Ready to rumble
25 May 2016
The landscape is changing for sub-custodians, with regulations shifting and clients becoming more and more demanding. Now that global players are showing more interest in individual markets, can the local guys work with them, or should they see them on their way?
Image: Shutterstock
How has sub-custody evolved over the last few years? What are the main drivers of change in the industry?
Ryan Cuthbertson: Globally-focused regulatory change means that custodians are tackling a number of challenges including IT infrastructure overheads and margin compression. At the same time, it’s more important than ever to explore new technologies such as distributed ledger, or blockchain, while also developing and investing in value-added services for clients.
From a client perspective, buying habits have also changed over the last few years, with more clients looking for a regional or global approach.
Finally, frontier and emerging markets continue to develop and become easier to access for foreign investors.
Marek Za?al: Sub-custody business in the Central and Eastern European (CEE) region is continuously developing hand in hand with the rest of Europe. This is namely due to the fact that CEE is not a separate or ‘autonomous’ region. Of course, it plays its unique role in larger European system, but CEE today is often just perceived in geographical or historical perspective.
We need to realise that, like many things, the world of custody is becoming more and more globalised, and CEE is just one of many parts of the world. In this sense, one of the trends that can be seen today is a more regional coverage, which appears to be more and more in demand from global players.
Still, some key custody industry players prefer to stick to the best available agent in particular markets, even if such an agent does not cover the whole region. It is, nevertheless, obvious that those providers that are able to cover the CEE region as one complex market are taking advantage of the economies of scale and mean to be a part of the regional coverage concept as a long-term and continuing trend.
Rob Scott: Sub-custody has not changed to a great extent over the last few years, performing the same basic functions and services for their clients—with a few notable exceptions.
Firstly, there is a more active dialogue and review with clients surrounding the consumption and use of services at the sub-custodian level. Sub-custodians, like many other market participants, are not immune to cost and regulatory pressures, and have been more transparent and open with clients. As this dialogue has increased, more efficiency has been achieved and clients have gained a better understanding of both their consumption of service and the associated costs.
Secondly, we have seen the emergence and evolution of new products and services, such as trade repository reporting, collateral management outsourcing and integrated direct market access with custody models, all of which serve to help clients with the cost of market participation and the associated regulatory compliance challenges. There is a focus on these products being important in some areas, for example Target2-Securities (T2S). Core settlement may be removed from local participants in favour of more centralised servicing.
Due to their local proximity and thorough understanding of clients’ needs, sub-custodians are able to be innovative and adapt to new business models, helping both clients and themselves to navigate through the market and regulatory challenges nimbly and effectively.
To what extent have regulations affected sub-custody, and how do they continue to do so?
Cuthbertson: The market has seen a huge shift in global regulatory change over the past few years, which will also continue into the future. Previously, regulatory change was viewed from a singular market- or country-specific view. However, regulations such as the Markets in Financial Instruments Directive (MiFID) II, UCITS, the Alternative Investment Fund Managers Directive (AIFMD), the Market Abuse Regulation and Directive (MAR and MAD), the Foreign Account Tax Compliance Act (FATCA) and the Common Reporting Standards (CRS) are taking a global approach that demands cross-border collaboration. As a result, custodians are increasingly fostering a harmonised post-trade environment through consolidation and standardisation, aided by the engagement and support of regulators.
Differing regulatory agency structures—such as the separate regulatory entities in Hong Kong, the UK and the US as opposed to a single entity in Singapore—and infrastructure development, such as the advent of the new Central Securities Depository Regulation (CSDR), add to the complexity and requirements that sub-custodians and their clients need to understand and comply with.
HSBC welcomes the regulatory changes and frameworks and continues to act as an agent for change, providing proposals and solutions for clearing, settlement and custody.
Scott: Regulation has had a profound impact on all market participants. Regulation, outside of increased reporting requirements, has principally concentrated on asset safety and segregation of clients. Within many sub-custodians this has prompted debate and discussion with clients regarding the use of omnibus versus segregated account structures.
It is usually the case that sub-custodians can and do segregate effectively in their systems, however in some cases there remain considerable challenges of full segregation at the local depository level. Sub-custodians continue to work with local infrastructure to solve this problem.
