Panellists discuss how the custody business is changing in Central and Eastern Europe, and what the new world will look like
How do central securities depositories complement custodians’ back-office operations?
Marek Za?al: We feel strong support from our local CSD, the Central Securities Depository Prague (CDCP), as they always reflect the fact that behind us—CDCP participants—is our client for whom we cooperatively find solutions. For such reason, CDCP regularly asks for practical business insight from participants so that implemented changes will bring added value to clients and also to participants themselves.
Its support and cooperation can be seen in two aspects. Firstly, there is a technical background, which means that participants are provided with a daily data feed that allows us to reconcile positions, send confirmations of settled trades or, for example, information on trade status on a daily basis.
Secondly, there is professional informational support that gives us regular updates on planned changes, optimisation, development, and generally, anything that can make the local market attractive. Moreover, CSOB regularly participates in status meetings on individual topics (Xetra, MTS, SWIFT connectivity, intra-day collateral management and T+2 harmonisation) with CDCP.
Juergen Sattler: Generally speaking, CSDs throughout our network provide a sophisticated and reliable service to their clients. They are a strong backbone of the domestic market infrastructure where custodians can build on their service offerings. However, client driven, tailor-made solutions are still not offered at the CSD. As a result, the role of the local custodian is still an important one in order to compensate for that particular shortfall of the CSDs’ service package.
RBI, accessing some of our offered markets directly via the local CSDs, has to enrich the service quality, especially on the asset servicing part of the product. The prime focus of CSDs seems to be on the transaction side of the business, but not on the asset servicing side.
Gokce Iliris: CSDs, intermediary institutions and custody banks are inseparable members of one big family that live and work together, in good and bad times. The regulator, on the other hand, is more like the big brother of the same family having the control and authority. In order to maintain a successful, working financial market, all of the mentioned actors and their stakeholders have to share the same ‘motto’ and concentrate their efforts for healthy and good working financial markets.
In many markets, bureaucracy, unnecessary paper work and less automation cause problems. Not only do they deteriorate the relationship between these parties, but they also make main corporate actions or settlement processes cumbersome. In order to avoid these problems, regulators, CSDs and custodians have to work together to get rid of the excessive load by taming these processes.
In Turkey, the Capital Markets Board (CMB), central bank, and financial infrastructure companies such as MKK (as the CSD) work together, especially on corporate governance practices and corporate actions processes, to further develop and make them more compliant with international and EU standards and principles.
A good example of this collaboration can be seen in the recent changes to the capital market and commercial laws. General assembly meetings can now be attended via electronic means. In fact, Turkey is the first country to make it a legal obligation for all Borsa Istanbul listed companies to organise both physical and electronic general meetings simultaneously. The main idea behind this change is to remove the boundaries to cross-border voting and increase corporate governance practices in Turkish capital markets.
MKK, with this in mind, developed an electronic platform and from this platform investors are now able to attend to concurrent meetings, pre-register their votes, watch the meetings live, express their comments and opinions online, and assign proxy to their custodians. Custodians are now able to receive electronic proxies from this platform, get rid of all the paper and manual work attached with proxy processes, attend meetings electronically (without needing to send any representatives physically), and save time and human resources. Expenses and operational costs have also decreased considerably with this new situation.
Value added services that CSDs will develop as per the need and demand of market players will not only help custodians’ to lower their back-office operation costs, but also help them to better serve their clients. Such initiatives are also important in attracting new foreign investors to their local markets.
How has custody business evolved in the last three to five years?
Za?al: In Central and Eastern Europe, the main trend throughout the years is clear: continuous convergence with western developed markets. We have done a lot of work in the last five years. For example, the CDCP was established, a new market was opened (MTS) and a new trading platform was launched (Xetra). There are still more projects to come, namely the central counterparty and SWIFT connection to CSDP.
In terms of operational flows, the most significant impact on matching and settlement was the introduction of an automated pre-matching procedure (hold/release mechanism). This enhancement brought greater comfort to customers, generated higher frequency of real-time status and significantly increased the overall straight through processing (STP) rate.
