This article appears courtesy of Global Investor
The 2009 AIG Global Funds Prospectus is worrying reading for investors who know little about post-investment risks in foreign markets. It lists no fewer than 32 principal risk factors. Not surprisingly, AIG take their responsibilities very seriously. The 2002 Prospectus listed 12 factors. The list is also worrying for the sub-custody community, for opposite reasons. Sub-custodians almost know too much about these risks, and as this article argues, it’s a mixed blessing, requiring well thought-out strategies.
The best sub-custodians play a valuable role in helping clients understand what is going on in local markets. They are close to the market. They know the local players, the regulations, tax, accounting and reporting requirements, how the market operates and operational pitfalls. They use their position to influence and encourage the way markets open up and develop best practices. Not only do they provide a first class custody product, they are also good problem-solvers and offer informed opinions where appropriate.
Recent market turmoil has given sub-custodians the chance to re-affirm their value. As Kevin Smith, head of the global network management team at BNY Mellon, observes “sub-custodians are not simply factories. There are always changes in regulations and processes to understand, and ‘new developments’ present additional challenges for investors”.
Sub-custodians can leverage their local knowledge and turn it into a valuable service. When they pitch for new business, their commitment and expertise in this area, coupled with experience from a broad client-base, can be a unique selling point. It’s a positive benefit to sell versus “we don’t make many mistakes”. It supports the sub-custodian’s desire to build stronger, longer-term client partnerships, and use the depth of relationship to cross-sell other products and services.
Occasionally, sub-custodians take this one step further and promote themselves as trusted advisors to clients. Borrowed from the investment industry and consultants, the concept is seen by some as a source of real competitive differentiation, and an antidote to the downward pressure on prices.
The dilemma facing all custodians, of course, is knowing where to draw a line between providing opinions, influencing change, advising clients on risks, and taking responsibility for those risks. It’s easier to assign responsibility in some custody-related areas than others, and there are grey areas where it is unclear where the buck stops.
Custodial banks have always been concerned with the grey areas. Clients look to their bankers if something goes wrong and it’s hard to recover losses from other parties. “We may have deep pockets but we’ve got short arms” a pre-credit crunch banker claimed, while admitting his bank sometimes took a commercial, not legal view of paying up. Corporate action notification and instruction mix-ups are classic examples where banks are not solely at fault. How big is the client, would they leave us? What are the reputational risks? Will new procedures prevent this happening again? It’s worth noting that in certain situations in-house lawyers have advised payment, and executives have said “no”. And custodians will rigorously defend themselves if they believe they have a strong case – for instance, where disclaimers clearly limit their supervisory responsibilities in client contracts.
Global custodians have a particularly difficult path to tread between advice and responsibility. They actively sell their ability to smooth out the complexities and ambiguities of investing across different markets. They promote the economies of scale and improved service-levels they negotiate from sub-custodians. They assure clients that they use rigorous risk reviews to select and monitor the “best in class” custodian in each market or they invest in their own local operations, providing competitive (i.e. different) levels of cover for different clients.
So it is not surprising that investors, advisors and regulators look to the custodians to take more and more responsibility for down-stream risks in local markets. This is raising alarm bells, as one senior custody sales executive explains. “Are we reaching a tipping point, where we are being taken too far into areas we cannot influence, like political risk? Can we be expected to build and kit out ‘nuclear fall-out shelters’ in over 100 countries, to cater for every risk scenario that can be drawn up? Take the scenario where clients invest in a small country with only few international standard sub-custodians, and then find that they are all unexpectedly hit by a political crisis. The costs of providing a shelter for this type of risk could be prohibitive in smaller markets.
Sub-custodians know a lot about the real risks of trading and holding investments, because they operate – as agents – in the “plumbing” of the industry and often worked to sort out the mess. They’d witnessed the impact of innocent mistakes, incompetence, unprofessional conduct, wilful negligence, deliberate fraud, theft, defaults, government appropriations, fines, imprisonment, natural disasters, wars, terrorism and so on.
They knew about cash and collateral risks. When counterparties defaulted, they saw the liquidity and asset recovery problems that hedge funds (in particular) had with enhanced cash funds administered on a pooled basis by prime brokers. Long before the credit crunch, they knew the difficulties of recovering securities in pooled funds or in jurisdictions without the legal concept of trust. They saw investors’ consequential losses when ring-fenced assets were locked up temporarily by bankruptcy administrators, and markets moving in the wrong direction.
