Update: Custody and Investor Services

CUSTODY & INVESTOR SERVICES: IN SAFE HANDS

By Anita Hawser

Custodians have seen their role expand as a result of recent regulatory and market-driven changes.

In the wake of Lehman’s collapse, Bernie Madoff’s $50 billion Ponzi scheme and the regulatory whirlwind that has ensued in a belated attempt to protect investors, the safekeeping aspect of the custodians’ role has received considerably more attention. Last November at a conference in Hong Kong, Information Mosaic, a provider of post-trade automation solutions, outlined the increasing pressure on custodians to provide more-detailed, nearly instantaneous information about the multiple counterparties to a trade. Manmohan Singh, the company’s head of product leadership, explained that being “at the heart of so many transactions and investment relationships” placed custodians in a unique position to monitor risk and help restore confidence to investors. “Clients want us to do more,” says Clive Bellows, managing director for Europe, Middle East and Africa at J.P. Morgan Worldwide Securities Services. “It is not so much safekeeping but more about accurate recording and valuation of assets in whatever structure the client is investing in, whether it is a pension fund or mutual fund.”

In what at times has resembled an arms race, custodians are constantly competing to provide clients with the latest transaction reporting, portfolio valuation and risk measurement tools. Last year was a particularly busy one for these kinds of announcements. In 2010 BNY Mellon Asset Servicing rolled out stress tests to US-based money market funds. The tests model the impact of interest-rate shocks, credit risk shocks and liquidity risk shocks in compliance with new regulatory requirements. Boston-based global custodian State Street announced enhancements to its risk analytics and servicing tools for institutional investors, including portfolio reallocation tools, economic stress tests and expanded investment coverage.

Peter Jacaruso, who looks after new product development for State Street, says a lot of the focus in the recovery period following the 2008 subprime mortgage crisis has been on what he calls buyside empowerment. “There is heightened sensitivity to risk in terms of complying with new regulations,” he says. In the US there is a regulatory push for money market funds to do more stress-testing. “While risk analytics and stress-testing existed prior to the crisis, what we are seeing now is demand for more fine-tuning and more emphasis on testing historical scenarios, such as the Lehman bankruptcy. This testing, along with more advanced modeling capabilities, helps clients understand the potential impact if something similar happens again,” Jacaruso explains. “It is also about modeling the impact of certain economic conditions investors may be sensitive to in terms of commodity price, currency or interest rate changes.” Improving transparency for clients is an ongoing process, Jacaruso adds. “Beyond your traditional risk exposures there is a lot of interest in seeing exposures at the entity level, rolled up to the ultimate parent, as well as the ability to stress-test those entity exposures.”

Stephen Ingle, derivatives product manager at BNY Mellon Asset Servicing, says custodians are becoming even more important in helping companies manage risk. “Every step of the process is about mitigating and managing risk,” he says. “Knowing your counterparty is very important. Historically, a number of investment managers haven’t been able to distinguish who the counterparty is. For example, if you trade with a particular market counterpart, the rates desk is the not same legal entity as if you trade with the equities desk.” Ingle maintains that custodians are well placed to determine who the underlying counterparty to a transaction is.

Ingle says regulation and changes within the industry have been so dramatic and rapid that it is not economically viable for most buyside firms to maintain the international operations needed to manage the regulatory environment. Increasingly, Ingle says, firms, particularly small to medium-size investment managers, are more inclined to outsource their operational and regulatory risk management to custodians.

Bellows: “We can compare and contrast valuations on any given day”

On the derivatives side, the business case for outsourcing is even more compelling, particularly when it comes to increased regulatory oversight of over-the-counter (OTC) derivatives and requirements for central clearing of certain instruments. “The over-the-counter derivatives industry is in flux as regulators and other industry participants try to create a market structure that reduces the systemic risks associated with this product,” says Stephen Bruel, research director for securities and capital markets at TowerGroup.

Eighty percent of the OTC derivatives firms TowerGroup surveyed for a recent report indicated that risk management was a key driver for improving OTC derivatives processing. And in terms of the functions where firms are looking to reduce risk, 74% of buyside firms highlighted valuations and 67% collateral management among their top three risk concerns. Custodians that have invested in derivatives’ valuation and collateral management capabilities believe they are well placed to help buyside firms. “What we have done for the past two to three years is position ourselves to deal with new regulations,” says J.P. Morgan’s Bellows. “We have developed independent valuation for derivatives in the regulated fund environment, which means we can compare and contrast valuations on any given day. Clients want derivatives confirmed quickly [and are] looking to us to help them meet the challenge of collateral management.”

Being able to service derivatives across their lifecycle is a capability custodians have acquired only in the past few years as trading of these instruments has become more institutionalized. BNY Mellon Asset Servicing developed its Derivatives360 offering, which Ingle says supports every step of the life cycle from execution of a derivatives transaction through to net asset value reporting. But building and maintaining these systems comes at a significant cost, Ingle says. “It requires a huge amount of expenditure per annum to maintain the platform and your position within the industry, to make sure you are up to date, as products change every couple of months.”

Ingle: “Every step of the process is about mitigating and managing risk”

Another area that custodians are watching closely is the regulatory requirement for clearing of certain OTC trades via central counterparts or CCPs. On the one hand, central clearing should make life easier for everyone involved, says Ingle. But not all OTC trades will be centrally cleared. Firms are likely to end up with a “bifurcated” OTC model, with some transactions cleared through a CCP and others done bilaterally. “That increases operational complexity, which is likely to result in more outsourcing by the buy side,” says Ingle.

Buyside firms are likely to face steep increases in the initial margin they need to post as collateral to CCPs, Ingle adds. This is likely to result in a reduction in securities balances at the buyside firm’s appointed custodian and the movement of these balances toward the custodian appointed by the CCP. In an effort to mitigate concerns around CCP-appointed custodians, BNY Mellon is developing a structure whereby a custodian pledges that a client has the required amount in its custody account. “The custodian will play a far more active role,” says Ingle. “For us it is not a major challenge, as we are not taking on additional risk.”