Secondly, due to regulation there has been a greater emphasis on clients to perform due diligence on their choice of local provider. This has led to increasing reviews of client set-up, account structures, reporting requirements and tax status, all of which have resulted in increased efficiency between the custodian and their clients as well as increased understanding of consumption of service.
Za?al: There is no doubt that there is a significant impact of regulation that is imposed on the sub-custody business. We can mention some of them: CSDR, UCITS V, AIFMD, the European Market Infrastructure Regulation (EMIR), MiFID, T2S and others. These present challenges that are still ahead of us, although a lot of work has already been done.
Generally speaking, the European fragmented market is continuously subject to unifying pan-European regulation. This, however, is not appropriate for such a fragmented market and thus its implications are large and mostly negative in terms of cost.
What are the main risks in the market for 2016?
Scott: The main challenge for a sub-custodian is the quick adaptation of their business model. It is interesting to note, however, that people have been talking about the demise of sub-custody models for many years and yet, despite this, many continue to thrive and evolve their services and adapt to new norms. This may be due to their comprehensive knowledge of client needs coupled with local knowledge of infrastructure and regulation.
Za?al: There are always many challenges and opportunities in the market, and it will not be different in 2016. In spite of this positively resonating background, there are several challenges in the Czech market that are continuously on the table for the long term. For example, the absence of the full nominee concept in the Czech CSD—perhaps the mostly frequently debated topic between local providers and foreign investors; missing SWIFT connections between the CSD and local providers, which are well familiar with SWIFT communication to their clients; and the wide range of regulatory requirements enforced by local, EU and other regulatory bodies.
There is still a market debate on asset safety and appropriate usage of securities account types. We are awaiting the planned amendment to the Capital Market Act, which will be more harmonised with another regulation, the CSDR. The effectiveness of these amendments is currently planned for the end of 2016.
Also, the Czech capital market is facing the introduction of a central counterparty (CCP), which aims to start functioning at some point in 2018. And, last but not least, we expect the local CSD, CSD Prague (CDCP), to continue in its efforts to become a single information source for all corporate actions. Since CDCP is not currently an official source recognised by law, local agents still have to use several different official sources.
Cuthbertson: There are many risks, with one of the most significant being the speed of change that regulation is driving, and the costs associated with it. It’s something no firm can afford to get wrong but it comes with a large cost to build and effectively measure.
Considering market specific risks, the ongoing slowdown and recent volatility in China has had an impact across Asia. Continued low commodities prices are affecting Australia, the Middle East and Latin America, leading to index decreases and lower assets under custody.
How do the challenges for emerging and frontier markets differ from those in the more established ones?
Za?al: This particular question does not have a one-sided answer, and it also depends on the classification of emerging, established and frontier markets. While large and developed markets face mostly regulatory challenges while infrastructural challenges might not be that tough—bearing in mind that these markets already handled infrastructural projects such as CCPs—for the emerging markets, the regulatory and infrastructural challenges are equally important.
It is true that some small markets outside of the EU and with low volumes might not be affected that much by the need for strict regulatory and infrastructural changes.
On the other hand, the small markets within the EU must tackle both sides of the coin—infrastructure and regulation.
Cuthbertson: Emerging markets pose different risks to custody through the somewhat closed and highly regulated nature of some of the markets. The world’s second largest economy, China, is still in the process of opening its capital account. Foreign exchange market restrictions pose further limitations, as do the structure of the markets.
Saudi Arabia is a prime example of an evolving, opening market. It is introducing foreign ownership limit changes and relaxing the size and characteristics for foreign investors entering the market.
By overcoming many of these hurdles, the markets are encouraging greater liquidity, greater investment and a decreased risk perception. This is something that will continue to change through continued de-regulation.
Scott: Servicing clients in emerging and frontier markets is challenging on two fronts. Firstly, in establishing a business case to enter the market in the first place, creating enough critical mass in order to reduce the challenges of increasing cost and changing business models for both providers and customers. The days of ‘build it and they will come’ are over. There has to be either a strategic and compelling reason to enter a market, or a reason of attainment of critical mass and client demand.
Secondly, emerging and frontier markets infrastructure and regulation are likely to be materially different to more established markets. Having a thorough knowledge and understanding of local specificities is key, in order to navigate the market effectively and reliably on behalf of the client. Understanding in detail not only settlement and asset servicing requirements but also items of tax and local compliance is paramount.
