Luxembourg has been forced to step back and take stock of the way things are done. In doing so it found that actually, the Grand Duchy is still a reliable and reputable financial centre, and asset servicers on location are more than happy to talk about its achievements. (part 1)
Regis Veillet (head of sales & client relationship, SGSS Luxembourg)
Martin Bock (head of product management, RBC Dexia Luxembourg)
Fabrice Godefroid (head of securities & funds services, Citi Global Transactions Services)
Tim Gandy (global head of fiduciary & compliance services, JP Morgan WSS)
Josee Denis (VP Emea sales & business development, BNY Mellon Asset Servicing)
Funds Europe: How has the financial crisis shaped how fund management companies think about their middle and back office operational requirements? And as a result what are the likely business drivers for the custody and asset servicing industry in Luxembourg?
Josée Denis, BNY Mellon Asset Servicing: Your first question is a good one because we are currently taking stock of 2009. Most of us around the table are going through a strategic planning exercise for 2010/2011. We ascertain the lessons learned from 2009 and consider how best we can build forward to support the fast-moving train that is the global fund industry in the next two to three years.
It’s always good to recognise, from a practitioner’s perspective, the business evolution of our clients over a year’s time and how we best supported that business. This highlights the key service offering requirements that we had to work on in 2009. Overall, I think the major focus in 2009 was on global cross-border fund servicing, specifically to support cross-border fund distribution. As we look at the competitive landscape in the asset servicing space, particularly global fund services and the RFP [request for proposal] activity in 2009, those requests did not diminish compared to better years. Even throughout the financial crisis, although difficult both internally and externally for all of us, the RFP activity did not stop.
This reflects that asset managers continued to believe in growing their assets and were still reviewing their strategic intent and business development requirements, even though transaction volumes were going to be low and that the funds business wasn’t going to grow as much. Having said that though, looking back at the few mandates that have been won/lost last year, most involved big fund groups that were looking to review their current service model and/or outsource what they were doing themselves to focus on what they do best: asset management. It was really those global cross-border fund groups that took the opportunity of this downturn to review their asset servicing strategy and say, "Do I want to continue doing the middle office and back office myself? Am I happy with my current service provider?"
The asset servicing competitive landscape has grown steadily over the last few years, particularly for Luxembourg domiciled funds. Most of us global fund services players have had to set up from five to 15 locations in the world to serve Luxembourg-domiciled funds that are distributed globally today. Clearly the appetite and need for global cross-border service provision is here to stay. Asset managers continue to review their asset growth strategies in line with their investment products range and the target countries and regions they wish to expand in. The service provider is thus no longer considered just a back office that maintains the administration of a fund but a key partner to handhold them in their global distribution strategy.
As practitioners, we now have to provide a dedicated distribution support service that ranges from providing local/global regulatory and tax expertise of key markets to having sound knowledge of local distributors and investor profiles, local product requirements, distribution channels, etc, in order to assist fund managers in their business development thought process. All the while having to continue to deliver a seamless operating platform across all jurisdictions where we serve these fund groups.
Tim Gandy, JP Morgan Worldwide Securities Services: If you look through the whole process there are two areas that need to be considered. One is around record keeping. For example, was everyone in the best position to know what their Lehman’s exposure and other exposures were at the time the collapse happened?
The challenge is whether you have everything on one global platform or whether it is across different platforms in different locations. As the crisis moved on, the other issue was difficulties around pricing, particularly bonds. That led to fund managers looking at their core responsibilities and core capabilities and coming back to consider outsourcing.
We’re seeing that even groups that have considered this before and came to a decision are now revisiting it. Due to the illiquidity in the market, many funds had to be suspended and the administration teams within the fund management companies came under immense pressure, and pricing of certain assets, as we all know, has been a huge challenge to everybody.
So we are seeing that outsourcing is back on the agenda and is very high on that agenda. Clearly the demands for what you can provide will be a test for all of the service providers, especially on the reporting side.
The other issue is risk awareness. While risk awareness has always been there, clearly the profile is much higher and regulatory focus and market demands are there. There certainly is momentum and it’s gathering pace.
Funds Europe: Which is a good thing for your industry?
Gandy: It’s a good thing. It will throw up challenges clearly, but we’re there, to service the client base.
