New technologies to provide new role for custodians

Distributed ledger technology (DLT) will reinvent the value chain for custodians, says HSBC's John Van Verre.
By Charles Gubert

Anybody in securities services who has attended one of Sibos or the Network Forum over the last few years may very well be assessing whether they need to urgently identify a new career path or learn how to code. Such has been the hype around the imminent disintermediation of the custody industry through innovative technologies including blockchain and artificial intelligence (AI).

Admittedly, the custody industry has faced a difficult time in the eight years that have elapsed since the financial crisis. Margins have dramatically reduced amid client pressure on fees, lower spreads due to reduced interest rates; a drop in securities lending activities; falling FX execution profits; regulatory capital requirements and operational headaches exacerbated by Brexit.

In such an environment, it is not surprising that many people feel the custody world’s efforts to remain competitive by reducing overheads will be in vain, pointing out the industry and some of its more archaic processes are at enormous risk of being automated out of existence through nascent technologies.

Others, however, disagree. Speaking at the Network Forum Asia Meeting (NEFA) in Hong Kong, John Van Verre, global head of custody at HSBC Securities Services, said the rise of distributed ledger technology (DLT) would provide the industry with a renewed impetus and relevance.

“The value chain will reinvent itself with the advent of new technology. If investors participate in a DLT infrastructure and every market in the world develops its own DLT solution for functions such as proxy voting, trade settlement and tax reclamation, then that will force investors to maintain hundreds of DLT channels, all comprising different standards. In other words, the investors’ life could get significantly more difficult. In this sense, the global custodians will play a role in helping investors in this multi-layered DLT marketplace,” said Van Verre.

Regulation will also serve the custodians well versus technological disruptors. CASS Rules outlined by the UK Financial Conduct Authority (FCA) require custodians to maintain an internal book of records when safekeeping client assets, something which may not be entirely feasible in a blockchain environment. Van Verre questioned whether a custodian’s node on a DLT would be sufficient to convince regulators that they were in compliance with the CASS recordkeeping rules.

Meanwhile, UCITS V and the Alternative Investment Fund Managers Directive (AIFMD) both introduce robust rules around client asset protection, subjecting custodians and depositaries to enormous liability if assets are lost or stolen. “UCITS V and AIFMD require counterparties to have balance sheet, and this is something which custodians obviously possess,” said Van Verre. Technology disruptors are not likely to have the capital base to back up liabilities, and will be focused on investing the money they do have in their core products.

Identifying new sources of profits will be critical for custodians. A handful are looking to ofset lower revenues in securities lending by loaning out high grade collateral to clients who will post it as margin on over-the-counter (OTC) derivative transactions being cleared at central counterparty clearing houses (CCPs) or with their trading counterparties in the case of esoteric or higher risk bilateral swaps. Loaning out such high-grade collateral would provide a fixed fee for custodians, particularly as such assets are in very short supply.

A number of custodians are also assessing how they can profit from client data in their possession. Van Verre acknowledged that custodians sit on piles of data, which could be monetised if aggregated correctly. It will require custodians to incorporate AI or predictive analysis software into their systems to comb through the data and turn it into intelligible materials for clients to use. “Such data analytics will provide clients with invaluable insights and trends,” said Van Verre. As such, custodians are likely to turn into providers of big data analytics.