A new role after the crisis ?
Banks act as securities depositaries for their clients at various levels. Retail and private banks maintain securities accounts for their clients and in many market also often act as brokers too, passing client orders, registering transactions etc. Globalisation of investor activities and the industrialisation of investment products have created a demand for more comprehensive investor services tailored for institutional investors. The developments resulting from this have created a mixed market response with a general tendency to increasing specialization on the one hand, but a desire to add-on auxiliary services by custodian banks on the other hand.
Holding client securities is clearly the core element of the business of a custodian. Most commercial and retail banks have conducted this business in the past and many still do. In many markets with restrictions on banking activities, local banks have a privileged position as custodians in their own markets for local clients. Even in the European markets, the fragmented system of securities settlement and the imperfect nature of settlement bridges between local markets and international central depositary banks mean there is still an important role for local custodian banks.
Nevertheless, there has been a strong tendency towards a more concentrated market structure over the past 15 years, with many credit institutes outsourcing their custody activities to specially created group entities. Smaller banks have either joined such ventures as a junior partner or moved their custody business entirely to another specialist bank, managing only the client accounts. This has effectively resulted in securities depositary services becoming a specialized segment of the banking industry. This is certainly so at the level of global custodians, but it is also increasingly the case at the level of local custodians.
Before looking at why this is so, we should examine the components of depositary services.
As the name “custodian” suggests, a depositary bank is a trustee, holding assets of clients on their behalf. Portfolio maintenance and recording movements is the basis of this activity. The bank will execute this task in accordance with restrictions and regulation in the country concerned. Even before looking at income tax types, the custodian may also have to cope with wealth tax, stamp duty and capital gains tax.
Income and corporate events must be managed, including informing clients of announced events in good time, transmitting client responses, where this is relevant and executing the resulting transactions ; again here, in compliance with local regulations and taxes. In some markets (notably Austria and Germany) capital gains tax and withholding tax is combined.
These activities demand information about relevant events for all the securities held by clients and a high level of reactivity. This can be achieved by attempting to automate processes, demanding complicated systems and continuous development. Such investment is only justified if significant economies of scale can be achieved. Alternatively, a bank may specialize on a segment of the process, outsourcing or selling other parts of the production chain. Typical examples of this would be the development of specialist transfer agents, or moving retail investor services onto separate platforms.
Global custodians display an extreme aspect of the problems facing local custodians. The tax and regulatory questions raised apply to all the markets covered. Internationally diverse institutional clients add the dimension of managing double-taxation across various combinations of jurisdictions. Managing client portfolios and settlements and passing accurate information about the current status to institutional clients in various locations requires expensive systems, which can operate in all the relevant time-zones. Not many banks possess such systems or are prepared to maintain and to develop them. This has lead to great concentration in this market. State Street, BNY and J. P. Morgan-Chase are the names which immediately spring to mind. HSBC, and Standard and Chartered are strong in Asian markets, while institutions like BPSS, CACEIS, and MUGC offer global services but mainly to local clients in their home markets.
The international central securities depositaries play a special role as a securities service provider in European markets. Like global custodians, they cover securities from a multitude of local markets. Historically the 2 European players come from different backgrounds.
Euroclear used to be the Brussels branch of Morgan Guarantee, which was split from the rest of the bank and eventually sold. It started as a normal depositary bank, but developed offshore services for securities. Growth came first with the development of the Eurodollar market in the 1980’s and later with the internationalization of German government bonds. The Euroclear model integrated 2 roles acting as depositary and as settlement agent between counterparties for OTC business.
Clearstream used to be Cedel in Luxembourg and AKV in Frankfurt, the latter being the security settlement agent for the Frankfurt stock-exchange. Cedel offered central depositary services and off-shore securities settlement. In contrast to Euroclear’s stand-alone role, Clearstream is vertically integrated with the exchange trading platform for German securities.
As mentioned above, although off-shore accounts may be held at ICSDs, a large portion of actual settlement in the European market is still executed in local markets, requiring either, local accounts and prior securities disposition or running the risk of fails on delivery over settlement bridges with ICSDs. The existence of the ICSDs displays the significant difference between the US and European securities markets. In the USA an integrated settlement system is available to investors through US custodians (who can reap considerable economies of scale on systems developed for that market due to its sheer size). In Europe, local markets require special handling with additional costs to manage business in other markets. ISCDs provide custodians and their clients a partial solution to this patch-work, but their main business continues to be in the settlement of international securities in non-domestic markets.
Managing cash flows
While cash transactions are often seen as a minor activity for depositary banks, clearly it is impossible to manage income payments or sales and purchases without adequate cash management. This is clearly a much more complicated issue for a global custodian than for a local depositary bank. Managing foreign exchange movements and cash flows between time zones introduces an element of complexity which simply does not exist in a single market.
