Custodians Under Pressure Refocus on Middle Office Basics

Squeezed from the top and squeezed from the bottom.

It’s only natural that custodians and other asset servicing providers are feeling the pinch. A barrage of new regulations, shorter settlement cycle, new European centralized settlement platform on the one side and, on the other,  mounting client demands are forcing custodians to refocus their attentions on the basics — their middle office.

“They [custodians and other asset servicing providers] have been consistent in their efforts for the past decade, but have a lot more impetus to be successful now,” says Denise Valentine, a senior analyst with Boston-headquartered research firm Aite Group who has authored a new report on asset servicing providers entitled “Asset Servicing Firms: A Brief Q&A.” While industry consolidation may have raised the competitive stake for asset servicing providers, they must still walk a thin line between helping fund managers and other clients adjust to a new post-trade processing environment and operating within strict budgetary guidelines.

In practical terms, that means that custodians will have to cut overhead enough to ensure they can maintain solid margins, at the same time as they are adapting their services. “Given the low interest rate and regulatory challenges, custodians have no choice but to reduce their costs and become more operationally efficient,” agrees Justin Fuller, senior director of financial institutions research for Fitch Ratings in Chicago. Revenue streams and margin are already being squeezed to the bare bone as fees for basic safekeeping and settlement services decline.

Enhanced operational controls, increased efficiency through automation, increased productivity through better workflow processes and data integration were cited by the 22 custodian bank and fund administration firms surveyed by Aite Group as topping the list of priorities for change. And aptly so. Without a well-oiled middle office process, costly errors can occur in client reporting, data management and reconciliation — the three specific areas where the 22 respondents to the survey conducted by Aite want to spend more time and money. Needless to say, a good part of their concern is making sure portfolio valuations and risk metrics will be correct and settlement deadlines will be met.

Custodians and fund administrators — the most common types of asset-servicing providers — don’t have much time to react to regulatory change and there will be plenty of discussion about what they have to face during SWIFT’s annual SIBOS conference in Boston this week. Operations managers at three of the custodian banks on their way to SIBOS to display their services at the exhibit hall or participate in discussions took time to talk privately with FinOps Report. The consensus: they are spending most of their time in the near future looking for ways to differentiate themselves from competitors.

“We’re having a lot of internal talks about what relationship management specialists need to tell our clients about what we offer. At the same time, we’re reevaluating all of our middle and back-office workflow management and applications,” says one operations manager at a US-headquartered global custodian. Of course, such an analysis also includes technology specialists at the same table to determine whether or not existing applications should be replaced or simply enhanced. Given budgetary restrictions, improvements rather than a full-fledged revamping are the most likely outcome.

What’s New

Come October 8, over thirty European markets will shift to a two-day settlement cycle as a prelude to a new central European settlement system operated by the European Central Bank. Called Target2 Securities (T2S), the platform aims to reduce the costs of domestic and cross-border post-trade settlement. To do so national European securities depositories will be forced to outsource their settlement functions to the ECB between 2015 and 2017 and compete with local custodians on value-added services such as securities lending, processing of corporate action events, tax reclamation, and collateral management.

On their part, custodians will be prompted to compete head on by either creating their own securities depositories as in the case of BNY Mellon, teaming up with international securities depositories such as Euroclear Bank and Clearstream to solidify their market positions as asset-servicing providers, or even being more flexible in their informational offerings. Chicago-headquartered Northern Trust, for one, announced last Friday that it would rely on the family of Euroclear depositories to link to T2S and Deutsche Bank to provide additional asset servicing work for clients of the global custodian whose assets are held by by a Euroclear-operated depository. 

Worried about just how much risk they are absorbing for the returns offered, fund managers and other customers are looking for more than cookie-cutter information on their reports on portfolio assets. They want to slice and dice the data. So custodians need to offer top-of-the-line performance analytics and attribution down to the asset class and individual security or financial contract. And they need to do so on demand. Based on Aite’s survey, some are having difficulties doing so, as they still rely on manual as well as automated processes to handle ad hoc reports.

Regulators will likely want some of the same data offered to clients. As fund managers try to fulfill regulations such as FATCA, AIFMD, Basel II and MiFID, they will turn to their custodians and fund administrators for help. Those asset servicing providers will have no alternative but to dig into their applications to track down transaction data, position data, client data and reference data, so their clients can fufill their reporting obligations. Risk data topped the list of the most important data elements, generating a vote of about 62 percent of respondents to Aite’s suvey, with client data a close second at 57 percent and reference data at 43 percent.

The service providers are expected to insure the accuracy of the data, which is where data management comes into play. Just as fund managers and broker-dealer clients need to set up the correct procedures for managing the quality and consistency of data as it flows through applications, so do custodian banks and other asset servicing providers. Such data management typically requires selecting a chief data officer — or someone responsible — for data oversight, policies and procedures, and potentially consolidating securities masterfiles and counterparty data files into a more streamlined system.

Accuracy Counts

As a rule of thumb, the better the data management of the custodian bank, the fewer the number of discrepancies that will be uncovered during the reconciliation process — the matching of details between the books of the custodian and its external customers or even internal applications. It helps if all of the middle and back-office applications are linked so operations staffers don’t need to re-key information — a common way for incorrect data to find its way into client and regulatory reports. Regardless of the level of sophistication of their data management regimes, custodians and other asset servicing providers also need to implement solid reconciliation technology and procedures to ensure they catch any errors as quickly as possible.

Accurate data and reconciliation procedures are critical not only to ensure correct reporting, but to also meet a two-day settlement cycle. Should a custodian bank or other servicing provider receive and process incorrect economic and settlement details about a trade, there is a good chance, the risk skyrockets that it will fail to settle the trade on time costing both the third-party service provider and its clients time and money. Securities depositories will be fining their participants for transactions which fail to settle on time and even for those which aren’t matched on time. Those fines will likely be passed along to end fund manager customers.

All of the self-improvement on the part of custodians and other asset servicing providers might benefit their clients, but will be a double-edge for operations staffers. “I’m worried my bank could become so efficient it will reduce staff so my job could on the line,” one custodian bank operations manager at a US global custodian shop tells FinOps. “On the other hand, when the bank isn’t efficient it means I have a lot more work to do and my job will be a necessary evil.”