October 2009

SUB CUSTODY: Tower of strength

Global custodians are scrutinising their sub-custody providers more rigorously to ensure financial stability, reports Fiona Rintoul
stonetower.jpgGlobal custodians are only as good as the sub-custodians that form their networks, and in the post-credit crunch environment, these networks have come under increasing scrutiny. The due diligence questions asked have changed, at least in emphasis.

Where previously a fund manager client was interested mainly in the global access afforded by a custodian, the risks involved in dealing with the network agents that support them in those markets are now a more compelling topic.

“The greatest challenges for custodians in this past year of economic crisis have been around providing data to help clients manage their counterparty exposure,” noted Geoffrey Cook, managing director of BBH Luxembourg, in this year’s Funds Europe Custody Survey published last month.

A major part of that counterparty exposure is, of course, exposure to the global custodian’s sub-custody network. Clients and global custodians want assurances about safety.

“Transparency, risk, financial strength and business resiliency will continue to be key drivers in the quest for asset safety,” notes Rajen Shah, managing director and custody product executive at JP Morgan.

“Risk is very much on the agenda,” agrees Göran Fors, global head of custody at SEB, the Nordic custody bank. “The crisis made us realise that if you have risk in the chain it is a very important thing to follow.”

Post-crisis, SEB continues to build its technology for monitoring all aspects of risk – something Fors says it would have been doing anyway. Further development will no doubt be necessary, particularly on the compliance side as new regulations such like Ucits IV come into force.

This is happening against a backdrop where the global custody business is changing. In some ways, leaving aside the particular difficulties wrought by the crisis, their business has become simpler as clients move towards more cautious investment strategies. There is talk of a ‘back to basics’ approach and a slowdown in the creation of new derivative instruments, as a well as a new appreciation of the services custodians provide.

Renewed interest
“We have seen increased demand and respect for traditional custody services as clients rediscover the importance of record keeping that segregates client assets and values holdings daily,” observes Declan Kehir, head of custody operation Europe at PNC Global.

While this respect a the service once taken for granted may be welcome, it comes with an additional burden. Clients want to know more about the mechanics of custody and about the custodial chain – the relationship between the custodian and the sub-custodian, and between the sub-custodian and the market itself – and it often falls to their global custodian to inform them.

“Clients want to know where their assets are if something happens,” says Kevin Smith, director of the global network management team at BNY Mellon. “Whose holding them? How are they holding them? We’ve received questions on a market-by-market basis. Everyone is reevaluating and wanting to understand how it works.”

SEB’s Fors agrees that clients are now seeking more information. “They want to know who we use and what the process is for evaluating the sub-custodian,” he says.

Running parallel to this ‘back to basics’ strand but somewhat contrary to it, is the fact that many global custodians are now also moving towards servicing an expanding group of clients in the post-crisis environment. Some, for example, see an opportunity for custodians to step into the prime brokerage market as investment banks move to curtail their prime brokerage capabilities.

In our survey, Citi, HSBC, Julius Baer, Northern Trust and State Street all said they had developed services for hedge funds, funds of funds or alternative investments in the last twelve months, or would develop them in the next twelve months. Other companies cited derivatives processing as an area slated for development.

So, how have changes brought by the crisis affected the selection and management of a sub-custody network on a practical basis?

Some global custodians have responded by paying more attention to the financial strength of their sub-custodians. “Financial strength has moved up the list of criteria,” says BNY Mellon’s Smith.

This wasn’t a big change for BNY Mellon, which has pursued a strategy of moving towards larger, more highly capitalised institutions since the mid-1990s. Thus, the bank uses HSBC in Asia-Pacific, for example.

“In Europe, things tend to be a little more fragmented,” says Smith. “We utilise ING in Central and Eastern Europe. In the other European markets there doesn’t tend to be a single domestic provider. Thus, we use BNP Paribas in France, and both Santander and BBVA in Spain.”

Along with financial strength, a key selection criterion for BNY Mellon when choosing a sub-custodian is that custody is a key business line for them. “We’ve seen people moving in and out of the business over the years,” says Smith. “If you look at the US, several of the top-tier banks have exited the custody business. We are looking for a long-term commitment.”

Another question is whether to stick with one provider or to run an alternative provider. This can be a particular issue in areas such as Central and Eastern Europe.

“People realise that banks can fall down,” says Ramy Bourgi, head of emerging markets at Société Générale Securities Services (SGSS). “It makes it more interesting and more difficult for global custodians. They are looking for a secondary custodian in a market where they already have an agreement just in case they get the jitters about the institution they are using. This never happened before the crisis.”

But, while having a second string to your bow might seem like an obvious solution to internal and external concerns about counterparty risk, it can create its own problems. First of all, experience shows that having two custodians won’t necessarily help in a meltdown situation.

BNY Mellon worked with two financial institutions in Iceland, but both were affected equally by the problems that market faced in the crisis. Iceland is, of course, an exceptional market due to its small size and the absence of international players.

“It was a country issue and a situation that developed over many years,” says Smith. “Hopefully, we will never see that same scenario again.”

Hopefully not. But the kind of extreme crises that bring banks down do, by definition, tend to be exceptional. In an interconnected world where, as has become clear, the repercussions of those interconnections are not always fully understood, one should perhaps not be too quick to discount the Icelandic example.

Certainly, SEB has moved to set up a contingency in markets where it didn’t have one before as a result of the crisis. But this does create issues about how to manage the back-up sub-custodian network. There is cost and effort involved in running a standby, so should you have one everywhere, and if not where should you have one – in the markets that are the most risky or in the ones that are most important to your business?

“If you look at the markets that make the press – Iceland, the Baltics, the Ukraine – they are not very big markets,” says Smith.

This means that in some of these smaller markets there may only be two banks. Everyone could thus end up with the same standby and they would be unable to cope if an event occurred and they were called into play.

There is also the issue of how much commitment you can expect from an understudy. Some global custodians may therefore prefer to run an active strategy in markets that are important to them. There are no easy answers and it will always be a judgement call.

Regulatory burden
“We have two sub-custodians in a select number of markets,” says Smith. “We are still reviewing our standby providers and will continue to review them this year.”

The onus on global custodians to pay close attention to the management of their sub-custody network and to educate clients about it has undoubtedly increased. Criteria that used to be a box-ticking exercise, such as the credit rating of the underlying institution, are now subject to scrutiny from clients.

The burden on global custodians seems certain to increase as new regulations come into play, particularly in Europe where we await Ucits IV and the hotly disputed Alternative Investment Fund Managers Directive. These new regulations are all going in one direction: that of placing greater responsibility on custodians.

This means the need to monitor and manage the sub-custody network actively will also increase, with a strong emphasis on evaluating and managing risk. The challenge then will be to make money and maintain the requisite level of investment in an increasingly demanding and tight market.

“The greatest challenge for custodians has been, and will continue to be, the ability to commit to long-term investment in technology, expertise and global presence, providing clients with tailored solutions that meet and anticipate their needs across the globe,” said Jacques-Philippe Marson, CEO at BNP Paribas Securities Services, in the Funds Europe Custody Survey.

You might think this would lead to upward pressure on prices. But, thus far, the signs are that this is not the case. “It hasn’t affected the pricing,” says SEB’s Fors. “Clients want everything.”

©2009 Funds Europe

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