It is no longer enough to make a sporadic visit or have a phone call. Global network managers have become detectives sifting through mounts of data to find any errors or potential risk. Their top priority: to prevent loss of investor assets held in markets far from the custodians’ home turf, say panelists and attendees at a recent event in New York held by The Network Forum, a new London-headquartered industry networking group for custody specialists worldwide.
“We are receiving far more questions about asset segregation than ever before,” says Reina Hauschild, vice president of network management for Chicago-headquartered Northern Trust. “Clients want to know how we will verify asset protection. Our review and auditing process has been enhanced to include a validation of responses received from local agent banks against independent legal counsel.” Asset segregation refers to the process whereby financial firms separate the assets — cash and securities– of their clients from their own.
Fund managers, broker-dealers, and other customers are willing to accept investment risk — or the risk that the value of their holdings in a foreign country’s securities may decline due to market conditions. They might even accept a limited amount of operational risk. The local custodian bank, often called a subcustodian, could miss a settlement deadline or a corporate action. However, no client wants to accept credit risk — or the potential that a local agent bank might embezzle client assets or even go bankrupt.
Then what? The global custodian would be forced to explain what went wrong to its clients and might even have to battle with bankruptcy trustees appointed by courts to determine who is entitled to how much compensation. Asset segregation is critical to ensuring that the global custodian’s client stands a chance of recovering its cash or securities.
Global custodians all claim to perform rigorous due diligence when it comes to selecting a local agent bank. But that’s when the work starts involving credit risk, information risk, record management, legal and compliance managers. “Network management is no longer simply about procuring a service with local custodians and negotiating fees,” says Marilyn Lipton, Americas regional head for Citi’s Global Markets Network Management. The ongoing monitoring includes sending local custodians an annual questionnaire to keep track of the local custodian bank’s activities and financial status and following up with periodic phone calls.
New AFME Questionnaire
A new standardized due diligence document recently developed by a group of global and local custodians working under the umbrella of the Association for Financial Markets in Europe (AFME) could help ease the pain of global custodian network managers by providing a boilerplate list of questions they can use when monitoring their local agent banks. However, the AFME’s questionnaire isn’t necessarily a global solution. “The AFME’s questionnaire is European-centric, focusing on the requirements of the Alternative Fund Managers Directive (AIFMD) and UCITS V,” acknowledges Lipton, whose bank will be using the questionnaire for the first time this year. So will BNP Paribas Securities Services, say officials at the French banking giant.
Citi and BNP Paribas Securities Services intend to add supplemental questions to reflect the asset-segregation and customer-protection rules of the US Securities and Exchange Commission, Commodity Futures Trading Commission, Financial Industry Regulatory Authority (FINRA) and UK’s Financial Conduct Authority (FCA) among others. The US Office of the Comptroller of the Currency, which regulates US banks, also requires that banks standardize and document the risk-weighting process they use to evaluate the safety of their assets and client assets held at all of their external service providers.
In an audience poll conducted at The Network Forum-hosted event, 60 percent of the respondents say they are most affected by AIFMD and UCITS V when it comes to segregation of client assets. About 50 percent plan to use the AFME questionnaire in their due diligence process for local agent banks. “It is an excellent starting point,” says Lipton. However, Northern Trust’s Hauschild said her bank is still evaluating how to use the AFME’s questions in combination with Northern Trust’s lengthier questionnaire.
Global custodians previously were not on the hook for assets lost through lost no fault of their own. Now under AIFMD and UCITS V they could be liable unless they can prove they did everything in their power to prevent such losses by local agent banks. The pan-European measures, which make it easier for alternative and traditional investment fund managers to sell their funds across the European continent, also require global custodians to have a back-up plan in case their relationship with a local agent bank ends. AIFMD and UCITV V require fund managers wanting to benefit from the European marketing passport to select depositaries to do their middle and back office operations work. Global custodians often end up serving as depositaries.
“We have identified a network of secondary subcustodians with which to sign contracts and have custody activity with them as well,” says Emmanuelle Riess, head of network management for the Americas at BNP Paribas Securities Services in New York.”Therefore, we perform due diligence on both our primary and secondary subcustodians.”
The task of protecting client assets is made complicated by the fact that there is a convoluted indirect registration of assets. Just who owns the cash and securities and can access them quickly enough if a local agent bank goes bust? In most countries, local agent banks hold the accounts on behalf of the ultimate fund manager or broker dealer through a single omnibus account — that means the names of the local banks. Local securities depositories, in turn, hold accounts in the name of local agent banks. Given that account ownership is represented in “omnibus form,” proving the rights of fund managers can become problematic in the event of either fraud, embezzlement or bankruptcy of the local agent bank.
