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  1. 1. Sub-custodian risk Sub-custodian Risk Monitoring: analysing shifts in industry practice The global financial crisis has prompted network management groups to review procedures for monitoring risk across their sub-custody networks and for ensuring that assets held with sub-custodians and infrastructure entities are well protected. Bob Currie reportsFinancial Services Research Q4 2010 In the wake of the global financial crisis, Tier 1 and 2 banks Indeed, under FSA regulations in the UK, broker-dealers and brokers have been reviewing their procedures for mon- and global custodians running their own network have pre- itoring risk across sub-custodian networks, CSDs and cash viously faced no explicit requirement to conduct regular on- correspondents. Derek Duggan, Director of Data Services site monitoring for their sub-custodians. Network managers at ratings, information and institutional advisory specialist would ask their sub-custodians to complete risk question- Thomas Murray, notes that in the past some global net- naires, in many cases supplementing this with additional work management groups have relied heavily in their sub- information acquired by conference call, and commonly this custodian risk monitoring on input from industry surveys, would satisfy their internal compliance requirement. Little, passive web conferencing or sub-custodian relationship outside the largest groups, was done at all to look at the and sales visits to complete their due diligence – and such local market infrastructure organisations, including CSDs. It an approach has obvious weaknesses. However, banks and is evident, notes Duggan, that some network groups were brokers now wish to verify this information themselves and not conducting regular on-site due diligence, particularly36 are taking necessary steps to do so. for the smaller, low-volume markets within their networks.
  2. 2. Sub-custodian risk Some broker-dealers had little in place technology to establish an efficient rolling for monitoring the performance of their six-monthly review process.” sub-custodian and for identifying points of risk. As a consequence, it was questionable Some of these inadequacies became clearly whether this level of passive monitoring apparent in the tumultuous days of Sept- provided the robustness and resiliency to Oct 2008. Shepherd contends that in days protect client assets adequately. following the Lehman Brothers bankruptcy, risk managers were approaching the European regulatory initiatives are now network team asking for a complete list forcing change. Both the Alternative Invest- of the counterparts that they are dealing ment Fund Manager (AIFM) Directive and with across their global networks – and, inDerek Duggan, the pending UCITS V Directives currently some instances it might take days or evenDirector of Data Services, require the global custodian to take re- weeks to assemble such a list (see furtherThomas Murray sponsibility for their sub-custodians. This, in S. Shepherd, Building on Stable Tech- notes Duggan, is a very sensitive issue in nology, FSR Q2 2010, pp 68-9). “For the the industry. Some global custodians have Head of Network Management, it should responded by expanding their own self be possible to draw upon an appropriate clearing arrangements, reducing depend- technology package in order to pull down ency on a network and keeping the risk a complete and up-to-date list within on their own balance sheet. There has also minutes, providing as much detail as the been pressure in this direction from asset risk management division, its credit team owners, which are demanding greater or its senior management might require,” transparency from their global custodians he says. “But many organisations at the regarding potential risks to their assets at current time are not remotely close to that market level. This level of risk disclosure reality. They may be able to go to a paper- is something that the US Securities and based file and pull down lists that they Exchange Commission, under its Rule have prepared some time previously. But 17f-7 to the Investment Company Act, they have limited ability to gain a real-time have required for mutual funds for nearly a consolidated view on key information: how decade. large is our current exposure to X and Y counterpart? How much did we pay sub- For Simon Shepherd, Chief Executive of custodian Z last month and how does this MYRIAD Group Technologies – provider of breakdown across the suite of services that technology and analytics to assist network they provide to us?” managers in monitoring performance across their supplier relationships – the Publicly, notes Shepherd, some network global financial crisis drove home to some management teams might declare that the network management groups the need for level of protection afforded to client assets urgent review of their internal procedures. is as robust as it possibly could be. But He makes the point, somewhat forcibly, he adds a caveat that this protection is as that sub-custodian risk monitoring is often robust as it could be when employing out- Financial Services Research Q4 2010 disjointed, ad hoc in nature, and lacking in moded, paper-based procedures that are quality. Because the process does not utilise highly labour-intensive. “If you work with available technology, this has often re- seven sub-custodians who are part of the mained a manual, labour-intensive process same group, but you call and spell them 25 that consumes too much time and is not different ways, including the parent, how conducted with necessary frequency. “It is comprehensive is your risk-reporting going possible to identify a dozen or more institu- to be?”, he inquires. tions across our industry that review their sub-custodian networks in their entirety no Review process more than once every three years,” he com- However, it is evident that Shepherd’s criti- ments. “In many cases, these organisations cisms are targeted at selected institutions recognise that they should be reviewing that have been slow to prepare for crisis their entire network every six months. But and slow to react in its wake. At the other 37 they do not have the manpower or the end of the best practice spectrum, there
