SPONSORED ROUNDTABLE: IN SAFE HANDS
Moderated by Dan Keeler
Key figures from the world’s leading sub-custodians discuss how they are helping their clients deal with the effects of the flood of new regulation.
Global Finance: Recent years have seen a flood of regulations introduced or proposed. Which are the most important from a sub-custody perspective?
Florence Fontan, head of public affairs, BNP Paribas: In Europe, new fund regulations including the AIFM (alternative investment fund managers) directive and the proposed revision to the UCITS (Undertakings for Collective Investment in Transferable Securities) framework will have a direct impact on sub-custodians. Both propose that the depository of any funds—the entity who has custody of the assets of the funds—has an institutional responsibility for those assets. Effectively, the custodian may have to indemnify the funds. So custodians will have more responsibility than they currently have and, if they are using sub-custodians, they will try to pass that responsibility to the service provider, which is the sub-custodian. As a result, sub-custodians’ contractual arrangements and costs will rise and their relationship with the global custodians will change. There is another market-specific set of regulations, including Dodd-Frank in the US and the European Market Infrastructures Regulation (EMIR), that will affect us. These will have an impact on trading and clearing and will require custodians to adapt to this new environment, potentially raising our costs. Finally, again in Europe, there is the Target2 Securities (T2S) initiative, which aims to provide a common platform to use on a CSD (central securities depository), which will be helpful because we will then be able to connect to a single platform and not have to adapt to each CSD’s platform. As well as regulations there are market initiatives—regional, local and global—such as stock exchange mergers, that will have also have a strong impact on sub-custodians.
Ulf Norén, global head of sub-custody, SEB: There are so many initiatives that it’s hard to put them all into the proper context—particularly as there is no or very little harmonization with other legislation. And many of them that have good intentions, say to break down national barriers in Europe, are actually increasing confusion and maybe even constructing further barriers. One particularly important one, though, is the Securities Law Directive, which will affect both the post-trade environment and the trading environment. Everyone dealing with securities will be affected by it.
Fontan: The SLD is an attempt—although it is very difficult—to harmonize how securities are treated, regardless of the model you have behind them. It’s about defining what a security is and who has ownership of it. You have different models worldwide. In Europe, if an investor buys shares, he owns a portion of the company. All the intermediaries are completely transparent—they just are facilitators for holding the shares, so if an intermediary goes bankrupt, it doesn’t affect the rights of the investors. The other model, which is mainly the US model, is called securities entitlement. You don’t have the property right over the issuer, but over whoever you choose to hold your assets. So the SLD will impact investor protection as well as the relationship between issuers and investors.
Mark Kerns, global head of investor services, Standard Bank: For decades, our industry has consistently had many key initiatives competing for limited industry bandwidth and often leading to delays in execution. Understandably, on the back of the financial crisis, that’s proliferated, so now the big issue is harmonizing the various global, regional, local and overall industry initiatives—and practically implementing them. From a sub-custody point of view, this results in a high degree of challenge but one that critically needs to be met where it’s relevant to the markets in which you operate. For example, the markets in which we specialize are at a different stage of regulation compared to the developed European markets. While there are clearly market authorities, central banks, CSDs and stock exchanges, the regulation that supports the securities industry is still in a developmental mode—and the products that are used in those markets are often much more limited than people see in the large European markets. For example, in Sub-Saharan Africa there is no security lending outside of South Africa. However, local regulators have generally focused on developing regulation that is in line with the developed markets.
Fontan: Following the crisis, there was heavy political pressure in the US and Europe to toughen the regulations to address the problem. In Latin America, Africa and Asia, though, regulators are trying to help the development of their own financial markets while making sure it’s done in a smooth way without taking all the risks that many developed markets have been facing recently. Regulators in Asia are looking from the perspective of their individual market’s situation, which is logical, and sometimes even enforcing stronger rules than those we experience in Europe or in the US. Our experience of dealing with diverse European markets proves very valuable, as we bring both global solutions and domestic capacity to the various markets where we operate.
GF: What will be the effects of all this regulation on sub-custodians?
Norén: Cost is one of them. More and more of the investment we have available to make the world a better place for the investor goes to mandatory spending following regulation. The same applies to management—it’s to a great extent consumed by regulatory shifts. But that creates opportunities. Some custodians will look at what’s happening and maybe decide to drop out of the market. You can be bullish and say, if those guys drop out, let’s go for it, see what we can do. For the average investor, though, services in general will become more expensive.
