How has European custody evolved in the last 12 months?
Jesper Linden: The industry has stood up extremely well during the ongoing COVID-19 pandemic. Following intense activity levels with record trading volumes and substantial asset value decreases most of the core components have returned to a kind of normality. Important, but as of yet temporary, changes have been instigated in areas like contract and power of attorney work (by use of electronic signatures), voting (by re-design of meeting execution and increased acceptance of e-voting) and taxes (by less strict demands for the physical documentation – paired with increased needs for information, that area is though at best squared out).
Daniel Pascaud: We see the custody business remaining on a consolidation track and CACEIS itself is a great example of this with our acquisition of KAS Bank, the Dutch pension fund servicing specialist and the joint venture with Santander’s S3 securities servicing entities.
Downwards fee pressure from our clients is a constant feature of the custody business with several large clients pushing to renegotiate contracts as they struggle with generating investment performance and face similar fee pressures from their own investors. Consolidation goes some way to combatting these pressures as economies of scale help spread the costs of product development and regulatory readiness.
Despite the fervent talk of technologies that would disrupt the custody environment, neither blockchain nor bitcoin have really made their mark on the business other than some cases of low hanging fruit. They have not shown themselves anywhere near capable of replacing complex in-house systems developed by custodians over the years and are currently simply an additional platform for which it is necessary to maintain an interface.
David Turmaine: In recent years, European custodians have evolved in the face of significant changes resulting from new regulations, emerging technologies and ever-increasing cost pressures. These challenges have continued to resonate over the past 12 months and to some extent are now ‘the norm’ for custodians. Faced with an environment characterised by inexorable change, custodians have continued to develop their IT strategies, introduce new products, and enhance their service models while also placing an increased focus on data.
COVID-19 has been a major disruption, tanking EU equity markets, triggering a surge in corporate bond spreads and a widening of government bond spreads, and prompting heightened activity across market infrastructures during the sell-off as volumes and volatility soared. This has prompted custodians to take stock, to reflect on where they were, where they are now and where are they going as the pandemic’s impacts accelerate a range of pre-existing trends and pose some new challenges.
Harald Kreuzmair: The major development was the ongoing COVID-19 pandemic and the related move to working from home. As if this was not challenging enough, we all experienced manifold numbers of transactions and volumes. Both, the overnight move to a work-from-home environment and the processing of an incredible workload went smoothly. Had you asked me about one of these challenges a year ago I would have had some doubts whether the industry could cope with that. Turns out that we accommodated both and we can say the industry weathered the perfect storm in fantastic shape. Specifically for Central and Eastern Europe (CEE) we saw no disruptions in processes, neither due to the activation of circuit-breakers nor trading holidays to catch up with the backlog of transactions.
Aside from COVID-19, we continue to see progress in automation driven by coding, machine learning and artificial intelligence (AI). In parallel, many institutions, such as custodians, central securities depositories (CSDs), stock exchanges and clients, work on standardisations and harmonisations in order to achieve process efficiency.
Somewhat disappointing is the continued lack of distributed ledger technology (DLT)-based implementations at scale and therefore the initial expectations of disruption, significant reduction of time and efforts and a collapse in settlement and safe-keeping costs are still not realised.
What are the biggest trends in the European custody space right now?
Turmaine: The COVID-19 pandemic has prompted custodians, like other financial services institutions, to accelerate the digitalisation agenda, and are accordingly assessing how to shift the focus of their operating and business models from technology that is used to the way in which people interact and execute delivery. Undoubtedly, the execution of large-scale transformation programmes is under review, with custodians analysing how the pandemic has impacted plans, priorities and team structures.
Enhancing engagement models is most certainly a primary focus right now, both technically and operationally as firms look at more flexible workplace and workforce models. Custodians are adapting to new ways of working such as how they service clients remotely and will be assessing the appropriate channels for engagement.
Data is bigger than ever. In particular, custodians are exploring how data mining can inform and drive smarter business decisions and surface meaningful intelligence around client trends and behaviours. Custodians may choose to look at data on an intra-day rather than the end-of-day basis to enhance decision making and likewise assess the digitalisation of client channels for data and services.
Technology will continue to be a key enabler as custodians look to manage ongoing change, with AI and machine learning and intelligent automation to the fore; at the same time, they are addressing the need for platform rationalisation for smart data solutions. The streamlining of know your customer and client onboarding processes, enhanced access to data and the monetisation of proprietary data are additional areas of focus.
