Nicholas Pratt examines the effect of new regulations, greater risk management and reduced profitability on the provision of sub-custody in the Nordics, Baltics and Central and Eastern Europe.
Sub-custody in Central and Eastern Europe (CEE) is provided by local banks that stick largely to their home markets, or by a select number of European banks, like Unicredit and ING, that have developed a sub-custody capability across the region. Ceskoslovenska obchondi banka (CSOB) provides sub-custody services in the Czech Republic and Slovakia.
As with other markets in Europe, due diligence demands have risen in the past few years, says Michal Brothanek, executive director of institutional banking at CSOB. This is a result of stricter regulations in the EU and US and also the stringent risk management of global custodians and other foreign clients. These demands have made sub-custody operations more expensive to run, says Brothanek.
“These costs have both external and internal character. For example, there are external costs for specialised external audit in the custody area and internal costs related to system improvements.”
The extra cost and heightened awareness of liability have not, as yet, resulted in custodians taking their sub-custody mandates back in-house though, he says.
“They still use local sub-custodians for their market knowledge, experience, and good establishment. Yet, some minor institutions which cease trading in certain CEE markets logically stop using sub-custodians as a result of cancelling their operations in a particular market.”
Each market has its specifics and the knowledge that CSOB possesses results from long-term experience with these markets, says Brothanek. For example, in the Czech Republic, the full nominee concept is not adopted, and there is a “two-layer evidence” instead. This means that ownership of securities is legally attributed to the person under whose name the owner account is open, and such an owner account can only be registered in the books of a central securities depositary (first layer) or in a local custodian’s books (second layer).
“In this respect, CSOB plays an important role as the provider with the widest scale of account structure options on the market,” says Brothanek.
Swedbank has provided sub-custody services in Estonia, Latvia and Lithuania since the mid-1990s after the Baltic states regained their independence. For the first years it operated a near monopoly until it was joined by SEB which entered the market relatively recently creating a Swedish-based duopoly.
The most notable characteristic about the Baltic sub-custody market is its size, says Tiina Nordberg, head of Swedbank Securities Services, Sweden, Luxembourg and the Baltics. The market suffered a heavy impact from the financial crisis. Subsequently its market capitalisation dropped in size, there were several delistings, very few initial pubic offerings and little stock exchange activity.
In terms of international investment, the Baltics were very popular in the late 1990s and early 2000s but the increased risk awareness among investors, couples with the small size of the market, has resulted in little activity since then, although it is hoped that the interest will return again soon.
The profitability of the sub-custody market in the Baltics is under pressure just as it is elsewhere in Europe. Estonia and Lithuania have already signed up to the European Central Bank’s Transfer2Securities (T2S) initiative for pan-European clearing. Latvia is likely to follow suit, meaning less revenue from settlement services and more focus on asset servicing.
This does mean, however, that global custodians are highly unlikely to be taking their mandates back in-house, says Nordberg, and they are likely to opt for fewer direct mandates in the region, especially if consolidation among global custodians continues.
Due diligence enquiries have centred on risk management, just as they have elsewhere, but the Baltic markets have been subjected to even greater demands, focusing on segregation of assets, bankruptcy proceedings, operational risk and business continuity. All these market pressures along with the liability demands of Ucits V are likely to lead Swedbank to revise its pricing model to take account of the changes in revenue streams. This, added to the small size of the market, means that Nordberg expects no new entrants to the market and the current Swedish duopoly will continue for the foreseeable future.
Sub-custody in Denmark, Norway, Sweden and Finland is provided by a quintet of local banks – SEB, Swedbank, Danske Bank, DNB Nor and Nordea. According to Göran Fors, head of custody at SEB, the extended requests for information and due diligence demands are likely to increase as more regulation, like the Alternative Investment Fund Managers Directive, comes into effect. But this has not yet led to a need for new systems.
“It is very much about the knowledge base and being able to answer all questions related to market risk. But we will have to provide more sophisticated information.”
It has not become more expensive to provide sub-custody services, at least not yet. Nevertheless, it is a fact that the liability sub-custodians take on on behalf of clients has increased, says Fors.
“This has increased our risk and we will, at some point, have to increase our revenue base to cover the increase in risk, or else get paid more for taking on more risk.”
It is likely to be a complex negotiation as there has been a substantial reduction in cost over the past 15 years and everyone expects that to continue, although perhaps not at the same pace.
“The discussion will focus on how the costs and fees are split and whether there can be separate fees charged for the liability while the transaction fees continue to reduce. We also need to review how we charge for the asset servicing – everything from corporate actions to tax handling.”
Despite the financial pressures and liability concerns, Fors does not expect many custodians to take their Nordic sub-custody mandates back in-house. “It is local expertise that makes the Nordic providers so important to clients. There is a trusted legal structure that reduces custodians’ fears about the safety of assets so most institutions continue to work with a local provider. But I foresee institutions coming into the Nordic market and setting up a self-clearing or self-settlement capability and then buying the more advanced asset servicing aspects from a sub-custodian like ourselves.”
JP Morgan uses Nordea as its prime sub-custodian across the Nordics region. While global custodians have considered taking their sub-custody mandates back in-house, in the Nordics this has not happened, says Bo Thulin, country manager, Sweden, JP Morgan Worldwide Securities Services.
“The legislation, the infrastructure, the economic climate and the relative strength of the local banks means there is a low risk of default among the sub-custodians but they will have to take on more liability as regulation dictates.”
Nordic sub-custodians also face an unfavourable dynamic in costs. Revenue streams are declining due to central clearing and a general reduction in transaction fees. But costs are increasing as a result of initiatives – such as the European centralised settlement engine for securities, T2S – the need for better risk control systems and general systems maintenance. Consequently, the cost for taking on more liability will have to be absorbed somewhere between investors, custodians and sub-custodians but, says Thulin, it is not clear what the answer to the problem is.
Whatever the answer, providing greater transparency will be key. “If there is greater transparency and less bundling then it will be easier for investors to see what they are paying for and easier for us to explain where there is greater liability involved.”
©2012 funds europe