Contingency networks needed to guard against sub-custody default

Global Custodians may need to maintain contingency to deal with risks of default, NeMa conference hears.
By Charles Gubert

There was debate at NEMA Dubrovnik 2016 as to the extent to which global custodians ought to maintain contingency networks to mitigate the risk of a sub-custodian default.

The Alternative Investment Fund Managers Directive (AIFMD), UCITS V and guidance from the International Organisation of Securities Commissions (IOSCO) stipulate custodian banks should have contingency plans in place for the sub-custody or corresponding banking network. “Asset safety and assurances against any sort of adverse impact at a bank is a key criteria for many clients and regulators. Regulations such as AIFMD and UCITS V require custodians to establish a back-up plan to guard against the risk of a local provider exiting a market or ceasing to exist for any reason. Most firms will operate a contingency network,” said Bettina Janoschek, head of GSS sales and relationship management at Raiffeisen Bank International.

Institutional investors have urged custodians to ensure contingency planning is maintained. The bulk of attendees at NEMA confirmed in an improvised poll that they had contingency plans in place. “It is very important our global custodians maintain a contingency network. It will be a difficult conversation for us to have with our board if we have to divest our assets in a market because a sub-custodian has discontinued market coverage or gone insolvent. As such, the importance of a contingency network should not be underestimated. In addition, having multiple providers and accounts set up for different funds can help improve the accuracy of information supplied to investors about any given market,” said Moulik Shah, assistant vice president for investment operations at Capital Group.

Different custodians adopt different network contingency planning mechanisms as a means to quickly port business to another provider. A “cold” contingency plan would typically involve a custodian alerting an agent that they are their standby provider but will not have a sub-custody agreement negotiated and signed nor any account opened. This would mean that business could not be ported quickly at a trigger event. A “warm” contingency plan may be a scenario where the custodian has agreements signed and accounts established with a secondary sub-custodian provider enabling the transition to occur. A “hot” contingency plan would see the custodian utilising two custodians in a single market. This would allow rapid switching in the event of one of the custodian’s agents being incapacitated or impacted by a risk event.

“We do not operate dual services in different markets as we do not have the volumes but we do look for medium solutions where we can have a back-up plan in place. If something happens, we can move over to another provider,” commented Michael Arup, global head of network management and CM Partner Banks at Danske Bank. However, this is not always straightforward in certain jurisdictions – particularly frontier markets – where alternate providers are not available; the credit quality of the providers is substandard; or the service offering is not in line with international best practices.

Again, there is the matter of cost. Operating a “hot” contingency plan comes is not cheap. International investors including fund managers are facing numerous regulatory overheads including AIFMD, the Foreign Account Tax Compliance Act (FATCA), the European Market Infrastructure Regulation (EMIR) and the Markets in Financial Instruments Directive II (MiFID II) as way of example. Fund managers – some of whom have struggled to deliver quality performance – have faced fee pressure from investors.  As a result, fund managers have sought to push down service provider – especially custody – fees.   It is therefore unlikely that fund managers will want to incur the additional costs if their custodian operates a bespoke and sophisticated contingency plan across its network.

One market participant acknowledged, however, that “hot” contingency networks would be prohibitively expensive, and custodians may be reluctant to shoulder the costs. Establishing “hot” contingency networks across multiple markets would add to “ridiculous” additional costs added the participant, especially if they were being set up in markets where segregated accounts were the norm. Shah acknowledged fund managers would resist paying for the additional costs, citing a contingency network was a mechanism by which to protect assets which is a core function of a custodian. He added that any custodian operating a robust contingency network or shadow network would be at a strong competitive advantage.

An article by BNP Paribas Securities Services acknowledged the bank utilised a shadow provider in markets where it did not operate through its proprietary network following a thorough RFP and on-site due diligence selection process. The article acknowledged this set-up gave the bank enhanced security and greater diversification. “We will be able to benchmark – nearly on a real time basis – permanently both providers on service delivery, fees and market information. For example, the appointment of a secondary agent bank in one of the markets has allowed us to realise up to 15% savings with our incumbent provider. Through this process we have challenged our existing agents both in terms of regional setup and service provision,” read the BNP Paribas Securities Services article.