Survival Means Cutting the Cost Base!

 At pretty well every conference I go to, or avoid, there is a topic about the need for the custodian to reinvent themselves. The consensus appears to be that such a metamorphosis will be achieved by custodians becoming fully fledged members of the digital economy, or by them transforming into risk businesses

At pretty well every conference I go to, or avoid, there is a topic about the need for the custodian to reinvent themselves. The consensus appears to be that such a metamorphosis will be achieved by custodians becoming fully fledged members of the digital economy, or by them transforming into risk businesses or, alternatively, creating “cradle to grave” securities life cycle services. The paradox, other than the conflicting nature of the different options proposed, is that the most logical answer for the future is a solution that embraces each of these and more.

And, worryingly, with a few exceptions, many in the industry appear to be in total denial of such an eventuality. Several of the proposed SIBOS Singapore sessions talk around a re-engineering of production and that is inevitable. I have often, in the past, commented on the profligacy, in an industry with a bloated cost base, of the huge duplicative effort undertaken in each organisation, or even multiple times within organisations, to achieve an objective allowing little, if any, service differentiation. To this has to be added the challenge of risk management. Our industry is still treating intraday risk as a marginal by-product, despite the growing constraints of Basel III. And some of the preferred solutions to that regulatory change are dangerous as they imply potential market settlement gridlock. We have, furthermore, to recognise the collateral albatross around our necks as more markets move to secured settlement and more transactions require prime collateral support. We have to ensure that we do not create impossible risk pockets for contingent liabilities, a frightening consequence of the regulatory, and often poorly understood, maelstrom that has hit the markets. And we have to recognise the need to work with infrastructure oligopolies, current or future, for they will be an integral part of the survival kit for the industry; they are not the enemy within as so many have depicted them.

Some years ago, I commissioned work to identify what could be outsourced to a remote location given the challenge of operating securely in many OECD markets. I was looking for cost arbitrage but also skill arbitrage, given the ready availability of qualified people in many offshore locations. It was clear that few functions within our business could be entirely outsourced. It was also clear that 90% plus of each function operated according to a rule book with limited multiple choice options. Only as the functions became over-complex, perhaps a new issue without a formal ISIN, perhaps a stock price which exceeded acceptable parameters across different pricing sources, perhaps a client instruction which was incomplete or the odd mind challenging corporate event was there the need for intervention by experts or communication with a client service person. In other words, as long as the exception process was well defined, most functions could be relocated. The implications of such a rule based outsource proposition are huge. It implies that the bulk of securities processing is an effective commodity, and it is primarily corporate and technological architectures that create the risks. Just as market settlement or the notary function was outsourced to the CSD community, and just as in T2S each CSD has little need for its own dedicated settlement module for eligible T2S securities, there is a pan industry multibillion dollar infrastructure and process out there where differentiation is a product of individual organisation inefficiencies. Obviously there is transfer risk in any platform change, but the challenge is worth taking. I would suggest we are talking of the ability of the industry to provide service excellence and, on my high level calculation, do it alongside 30-40% plus cost reduction as we remove redundancy and gain scale benefit.

The risk management challenge is harder to manage. The solution, as some have suggested, is not in a move to trade by trade settlement in CSDs, albeit that is a palliative. Liquidity will always be needed. Auto collateralisation is of extreme value in entities with large government securities principal trading positions. But there are two critical changes needed in process. The first is to broaden the collateral pool and the second is to amend the law to ensure that a lien exists with each intermediary for transactions in the course of settlement. But the collateral pool needs also to be reassessed. There is a danger that current haircuts are based on relatively short term performance criteria rather than performance at times of extreme stress. We all know that collateral works in normal markets but it has to be robust enough to work in extreme conditions when normal daily market deltas change from the odd percent and may move into double figures while givers of collateral play it safe by calling back assets. And regulators must give more guidance around the ambiguity for liability. It is immoral that they play on the fear factor of the takers of risk, who prefer silence rather than sanity around the wipe out risk potential of much of the recent liability arbitrage promoted by new regulation.

There have been many sound moves in recent years. There are still too many of them, but the creation of Trade Repositories is a right move although there is a risk that they become data depositories rather than an engine for regulatory oversight aiming at curtailing excess systemic risk. The SWIFT KYC initiative is a good start although there is plentiful scope for expansion of that service. There is a need for infrastructures to grasp the nettle of securities and legal entity data repositories and drag much of that technical backwater into the 21st Century! There is a need for digitalisation of the value chain, and, especially, as will be discussed in one session at SIBOS, the issuer to investor leg.

But these are components and each player in the market should seriously look at their entire processing environment and ask why they are doing it, whether they could change their model as well as the value propositions potentially on offer.