If fund managers can outsource middle and back-office operations and even trading desks, why can’t global custodians outsource network management due diligence and monitoring?
That’s the question over a dozen former global custody network managers who spoke with FinOps Report over the past month are asking as concerns mount that the COVID-19 pandemic could eventually prompt banks to start slashing budgets. Network management is a cost center and chief financial officers might eventually wonder whether retaining the entire task in-house is worth the effort and expense as revenue generating units, such as prime brokerage, are starting to balk at allowing the costs to lower their bottom lines. Depending on the size of the bank’s global network and the number of network managers involved, the annual costs savings relying on a shared service model could easily come to over US$1 million. That’s not including additional savings from replacing annual on-site due diligence visits with virtual visits which could amount to over US$500,000 annually for a large global custodian. Fund managers are also beginning to wonder whether they are getting their monies worth paying for all the work due diligence network managers perform in overseeing local agent bank relationships.
“The shared service model for custody network management can provide a balance between cutting costs through redundancies and providing better data analysis to decision-makers,” says Gregg Sisco, managing principal of Global Network Management Services, a Monmouth, New Jersey based startup specializing in network management due diligence and relationship management. “Network management teams could be reduced to core groups to digest and review the data analytics.” Ideally, those analytics should be provided in real-time rather than on a quarterly or semi-annual basis particularly as operational delays and glitches can occur more frequently if staff works remotely as highlighted during the pandemic. Global custodians aren’t willing to publicly specify what problems occurred, but there is plenty of industry talk that the number of trades which failed to settle on time increased by at least twenty percent in March and April for some local custodian banks in Asia, including India. The two-fold reason: trade volumes spiked by over 50 percent and offshore processing centers were temporarily shut down with no back-up sites immediately available.
Local agent banks, otherwise known as subcustodians, are critical to the investment operations process for asset managers and owners. Fund management firms hire global custodians to safekeep their assets domestically and overseas. Those global custodians also help perform a number of other tasks which fall within the broad range of asset servicing functions, such as clearance and settlement, dividend and income payments, voluntary corporate actions processing, tax reclamation, securities lending and borrowing, and proxy voting. Global custodians rely on local agents outside of their home markets to handle all of the settlement and other operational work as members of national depositories, thereby becoming the eyes and ears of the global custodians on the ground working on behalf of its fund manager and asset owner clients. Some global custodians–namely Citi– rely primarily on their own branch offices to perform the role of agent banks, but most such as BNY Mellon, State Street, Brown Brothers Harriman and Northern Trust, use third parties. BNP Paribas Securities Services, among others, relies on a combination of third parties and its own branch offices. (Citi does depend on some third-party agents in over a dozen markets, but the volume of processed transactions in those markets represents less than five percent of total global transactions, say industry sources). HSBC, Standard Chartered, and Citi are often cited as the largest regional players with HSBC and Standard Chartered dominating Asia and Citi dominating Latin America. BNP Paribas Services, once known for its work in Western Europe, has expanded its reach to the US, Australia and Latin America while HSBC remains top dog in the Middle East.
Network management is the industry buzzword used for a plethora of tasks ranging from keeping track of local market regulations and changes, monitoring local securities depositories, hiring a bank when entering a new market, or keeping track of the performance of an existing service provider. The analysis typically includes operational and financial metrics which are reviewed with credit, operations, risk, financial and legal departments. Network managers are typically the middlemen sifting through all the information. “The influence of network managers varies depending on the bank,” says Alan Cameron, the London-based head of broker market strategy for BNP Paribas Securities Services. “In some cases, they are the decisionmakers, voting on when to keep or fire a subcustodian, while in other cases they are simply information transmitters, and in others they have a say in the decision,” he explains. BNP Paribas Securities Services relies on a validation committee of decision-makers comprised of members of the network management steering committee representing the depositary and fiduciary units as well as compliance, credit risk, operations, custody solutions, cash management and liquidity departments.
Network managers are typically promoted from within from middle and back-office operations departments as most of the due diligence and monitoring work requires a solid knowledge of post-trade operations. The review process for local custodians consists of hundreds of pages of questions, annual on-site visits, and continual phone calls and emails. Rather than craft their own due diligence questionnaires, most global custodians are relying on a boilerplate 500-question questionnaire devised by the London-based trade group Association for Financial Markets in Europe (AFME). Even so, global custodians will still add several dozen questions of their own in supplemental questionnaires typically focused on local market regulations on asset segregation and customer protection. At issue is that everyone agrees that most of the due diligence questions can be standardized, but no one seems to agree on whether to have the responses evaluated in-house or by a third party even though most of the responses are in a yes or no format. Changes to the responses from the previous questionnaire can often prompt more discussions with legal, operations, risk and credit teams.
So far, the London-based firm Thomas Murray appears to be the only game in town when it comes to offering the full spectrum of outsourced network management oversight. However, of the firm’s total of 44 global custodian clients, only eight — with the newest being National Bank of Greece– have taken the leap to ask for all the due diligence and oversight work with the exception of compliance, business negotiations, and relationship management. The full monte means that Thomas Murray’s network management department will do all of the on-site visits, ask all the questions, process the responses and grade the local custodian based on its operational efficiency and financial strength similar to how a rating agency grades a municipal or corporate debt instrument. The top score is a triple A. Thomas Murray’s analysis will also include an explanation of what the local custodian needs to do to improve its rating. The remaining 36 global custodians using Thomas Murray count on the service provider for more limited tasks such as analyzing local markets or sending out due diligence questionnaires. Sisco, the former head of global network management for Citi and Morgan Stanley, says his firm will also handle due diligence, risk management and performance management on agent banks and markets.
