Failure to change could shrink industry, custodians warned

NEMA calls on industry to initiate radical change.
By Charles Gubert

Perhaps one of the most glaring themes at NEMA in Hong Kong has been the recognition in the custody industry that radical change is required if the business is to fulfil its potential over the next few years. Some would probably go further, and argue a failure to change could precipitate the demise or significant shrinkage in the custody world.

The last few years have not been kind to custodians. Fees have been pushed down at a time when custodians are taking on more risk than ever due to the enactment of UCITS V in March 2016 and the Alternative Investment Fund Managers Directive (AIFMD) in July 2014. These rules – along with other obligations such as Basel III – have forced banks to go on rampant hiring sprees, particularly individuals with legal and compliance backgrounds, not to mention build up capital buffers. The low/zero interest rate environment has been particularly punishing as operating costs went north at custodians.

“The cost of doing business has certainly gone up at custodians, and there are still more regulations to come including the Markets in Financial Instruments Directive II (MiFID II), BCBS IOSCO collateral rules for un-cleared over-the-counter derivatives (OTCs) and the fall-out from the UK’s exit from the EU. That being said, I believe the industry has handled regulation very well. Moving forward, I do not believe the impact of regulation will be our biggest issue, but custodians are going to have to ensure they are profitable, and can grow their businesses,” said Ian Banks, head of securities services for Asia at HSBC.

Investment in technology will be crucial. Automation is key if custodians are to continue delivering a quality service. Any attendee of NEMA over the last two years will also acknowledge that fin-tech is an ever dominant theme. Custodians recognise that technological innovations such as Blockchain, machine learning and big data will have some impact on their day-to-day activities. The extent of this impact is debatable, but change will have to be enabled in some form as clients become more tech-savvy.

Many custodians are entering strategic or equity partnerships with disruptive technology providers where synergies are apparent in solving long-standing business problems or client challenges.  However, this does pose challenges. Many fin tech providers will operate in an alien culture to banking although having a diversity of thinking rarely hurts an organisation. But custodians must be mindful of the risks around working with some fin techs or disruptive technology.

“It is essential that banks are certain that new or disruptive technology is robust, sustainable and secure. Track record is absolutely key, but we must understand how the technology works. The regulators are approaching fin tech from the same angle, and these fin tech providers need to demonstrate end-to-end security and sustainability,” said John van Verre, Global Head of Custody at HSBC Securities Services.

Working with a substandard fin tech firm will likely incur regulatory scrutiny. International regulators including IOSCO have warned that fin tech could have risks that may affect market stability. This is a valid point and any breach – particularly if it affected sensitive client data – could pose huge problems. Cyber-crime is a problem that firms are grappling with, and security must be best of breed at fin tech firms. Nonetheless, a growing consensus recognises that traditional paper driven practices at financial institutions present an equal fraud risk to that of cyber-crime.

Talk about fin-tech replacing the traditional players in custody, clearing and settlement is simply not true. The reality is that these infrastructures will collaborate with fin tech innovators and improve their services through automation and disruptive technology. By embracing fin-tech intelligently, custodians will likely remain relevant.