The combined effect of multiple regulatory initiatives has forced custodians to re-evaluate their strategies. Not only do they need to understand how they impact their own business, but also the potential implications for their clients, and even their clients’ customers, across multiple regions. 

Establishing a local presence everywhere is too costly to consider as there are just too many markets in the world for this to be a sustainable model. 

“The increase in regulation and the greater emphasis on asset safety means that local custody is more important than ever,” says Alan Cameron, head of sales and relationship management international banks and brokers at BNP Paribas Securities Services. 

“It is more credible for the largest players in the major markets but only if they can provide this service separately to other global investors. Of course, all this has to be balanced against the asset safety advantages that may come from establishing a local presence.” 

Ronnie Griffin, global head of trustee & fiduciary services at HSBC, notes that from an existing custody provider perspective AIFMD and UCITS V have resulted in the reconsideration of the range of sub-custody markets supported and the ability to manage liability provisions under these regulations. 

“This has also entailed consideration of local market infrastructures, the market counterparty and the cost to service, as well as the demand for each market globally,” he says. “Certain providers have developed strategies to commence or expand a global custody offering or to try and partner with existing providers.” 

Societe Generale Securities Services head of product engineering, Etienne Deniau, reckons AIFMD and UCITS V have pushed all depositories to further improve the management of their global custody, regional custody or sub-custody networks and implement more stringent recordkeeping and reconciliation. 

Penelope Biggs, head of the institutional investor group for EMEA at Northern Trust, observes that many custodians have implemented new organisational and governance structures and invested in expertise. 

Joint initiatives 

Enhanced due diligence requirements have also triggered joint initiatives between fund depositories, either directly or through third parties (mainly consultants and law firms) in order to share costs for countries where they hold limited assets. 

“In some cases, depositories that previously provided services mainly for funds managed by an entity of their own group have ceased to do so, shifting the funds to a third-party depository,” says Deniau. 

“In the UK, however, a number of fund accountants of alternative funds have applied for and received a depository licence and have delegated their global custody – representing a marginal part of the assets of the funds they service – to large custodians.” 

He observes that Solvency II has also encouraged initiatives between investors and providers in order to define a common format of data exchange for fund holdings, while T2S may also lead issuer CSDs to further develop investor CSD offerings to potentially compete with global custodians. 

According to Daniela Peterhoff, partner and head of market infrastructure at Oliver Wyman, many custodians are rethinking their market coverage, pricing and product mix as well as operational setup. “We expect this trend to lead to a further polarisation of the landscape between tier 1 and tier 2. At the same time, global custodians and sub-custodians are subject to a rebalancing of areas of expertise.” 

Custodians have had to adapt their strategies under the new regulatory framework, developing depositary services in new domiciles to continue to support their clients that were previously not required to have such services, adds Terry Alleyne, global custody product manager at Citi. 

“They have leveraged their capabilities across depositary and custody services and reviewed the feasibility of single product offering under the new liability brought about under AIFMD and the UCITS V regulations.” 

Hani Kablawi, BNY Mellon CEO for EMEA asset servicing, observes that the volume and scale of regulatory change programmes shows no sign of abating and does not expect this situation to change over the next couple of years. 

“Regulatory change – both prudential and conduct – has become a constant,” he says. “We expect conduct rules will have an impact into the next decade but the prudential agenda may plateau between the end of 2017 and late 2018.” 

Lessons learned 

Kablawi says it is not just a case of complying with regulations. “It depends on the products and services our clients will need and how we are compensated for the additional risks and costs of offering these products and services. We have taken the lessons we have learned from AIFMD, for example, into other programmes such as UCITS V.” 

The current attitude of custodian banks towards prime broker services depends on the business mix, geographic coverage and risk appetite of the custodian, says Peterhoff. “Directionally, we see a slightly reduced appetite for these services as a result of all the regulatory work and risk. Costs have definitely increased. 

The speed of change often exceeds the capability of adapting – for example, we see a number of custodians repricing their broader franchise and/or testing models of allocating increased risk to the market.” 

Biggs notes that the hedge fund sector is of strategic importance to many custodian banks and that Northern Trust continues to closely monitor European regulatory developments as they relate to third parties. Towards the end of this year she expects greater clarity to emerge on which US managers and hedge funds can access the European marketing passport. 