“Thomas Murray will be performing the monitoring of our global custodian and international central securities depository counterparties and the underlying network of subcustodians for the 30 markets we service,” says Christos Garoufalis, head of custody network management and development for the Treasury and investment operations division of National Bank of Greece in Athens, “The monitoring service will include detailed risk and capability assessments accessed via Thomas Murray’s market data platform and risk rating reports supported by news flashes.” He insists that cost savings was not the motivating factor behind his bank’s decision to outsource its due diligence and monitoring work as costs in some cases will actually increase. Instead, National Bank of Greece’s staff of six network managers can now spend more time focused on servicing clients, establishing new products and streamlining processes. Additional benefits include the assistance on keeping up with changing regulations, technology and compliance requirements. “While compelled to reevaluate our operating costs and balancing all our business variables at the end of the day we decided that our main objective remained to safeguard and support our clients’ interests at all costs,” says Garoufalis.
The larger the global custodian, the higher the cost savings to using a shared service, but the less likely the bank will be amenable to a full-blown offering. “Maintaining personal relationships is critical,” says Cameron who also represents BNP Paribas Securities Services as chair of the AFME-sponsored task force designing its standardized due diligence questionnaire. “Those relationships are critical in case of an operational glitch which needs correcting and it is unlikely that more banks will still want to outsource the entire due diligence process.” Yet another explanation given for relying on network managers is that monitoring local agent banks also incorporates advocacy work in promoting changes to local regulations to ease foreign investor entry. Thomas Murray does keep daily updates on economic and regulatory changes in each market, but falls short of lobbying regulators specifically on behalf of clients.
However, the COVID-19 pandemic has hampered, if not eliminated the potential for overseas travel so such lobbying work is starting to dissipate. Global network managers are now far more focused on doing the basics to ensure the local custodian is up and running and can do all of the required operational work. Ross Whitehill, chief executive of Thomas Murray, acknowledges that his firm has temporarily halted on-site visits as some countries are prohibiting international travelers altogether and others are requiring two-week quarantines making any work infeasible. “We are relying on more documentation and asking for screen snapshots to prove holdings, position reconciliations and segregation of cash and securities positions,” says Whitehill.
Fund management operations and compliance executives who spoke with FinOps Report also say that a common defense made by global custodian network managers in retaining their network management teams is that the due diligence they perform is their secret sauce. They allegedly do it better and more effectively than their rivals. However, as buy-side executives note, in some markets there are only a handful of subcustodians to choose from while in others a single bank might dominate the market. “What kind of due diligence can a global custodian do when Citibank is really the only game in town,” quips one fund manager operations director referring to South America.
Yet another operations director at a fund management firm questions whether a global custodian can actually be trusted to do due diligence on its own branch office. Whitehill says that his firm is now being asked by some global custodians — he wouldn’t say which ones — to evaluate their own branch offices to ensure an independent oversight process. BNP Paribas, for one, confirmed that it uses Thomas Murray to perform global market intelligence and subcustodian surveillance on 25 out of the 90 markets serviced in which it uses its own offices.
However, even if shortcomings are uncovered global custodians won’t replace their branch offices with third parties. “There has not been an instance in which the branch office is switched for a third-party custodian based on the required improvements being made.” admits Whitehill. Sisco acknowledges that even in the case of global custodians using third-party local custodians, replacing one subcustodian for another is rare having occurred only three times during his tenure at Morgan Stanley. “It is a lot easier to have the existing provider fix its problems rather than switching to a new agent bank,” he says. “The biggest issue is just how many banks relying on their own brick-and mortar branch offices are actually using third-parties to evaluate their services.” Sisco’s answer: too few. “From the outside looking in, it’s probably in the bank’s best interest to have its branches and subsidiaries evaluated by an independent arms length third party provider to avoid a potential conflict of interest,” he says.
Some former global custody network managers predict that automating the due diligence review process is one alternative to reducing the number of network managers. Artificial intelligence, machine learning and distributed ledger technology are being discussed at behind the scenes at most of the largest global custodians, they say, but no one could specify just which bank had made any progress. State Street was cited by several fund managers who spoke with FinOps Report as being the most advanced with data analytics in its network due diligence process. “While we have worked hard to ensure a highly efficient due diligence process we are in speaking with our providers across our subcustody network about the feasibility and benefit of implementing artificial intelligence to make further enhancements to the process,” says BNP Paribas Securities Services’ Cameron.
Twenty years ago Bank of Bermuda, now part of HSBC, was the first bank to select Thomas Murray to perform all of its network management and due diligence analysis for local agent banks based on cost-savings, expertise and operational efficiencies. While there have been intermittent industry rumbles that outsourcing using a shared business model is the way to go for the short-term network managers appear to be still in demand. “It’s something global custodian banks are talking about more now,” says Whitehill.
Whether or not the coronavirus pandemic becomes the final impetus for global custodians to move to a shared business model of outsourcing network management remains to be seen, but it is certainly worth considering. It could end up being a topic of heated debate at The Network Management Forum’s virtual summer meeting from June 29 to July 2.