Will investors be happy to give up local, sub-custody providers? Nicholas Pratt finds the arrival of centralised settlement means they may have to.
Target2Securities (T2S), a project to harmonise the settlement process in Europe, went live in June. The T2S platform provides a single central system for settling euro-denominated securities, and the European Central Bank (ECB), which is behind the project, hopes it will reduce the cost, speed and complexity of settlement.
This would surely be good for news for everyone – but not so for some of Europe’s regional banks that for years have been providing local custody services for pension funds and asset managers. They also act as sub-custodians for global custodians that want to extend their branch network across Europe.
The emergence of T2S could see the regional banks losing out in their local markets in the same way a village café might when a motorway bypass redirects passing trade.
The T2S platform will allow market participants to access a pan-European settlement platform through a single entry point. Consequently, some global custodians without a direct custody network in certain European countries will be able to access clients in those countries through T2S rather than via a sub-custodian. Also, local central securities depositaries (CSDs) can now encroach on local custodian territory by offering their own asset servicing. So not only will the sub-custody banks face the prospect of being bypassed by global custodians, they could also face competition from local CSDs.
“I don’t believe that T2S is a nail in the coffin of the local sub-custodians, except for a small subset that have taken no action, but it will have an unfavourable impact,” says David Maya, partner at Oliver Wyman, a consultancy, and co-author of a recently published report, Securities Services: The Good Times Are Over, It Is Time To Act.
Sub-custodians may still be retained to run accounts but it is a far-from-ideal scenario, says Maya. “They lose ownership of the client and their service becomes a commodity with no scope. The only silver lining is that they have not lost the business altogether.”
This means many local custodians will have to change their client focus, says Maya. “They can choose to target local investors that only invest locally or within a small region. Or they can partner with a global custodian looking to extend its branch network and hope that will make them less vulnerable.”
The larger local custodians in Europe are highlighting the fact that they have been adapting their service models for a number of years now, adding new services such as collateral management and moving away from commodity services such as custody and clearing. They are also highlighting that, even though T2S allows for pan-European settlement, there will still be very large local markets in the likes of France, Spain and Italy where securities will be settled through domestic platforms that could offer enough volume for local sub-custodians to survive.
Furthermore, T2S does not completely remove local sub-custodians from the post-trade process, says Rob Scott, head of custody and collateral solutions at Commerzbank. “The local sub-custodian is still very much needed to provide a range of value-added services, including local clearing, corporate actions, market advocacy, taxation, cash optimisation and other customised services. In addition, larger sub-custodians will continue to be used by, for example, the international CSDs like Euroclear and Clearstream acting as the single point of entry for them to access local markets.”
Similarly, Austria-based Raiffeisen Bank International (RBI)has chosen to position itself as a gateway to Central and Eastern Europe. “Clients who choose to come to the Austrian market directly and maintain cash and securities account with RBI will have a risk- and cost-efficient, easy access to the rest of our markets,” says Attila Szalay-Berzeviczy, head of securities services at RBI. “As we are the only bank in this part of the world which has this approach, we can say T2S gave us the reason and the opportunity to make our client service more competitive than ever before.”
SITTING ON THE FENCE
One challenge for participants is that many clients are yet to decide how they will connect and operate in a post-T2S model. “It is hard at this stage to say exactly how much real impact T2S will have on local sub-custodian models because most clients are still sitting on the fence,” says Scott. “They are waiting for the major markets and volume to join, and then for service and pricing transparency of the entire value chain.”
T2S implementation was phased. The national CSDs of Switzerland, Malta, Romania and Greece, which account for less than 10% of Europe’s annual trading volume, went first. This first wave was also meant to include Italy, which belatedly reported for duty in September.
In 2016, the largest CSDs of Belgium and Germany will go live, making it easier to judge just how much volume will go through the new settlement platform and how much will continue to be cleared via local custodians and local CSDs.
T2S has also had a technical impact for local sub-custodians by way of the investment in new software and systems to accommodate the new functionality offered by T2S, such as linking and partial settlement. To offer the full range of T2S services would involve serious investment.
Whereas global custodians can afford to cater for the full menu of T2S offerings, local players have had to be more circumspect. “Each custodian has had to make the choice about whether the software changes are worth the investment,” says Hans Koek, senior project manager T2S at Holland-based KAS Bank. “We consulted closely with our clients about what services they would want to use and conducted an impact study.”
For example, given that clients said they would use only part of the service for linking settlement instructions, KAS Bank has implemented only part of the software, rather than adding unnecessary complexity and cost.
Nor does Koek think that reduced settlement fees will be the biggest feature of T2S. The project will have failed if the cost of settlement is not reduced by 90%, said the ECB when launching T2S, a message that has changed since it became evident the reduction was going to be nowhere near that.
“The benefit of T2S will not be the reduced cost of settlement,” says Koek. “Once all the ancillary costs are added, it will be somewhere between 30 and 50 cents, which is not much less than it is at the moment.”
The real benefit will be a simpler settlement structure and a more harmonised landscape, which in turn is the biggest threat to local sub-custodians because it will be easier for global custodians to offer services in countries where they do not have a direct custody offering. It will also be possible for CSDs to offer asset servicing, thereby creating more competition for local sub-custodians. “If you are only offering local custody in one or two local markets, you will need additional revenues,” says Koek.
Even though a local custodian that offers local services will find it hard to survive, things will not just switch over, says Koek.
Koek also expects the biggest threat to local custodians to come from CSDs that will offer asset servicing and reduce the need for local custody – something that could take three to five years.
Commerzbank’s Scott agrees that even those local custodians operating in low-volume markets will not start disappearing quickly as a result of T2S. “Yes, the universal banks have bigger budgets and coverage but the idea that all the sub-custodians will consolidate and several will go out of business is just not true. There will naturally be elements of consolidation with large service providers but local sub-custodians in high-volume markets will still have a major role to play and if they are forward-thinking in their business model, they could actually be in a position to increase wallet share of clients with the introduction of new products and services.”
As KAS Bank’s Koek says: “In the end, participants will choose the cheapest solution for clearing and settlement, but our clients do not choose us for that. They choose us for the client reporting, regulatory guidance and compliance and the benchmarking. If we only offered commodity business like we did ten years ago, we would not be here today.”
Ironically, one of the saving graces for local sub-custodians may well be increased regulation and harmonisation. While some aspects of their traditional revenues, such as settlement, may be marginalised by the likes of T2S, increased global regulation requires buy-side firms to place greater importance on their fiduciary responsibilities in the appointment of providers.
This is forcing providers to think creatively about areas like account segregation and to develop services, while the extra due diligence potentially gives these local players a stage on which to showcase their strengths and competitive differences. That’s regulation – it gives with one hand and takes with the other.
Will asset managers miss sub-custodians that disappear? Pension funds have a strong preference for providers that speak their language and have presence in local markets and on working groups.
Oliver Wyman’s Maya suggests T2S casualties will not be so missed. “If there is consolidation in the sub-custodian market, you will get potentially stronger players with more scale that are better able to address their clients’ needs. There will be fewer providers to deal with and more value-added services.”
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