Custody & Investors’ Services - Global Finance Magazine

RESTORING TRUST

By Paula Green

Custodians are dealing with the impact of major regulatory reforms and a loss of confidence in investors’ services safety after the devastation of the MF Global debacle.

The expanding web of government regulations permeating the banking and securities industry is capturing the time, money and manpower of global custody banks managing tens of trillions of dollars around the world. In a desperate attempt to restore confidence in global capital markets rattled by the series of annual crises that have shaken markets worldwide, regulators keep turning out pages and pages of new rules and directives meant to keep the markets functioning smoothly. This is having a big impact on global custody and investors’ services—affecting servicers as well as end users.

Paul d’Ouville, senior vice president and global head of product management at Northern Trust, says that regulatory reform was essential to address systemic risks. “They needed to make investors feel safe and sound in order for the capital markets to function,” he says.

Nadine Chakar, head of BNY Mellon Asset Servicing’s global financial institutions group, adds: “The regulations are a positive if it’s what it takes to restore people’s confidence.” That safety and confidence in custody banking has been sorely shaken by debacles such as MF Global, which violated one of the sacred rules of custody services—the separation of assets.

Originally a mechanism for customers to deposit assets for safekeeping, custody banking was not meant to be a risky business. The bank or custodian institution “serviced” clients’ assets and garnered fees by helping investment managers and securities issuers issue, move and guard all types of securities.

Asset segregation is one of the most important functions of a custodian bank. “The safety and soundness of assets is one of the biggest concerns of our clients,” says Chandresh Iyer, global head of custody and investment administration services at Citi Global Transaction Services.

Tomasz Grajewski, head of global securities services for UniCredit Group, believes the MF Global situation demonstrated the challenge facing investors as they monitor client money rules. The issue is not just establishing the appropriate account structure but “ensuring that one’s service provider has the right operational framework and compliance ethos to ensure that the spirit, as well as the word, of the law is complied with.”

The end result is that custodians—and their clients—now maintain closer oversight of the structure of securities accounts, demand a much more detailed analysis of beneficial ownership (versus legal ownership) in default situations and maintain more stringent and regular analyses of supplier solvency and liquidity, he adds.

CHANGING LANDSCAPE

Yet the practical fallout of complying with the plethora of regulations—from the Markets in Financial Instruments Directive that surfaced in Europe in 2004, to the exhaustive Dodd-Frank legislation that came out of Washington in 2010—is enormous for both investors and their custodian bankers.

Charged with the job of explaining these regulations to their clients, custodians are hiring new staff as well as tapping into the expertise of existing employees to comb through hundreds of pages of regulations, prepare comment for public hearings, sit at conferences, revise input, catch the ears of politicians with targeted lobbying efforts and adjust actual practices to comply with the changing rules.

Custodian bankers then have to sit down with their clients and lay out the new demands, helping clients decide how to retool—or even invent—the technology platforms they need to ensure that their operations are in compliance with the emerging regulations.

Kelly Mathieson, global custody and clearance business executive for J.P. Morgan Worldwide Securities Services, notes: “It’s a changing regulatory landscape. And it’s shifting the playing field on how assets are traded, invested and held.”

Yet the surge in regulations has its upside for the industry and investors. The give-and-take between the industry, regulators and legislators is boosting transparency. “It’s increasing the drive and need for transparency as the governance process becomes more open,” says Chakar. “People can make more informed decisions and will be in a better place.”

REGULATIONS TAKE ON NEW DIMENSIONS

Known formally as the Wall Street Reform and Consumer Protection Act, the Dodd-Frank Act was a 2,319-page response to the crisis that took shape with the collapse of Bear Stearns.

By comparison, the Glass-Steagall Act, or the Banking Act of 1933—which established the Federal Deposit Insurance Corporation (FDIC) in the US and introduced banking reforms after the 1929 stock market crash and the ensuing Great Depression—was only 37 pages long. Nearly 70 years later, Congress tried to rein in the corporate excesses and subsequent accounting scandals that surfaced in 2001 with the passage of the Sarbanes–Oxley Act of 2002. It covered 66 pages.

