September 2013

GLOBAL CUSTODY: Risky lending

VaultFor a global custodian, assets have been shown to be at risk when they are out on loan with a prime broker. Among other questions, including about provider consolidation by asset managers, Funds Europe asked how banks deal with this risk.

CHARLES COCK, HEAD OF CLIENT DEVELOPMENT, BNP PARIBAS SECURITIES SERVICES

Prime brokers can increase the liability of depositary banks where they temporarily hold assets for their hedge fund clients, such as rehypothe-cation. What is your risk management approach to this?
We ensure that controls are in place to monitor the level of assets that have been rehypothecated in relation to the fund's level of indebtedness to the prime broker.  These controls can be performed by us, or we can rely on a statement of controls from the fund manager, subject to an annual on-site review. The fund manager will typically monitor rehypothecation levels on a daily basis, either via internal processes or a middle-office outsourcing provider.

Also for reasons of depositary liability, how are you managing your sub-custody network? What have been the relevant changes, if any?
Network management has always been important to us and Alternative Investment Fund Managers Directive (AIFMD) has had no impact on the way we manage our sub custody network. Our approach to safeguard assets is to expand our proprietary network. Last year we included the US and Australia. Over 90% of our clients’ assets are held within our proprietary network. We appoint sub-custodians based on defined criteria, which include financial strength, reputation, and breadth and quality of services provided. The non-proprietary BNP Paribas sub-custodians are branches of international banks with strong financial standing and solid credit ratings. Rigorous due diligence processes are undertaken during the selection process and ongoing monitoring.

Which value-added services have been in most demand over the past year? What have been the drivers? How do you see demand evolving over the next year?
We are experiencing demand from clients to service operational changes in response to regulatory requirements. Optimisation and protection of collateral are becoming critical decision factors; whether long or short, clients want to be able to maximise the use of their assets.

Asset protection remains at the forefront of clients’ minds and very much at the core of BNP Paribas missions.  When considering the security of their assets, we encourage clients to consider three factors regarding their custodian: financial strength and stability, operational security and processes and their legal framework.

We are experiencing demand for outsourcing that involves more intellectual and value-added tasks. Clients are asking for front office functions such as dealing services and passive overlay.

DARON PEARCE, HEAD OF INSTITUTIONS (EMEA), BNY MELLON ASSET SERVICING

Prime brokers can increase the liability of depositary banks where they temporarily hold assets for their hedge fund clients, such as in cases of rehypothecation. What is your risk management approach to this?
There are two possible approaches, both of which reflect the fact that an alternative investment fund (AIF) can only have one depositary, and that depositary can delegate the safekeeping of assets to one or more custodians.  In one model the depositary could delegate safekeeping of some or all of the assets of an AIF to prime brokers, and in the agreement transfer liability to the prime brokers.

The alternative approach would be for the depositary to appoint a single custodian that would retain control of the assets.  The custodian would offer enhanced services to the AIF and their prime brokers to move assets and collateral – under instruction from the AIF and prime broker – to support the rehypothecation of assets.   

Are investment managers with global businesses consolidating their asset servicing providers? In your experience, which fund centres are benefiting?
Large investment managers in particular are focusing on the active management of a smaller number of more strategic service partnerships.

Which value-added services have been in most demand over the past year? What have been the drivers? How do you see demand evolving over the next year?
Regulatory changes mean clients are facing a seismic shift around collateral over the next year.  It is not only the need for more collateral that impacts the client but also the increasingly complex way in which it will need to be applied – be it segregated, optimised or transformed.

In becoming the first custodian to establish a central securities depository (CSD), we are facilitating an internalisation of the securities value chain that means our clients will benefit from greater efficiency and reduced risk.

We have currently secured Issuer CSD status, and the next phase is to seek regulatory approvals for Investor CSD status, facilitating linkages with other CSDs. Ultimately, we will connect to the Eurosystem’s T2S platform, which promises to reduce the costs and risks associated with settling trades in Europe.

PIERRE CIMINO, MANAGING DIRECTOR, CACEIS BANK LUXEMBOURG

Prime brokers can increase the liability of depositary banks where they temporarily hold assets for their hedge fund clients, such as in cases of rehypothecation. What is your risk management approach to this?
The combination of an asset restitution duty on the part of the depositary, and the prime broker’s use of assets for rehypothecation, securities lending and repos, creates complexity both on a technical and risk management level.

Our approach means funds’ prime brokers undergo a strict due diligence procedure before they are authorised. This due diligence is repeated on a regular basis.  If for any reason a prime broker is not authorised, then the fund is not permitted to use that prime broker. Furthermore, a precise contractual framework is established that governs the permitted actions of the prime broker as well as its relationship with the Caceis depositary.  Information flows between the prime broker and the depositary are subject to detailed monitoring, especially when rehypothecation is involved.

