We leave the bad news for custodians until last in this month’s special report on securities services. Andrew Williams of Mercer Sentinel outlines the difference that a good transition-management process can make relative to a bad one. Then he questions which of those categories leaving it to your custodian falls into. It’s the kind of message custody banks have become all too familiar with over recent years.
Just as core custody services have been commoditised and margins compressed, banks have also seen increasingly specialised providers stealing juicier add-on services, like transition management, that they used to provide by default.
But maybe things are looking up. For example, going from trust-based defined benefit to contract-based defined contribution provision in the UK had looked to be bad news for global custodians. But as DC assets grow, sponsors are more persuaded of the case for trust-based schemes. That could make DC look more like DB, with a more obvious role for global custodians – especially if trusts find room for more esoteric investments like private equity and infrastructure.
But help is coming from the blizzard of post-2008 regulatory interventions, too. Legislation such as the Alternative Investment Fund Managers Directive (AIFMD) attempts to push valuation of a range of alternative investments through a system of legally-liable custodians – clearly a challenge, but equally clearly an opportunity, as their appetite for acquiring hedge fund administration businesses attests. As pension regulators, particularly the Netherlands’ DNB, ask tough questions about the extent to which trustees are ceding core responsibilities to fiduciary managers and consultants, custody banks sniff an opportunity to win the valuation and reporting work that trustees will need to demonstrate that they remain in control of strategy. At the very least, the industry sees its position at the hub of all of a pension fund’s data as the perfect one from which to provide checks and balances to fiduciary managers.
AIFMD and UCITS are also redefining the role of depositories in Europe by saddling them with operational-loss and fraud liability. The capacity for local depositories to take this on is being questioned, opening up the potential for larger global custodians to move in on their business or acquire them.
As ever, the scale of the opportunity is debatable and exploiting it easier said than done. Moreover, regulatory swords often turn out to be double-edged. The European Market Infrastructure Regulation (EMIR) is a good example. In forcing derivative trades into central clearing, which requires the posting of initial margin that does not happen in the OTC world, EMIR potentially creates immense demand for cash and collateral transformation that could boost both custody banks and securities-lending agents.
But attempts to extend EMIR-like reporting processes into securities lending via shadow-banking regulation could make the whole thing too expensive to be viable. And EMIR itself seems to require that the initial margin required for cleared derivatives be held with central securities depositories (CSDs) rather than custodians unless it is in the form of cash. Custody banks claim that this will make the system less competitive and more risky, but so far to no avail; and only one has taken the expensive decision to establish itself as a CSD.
It should come as no surprise that the securities services business is going through such profound change. Finance is being subjected to its most thoroughgoing regulatory overhaul for several generations, and what are securities services, if not finance in its purest forms? The jostling for position has barely begun. Our report attempts to delineate some of the new rules, new challenges and new opportunities that are emerging.