Ulf Noren: Dealing with the new normality has forced the industry to innovate its client-facing role as travel is either banned or visits are not welcome. Building technology communication tools that can be used to uphold the dialogue is something ‘everyone’ is busy doing. From a business performance and continuity perspective, the focus has shifted a lot to compliance, taxes, technology and IT security. This is reflected in how and where custodians spend time and money and how we recruit. Not finding sustainable business reasons to stay and continue the full race has on a few Nordic occasions showed that the step to say goodbye has been shorter and quicker.
Pascaud: European trends remain industry consolidation to secure profitability from economies of scale while downward pressure on fees from clients continues. Digitisation and automation are also key trends driven by the need for process efficiency and cost reduction.
Kreuzmair: Automation is the name of the game to bring down costs further and improve speed. On top of this, data, analytics and the intelligence gained from this become ever more important. On one side it allows everybody to obtain a better insight into their own business, on the other side we can give valuable feedback as to what works well and what does not. A nice by-product is the possibility to identify solutions, create additional services and cross-sell with other products.
What are the biggest challenges facing custodians in Europe?
Pascaud: Cost efficiency remains by far the biggest challenge. The slow reduction in fees, the disruptive technologies nibbling at certain areas, the regulations adding to the
administrative burden.
Robotic process automation, AI and an overall increase in the digitisation of the industry combined with the economies of scale possible through ever greater consolidation are some of the main ways custodians are looking to increase efficiency.
You’ll have to be one of the biggest to survive.
Linden: One of the challenges includes making sure that income minus cost generates a positive number.
That number will though unfortunately be used for the investment necessary to keep up with mandatory changes following regulatory change and internal/external non-authority driven compliance, audit and security reasons.
The tax area is as challenging.
The far-reaching changes in 75 percent of the markets we play a role in contain many elements of liability and it is definitely one area where you can’t afford to fail.
How will CSDR affect custody business in Europe? And what other regulations have been/are significant to custodians?
Pascaud: The Central Securities Depositories Regulation (CSDR) will force all players in the settlement space to increase the rate of settlement efficiency as it brings in the concept of financial penalties for parties responsible for postponing trades. CACEIS is actively working to promote the efficiency of trade settlement by developing a management information system that will highlight on a dashboard those trades that are pending and where the responsibility for the delay. In reducing the administrative workload relating to failed trades, the entire settlement process will gain greatly in efficiency. Although CSDR implementation has been pushed back until 1 February 2022, we are delighted to be a step ahead and already working to improve settlement processes.
Apart from CSDR, two other regulatory measures will have a huge impact on our operational processes – Securities Financing Transactions Regulation (SFTR) and the second Shareholder Rights Directive (SRD II). Both will cause a significant rise in the administrative workload and consequently drive up the costs of doing business too. SFTR requires the custodian to monitor thousands of flows every day, with a long list of reasons why transactions may be rejected. SRD II on the other hand brings in additional complexity with its famous 4pm deadline. There is lots of work ahead.
Noren: It is still a bit early and not all CSDR features are in place yet. Ideally, CSDR will be an important framework in order to standardise the safe and consistent treatment of settlement in Europe. An important driver for the creation of the regulation was thoughts around CSDs ability to stand up and being resilient. We believe European CSDs have demonstrated such resilience over the years even without CSDR but streamlined and consistent rules are always welcome. The harmonisation that follows with CSDR at some stage will pave the way for further harmonisation in other areas. At the moment most focus is put into dealing with the Settlement Discipline Regime that thankfully has been postponed.
Linden: Yes, SRD II is a mega project for all organisations and as these efforts are still ongoing after the recent introduction, a level of preparedness lower than the industries normal standard has been observed. Also here, many benefits would have materialised if it had been granted a further delay. In this region, many pair of eyes are seeing in the direction of Finland as the first adaptor of the TRACE model for taxes. This will happen as of 1 January 2021 and it is with a sense of urgency we see the date approaching.
Kreuzmair: Listening to industry voices/complaints on the penalty regime I have a somewhat different or more relaxed view about this. If it helps to reduce open/not-settled transactions systematically I am all for it and clearly, there are costs to the counterparty honouring its obligations by another one not honouring theirs, so it is only fair to attach a price on this. If the industry comes to a different and more practical solution, the better. As a service provider, we see the settlement discipline regime as a pretty complex exercise, so a more pragmatic approach will help. Let’s see where we are heading.
Turmaine: CSDR has been a top priority for European custodians in the last couple of years. With settlement internalisation reporting having gone live in July 2019, the focus has shifted to CSDR’s settlement discipline regime.
CSDR contains several features with various impacts on the ecosystem with the intent to enhance the efficiency of securities settlement in Europe and offers a path to industry best practice to eliminate some of the inefficiencies and risks within the pre- and post-trade environment. To achieve it sets out a number of requirements for market participants.