Also for reasons of depositary liability, how are you managing your sub-custody network? What have been the relevant changes, if any?
Caceis’s policy is to select the best sub-custodian bank in each market in complete independence and we currently have a sub-custody network which covers some 90 countries worldwide.

Are investment managers with global businesses consolidating their asset servicing providers? In your experience, which fund centres are benefiting?
We are seeing clear evidence of a two-stage consolidation process among investment managers.  Firstly, they are consolidating their business with a single asset servicing provider in order to reduce complexity, risk and costs.  And secondly, for the same reasons, they are consolidating their global product ranges to a single product range with the aim of distributing it internationally.  In terms of fund centres, Luxembourg appears to be benefitting from this trend.

Which value-added services have been in most demand over the past year? What have been the drivers? How do you see demand evolving over the next year?
Driven by regulation and investor security needs, services linked to risk management, collateral management, over-the-counter derivatives clearing and investment reporting are in demand.

HOWARD RAPLEY, EMEA HEAD OF GLOBAL CUSTODY, CITI

Prime brokers can increase the liability of depositary banks where they temporarily hold assets for their hedge fund clients, such as rehypothe-cation. What is your risk management approach to this?
We perform daily asset rehypothecation-level testing and reporting to the alternative investment manager and prime broker to make sure the agreed asset rehypotecation levels are correctly managed. The accuracy and reliability of our reports are then assessed via onsite inspections and ongoing due diligence programmes.

Also for reasons of depositary liability, how are you managing your sub-custody network? What have been the relevant changes, if any?
Custodians with large proprietary sub-custody net-works are at an instant advantage when asset safety is core to your business. The improved control and asset visibility on offer means risks can be better mitigated compared to the requirements of managing a third party sub-custodian network. This does not mean you can rest on your laurels. It is vital you have in place the most stringent daily monitoring procedures and regular due diligence checks for your entire sub-custody network (both proprietary and third party) as well as for the local market infrastructures and regulatory frameworks in which you operate.

Are investment managers with global businesses consolidating their asset servicing providers? In your experience, which fund centres are benefiting?
The size and complexity of outsourcing contracts across Europe (especially in the UK, Luxembourg and Ireland) has grown as the industry becomes more comfortable in outsourcing across the middle and back office. The search for operational alpha and efficiency has lead investment managers to outsource more bespoke parts of their business, such as the intra-day investment book of record reporting, on a regional or global basis.

Which value-added services have been in most demand over the past year? What have been the drivers? How do you see demand evolving over the next year?
With European Market Infrastructure Regulation and Dodd-Frank on the horizon, this focus on transparency, asset safety, counterparty risk and data complexity has intensified. This has escalated the demand for segregated collateral and custody solutions to help manage these challenges.

JOHN VAN VERRE, HEAD OF GLOBAL CUSTODY, HSBC SECURITIES SERVICES

Prime brokers can increase the liability of depositary banks where they temporarily hold assets for their hedge fund clients, such as rehypothe-cation. What is your risk management approach to this?
HSBC  has established a control framework to actively manage the risks of client assets held with prime brokers. The introduction of a new function, AIFMD Controller, will oversee the governance model around the control frame-work to escalate and resolve issues while providing a holistic view over the network of agents and potential risks identified.

Also for reasons of depositary liability, how are you managing your sub-custody network? What have been the relevant changes, if any?
All agents and their operating environment are subject to a rigorous selection, risk assessment and approval process. We conduct regular on-site visits. The frequency is determined on a risk-based approach which does not differentiate between group and third-party providers. As part of the introduction of the AIFMD, a review was undertaken of our due diligence and risk assessment processes for agent banks and third-party prime brokers to ensure we continue to monitor our agents to the highest standard across the whole network (including non-AIFMD markets) in line with the AIFMD.

Are investment managers with global businesses consolidating their asset servicing providers? In your experience, which fund centres are benefiting?
There are examples of clients moving towards and away from consolidation. We have observed clients who have split their mandates between multiple providers to reduce counterparty risk and it is also evident that there is demand to consolidate, simplify asset manager operations and realise economies of scale. However asset owners and managers may find it challenging to run significant consolidation and regulatory-change programmes concurrently, thus the move to consolidation is likely to be gradual.

Which value-added services have been in most demand over the past year? What have been the drivers? How do you see demand evolving over the next year?
Apart from an increasing demand on off-balance sheet short-term investment alterna-tives driven by capital preser-vation rather than yield, we have also observed numerous requests on solutions around collateral reinvestment, (includ-ing processing of value adjust-ments, valuation, recon-ciliation, automated reinvest-ment and custody). Collateral transform-ation is increasingly used by clients to generate meaningful incremental returns from high quality assets that are currently producing low-yield returns.

