The custodial chain
5 August 2020
Credit Benchmark’s Mark Faulkner highlights the challenges around the safekeeping of assets in specialist sub-custodian networks
Image: Credit Benchmark
Can you give us a brief overview of Credit Benchmark’s white paper on the interconnectivity and hidden credit risks within the custody market?
It was the second of a series of papers. The foundation of the series is an analysis of the credit risk within the interconnected networks that underpin the financial markets worldwide. The first was about the global network of central clearing counterparties (CCPs), their interconnectedness and that of their membership; this second paper highlights the different types of specialist sub-custodians supporting the global custody networks of the eight largest global custodians.
What challenges do asset owners face when it comes to the safekeeping of their assets?
In most instances they need to outsource the custody of their assets to specialists. Being a custodian – global, regional or national – is a complex and challenging role to fulfil. Over time the market has consolidated significantly and the main challenge for asset owners is the selection of a partner that best fits their needs. An entire industry has grown to help support this critical decision-making process.
What we are effectively saying is that it is now possible to integrate real-world credit risk into this decision-making process, and to ignore credit risk in this process is a mistake. The ability to understand the credit risk of a provider and their sub-custodian network is when a client makes a decision, therefore, to be able to monitor changes over time automatically is a major step forward in practical real-world risk management. We are not saying that clients necessarily have explicit credit risk to particular sub-custodians.
What we are saying is that ‘a chain is only as strong as its weakest link’ and that ‘possession is 9/10th of the law’. We would argue that it is the duty of asset owners and their advisors to understand how strong their custodial chain is and which entity has possession of their assets. Making such important decisions based on the best possible information available is always sensible and prudent.
How does a sub-custodian network operate differently to a global custodian?
The global custodians are powerful, global, consolidating machines that are able to compile and report the information necessary for their clients to receive an accurate and detailed picture of their assets in many different ways.
The role of global custodians is hugely complex and requires a commitment to technology and expertise. This explains the scale of a relatively few players and has driven consolidation within the industry — a trend that has been ongoing for decades. The sub-custodian network players specialise in particular markets or asset classes and send data up to the global custodians.
Why are some sub-custodian entities not rated by main credit rating agencies? Do you think more regulation needs to be implemented around this?
The answer to this question requires an elementary understanding of the credit rating agency’s (CRAs) business model. The CRAs operate an ‘issuer pays’ business model. Their capability to rate entities is therefore driven by that entity’s willingness to pay for a rating, which is often driven by their issuance of debt or other securities. The larger CRAs rate about 16,000 entities which in turn issue over two million CRA-rated issues. Some of the sub-custodian entities are not rated by the CRAs because the entities that provide sub-custody services do not pay for a rating as they do not issue debt securities.
The issuer pays model has been under significant regulatory scrutiny since the global financial crisis of 2008. What is needed is the combination of diligent analysis, transparency and curiosity that has driven the creation of real-world, ‘skin in the game’ credit consensus that can illuminate the debate on credit risk. So, where does one get the necessary credible information? It is not the place of the custodians to share their own credit view of a particular sub-custodian with a curious asset manager or their advisors.
What about doing it yourself? It is an expensive and major undertaking to do the analysis and constantly monitor the credit of sub-custodian’s in-house and the resultant proprietary view is based on only one opinion or model’s perspective. This is where the data based on the collective aggregated and anoymised real-world risk assessments of many financial institutions, comes in to play.
What are the biggest threats around the security of a firm’s assets during volatile times such as the current COVID-19 pandemic?
First and foremost, this is a complex global health crisis. The extent to which financial firms and their effectiveness are impacted and compromised by this crisis is still to be determined. The banks of the world are in much better shape from a capital perspective than they were at the time of the global financial crisis. The regulators should take credit where credit is due for ensuring that this is the case. That being said, not all banks are created equal, which is why it is so important to access the best credit information available and to monitor and be alerted to any deterioration of the entities that safe-keep your assets at all times.
How important is it to monitor creditworthiness and real-world risk as changes occur?