Sattler: The major trend to be detected over the last three to five years was a strong focus on consolidation of the markets on various levels. First and foremost, the number of sub-custodians in the markets showed a clear trend towards the south. The business moved mainly to regional providers in order to create substantial efficiencies regarding administrative cost, operational risk, as well as financial risk and contractual risk in terms of the legal agreement.
The sub-custodian’s role is vital for risk mitigation in all areas of the product offering. Moreover, the vast number of regulations approaching the markets challenges all market participants of the entire value chain of the custody business. The various regulations do not only provide market players with more security and efficiencies, but also with higher costs based on required IT developments and additional expenditures on the administrative side, such as segregation of accounts at the client level throughout most of the global markets.
Iliris: In parallel with the financial markets, the custody business also evolved and became more complex in the last couple of years. Especially after the financial crisis, local and global authorities concentrated more on applying new regulations to financial markets and the custody business. When you look at the lessons learned from the crisis, you might well see where the custody business goes and how it evolves. For instance, five years ago the focus was on asset size and the value of the assets under custody.
Today the focus is more on asset safety and (minimising) risk in assets. The scope of the services provided by custodians were always broad but with CSDs providing more custodian-like value-added services, the quality and scope of the services (such as tax services, asset servicing and account operating) provided by custodians gained more importance.
I believe the only unchanged fact about custody business is the value that custodians’ clients would like to receive for the money that they pay. As competition between custodians, with CSDs coming into the picture, increased dramatically and putting operational costs aside, the custody business is now transforming into a more CSD-like and tailor-made business, where players are fighting to retain their existing clients.
The custody business’s existing ‘know your customer’ (KYC) policies have received much more attention than they have in the last five years. It is now more important and critical for regulators and custodians to have the most accurate and reliable information about clients. KYC policies are the utmost priority to avoid penalties. In that sense, like the evolution in the custody business, client due diligence processes have also evolved based on the changing needs of financial markets.
Is automation of back-office operations a necessity or a luxury?
Za?al: It is certainly a necessity. Our clients are always very well informed about the STP status of agents in the market and if we want to achieve 100 percent service for clients (and it is understandable that they always require such a service), we have to automise. Today, the level of operational risk plays an increasingly greater role, not only towards clients and proper settlement of their transactions, but also towards control and regulatory mechanisms within the agent. Automation enables significant mitigation of operational risk and increases efficiency of the back office and related departments. Automation significantly reduces cost in the long-term.
Sattler: It is an imminent necessity. Without a high degree of automation the challenges that the markets force on participants will not be met successfully. To know, and above all, to manage operational risk, is and will be the major differentiating factor among service providers. The overall efficiency of an organisation and the back-office operation represents the one and only guarantor for a long-lasting and sustainable business model.
Iliris: It’s not wrong to say that automation in back-office operations is definitely a necessity.
Any kind of manual process, paper work or hands-on-effort in any operations department but especially in the back-office operations of custody banks, result in excessive consumption of human resources, lower control over ‘manual’ processes and an increase in the level of operational risk that custodians are normally subject to. Automating the cumbersome processes, making them lean and more efficient helps back-office operationsnot only in performing smoothly but also in providing consistent, reliable and better services to their clients.
Also, in an environment where ‘operational costs’ have gained importance more than ever, automation brings efficiency, lowers those costs, maintains better allocation of resources and helps custodians to support capital and liquidity requirements that regulations such as Basel III stipulate.
Looking at the debate from another point of view, some may say that automation requires high technological investments and money and time. This is a true argument, however, with the help of differentiated services, increased cross-border transactions and economies of scale, automated processes and smoothly performing back-office operations, I believe custodians will have the opportunity to lower their fee schedules (as a result of decrease in costs), retain their existing clients and increase their satisfaction level, acquire new clients, and offer new services/products. In that sense, in the medium to long term, automation will definitely provide better returns compared to the cost of investment.
How do you envisage the custody business changing over the next 10 years?
Za?al: Without the benefit of a crystal ball, we can assume that the Central and Eastern European custody business will continue its inclination towards harmonisation on the EU level. Local markets will be more and more interconnected and their standards will tend to be unified. On the other side of this story, we still cannot forget challenges stemming from fierce European regulation. I am afraid that this will be the most thorny problem of the following decade. It will be our highest priority to balance between the harmonisation and effectiveness, on the one hand, and creativity and complications on the other.