Fabrice Godefroid, City Global Transactions Services: What I’m hearing here around the table is very much in line with what we believe are the sort of issues we’re facing. In 2009 we sponsored an independent study by Create-Research. In it we asked 230 asset managers across 30 countries what they plan to change about their business. One of the conclusions was that today we are at a tipping point. We’re going to do things differently than how we used to do them. We understood that the asset managers will be more focused and that there are going to be a lot more alliances on the asset management side. So, how does that translate into our business as the back office providers? We believe that we need to look at transforming our shop from manufacturing to distribution. This is key, but it needs to be done in a smarter way.
If I take the example of Asia, Asian investors today have an appetite to get into the Brazilian market. If you go into Brazil you’ll see that they’re missing liquidity. So the question is how do you build the bridge between the distributing depository in Asia, bringing money into the process of IPOs and bringing the liquidity into Brazil?
We need to be fully integrated, which brings us to another question: are you on one platform or do you have many platforms?
We believe that we should be common at our core with custom where it matters. The key is to find the right balance.
Martin Bock, RBC Dexia Investor Services: We take more a high-level approach on how we can position these services to best serve our clients. On the one hand, RFPs have not stopped in 2009 and also in these first few weeks of 2010. Outsourcing is back. It never really stopped, but it’s back in a different way.
It’s not just outsourcing for outsourcing’s sake. You spoke about middle office, there’s a lot of discussion about what exactly is middle office, and what exactly, as a fund promoter, do I want to outsource? Why and to whom? And it’s not only to whom it’s outsourced but also how it’s done, how I’m getting the feedback, how I am getting my reporting.
You need to be able to not just look at your small Luxembourg market for your Luxembourg product but consider the geography where it’s distributed and offered from Luxembourg.
We took much more time explaining to our clients, not only ‘yes we do it’, but ‘how do we do it, how can we deliver transparency to you? How can we engage also with you in something that caters to your needs in terms of reporting?’
So in the end we saw outsourcing much more as a positive trend towards trust. I’m not selecting someone I pay to do something, but I’m selecting a partner that has an impact on the quality of my products, on the reputation my products have in the market, and then also on their success.
At the beginning we were a bit sceptical, we thought this [the crisis] would be the end to outsourcing and everyone would insource. Actually it turned out that this was not true at all, on the contrary it’s like you’re more valuable, even if you do back office or middle office, it’s a very important element of the value chain.
Régis Veillet, Société Générale Securities Services: I agree with the last remark that the industry will probably see more of a partnership approach between service providers and clients as a consequence of the financial crisis.
We talked about the pricing issues that we had during the crisis, we talked about Lehman. We probably all have clients that had relationships with Lehman. This is what really tested the infrastructure of the market to see if everything was ready and working in real life. It was supposed to work on paper, and clients and service providers really worked as partners to overcome the crisis, this probably helped to rebalance the relationship between all the actors within the industry.
That’s why we are seeing more of this partnership approach than we were seeing before.
On the product side there is a trend that we are starting to see, which is the convergence between the hedge fund markets and the mutual fund markets. This has accelerated because for good or bad reasons, hedge funds have been under the spotlight throughout the financial crisis. The assets are gone so they are looking for new sources of revenue and now they’re trying to tap the mutual fund market. Those clients work differently to the more traditional asset managers here in Luxembourg, so we have to adapt to those new needs and this new way of working.
Godefroid: Do you mean the convergence of the products or do you mean the offshore funds being redomiciled in Luxembourg or another fund centre?
Veillet: The trend is more for the hedge fund manager to tap into the Ucits market, so what they do is they adapt their hedge fund strategy to a Ucits constraint.
Godefroid: We’re certainly seeing this, and have seen for some time. There has been significant interest from investment managers in this area. Some investment managers have pushed their Ucits III fund structures as far as they can in order to secure another solid distribution channel.
Denis: I completely agree on the fact that hedge fund managers are reviewing their product strategies and looking at converging to Ucits III-type products that are more adaptable and accessible to the market. From my perspective, the investment products landscape has changed in that we have seen a sharp increase in the use of sophisticated Ucits, which basically reflects a strong exploitation of permitted Ucits III strategies. This helped to drive the distribution expansion in this space and the increasing convergence with alternative fund products. We have seen an increasing growth of these sophisticated Ucits over the last two to four years with Ucits developments proposing long/short strategies, commodity indices, hedge fund indices, etc. From an asset servicing perspective, we have evolved from a traditional fund administration service offering to a fund administration model that today supports sophisticated Ucits as well as specialised funds, such as real estate funds, sharia funds and ethical funds.