On the other side of the Atlantic, the European Commission has been busy trying to create a single, more competitive market with its Markets in Financial Instruments Directive, or MiFID. In a move that will increase investors’ reliance on custody banks, the directive will require more-stringent reporting requirements and regularly updated order execution policies.

Custodians also have a wary eye on Europe’s Alternative Investment Fund Managers Directive. This legislation aims to create a harmonized framework for monitoring and supervising the risks that alternative investment funds, such as hedge, private equity or venture capital funds, create for investors and fund managers. As Tomasz Grajewski, head of global securities services at UniCredit Group, says about the two core issues facing the custody world: “On the one hand, there is a better appreciation of risk and therefore a demand for top-quality risk mitigation strategies. On the other, there is concern at the scale of regulatory change.”

The regulations can act as a catalyst for change. “The conversation of regulation is not a bad one,” Chakar adds. “It’s an opportunity to reshape the financial services industry.”

Mathieson agrees. “There’s a massive conversation going on. We don’t feel the regulations as a restraint. We have a healthy respect for [them].” Since its expansion more than three decades ago when US legislation forced pension plan sponsors to separate investment management activities from custody of the underlying assets, global custody has mushroomed to envelop all types of pension plans, hedge funds and, more recently, deep-pocketed sovereign wealth funds from the Middle East and Asia.

Industry observers are mixed on growth prospects for the industry, which now has about $100 trillion in assets under custody protection around the world. Some say expansion will be propelled by the growth in increasingly sophisticated financial instruments and the emergence of new markets and clients. With the US market near the saturation point, Robert Dame, senior vice president of State Street Corporation in Boston, expects more growth to come from markets in Asia-Pacific and South America.

“Key…is whether markets will regain…lost confidence. This will depend on…[reducing] banking tensions in general, and euro stability in particular”

– Tomasz Grajewski, UniCredit

Grajewski notes that many of the industry’s revenue drivers—new money flowing into pension and mutual funds, interest rate levels and market indexes—may well remain at depressed levels. “Key for all is whether markets will regain some of the lost confidence. This will depend on the rollout of solutions for [reducing] banking tensions in general, and euro stability in particular,” he adds.

BETTER REPORTING AND ANALYSIS

As the capital markets and their underlying instruments and accompanying regulations become more complex, the hunger for more sophisticated analysis and regular reporting of statistics is growing among all types of investors. “There’s an insatiable demand for data,” says Nadine Chakar, head of BNY Mellon Asset Servicing’s global financial institutions group. “Clients are overwhelmed by the changes and relying on us to help them.”

Chandresh Iyer, global head of custody and investment administration services at Citi Global Transaction Services, says corporate executives want to know their custodian has a substantive strategy in place to weather the increased volatility and shocks facing the financial system. “The amplitude of volatility is much greater, and the magnitude of market information is much greater, as technology increases the speed at which that information flows around the world,” Iyer says. “Contagion risk is another issue that custodians need to keep on top of. How a risk occurring in one part of the world is handled impacts markets in another very quickly.”

Iyer, Citi Global Transaction Services: The safety and soundness of assets is one of the biggest concerns of clients

Companies and investors of all sizes are increasingly turning their asset-servicing functions over to custodians, rather than sinking the time, effort, manpower and dollars into building a system and keeping it running efficiently. A small, start-up asset management firm or hedge fund spun out of a large investment bank by portfolio managers or traders, for example, might not have the manpower or financial resources to set up a back office infrastructure. A large asset manager may outsource its back office functions to avoid carrying the fixed costs of staff, equipment and software through the ups and downs of wildly fluctuating asset values.

Advances in mobile technology applications are also capturing more attention as investors move to tap into market volatility and execute decisions on a more timely basis. “We’ve had to reengineer and rethink our business model,” Iyer adds.

Robert Dame, senior vice president of State Street, agrees that clients want online delivery systems to quickly absorb the increasing amounts of data. In autumn 2011, for example, State Street released a mobile application for the iPad targeted at executive-level portfolio and fund managers. It gives users a chance to view their entire investment portfolio at a glance, including risk-exposure analysis, net-asset-value summaries and fund flows.