A version of this article first appeared in Global Investor magazine in May 2007
In common with virtually every other area of the financial services industry, custody has undergone enormous upheaval over the past decade. In common with virtually every other area of the financial services industry, custody continues to experience change and continues to evolve. This evolution is epitomised by the use of the terms ‘securities services’ or ‘asset servicing’ to describe the industry as it moves further up the value chain and away from its roots in simple safekeeping, and tackles head on the challenges posed by increasingly complex derivatives contracts.
“The increasing diversification of investment activity, additional asset classes and the extensive use of alternative and derivative instruments on a global scale has placed asset servicing firms as key partners for investment managers,” adds Francis Jackson, head of New Business Development and Client Management for JPMorgan Worldwide Securities Services in Europe, Middle East and Africa. “Describing that as custody would be like comparing the horseless carriage to a Formula 1 race car. With the emergence of middle and back office outsourcing, asset servicing is now a capital allocation decision made at corporate board level, which is not something that the market is used to from a ‘custodian’.” In order to be closer to clients in key growth markets, JPMorgan says it is setting up sales and relationship management offices in South Africa, Switzerland and the Middle East, following similar moves in the Netherlands and Germany. JPMorgan will hire locally to staff these offices, says Francis Jackson.
In his consideration of the evolving landscape, Douglas A. Donahue, Partner and Head of Investor Services at Brown Brothers Harriman & Co, broadly echoes a number of these themes and digs into the infrastructural nuts and bolts. “An exciting new wave of innovation by asset managers, led by the increased use of OTC derivatives in mainstream portfolios, is shifting the landscape for service providers by increasing service scope and complexity and creating new areas for differentiation,” he says. “The growth of OTC derivatives is due to demand for better returns, innovative product launches, as well as regulatory changes, such as UCITS III, that allow more widespread use of these instruments. As a result, asset managers have placed derivatives capabilities at the forefront of their selection criteria for service providers.”
The challenges posed by these changes include a large operational element, and every major participant in the industry formerly known as custody must work out how best to adapt. For its part, as a custodian and an administrator, Brown Brothers Harriman looks to reduce the operational risks with processing OTC derivatives, says Donahue. The focus is twofold: (1) on creating an environment for straight-through processing (STP) and reconciliation of OTC derivatives, and (2) working with clients on appropriate methods for valuation in order to ensure proper portfolio valuation, collateral management and risk reporting. “Much of the industry’s automation focus has traditionally been on the front office,” he comments. “With the increased use of OTC derivatives by traditional asset managers, there has been a shift to focus on automation alternatives in the middle and back office. There is an opportunity for custodians and administrators to differentiate themselves in this space. The customised, unique nature of each OTC derivative contract makes them more challenging than any other instrument we’ve serviced in the past. So that requires a new way of thinking about STP.”
BBH is a pilot participant in SWIFT’s implementation of the FpML standard for OTC derivative trade notifications from the investment manager to the custodian, he takes the opportunity to remind readers. In addition, it is actively working with DTCC Deriv/Serv and SwapsWire on post-confirmation STP solutions. “The industry efforts that are underway today are all important milestones on the journey toward an STP environment for OTC derivatives,” he elaborates. “But for each instrument type solved, another one is created. Partnering with clients to service their complex OTC derivatives portfolios is an important long-term investment in supporting their innovation strategies.”
It is clear, then, that the rise in OTC derivatives usage by traditional asset managers has fundamentally changed their decision criteria for selecting a service partner. In the gospel according to Donahue, the capabilities which have become a differentiator in the selection process include:
Commitment to servicing derivatives as an asset class. The service provider must demonstrate a leadership role in industry forums to promote automation, define standards, and establish best practices on behalf of the asset management community;
Operational efficiency in derivatives processing. STP and automation capabilities, as well as flexibility of operational processes and systems to accommodate varied instrument types, are important prerequisites. We believe that making derivatives processing and valuation a core competency on the same platform as other asset classes mitigates risk;
A tested risk management approach around derivatives processing and valuation, including pre-determined client-specific procedures to communicate/escalate exceptions; and
A client-focused strategy that brings thought leadership and intellect to bear on understanding and solving client challenges.
All the major custodians have something to say on the changes that are taking place, and State Street is, as one would expect, no exception. “The growing appetite for derivatives stems from the quest for ever higher absolute returns,” says Patrick Centanni, head of State Street's product and technology solutions team. “At the same time, derivatives enable asset managers to avoid certain risks while enjoying more consistent returns, thus providing a measure of capital protection. As these drivers gather momentum, the growth in derivatives-based products and transactions raises new challenges for the systems needed to process and manage them.”
