COMPETITION, REGULATION AND TECHNOLOGY
Moderated By Joseph D. Giarraputo
At a roundtable in London, Global Finance brought together key figures in the subcustody industry to discuss how they are responding to the many challenges posed by the eurozone crisis, the failure of MF Global, regulation and the need to expand into new markets and products.
Joseph D. Giarraputo, publisher, Global Finance: What scenarios for the outcome of the European debt crisis must a subcustodian consider?
Tomasz Grajewski, global head of UniCredit Global Securities Services: There are unknown factors definitely in the equation. This is the conclusion derived from the number of major exercises, which have taken place in London and elsewhere. From that perspective, little detailed planning seems to be possible at this stage. In the event of a major disruption, we need to ensure that the authorities give clear and prompt guidance to the markets. Even in the worst-case scenario, equities (which constitute the bulk of our client assets) would be less impacted than bonds and, especially, cash. At an institutional level, from the client's perspective, it is important that they focus on risk due-diligence. Risk management is not just about crises; it is more about issues such as capital adequacy of providers and making sure that local custodians meet the right benchmarks.
Ulf Norén, global head of subcustody at SEB: Europe is facing a multidimensional crisis where we have a debt crisis but also a confidence crisis. We have to think the unthinkable. We need to look at what the support system for the banking system is going to look like. We also need to look at the severity, length and the construction of the currency restrictions that will follow. What we need to do is an analysis at an infrastructural level, a product level and a capital management level. We also need to conduct a legal-impact analysis. What is needed is an in-depth dialogue with clients, regulators and competitors.
I'm more concerned at a micro level. What will happen to the contractual obligations? What will happen with my cash position? How will we deal with that FX contract? How do we deal with the obligations we have towards one another on corporate actions and income distribution, both in fixed income and on the equities side?
Alistair Jones, head of sales and relationship management Europe, subcustody and clearing, HSBC Securities Services: The cash liquidity side is consistently becoming a challenge. A lot of the liquidity that used to be there in the past is no longer readily available. If the debt crisis worsens, then we constantly need to improve our best-practice plans. We're not the biggest player in the eurozone for subcustody, so our impact is perhaps less than some of my colleagues here, but nevertheless we play an important role in the life cycle. We've also worked well together with our peer group to ensure that our plans are strong and robust from the point of market infrastructure down to our internal controls and processes.
Alan Cameron, head of client segment—broker dealers and investment banks, BNP Paribas Securities Services: We really just have to learn to live in a period of heightened awareness. Right now it's very important that we keep our clients up-to-date with what we're seeing and hearing on the ground. Then we have to be ready for sudden action if required. It could just be a surge in volumes following a very quiet period, or it may be something requiring more robust responses. That's really about all we can do at this point. It is important that the industry works together and talks together on this.
Giarraputo: Following the collapse of MF-Global, the safety and soundness of customer assets is being questioned. What role can subcustodians play in ensuring the safety of these assets?
Jones: We've worked very closely with clients since the financial crisis and modeled various what-if scenarios similar to the previous question. We then worry about what happens if one of those were to go into liquidation. What's the contractual position as a peer group? We're also much more concerned about market infrastructure as well than we were previously because now it plays an incredibly pivotal role. We also look at the protection that we can offer clients in the event of something happening and a number of these measures that could be improved, and, again, modeling to see what we can do should some of these things actually happen. But really it's about making sure that the assets are fully protected and that at any moment in time we know where we stand with regards to customer assets, and who the beneficial owner is.
Norén: Previously, we went through the motions of due diligence. Now it is more about encouraging active due diligence. As Andrew Rand from Brown Brothers Harriman stated in an interview recently, "Due diligence is really something that should happen every day." So that's the sort of model we need to get to. We all need to be guided on how we handle this to a great extent by both AIFMD (Alternative Investment Fund Manager's Directive) and UCITS V, which contain quite detailed wording on responsibilities that are going to be put on global custodians for their network. As subcustodians, these sort of transfer demands will continue to make our daily lives colorful going forward.
Grajewski: There are three important things. First of all, as custodians, we need to ensure that the legal structure we've got in place ensures the safety of client assets. The second point is that we need to lobby for changes within the markets to maximize the safety of assets and clear segregation of client assets. The third point is a combination of probity and operational integrity at the custodian. The custodian's probity must be undoubted; they must have an unquestionable reputation. Operational integrity is ensured by segregating the assets already at our level, and, wherever required and possible, at the level of the central depository.
I can refer to one example of this from Central & Eastern Europe. In Poland we have, in response to client pressure, been fighting for omnibus account structures. Finally, these were introduced in 2012, but—surprise, surprise—not all clients want to take advantage of them. I am sure there will be movement towards that structure, but the view that segregation increases asset protection is slowing down any changeover, despite the fact that segregation increases cost and complexity.
