Securities Services: Testing times ahead
With consolidation and growth expected in the European custody markets in the coming years, Luxembourg could be one of the biggest beneficiaries, says Iain Morse
Of all Europe's custody markets, Luxembourg promises the most for the industry - not just because of the assets domiciled there but also due to the potential for growth in these assets over the next decade, believes Marty Dobbins, senior vice-president and managing director at State Street Bank in Luxembourg. The top five custodians are responsible for more than 50% of Grand Duchy domiciled assets, a market share worth around €1trn at the end of 2009. JP Morgan was market leader with €327bn, followed by State Street with €186bn.
Fund administration has been a profitable growth area of business, and most global custodians see Luxembourg as the main battleground for the future of European and globally distributed mutual funds. Competition for market share is strong. But custodians, both global and European, are now weighing the possible consequences of two EU directives on the industry.
The UCITS IV directive, applying to mutual funds, is intended to hasten a process of consolidation and rationalisation in the cross-border funds industry. "Luxembourg will be a net winner from UCITS IV but change will be gradual," warns Thierry Blondeau, partner at PriceWaterhouseCoopers in Luxembourg and European UCITS IV project leader.
More controversially, the proposed Alternative Investment Fund Managers (AIFM) directive is intended to regulate ‘onshore', Luxembourg domiciled or distributed alternative investments, such as private equity, property and hedge funds. "The way the custody bank's responsibility is defined under the directive may have far reaching consequences for the industry," adds Blondeau.
Meanwhile, the Central Bank of Luxembourg and Clearstream, the Luxembourg-based central securities depositary, have launched LuxCSD, a central securities depositary service for Luxembourg. LuxCSD should go live early next year, promising the settlement of securities in central bank monies, reducing risk for market participants. LuxCSD is also part of the Grand Duchy's preparation for the launch of Target2-Securities, the settlement system that the European Central Bank intends to introduce in 2014. LuxCSD will have consequences for the European depotbank and custody industry simply by reducing the market fragmentation and inefficiencies that have allowed local custodians to survive.
UCITS IV will also affect fund the management industry and on Luxembourg-based custodians and administrators. A key component is the merger of UCITS funds; the use of master-feeder structures will effectively amalgamate assets in larger and larger pools, which will throw up a number of issues, not least the treatment of tax and sales tax arising from unit holders in different jurisdictions, transaction record keeping, NAV reporting and an increase in reporting with risk management tools. Expect a decline in the number of management companies each operating in a separate jurisdiction under a single owner to unitary, passported management companies. Luxembourg will want to host these companies.
"Don't expect a big bang but change will take place over the years to come," comments Blonedeau. Their proliferation will centralise the selection of custodians, just as the underlying asset pools also increase in size. Local custodians will certainly lose business as a result.
Indeed, it is hard to see any side of UCITS IV that does not tend to favour the global custodians against their local and continental rivals. UCITS IV will also rationalise the notification process, reducing the time from review to launch of a fund to a 10 days. But this will oblige the fund management company to demonstrate very robust internal processes, not least when it comes to meeting national regulations on the sale and marketing of funds. With this comes the new key investor document (KID) and an enhanced requirement for consistency between prospectus, KID, website, fund fact sheets, and any other fund-related communications. The KID requires a custodian or administrator capable of interfacing with the fund management company and its legal advisers across this range of topics.
If the consequence of UCITS IV will be to increase fund sizes and price competition among industry service providers, the consequences of AIFM are less certain. This has been designed to capture alternative investments marketed in the EU, regardless of whether relevant fund managers are domiciled there.
The definition of an alternative investment fund is intended to be broad, including all non-UCITS funds, in whatever legal form, and wherever established. AIFM is also likely to require a description of the fund valuation process and pricing methodology for assets, including the methods used in valuing hard-to-value assets. Fees and charges will also be rendered explicit, with an emphasis on liquidity management and the redemption process. Many AIFMs will fail to meet these requirements without a custodian.
For depotbanks and custodians, there are other more alarming parts to the AIFM directive. EU-licensed AIFMs will be obliged to use an independent depositary but only EU licensed depositaries will be permitted to play this role. They in turn will be liable for any loss on financial instruments which they hold on behalf of investors; restitution will match any loses. Additionally, when a custodian employs sub-custodians they will not be permitted to offset or delegate this liability.
This will certainly add to the cost of custody for AIFMs as primary custodians seek to buy insurance against the risk of counterparty default. "When one of these custody deals is priced, all the associated risks need to be priced into it," observes Mario Pirola, chief administrative officer at JP Morgan. The likely outcome is that many custodians will not want to be involved in this business. Only the biggest will find themselves able to afford the insurance.
Beyond this there should be plenty of scope for custodians to sell their value-added services to the AIFMs. The latter will be required to establish very robust and explicit governance controls. Included in this will be risk management functions that are to be kept distinct from portfolio management functions.
Portfolio stress testing will also be a required feature of this new regime. This requires portfolio pricing on a constant, robust basis, and it is likely that custodians will provide much or all of this capability.