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In the wake of the crisis, the giant AP1 is looking for a new global custodian and is setting stringent operating conditions. Iain Morse reports

Sweden's mighty Första AP-fonden (AP1) is reviewing its custody arrangements. With net assets under management of SEK181bn (€19.4bn), it can afford to set stringent standards for global custodians. They must have a long-term credit rating exceeding an A/A1 or A rating, and have been rated by S&P, Moody's or IBCA. They will also need to demonstrate that they have no less than $1trn in assets under custody.

This is top-tier custody business. AP1 will allow the winner to appoint sub-custodians, but itself does not want to deal with more than one. The successful applicant will also be required to protect the fund against any potential loss of securities if a sub-custodian becomes insolvent. It will need a European, although not Swedish, operations centre, and be open for the same hours as the MSCI All Country World index.

As always, subsidiary questions to be answered by applicants reveal a lot. AP1 wants to know the number of each applicant's clients, divided into bands from less than $10bn (€7.3bn) to $30bn-plus. The number of Nordic clients will also need to be revealed, including local Nordic assets as well as those external to the region. SRI filters will also need to applied to an investment portfolio run by internal as well as 15 external managers. Real estate, private equity and hedging strategies are all included in the overall portfolio.

It is hard to see any Swedish custody bank qualified to win this mandate. None really qualifies even to enter although a couple claim to offer global custody services from Stockholm. AP1 does not disclose the identity of its custodians but almost certainly it will appoint or re-appoint one of the US giants. JP Morgan and Northern Trust, which is already custodian to AP3, are likely to be among the contenders, as are Citi, State Street, which provides custody services to AP2, and Bank of New York Mellon.

"The Swedish custody market is dominated by the AP funds," says Ben Gunnee, European head of Mercer's Sentinel group. "They are hugely important in setting the Nordic agenda on issues like custody and they set an example." The AP funds, and another 5-6 life and pension companies are Sweden's top tier investors. "As a group, they stand out as using not only core custody services but also additional value added services across a wide spectrum," he adds.

In Finland, for instance, custodians are not usually asked to provide risk analysis to clients. But this is included in the list of service requirements itemised by AP1 in its current review. Portfolio diversification, an unusual degree of intellectual openness and a lack of latent hostility to foreign service providers all characterise this Swedish top tier. There has also been political debate over whether the AP funds can find costs savings by consolidating and sharing their service providers, including custodians.

"Could all the AP funds use one custodian?" asks Lena Smedby Udesen, chief financial officer at AP2. "Yes, in principle. But I am not convinced. A single custodian would concentrate counterparty risk and this risk can amplify or decrease depending on the type and range of services required from a custody bank." And some synergies are not there to be exploited by a single custodian; the AP funds have diversified into foreign currency denominated assets but this risk is hedged by the Swedish treasury and central bank. Behind this is a more nuanced point; the AP funds have separate internal cultures. "Generally they try to avoid all hiring the same service providers, which keeps the overall system competitive and open." says Gunnee.

Gunnee also says that Swedish top-tier investors are willing to contract directly with US banks rather than via a local bank. But it hasn't always been this way. "Five and certainly 10 years ago the role of local banks was far greater than it is today," he adds. A partnership with a local, Swedish bank is only required when a local depositary bank is also required. The latter is needed for Swedish funds distributed to third party investors. This is important because despite the lack of regulatory barriers to entry for foreign custodians, Sweden's substantial fund management industry, which includes a quite large community of domestic hedge funds, must all use a local depositary bank.

This requirement presents domestic custodians like Nordea Bank, Handelsbanken and SEB and Swedbank with an advantage over their global rivals. The four main Swedish custody banks all service ‘captive assets' managed by their in-house asset management operations.

"When it comes to custody services for our independent asset managers and the indigenous hedge fund industry, we have by far the largest market share," says Göran Fors, head of custody services at SEB. This may be true for SEB, but the real question is how sustainable each of these local custodians would be if they did not have captive asset business as well as that obtained in the open, competitive market place. Swedbank, for instance, has a substantial in-house asset management business. "If you took away these captive assets some at least of the local custodians would not be profit making they would have to rethink their business models," thinks Gunnee.

These local custodians have all entered some kind of alliance or partnership with a global provider at one point or another. Nordea had a partnership with Bank of New York but then sold its entire global custody business to JP Morgan, while Swedbank has a partnership with JP Morgan and Handelsbanken with Northern Trust. "We use agent banks for domestic holdings but local players have difficulty keeping up the level of investment required to be genuinely global custodians," says Bo Thulin, branch manager of JP Morgan Worldwide Security Services in Stockholm.

Each of the four domestic custody banks say they are in the Swedish and wider pan-Nordic market in the long term and have invested accordingly. But doubts about the sustainability of all four remain.

"The choice for one or more of our rivals will be to either sell their book and retire or go into partnership with a global custodian as we have done," says Jonas Modigh, head of custody at Handelsbanken. If the global custodians win more direct business this will put yet more pressure on the local players.


 

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