  3. 3. Sub-custodian risk are also banks and brokers that have taken has in place with sub-custodians. This has early and comprehensive steps to ensure included an appraisal of documentation, that they have robust procedures in place including service level agreements and any and to remedy any weaknesses that may parental guarantees that a bank may offer become apparent. across its branch network. The objective is to ensure that levels of protection afforded Managing Director of JPMorgan Network to client assets are as high as they can be Management, Elizabeth Fortier, indicates – and also to remove the possibility that that JPMorgan has conducted a detailed standards of service delivery may slip during review of its existing protocols in the wake periods of financial trauma. of the global financial crisis – and has been encouraged by how well its procedures for Beyond the above, Fortier outlines two sub-custodian selection and monitoring important developments that JPMorgan stood up during this period of economic network management has made to its sub- upheaval. custodian appointment process. The first is to appoint “back-up” sub-custodians in Subsequently, JPMorgan has maintained selected markets across its network. “We broad continuity with these established have established accounts with a second Little, outside the largest groups, was done at all to look at the local market infrastructure organisations, including CSDs. It is evident that some network groups were not conducting regular on-site due diligence, particularly for the smaller, low-volume markets within their networks. Some broker-dealers had little in place for monitoring the performance of their sub-custodian and for identifying points of risk. As a consequence, it was questionable whether this level of passive monitoring provided the robustness and resiliency to protect client assets adequately. procedures – but has also made selective sub-custodian in a number of locations, adjustments to internal policies in order providing contingency provision that will to strengthen its ability to respond as an help us to react quickly should we identify a organisation to potential risks. Specifically, potential threat in any of these locations,” it has introduced amendments to internal she says. Looking back 10 years, JPMorgan communication protocols to ensure that it had dual agents in a number of markets as can coordinate a prompt and formalised it managed the Y2K problem and transition response across key divisions within the to the euro. This provided a back-up plan, organisation. The goal is to ensure that key should any of its sub-custodians experienceFinancial Services Research Q4 2010 personnel have access to necessary infor- difficulties during these project migrations. mation, their responsibilities are clearly de- However, this is the first instance since that fined, and that appropriate data is in place time when JPMorgan has taken a decision to support prompt decision making during to appoint a back-up sub-custodian as a times of financial stress. “These relatively contingency measure. small adjustments to our internal proce- dures can make a big difference in enabling Second, JPMorgan is assessing the poten- key staff to determine the appropriate tial benefit of employing direct custody course of action and execute quickly under arrangements in more markets globally. crisis conditions,” says Fortier. JPMorgan Worldwide Securities Services recently established a sub-custody opera- Also, JPMorgan network management tion in Ireland to complement the custody has conducted a comprehensive review and clearing presence that the bank already38 of the contractual arrangements that it has in India, Russia, Taiwan, Australia and
  4. 4. Sub-custodian risk New Zealand, the UK and the US. With this Through this model, Clearstream has development, JPMorgan network manage- created a set of tools designed to offer ment has the option of utilising a group maximum protection to beneficial owners sub-custodian as a means to control risk regarding the safety of their assets at more effectively across its sub-custodian market level. “This is not to imply that we network. Strategically, the bank will aim to disintermediate our banking clients continue to explore avenues for business and to reach out directly to institutional in- expansion and this will include potential vestors as our future customers,” says Gem. opportunities to establish on the ground “However, we do wish to offer a robust custody and clearing coverage in more and flexible set of service options to this in- markets worldwide. vestor community – and we recognise that in some instances a pension fund might feel Clearstream’s Head of Network Manage- most comfortable in, for example, lending ment and Executive Board Member Mark securities for asset optimisation purposes Gem reports that, within his organisation, through Clearstream as an ICSD rather thanElizabeth Fortier, change has also been incremental rather via its commercial bank custodian.”Managing Director,JPMorgan Network Management than representing an all-embracing over- haul of network management practice and FSR asked Mark Gem