Industry experts discuss how COVID-19 has changed the role of the custodian over the last year, and why this coming winter could prove to be their most trying season yet
What a difference a year makes. Last November, the AstraZeneca jab was near to distribution, and across the Atlantic, medical industry giants Pfizer and Moderna were putting their potential COVID-19 vaccines through regulatory hurdles. Many of us were still working remotely and were yet to know the outcome of the 2020 US presidential election.
As another year approaches its close, what can we expect to be the leading opportunities and concerns for the wider financial market and global custodians in early 2022? It is highly likely that, initially, the custodian’s calendar will be filled with plans and meetings to prepare for the Central Securities Depositories Regulation (CSDR) mandatory buy-in regime, which is currently scheduled for 1 February.
In addition to battling through this regulatory mist, the take up of digital developments, such as application programming interfaces (APIs), artificial intelligence and machine learning technologies, will likely be accelerated — encouraged by the necessity of hybrid working, which for many custodians will very likely still be the day-to-day reality across the winter months.
This new reality, spanning from the first lockdown until present day, has highlighted the need to increase automation and efficiency, from pre-trade all the way through to post-trade and settlement. While this is great news for the industry fintech startups and established industry service partners custodians may outsource to, the custodian still faces a pressure to keep up with the speed of this change — and its costs.
“The COVID-19 pandemic has pressured custodians, like other financial services institutions, to accelerate their digitalisation and modernisation agendas,” says Samir Pandiri, president of Broadridge. “The pandemic was the final catalyst for many firms to look at their options afresh and begin leveraging process efficiency, reducing operational risks, and improving resilience.”
Another constant through 2021 has been the increasing use of cryptocurrencies and digital assets, which went from being the extra at the back of the stage to supporting actor, alongside traditional assets as the recurring lead.
By its rapidly-evolving nature, this particular development will on the one hand increase market collaboration and standardisation, but on the other hand, may cause more fragmentation for custodians as clients look to invest in traditional assets alongside evolving digital ones.
And that’s only one part of the complicated equation. As Broadridge’s Pandiri warns: “The challenges facing custodian banks are extensive and deep-rooted.” This will be a trend that will keep evolving, with the future of assets becoming increasingly digital-led. There could come a time in the very near future when there may be no clear distinction between traditional finance and crypto in fact, because outdated and slow banking processes will improve by incorporating advanced technologies.
Among those bringing cryptocurrencies and digital assets to the fore this year has been Euroclear, who just last month finished its trials for settling French treasury bonds on a test blockchain, while LiquidShare and Banque de France utilised central bank digital currency for interbank settlement purposes back in early July 2021. More recently, U.S. Bank launched its cryptocurrency custody services which will be available to its global fund services clients.
“The proliferation of digital assets — many of which are non-fungible tokens — will continue to dominate industry discussion along with what role custodians should play when it comes to these digital securities,” says Matt Johnson, director, digital platform management and industry relations at DTCC.
Although a lot has happened in that space this year, that adjustment and move to change takes time, says Justin Chapman, global head of market advocacy and innovation research at Northern Trust.
“Even some of the most disruptive innovations are the result of years, if not decades, of development,” he says. “The new developments we have seen over the last year are the product of existing trends toward the digitalisation of the industry’s infrastructure and we are just beginning to see the maturation of these exciting innovations.”
Though having the technology ready and available is one thing, having the resources, people power and capital available to adopt that technology is another.
A trying season
Under-investment in post-trade has caused a lack of industry visibility into custodian expenses, a Meritsoft survey found in September. The report, entitled “A New Era for Trade Expense Management”, found global investment banks are spending vast sums each year on their brokerage fees and billing operations — while data challenges, lack of automation and legacy technology are making it difficult for investment banks to fully understand and therefore optimise their spend across the organisation.
“With bank operations becoming increasingly complex through globalisation, consolidation and new asset class activity, this problem is in danger of spiralling out of control”, said Daniel Carpenter, commercial lead and head of regulation at Meritsoft at the time.