Vital. This newly available data source is updated fortnightly and comes from 40 global banks with their “skin in the game” not one source paid by the company being rated. The ability to monitor changes and be alerted automatically is a game changer
It was the second of a series of papers. The foundation of the series is an analysis of the credit risk within the interconnected networks that underpin the financial markets worldwide. The first was about the global network of central clearing counterparties (CCPs), their interconnectedness and that of their membership; this second paper highlights the different types of specialist sub-custodians supporting the global custody networks of the eight largest global custodians.
What challenges do asset owners face when it comes to the safekeeping of their assets?
In most instances they need to outsource the custody of their assets to specialists. Being a custodian – global, regional or national – is a complex and challenging role to fulfil. Over time the market has consolidated significantly and the main challenge for asset owners is the selection of a partner that best fits their needs. An entire industry has grown to help support this critical decision-making process.
What we are effectively saying is that it is now possible to integrate real-world credit risk into this decision-making process, and to ignore credit risk in this process is a mistake. The ability to understand the credit risk of a provider and their sub-custodian network is when a client makes a decision, therefore, to be able to monitor changes over time automatically is a major step forward in practical real-world risk management. We are not saying that clients necessarily have explicit credit risk to particular sub-custodians.
What we are saying is that ‘a chain is only as strong as its weakest link’ and that ‘possession is 9/10th of the law’. We would argue that it is the duty of asset owners and their advisors to understand how strong their custodial chain is and which entity has possession of their assets. Making such important decisions based on the best possible information available is always sensible and prudent.
How does a sub-custodian network operate differently to a global custodian?
The global custodians are powerful, global, consolidating machines that are able to compile and report the information necessary for their clients to receive an accurate and detailed picture of their assets in many different ways.
The role of global custodians is hugely complex and requires a commitment to technology and expertise. This explains the scale of a relatively few players and has driven consolidation within the industry — a trend that has been ongoing for decades. The sub-custodian network players specialise in particular markets or asset classes and send data up to the global custodians.
Why are some sub-custodian entities not rated by main credit rating agencies? Do you think more regulation needs to be implemented around this?
The answer to this question requires an elementary understanding of the credit rating agency’s (CRAs) business model. The CRAs operate an ‘issuer pays’ business model. Their capability to rate entities is therefore driven by that entity’s willingness to pay for a rating, which is often driven by their issuance of debt or other securities. The larger CRAs rate about 16,000 entities which in turn issue over two million CRA-rated issues. Some of the sub-custodian entities are not rated by the CRAs because the entities that provide sub-custody services do not pay for a rating as they do not issue debt securities.
The issuer pays model has been under significant regulatory scrutiny since the global financial crisis of 2008. What is needed is the combination of diligent analysis, transparency and curiosity that has driven the creation of real-world, ‘skin in the game’ credit consensus that can illuminate the debate on credit risk. So, where does one get the necessary credible information? It is not the place of the custodians to share their own credit view of a particular sub-custodian with a curious asset manager or their advisors.
What about doing it yourself? It is an expensive and major undertaking to do the analysis and constantly monitor the credit of sub-custodian’s in-house and the resultant proprietary view is based on only one opinion or model’s perspective. This is where the data based on the collective aggregated and anoymised real-world risk assessments of many financial institutions, comes in to play.
What are the biggest threats around the security of a firm’s assets during volatile times such as the current COVID-19 pandemic?
First and foremost, this is a complex global health crisis. The extent to which financial firms and their effectiveness are impacted and compromised by this crisis is still to be determined. The banks of the world are in much better shape from a capital perspective than they were at the time of the global financial crisis. The regulators should take credit where credit is due for ensuring that this is the case. That being said, not all banks are created equal, which is why it is so important to access the best credit information available and to monitor and be alerted to any deterioration of the entities that safe-keep your assets at all times.
How important is it to monitor creditworthiness and real-world risk as changes occur?
Vital. This newly available data source is updated fortnightly and comes from 40 global banks with their “skin in the game” not one source paid by the company being rated. The ability to monitor changes and be alerted automatically is a game changer
NO FEE, NO RISK
100% ON RETURNS If you invest in only one asset servicing news source this year, make sure it is your free subscription to Asset Servicing Times
100% ON RETURNS If you invest in only one asset servicing news source this year, make sure it is your free subscription to Asset Servicing Times
