Magazine Issues » October 2012

SUB-CUSTODY: The heart of the matter

Russian dollsSub-custodians face an unprecedented level of challenges, from regulation to infrastructure. Nicholas Pratt looks at how they are dealing with them.

Sub-custody is not what it used to be. In the past, sub-custodians may have operated in a relatively light regulatory environment but this has changed markedly in the finincial crisis years. The effects for sub-custodians have been both explicit and implicit.

Regulation such as the Alternative Investment Fund Managers (Aifm) Directive has made global custodians liable for the safety of assets in their sub-custody network, and this has led to greater monitoring of the risk management practices of the agent banks they appoint in various international markets.

In addition to regulation and the associated costs of compliance, there are also the costs of technology development as sub-custodians improve their risk management processes and those operating in multiple domiciles look to centralise their reporting systems across different jurisdictions.

There are also competitive and economic challenges. With a handful of large global custodians dominating so much of the industry, from asset servicing to transactional banking, regional banks are finding their opportunities limited. Sub-custody represents one revenue- generating stream but competition is fierce, standards have risen and the need to show expertise and reliability has never been more evident.

“The major change has been an increase in due diligence, with special attention being paid to the structure of client accounts and the controls in place to ensure safety of client assets,” says Tomasz Grajewski, head of global securities services, Global Transaction Banking at UniCredit, the Italy-based bank that has established a sizeable sub-custody presence in Eastern Europe.

“Furthermore, there is more detailed analysis of the balance sheets of custodians given the importance of cash in the equation. The assumption of sub-custodian risk under the Aifm Directive and numerous other regulatory changes is a material issue and clients are always looking for enhanced account structures that minimise risk – both in terms of cash and custody accounts.”

In order to satisfy these due diligence demands Unicredit has adopted a region-wide, common risk policy with a focus on protection of client assets. “We have also enhanced the external audit oversight of our business to ensure that we are always to the fore of best practice for custody services,” says Grajewski.

The increased attention to due diligence and risk monitoring inspired by the Aifm Directive is not limited to Europe and is just as prevalent in emerging and frontier markets, like Africa. “Overall, we have seen due diligence requirements and documentation becoming more extensive, particularly in terms of risk factors and risk mitigation,” says Mark Kerns, global head of investor services, Standard Bank, a South Africa-based bank that is the dominant sub-custodian in Africa.

“In the Africa region, there is also an increasing demand for more detailed external audit reports from sub custodians. Holistically, the volume of work and cost of servicing global custodians in the region is picking up as a result of the additional requirements to monitor risk.”

Standard Bank has also had to invest heavily on technology and infrastructure to ensure its service is robust and efficient enough to meet custodians’ demands and to demonstrate the enhanced safety of their clients’ assets. “Within this, risk mitigation and safety of client assets are top of mind,” says Kerns.

“We have had two major developments in the last year that ensures greater safety of client assets, the first one being the segregation of Standard Bank’s proprietary assets and client assets in South Africa. We have also implemented a regional custody hub service to provide clients access to African markets, while facing off with SBSA [Standard Bank of South Africa].

“We are currently working on introducing a portal which clients will have access to. This portal will provide extensive market information which clients can utilise to manage their risk.”

As burdensome as the increased due diligence demands and risk reporting may be, a greater threat to sub-custodians is that custodians simply decide to take back their mandates and subsume the custody responsibilities themselves, especially in the emerging markets that are generating increasing investor interest and where a physical presence may hold strategic benefits for custodians.

However, for the less developed markets that don’t yet have the allure of some of the Asian and Middle Eastern domiciles, employing a sub-custodian still represents the most effective option. And as the accompanying map of sub-custody networks in different international regions shows, there is still plenty of opportunity for regional banks in their respective regions.

“Outside South Africa, markets in Africa are too small to justify a local custody operation and, therefore, taking the sub-custody mandate in-house is not likely,” says Kearns.

“Furthermore, global custodians do not have the reach required in the region. It is unlikely that we will see any material movement in this direction in the near future.

“So we envision that global custodians will likely continue to use regional providers especially for markets where they have limited activity. This will reduce their risk exposure to multiple markets.”

©2012 funds europe