Custody Network Management: The Rise of the Super Risk Manager

Second article of our two-part series on third-party risk management. For the first article, click here.

Hands-on relationship manager. System Analyst. Recruiter. Negotiator. Risk Manager. Hatchet man.

Whoa! Too many job descriptions requiring far different different personalities and skills. They couldn’t possibly all be handled effectively by any single individual.

These are just a some of the roles that regulators and fund management firms seem to expect when it comes to custodian network managers. In fact, their employers load this position with a herculean number of functions in monitoring a growing number of local agent banks a lot more diligently than ever before.

Why has this position become so crucial and so overwhelming? The Alternative Investment Fund Managers Directive (AIFMD) and UCITS V have changed the rules of the network management game. Likewise, the boards of fund management firms are leaning on their custodians for reassurance, as they seek meet to their fiduciary obligations by ensuring investors are being sufficiently protected from possibly unscrupulous or slipshod post-trade service providers.

What are they worried about? Anything from a trade which fails to settle on time all the way to a lost or stolen asset due to the financial collapse or fraud of a local agent bank. However, it is the potential loss of a client asset which has global custodians worried the most. Until recently, they they didn’t have to fear being on the hook for lost assets through no fault of their own. Now, under AIFMD and UCITS V they are liable. Unless they can prove categorically that they did everything in their power to prevent such losses.

UCITS V and AIFMD open the door for alternative and traditional fund managers to benefit from the “marketing passport” offered by European regulators, but the funds are required to appoint depositary banks — typically global custodians — to do middle and back-office operations work. Global custodians have to be prepared for the new heavier legal onus that comes with the business. The result is an obsessive level of attention and a “guilty until proven innocent” approach to monitoring their downstream partners.

Ultimately, it all comes down to the global network manager to handle the workload and the task is mindboggling. A recent listing for a custodian network manager in an online recruiting site didn’t just list the obvious and already heavy responsibilities of tracking operations and performance of subcustodians and local correspondent banks, but also risk analysis and reporting to management and the board, publishing reports for fund managers, recruitment and price negotiations with potential new downstream partners, presenting at new investor meetings and regulator meetings, and advising a range of internal departments. The most unpleasant task — recommending that subcustodians that don’t make the grade get fired.

The Big Twist

Arguably all that is still pretty straightforward, even if it doesn’t allow much time for sleep. Where it becomes complicated is how the international vagaries of  indirect registration of assets and their segregation play out in worst case scenarios. The issue: just who “owns” the cash and securities and can access them quickly enough if a local agent bank goes bust.

In most countries, local agent banks hold the accounts on behalf of the ultimate fund manager in the name of the global custodian through a single omnibus account. Local securities depositories, in turn, hold accounts in the name of local agent banks. Given the so-called omnibus form of account ownership, proving the rights of fund managers can become problematic. Just as nerve-wracking, anticipating what bankruptcy trustees and administrators appointed by local courts will do when it comes to reconciling the books of the failed local agent bank and returning assets to the fund management firm. It could take months if not years depending on local laws and whether or not the ownership of the assets is disputed.

The result: gone are the days when a network manager simply meets and greets counterparts — at a local agent bank or depository — with a handshake and taking their word that they are fulfilling their operational obligations and are on solid financial ground. “Given that the network manager is the bank’s front line of communication with fund managers and local agent banks it stands to reason that he or she has to be an effective communicator, negotiator and even risk manager,” explains Paul Chapman, managing director of executive search firm HornbyChapman in London. “Historically, network managers were always plucked from the ranks of custody operations departments, but the word risk now needs to appear on their resumes.”

Risk Literacy

The most qualified network manager must also have worked in an operational risk, credit risk or even compliance department. Simply understanding custody operations — how trades are processed — won’t cut it, because post-trade processing glitches are just the tip of the iceberg in what global custodians must address.

Global network managers naturally insist that they always pick the best local agent banks and monitor them carefully. After all, those are the banks which are members of local securities depositories and offer an array of value-added services beyond simple safekeeping. “Global custodians verify and ensure that their local agent banks are financially and operationally robust. We focus on credit, commitment, client service and cost, ” says Emmanuelle Riess, director of network management for the Americas at BNP Paribas Securities Services. “That verification involves onsite visits and in-depth reports.”

Such verification doesn’t end after the contract is finally inked. In addition to occasional in-person visits, network managers may once have relied heavily on the reports sent by the local agents to reflect the number of trades which are settled on time, or fail to settle on time as well as any changes to deadlines for settlement instructions, or any glitches with cash transfers, securities lending transactions, voting instructions or corporate actions.

Global network managers will likely continue to read those reports, but now also will be looking for more information about “events” — what went wrong, who was at fault and how it can be prevented in the future. After all, neither the global custodian nor the local agent bank can afford to overlook a hint that more operational problems may be on the way.

“The global custodian doesn’t want to be called on the carpet by any fund manager wanting to know why its trades in a particular market aren’t settling on time, why cash or securities were sent to the wrong party, why its election on a voluntary corporate action didn’t make its way to the issuer, or why its vote for an overseas meeting didn’t find its way to the foreign corporation,” says one UK fund management operations manager.

Shadow Accounting

Next up: verifying the creditworthiness of the local agent bank and the cash left with the local agent bank. Network managers need to constantly stay in touch with credit risk analysts to ensure they don’t miss the warning signs that the local agent bank is tanking and to ensure that they don’t exceed the agreed-upon credit line limits.

Network managers also need to keep track of the credit exposure to a local agent bank based on intraday and overnight credit lines, each of which have a different bearing on the use of the global custodian’s capital. Rule of thumb: the riskier the local agent bank and the larger the intraday and overnight exposure, the higher the global custodian’s cost of capital.