Cameron: Of course, a great deal of attention is rightly focused on the credit standing and regulatory status of the institutions holding assets. However, it is also important for clients to review what has been agreed contractually, and for them to ensure that it is understood by all parties concerned and put into practice. Understanding how the multiple market infrastructures act is an area of increasing attention.
Giarraputo: There's been increased fragmentation of trading venues in Europe. What impact is it having on subcustodians and their clients?
Cameron: Increasing fragmentation really comes from the trinity of competition, technology and regulation. It doesn't always have a huge impact on the custodian as they are often settling transactions that have been netted down by the central counterparty clearninghouses. But many of the custodians also act as general clearing members (GCMs) of the CCPs, and it's here that they really get involved in this fragmentation issue.
In that respect, there are both good and bad aspects of fragmentation for custodians. On the plus side, there is a real need for the custodian to act as a GCM. There are so many CCPs in Europe–23 at the last count– and more coming all the time. So it is a very reasonable and economic plan for trading members to outsource clearing to a GCM rather than connect to all of the CCPs themselves. The problem the GCMs face is that there are so many CCPs that it's hard to actually get costs down.
Grajewski: As custodians are part of the investment life cycle in the latter stages, it's more about adopting the procedures related to the CCP. At least in Central and Eastern Europe, we do not have so many CCPs. Whenever we act as the operator for a remote member within our region we are driven by their choice of markets and infrastructures. But by and large, any changes on the trading side have much less impact on us
Norén: It's certainly true when it comes to trading that it only basically concerns the subcustodian at the clearing level. Fragmentation has been bad in that respect as it has forced us to make investments in the post-trade field that we wouldn't necessarily have prioritized from a strict role perspective. On the other hand, subcustodians are there to bridge the gaps and irregularities, so fragmentation also generates more activity as well.
Jones: The majority of the different trading venues were initially created to help drive down the prices of the incumbent or the monopolies that may have existed previously. In that regard they were a success as trading costs have decreased. But in my experience, the overall costs of trading, clearing and settlement have increased because of the numbers of central counterparties, which means we've got to post margin, variation-margin and joint-default funds. A number of these different trading venues also have different rulebooks for how certain trades are handled in the event of a failure. In the back office, that creates a lot more inefficiencies and complexity, which increases risks and costs.
Giarraputo: There are a wave of new rules and regulations coming at custodians and their clients. Which do you think will be the most troublesome or beneficial?
Norén: Most of the regulations will be damaging to the industry as a whole. It will drive cost and force an artificial streamlining of behavior especially, and it will also punish the volume drivers, for example, the high-frequency traders. We have counted up to 24 major regulations and at least 45 that will have some kind of impact. Of the 24 major regulatory initiatives, AIFMD will hit us a lot because it places so many requirements onto our client base.
Cameron: Maybe I could shoehorn Target2-Securities (T2S) into this question. It's neither a rule nor a regulation, but it's definitely the most important thing on the horizon, and we're still waiting to hear whether the CSDs are going to participate. We still don't really know the costs. We don't know how they're going to be passed on to us. We don't really know what T2S functionality the CSDs (central security depositories) are going to use.
Jones: The number of regulations that are being debated, planned and considered is a concern. However, I think it's interesting to note that from a subcustody point of view we're actually still very lightly regulated, but we will be impacted by all of these proposed changes. The cost of implementation and compliance is a challenge, as a number of these regulations are happening at a similar time. The status quo is also not attractive or desirable, but with the cost of regulatory change and if we have to plan for T2S as well, that's going to be quite a traffic jam in our organizations to implement.
Grajewski: Much of the new regulation is reasonable; it's all about stability of the markets and protection of investments. But the issue is with the scope of these changes, and the fact that they go too far. They impose too high a risk on us as the custodians.
Giarraputo: What is the status of the harmonization of rules, regulations and practices within Europe?
Grajewski: In reality there's little harmonization within the CEE. The key about harmonization in the future is that it will be driven by the trend to move from EU directives to regulations. With directives you need to have them enacted within each country. Then there is a possibility that there will be different interpretations; regulations allow a common approach.
Jones: The industry has invested a huge amount of time in trying to drive and improve harmonization. Regrettably, however, the amount that has been delivered is very limited.
A number of these harmonizations will require national securities law to be repealed in a number of member states, and right now that's not [at the] top of everybody's list. Potentially, you also need to ensure that harmonization is complementary to initiatives such as T2S but also creates and maintains a competitive European market.
Norén: Regulations don't take into account the global coordination of initiatives. There's still the possibility for national interpretation and implementation. There are also bottleneck problems. I come from markets where the infrastructure in each market is small, and it's the same people involved in all of these changes.
Giarraputo: Custodians have been promoting outsourcing to their clients for several years. What is the current status of these efforts?
Cameron: We have a healthy broker-dealer outsourcing business, and there is increased awareness amongst the broker-dealers of the advantages of moving to variable costs from fixed costs, as you would expect, given the difficulties in the marketplace generally. We are seeing larger firms look at broker-dealer outsourcing services than we would have imagined even one or two years ago.