ROB WARD, MANAGING DIRECTOR, GLOBAL CUSTODY & CLEARING, JP MORGAN WORLDWIDE SECURITIES SERVICES

For reasons of depositary liability, how are you managing your sub-custody network? What have been the relevant changes, if any?
Sub-custodian banks on an annual basis must submit written confirmation of certain information related to the safekeeping of our clients' assets as well as certain undertakings.  Sub-custodians are required to promptly notify JP Morgan of any material adverse change in their financial condition as well as any changes in legal structure.  In addition, sub-custodians must advise of any material operational changes expected to have an adverse impact on their ability to provide routine sub-custodial and related services.

Are investment managers with global businesses consolidating their asset servicing providers? In your experience, which fund centres are benefiting?
Yes, this is certainly a trend that is picking up and the centres benefitting most are Luxembourg and Dublin.

Which value-added services have been in most demand over the past year? What have been the drivers? How do you see demand evolving over the next year?

Key focus over the past year on derivatives, driven by regulatory change (Emir and Dodd Frank). The potential benefits to be gained from collateral optimisation programmes could be material and this means there will be significant demand for this over the next few years.

WILSON LEECH, HEAD OF EMEA REGION, NORTHERN TRUST

Prime brokers can increase the liability of depositary banks where they temporarily hold assets for their hedge fund clients, such as rehypothe-cation. What is your risk management approach to this?
Our rigorous approach to risk management enables us to manage the impact of AIFMD and associated risk, which varies according to client type.

The hedge fund sector has seen a trend for cash and unencumbered assets to be held away from the prime broker at a depositary.  In response, Northern Trust has deployed a model that holds both unencumbered and encumbered (margined) assets. It may take time for a fully mature industry model to develop, especially with the partial exemptions for non-EU funds and managers until 2018.

Also for reasons of depositary liability, how are you managing your sub-custody network? What have been the relevant changes, if any?
With the advent of AIFMD, we have introduced specific enhancements, which include upgraded country risk information for clients and assessment of suitability of markets for AIFs. Additionally, Northern Trust is undertaking a review of its current European custody strategy in the light of the evolving European infrastructure and regulatory landscape.  AIFMD forms a major component of this review, which explores all potential models that limit the depositary liability under AIFMD.     

Currently, we have made minimal changes to our sub-custody network, and any changes have been driven by our longstanding commitment to providing clients with the most efficient, creditworthy and quality providers.

Which value-added services have been in most demand over the past year? What have been the drivers? How do you see demand evolving over the next year?
Clients continue to turn to us for insights and solutions to help them stay on top of, comply with, and maximise opportunities presented by the continuing raft of global regulation. This is providing us with the opportunity to be more integrated with our clients and develop more valuable relationships as a result. 

Are investment managers with global businesses consolidating their asset servicing providers? In your experience, which fund centres are benefiting?
The trend to consolidate asset servicing providers is an inevitable by-product of the acute focus on risk management and need to focus on the core business. By consolidating with one provider, investment managers benefit from a uniform approach to pressing operational issues such as global regulatory developments, risk/performance monitoring, more predictable costs and a more robust platform.

MARC BRIOL, CEO, PICTET ASSET SERVICES

Prime brokers can increase the liability of depositary banks where they temporarily hold assets for their hedge fund clients, such as in cases of rehypothecation. What is your risk management approach to this?
As a matter of principle, and given our clients’ profiles, we do not use prime brokers as sub-custodians. However, our clients do enter trades with certain counterparties, which trigger the need to move collateral. In that case, we would highly recommend banning re-hypothecation and making sure strict segregation is enforced. We do operate set ups whereby the collateral, for counterparty risk consideration from our clients, is held with us on counterparty-specific accounts.

The various industry initiatives around Emir and Dodd Frank in particular, will over time significantly reduce the need for bilateral clearing and thus ultimately reduce the risk for our clients.

Also for reasons of depositary liability, how are you managing your sub-custody network? What have been the relevant changes, if any?
There is definitely a renewed and strong emphasis on proper segregation of duties, operational integrity and risk management framework for asset services.

We did not really alter the way we engage with local providers, authorities and market infrastructures following the recent regulatory developments, in particular AIFMD. We have an experienced team of network managers, which is in daily contact with our network, assessing the quality of the service and making sure strict ring-fencing of clients assets does occur in all markets.

Are investment managers with global businesses con-solidating their asset servicing providers? In your experience, which fund centres are benefiting?
This trend has been seen from sometime now and we expect it to accelerate. Even without having a global business, important regional asset managers should really consider the benefit of regrouping their assets with one single provider to benefit from economies of scale and a possible one-stop shop approach.

