The landscape for custodians and sub-custodians is about to alter dramatically, thanks in no small part to the Alternative Investment Fund Managers Directive, which will make global custodians liable for the actions of their sub-custodians, leading to uncertainty over risk pricing and the future role of sub-custodians.

Banking scandals are nothing new, but soon one thing will change: establishing who is liable when something goes wrong. And so the plumbing that underlies the world’s investable assets – the global custodians and their sprawling network of sub-custodians – is adapting to a new era of regulation.

“The industry has become increasingly driven by risk management and regulation,” says Chandresh Iyer, head of global custody and investment services at Citi.

AIFMD impact 

One regulation that is of concern is the Alternative Investment Fund Managers Directive (AIFMD), whereby global custodians will be liable for the misdemeanours of their sub-custodians. Although global custodians have long prepared for such regulation, the industry is still grappling with how to price for the additional risk, especially when traditional sources of revenue have dried up. “Risks have to be priced at some stage,” says Ulf Noren, global head of sub-custody at SEB, of the changes in the industry.

This element of risk is also pushing global custodians to consider whether they should take on the additional risk themselves rather than rely on sub-custodians. “Custodians are trying to extend upstream in the value chain,” says Mr Iyer, who adds that the regulatory changes and the unbundling of the value chain is creating a “rejuvenation of the industry”. Others describe the trend as a convergence of global custody and sub-custody.

The poster child for such a convergence is JPMorgan, which has expanded into sub-custody – a decision that observers say was taken so the global custodian could manage more of the value chain itself. 

Laurence Bailey, JPMorgan’s CEO of worldwide securities services for Asia-Pacific, says that the common description of JPMorgan re-entering the sub-custody market is something of a misnomer. “We have self-cleared in a lot of countries for a long time,” he says, giving the examples of the UK, Australia and Taiwan. “We are not re-entering, we are expanding.

“As we have grown as a global custodian, the scale we have means that we have the ability to be one of the larger holders of securities and a large client for our sub-custodians. We are now bringing that in house – we have the scale to be competitive on price and risk.” He adds that the worldwide securities services business at JPMorgan had already become the custodian to other areas of the bank and it made sense to bring those capabilities in house.

“We have moved with our client demand,” says Mr Bailey. “Brazil, Russia, Taiwan, India, Hong Kong – these are the countries people are going to.”

Regulatory burdens

Many executives define their strategies in terms of their clients, but the broader issues of the increased regulatory burden are not far from their thoughts. 

“The regulations are changing people’s thinking,” says Timothy Keaney, CEO of BNY Mellon Asset Servicing. “The regulators want us to be the ‘throat to choke’. It gives the opportunity for players like us to step up and grab the mantle of control and oversight and charge more for the services.” 

When asked about the option of expanding into sub-custody as a way of maintaining that control, Mr Keaney says: “We have a very different view on it.” He explains that there are only five markets where BNY Mellon does "local-local" custody and supports the full value chain: the US, Canada, the UK, Germany and the Netherlands.

The regulators want us to be the ‘throat to choke’. It gives the opportunity for players like us to step up and grab the mantle of control and oversight and charge more for the services

Timothy Keaney

Elsewhere, the global custodian works on building its network of sub-custodians. Mr Keaney believes the best way to handle the risk of the new environment is to manage a strong network. “We cannot be best in the world in 120 markets,” he says, adding that trying to be a global and sub-custodian in many markets is unrealistic. From the client’s point of view, Mr Keaney says: “I do not think it is any more risky because we are clear on where we are the best.”

Readjustment period

The industry as a whole is adjusting how to price for these new risks. Mr Keaney explains that there were previously four pillars of pricing: fees, net interest income, securities lending and foreign exchange. “After the crisis all of the capital markets revenue evaporated,” he says of the industry-wide trend. And in a low-interest-rate environment, there has been a refocus on the fees and many are rethinking how to price their services.

“All sources of revenue are being pressured,” says George Nast, global head of products at regional player Standard Chartered. Historically, he explains, the custodian would accept lower fees on core asset servicing if they knew they could make it up on securities lending, foreign exchange margins and cash. “In the current interest rate environment, the industry is going to ask itself – with the added cost of regulation and liability – whether the core product is priced appropriately in the current environment,” says Mr Nast. “The history of making money somewhere else is coming to an end.”

Martin Anderson, head of network management at global custodian RBC Investor Services, says: “The increased regulation is increasing our cost of business in terms of the oversight over our network.” He adds that there is continuing debate in the industry about where the additional cost should be borne, an issue that has yet to be resolved.

“For us, as a buyer of services, it is about getting the right balance. It is not necessary to go to the cheapest deal – it is about getting the best deal for us and our client, and balancing the cost, the risk and the service we receive. Increasingly, the service and risk considerations are taking priority,” says Mr Anderson.

Client demands

Mr Anderson reflects the view of many observers that since the financial crisis, the stability and credit rating of the institutions in the custody network have become of paramount importance.

Dr Anshuman Jaswal, senior analyst at consulting firm Celent, says clients are also making other demands. “There is an increasing demand for accountability and transparency from clients – they want to know where the funds are kept at a particular point in time,” he says. The need for more clarity is not just a response to regulation, he explains, but the client demands.

“Clients' needs are changing. They are geared towards risk management, safety of assets and the need for more transparency and real-time information,” says Mr Iyer at Citi. “The definition of custody is changing, along with the level of services and solutions that can be provided.” 