To ensure that the local agent bank has sufficiently protected the assets and cash of the ultimate fund manager by segregating or separating them from their own assets, global custodians insert specific language in custody contracts. They then follow up with continual reconciliation of the holdings and transactions of the accounts at the global custodian and those of the local agent bank. If the books don’t match up, it could mean the fund manager’s assets are stolen or lost.
Verifying legal segregation will also involve reading periodic attestations from the local agent that the cash and securities of the fund management firms represented by the global custodians are separate from those of the local agent bank. “We now require our local custodians to give us screen shots showing us the legal title to the segregated account is the name that was initially requested to ensure client asset protection,” says Lipton. “When possible, that requirement also extends to how records are maintained at the local central securities depository.”
Officials from other global custodians attending The Network Forum-hosted event acknowledge that they plan to be more proactive in requesting attestations from local agent banks and explaining to clients just what those attestations mean. “We need to understand what the local custodian can and cannot guarantee in terms of protecting our client assets,” says one global custody network manager. “It is often dependent on the regulations of the local market.”
Global custodians must also verify the creditworthiness of their local agent bank, as well as the amount of cash left with their local agent banks on a daily basis. Network managers need to constantly stay in touch with credit risk analysts to ensure they don’t miss the warning signs that the local agent bank is financially failing and to ensure they don’t exceed the agreed-upon credit limits. The larger the intraday and overnight exposure, the higher the global custodian’s cost of capital.
Reasons to Leave
The cost of replacing a local custodian is so prohibitive, say global custodian network managers, that they make every effort to correct problems before the relationship sours. Network managers, operational risk managers, credit risk managers, legal department managers and compliance managers at global custodian banks will typically have monthly calls with local agent bank representatives to discuss the agent bank’s performance, based on its service level agreement.
Topics will likely include the local agent bank’s straight-through processing rates based on monthly service level reports. Those reports specify the percentage of trades settled on time and the percentage of corporate actions processed by the appropriate deadline. Explanations must be provided for any mistakes, such as failed settlements and missed corporate actions.
Ultimately, local agent banks will be given some type of risk rating or grade depending on the results, say global custodian bank officials. In the case of BNP Paribas, the rankings are satisfactory, globally satisfactory, medium satisfactory and unsatisfactory. The results are reviewed on a quarterly basis by a network management steering committee which include network management, product compliance, legal, regulatory reporting and risk and control departments to decide whether to retain the local agent bank relationship to remain in the market at all. When necessary, a decision could be made even more quickly depending on the severity of the operational errors or financial status of the local custodian.
The decision to leave a market may be about more than sub-custodian performance. In some cases, the potential for asset loss is too great because of solvency laws or changes in local regulations, says Riess. Earlier this year, BNP Paribas exited eight markets for that reason. They were Bosnia and Herzegovina, Jordan, Lebanon, Ecuador, Venezuela, Swaziland, Zimbabwe and the Ukraine. Of the 90 markets which BNP Paribas now services as a global custodian, 27 rely on its own branch office for local custody. The remainder rely on third-party providers.
Given that fund managers and other clients may demand to know how their assets are being protected, global custodians also have to decide how much to disclose about their due diligence process. That includes whether or not to discuss the exact answers provided by their local custodians to questionnaires and other reports. “We may need to provide some of the answers received depending on what is asked by fund boards,” says Riess.”
The deluge of information that global custodians now have to process from local custodians to satisfy investor demands will ultimately prompt them to consider just how, if ever, they will pass along the additional costs to customers in the form of higher fees. Panelists and attendees at The Network Forum-hosted event say that, for now, they will likely absorb the expense. Still, they are taking steps to keep costs in check as global custodian profit margins have been shrinking.
“It is a matter of being smarter in how we operate and analyzing where we can reduce costs using technology,” says Lipton. BNP Paribas Securities Services has digitized its global custodian service level agreements so that they are easily accessible to internal departments as well as local custodian bank teams. “We need to further provide the network manager with better data analytics tools that will help focus on changes to regulatory requirements rather than simple workflow management,” says Riess.
MYRIAD Group Technologies Ltd (MGTL), a London-headquartered technology firm specializing in network management oversight, says that its new due diligence platform CODUDE can help global network managers send out AFME-based and proprietary questionnaires to local agent banks and evaluate their responses more quickly. The shared-service platform allows global custodian network managers to forward questionnaires to multiple agent banks concurrently and score their responses as satisfactory or unsatisfactory. As a result, the global network manager and its counterpart at the local agent bank can focus their time reviewing only unsatisfactory answers rather than all of them. Credit Suisse, which helped MGTL develop CODUDE, is the platform’s first user.