Fontan: There are the additional costs due to the new regulation, but there is a second element, which is that regulations do not only affect us, but also affect our clients. We can help them, by providing services such as reporting, or helping them in their own compliance for this new regulation. For example, more and more transactions will be required to go through CCPs (central counterparty clearing houses,) which will require collateral. We can help clients access those CCPs and also help them put up the required collateral. Finally, we have a role to play in helping clients manage the complexity that is the result of the tangle of new regulations.
Kerns: One of the issues that the regulatory changes have raised is that global custodians and global clearers will need to take on, in some cases, the liability for activities they perform in markets on behalf of the clients that contract with them in their capacity as a fiduciary, for example, as a depository bank. That opens up a whole interesting series of questions, such as where can that be passed on from a sub-custody point of view? We have to decide what liability we are prepared to take in support of the end-client of our client? That leads to cost and a whole range of broader banking relationship issues. Our clients need to make a clear assessment of what risks they’re prepared to take at a local market level and what risks they’re prepared to take as it relates to the counterparty they’re dealing with. We’re already seeing something of a paradigm shift where organizations that do a lot of their own sub-custody also provide it as part of a global custody solution. A driver for that is what’s happening from a regulatory and liability risk-management point of view as well as the commercial opportunity.
GF: Will the new regulations be effective in helping sub-custodians manage risk?
Fontan: Regulation shouldn’t help sub-custodians manage risk as risk management is already part of their business-as-usual, but the liability attached to the new business will reinforce the focus on risk. Regulation will trigger full reassessments of what type of risk sub-custodians accept and whether the revenue attached to the risk is appropriate.
Norén: Some may actually increase the risk we bear. Take CCPs. I’m generally glad that we introduced CCPs, but their risk model is not that transparent, so it’s hard to fully assess your exposure. And allowing CSDs to take a credit risk or to take any role except for the agent role in securities lending adds risk. In some ways, the regulations are increasing the risk more than mitigating it.
Kerns: There’s been consolidation in every aspect of how the capital markets are supported. Consolidation of exchanges, of CSDs, of custodians, of regional and local market providers. You could say that consolidation leads to significant organizations, high degrees of liquidity and a strong focus on risk management. Or you could argue that a diversity of providers mitigates risk through separation. It’s inevitable, though, that across the capital markets infrastructure there’ll be greater consolidation. And ultimately you could find that you’re consolidating risk in an ever-decreasing range of infrastructure providers that support a global operating platform.
GF: Is fragmentation still an issue in Europe, and if so, how is it affecting sub-custodians?
Norén: Fragmentation is still an issue in Europe and is affecting more than just sub-custodians. There are too many in each country, and in Europe as a whole. We also have too many CSDs and too many CCPs. And we have fragmentation in the trading arena as well. But we may be at a turning point—to remain active as a sub-custodian you need to make sure you can handle the trade flow and the clearing flow, and that you’re equipped to handle the settlement flow. In addition, we have been investing in the asset servicing area. At the same time, a lot of the components of the sub-custodian’s business are being hurt. We don’t have any interest income to speak of, with this zero-interest-rate environment, and the regulatory and trading-side initiatives are all about reducing the numbers of transactions. It is a complicated and expensive business to be in and because of that we may see more consolidation.
Fontan: There are contradictory events taking place, some that would lead to consolidation, while some would promote fragmentation. On the trading side you could see mergers of platforms, which will reduce fragmentation. At the same time, you have a trend to create new CCPs—although there is also an initiative to merge some CCPs. T2S is also a driver for consolidation, but there is also the prospect for competition between CSDs, which will introduce more complexity. With clients looking for more pan-European or regional offerings it’s down to the sub-custodians to help them cope with that fragmentation and all this mess.
Kerns: There’s been quite a lot of consolidation of custodians and sub-custodians already in Europe. At the same time, though, there’s been a multiplication of venues for trading. So there is room for more rationalization of providers at all levels of the capital markets infrastructure, and it will be driven by economics or a requirement to take too much risk relative to the economic reward. Outside Europe, particularly in Africa, there is a very different dynamic. Typically, each country has built its own capital markets infrastructure, but now we’re seeing increasing regional cooperation, with, for example, multiple markets in East Africa and West Africa working together.
GF: What new pricing models or business models are appearing, and what challenges are they addressing?