Gandy: There’s a lot of education for us to do for this type of product [sophisticated Ucits] because those clients are obviously not used to the constraints of the Ucits environment.
Godefroid: We are seeing promoters move their strategy into a more regulated structure, such as a Ucits, in order to take advantage of the increasing damand for more regulated products in the alternative investments arena.
This flow is clearly in favour of Luxembourg. We are seeing an increasing number of offshore businesses redomicile their funds into Europe, converting them to more regulated structures. Of course, this is increasing confidence amond investors.
Bock: One of the big advantages of a regulated framework, be it Ucits or another one that may be being drawn up for hedge funds, is that there is a lot of trust in the market for these products. Though probably not entirely justified, there was a lot of mistrust around the unregulated over-the-counter product – about its transparency and the underlying assets it invested in.
So this [the move of hedge funds to a Ucits framework] is a very positive sign. I can only reiterate it is also business that Luxembourg needs to capture much more of because this is what we are very good at – providing frameworks and maximising the potential to take them abroad.
Denis: Going back to the question on what has changed for us practitioners, I think the education piece is quite important. In order to support this evolving fund administration service offering to a specialised and sophisticated funds model, you must ensure that your operating model adapts to the specifics of the products you now have to serve. Most important, there are no tailor-made solutions in this space and one size does not fit all. A key consideration as well is that you must have ‘specialist administrators’ that understand these products and the administration requirements of these. Maintaining and servicing a sophisticated Ucits is very different than a mainstream long-only fund.
Most of us practitioners serving these new emerging fund types have had to segregate our operations teams in line with these products and educate internally as to the key operating differences between a long-only funds versus these more sophisticated Ucits.
Gandy: They [sophisticated Ucits products] are, by definition, more complex, which means more questions around the pricing arrangements. The Alternative Investment Fund Managers Directive (AIFM), whatever final form it may take, will change the landscape again.
At this point in time, this is giving the hedge funds the opportunity to come in through Ucits. If practically all unauthorised funds come into an authorised arrangement under AIFM, then they will be able to go after broader strategies than Ucits allows. So we have to try and take into account what changes to the landscape will arise from this.
Godefroid: Also, the CSSF [Commission De Surveillance Du Secteur Financier – the Luxembourg regulator] is asking the industry about how that type of business is now entering the Ucits space.
If we return to Ucits IV quickly, there is one key difference between Ucits III and Ucits IV. That is the way they’ve been processed. There’s no deadline, there’s no obligation. It’s an option, it’s there, you can use it or not, you can consolidate your business, you can change your management company domicile, but there is no obligation as there was with Ucits III. I suspect that the industry will follow the options given: consolidation, management company reconciliation and so on, but this will not happen at the speed we were expecting a year ago. It’s going to take time.
Gandy: There has to be a compelling case for it. There are so many other points of focus at the present time; with regulatory changes, and taxation, etc. Certain aspects of Ucits IV will lend themselves to some situations. For example, fund range consolidation looks attractive but they still have the taxation issue to be dealt with. The master/feeder arrangements are another, so from a distribution aspect, this can be a key issue.
On the regulatory side you need to look at what Ucits IV brings in relating to the depositories. For example, that they have to have arrangements to share information on a look-through basis in master/feeder funds, which was an issue in the Madoff scandal.
Those are key initiatives we would all want to subscribe to, but one of the difficult things is the question of when Ucits IV will bite, particularly on the redomiciliation of the fund managers. Does it have to bite? The status quo can prevail.
Veillet: There’s a question mark that is hanging on the answer to the question of how and when Luxembourg is going to close the Madoff issue. And how and in what form are we going to get some clarification on the responsibilities of the depository bank across Europe? That might be one of the issues that decides whether Luxembourg is going to come out as a winner of Ucits IV or not.
Denis: I have a more positive view on the potential impacts of Ucits IV to the Luxembourg fund industry. I see Ucits IV has an opportunity for Luxembourg to finally be recognised as a distinct global fund administration centre with over 25 years of experience in global cross-border fund servicing, today supporting over 55 countries of sale and the associated legal and regulatory reporting, investor and distributor servicing, etc. Take for instance the management company passport. Some think that this may well push asset managers to think of administering their products in a domicile that may be cheaper than Luxembourg.
