The use of artificial intelligence appears to be an elusive ideal, acknowledge panelists and attendees at a recent global custody event in New York hosted by The Network Forum, a London-headquartered networking group for custody specialist worldwide. Instead, the drudgery of creating and sending local agent banks dozens if not hundreds of questions and manually reviewing all of the answers is the accepted norm.
Does it have to be? Not if global custody network managers have their say. The problem is that no one seems to know what it will take to push C-level management to make the necessary investment in artificial intelligence that could cut down on the manual oversight workload. “Due diligence and monitoring of local custodians is a cumbersome challenge and we don’t expect our banks to invest in any new technology to help out,” bemoans one global custody network director at the private event hosted by The Network Forum where panelists spoke with FinOps Report strictly on condition of anonymity.
The only solution offered by one panelist at a European-headquartered global custodian was for major accounting firms to certify subcustodians as legit. However, neither he nor other panelists could explain how that alternative would work considering that global custodians retain legal responsibility — and liability– for monitoring subcustodians.
Apparently, global custodians either haven’t figured out where to spend the money on implementing artificial intelligence for conducting due diligence on their local agent bank partners or whether the cost is worth the return. An impromptu survey of attendees at The Network Forum-hosted gathering showed that only seven percent had considered using artificial intelligence in their due diligence process. When questioned by a panel moderator, none of the attendees was willing to confess taking any initiative.
The hesitancy to change the old-fashioned blood, sweat and tears involved with network management is understandable considering how much is at stake. The primary responsibility of global custodians is to protect investor assets under their roofs and those of local agent banks or subcustodians. In some cases, the local agent banks could be branches of global custodians, while in others they are unrelated service providers. Regardless, global custodians don’t want to deal with legal or financial liability if their own branch or third-party entity loses client assets due to bankruptcy, embezzlement or a cybersecurity breach.
Some global custodians are starting to rely on sending prospective local agent bank partners a due diligence questionnaire created under the auspice of the Association of Financial Markets in Europe, the London-based counterpart of the US Securities Industry and Financial Markets Association. Yet despite all the praise network and operations managers at The Network Forum-hosted event heaped on the AFME for standardizing the due diligence process they were quick to point out that the number of questions on the organization’s questionnaire just keeps growing.
In January 2018, the AFME announced that it would add twenty more questions to the earlier 2016 version of the questionnaire to allow firms to avoid sending a “sizeable addendum” of extra questions. (The full set of questions can be found on www.afme.eu). Still global custodians, particularly US-headquartered ones, tell FinOps Report they will likely still have to add their own list of questions required by either risk, legal or operations managers to match local regulatory requirements. The AFME would not disclose the number of global custodians using its questionnaire on the grounds it doesn’t keep track of that data.
If comprising questions to ask subcustodians were hard enough, analyzing the responses can be mindboggling. The 80/20 rule applies: twenty percent of the responses generate eighty percent of the review by a village of experts. The follow-up questions, attendees at The Network Forum-hosted event told FinOps Report, typically involve how subcustodians segregate client assets from their own, fulfill anti-money laundering rules for customer onboarding and prevent cybersecurity attacks.
Global custodians might spend a lot of time picking their new partners based on criteria established by risk management, finance. legal and operational boards which create specific capital and operational requirements. However, global custodians appear to be more lax when it comes to their oversight of local custodians, acknowledge network managers at The Network Forum-hosted event. Switching subcustodians can be so costly that global custodians might be willing to look the other way for small errors that can be immediately corrected.
Global custody network managers may even be too eager to take whatever their peers at local agent banks say at face value, because they don’t have the time to verify all their responses. “Annual visits remain the norm and global custodians sometimes rely too much on what subcustodians inform them about local market conditions,” recalls Carl de Lisi, a former global custody manager at BNY Mellon who now advises investors on distressed assets.
