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ASSET SERVICING: (1) Going into Custody

Turmoil in financial markets has focused investors’ minds on the role of their custodian banks and caused them to ask: How liable are custodians to reimburse me when assets are lost due to fraud or failure? This complicated issue will impact fees, says Nick Fitzpatrick

world.jpgStock market crashes can be rewarding for asset servicing firms. The industry, populated mainly by custodian banks, usually sees a spike in clearing and settlement revenues on the back of increased trading when markets melt down. Then, as their clients struggle post-crash, asset servicers get to market the longer-term benefits of their outsourcing functions for back and middle offices. They claim that if fund managers outsourced administration and other backroom activities, it would leave investment managers free to get on with managing money and position them to scale up more easily in the upturn.

The dotcom crash pre-empted a wave of outsourcing to custodian banks and the latest crisis could do the same. For example, the collapse of Lehman Brothers will have caused some hedge funds to question the wisdom of custodising assets with the same people that do their prime broking.

Hit hard
But the latest financial crisis has hit asset service providers harder than any other crash in recent decades. First, some of the large US-based players in global custody have had to take financial aid, or ‘Tarp’, from their government, even if they did not need it. Providers like BNY Mellon furiously stressed they did not need the aid, but were requested to take it by the US regulator in order to, effectively, disguise who the weaker banks were in America’s industry. BNY Mellon has since paid its Tarp back.

But the event with much longer-term consequences is the Madoff scandal. A number of investors in Madoff-related funds are suing UBS’s custody unit in Luxembourg for compensation. This move has rocked the world of custody.

Custodians now fear that placing greater liability on them in cases like fraud will increase the risk in their businesses. The issue for fund managers and institutional investors is that custodian pricing models may have to change to reflect this.

Yes, we are safe

The Funds Europe Asset Servicing Panel has drawn together a number of leading European and global asset servicing firms
to discuss how the current state of capital market behaviour and the changing nature of regulation may affect them and their clients.

An overarching feeling among many providers is that, yes, assets held by custodians are safe. But there is also a simmering anger that regulators and courts will allow compensation claims against custodians simply because, out of the entire investment management value chain, it is custodians that have the deepest pockets and have the best ability to cough up.

One participant argues that full investor protection has turned custodians into virtual mono-line insurers, while another says: “The Lehman Brothers debacle proved we have a very good infrastructure when it comes to ensuring that third-party assets are safe. We’ve proven that the regulatory framework for securing client assets – by ring-fencing them and putting them off balance sheet, etc – works, and  I don’t know what else we can humanly do to ensure this works any better than it already does.”

The latest stock market crash does not promise to be so rewarding as its predecessors.

©2009 funds europe