Fontan: There is a clear trend toward more transparency in pricing and for unbundling services. Clients want to be able to see each component of your service. However, there is no agreement within the industry on how to unbundle, which makes it difficult to compare between different providers and different markets. At the same time, clients are asking for a global offering across assets, across geographies or across type of services. They want a suite of services, but they want to be able to see what they’re paying for each one. Since the crisis, liquidity has become an important component, too. If we provide liquidity in the system, on behalf of our clients, we need to factor it into our pricing. The difficulty is quantifying and valuing that liquidity. Everybody recognizes the value of liquidity, but how you include that in your pricing model is a different story.
Kerns: The organizations buying services from us are very sophisticated, so they like to understand each of the components of your offering and what you charge for them. Unbundling helps them understand the pricing and is likely to continue, but not necessarily to a level of unbundling within custody between corporate actions, income collections and so forth. We’re also seeing a shift from the cost-plus mentality to a relationship pricing arrangement. From a business model point of view, the financial crisis has triggered more interest in regional solutions. Organizations are looking for counterparties that can cover multiple markets for them in order to reduce the number of counterparties they’re dealing with. They’re choosing that regional provider based on credit profile, risk profile, service capability, market coverage and the range of products they offer, which means you’re dealing with a bigger relationship. That whole relationship is where the business models are changing—the more you do with an organization, the more you’re going to look at what the economic relationship should be.
Fontan: We’re moving from a pure service provider relationship to more of a partnership.
Norén: I’m still convinced that costs need to continue to go down. In order to do that while continuing to handle the growing complexity of our role, we need to do two things. One is to reengineer our complete operating model so it has a center of excellence that can handle the plain-vanilla services that can benefit from volume concentration. Second, we need to have a clear discussion with clients about the complexity of the services they need from us and the costs of those services. I fully agree that you need to unbundle both services and fees and you need to fairly price the risk we absorb and the liquidity we provide. The service model needs to be constructed around risk-management and collateral management. Quality has reemerged as a crucial characteristic, too. You have to be error-free and to provide thought leadership.
Fontan: Right. Before the crisis it was all about price. Now, the quality of your operation and your credit rating have risen to the top of the list. Not just the quality of day-to-day operations, but also in terms of crisis management. This is a long-term partnership—clients are looking for somebody who will support their business and accompany them across the changing environments we’re facing, so they need to be confident we’ll still be in this business in two years’ time.
Kerns: Yes, there has been an evolution of the relationship over the past three years to where organizations want to work on a longer-term basis. The conversations with clients are much less about price and more about strategy. They want advocacy and they want market knowledge, so the buying process and the negotiation process have become more constructive and much more reasonable. There’s much more value being attributed to the other things that you can do.
GF: As investors become more adventurous in seeking returns, are custodians extending their geographical coverage and expanding their range of service offerings?
Kerns: Yes. The regional providers are either deepening their penetration of clients in particular markets or looking to add market coverage so their offering is more comprehensive, particularly to the global buyer. The broader the coverage you have, the more appealing you are to organizations that are looking to develop partnerships, mitigate their risk, deal with institutions that they know well, and indeed, often have a broader corporate relationship with. We’re also seeing that providers are looking to offer more capabilities. A good sub-custodian is also a very strong domestic provider in their own market. For example, we’ve got a very big business in South Africa, which is beneficial for our South African intuitional investor clients, but it’s also beneficial for international investors coming into the country. You’re part of the fabric of the country, you have broad capability, you’re very well attached to and collaboratively work with the CSD, the stock exchange, and all the infrastructure providers. Your presence in the domestic markets in which you operate is a vital factor in terms of your own business model, but also in your appeal to an international buyer.
Norén : I agree. Expansion and product development are absolutely crucial. And when you move into new markets it is absolutely necessary to prove that you can provide some enhancements to those markets. You need to come up with solutions and to do it constantly and publicly. You can’t sit on your own solutions, you have to present them. Even though, in a transparent world, the benefit you get from creating your own exclusive solution may be short-lived, at least you get the credit for having achieved it.
Fontan : Investors are being more adventurous, but they’re not back to the full spectrum. They’re back into new markets, in terms of geography, because they want to benefit from growth in the emerging markets. We have accompanied our clients and expanded our geographical coverage, offering sub-custody services in Brazil or India. From a product perspective, they are not back to writing complex products, but they’re open to a broader range of products, many of which should be core services from the sub-custodians.
GF: The pressure on single-country providers is growing. Will we see more consolidation?
