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Global custody business on the move

Global custody is a first step to reducing costs and strengthening control in the investment process. Maurice Baum of MeesPierson explains the history and looks to the future
Five years ago, most pension funds invested mainly in domestic assets. In recent years, the number of countries in which funds invest has increased from an average of five to 10 to more than 50 to 70. The derivatives market also features more strongly in portfolio positions.
These two phenomena – cross-border investment and the growth of investment instruments – have created a need for better control of the assets and risks involved, together with a demand for greater uniformity in reporting.
This shift in focus among institutional investors has forced custodians to expand their international presence and to follow their clients into the countries in which they are investing.
The provision of global custody services has been the first response to changes in asset allocation and strategies. As the volume and value of investments increases and their geographical diversity grows, pension funds have delegated the safekeeping and settlement process to one or two global custodians.
Over the years, manual information flow has been replaced by a global custody workstation called the ETD (electronic trade delivery) system. The major advantage of the workstation is the standardisation and centralisation of reporting, enabling pension funds to evaluate their positions on a daily basis.
Globalisation of investments has prompted the asset management industry to focus on market segments, such as small cap, mid cap, Pacific or Europe. The volatility of non-domestic assets has also focused the attention of plan sponsors on risk management.
Due to the growing complexity of asset management, pension funds are increasingly outsourcing their asset management activities, either partially or totally. Since they now manage more equity and diversified assets, pension funds have been driven to adopt a more structured approach to the investment process.
This situation has encouraged global custodians to provide integrated reporting by all external and internal asset managers of pension fund assets.
Global custodians have been asked to provide the financial logistics to support a more structured approach to the investment process. Increasingly, custodians are approached by their clients with the request: “Can you help us to manage our managers?”
Global custodians targeting pension funds in particular are having difficulties in communicating with asset managers and pension funds managing their assets, either totally or partially.
Large pension funds have the same profile as asset managers in terms of their communication with global custodians: Some of them manage the larger part of their assets themselves and they tend to deal with multiple global custodians.
This has created a need to improve communication between asset managers and custodians. Working groups have been intensively involved in the development and standardisation of communication protocols such as SWIFT, ISITC and FIX.
There is also a growing need for integrated derivatives and securities reporting. Today, these needs are only partially addressed by global custodians, despite the fact that derivatives reporting is vital to risk control. This is partly because most specialised custodians, unlike broker-dealers, do not have a lot of experience in the clearing of derivatives. Historically, banks focus on asset management and custody services, while brokers usually provide asset managers with execution and derivatives clearing services.
To avoid a conflict of interest between the trading and clearing of derivatives, asset managers and pension funds ought separately to appoint a broker for the execution and a clearer for derivatives clearing. This is similar to the separation of functions between asset management, brokerage and custody.
Another challenge for the next decade is global electronic trading and integration between front and back offices.
Alliances, consolidations and joint ventures are also taking place between exchanges. DTB and Soffex have created a single trading platform: Eurex. Consolidations have taken place in Amsterdam and Brussels and the largest initiative has been the alliance between the Frankfurt and London Stock Exchanges.
This trend will have a strong impact on remote trading. Back-office processing is also set to move in the same direction. Alliances between European central depositories are posing a threat to local clearing and custody.
New electronic exchanges have been created over the past four years, including AIM, Nouveau Marché, EASDAQ, Neuer Markt, NMMAX and Euro.NM. Private exchanges and crossing networks, such as Posit, Optimark or Tradepoint, are also providing remote electronic access. Institutional electronic brokers, like Instinet, Interactive Brokers, GlobalTrade and BondNet are expanding globally.
Institutional electronic order routing networks, such as Liberty, GL Net, Tradeware Net and Merrin Financial, are providing access to a wide range of marketplaces.
Institutional investors have, on the recommendation of consultants, been involved in in-depth request-for-proposals (RFP) processes to select global custodians. In addition to the implementation of a service level agreement between custodians and clients, consultants have drawn the clients’ attention to matters such as risk and liability. In terms of fees, one basis point or less may trigger a heated debate between clients and custodians. The same principle has been applied to the selection of external asset managers.
The inventory of total transaction costs is a long and complex exercise. In short, there are many areas of hidden costs and risks that are not fully taken into consideration by asset managers and pension funds today. These include:
l Processing costs of broker confirmation by the middle office. To control total transaction costs and related risks, besides straight-through processing (STP) issues, transaction fees paid to the broker, execution price (best execution), market impact (price fluctuation due to a trade) and opportunity cost (costs of non-execution at the right time) need also to be taken into consideration. Some asset managers are already asking their brokers for volume-weighted average price (VWAP) to control the brokers’ trading efficiencies. This is a very good step towards controlling transaction costs.
Electronic trade confirmation (ETC) systems are not widely used by asset managers today, even though they have existed for more than 10 years. ETC facilitates STP. Global custodians have implemented electronic trade delivery (ETD) systems to improve communication between asset managers and custodians during the settlement process.
The total processing costs of a trade must be evaluated taking into account the following activities, which may vary from asset manager to asset manager:
p input of the trade to the asset management system;
p telephone call to the broker;
p waiting for the broker telephone confirmation;
p writing an ‘order sheet’ or a ‘slip deal’ and delivering it to the middle office;
p processing of matching between order book and broker execution confirmation;
p input processing of the order into the back-office system;
p reception of broker execution confirmation by fax;
p input processing of execution confirmation into the back office;
p input processing of execution confirmation into the global custodian ETD application for settlement;
p matching of settlement data between the custodian confirmation and the back-office database.
Some asset managers are already using e-mail (Excel spreadsheets), but are not necessarily using ETC for trade confirmations. It is clear that a great deal of automated activities are involved before and after the trade is executed. Electronic order routing systems integrated into order management systems are dramatically reducing the total investment costs. In a matter of two to five seconds, real-time cross-border routing, execution and confirmation are available thanks to these electronic networks.
l Processing costs of settlement confirmation to the custodian by the middle office. When asset managers make use of global custodians’ ETD systems, they reduce the administrative workload. It is quite easy to implement an interface (file import and export) between the asset manager’s back office and the global custodian’s ETD system. Once again, the total costs of middle or back-office processing relies heavily on the degree of automation and integration with the front office.
If global securities services providers want to provide an integrated solution to institutional investors, they will have to “rebrand” themselves to provide global transaction processing and routing. This service will soon include unified and integrated derivatives clearing and custody, as well as order routing systems.
Maurice Baum is director of marketing and product development at MeesPierson Information Bank

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