Which value-added services have been in most demand over the past year? What have been the drivers? How do you see demand evolving over the next year?
We are increasingly asked to provide sophisticated collateral management services and management company services through our dedicated legal structures.

GÖRAN FORS, HEAD OF ASSET SERVICING, SEB

Prime brokers can increase the liability of depositary banks where they temporarily hold assets for their hedge fund clients, such as in cases of rehypothecation. What is your risk management approach to this?
We will apply our normal risk management procedures as a depositary bank, including our extensive reporting from our prime collateral services.

Are investment managers with global businesses consolidating their asset servicing providers? Which fund centres are benefiting?
The increased possibility to consolidate under various new regulation, together with the necessity to do so given the increased burden of regulation and continued pressure on profitability, is driving the pace of these types of discussions in most major institutions. The risk/reward analysis is complex and many are finding that what on paper looked appetising is in practice more difficult. The centres benefitting are Luxembourg and Ireland, but there are some managers that consolidate in the other direction; primarily those with an investor base  concen-trated to the home market.

Which value-added services have been in most demand over the past year? What have been the drivers? How will demand evolve over the next year?
Advanced accounting services (share class hedging, pooling techniques, complex investment instruments, high frequency trading strategies, and so on), including the ability to do so  across relevant jurisdictions. The ability to support the funds with reporting under various new regulations such as Foreign Account Tax Compliance Act and the AIFMD is rapidly coming to the forefront of discussions.

ETIENNE DENIAU, GLOBAL HEAD OF BUSINESS DEVELOPMENT, ASSET MANAGERS AND OWNERS, SOCIETE GENERALE SECURITIES SERVICES

Prime brokers can increase the liability of depositary banks where they temporarily hold assets for their hedge fund clients, such as in cases of rehypothecation. What is your risk management approach to this?
The current model adopted in France is very similar to this, which has provided us with the tools and expertise to implement strong risk management processes across the breadth of our depositary network in 15 countries. We would therefore expect a minimal impact on our risk management process. Furthermore, should the broker use a transfer of property, it would in effect remove the liability of the depositary bank.
Nonetheless, if the broker employs rehypothecation, we request a higher level of transparency.

For instance, the broker must provide real-time reports detailing all affected positions, and the reuse must be accepted by both parties (by us and the broker).

Also for reasons of depositary liability, how are you managing your sub-custody network? What have been the relevant changes, if any?
Our current process for selecting a sub-custodian is very stringent, whereby we employ a strong due diligence programme.

Full market investigation is conducted during which candidates are screened under various criteria: security and control, financial integrity, service quality, standard of care.

Internal teams evaluate the reactivity and the quality of the sub-custodians with an emphasis on settlement, corporate actions, tax reclaims and reporting processes.

SGSS monitors the day to day activities with the sub-custodians and perform an in-country review once during a rolling 12-24 month period.

Internal assessments are conducted by both the risk management and network teams to review the ratings of sub-custodians on a quarterly basis.

Should the rating of a sub-custodian fall below an acceptable standard, a change in sub-custodian would be immediately initiated.

ENDO BAUMGARTNER, HEAD ASSET SERVICING, UBS

Prime brokers can increase the liability of depositary banks where they temporarily hold assets for their hedge fund clients, such as in cases of rehypothecation. What is your risk management approach to this?
In general, depositaries will need to increase the oversight and monitoring of prime brokers’ rehypothecation activities to ensure that they are within the pre-agreed limits as required under AIFMD. There are three predominant models available to depositaries: First, the delegation of safekeeping to the prime broker under a full discharge of liability, second a bilateral agreement between the depositary and the prime broker with respect to the prime brokers’ liabilities in the event of a loss of assets and third, for depositaries - along with its sub-custodian network - to hold all assets of the fund which is more appealing to depositaries but not practical or feasible from a prime brokerage perspective. At UBS, we tend to make use of the first approach.

Are investment managers with global businesses consolidating their asset servicing providers? In your experience, which fund centres are benefiting?
We see a clear trend towards consolidation. For clients it became important to get solutions from fewer expert solutions sources in an integrated manner rather than receiving different solutions from several providers. Also, having access to booking capabilities in all time zones is key for globally operating clients.

Which value-added services have been in most demand over the past year? What have been the drivers? How do you see demand evolving over the next year?
We see an increasing demand with regard to sophisticated reporting services. Therewith, transparency and safety are the clear drivers and stand in the centre of our clients’ actions. Also, with regard to cost, transparency plays a bigger role, in particular in terms of the total costs of investment vehicles. The importance of these topics will even increase over the next years.

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