During the last two years the global investment industry has learned a lot more about these risks. Andrew Osborne, Northern Trust’s global head of Network Management, echoes the sentiments of many when he says: “The investment industry has taken a significant step back to basics. We’ve always taken risk management extremely seriously at Northern Trust and have seen many investors get excited by new vehicles and new opportunities. Now they’ve realised that those investments are not worth much if you can’t prove the right of title, or the safety, security and soundness of assets.”
“It’s become much easier for risk managers to get heard,” confirmed an investment management executive. “Concerns were raised about where global custodians and their sub-custodians were placing cash; how pooled assets were being re-hypothecated; and why we only used one rather than two or three prime brokers for accounts. But in common with many others, we opted not to change, given the extra administrative costs and potential loss of revenues. Now everyone is getting to grips with the scale of our exposure across different instruments and counter-parties. We’re able to bolt more stable doors; we’re introducing better controls over where our client assets are invested, how they are held, with more transparency at a sub-custody level.”
The risk dilemma remains, however, in areas where custodians have no direct influence over what happens in the market, but where they are directly involved. Recent events have surprised even experienced custodians.
In a world where investment managers invest in cash/funds managed by other investment managers, few could have predicted that any global investment management group would be fraudulently run. Rogue traders and smaller firms had been exposed, but not major billion-dollar enterprises. It just didn’t seem possible in this day and age. But it did happen. Custodians are at the centre of operational and legal “discussions” around the Madoff fall-out, involving investors/advisors, custodians, the CSSF in Luxembourg, as well as debates on UCITS/EU directives.
Few could have predicted the political role of the state in stemming systemic losses. Custodians knew the theory of systemic risk, and could see the risks in countries with under-developed operational or legal infrastructures and volatile political climates. But we were blind to how it would play out in the largest investment centres. Some firms and asset classes/owners were saved. Others were left to fail or default. Major universal banks were taken under state protection and local regulations were changed overnight. We’ve all learned to expect the unexpected.
There are many issues relating to this topic. But from a sub-custody perspective, there is a lot to learn from how leading executives are leveraging their firm’s knowledge in a way that supports clients, and limits their firm’s own risk liabilities.
First of all, custodians are thinking the unthinkable. Clients rightly say: “We don’t want any more nasty surprises.” Custodians are rigorously assessing different risk scenarios and stress-testing their policies and contingency plans. This is already well underway in sub-custodial network management, where the spotlight is on all custodians and various contingency plans are in place, or are being considered. But custodians are also thinking outside the box. Are new and emerging countries really the most risky? Some of the most significant risks lie far closer to home. What could go wrong next? What level of response is appropriate in each scenario? Taking enhanced legal opinions, how would specific scenarios play out? The good news is that custodians are also taking advantage of opportunities that uncertainly brings, to develop new products and reporting/analytics/monitoring services that will support client needs.
Secondly, custodians continue to try to ring-fence what they should and should not be liable or responsible for. This is even more important as people talk about compelling new risk scenarios at sub-custody and depository levels. A lawyer interviewed for this article commented that he found it easier to pin down risks in custody contracts than risks in investment management contracts. Custodians must not allow un-assigned investment risks to creep into their area of responsibility, at least not without adequate compensation. Along-side contractual and regulatory work, custodians continue to educate market participants and lobby regulators about where custody risks begin and end, versus investment and other risks. Fortunately, there are plenty of real-life examples to support this process, and many more investors know the right questions to ask, even if the solutions are debatable.
And finally, sub-custodians are starting to use concepts like trusted advisor more carefully. It covers terms that potentially have serious legal and compliance consequences. Clients need to buy into the proposition as well – which they’ll do with open arms if they can outsource risk. Most global custodians are clearly uncomfortable with the concept. According to Andrew Osborne, sub-custodians should use it only with a “huge disclaimer”. Smith said he wouldn’t use the term to describe his relationship with sub-custodians. “We expect our sub-custodians to be aware and informed, and even give us an opinion in certain situations. Market advocate is a more appropriate term.”
Custodians are paid to deliver many valuable services. But they are not specifically paid to be investment risk advisors, or political/country analysts, or lawyers, tax and accounting experts with enhanced opinions, or credit/counter-party rating agencies. Some clients may rely on their custodians for opinions and services in these areas, but that’s the client’s decision, at their risk – and right now that’s where the buck should stop.
By Simon Murray
