New regulation is changing the relationship between custodians and depositories – but will this tilt the market in favour of global or local institutions? Iain Morse investigates

Are global custodians going local under the pressure of regulatory change? In the
EU, the answer is nuanced, depending, in part, on understanding the difference between custodians and depositories, in part on different business models in the industry. Custodians, after all, do not have to be depositories, although depositories have to do some of the tasks carried out by custodians.  

“All of us are certainly rethinking and re-engineering our business models,” concedes Willie Slattery, head of global services in the EMEA for State Street Bank.

Some global custodians have chosen to operate directly only in their domestic markets or in the largest EU markets, while entering into a variety of other business accommodations with local depositories in other markets. Others have chosen direct entry by acquisition or establishing their own depositories.

“These business models have co-existed until now, but the new regulatory environment will change this,” notes Stephen Kinns, senior consultant at Crossbridge, a consultancy specialising in securities services.

Beneath, there remains a cottage industry of local depository banks operating in national markets. These often hold only captive, domestic equities, bonds and real estate. “Some have little portfolio turnover,” says Florence Fontan, head of public affairs at BNP Paribas.
“They must invest to stay in the game.”

Meanwhile, the terms ‘custodian’ and ‘depository’ are treated as roughly synonymous in the ‘Anglo-Saxon’ world but not so in EU member states once subject to the Napoleonic Code. The difference is simple: Anglo Saxons embrace the notion of trustees as separate legal actors, a concept absent from the Code, from which developed the notion of a depository as a sort of quasi-fiduciary.

To understand the significance of this we need to consider the wave of regulatory change that has run through the financial services industry.

The most important regulations for securities services in Europe are the Alternative Investment Fund Managers Directive (AIFMD), the latest Undertakings for Collective Investments in Transferable Securities Directive (UCITS V), and the European Market Infrastructure Regulation (EMIR). Other projects such as Target 2 Securities (T2S) will also have effects. With these have come new regulators such as European Securities and Markets Authority (ESMA).

The EU first created a regulatory framework for UCITS in 1985 with the goal of creating a cross-border alternative to funds domiciled in respective member states. Then, as now, the continental notion of a depository was wider than that of a custodian: depositories dealt with safekeeping, collecting and applying income, and carried out sundry other functions, including aspects of fund administration and communication – but also, vitally, played a governance role, including fund compliance.

Continental business practices include depositories and wider banking groups having executives delegated to the boards of the same fund management companies using the depositories’ services. Anglo-Saxon practice slices these activities up in a different way: custodians are strictly separate from trustees and have no role in setting governance or policy. Trustees can delegate discretionary powers to sub-committees and advisers but not directly to custodians, who can only report to trustees.

Over the intervening years, the number of unregulated funds expanded rapidly, but practices in the unregulated fund industry created risk of fraud and operational loss arising from lack of oversight, and the under-regulated role of prime brokers. Where a depository or custodian was appointed to an alternative fund, they found themselves dealing with prime brokers, often offshore, which functioned as sub-custodians. Lehman Brothers, Madoff, defaults, sub-prime, zombie banks – all combined to turn regulators’ scrutiny to the role of depositories, and AIFMD and UCITS V are re-defining their role.

The focus here is on: locating liability; which assets can be held in safekeeping by a depository and which cannot; which institutions can act as depositories and which cannot, and so on. Depositories will be held liable for the timely restitution of any assets they hold in safekeeping which are lost.

Under the AIFMD this is a non-transferable liability, except where the first depository agrees with a second, acting as a sub-depository under the same regulatory regime, to accept the relevant liability. In some asset classes a prime broker might assume this liability but the depository retains a greater degree of liability than when liability passes to a sub-depository – or, in other words, when the prime broker is not seen as equivalent to a depository. Under UCITS V transfer will not be permitted.

“You have to ask whether a UCITS provider will want anything less than a depotbank and global custodian combined,” argues Fontan. “Particularly as some will also offer AIFMD-regulated funds.”

Depositories are also being given greater responsibility and liability for governance issues in relation to funds for which they provide safekeeping. This is inevitable, given  ‘strict liability’. Information about every aspect of fund operations, transactions, cash flows, and compliance with mandates must pass through the depository performing oversight.