whether he feels the supporting operations. In many cases, he account operator model has been accorded suggests, network managers across the greater credibility on the back of develop- industry have taken all reasonable meas- ments in financial markets in recent times. ures to ensure that client assets are well “Yes we do,” he responds. “We do not protected across their global networks. claim that the account operator model However, the global financial crisis has provides better protection for client assets highlighted a number of areas where in instances of insolvency. We are not approaches to risk management may be certain that it does. But what the account changing. operator model does offer is the means toFor the Head of Network Management, it should be possible to draw upon an appropriate technologypackage in order to pull down a complete and up-to-date list within minutes, providing as muchdetail as the risk management division, its credit team or its senior management might require. Butmany organisations at the current time are not remotely close to that reality. They may be able to goto a paper-based file and pull down lists that they have prepared some time previously. But they havelimited ability to gain a real-time consolidated view on key information ... Financial Services Research Q4 2010 One such area is continuity planning. manage continuity in the event of a default Clearstream’s approach to ensuring conti- at the agent bank. This provides us with nuity, he explains, has been to seek direct a higher level of control over our account access to the financial infrastructure wher- information and the possibility that we can ever possible. In line with this objective, it get alternative operational arrangements has employed an operated account model up and running at short notice should our whenever practical, enabling Clearstream agent bank fall into difficulties.” to establish direct access to the CSD, and when possible the payment system, even For Gem, another implication of the global in instances where, from an operational financial crisis is that it has instilled a perspective, it still requires intermediation greater appreciation across the industry of 39 from a local sub-custodian. the potential value of central bank money
  5. 5. Sub-custodian risk settlement. One of the benefits extended raised the number of staff employed in its by the launch of LuxCSD – the initiative central risk management division and it has of Clearstream and Banque Centrale broadened the range of expertise within de Luxembourg to establish a CSD for this function. In network management, Luxembourg and to provide domestic ac- BBH has appointed a dedicated chief risk cess for the Luxembourg community to the officer and compliance officer, along with TARGET2-Securities (T2S) infrastructure a number of risk analysts that will support – will be its ability to settle international their activities. This CRO for the network securities in euro central bank money ahead management function will report directly to of the release of T2S. “Situated on top of the Head of Risk for BBH. “The intention is the CeBM settlement options provided by to ensure that we are fully compliant with Clearstream CSDs, we have the capacity to our own internal policies and procedures provide a consolidated custody value-added and that these are properly aligned with service layer, including position manage- external regulatory commitments that we ment,” he says. “This offers the flexibility must adhere to as a firm,” says Rand. that customers require to meet their settle- ment and asset servicing needs both prior Alongside this, BBH has taken a decision to to the release of TARGET2-Securities and increase from four to five the number of lo- after implementation of the T2S platform.” cations in which it has network management staff represented throughout the world. Continuous communication With network managers situated in Boston, In efforts to draw lessons from the global Hong Kong, London, Luxembourg and Mark Gem, Head of Network Management financial crisis, Brown Brothers Harriman Tokyo, this enables BBH to remain close to and Executive Board Member, (BBH) has conducted a comprehensive the source of its business, namely the asset Clearstream appraisal of operational procedures and owners, and also to be as near as possible JPMorgan is assessing the potential benefit of employing direct custody arrangements in more markets globally. JPMorgan Worldwide Securities Services recently established a sub-custody operation in Ireland to complement the custody and clearing presence that the bank already has in India, Russia, Taiwan, Australia and New Zealand, the UK and the US. With this development, JPMorgan network management has the option of utilising a group sub-custodian as a means to control risk more effectively across its sub-custodian network. risk controls which spanned more than 12 to the sub-custodian banks employed across months and which continues on an ongoing its global network. Consequently, BBH hasFinancial Services Research Q4 2010 basis. Andrew Rand, BBH’s Global Head of network management officers located in Network Management, tells FSR that BBH each time zone that can respond at any early has long been risk averse as a company, a point to any risk concerns or operational is- factor closely linked to its partnership struc- sues that might develop at market level. ture, and it has set the bar high in terms of risk management standards, including its The focus of this strategy, notes Rand, is to monitoring of risk at sub-custodian level. maintain a culture of continuous communi- On the basis of this detailed procedural re- cation between BBH, its sub-custodians and view, BBH has elected to supplement its risk its beneficial owner customers. From a sub- management capability in several areas. custodian monitoring standpoint, BBH net- work management has a rolling quarterly One important response has been to review process in place through which each increase the number of staff dedicated to of its sub-custodians is expected to keep40 risk and compliance. At bank level, BBH has BBH fully updated on their financial status