We already have various Alfi working groups looking at Ucits IV across many subjects. From a pure investment management operations standpoint – be it custody, fund accounting, cash management and transfer agency, for example, and particularly on the transfer agency and fund distribution support side, the Alfi TA Forum working group is currently defining guidelines on the migration of funds business from one fund administration service provider to another from a domestic standpoint. This exercise over the course of this year will then enable us to review the migration of funds business to and from Luxembourg to another EU jurisdiction in order to ascertain all of the legal, regulatory, operational and quality assurance implications of Ucits IV and the management company passport. That is what we, practitioners of the industry, also call ‘operational readiness’ when Ucits IV is transposed into Luxembourg law.
Bock: Ucits IV is a toolbox and while I fully agree that there is no specific deadline, I think that’s a big advantage. Ucits III was more product oriented, many promoters were only looking at their product strategy and then they were so focused on deadlines that it was just about ticking boxes.
We have conducted interviews not only with our clients but also with asset managers in the industry, and most, virtually everyone, has started to look into Ucits IV, but not just reading the text but asking what does it mean for me? How can I use these tools? We asked the question, ‘what would be the criterion on the basis of which you would decide to concentrate funds on a certain jurisdiction, which doesn’t have to be Luxembourg, it can be any jurisdiction?’ What came out clearly was, ‘it’s not where I have my headquarters, it’s where I find the best expertise for my products which are not local products but which I need to distribute’, and these are the strengths of Luxembourg. Luxembourg would have a big advantage because it’s much more about the providers in offering the solutions to support the mergers, the master feeder structures, rather than just thinking we are already there.
Godefroid: I am based in Luxembourg and can confirm that the feeling in our company was the same. However, we chose to go one stage further. There is no point in comparing Luxembourg with any other domiciles as we are confident it will continue to be a leading funds domicile. The same goes for Ireland too. What is important is that we continue to give our clients with ranges of products in both domiciles access to the services and geographies they want in the right timeframe.
Through our global operating model our clients have the support of local service experts as well as our global centres of excellence. Therefore a fund promoter only has to choose the domicile that will fit their product’s characteristics or distribution requirements while our ‘follow the sun’ approach to processing gives them the latest fund/portfolio analysis. Our clients know that irrespective of the domicile of the funds, we can support their distribution needs via our single European hub which is made up of four or five hundred people who speak the local language of the fund domicile. With so many uncertainties around Ucits IV, such as the where and the how, it is essential investment managers have all the options available to them.
Gandy: I quite agree. It underlines the need to have a global platform but then be able to face off specifically to each market. Let’s use Ucits as an example. You’ve got the main core of regulation and then you have additional local requirements. We’ll have to see once we get through the current consultation process how far that codifies the rules, but I’d anticipate we’ll still have local add-ons specific to each jurisdiction. You’ve got to face off to each of those and then consider what type of funds they attract to that jurisdiction to be able to offer the right service. From all of our bases we obviously want to get as good a core as possible, so a global platform is a very key driver.
Veillet: For the last five years we’ve built a platform that services our clients in exactly the same manner. Regardless of the domicile being Italy, Ireland or Luxembourg, they have the same reporting, thanks to our ‘hub and spoke’ organisation, but we prefer to speak about a centre of excellence because we don’t obviously hold everything at the same place. We put a lot of emphasis on the local presence also because we believe that you can have a hub to a certain extent but you still need the local feeling to serve the client.
Funds Europe: Some of you mentioned depositories and the next question is about the role of the depository. How did you respond to the best practice guidelines issued by Alfi, regarding the safekeeping of assets held through the traditional custody network? Would you say they formalised what was being done already or were there any changes to be made in the way business was carried out?
Denis: Hopefully there was no need for major changes. This industry is longstanding and mature. I see these best practice guidelines as a validation exercise tool. Depository and custody is considered a commoditised industry that is standard and pretty straightforward. Hence we’ve been used to a somewhat standard operating model for quite a number of years. This focus on the roles and responsibilities of the depositary bank was a welcomed refresher call. This focal point on the safekeeping of the assets function provided us all with a chance to revisit the servicing model in place. In my opinion the guidelines were very well received and brought all the industry participants together to exchange and share a common view. It was good to have this reminder as to what our expected roles and responsibilities truly are and to confirm these to the financial services industry.
Gandy: The very basic issue is that the Madoff scandal should not have occurred. The industry should have had the controls in place to deal with this kind of situation.
