September 2011

SUB-CUSTODY: Supervise this

Stones-on-a-beachWith custodians now obliged to assume more liability for their sub-custody arrangements, Nicolas Pratt assesses to what degree risk management has improved. Regulatory change is forcing custodians to assume more responsibility for the sub-custodians they appoint. In the wake of the Lehmans default of 2008, efforts have been made to bring more clarity to any areas where the process for dealing with a default is not standardised.  According to Thomas Murray, the custody ratings firm, a number of banks and brokers have spent the last twelve months reviewing their procedures for monitoring risk across their sub-custody network. “In the past some global network management groups have relied heavily on their sub-custodian risk monitoring on input from industry surveys, passive web-conferencing or sub-custodian relationship and sales visits to complete their due diligence which has its obvious weaknesses,” says Derek Duggan, director of data services at Thomas Murray. This apparent lack of due diligence has not contravened legislation in many European markets. The UK’s Financial Services Authority, for example, makes no explicit requirement for regular on-site monitoring of sub-custodians, even if it could be argued that the risk questionnaires sent by custodians to their sub-custodian network fall below the accepted level of robustness needed to protect clients’ assets. However, new industry rules in Europe such as the Alternative Investment Fund Managers Directive and Ucits V, both address the issue of sub-custody and the liability that custodians must assume in the case of a default. The rules are not yet finalised, meaning that it is still “a very sensitive issue in the industry”, says Duggan; however, custodians are responding to the inevitable pressure from regulators as well as their own clients by setting in place continuous and active sub-custody risk monitoring and making this information available to their clients to provide beneficial owners with a transparent and up-to-date picture of the risks that may impact their assets.  ‘Tipping point’
"We feel that we are at a tipping point in the industry,” says Duggan. Some banks may await further clarification around regulation before taking firm decisions while others may wish to be at the leading edge of industry standards ensuring that they support their risk evaluation with quality data input and a robust methodology. “Whatever the outcome of future regulations, custodians and brokers need to adequately demonstrate to the asset owners that they are taking proactive steps to ensure the safety of their clients’ assets through a rigorous programme of monitoring,” says Duggan. Many custodians insist that they had proper procedures in place prior to the Lehmans default and exclusive of any proposed regulatory requirements. “As far as Société Générale Securities Services (SGSS) is concerned, even pre-Lehmans our monitoring of sub-custodians was robust,” says Bruno Prigent, deputy head of SGSS. “What Lehmans did was to highlight the differences in the interpretation of regulation from one country to another. And three years on, the situation has still not been clarified. There is no harmonisation across Europe with regard to the responsibilities and obligations of custodians; depending on the country, these can range from a supervisory obligation through to an obligation for the immediate restitution of assets. Ucits V should clarify and harmonise this aspect of responsibility, which is fundamental for investors.” For SGSS the management of sub-custodians is governed by an analysis of the conditions in the country concerned, says Prigent. “It is not our ambition to be present everywhere in the world, but SGSS is present in 80 countries. We analyse the country risk, then the credit risks associated with local players and conduct due diligence to identify the best provider. On a day-to-day basis we undertake a qualitative supervision of our providers as well as regular due diligence.” Other custodians are more forthcoming about the industry’s limitations in the pre-Lehmans era. The original financial crisis of 2008 made it very clear that there was an industry-wide knowledge gap among custodians as to what their obligations were, says Tim Wood, who runs the sub-custody network for RBC Dexia Investor Services. “As a result we updated our Continuous Risk Assessment model, which is a 32-point monitoring tool that is applied on a daily, monthly and annual basis to all of the sub-custodians that we employ. We also made it clear to any sub-custodian that wanted to be appointed in any new markets that they had to meet our eligibility criteria.” The criteria relate to detailed financial information, credit ratings and detailed information such as operational processes and business continuity planning, says Wood. “So we are very much aware of what our sub-custody liabilities are and how they differ in each country or market. We usually do not employ sub-custodians that only operate in a single market but prefer to use multiple-market sub-custody providers because of the reduced risk profile and the greater level of protection it can offer us.” Wood says that while RBC Dexia has strengthened its risk-monitoring model, it has not had to make any dramatic changes to sub-custodians it employs. Nor has it had to withdraw from any markets due to the increase in sovereign risk, largely due to the bank’s policy of only using multiple-market sub-custodians with minimum exposure to sovereign risk. “We have, though, been asked to open up in certain new markets, such as the Ivory Coast, but chosen not to because there was no provider that came close to meeting our sub-custody requirements,” says Wright. The debate as to whether custodians should set up bricks and mortar presences of their own rather than employ sub-custodians is one that comes up regularly, says Wright. “For us it is largely a question of scale. If we are employing a sub-custodian to do a large amount of work then it might make sense for us to take on that role ourselves but it is a substantial cost to set up in a new market and additional operational risk, amongst other things. And there are other issues to consider – the complexity of the market, whether it is a market of strategic focus for the bank, the barriers to entry and the level of competition.” Regulatory ambiguities
According to Sandrine Leclercq, general counsel for asset servicing firm Caceis, there is still a lack of answers in terms of regulatory requirements. For example, it is not yet clear what exemptions exist for custodians and the liability they have for their sub-custody network. “There is some debate about what constitutes an external event beyond the control of the custodian and external to its sub-custody network. It is an area the industry needs to examine in more detail. Custodians can’t be held liable for events beyond their control but nor should they evade their responsibility.” The other door that is still open, says Leclercq, is all those situations where the investment decision of the management company leads to greater custody risk. For example, the investment manager may choose to invest in a certain country where sub-custodians represent a greater risk or may choose to use a prime broker in a sub-custody role. Prime brokers are not subjected to the same requirements as custodians, such as segregation of assets. “Should a custodian be responsible for a prime broker acting as a sub-custodian on the wishes of the investment manager?” asks Leclercq. “They should be responsible for the monitoring of that prime broker, but how far should any liability go?” According to Leclercq, the arrangements for monitoring sub-custodians that custodians had in place prior to the financial crisis and the directive were already comprehensive, especially in France. “There was a strong regime involving paper checks and on-site visits. But there has always been a subjectivity about what should constitute due diligence and there is now a debate about what should be checked, how much segregation is needed from your correspondent bank and how this should be influenced by the asset types involved.” Clearly defined roles
Whatever emerges from the debate, Leclercq believes it is important that custodians ensure that the role of the investment manager and the custodian do not overlap. “The custodian is there to provide a secondary layer of protection. Prior to Lehmans, the custodian was almost acting as an insurance company to the fund. The custodian should ensure that it provides as much risk information as possible but that should not lead to the investment manager paying less attention to its own risks.” This issue is exemplified in the decision taken by an investment manager as to which markets it chooses to invest in. “The investment manager should be able to invest in any country it wants to but if it chooses to invest in a black-listed domicile, it should be the custodian’s job to tell them which countries are black-listed. It then becomes the liability of the investment manager or their end-investors.” Providing more information does come at a cost to custodians, and more liability means they need greater capital reserves, something which will add to the exclusion of small players from the custody market, says Leclercq. “The enhancement of the supervision process will mean more initial investment for custodians. They have to provide additional security and integrate additional functions such as due diligence and risk information. But they will not be able to avoid passing on some of this cost to their investment managers. Custodians’ fees should perhaps be related the level of risk attached to an investment manager’s investment strategy.” ©2011 funds europe

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