This is why so many global custodians still employ and engage the sub-custodians in these markets until either there is enough of a business case to enter the market in a direct manner themselves or there is a strategic imperative to do so. It is sometimes simpler to use an established partner in these markets.
Can sub-custodians compete with the larger global custodians? Are there any advantages to being a smaller player?
Scott: I believe there are still very compelling reasons to use sub-custodians. They are the best placed to understand local clients’ needs and requirements, regulations, and market nuances and specificities.
They are also best placed to represent the interests of clients locally with regulators and market infrastructures due to both proximity and local contact.
Sub-custodians are also usually more adept at servicing clients’ changing needs as well as those of regulators. They are usually quicker at changing their underlying systems and reporting requirements due to various degrees of flexibility and a high level of customisation housed within their core technology platforms.
By retaining both flexibility and a real detailed understanding of the client and the market, the proposition of sub-custodians is a compelling one. I foresee a continuation of business growth despite wholesale changes in market initiatives such as T2S. There will always be the need to service clients locally, with detailed understanding and market representation, and to do so in a quick and effective manner, customised to the client’s needs.
Cuthbertson: With the exception of state-mandated markets, there are only two markets in Asia and virtually none in the Middle East where truly domestic custodians remain prevalent. Global investors want a globally consistent experience as well as access to global liquidity and credit, so it is becoming more and more difficult for single market players to offer this.
Historically, the case can be made that a single market player may have had a better focus or more local insight, however the large global players have been well-established in their chosen markets for significant periods of time now, and this advantage has dissipated considerably.
Za?al: It is obvious that there are various entities in the market, and both global and local players are presented. The question is, who can better respond to clients’ needs, which are more and more demanding?
Local players are a very important link in the chain, offering a deep knowledge of the local market, a developed network of market links and connections and, of course, a direct presence and specific local language. On the other hand, global players benefit from their broad coverage of various markets, economy of scale and large global presence. So, both local and global players are an essential part of the industry chain, and each of them plays its unique role.
It will be more and more important to consider whether such a role will become static, or whether these players will take a step further and become more diverse. In other words, local players might be thinking more globally, trying to concentrate on other markets, whereas global players might focus on each individual market more closely, becoming significant competition to established local sub-custodians.
Ryan Cuthbertson: Globally-focused regulatory change means that custodians are tackling a number of challenges including IT infrastructure overheads and margin compression. At the same time, it’s more important than ever to explore new technologies such as distributed ledger, or blockchain, while also developing and investing in value-added services for clients.
From a client perspective, buying habits have also changed over the last few years, with more clients looking for a regional or global approach.
Finally, frontier and emerging markets continue to develop and become easier to access for foreign investors.
Marek Za?al: Sub-custody business in the Central and Eastern European (CEE) region is continuously developing hand in hand with the rest of Europe. This is namely due to the fact that CEE is not a separate or ‘autonomous’ region. Of course, it plays its unique role in larger European system, but CEE today is often just perceived in geographical or historical perspective.
We need to realise that, like many things, the world of custody is becoming more and more globalised, and CEE is just one of many parts of the world. In this sense, one of the trends that can be seen today is a more regional coverage, which appears to be more and more in demand from global players.
Still, some key custody industry players prefer to stick to the best available agent in particular markets, even if such an agent does not cover the whole region. It is, nevertheless, obvious that those providers that are able to cover the CEE region as one complex market are taking advantage of the economies of scale and mean to be a part of the regional coverage concept as a long-term and continuing trend.
Rob Scott: Sub-custody has not changed to a great extent over the last few years, performing the same basic functions and services for their clients—with a few notable exceptions.
Firstly, there is a more active dialogue and review with clients surrounding the consumption and use of services at the sub-custodian level. Sub-custodians, like many other market participants, are not immune to cost and regulatory pressures, and have been more transparent and open with clients. As this dialogue has increased, more efficiency has been achieved and clients have gained a better understanding of both their consumption of service and the associated costs.
Secondly, we have seen the emergence and evolution of new products and services, such as trade repository reporting, collateral management outsourcing and integrated direct market access with custody models, all of which serve to help clients with the cost of market participation and the associated regulatory compliance challenges. There is a focus on these products being important in some areas, for example Target2-Securities (T2S). Core settlement may be removed from local participants in favour of more centralised servicing.