Key among those is a single set of prudential and supervisory requirements for CSDs and other institutions providing banking services ancillary to securities settlement. The requirement for CSDs, and in turn the CSD participant, to offer their clients a choice of omnibus or individually segregated accounts is another. The regulation also stipulates a set of measures to prevent settlement fails, including cash penalties and the mandatory buy-in of trades that fail to settle from the fourth business day after settlement due date. Other requirements include dematerialisation — representing all transferable securities in book entry form i.e. electronically recorded in the CSDs before trading on regulated trading venues — and freedom of issuance in any EU member state, providing issuers with a choice of CSD rather than obligating them to use the CSD in which they are domiciled.
CSDR presents opportunities for the custody community to launch new or improved services and achieve higher rates of settlement efficiency for its clients. Examples include: fails reporting with projections of cash penalties and buy-in risk; reconciliation of penalties; and collaboration with securities lending providers/buy-in agents to help clients manage to avoid or manage mandatory buy-ins. Such services will be a source of competitive advantage for custodians going forward, given how inefficiencies around the processing settlement instructions or provision of detailed reporting can damage client relationships and give rise to disputes over associated penalties.
Another regulation impacting custodians is SRD II and its requirements around shareholder identification, the transmission of information and the rights of shareholders. Unlike CSDR, a proposed delay to its implementation was rejected and the directive went live at the beginning of September. The complexity of the changes involved meant that readiness levels across the market were varied, and at the time of writing a number of firms are still in the process of upgrading their messaging standards.
How has the increase in technology changed European custody business?
Turmaine: Historically global financial service providers have been resistant to technological innovation. However, times have changed and now custody service providers see a genuine competitive advantage and a means to driving client penetration and revenue, as opposed to viewing operations and client service as a necessary yet large expense. They are using a combination of applied advanced data analytics, new metrics, end-to-end process automation and policy change to make this happen.
Operational technology has been slow to scale over the years and combined with a lack of investment in the back office, this has resulted in many institutions struggling with ageing legacy applications that have grown in complexity on a massive scale. This has negatively impacted the ways of working and process effectiveness.
The convergence of maturing technology and an organisational commitment to digital transformation has created a golden opportunity for the European custody community to improve their capabilities.
By focusing on these priority areas, management has an opportunity to solve some of their most frustrating challenges. More importantly, they have an opportunity to protect the organisation’s margins and competitive advantage by improving efficiency and strengthening key client touchpoints.
The adoption of client lifecycle management technologies, coupled with a renewed recognition at the leadership level that operational service plays a critical role in ensuring client service satisfaction, is empowering custodians to explore solutions and effect real change.
Going forward, in order to enhance capabilities and improve the client experience and overcome internal processing constraints, global financial institutions will need to blend big data technology with highly automated business process operations. The next-generation approach must be designed to deliver significant cost savings, faster and more efficient onboarding of clients and their assets, and be more defensible from a regulatory perspective. Doing so will allow institutions to create competitive advantage and build stronger client loyalty in what is becoming an overcrowded marketplace.
Noren: Not as much as one would have hoped for. The custody ecosystem is, despite many onlookers attempts to look upon it like bread and butter, immensely complex with a variety of rulebooks and so many components that have no given way for standardisation. It happens by way of a myriad of small steps and although many opportunities are imbedded in foreign exchange use of DLT, by digital enabling as an umbrella term, very little of substance has materialised. We are firm believers in increased speed of the use of AI instead of robotics playing strategic roles as permanent solutions versus the tactical role it should really play until a root cause problem is fixed. We also believe in the use of technology to design client-based solutions for static problems and developed our first private API that can be used to address the industry’s two most asked questions, namely ‘what id my status, what is my position?’.
Pascaud: Custody is a highly-regulated business and even though technology such as blockchain is fast-evolving and potentially disrupting, there are so many regulatory hoops to jump through that it requires huge amounts of IT development costs to meet the all the requirements custodians are held to. The in-house legacy systems of custodians present a level of complexity that blockchain cannot currently meet which is why it remains on the fringes, picking off the more simple tasks. We don’t see technology in general having a huge impact on the custody business during the coming years except perhaps in the area of user interfaces.
The custody industry has been around since at least the 1960s and in that time many of the processes have been perfected and the business has industrialised. However, the industry itself has remained pretty similar and has not (yet) undergone any major disruption or transformation. The settlement process, the corporate action process, the forex process still relies on SWIFT to exchange cash or securities, and the 20022 standard SWIFT messages launched years ago has still not been fully implemented.
