How have the regulatory risks faced by custodian banks changed since 2008?
The principal risks for custodian banks used to be very much operational, particularly in corporate actions. There was always a theoretical risk of loss of assets, but actually custodians were quite protected, as they would usually be mainly liable in the case of fraud, negligence, or wilful default. It was driven by contract, not by any particular statute, and if clients couldn’t prove any of these things then the custodian would generally not be liable.
Clearly, under the Alternative Investment Fund Managers Directive (AIFMD) and UCITS V, custodians now have liability for the loss of assets, and that is being imposed much more strictly. They are still liable for fraud, negligence and wilful default, but if assets are lost, then immediate restitution must be made for those assets. Immediate means immediate, so it’s not a matter of fighting in the courts before restitution occurs.
On top of that, there is now a reverse burden of proof, which vastly increases the risk of liability. In the past, if assets were lost, it was up to the client to prove the custodian had done something wrong. Now, the custodian generally must prove it has done everything right, which is a rather different standard of proof and much more difficult to do.
Conversely, the operational risk from the likes of corporate actions has reduced somewhat over the years, largely because of automation. The risk is still there, but it is very much reduced because there are better methods of interpretation and more efficient ways of getting things done. Matters are definitely going in the right direction here.
There has been an overall regulatory structure put in place since 2009, whereby the infrastructures—the central counterparties (CCPs), central securities depositories (CSDs), exchanges, and such—are now responsible for volumes. Banks and, to a lesser extent, insurers are responsible for absorbing the risk from the system if something goes wrong, because there are other parties who either can’t pay, such as the infrastructures themselves, which are generally relatively poorly capitalised, or who won’t pay, like the taxpayer. Governments are encouraging better capitalised banks behind the whole system, enabling them to act as a fail safe for the global financial system.
As well as risk exposure for custodians, there is also a question of what has been tightened up, such as legal risk in terms of ownership of assets, and cross-border ownership. There was always a cross-border problem, as shown by Lehman Brothers, with identifying assets owned by the institution and those owned by clients, so custodians have to be absolutely clear in the future. A lot of work has been done under some regulations already, be it the European Market Infrastructure Regulation (EMIR) the Securities Financing Transaction Regulation (SFTR), or the Markets in Financial Instruments Directive (MiFID), to clarify what happens in the case of cross-border holdings, but there is a lot more to be done in securities, property and conflict resolution law.
Have the regulations brought about unintended consequences?
One consequence in particular is concentration risk. Previously, high-grade banks often operated through bilateral clearing, and that was actually quite an efficient way of doing things.
Now, there is going to be both initial and variation margin in pretty much all cases cleared through a CCP, and even outside those structures. If a CCP is netting everything, that makes the system more efficient with fewer settlements and lower levels of capital required, but what happens if it goes bust? Chaos.
Concentration risk may not exactly be an unintended consequence, but it is a consequence that has only come around from putting everything into CCPs, and regulators and firms are working on the correct recovery and resolution responses.
All of this change is costing a lot of money for clients and banks. If a bank is spending money on something, there are only two sets of people who can possibly pay. One is the bank’s shareholders, but that will reduce the capital of the bank, which is something they’re trying to protect. The other is the investors, but it’s also not attractive to dump more costs on them, or their intermediaries, various investment structures, and ultimately the individuals who have bought the investments in the first place. Again, it’s probably too strong to call it an unintended consequence, but it is something that has come around as a result of the regulations.
Another issue arising from the CSD Regulation (CSDR) is the ‘depository challenge’. This is what happens when CSDs challenge custodians for business, perhaps as a result of CSDs losing settlement activity to Target2-Securities (T2S). Under CSDR, however, CSDs can now widen the scope of what they do, possibly moving into the area of custodians. This could narrow the opportunities that custodians have, but one line of business they can stick with is managing corporate actions. CSDs could technically manage corporate actions, but they often can’t take the risk on them because they don’t have the capital necessary to provide the compensation when problems arise. It’s hard to see corporate actions moving away from the custodians.
That leaves a further problem: the imposition of price rises. Every member of the securities services value chain would love to impose price rises—they’re all finding it hard to make ends meet—but it is difficult. A lot of costs are being absorbed by intermediaries, and banks’ balance sheets are being used as a kind of reassurance that assets are safe. Effectively, they’re being used for free.
Are regulators asking too much of custodian banks?
I don’t think regulators are asking too much of custodians—the major custodians are certainly in no danger of disappearing down the plug-hole. The issue is commercial, meaning that custodians have to make a decent return on equity for shareholders and they have to find a method of doing that. It could be by reducing costs elsewhere, by being more efficient, for example, by outsourcing some tasks to specialists, or by increasing prices somewhere, particularly if they think they’re going to be bearing a risk or undertaking new work that they don’t feel they’re being compensated for.
Broker-dealers and asset managers are in the same boat, and I have a lot of sympathy for all participants in the chain at the moment—a lot is being asked of them—but the regulatory programme is entirely necessary. There may be the odd thing that firms will quibble with, or a bit of legislation that the industry will take to Brussels to try and change, but at the end of the day, something had to be done in 2009 and this is the direction the politicians and regulators have decided to take. It just happens to cost a lot of money, so it comes back to the old question: who pays?
There is also an issue of project congestion, and it’s really reaching a peak now. All sorts of rules came out after 2009: MiFID I was already in place, and EMIR and CSDR are coming into effect now; MiFID II is coming in, much of which is based on what happened in the crisis; and there is also the SFTR coming in. On top of that, the first wave of T2S went live on 22 June, AIFMD is up and running, and the second level of UCITS V is expected soon.
Over the next few years there is going to be a lot to implement alongside other regulatory and compliance programmes, and finding the resources to do all of this can be difficult. Many firms have ended up working flat out to manage it all.
Is there an end in sight?
Yes and no. Hopefully we won’t have another crisis like that in 2008 anytime soon, so we won’t immediately need further new remedial regulation such as AIFMD, UCITS V or EMIR brought in. But there will be other things that haven’t been pushed all the way through yet, such as legislation for shadow banking and money markets, where existing regulations will be reviewed and updated.
I’m sure that as we return to being more hopeful, the growth and harmonisation agenda, which was on track until 2007, will come back again, as evidenced by the capital markets union initiative. There will probably be a lot more legislation arising from that, including in the areas of securities law, company law, insolvency law and certain elements of market practice. These changes, of course, won’t be as focused on mitigating risk as before, but more on encouraging cross-border business within the EU.
It’s not that the regulators want to control everything—they create the new regulatory structure because it is needed. If there is going to be significant cross-border trading across the EU, there have to be some common rules in place for everybody.
The crisis-reaction regulation might end, yes, but existing regulations will be reviewed and there will be more to come from the growth agenda. The landscape is still getting very, very busy, and I don’t see any sign of regulation going away.
← Previous interview
KNEIP
Mario Mantrisi
Next interview →
ITRS
Guy Warren
Image: Shutterstock 
.jpg)