Norén: On a social media website that we support, called the Benche, we asked how many sub-custodians people believe will remain in Europe by 2016. Based on initial results, more than half of the respondents believe there will be fewer than nine. That’s down from more than 50 at present, so it represents considerable consolidation. That corresponds with our view. Competition and price pressure will continue to be the main drivers, but another factor is that regional and pan-European providers have proved they can service clients across country borders, and that they are quite good in market advocacy as well. So the regional trend will continue—and a bit further down the line a pan-European trend will do the same kind of damage to regional custodians that regional custodians have already done to domestic ones.
Fontan: The pressure is coming from two areas. First, is economic. With interest rates down you cannot count on that revenue resource. There is strong pressure on prices, so you need to reduce your cost base and you need economies of scale. In your domestic market, the scope for that may be limited. Second is your client. We’re moving to more of a partnership relationship and, as a global custodian, we cover 100 markets. I cannot build a true, long-term relationship with 100 providers, one per market, so I will privilege some relationships, which will hurt single-country providers. Those we do work with will have to be niche players that have top quality for a market where there is nobody else I can trust.
Kerns: If an international organization that’s buying in-country services in, say, five markets can get them from a single provider they already have relationship with, that opportunity is much more compelling. That leaves the single market provider looking less attractive to the international in-bound investor, but it still does leave the domestic market. So the survival of the single-market custodians will be dependent on their ability to maintain a deep business in their own domestic market, and rather less about their ability to offer sub-custody services.
GF : Are clients encouraging the regional players to move into new markets?
Fontan: Sometimes our clients ask if we’re planning to go into a particular market because they’re not happy with the service they’re getting from a local custodian. Another driver for us is the other divisions of the bank. We have an asset management arm and an investment bank arm. If that internal business has important assets in one country, is it worthwhile for us to go directly to that country, just to serve the BNP Paribas group globally?
GF: Recent events have prompted a rash of product innovation. What are some of the most useful new services, from a client perspective?
Fontan: A lot of product innovation has been triggered by regulation and by changing operating models, trading methods or types of assets traded. With the fragmented landscape in terms of CCPs, for example, clients are dealing with a bewildering array of organizations. We are working to consolidate that view by creating an environment where it appears as if the client has only one CCP in front of him. That not only helps clients deal with the complexity but also optimizes the costs. Another example that can help our mid-tier clients keep their costs down is our outsourcing service, which enables them to rely on our mutualized cost base, so we can provide them with lower cost than their in-house cost. We are also adding new types of services, such as three-party settlement services, where we guarantee settlement for their clients. Having a guarantee from BNP Paribas can help a mid-tier broker sell its offerings and remain competitive from a cost perspective—and also from a credit rating perspective. Finally, we are developing ways to help clients with whatever type of activity, and whatever type of assets they need—whether it’s cash, equities, bonds or derivatives. The next challenge is how can you optimize the collateral of your clients across those assets? Essentially, the client is looking for us to optimize our offering to help them cope with a difficult and changing environment.
Norén : In the Nordic region, we’ve gone from a bilateral settlement environment into a counterparty clearing environment, which is a big, big change. In order to establish our clearing services system, we jumped out of our product silo in sub-custody and asked the guys in trading and capital markets to help. Out of that cooperation came a lot of good things, including a very good cross-margining model, where you not only can cross-margin between products, but also between venues. We have also spent a lot on the credit and collateral side because we think some of the more determined battles will happen in that field. A third focus is our self-servicing models where larger clients have their own accounts at the CSD. You have scalability, so you can take on more settlement activity if you want to, but you employ someone to do the servicing for you. Another area that we believe in is sharing and social media. We’ve funded the Benche and hope it will develop into something user-driven. We do make sure that we share our opinion on, for example, regulatory issues but it’s open for anyone to comment or to get involved. We are sharing information now, but as it grows and gains traction, hopefully we will be able to learn from it, too.
Kerns: From an Africa perspective, we’re in quite a different place. Capabilities that are well established in the developed markets are still in their infancy. There are some areas where Africa is actually ahead of other markets. Mobile banking, which is still in its relatively early stages in Europe, is becoming part of the fabric of some of the African markets. But what’s exciting is that capabilities we’re very familiar with in developed markets, like securities financing, securities lending, collateral management and tri-party repo, are very topical areas of innovation within the region. There’s increasing demand, and regulations are changing to enable things like securities lending to be functions of how the markets operate. There are still major issues with the broader infrastructure—electricity, telecommunications and so on—in many African countries, so the cost of doing business and ensuring business continuity is very high. While you can have the latest technology and developed market capabilities, it’s still built on developing infrastructure. But there’s a lot of forward momentum and progress.