Due to their local proximity and thorough understanding of clients’ needs, sub-custodians are able to be innovative and adapt to new business models, helping both clients and themselves to navigate through the market and regulatory challenges nimbly and effectively.
To what extent have regulations affected sub-custody, and how do they continue to do so?
Cuthbertson: The market has seen a huge shift in global regulatory change over the past few years, which will also continue into the future. Previously, regulatory change was viewed from a singular market- or country-specific view. However, regulations such as the Markets in Financial Instruments Directive (MiFID) II, UCITS, the Alternative Investment Fund Managers Directive (AIFMD), the Market Abuse Regulation and Directive (MAR and MAD), the Foreign Account Tax Compliance Act (FATCA) and the Common Reporting Standards (CRS) are taking a global approach that demands cross-border collaboration. As a result, custodians are increasingly fostering a harmonised post-trade environment through consolidation and standardisation, aided by the engagement and support of regulators.
Differing regulatory agency structures—such as the separate regulatory entities in Hong Kong, the UK and the US as opposed to a single entity in Singapore—and infrastructure development, such as the advent of the new Central Securities Depository Regulation (CSDR), add to the complexity and requirements that sub-custodians and their clients need to understand and comply with.
HSBC welcomes the regulatory changes and frameworks and continues to act as an agent for change, providing proposals and solutions for clearing, settlement and custody.
Scott: Regulation has had a profound impact on all market participants. Regulation, outside of increased reporting requirements, has principally concentrated on asset safety and segregation of clients. Within many sub-custodians this has prompted debate and discussion with clients regarding the use of omnibus versus segregated account structures.
It is usually the case that sub-custodians can and do segregate effectively in their systems, however in some cases there remain considerable challenges of full segregation at the local depository level. Sub-custodians continue to work with local infrastructure to solve this problem.
Secondly, due to regulation there has been a greater emphasis on clients to perform due diligence on their choice of local provider. This has led to increasing reviews of client set-up, account structures, reporting requirements and tax status, all of which have resulted in increased efficiency between the custodian and their clients as well as increased understanding of consumption of service.
Za?al: There is no doubt that there is a significant impact of regulation that is imposed on the sub-custody business. We can mention some of them: CSDR, UCITS V, AIFMD, the European Market Infrastructure Regulation (EMIR), MiFID, T2S and others. These present challenges that are still ahead of us, although a lot of work has already been done.
Generally speaking, the European fragmented market is continuously subject to unifying pan-European regulation. This, however, is not appropriate for such a fragmented market and thus its implications are large and mostly negative in terms of cost.
What are the main risks in the market for 2016?
Scott: The main challenge for a sub-custodian is the quick adaptation of their business model. It is interesting to note, however, that people have been talking about the demise of sub-custody models for many years and yet, despite this, many continue to thrive and evolve their services and adapt to new norms. This may be due to their comprehensive knowledge of client needs coupled with local knowledge of infrastructure and regulation.
Za?al: There are always many challenges and opportunities in the market, and it will not be different in 2016. In spite of this positively resonating background, there are several challenges in the Czech market that are continuously on the table for the long term. For example, the absence of the full nominee concept in the Czech CSD—perhaps the mostly frequently debated topic between local providers and foreign investors; missing SWIFT connections between the CSD and local providers, which are well familiar with SWIFT communication to their clients; and the wide range of regulatory requirements enforced by local, EU and other regulatory bodies.
There is still a market debate on asset safety and appropriate usage of securities account types. We are awaiting the planned amendment to the Capital Market Act, which will be more harmonised with another regulation, the CSDR. The effectiveness of these amendments is currently planned for the end of 2016.
Also, the Czech capital market is facing the introduction of a central counterparty (CCP), which aims to start functioning at some point in 2018. And, last but not least, we expect the local CSD, CSD Prague (CDCP), to continue in its efforts to become a single information source for all corporate actions. Since CDCP is not currently an official source recognised by law, local agents still have to use several different official sources.
Cuthbertson: There are many risks, with one of the most significant being the speed of change that regulation is driving, and the costs associated with it. It’s something no firm can afford to get wrong but it comes with a large cost to build and effectively measure.