His recommendation: network managers at global custodian shops need to lean more on centralized data managers to keep track of local market changes that can affect investments. Those data governance specialists can mine through news clippings, newswire services and other sources of data to uncover anything from new registration or operating controls at national securities depositories to nationalization of a major bank or company. Trust but verify should be the motto, says de Lisi. Yet not all global custodians actually have centralized data analysis groups. BNY Mellon and State Street were cited by attendees at The Network Forum-hosted event as being the most likely. Some global custodians rely too heavily on network managers to do the necessary information tracking.
One area of particular concern to some custody operations experts is that of taxation. Even if global custodians were always able to correctly keep track of changes to double tax treaties or tax laws of foreign countries, they need to pay closer attention to the withholding tax capabilities of local agent bank partners. Mistakes in calculations– namely over-withholding– can easily end up eating into fund managers’ performance results.
At a minimum, global custodians should ask prospective local agent banks about whether they offer “tax relief at source” or calculate and withhold the correct amount of tax at the time an income or dividend payment is made, according to Len Lipton, managing director at GlobeTax, a New York firm specializing in withholding tax operations outsourcing for custodians and institutional investors. Investors would prefer receiving the proper tax rates up front rather than having to rely on their global custodians to help them navigate the cumersome process of asking foreign tax authorities for tax refunds on their behalf.
As a rule of thumb, global custodians offer withholding tax processing as part of their overall custody responsibilities. Yet in order for clients to benefit from “tax relief at source” they must provide their global custodians with the correct documentation of entity status and domicile as explained in manuals ranging from two hundred to five hundred pages long. The specific documentation required is set by each country of investment and the requirements of the subcustodian operating in that market. Even the best-written manuals may contain instructions that have not been updated, according to Lipton.
Not all local custodians will offer tax relief at source for global custodians whose clients’ assets are held within omnibus accounts. “The subcustodian won’t want to bear any risk or additional work involved in moving accounts based on each client’s entitlement to different rates of withholding tax,” explains Lipton. “Some subcustodians will require that the fund manager’s accounts be registered in the name of the underlying fund, which could end up costing the fund manager higher custody costs.”
Given the enormous amount of data that global custodians have to analyze when it comes to selecting and monitoring subcustodians, artificial intelligence seems like a likely alternative to old-fashioned gruntwork. Artificial intelligence can help global custodian network managers and other executives scan information far more quickly and effectively than humans by finding and discovering a string of words that identifies the required answers.
Using artificial intelligence might not be feasible when it comes to selecting a local agent bank, but it could be when it comes to the subsequent review process. “There is too much analysis that must be done from scratch and decisions can be subjective, explains de Lisi. “However, a global custodian can code a rule set that contains the desired responses and recorded answers that had been provided to other RFP/RFI responses.” When the algorithms used discern changes between responses to due diligence questionnaires from one year to the next, data governance teams can bring network managers, risk managers and legal departments to the table for further review of the local custodian.
Yet another potential use of artificial intelligence for global custody network managers, says de Lisi, is monitoring geopolitical activities such as tax changes which could affect investment returns. Some countries, such as Japan, require exchanges to add a tax on the purchase price of an equity for foreign investors.
Every bit of extra information helps guarantee customer satisfaction in a competitive industry with dwindling margins. “Global custodians often learn of market changes after a customer complains or when everyone else does,” says de Lisi. “Being the first to know provides a global custodian with an edge to better monitor its subcustodian and grow the global provider’s assets under custody.”
Lipton suggests that artificial intelligence might be used to help reconcile data discrepancies between the records of global custodians on beneficial asset owners and those of local and foreign tax authorities. Such reconciliation could ensure the correct withholding tax is applied to investor accounts up-front when income or dividend payments are made.
Global custody operations managers at The Network Forum-hosted event tell FinOps Report that some custodian banks are investigating the use of artificial intelligence to reduce research time. State Street, for one, has publicly disclosed that it uses artificial intelligence to determine which research reports analysts should review.
What will it take for the global custody industry to adopt artificial intelligence at a more comprehensive level for more effective network management? One forward-thinking global custodian might do the trick.