“We have stopped talking about sub-custody versus global custody, but rather asset servicing for different client sectors,” adds Drew Douglas, co-head of HSBC Securities Services, who adds that the distinction between the global custodian and the sub-custodian is "definitely getting closer". The factors driving this, he says, are regulation, the need for greater efficiencies, risk management and geo-political shifts.

Global expansion

With a strategy of 'grow global and enhance sub-custody', HSBC is using its international network to expand globally from its traditional business as a sub-custodian. “We have been building the global custody platform so we can service clients from end to end,” says Mr Douglas. “Expanding your self-clearing network can be easier for universal banks, because they often have banks on the ground for other reasons.”

On the question of how HSBC’s global expansion is changing the relationship with its global custodians, Mr Douglas says: “We don’t do it to compete with them – global custodians are a very important client segment for us. I believe they understand that we are not building our capability to compete over global custody. There is competition, but they understand we will provide services to each other where it makes sense, and in other areas we will compete.”

Don Linford, head of international securities solutions at Itaú Unibanco, says: “Competition is definitely a world we live in. Clients are clients and they are also competitors. There are clients of ours who compete with us for offshore business or even sub-custody, and at the same time use us as a service provider for those they cannot provide.” 

Simon Cleary, global head of custody services at Standard Chartered, says that there is a blurring between the global custodians and the sub-custodians because local investors are growing beyond their traditional borders and looking for regional solutions. To those clients, the solutions look and feel like global custody, but they are in fact provided by a regional player.

A matter of scale

For regional players such as Standard Chartered, their strategy is attributed to the shifts in the global economy and growth in emerging markets, rather than as a direct response to regulation. “For us it really is the growth of the region that is the big driver,” says Mr Nast. “We are clearly impacted by regulation, but I still believe that the core of [the bank’s strategy] is the growth that we are seeing around our footprint.”

“The ever-evolving regulation is the big challenge,” says Mr Linford at Itaú Unibanco, adding that with the rising cost of new rules and regulation, “scale is extremely important for people in this business”.

Competition is definitely a world we live in. Clients are clients and they are also competitors. There are clients of ours who compete with us for offshore business or even sub-custody, and at the same time use us as a service provider for those they cannot provide

Don Linford

The need for scale has given rise to the question of whether the global custodians will expand to the point where they swallow up sub-custodians in a wave of consolidation. 

Charley Cock, global head of client development at BNP Paribas Securities Services, argues that the convergence of global and sub-custody is not a wider trend in the industry. “It is a small world with a short list of players. Depending on the identity of the institution, they operate exclusively as global, or very much as a sub-custodian. There are very few who operate in both,” he says. “The core client business in each universe is different,” adds Mr Cock, explaining that global custodians typically deal with institutional investors whereas sub-custodians deal with financial institutions.

“The global and local spaces continue to expand. BNP Paribas happens to be both a global custodian servicing a geographically diverse institutional client base and a sub-custodian operating in more than 30 markets. Yet apart from ourselves, JPMorgan, HSBC and Citi – which all have capabilities in both fields – I do not see any new players emerging with combined global and sub-custody capabilities," says Mr Cock.

He says that entering a new market brings numerous challenges, such as acquiring a banking licence, the local regulations and establishing cash and liquidity capabilities. “It is not a light decision. Just opening a bank for the sake of being your own sub-custodian by and large does not make sense.”

Mr Noren at SEB says: “Based on the experience of our markets, it takes [a great deal of] experience and investment to become a top agent bank. In markets that are quite standardised such as the Nordics, there are still local peculiarities.” He argues there may be a blurring between the global and sub-custodian, “but very few players have the financial muscles to go ahead and do that”.

Mr Cock says that the preferred choice for large trust banks, such as State Street, BNY Mellon or Northern Trust, is to keep working across the globe with sub-custodians, despite there being some changes in their buying behaviour. “They tend to lump the purchasing with a few regional players. We see the list of providers of sub-custody services shrinking,” he says.

Feeling the pressure

Mr Cock believes that the need for economies of scale means that those who cannot achieve critical mass in more than one market are unlikely to survive. When asked if it is possible to be a niche player, Mr Cock simply says: “I do not think so.” Commenting on the prospects for a 'local-local' sub-custodian that operates in only one or two markets, he says: “The days of those institutions are numbered. Banks that only offer custody in a single market are limited to that market’s institutional client base. In parallel, their sub-custody offer will also be limited to their home market. They’re facing a very bleak future.” 

“Sub-custodians are being squeezed,” says Mr Jaswal at Celent. “There is a lot of pressure on the fee model of the sub-custodian specifically.” Though this does not necessarily mean that the single-market custodian will become extinct. Mr Anderson believes there is potential for a single market sub-custodian to be successful. “Across a network you do not want a concentration of risk – all the eggs in one basket – where there is one provider in all markets,” he says.

With regards to the speculation that the global custodians could swallow up the local players, Mr Linford says: “I believe there is a healthy space for local custodians to play in their niche.” 

However, Mr Jaswal says that when it comes to pricing, the sub-custodian is also at a disadvantage in the relationship as the global custodian often has a better bargaining position when it comes to negotiating fees. The nature of those fees, however, is likely to change as the industry continues to develop a pricing model that accounts for the cost burden of regulation as well as the changing demands of their clients.

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