With the use of OTC derivatives by asset managers on the rise, custodians face increased manual intervention and greater complexity. Chas Isaac, Managing Practitioner, City Practitioners, believes that many custodians are struggling to cope, hampered, in particular, by immature STP processes, inadequate technological infrastructure and a shortage of knowledgeable resources. In this article, he outlines what they can do about it.
A combination of changing regulation (e.g. UCITS III) and new investment approaches (e.g. Liability Driven Investment) are driving greater use of derivatives by fund managers. Custodians are feeling the impact, finding themselves faced with greater processing challenges. To make matters worse, the choice of derivatives to be supported by custodians is often client driven.
More positively, the industry trend is creating a new commercial opportunity for custodians: providing clients with the extra services necessary for derivatives processing can be highly profitable. Combined with industry overcapacity, increasing commoditisation of services, plus ever present pressure on custody margins, this represents a vital way for custody providers to differentiate their offerings and win more mandates.
Research by City Practitioners indicates that not all custodians are in the best position to take full advantage of this opportunity. Existing custodian core processing systems have been honed over the years to deal efficiently with large volumes of simpler asset classes (e.g. Equities, FX and bonds) while very few service providers have high volume core OTC derivatives processing systems in place. Indeed, the OTC derivatives custody market is currently characterised by a high level of manual intervention, translating directly to high cost per trade, and lack of cost-effective scalability. Worryingly, with the forced OTC derivative volume growth, the high level of manual intervention is likely to expose service providers to a greater degree of operational and settlement risk.
At the same time, a lack of OTC product and process knowledge hampers service providers while skilled OTC operations resources are in short supply throughout the industry. Additionally, over the years, investment in both technological infrastructure and human resources has focused on revenue generation and cost reduction i.e. diverting investment from back to front office activities. This leaves back office service providers with a small pool of available and appropriately skilled resources.
A lack of readily available market prices and reference data for OTC trades is also adding to custodians difficulties: even seemingly simple reference data such as holiday calendars for different financial centres can be difficult to agree between counterparties, creating a significant impact on the exact timing of cash flows. On the other hand, the need for independent market pricing has seen the emergence of new relationships between custodians and third party pricing specialists, while the provision of independent pricing has also created an opportunity for custodians to offer value-added services such as portfolio valuations and credit risk assessment.
So where are the greatest areas of improvement required?
* Higher levels of STP: whilst OTC trades are not captured electronically at source, and the variety of terms and conditions associated with each trade remain non-standardised, manual intervention and dealing with fails will keep processing costs per trade high. Thus far, multiple service providers have encouraged their own interface standards, which results in a lower take-up rate and increased manual intervention. This situation will persist until increased volumes drive participants into adopting common standards.
* Emerging industry standards: derivatives processing capabilities must accommodate increased usage of industry standard electronic data format by investment managers (e.g. FpML standards). Research indicates that 50% of investment managers are using, or planning to use these services in the next twelve to twenty-four months. Unfortunately, custodians will bear the brunt of the early costs associated with processing non-standardised trades
* Flexibility and scalability: Solutions and processes must be both in order to cope with the rapidly evolving and non-standard nature of the OTC market. Functionality and data structures of existing systems may not support OTC trades, while particular care must be taken with the integration of new capabilities into existing architectures.
* Improved market and reference data: derivative servicing capabilities require greater agreement on pricing methods and standard sources of market and reference data, compared to traditional custody business. Data acquisition and management challenges constitute a significant component of any OTC derivatives implementation.
* More sophisticated analysis and reporting: web-based tools are preferred by clients, who are also demanding more sophisticated graphical tools, as well as a base level of reconciliation support such as slice and dice and drill through reporting.
Through appropriate investment in people, process and technology, service quality and scalability should improve, allowing custodians to offer a wider range of value added services, such as collateral management, risk reporting, valuation services, compliance reporting, performance measurement and fund administration. In addition, the creation of more sophisticated derivative processing capabilities will also allow custodians to target new customers, for example, by offering pricing of OTC derivatives to hedge funds.
Importantly, as these services are not yet commoditised, and are priced upon the basis of quality, this also creates an excellent opportunity for custodians to increase profit margins.