Considering market specific risks, the ongoing slowdown and recent volatility in China has had an impact across Asia. Continued low commodities prices are affecting Australia, the Middle East and Latin America, leading to index decreases and lower assets under custody.
How do the challenges for emerging and frontier markets differ from those in the more established ones?
Za?al: This particular question does not have a one-sided answer, and it also depends on the classification of emerging, established and frontier markets. While large and developed markets face mostly regulatory challenges while infrastructural challenges might not be that tough—bearing in mind that these markets already handled infrastructural projects such as CCPs—for the emerging markets, the regulatory and infrastructural challenges are equally important.
It is true that some small markets outside of the EU and with low volumes might not be affected that much by the need for strict regulatory and infrastructural changes.
On the other hand, the small markets within the EU must tackle both sides of the coin—infrastructure and regulation.
Cuthbertson: Emerging markets pose different risks to custody through the somewhat closed and highly regulated nature of some of the markets. The world’s second largest economy, China, is still in the process of opening its capital account. Foreign exchange market restrictions pose further limitations, as do the structure of the markets.
Saudi Arabia is a prime example of an evolving, opening market. It is introducing foreign ownership limit changes and relaxing the size and characteristics for foreign investors entering the market.
By overcoming many of these hurdles, the markets are encouraging greater liquidity, greater investment and a decreased risk perception. This is something that will continue to change through continued de-regulation.
Scott: Servicing clients in emerging and frontier markets is challenging on two fronts. Firstly, in establishing a business case to enter the market in the first place, creating enough critical mass in order to reduce the challenges of increasing cost and changing business models for both providers and customers. The days of ‘build it and they will come’ are over. There has to be either a strategic and compelling reason to enter a market, or a reason of attainment of critical mass and client demand.
Secondly, emerging and frontier markets infrastructure and regulation are likely to be materially different to more established markets. Having a thorough knowledge and understanding of local specificities is key, in order to navigate the market effectively and reliably on behalf of the client. Understanding in detail not only settlement and asset servicing requirements but also items of tax and local compliance is paramount.
This is why so many global custodians still employ and engage the sub-custodians in these markets until either there is enough of a business case to enter the market in a direct manner themselves or there is a strategic imperative to do so. It is sometimes simpler to use an established partner in these markets.
Can sub-custodians compete with the larger global custodians? Are there any advantages to being a smaller player?
Scott: I believe there are still very compelling reasons to use sub-custodians. They are the best placed to understand local clients’ needs and requirements, regulations, and market nuances and specificities.
They are also best placed to represent the interests of clients locally with regulators and market infrastructures due to both proximity and local contact.
Sub-custodians are also usually more adept at servicing clients’ changing needs as well as those of regulators. They are usually quicker at changing their underlying systems and reporting requirements due to various degrees of flexibility and a high level of customisation housed within their core technology platforms.
By retaining both flexibility and a real detailed understanding of the client and the market, the proposition of sub-custodians is a compelling one. I foresee a continuation of business growth despite wholesale changes in market initiatives such as T2S. There will always be the need to service clients locally, with detailed understanding and market representation, and to do so in a quick and effective manner, customised to the client’s needs.
Cuthbertson: With the exception of state-mandated markets, there are only two markets in Asia and virtually none in the Middle East where truly domestic custodians remain prevalent. Global investors want a globally consistent experience as well as access to global liquidity and credit, so it is becoming more and more difficult for single market players to offer this.
Historically, the case can be made that a single market player may have had a better focus or more local insight, however the large global players have been well-established in their chosen markets for significant periods of time now, and this advantage has dissipated considerably.
Za?al: It is obvious that there are various entities in the market, and both global and local players are presented. The question is, who can better respond to clients’ needs, which are more and more demanding?
Local players are a very important link in the chain, offering a deep knowledge of the local market, a developed network of market links and connections and, of course, a direct presence and specific local language. On the other hand, global players benefit from their broad coverage of various markets, economy of scale and large global presence. So, both local and global players are an essential part of the industry chain, and each of them plays its unique role.
It will be more and more important to consider whether such a role will become static, or whether these players will take a step further and become more diverse. In other words, local players might be thinking more globally, trying to concentrate on other markets, whereas global players might focus on each individual market more closely, becoming significant competition to established local sub-custodians.
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