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Global custodians play a critical role in the financial services industry. They serve as intermediaries between investors, brokers and markets and provide services ranging from safekeeping assets to settlement, asset servicing and reporting. By ensuring the smooth flow of securities transactions, custodians contribute to the stability and integrity of the global financial system. However, they continue to face many challenges.
Margin compression is significant as investor clients have choice and will drive for reduced rates
Ageing technology stacks that are hard to change and becoming more expensive to maintain
Access to high quality and real-time data allowing quick identification of risk.
Finding competitive advantage to differentiate from peers in order to win new business and retain existing clients
Preparing for the challenge of digital assets
This article looks to explore these challenges and discusses the potential solutions.
1. Ageing Technology
Many custodians have proprietary platforms, and although they may have high STP rates and be capable of the required heavy lifting, are often very old – sometimes more than 30 years old. These are expensive to maintain and very difficult to change. In addition, many of the individuals that understand the nuances are moving out of the industry.
These platforms can be a barrier to efficiency and innovation. The limited scalability plus time and expense needed to upgrade become an increasing issue as markets and clients drive for faster processes - for instance in response to T+1 in North America, and the wider anticipated move from global markets to shorten settlement cycles. As the markets evolve, custodians need scalable and nimble solutions to accommodate the growing needs of their clients.
This has been somewhat addressed by upgrading the black and green screens to a new UI; some have also upgraded their database away from batch. But for many the core of the platforms and the code remains the same, and a complete change to a modern platform is proving to be very risky and highly expensive. Indeed, there are potentially integration points and sub processes that aren’t even known, so an exact list of requirements can be very difficult to retrieve. In addition, a custodian can’t temporarily suspend service, making a platform change even more problematic.
An alternative being explored is moving to new technology in a programme of componentisation. Lifting specific processes out of the old technology and replacing that piece with new technology. It’s a slower migration but a lot safer, and this strategy can also have other considerable benefits. The custodian will likely have affiliate partners in its organisation that are also involved in securities processing - broker dealer, prime, funds admin, wealth – and although having a different overall set of requirements, will share particular components. The strategy therefore of componentised modernisation could result in significant savings across the organisation, achieved through the mutualisation of cost to build followed by ongoing shared costs for maintenance and change (market/regulatory/Swift). A similar benefit of cost mutualisation applies if the custodian uses a technology vendor for its solution, leveraging a shared cost model across a wider user base.
2. Margin Compression
As discussed, custody platforms are a fixed cost with mostly proprietary and ageing technology, so any reduction in fees has a direct impact on profit. Investors know they have choice in a highly competitive market and will seek reductions in rate cards at every opportunity, often going to RFP to drive home their point.
Custodians are focused on reducing cost while also maintaining a very high level of service to clients, and on finding value added services that will differentiate them from their competitors. To achieve this, the ability to gain meaningful insights into manual processes, risk and client service from high quality business intelligence is critical. However, this is only achievable through access to real-time, accurate data that can quickly and efficiently highlight areas for improvement.
3. Access to Data
All personas across a custodian need access to high quality and real-time data. This can range from the analyst needing to prioritise their work, a manager needing a view of metrics, a risk manager needing to understand exposure to a given market or counterparty, or a client manager needing data on client behaviour.
Data visualisation and contextualisation can provide business intelligence, leading to meaningful insights to reduce cost, minimise risk and improve client service. All that data is available - the challenge is to collect, normalise and present the information, accurately and in real time. There are tools available to do that, but investment is needed into reliable and modern databases plus configurable, user-friendly dashboards built using modern and flexible technology.
4. Finding Competitive Advantage
There are multiple services provided by custodians. Some are standard and expected to work with minimal delays and issues - trade instructions for instance, although critical, this process normally has high STP with minimal exceptions. However, where there are clients still sending a manual or analogue instruction, this needs to be intercepted and repaired, leading to manual work. Manual work of course results in increased cost and risk. The result of all of this is the burdensome maintenance of a technology platform plus added risk and expense from exception processing. For a standard process, there is little opportunity to add value or differentiate service – no competitive advantage to be achieved, but ongoing cost and risk.
A solution being considered by some custodians is to fully outsource this type of service where there is little competitive advantage. For example partnering with a provider for all areas of instruction capture (trades, cash, FX, funds, sec finance) to provide full technology and processing could be a viable and manageable solution. With this approach, the challenge of maintenance and introducing technology innovation such as AI to further automate is with the provider. The cost is mutualised across the various business lines and with other clients of the provider, so the custodian can focus on the true value added and differentiating services, such as Asset Servicing.