Cash accounts must be maintained in all markets covered, either at the local sub-custodian or as a separate cash account at another bank in the same market. The market structure in some markets may demand a specific structure for cash accounts. A depositary bank in Europe, offering professional level services to institutional investors will have difficulty managing high volume same day Euro payments without being a direct Target 2 participant. ICSDs use the ESCB structure for managing cash collateral covering security settlements.
As ICSDs push to achieve higher matched ratios of daily clearing in night-time processing, banks are obliged to put up the required cash amount in the evening. As cash clearing does not run at night, there is a clear advantage in being able to re-utilize cash deposited at the central bank to cover Target payments during the day and night-time processing at night, as offered by Clearstream.
While not an issue in a single market, restricted currency markets impose significant additional costs on global custodians. Frequently, they must assure sales (and sometimes purchases) of local currency are accompanied by adequate documentation. Frequently countries with exchange restrictions also operate 2 tier account regimes for residents and non-residents. In times of crisis, the rules can change over-night, so the custodian banks (both the local custodian and the off-shore global custodian) will be at pains to avoid being left with non-saleable residual currency amounts or other non-disposable currency assets.
At the most fundamental level, this is nothing more than receiving and delivering securities to and from exchanges, brokers, ICSDs and CSDs on behalf of clients. This requires the reception or transmission of the corresponding Swift messages or the use of the corresponding proprietary message system at the ICSD. It also requires confirmation by the client of the transaction and confirmation by checking directly in the client portfolio, that the securities are really there.
In many markets, the depositary bank will operate an omnibus account, where the bank maintains one (or at least a limited number of) accounts in the national clearing system or ICSD. The separation of individual client accounts is managed internally in the bank custody system. Most markets require that the bank’s own securities (should it have any) are segregated from client assets. In some markets the clients must also have externally segregated accounts. The account maintenance automatically also becomes a network management issue in such markets.
At a more subtle level, the question of transaction management is also a question of transaction facilitation. In completion for business, custodians have competed to offer assured settlement, by managing the complete cash chain, including foreign exchange, but also by offering short covering if a security is not available for delivery. From the custodian’s point of view, actual settlement is risk free. Clients often prefer contractual settlement, i.e. e. Settlement on the agreed value date. This can involve the custodian in a chain of additional transactions.
For a custodian, there are advantages in being able to offer clients one-stop-shopping for their securities transaction management, not the least of which is the commercial effect of a wide offering on potential clients. On the matter of transaction facilitation just mentioned, it is convenient for clients to be able to buy a security denominated in a foreign currency and for the depositary bank to execute the foreign exchange. The client need only maintain a cash account in one or a few main currencies. The custodian can earn some profit on the forex deal.
Clients appreciate receiving interest on cash balances temporarily at the custodian bank. Many funds are obliged to maintain a certain cash balance, which they must invest. If the custodian offers remuneration for such balances, the fund avoids having to add treasury management as a separate task to asset management.
In this search for convenience by investors and profit by custodians, there is a clear trade-off when clients are institutional professionally run operations, which need to return the best possible results. Rather than being captive clients to their custodians, many institutional investors also execute such auxiliary transactions with their brokers. As these are generally investment banks, they are high profile, aggressive market players, covering many markets. Still the institutional clients do not generally want to run a back-office for treasury products. This gap is filled by custodians, who offer third-party processing for a range of financial products.
Not all third party business will be facilitating securities transactions. Many of the derivative products traded by institutional clients with their brokers are an inherent part of the overall portfolio, including hedging transactions like options, swaps or CDS. It is therefore convenient and may even be a requirement to hold the portfolio under one roof, if clients wish that combinations of transactions are accepted as valid hedging positions.
Some of the transactions may actually be part of the portfolio enhancement, adding a layer of income beyond simple passive portfolio management. We have already mentioned interest bearing cash deposits. Security lending could also fall into this category, where investors seek additional gain from lending their securities, either to the custodian or to one of their brokers.
These transactions offer custodians the change to participate either directly, as trading partner for their clients or as back-office provider for third party services. This type of auxiliary product brings 2 important features : collateral management and portfolio revaluation. Often the custodian will offer to manage collateral itself, internalising the costs, but also issues like cash management. To be able to do this the custodian must have access to adequate pricing tools.
While this is a big question for fund management, it only really becomes important for a custodian if it either offers this as a service to clients, or if it is managing collateral for clients. Asset pricing seems a pretty straight forward issue for traditional securities types, but even here, most securities do not actually trade on any given day. Many corporate bonds never trade. They are issued and then redeemed with no turnover in the secondary market. Revaluation prices are generally calculated by the issuer and other price makers based on bench-mark bonds and credit risk weighting coefficients (usually ratings). Most shares do not trade daily either. Price makers mark the prices up and down based on what is happening in the big indexes.