Depository re-location will also re-shape the industry. AIFMD-regulated funds will be virtually obliged to use depositories located within the EU or other jurisdictions recognised by the regulator, a strong incentive to choose an EU-domiciled depository.

Post-Madoff, the monitoring of cash flow within funds is another major area of concern for which the depository will be centrally responsible and liable. The depository must be able to identify all non-trivial cash flows and reconcile them on a real-time basis to uncover any fraudulent activities. Once again, delegation is permitted but only to regulated entities, and the depository must take appropriate action as and when any irregularities are detected. Under UCITS V, the principal depository is likely to be held liable without delegation permitted.

The full effects of these changes will only be felt over time but consensus holds that AIFMD and UCITS V will favour large-volume depositories and custodians. However, this view may under-estimate the differences between depository and custodian business models and the cost consequences of regulatory change.

For a start, as their liabilities amplify, depositories will pass the relevant costs on to the fund management industry, which has no choice but to use the depositories. Secondly, the increase in depository costs may be more incremental and client-specific than those incurred by global custodians. In custody, economies of scale have played entirely in favour of the global custodians that can afford to develop IT systems which, once set up, can process huge quantities of data.

The cost of insuring depositories against strict liability is not yet clear. Custodians already carry insurance and it is far from clear whether, on past history, strict liability would have been triggered with any frequency.

“Our clients have been searching their books to find examples and find very few,” notes Kinns. “I suspect that this risk and the consequent cost of insuring against it may be being over-estimated.”

Stepping back a little, we can see a new basic architecture developing. All funds regulated by either the AIFMD or UCITS V require a triangular management and governance structure comprising fund management company, fund and depository. The depository must encompass a further triangular structure between depository, custodian and fund.

So, funds need depositories and custodians; depositories need custodians; but custodians don’t necessarily need depositories. This asymmetry gives custodians an advantage over depositories but only as long as the latter remain as inefficient as they are currently. Global custodians that have the largest depository networks will be able to exploit this advantage while custodians without should be concerned over losing market share to their vertically-integrated competitors.

There are signs that the global and larger Europe-domiciled custodians are already preparing for the consequences of this: back and middle offices are being rationalised and headcounts cut where their substitution by systems is possible without loss of service quality. Off-shoring is now being superseded by near-shoring within the EU. Alternative investment funds, in particular, will want to make site inspections and operational risks will need to be contained within the EU.

At present, depositories are single-country, domiciled in the market they serve. This regulatory inefficiency serves as a barrier to entry for custodians – the cost of establishing a depository runs into several hundred thousand euros without accounting for office space or staff. Another widely predicted development following the AIFMD is the future creation of a depository passport. This concept is the logical outcome of the current passporting system for UCITS and AIFMD funds. A passported depository run by, say, a pan-European or global custodian, would confer significant cost advantages.

The likely outcome of this is that the global custodians will buy or set up wholly-owned depositories, which appears to be a relatively efficient way to deal with strict liability and pay the cost of the systems required for the depositories’ enhanced governance functions. But none of this will happen very quickly.

“Take the Nordic region as an example,” says Belinda Burgess, head of the region for Northern Trust. “Inertia, close relations between local banking groups and corporate clients which already cover a wide range of service provision, personal relations, and cultural factors, all play a role.”

However, there are some examples already, not least in Germany, which still has more than 40 regulated depotbanks. Dutch custodian KAS Bank has had a wholly-owned depotbank in Wiesbaden since 2010. Commerzbank sold its depotbank to BNP Paribas in July this year; the French custodian bank is already the largest single provider of depotbank services to domestic German fund managers.  

Why is the deal emblematic? Commerzbank decided that its depotbank was non-core and that its sale would not damage its existing, associated business relationships.

The Commerzbank depotbank is being transferred in its entirety, without redundancies and with full confidentiality maintained. If mighty Commerzbank feels able to do this, others will follow.

This depotbank offers third-party fund managers a full range of services, with 80 employees and assets under safekeeping worth some €93bn, and clients that include Allianz Global Investors.

“We are pleased with the decision in favour of BNP Paribas due to their many years of experience,” says Michael Hartmann, head of operations at Allianz. “We will appoint BNP Paribas as depository and custodian for the German-domiciled UCITS of Allianz Global Investors.”

This deal is probably the shape of things to come.