Iain Morse assesses trends in the custody markets of the Nordic countries

Market reform in the Nordic region is creating new and significant business opportunities for global custodians. Just weeks ago, Northern Trust opened an office in Stockholm to service the region and it already has an alliance with Handelsbanken. A year after buying Nordea Bank’s custody portfolio, JP Morgan has also significantly increased its Nordic team, opening offices in regional capitals. The bank also has a local alliance with Swedbank. BNY Mellon already had an office in Copenhagen and partnered Nordea before the JP Morgan deal.

What lies behind this invasion? Sweden, Finland, Denmark, and Norway all have well-funded indigenous pension and insurance industries. There are an estimated €1trn worth of Nordic assets to custodise. At least €550bn are owned by 25 local institutions, 24 of which are pension funds, and which last year responded to a report on the Nordic market from BNY Mellon, ‘Inside the Engine Room’.

Not surprisingly, post Lehman Bothers, the same report shows respondents putting high emphasis on operational risk reduction, which nowadays usually translates as minimising counterparty risk. This is an area where global custodians have an unarguable advantage over all but their largest local rivals. “The Nordic institutions with large portfolios are sophisticated and open minded. They are looking to cut costs and better control portfolio risk,” says Madeleine Senior, the recently appointed Nordic Region managing director at Northern Trust. This puts a lot of emphasis on the so-called non-core, value added service components available from the custodians. “Custodian-provided and state of the art risk metrics are a key requirement for our clients. They want granularity on issues like performance attribution,” adds Senior.

Denmark, Finland and Sweden are all more or less committed to creating a single marketplace for settlement, clearing, cash collateral and any exploitable cost saving to be made from these across the full range of custody and prime brokerage services. Norway, outside the euro, is more intent on following a one-country approach. As time goes by, the three Baltic mini-states, Latvia, Lithuania and Estonia will all be assimilated into this new Nordic club due to their links with Sweden. Of course, local banks are ready to resist foreign incursions, but face the same disadvantages as local custodians elsewhere; the portfolios held by their clients are ever more diversified and complex.

Meanwhile there have been some big structural changes in the way Nordic capital markets operate, all leading to greater transparency and efficiency, and playing in favour of the global custodians. Two years after MiFID, the region is seeing the advent of multilateral trading platforms (MTFs) such as Chi-x, Turquoise, Nasdaq-OMX, Bats Trading Europe, Smartpool, and now Burgundy. “Regional agent banks are losing income as a result of netting via the MTPs and there is no obvious way for them to compensate with income from elsewhere,” warns Johan Wennerburg, vice-president of product services at Handelsbanken.

The MTF’s are regularly taking 6-8% of daily trading volumes and up to 18% of volume on particular days. “Another half dozen MTFs are set to open and there is a widespread fear that that this will lead to liquidity fragmentation in the Nordic market,” warns Göran Fors of SEB. Burgundy is already trading and is intended to be the largest Nordic MTF, capturing 2% of trading volumes from Nasdaq-OMX Stockholm. The key impact of Burgundy is that it permits local matching of Nordic equities reducing volumes and income to both national exchanges and local custody banks.

The need to lower transaction costs has already prompted the establishment of central counterparties (CCPs) like EMCF , EuroCCP and SIS x-clear. In October this year, Nasdaq OMX and EMCF announced the launch of a full central counterparty clearing service on the Nasdaq OMX exchanges in Copenhagen, Helinski and Stockholm.

At present, only nine securities will be mandatorily cleared through this CCP but this number is bound to rise. Cost reduction has also prompted changes among central security depositaries (CSDs) with initiatives like Target 2 Securities (T2S) and LinkUp Capital Markets. T2S will be a platform for settlement against ECB monies and Euroclear has meanwhile recently launched its Euroclear Settlement of Euronext-zone Securities (ESES) platform. “The effect has been that Belgium, France and the Netherlands are now on the same CSD platform,” says Fors, “Euroclear has since acquired NCSD, the CSD of Sweden and Finland.”

The next five to 10 years are bound to see major change in the Nordic custody industry. At present there remain a number of regional and one country custodians offering either sub-custody, global custody or both. Tie-ups and sell-outs to global custodians are an obvious trend. The LinkUp Capital Markets project will also have an effect on the market as CSDs start to compete with custodians by matching, lending and borrowing - key revenue earners for custodians. Local custodians like SEB, Danske Bank, Pohjola Bank and Den Norske Bank will meanwhile emphasise their local knowledge, exploiting any advantages that arise from language, local regulation and so on.

These local, tactical issues generally work in inverse proportion to client size and sophistication. From past experience the largest pension funds, such as those participating in the BNY Mellon survey, will look past them. As elsewhere, some may opt to use both a local and a global custodian. Global custodians have already taken care to know the market. “We must understand their corporate culture,” notes Senior. “They appreciate transparency and put a strong emphasis on matters such as socially responsible investing.”

The cost of maintaining global custody infrastructure is already widely acknowledged as a major economy of scale operating in favour of the largest global custodians. There are other less visible costs that will also help shape the Nordic market. To stay competitive and to defend their positions vis-a-vis local broker dealers and banks, local custodians will need to become general clearing participants on all the CCPs that clear Nordic securities. It is unlikely that all the current local custodians will have the resources to pay for this.

While transaction volumes and matching are predicted to rise sharply via the new CCPs, the corollary is that the volume of bilateral trades will fall sharply. For local custodians, and sub-custodians, this will result in a significant loss of revenue. As the revenue from exchange traded transactions goes into decline, custodians will be forced to compete for far larger market shares to maintain their revenue streams. Clearing may also develop as a potential source of new revenue. But this requires robust risk management and, particularly, expertise in collateral management. Once again, not all the current participants will be prepared to meet the costs involved in this.

There is a consensus about the future shape of Nordic custody that is already familiar from the UK and the Netherlands. Local custodians are already under cost pressure and suffering income decline. The global custodians are targeting not only the largest but also mid-sized pension funds, particularly in Sweden and Finland. No more than four regional banks are judged to have the resource and determination to stay in the market either on a free-standing basis or through alliances with global custodians. One by one, the weaker local custodians will exit the market as it becomes ever more efficient and concentrated.