“Perhaps the greatest challenge is that, to a large extent, the technology platforms in use today have been designed to support more traditional investment products, i.e., equity and fixed income transactions. These legacy systems are now being tasked, at both the front and back ends, with processing vastly more complex transactions for which they were not specifically designed at a rapidly growing volume. For example, since these instruments are traded largely over the counter, they are negotiated trader-to-trader, and their valuations derive from sophisticated pricing models. As volumes in OTC derivatives expand, the need to confirm transactions with great accuracy and speed grows, as does the possibility of valuation errors that can occur while booking trades.”
“Whereas an equity or bond trade is typically a one-off transaction, most derivative transactions have an average life expectancy of three to four years. Some may even span up to 30 years. Throughout the life of a derivative, periodic events may occur that require calculations and adjustments, such as interest fixing dates e.g., in the case of an interest rate swap. The capabilities required to meet the intricate processing challenges that derivatives present underscore the rationale for outsourcing to a provider with the expert capacity to meet a specialized need. For asset managers, derivatives' sheer complexity argues strongly in favour of investing their resources in the front office, rather than in the underlying technology and expert staffing required to do the job of post-trade processing and support.”
Further illustrating the ongoing readjustments to changing client needs with which the industry has become so familiar is the recent announcement by Société Générale Securities Services (SGSS) of the launch of a middle-office service for structured and OTC products, following its ‘commercialisation’ of pricing services, performance attribution and risk calculation for complex derivative products. SGSS says the grouping of these four services in a new asset servicing offer is a concrete response to the needs of operators in the financial markets. Fund management companies, private banks, trading rooms, issuers, and others can now delegate the technical and operating processing of complex derivative products covering all asset classes (fixed income, foreign exchange, equities, credit, inflation and commodities). SGSS’s Dublin arm was also recently appointed to provide a full suite of fund services to HFIM Evolution Funds, the Irish-domiciled inaugural fund of hedge funds launched by London-based manager HFIM.
Despite the wave of consolidation experienced in the industry throughout the 1990s and into the 2000s, and ignoring for a moment the merger between The Bank of New York and Mellon, providers remain highly fragmented. Many ‘custodians’ forecast that further consolidation will take place. The most obvious location for the next sustained bout of change, though, is arguably continental Europe. It has traditionally lagged behind the Anglo-Saxon markets in financial change but is now facing up to a reality that is unfolding in a way that might not have been exactly as expected. When the major US players completed their takeover of the vast bulk of the custody business in the UK in the 1990s, many industry observers assumed at the time that it would be only a matter of time before they rolled up the map of continental Europe in the same clinical manner. The map of Europe, then, remains pretty firmly unrolled up. In fact, one interesting quirk demonstrates a certain resilience in continental Europe that was not shown by their UK counterparts. Sebastien Danloy, Global Head of Sales for Investor Services at SGSS, points out that while a decade ago there was not a single European provider in the world’s top ten custodians, there are four today: UBS, HSBC, BNP Paribas, and, of course, SGSS.
SGSS is nothing if not ambitious, and Danloy argues strongly that its acquisition in 2006 of the Italian custody operations of UniCredit Group serves to demonstrate its growing credentials as a force to be reckoned with in international securities services. The €548m acquisition of the custody and fund administration arm of the entity known as 2S Banca forms a central plank of its strategic plans to transform itself into a major pan-European custodian. 2S Banca was the second-largest custodian in Italy with more than €455bn in assets under custody and nearly €80bn in funds under administration at the time of the acquisitionand offers opportunities for further significant growth, says SGSS.
“This purchase means we are now a top three player in three European markets,” adds Danloy. “You won’t find any other single player in this position.” Other industry players brush off the bank’s aims and claims as overstated, and question whether its grasp will exceed its reach. The reality is, of course, that only time will tell whether the part it plays in the expected consolidation reshaping of the European asset servicing industry will match its Gallic rhetoric.