Many banks have been moving their custody and prime brokerage businesses closer together as they believe that there are synergies to be gained from this, says Cameron. “For most this is still a work in progress – although the target clients often overlap, the focus of attention differs. For custodians custody is at the centre of the plate, for prime brokers it is a by-product.” 

Griffin says certain clients will buy the services of traditional custodian banks alongside those of a prime broker and will choose to move assets between the two, dependent on their views of risk, return and investor preferences. 

A number of the prime brokers require services from those custodians that have strong local market infrastructure, local knowledge and financial standing to be able to provide their local custody solution. 

According to Deniau there are still some difficulties for US-based prime brokers on issues such as segregation of assets and reporting. 

Risk impact 

Regulatory change has impacted the risk and cost of providing custody services, with the degree of impact depending on the additional liability custodians contractually agreed to under AIFMD and to a lesser extent UCITS V. Further costs may be on the horizon once ESMA clarifies the required asset segregation model for AIFMD and UCITS funds. 

“Any requirement to segregate AIF and UCITS fund assets in individual accounts from existing pooled arrangements will not only increase costs, but may also be a challenge for a number of other business operational models, including prime brokerage and securities finance,” says David Morrison, global head of trustee and fiduciary services Citi. 

The frameworks imposed by fund regulations have clearly increased the cost of offering custody and depository services. Assessing the level of risk for the restitution of assets is challenging and assumptions that are needed to establish a restitution risk model are quite difficult to define, according to Deniau. 

“For instance, if country risk were to be taken directly into consideration for the evaluation of such a risk for a given country, it would considerably hamper investments in most emerging markets,” he explains. 

“Similarly, does a beneficial owner CSD in a low credit country offer more risk than an omnibus type CSD in country that has a good rating? Most risk models predict a cost which is far more expensive than the actual cost, possibly due to the impact of hardship exclusions.” 

Custodians have been asked by regulators to take on more risk and the amount of capital that is required to cover them will only increase, while margins are tight, adds Cameron. “However, it is up to the custodians to improve processes and find economies of scale which will allow them to stay competitive and avoid passing extra costs on to clients.” 

Griffin agrees that, from a traditional custodian bank’s perspective, regulation has imposed additional costs stemming from additional day-to-day operational processes required by certain of these regulations as well as the increased restitution risk on the services required. 

Scale advantage 

In an activity that has become a scale business, Kablawi accepts that custodians have to consider whether cash flow enables sufficient investment in technology improvement as well as regulatory compliance. 

“Custodians or investment services companies that have scale and are focused have a natural advantage because they can meet the busy regulatory change agenda and invest in innovation and technology,” he says. 

“As to whether this will lead to consolidation in custody and fund services, the direction of the market would suggest so, but it is hard to say. I thought this would happen earlier in the decade but it did not materialise.” 

Cameron expects consolidation to continue, with the biggest custodians becoming even bigger and using that scale to offer their clients economic advantages. “The challenge will be to retain service levels and the winners will be those that really stay close to their clients, understand their needs and embrace new technologies to meet those needs.” 

According to Griffin, consolidation will continue where opportunities arise to bundle custody and fund services to realise benefits for the end client and the custodian, provide access to superior technology and innovation or enhance product offerings. 

Deniau is concerned about the effect of increased costs and heightened regulations. “To mitigate this, regulators have begun to impose further constraints on systemically important financial institutions,” he adds. “This could mean that there might be a bright future for players that remain below the systemically important financial institution threshold.” 

Marginal players will see the costs of continued global regulatory changes while the pricing pressures being passed through to custodians from their clients make custody a scale game, says Alleyne. 

“As consolidation increases, we expect to see a concentrated set of global players in the industry that have the balance sheet to continue to invest in the business,” he continues. “Global players focus on developing value-added services and become key partners to their clients by extending the investment management offering across the value chain.” 

There will also need to be a consolidation of fragmented segments over time, concludes Peterhoff. “It is quite likely that providers will adopt platform sharing strategies and/or collaborate with a market infrastructure provider post-T2S.”