Sattler: The industry will experience further consolidation both on the clients’ side and the local market level, the providers. The one offering the most efficient service model will prevail. Scale on volumes will count even more than it does today as the investments needed to stay on top of the food chain will grow systematically and rather exponential than linear.
Iliris: To better comment on this question, we should examine custody business and CSD business together as they are the two key denominators of post-trade world, like the right and left foot preceding each other.
The post-trade world is passing through a series of change shaped by new regulations, existence or establishment of new players (new custodians and CSDs), development of a new settlement platform (T2S), harmonisation of corporate actions processes, and more. Therefore, CSDs and custodians have much to do to comply and adapt to these new initiatives and in fact face high costs to make necessary investments. Especially, regulations addressing more transparency, increased asset safety and enhanced risk mitigation require big investments, not only in terms of systems but also people.
Moreover, T2S is another crucial initiative that CSDs and custodians need to be a part of. The new platform, with its high investment costs, still carries considerable ambiguities.
In order to cope with these ‘variables’, post-trade actors, especially CSDs and custodians, started to shift their roles from what they used to perform to a rather more extended and new one, trespassing each other’s boundaries. CSDs, providing services that custodians used to provide, and custodians becoming CSDs, show how the new post-trade world is going to be pictured.
In the next 10 years, first fragmentation and then consolidation could be seen among CSDs and custodians. CSDs that do not differentiate their services and fail to establish new links with other CSDs and try to survive only with the revenues generated from the core functionalities will most probably be left out of the competition.
On the other hand, custodians that fail to extend the scope and quality of their services fail to retain their existing customers and cannot be a part of T2S will also be left outside of the future post-trade world. As the revenues that custodians generate from core transactions or custody services shrink, custodians must tap into new businesses to concentrate their efforts, such as securities lending, collateral management or derivatives clearing. In fact, custodians that are willing to establish new CSDs or transform into CSDs should also comply with the new CSD Regulation (CSDR) in addition to the existing laws and regulations that they have to comply. CSDs on the other hand, should also focus on corporate governance and asset servicing for the next 10 years.
What effect will T2S have on the custody business?
Za?al: From a CSOB perspective, T2S can be perceived either as an opportunity or as a challenge. It depends on the given position in the market and practical analysis of the whole project. I am convinced that every single entity that is involved in the T2S project will make such an analysis of their own. Either way, CSOB will definitely be ready to transform these challenges into opportunities.
Sattler: The good-old custody business will change dramatically. T2S will turn the currently existing business models upside down and create a totally new infrastructure in markets. The opportunities will hopefully outnumber the downside effects for market participants. However, adoption to the new environment is still on-going across the industry and it is still up in the air as to what future service offerings will look like.
Iliris: There are many advantages that T2S is believed to bring to the financial markets and two of them are the increase in competition and decrease in transaction and settlement costs. In this context, the custody business will definitely be affected by T2S, at least from ‘costs’ point of view. CSDs giving more custodian-like services and custodians’ transformation into CSDs and the expected fragmentation in the post-trade environment regardless of the (CSD or custody) business can be all linked with T2S.
I am not so pessimistic about the effects of T2S on custody business and tend to think more on the positive side. I believe custody business will find new areas for business with T2S. The platform will facilitate new products and new post-trade services for custodians. For instance, some custodian banks have already declared that they are going to be direct participants of T2S. This is also a starting point for custodians or custody businesses to provide new services to their clients and can be considered an indicator that they will have the opportunity to broaden their current client portfolio and geographical reach. In fact, according to a recent study conducted by Clearstream (supported by Oliver Wyman), “a global custodian with €400 billion in assets under custody across major T2S markets could save up to €50 million”.
There will also be much more competition than ever in the post-trade environment, particularly between custodians. Therefore, I also think that there might be some consolidation in the market, too. Custodians merging with other custodians or custodians concentrating more on ‘niche’ and differentiated services could be seen in the long run.
In order to benefit the most from T2S and changes in the post-trade environment, I believe a cooperative rather than competitive approach would be more feasible and beneficial for custody business.