Last but not least: ensuring that the local agent bank has sufficiently protected the assets and cash of the ultimate fund manager by “segregating” or separating them from its own assets. Although it might sound like an issue to be handled strictly by a legal or compliance department, it is also dumped on the lap of the operational risk manager who will have to reconcile the holdings and transactions of the accounts at the global custodian with those of the local agent bank. Hopefully the books will match up, because if they don’t, both the global custodian and local agent bank will have to find out who is wrong and correct the error. The discrepancy could be the first warning sign a fund manager’s assets are lost or stolen.

Legal segregation will also involve understanding periodic statements — or attestations — from the local agent bank that the cash and securities of the fund management firms represented by the global custodian are held separate from those of the local agent bank.

Pruning the Dead Wood

The endgame: “The global network manager must ultimately interact with credit risk, operational risk and legal departments on a continual basis,” explains Giles Elliott, managing partner of AlfaSec Advisors, a consultancy specializing in global custody operations in Singapore. “It stands to reason that the global network manager will monitor a range of reports from his colleagues and local agent banks on a daily basis.”

Riess says that network managers at BNP Paribas Securities Services will review the same factors after the contract is signed as it did during the due diligence process: creditworthiness, commitment, market strategy, client service and cost. They want to see evidence that the local agents intend to stay in the securities services business, such as continuing investments in their operating systems, technology, customer service and reduced staff turnover. Of course, the global network manager is also responsible for recommending that the plug be pulled on the relationship with the local agent bank that becomes worrisome in operational performance or financial stress. Given that the legal liability for the global custodian bank is so high — as is the cost of replacing the local agent bank — the decision will likely be a team effort. The global network manager, the operational risk manager, credit risk manager, legal department and compliance will all sit at the same table to decide whether or not a divorce is in order.

Those are the same players who periodically meet to talk about just how well the local agent banks are doing. Such pow wows, which might previously have taken place on a quarterly or semi-annual basis before are now as frequent as every two months or even monthly, global custodian compliance managers tell FinOps Report.

How Much is Enough?

With so much at stake, the global custodian bank also has to make a tough call on how much it should tell the fund manager client about its activities. “Following the rules of AIFMD, we provide them with information on the financial and operational soundness of our local agent banks through a scorecard in which we monitor risk performance indicators,” says Riess. “However , that’s not an easy task considering the variety of questions asked, so we have to make a decision on how much information to provide.”

The most critical question posed by fund managers — and the one apparently posing the most difficulty for global custodians — is “Just how are you protecting my assets.”

Neither regulators nor fund management firms are willing to take for granted that the global custodian has selected the most financially sound local agent banks and has an adequate grasp on operational and legal issues. In particular, the global custodian will have to prove that it is verifying that the cash and assets are appropriately ring-fenced and quickly accessible in the event something goes wrong.

“It is not difficult for the network manager to explain that the assets are segregated, but it is difficult to explain what legal protection segregation offers as it often depends on the laws of the local market where the assets are held,” says Sandra Holmqvist, global network manager at SEB in Stockholm. “The word segregation can easily be interpreted differently than intended by the local fund management firm if the overall account structure in the market is not explained correctly.”

Case in point: a segregated account to hold assets belonging to one client opened by the global custodian with a local agent bank is not the same as a segregated beneficial account but both accounts are referred to as segregated accounts. Network managers need to be careful to explain to fund manager customers that the phrase segregation used in reporting may not be the same as segregation for the sake of investor protection.

What About Outsourcing It?

Given the role of global network management has become so onerous, it stands to reason that global custodians might want to just pass on the responsibility to the custodial services of one of the mega international securies depositories. But even that might not be a panacea. “We are governed under Luxembourg law and follow its rules governing how we ensure the safety of client assets,” explains Godefroid Lamboray, head of network management for EMEA and APAC at Clearstream in Luxembourg. The law doesn’t specify just what Clearstream must do, but it does require Clearstream to prove it has properly selected and monitored its subcustodians.

The potential for losing the assets of a global custodian or broker-dealer member is mitigated by what Lamboray’s colleague international network manager Russell Callaway calls such “vigorous” oversight, including frequent onsite visits. Their frequency depends on the value of assets held at the local agent bank. Clearstream will also provide its global custodian and broker-dealer members with internally audited and externally audited “attestations” it is doing its job to the hilt.

But when it comes to answering the most important question: what will Clearstream do if a local agent bank loses a client asset, its response is telling: it has never faced such a scenario. The opinion of one New York securities law expert familiar with international depository practices is that it’s questionable whether global custodians or broker-dealers would be reimbursed, because it depends on local contracts. “I tell my fund manager clients that if their global custodian or broker-dealer is holding their assets at an international securities depository, not to hold their breath if something goes wrong at the local agent bank level,” he tells FinOps.

Whether they do it themselves or rely on an international securities depository for network management, global custodians are not going to have an easy time reassuring fund managers, who face far more rigorous scrutiny from their own boards of directors. The fact that there are inevitable uncertainties doesn’t help.

“There is no foolproof answer to what will happen in the event an asset is lost by a local agent bank or local securities depository,” one compliance manager at a US fund management firm tells FinOps. “Rather than depending on what the global custodian tells us, we are also doing our own homework.”

How much homework? Apparently everything they can think of. “We ask the global custodian to provide us with extensive operational and legal explanations of how trades are processed at the local agent bank and securities depository, how cash and securities are segregated, and in whose name accounts are registered,” says the compliance director of a European fund management firm. “We then ask our own operational and credit risk departments for their opinions. Last but not least, our external counsel comes to the table to explain foreign laws and what they mean to asset ownership and investor protection.”

For global custodian network providers, the extra stress has just become part of their everyday life. “It’s all in a day’s work now,” says one global custodian network manager. “If I ever quit this job, I can always become an air traffic controller.”