Outsourcing core and focusing on value add seems to be a sensible solution. This equally applies to some markets where $billions of assets are outsourced to a third party. A global custodian will have a network of third party agents providing custody in various local markets. This makes sense where the market is smaller or more complex. Custodians however are looking at major markets where they use a third party and considering if they should instead self clear through a proprietary local branch, and there are a number of reasons why this may make sense.
The custodians’ clients are institutional investors with a growing concern about corporate governance and improvements in local infrastructures. The investor wants to be sure that their service provider has a seat at the table in the local market and is able to advocate change for the better. This is less achievable if the local market activity is outsourced to a third party. A custodian who is also a member of the local CSD can be active in the local market by participation in local market practice groups and having a voice for change and improvement. The local market expertise that is therefore created is valuable to directly solve any issues or complexities.
Direct custody can also reduce risk for the custodian. Reconciliation used to be affected by comparing agent statements to internal ledgers and identifying any breaks. However, Custodians now need to also make sure that the Statements are accurate and the assets represented are also safely held at the CSD. This three-way reconciliation adds further cost. Of course, client service is also improved through Direct Custody – Settlement and Asset Servicing cut offs are improved as a link in the chain has been removed.
The key area for service differentiation is asset servicing – corporate actions, income and tax. Not only is this the key service differentiator for clients, asset servicing is also the highest risk process in a custodian’s operations. These processes are less automated than most, are highly visible to very discerning clients and can very easily go wrong – resulting in potentially large financial losses that can run to multi million dollars. Even with years of automation and additional controls, there are still corporate actions losses that make the headlines.
As a result, this is an area that receives a lot of focus. Industry groups regularly discuss ways to harmonise processes and reduce risk, but with the sheer variety of events that are often complex, there are still many challenges in finding a truly automated process that is competitive and safe.
A much discussed, but still unresolved solution is fixing the issue right at the start of the process. That is the event creation – when the event is first announced by the issuer. It is critically important for the custodian to be certain they have all the details of the event correct before sending to their clients. This involves gathering details from multiple sources, scrubbing the data to identify any conflicts, then fixing the conflicts before creating a ‘Gold Copy’. The process is costly, prone to error and adds delay to the end client receiving the information.
The key to change globally is harmonisation and standardisation of the data from the start of the investment chain, this being the issuers and the issuer agents. The standardisation of this data will facilitate automation and enhanced interoperability. Digital information generated at source removes the need for any additional sources and therefore any event scrubbing. This can be described as ‘Issuer to Investor, Digitised at Source’ and would be a true fix-all solution. The good news is that parts of the industry are making progress towards this solution. Two good examples of digitisation at source are ASX in Australia and SIX in Switzerland. In these markets, Issuers and Issuer Agents are mandated to publish event information in an agreed and machine readable format to the market infrastructure. This approach is also being advocated by industry bodies: ISSA in its recently published data-sourcing white paper, SIFMA with its corporate actions standardisation position paper and the Broadridge and DTCC proof of concept (sourcing corporate actions announcements from issuers and agents) that was announced in November, 2022. This traction needs to be maintained with the same solution being applied globally, adding significant benefit to investors and reducing costs for custodians.
5. Preparing for the challenge of digital assets
There is no doubt that digital assets are growing and fully expected to provide cleaner, faster and cheaper ownership through an immutable method of transfer. As such, custodians need to prepare and be ready for providing safekeeping and asset servicing solutions for these assets.
There are many types of digital assets, however for the custody of securities there are two key categories that need to be considered: tokenised assets and digitally native assets.
A tokenised asset is where the underlying security has been issued in a traditional format, then subsequently tokenised into digital form. The underlying nature of the asset hasn’t changed, but the method of transfer and safekeeping has been digitised.
A digitally native asset is where the original issue of that asset has been into a digital ecosystem.
As the digital assets markets continues to grow, the need for custodians to provide secure safekeeping for institutional clients becomes increasingly important. The challenges to this are maintaining the benefits derived from holding assets digitally, without compromise to regulatory risk and pristine controls. This isn’t just providing custody for both digital and traditional assets - custodians should also consider building or buying DLT solutions to allow assets to be tokenised and easily transferred. For instance, tokenising a debt instrument and facilitating repo transactions yields significant benefits to the investor and the service provider.
Adhering to any new regulations will of course be critical. The regulatory landscape for the custody of digital assets is still uncertain, but new regulations are to be expected. As such it would be prudent for custodians to engage with regulators for two-way discussions about which new rules are needed and how they will be applied.
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