In the meantime, the long-overdue consolidation of the Italian banking market will inevitably present non-Italian custodians with new opportunities that a number are interested in taking maximum advantage of. “The market will change because Italian funds are haemhorraging assets at the rate of around €4bn a month, partly because of the way custody and fund administration fees are levied on the funds in question rather than paid by the asset managers,” says Carlos Sanchez, of RBC Dexia in Italy. “Costs are also disproportionately high in Italy because the vast majority of the business is captive, with custody and asset management being provided by the same group; there is no incentive to cut fees, and the asset manager cannot take a unilateral decision to move the assets because a change of provider will hit the parent bank’s profit and loss account.”
The consensus view is that more consolidation will take place in Italy’s banking industry, with both purely local deals and cross-border transasctions featuring, for two quite different reasons. Firstly, smaller banks who currently provide custody as a logical add-on to existing services to meet client needs, will find themselves faced with the same dilemma that UK custodians faced in the 1990s, namely that as markets and products become more complicated and technology-led they will need to decide whether to make the necessary investment or exit the business. Secondly, those with reasonably sized custody businesses could well set out to use the proceeds raised from the sale of that business to finance growth ambitions in other areas, as UniCredit is widely agreed to have done.
“UniCredit needed cash to buy HVB in Germany, so sold its custody unit to SocGen,” observes Carlos Sanchez. “Perhaps others will follow them.” RBC Dexia’s strategy, meanwhile, is to try to find partners or to make acquisitions to reach critical mass and establish a sound market position, he says, in a market that is 20 years behind the times but “could catch up quickly with the right changes in the regulatory environment”.
BNY/Mellon Update Sidebar
Much has been written about size and scale being critical factors for success in a consolidating custody industry, observes Tim Keaney, senior executive vice president and head of global investor services at The Bank of New York. And he should know, given the ongoing merger between BoNY and Mellon. “Those factors are critical and we expect our proposed merger with Mellon to give us compelling competitive advantages on both dimensions globally,” he says. “However, as we merge our organisations, we are particularly focused on creating a cultural and organisational fixation on client service because we know that exceptional service leads to client retention and expansion of relationships, which leads to revenue growth.”
“High quality customer service requires a formal, disciplined process focused on a variety of areas, including objective feedback from clients, sophisticated technology and servicing platforms, knowledgeable customer-facing staff, and the alignment of incentives to drive performance. For example, since the proposed merger was announced, we have stressed the importance of losing no customers and pursuing a thoughtful and deliberate process for transitioning clients to the combined organisation. As part of that, we have been actively engaged in soliciting feedback and suggestions from our clients so we can extract the most favorable genes from each of our organisations to develop our new organisational DNA.”
“We know the proper investment in and deployment of technology will be instrumental in helping clients capitalise on their growth aspirations. Put another way, as the globalisation of investment activity accelerates, market structures change, and financial instruments grow in complexity, the ability to harness and deliver technology platforms that keep clients at the forefront of change in an easy-to-use way will be a competitive differentiator.”
Securities Lending Sidebar
The rise of auction platforms for securities lending continues apace, though almost everyone agrees they are not suitable for, well, everyone. eSecLending, one of the most talked about in the market, says it has seen several major developments in the market over the past year, the primary development being the sheer proliferation of auction offerings in the marketplace. “More and more providers are beginning to realise the added value an auction can provide to a beneficial owner and are beginning to incorporate this type of product alongside their traditional service offering,” observes Chris Poikonen, MD of Auctions and Trading for eSecLending. “The auction model is also gaining wide acceptance amongst the beneficial owner community because it facilitates optimal price discovery, promotes transparency and offers results that are measurable and auditable for to report to Boards.”
The auctioning of assets to a global pool of pre-approved borrowers forces borrowers to compete for assets in a blind auction where there is not a known ‘market’ rate, he explains. Following the segmentation of assets into auctionable lots to match borrower demand, client assets are awarded to those borrowers who offer a premium return. Market inefficiencies are captured for the benefit of the lender, which is in sharp contrast to traditional agency programs where inefficiencies are generally passed on to the benefit of the borrowers.
“The increased demand for auctioning portfolios is not just a result of eSecLending’s involvement in the marketplace, says Chris Poikonen. “Beneficial Owners want to know where their returns are coming from and how their securities are being lent. They have also asked for a more transparent, regulatory friendly, and fully auditable process that will stand up to increased scrutiny.”
eSecLending reports that by April 2007, it had auctioned over $1.1 trillion in global equity and fixed income assets since the inception of the firm and currently has approximately $125 billion in on-loan assets. It supports clients in the US, the UK, continental Europe and Asia Pacific, and says it is continuing to experience significant increases in the level of portfolios placed via their auction process from both existing clients and new ones.