, for example, there is country risk and no possibility of selecting a first-class sub-custody player to support us there. But we only have small volumes in Africa. The instances of where we have large volumes and no possibility to segregate assets is relatively insignificant.”
But, on the other hand, the same pickiness displayed by other financial institutions is leading to opportunities.
“Part of our strategy is to act as a local custodian in some emerging markets where Société Générale, our parent bank, also has a large presence. We have noticed in certain markets like these that some institutions have selected us exactly because we are part of a big international banking group.”
Equally, custody players that have no large parent in a particular country will not act there, according to Closier.
“In Russia, for example, where Société Générale has a large presence with 20,000 people including in custody, we have noticed that other international players will not operate there unless their parent bank also has a presence. Rosbank is our bank in Russia, though it is controlled by Soc Gen.”
All this shows how the financial crisis has had an impact on business models. Closier says: “In Europe, a strong feeling that I have is that the impact of the crisis will have an affect on the consolidation of the infrastructure of the post-trade industry.”
Consolidation of European market infrastructure over the past few years has had a positive effect. It means that “working in Italy, Luxembourg, France, Belgium and Holland is essentially the same in many cases”. But there are still problems with emerging infrastructure and regulations, which are important to pan-European custody providers and their pan-European fund-manager clients.
The custody and asset servicing industry will need to adapt to considerable changes in the next few years in the run-up to Target2Securities in 2013. T2S, as it is also known, is the future platform for the settlement of almost all bonds and equities in Europe.
“A lot of other things will have to be built around T2S to support it, and that will lead to a different set-up for custodians and it will strongly affect the European industry.
“For example, a large broker or global custodian will be able to choose to have direct access to T2S for securities settlement or to outsource it to a central securities depositary or sub-custodian. The trouble is they may use one set-up in one country and a different set-up in another, so T2S will impact not only the environment, but also revenues and business strategy.”
Europe is evolving but is still complex, he says, and the crisis-related regulation does not make things always easier.
“The responsibilities of a depot bank after Lehman Brothers and, particularly after Madoff, are still not clear and the situation is still different from one country to another.
“In France it is now relatively clear, but this is just one country. Responsibilities are still not clear in Luxembourg, while Italy is considering a relatively light interpretation of depot bank responsibilities.”
Similarly to the way that hedge funds felt unfairly punished for short selling, Cloiser feels that custodians are also being beaten by regulators flailing a stick.
“Although custodians were not responsible for big systemic losses in the financial crisis, regulations designed to deal with systemic risk are part of the same package of regulation that also affects custodians. The consultation around Lehman Brothers and Madoff and the associated risks concerning depositary banks was an example.”
On a much brighter note, Closier says that he sees a recovery from his vantage point in the industry, primarily gauged by a reversal of asset outflows in the past few months, and new mandates.
“There has been a positive evolution in our business that has seen assets coming in from major clients, and new mandates. He adds: “However, it is necessary to keep cool about this situation when it happens. There are, after all, still bad days in the markets to be had.”
Hopefully there will be none as bad as the days after Lehman Brothers’ collapse.
©2010 Funds Europe