Grajewski: We don't see outsourcing being as big as it is in the US and Europe. Having said that, what we see is component-based outsourcing—taking certain functions and then giving this to the agents. Obviously for the clients we can be a banker, a counterpart, a custodian, and a distributor, but it is still more on a relationship basis rather than traditional outsourcing.
Norén: From a subcustody position, a lot of smaller broker-dealers have already [given] or are considering giving up their trading membership and are instead using direct market access (DMA) or DMA-like solutions. On the global custody side, we see a strong trend among clients towards outsourcing fund administration, but also other selective outsourcing possibilities are considered at an increasing level.
Jones: It's more mature in Europe to look at outsourcing or even co-sourcing, depending on how you want to phrase it. With regards to Asia, where we have a very large presence in custody, there's an increasing willingness of clients to look at this since the financial crisis.
Giarraputo: What's the current state of business for subcustodians?
Jones: We all look back at last year and think, "Wow that was a tough year." But actually for us it was quite interesting. We processed record volumes, and we ended the year with record values of assets under custody. So for us, we'd say that the business was good. However, we're all experiencing margin compression. That remains a concern, and we all need to ensure that as custodians we're being properly compensated for the risk that we undertake.
Grajewski: We have seen a drop in the value of assets. Having said that, in many countries we have been appointed clearing agents for new remote membership business, and in a sense, we've been compensated by the high volatility and big volumes resulting from this.
We also see opportunities as a result of the split between settlement and asset servicing as part of T2S. There is likely to be demand for a kind of new asset-servicing function and for more services related to liquidity. In our region, obviously Austria, Slovakia and Slovenia are part of the eurozone, so they will be affected from 2015. As a group, we will also continue our strategy of looking towards the east—extending to the CIS region, Belarus and Mongolia as examples, a trend that is driven by client demand.
Cameron: Credit is tight, and business conditions are tough. It's hard to be having a good time when your clients are not having such a good time. So we need to focus on getting some of the core things right, and top of that list right now is driving down costs.
Norén: We are in a competitive region, and we have an interest-level situation that is not at all helpful when it comes to revenue generation. Yes, these are challenging times, but I still think that being a subcustodian or working in the post-trade space, as a whole, is a good place to be. However, I don't think there will be too many doing that going forward. And those that want to do that need to take a good look at business and operational models.
Giarraputo: How do you expect the roster of participants in the European subcustody market to change?
Jones: If T2S is implemented, then it's a complete game-changer. The whole European operating model will completely transform. There'll be fewer providers.
Grajewski: Whenever you ask this question, the answer is, yes, the competitive landscape will be streamlined, but all of a sudden, if you look at the market, the custodians and market participants are still around. These days, however, there are two major differences. First of all, the single-market providers definitely cannot guarantee sustainable growth for their organizations, and then for the stakeholders. The second is, especially post-Lehman and the debt crisis in Europe, we hear that in many cases, organizations do not treat securities service as a core part of their business. The result will be that some of the players will have to exit the business.
Cameron: Over the last few years we've seen this industry consolidate through a pursuit of scale driven by the need to keep investing in technology. Now banks are moving into a period of balance-sheet and liquidity constraints, so one can only assume that there will be more banks wanting to get out than we've seen in the past.
Norén: For sure there will be fewer participants, and the remaining ones will be subject to fee and competitive pressure. Regional providers are a better fit for cross-border client needs by way of running a client-driven agenda across multi-country borders.
Giarraputo: What new products or services can we expect to see from custodians?
Norén: As a subcustodian we need to focus and to understand different needs that come from different client segments. We need to become much more in-depth and spend more time on each and every relationship to make sure that we are doing the right things. Once you have positioned yourself to be a strategic partner to your clients, you need to look at what it triggers in terms of products. Looking at the European environment, there is definitely much more need when it comes to sophistication in derivatives clearing, collateral management and cross-margining products between marketplaces.
Cameron: With respect to new products, one would be continued geographical expansion into new markets. Secondly, there are new products in and around clearing, collateral and outsourcing services. Thirdly, I would put selling old products in new bundles—being willing to service clients with either custody or settlements alone. As time goes on we will see such services as corporate actions and proxy voting offered as stand-alone services.
Grajewski: Partnership is important, and knowledge about the client's needs and their plans for the future is key. These days it's not just about launching new products. It's more about getting service delivery right the first time, plus enriching whatever we do for the clients.
Jones: We continue to look at possible new market expansion and new products, or where we have a product in one location, we try to harmonize it or roll it out to anywhere that's appropriate. The best practice, whether our client is dealing with this in Latin America, Europe, Middle East or Asia, is, we've got to make it look and feel identical. They want more consistency of reporting, and they want us to be country- or market-neutral in some cases.