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Selecting global custodians: a paradigm shift in asset protection?

The world of global custodians has undoubtedly seen one of the greatest waves of new regulations changing not only their landscape, but also the way their institutional clients review their custody providers.

Regulations and market stimuli

Regulations such as the Alternative Investment Management Directive (AIFM-D), Undertakings for Collective Investment in Transferable Securities V (UCITS V), and soon to be implemented Directive for Institutions for Occupational Retirement Provision 2 (IORPII) all have in common to increase investor protection amongst others.

Other stimuli that are aimed at increasing transparency and protection which are relevant for the global custody market are:

  • the resolution planning exercise under the Dodd- Frank Wall Street Reform and Consumer Protection Act,
  • the finalization of the post-crisis reforms under Basel III,
  • Basel Committee’s suggested changes to the assessment methodology for Globally Systemically Important Banks,
  • And the European Commission’s ambition on structural reform of banking in the EU through for instance Capital Requirement Directive IV (CRDIV).

In varying degrees all these regulations and market stimuli affect the way institutional investors are interconnected to the global custody industry.

 

Research

Societe Generale Securities Services recently completed research on the historical evolution of the global custody industry. The research reveals that institutional buying behavior in the global custody industry has emphasized on price as one of the most important buying criteria, and, simultaneously, global custodians tend to compete on price as a key differentiator when entering into competitive bidding.

Using applied microeconomics, it can be concluded that the market over the past 25 years has continuously found its equilibrium, but it can also be concluded that the number of global custodians offering services to European institutional investors has decreased substantially in some countries due to the economies-of-scale challenge global custodians have faced under price pressure.

However, as per the Financial Conduct Authority’s (FCA) Business Plan for 2017/2018: custody banks provide critical support services to the funds industry and trading activities, which require them to be accurate, secure and resilient. The FCA has therefore planned a review of the global custody sector over the next two years.

Enhanced methodology for selection

institutional investors have focused mainly on two critical lines of defence of a global custodian’s business practice when selecting a global custodian

Historical experience and research shows that institutional investors have focused mainly on two critical lines of defence of a global custodian’s business practice when selecting a global custodian. The first line of defence is segregation of client securities from the custodian’s balance sheet and a high-quality sub-custodian selection and monitoring process.

The second line of defence is the global custodian’s strategic, tactical and operational risk framework including security measures against material events. Both lines of defence are pre-event risk mitigations.

Under aforementioned regulations such as AIFM-D and UCITS V, and in the unlikely, low-probability event of loss of assets, a third line of defence becomes equally important, namely a global custodian’s credible capital position versus the risks they are exposed to. Empirical research suggests that capital protection as the third line of defence may increase in the future as a more dominant factor when selecting a global custodian. With regards to capital protection the market has not found its equilibrium as of yet under new regulations. To support adequate analysis and decision making on capital protection, new methodologies have been developed to support institutional investors based on increased information and transparency available to the market. In a market where transparent decision making by financial institutions is fundamental to society under new regulations and investor protection is paramount, enhanced methodologies for custodian selection are welcomed by institutional investors.

Maximise prevention and paradigm shift

New regulations are now mostly implemented, and the interconnected stimuli of supervisors and regulators have fueled the market. As more information and methodologies become available to institutional investors to evaluate global custodians, buying behavior of institutional investors is likely to turn towards maximizing prevention and investor protection. The emphasis on three lines of defence, rather than the historical two, allow for the paradigm shift in asset protection to reach new heights.