Just six months ago, in my blog, I questioned whether the path to reality would start at Sibos Osaka. I saw four core issues for the industry to tackle, namely infrastructure design, industry profitability, risk management and technical standards. Several industry leaders had read the blog and supported the concerns expressed. Indeed, at least one of the panelists in the session I moderated in Osaka was nervously reading the blog for fear that he could be challenged on at least one of the issues during the session.
Six months on, I feel there has been little visible movement, other than on infrastructure, and that is disappointing. So having talked to colleagues around the industry on a non-attributable basis, do I feel that reflects reality? The answer is that there may have been more progress, at least at the top teams, than one would suppose from public declarations from their more publicity-hungry associates!
Profitability is under scrutiny, and there are signs that prices from the fund and broker-dealer community have bottomed out. Given the two basis point average return on global assets under custody and costs of around 1.25-1.50 basis points on average, this is not surprising. However, the responses are not universally good for all players. New sources of revenue in any meaningful quantum, from products such as collateral management, are being gained by the largest of the global players and the ICSD fraternity rather than across the market. But these flows are being countered by declining interest in stock lending and borrowing, driven in part by the expected capital changes in indemnified lending programs.
The move to central clearing of the OTC market is leading to added clearing revenues, especially for those with a strong footprint in the alternative fund sector, as is an apparent movement of funds away from non-commercial bank prime brokers to commercial bank-owned prime brokers or prime service providers. However, spreads on FX flows are under threat as greater transparency reduces alleged "gouging," whilst NII, both spreads and absolute returns, remain weak with interest rates showing few signs of moving off the bottom. In this light, cost is again under the microscope, with sub-custodian fees and investment plans being hit. And, more worryingly for business performance, headcount appears to be under attack, both at the high-cost expertise end and the more clerical worker bee community.
Risk is still preoccupying most of the industry leaders. There is a somewhat more relaxed reaction to the changes implicit in AIFMD and UCITS, with sub-custodian default risk being viewed against the almost zero loss experience of the last decade, excluding losses on rehypothecated assets following the Lehman affair. However, there is concern, following the initial ECB decision to include guaranteed (sub-€100,000) depositors in Cyprus banks in the "bail in," that perhaps assets under custody, even if ring-fenced in law, could be part of a future program. By my reading of AIFMD, there are grounds to suggest that this would not be custodian risk, but the reality is that judgment is based on a fair interpretation of the regulations rather than a political one. The cash management challenge, which was seen as a core problem, is now recognized to be manageable but only at a cost, and certain structures may in future find it hard to find a depository if their cash accounting is overly complex. But the financial cost of risk, both in terms of regulatory charges and internal control costs, is increasing rapidly, and the market does not appear to be clearly differentiating the different risks of different funds in their pricing. It could be argued that long-only funds are still somewhat overpriced from a risk perspective, and complex absolute-return ones priced too low.
There are interesting moves on infrastructure, but these are marginal. T2S has not yet propelled any of the small CSDs to review the value-added of their business models, and none of the ICSDs or larger custodians have come forward with any meaningful alternative to a national CSD. The concept I have proposed on many occasions, where the local CSD is limited to the notary function (to avoid requirements to change complicated national property laws) and local relationship management, whilst outsourcing all operations, does not appear to have gained any traction. The major moves are at exchange level and CCP level, with further evidence of a trend to consolidation, albeit these are of modest size. The LSE have finally agreed revised terms for a majority stake in LCH.Clearnet; Warsaw Exchange is in discussion with Vienna (although the target alliance appears challenging to achieve); and EuroCCP has merged with EMCF. The launch of the BNY Mellon CSD and the challenge from Monte Titoli to the ICSDs in their core international securities product are symptoms of a need for fresh thinking, perhaps, rather than major changes in market dynamics.
As for standards, these are still a struggle. Although some are using T2S as a means of moving to ISO 20022, we still have a plethora of standards and pseudo-standards with no means of ensuring the industry removes the inefficiencies and risks of communication protocols. This is an area apparently ignored by regulators, due to their own technical deficiencies, for they are usually lawyers or paralegals rather than process managers. And a major legal firm, when we were discussing the option of an operational data sheet in all new issues, expressed total conviction that standards were a major risk for the market as compliance indicated certainty, while legal documentation and definitions were carefully crafted to ensure constructive ambiguity.
So what do we need to move the market forward? I was interested how many firms, especially in the sub-custody sector, still measure their markets against the G30 standard. Not the highly detailed and somewhat over-engineered 2003 G30 standard, but the much more succinct nine recommendations from the 1988 report. Perhaps we need to consider a new report that has a manageable number of achievable recommendations with clear key performance indicators, a realistic timeline and regulatory support. That drove the 1988 initiative and was spoilt by convoluted language and studious ambiguity in the 2004 one.