He added: “Our findings provide a compelling business case for board members to invest in solutions that shine a light on this costly and opaque area of the trade lifecycle.”
For custodians, in their role as service providers, it is imperative to gauge a thorough understanding of their clients’ business, as well as their capabilities and objectives, coupled with the leveraging of the latest technology in an effort to reduce fails.
At the Association for Financial Markets in Europe’s (AFME’s) recent Post-Trade Conference, Johnson said: “It has very much to do with behaviour and how committed firms are to change things for the better. There are still around 10 per cent of financial institutions still using manual operations.”
One answer to leveraging the latest technologies could be an increase in outsourcing of more trading services. This way, custodians can have access to their desired technology platform without the associated costs of maintaining it in-house.
“Outsourcing is increasingly seen as a preferred way to deliver more flexible pricing models, and to achieve optimal business structures,’’ says Pandiri.
“The pandemic has been the catalyst of unprecedented changes to the financial landscape, and outsourcing allows banks to enhance business resilience and future-proof their operations,” he affirms.
Stormy weathers
Since the emergence of the COVID-19 pandemic, active promotion of sustainable development has become a central part of the financial market’s consciousness, which has been supported by regulators and national governments alike. The 2021 United Nations Climate Change Conference (or COP26) is coming to and end and will likely activate further progress in this space.
In the investment space, environmental, social, and governance (ESG)-related initiatives have become more than just a passing trend in driving asset growth. ESG asset classes are here to stay as the need to preserve a livable climate comes more apparent.
By changing our habits, we can tackle the climate emergency and build a sustainable world, says the UN. To this end, new ESG asset types have emerged in the market, such as green bonds, social bonds, ESG index derivatives, ESG-focused funds and exchange-traded funds, to name just a few.
However, constantly keeping up with these contemporary asset classes, as well as the trend to keep up with technological innovation and the changing nature of digital assets, all the while battling regulation hurdles, is a lot for any custodian to digest.
As Northern Trust’s Chapman says: “Balancing the sheer variety of new digital developments and emerging asset classes with our continued investment in current product capabilities, while offering significant opportunity for the industry, has the potential to create operational fragmentation, resulting in the necessity to navigate and manage multiple ecosystems simultaneously.”
“From this we see a need for greater industry collaboration and standardisation,” adds Chapman. “It is particularly pronounced in global regulatory structures where diverse approaches to digital assets and cryptocurrencies create potential for ‘regulatory arbitrage’.”
Spring forward
Suffice to say, the CSDR Settlement Discipline Regime (SDR)’s mandatory buy-in ruling is the first major regulatory hurdle facing custodians as we bring in the new year. The ruling is set to be implemented on 1 February, though the European Commission has hinted it will be releasing its review on this in January 2022.
“Custodians’ responsibilities and scope of work related to trade processing will significantly increase under CSDR’s SDR,” warns DTCC’s Johnson.
“There are many buy-side clients who will likely rely heavily on their custodian network to understand not only the status of their trades as well as how many trade fails there are. Some may also need custodian support for the reporting and reconciliation of financial penalties. All of these additional custodian responsibilities will create pressure on their resources and bandwidth.”
He adds: “At the same time, competitive pressures across the custodian segment have increased as a result of SDR-related services, as more custodians begin to offer superior or premium services to help their buy-side clients comply with SDR.”
As well as CSDR, the move to T+1 from T+2 remains a short-term hurdle, but expectantly a long-term solution where global trading is concerned; this is also a move that will further “necessitate changes in [custodial] process and operations”, says DTCC’s Johnson.
Having the agility to change may again ring true here as the weapon to survive. Though, as Northern Trust’s Chapman affirms: “Despite all this change, asset servicers must remember that — even as innovation brings new challenges and opportunities — their primary responsibilities are asset safety and client service.”