What are the most prominent opportunities to be had for custodians in Europe?
Pascaud: The biggest opportunity for the large custodians is to continue on the consolidation route by acquiring or partnering with other market players that are facing difficult times due to the reduction in revenues and increasing expenses.
The European custody market is still far too much fragmented and there remain many opportunities to consolidate and take advantage of economies of scale.
Linden: Continuing to prove relevance as a service provider for the region as consolidation of the market continues. While wishing we could be more fancy — and this is no attempt to downplay the need for new technology solutions — the most prominent opportunity will come to the one that is prudent, diligent and comply with the rulebook(s) in a way that also the client in the partnership can sleep well at night and remain compliant.
Turmaine: The emergence of digital/tokenised assets presents a key opportunity for custodians. Client demand is starting to grow in this area, as institutional investors look to diversify into other non-traditional asset classes that are issued in the digitised/tokenised form. To support this, custodians will need to invest in blockchain technology to facilitate the settlement and safekeeping of these types of assets. Furthermore, offering this type of capability will create new opportunities to service the issuers of digital/tokenised assets, thereby opening up a new market for their businesses.
If deployed in the right way blockchain technology can facilitate the transition of traditional custody services onto the platform, as well as support new products and services to drive operational and cost efficiencies and enhance the client experience from a cost and performance perspective.
The business is becoming more data-driven. Intelligently-derived data is a valuable asset, and for some organisations, the ability to mine this data effectively represents a significant — and sometimes prohibitive — investment. There is an opportunity for custodian banks to provide data analytics services to provide their clients will intelligent and meaningful insights into their business performance, trends and behaviours to satisfy their own business, risk and regulatory needs.
Kreuzmair: It seems that the consolidation on the custody side is more or less done and I see the industry now focusing on fund services, either in the distribution or trading and brokerage platforms. The real opportunities are longer term.
How do you envisage the custody business changing over the next 10 years?
Kreuzmair: I expect a broad-based move to digital securities and the creation of an ecosystem challenging all elements in the chain, stock exchanges, CSDs, custodians, traders, sales, notaries, law firms and tax experts. In the extreme, everybody including the end-investor is connected in a fully automated way to everybody, thus eliminating the need for most of the services rendered today by the said institutions.
Personally, I believe that investors, institutional and retail, are human beings and we prefer to deal with other human beings while at the same time benefiting from a much-improved customer experience. So, while the truth this time may not lie in the middle, we will see substantial changes in our industry.
Turmaine: Next-generation technology presents custodians with opportunities to position themselves differently within the ecosystem. Transactional fee revenues are under pressure as settlement volumes continue to decrease and external post-trade infrastructure costs increase. To counteract the impacts of this continuing trend, custodian banks will need to find ways of positioning themselves in other areas of the value chain and consider how they might directly compete with investor/issuer CSDs and other post-trade service providers.
Technology will clearly play a prominent role in realising these opportunities. Similarly, custodians also need to consider whether their legacy platforms are fit-for-purpose and — more importantly — future-proof. It is unsustainable to continue implementing standalone solutions to support new markets, products and services, or cannibalising legacy platforms to perform non-core functions. This will only further complicate already complex and highly fragmented infrastructures and increase IT, operational and compliance costs, further eroding profitability.
Pascaud: The biggest opportunity for the large custodians is to continue on the consolidation route by acquiring or partnering with other market players that are facing difficult times due to the reduction in revenues and increasing expenses.
The European custody market is still far too much fragmented and there remain many opportunities to consolidate and take advantage of economies of scale.
Linden: 10 years is a long time but in the custody context, more a mid-term perspective. We are still dealing with the implementation of features originally designed to mitigate effects from the banking and liquidity crisis from 2008/2009, which is 11 to 12 years ago. We thereby believe, when looking at our region that we will see further consolidation of the infrastructure, we will see consolidation in the sub-custodian space and we do believe that two regional banks and two banks of more European reach style will dominate our turf.
Noren: We do also believe that the volume game will step up and that business relevance analysis is made more frequent than today. The race to the bottom on margins will have to stop at some stage during the envisaged period but unfortunately not very early in that cycle. The heavy investment will be made in compliance with regulations, both new upgrades of existing ones and new such. The EU agenda on this front shows no sign in having the pendulum shift towards the previous modus of self-regulation.
So to say. There will be technology shifts of magnitude and the SWIFT ambitions in the field is encouraging. Having the most important partner for our business world showing leadership is great. Last, the most important part will be depending on the people in the industry. This is a business based on competence, trust and personal intention to do good and it will remain so – a true peoples business also in 10 year’s time.