What we have to look at is that as the fund management industry has looked for new investments and new markets, as your sub-custodian network increases then there may be different challenges in different markets.
I don’t like the word, but yes it is commoditised – to that degree this should be ingrained in everything that we do.
It [the Madoff scandal] has raised the profile of what we do with the fund managers. They may not have had such a focus on ‘what is the sub-custodian network out there and how do you ring fence these assets?’ It is something that we’ve all always subscribed to and dealt with, but to me it is a reaffirmation of everything that we should have always been doing since Ucits first came out.
Denis: One very good outcome is that it brought much more emphasis on fund managers to ascertain their own underlying responsibility, particularly if they ask to have their assets maintained and managed outside a designated sub-custody network. At the end of the day the fund managers have the ultimate responsibility as to whom they choose and this guidance clarified this.
Bock: It not only clarified, but it has also codified what we do. It’s a code of conduct, even if it’s a Luxembourg-based code of conduct. You can use it in discussions with third parties, especially those that previously had tended to say, ‘You have to use that custodian because I want to use it too’. It gives you, not only the arguments, but more background in saying, ‘look there are some criteria under which we have to work’. The document is to no-one a real surprise, but it’s really a confirmation of good standards and that raises the quality of the industry in general. Although everyone was practicing economic research on where the sub-custodians are allocated, it reinforces it and gives it some foundation.
Veillet: It’s a pity we needed to have Madoff to open a discussion on the clarification of the responsibility of the depository bank. I do not like the word commoditisation because even if it might be true that some parts of custody are really commoditised products, that tends to completely remove the fiduciary part of the job, which is where our responsibility as a depository bank is, our responsibility to the end investors, and in that respect the industry has dramatically evolved.
New asset classes have emerged and some of those asset classes are maintained outside of the traditional sub-custodian network and it has never been really clarified what the responsibilities of the depository bank are for those assets. I agree that the Alfi paper should not have come as a surprise for anybody in the industry, but it’s urgent that there is a position taken at the European level regarding the responsibilities of the depository bank.
Funds Europe: Is there a concern that there will be responsibilities placed on the depository banks that aren’t appropriate?
Veillet: The problem is not so much what type of responsibility we’re going to put on the depository bank because at the end of the day what you need to consider is the cost and the benefit of what is going to be decided. If we say the depository bank is fully responsible at first demand for everything, obviously custodians will have to take that risk into account in their pricing model and somebody will have to pay that cost.
Denis: And it’s not going to be such a commoditised industry anymore.
Veillet: Exactly, it’s not going to be commoditised anymore. It’s a cost versus benefit analysis.
Bock: As far as responsibility goes, what is exactly safekeeping and restitution? The Alfi document is a good starting point and I fully agree that the issue needs to be raised at a much higher level, the European Union level.
Veillet: Yes. We said that Luxembourg is well placed for Ucits IV, which is true. Operationally we’re probably the best place for Ucits IV, but there’s still a threat
The fund manager can say, ‘Okay, I want to go to a domicile where I will find service providers to partner with’, but at the end of the day he still needs to sell those products to the investors; if the investors don’t want the Luxembourg Ucits anymore because it’s not clear what the responsibilities of the depositary bank are and more generally how well they are protected, the asset managers might have to find a new solution. So we need to clarify that definition as fast as possible.
Gandy: Looking at the Ucits consultation and the AIFM, and having seen a huge swathe of industry responses, everyone is making the strong point that Ucits was introduced in 1985 and the types of underlying investments have changed a lot since then.
Therefore it is a good time to have a review. That review needs codification, as you say, Martin, around what exactly is involved, and if, from a depository custodian point of view, we’re going to be asked to deal with new issues and assume greater responsibility, then there is a challenge. Will the industry be prepared to pay for this?
I anticipate that there will be the two classes; one will be what can be called safekeeping, and the other will be record keeping and monitoring from the fiduciary point of view.
What you need to ask is whether the depository, in its fiduciary capacity, is comfortable that those assets are held to the order of the fund and whether they comply with the investment guidelines of the fund.
But it has to be remembered that when fund managers make the investment decision, part of the consideration around that decision relates to the market it goes into, such as the market infrastructure, and insolvency laws, etc, in that marketplace. If it does move outside of what the depository can offer then that is the point where that responsibility should change.
End of part 1
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