This becomes an important question if collateral is being managed to cover securities lending or if derivative positions are re-valued based on prices in the market. Offering revaluation as part of the custody bank product portfolio can therefore only be on a best-effort basis with collateral management requiring a margin for error.
Offering this service as a prime brokerage back-office provider multiplies again the questions related, as the client (likely to be an asset manager) and their counterparties (investment banks) will be trading on a leveraged collateral base, where errors in revaluations will have even more impact. It has to be said that prime brokerage models are presently less wide spread than 1 or 2 years ago.
Managing non-traditional instruments
The growth of derivates did not initially play a role for depositary banks. Generally, derivatives could be seen as assets (or liabilities), but were not securitized. The growth of securitization of composite products has had the effect of leaving depositary banks requiring sufficient information to process and revalue these products. As funds have increasingly included derivates in their strategy, the depositary banks holding their assets have had to process these products too.
The problem posed by such products to a custodian is first and foremost managing the cash-flow generated. Many products have irregular, event-dependent cash-flows which require the capture of the correct information and then the calculation of the components in-order to determine payments to be received and bookings or payments to be made.
If revaluing services are being offered to the clients concerned the secondary problem posed is to determine the value of the asset. This will also require access to the relevant data (prices of the underlying products), calculation according to the revaluation model and possible adjustments for factors such as historic volatility and age or density of quotes to weight the revaluations calculated, if the result is to be used in a collateral calculation.
Access to price data requires firstly access to data providers and subscriptions to be able to use the data provided. Secondly, the bank requires systems with sufficient ability to use this data to be to calculate the value of the assets in the portfolio. Many data suppliers will provide trade data with little indication for the actual turn-over executed.
Commercial situation of depositary banks
Custodian banks have been competing for business by offering a wide range of depositary services and reducing fees in return for the right to borrow the securities under custody. Some of the services offered are a direct result of this, with collateral management a direct result of this business. The growth of non-traditional instruments in institution’s and fund’s portfolios and the growth of prime brokerage models have resulted in an increase in the importance of collateral management and the related question of asset revaluation. The ability to handle this business is a selling point for depositary banks.
The systems and operational procedures to permit these activities to be handled effectively are expensive to set-up and integrate with existing traditional operations. There are major economies of scale which can be reaped in these activities.
Handling third party business of clients permits these to trade with whomever they wish, without worrying about the back-office processing. This service effectively in-sources the back-office handling of treasury, forex and security lending or repo business from clients, building on the systems and processes already in place. Again, economies of scale apply. BNY reputedly bought Pershing in 2003 from Credit Suisse mainly for its brokerage trading out-sourcing systems- they paid USD 2 bil.
Summary of trends post crisis
Summary of environments
Custody systems are complicated and expensive to develop and maintain ; global custody systems even more so (in discussions in the past a global custody system would cost between USD 150 and USD250 mio).
The Custodians have expanded the range of services and products covered, but the concentration in the custodian market has increased.
Fees may be reduced in exchange for access to securities in lending schemes.
Currently visible trends
Interest in prime brokerage models collapsed after the Lehman’s closure. Efforts were made to prevent short selling in some markets, by preventing security lending. Ironically, this contributed to market instability, as short-cover loans were stopped too.
Security lending in non-government or government agency assets almost stopped for about 3 months. Even assets viewed as government agency securities, like Ginny Maes and Freddie Macs lost their status. Activity has returned to the market, but lending is mainly in the high quality end of the market.
Ratings lost credibility as a way of measuring risk, throwing collateral management into disarry. This has resulted in haircut models being reviewed and adjusted to be more conservative. Many market participants were forced to realise collateral taken from Lehman (Lehman reputedly had about 30% of global security borrowing on their books). Generally, lenders could realise collateral and the fact that there were few direct knock-on insolvencies can be seen as positive. Nevertheless, many custodian banks managing collateral had great difficulty realising sales at anywhere close to the revaluation prices.
The difference between revaluation rate and realised sale shows up as a direct loss for the clients (or the custodian themselves, if managed over their own book). Admittedly, in the falling market it was difficult to execute sales. Still, collateral managers will look critically at the collateral they take and it can be assumed that other criteria other than just the closing price will play a greater role in collateral management models- age of last quote, last trade, market depth (if available).
The progression of difficulties in banking and the automotive sector continue to weigh on corporate bonds as an asset segment.
As many depositary banks are paid in relation to the value of assets, the massive drop in asset prices has hit income. This has forced these banks to review their cost side, forcing quick cost cutting measures. Generally, services or developments aimed at the growing hedge fund market were stopped or cut. This can be seen as a return to basics as a knee-jerk reaction, though we are likely to see many derivative products re-emerging under a changed regulatory framework.