  6. 6. Sub-custodian risk and to communicate any significant changes on-site visits, notes Rand, is the ability to talk that may be taking place in their service directly to key personnel within the regula- environment. “As part of this strategy, we tory authorities and financial infrastructure. maintain a schedule of on-site visits, as well These discussions help BBH staff to build as videoconferencing, telephone calls and a clear picture regarding how pending web-based reporting, that will ensure timely changes at market level are destined to information flow from each of our agent impact the foreign investor. banks,” he says. Continuous risk assessment Expanding on this point, Rand volunteers Richard Barker, Senior Manager Network that in the network management world Services, Network Management at RBC there tends to be a glamorised perception Dexia Investor Services, tells FSR that his of due diligence which involves a network organisation has introduced a series ofWe do not claim that the account operator model provides better protection for client assets ininstances of insolvency. We are not certain that it does. But what the account operator model doesoffer is the means to manage continuity in the event of a default at the agent bank. This providesus with a higher level of control over our account information and the possibility that we can getalternative operational arrangements up and running at short notice should our agent bank fall intodifficulties. manager stepping onto an aeroplane and adjustments to its risk monitoring strategy in crossing continents to conduct on-site visits response to the financial trauma witnessed with each agent several times per year. globally over the past three years. Approxi- However, this may not be an accurate repre- mately two years ago, it established a Net- sentation of what good practice involves. “In work Management Working Group, chaired our mind, due diligence is something that by Tim Wood, Head of Network Manage- happens every day,” he says. “When we do ment. This committee meets every second conduct on-site due diligence, much of our week and is attended by representatives analysis is a verification of the due diligence from eight different divisions within the bank that we have been conducting, on a daily whose responsibilities overlap with network basis, throughout the year. We have a wide management, including operations, client range of tools available to us at our desks service, sales and relationship management, that enable us to conduct frequent and credit, legal, compliance and risk. This com- detailed risk assessment. When preparing mittee has a duty of care around transpar- video-conferencing and conference calls with ency and good governance for the organi- Financial Services Research Q4 2010 our local agents, we prepare these evalua- sation – and all key decisions affecting the tions with the same rigour as we do when future strategy of the network management travelling to market to conduct an on-site team are evaluated by this central decision- review. This will include an extensive review making body. RBC Dexia Investor Services of service level agreements, any pressing has also introduced a sub-custodian risk legal and compliance issues, and ongoing report, which is produced weekly and tracks changes at market level that may impact our and records 26 different sets of metrics and ability to process transactions or to safekeep data highlighting various warning trigger client assets.” More generally, BBH maintains points. This serves to provide advance notice close contact with a sub-custodian’s senior that a sub-custodian may no longer meet management in order to retain clear under- RBC Dexia’s minimum appointment criteria. standing of their strategic thinking and the direction in which they are taking the com- In September 2009, RBC Dexia took a 41 pany. Much of the value gained from making decision to review the geographical struc-
  7. 7. Sub-custodian risk ture and organisational coverage of its From a sub-custodian standpoint, Colin network management department. It now Brooks, Global Head of Sub-Custody and has network staff situated in four centres Clearing at HSBC Securities Services, has of excellence globally, located in Toronto, witnessed an enhanced focus on sub- London, Luxembourg and Singapore. This ar- custodian risk monitoring in many guises. rangement provides global network support “This is apparent when we receive a for RBC Dexia’s business 24 hours per day, due diligence visit, or we are required to ensuring that network staff remain close to complete a due diligence questionnaire or sub-custodians, to local market infrastructure an RFP,” he says. “In each case, we have and to clients. This allows the network man- noted a rise in the level of detail required agement team to react promptly to any risk by these risk assessments. Our clients are concerns that may develop at market level. seeking additional detail around how we reconcile trade and holdings information Overarching these provisions, RBC Dexia with clearing houses and depositories. They network management department has a are seeking detailed information regarding methodology in place that it has labelled our financial stability; and the business Continuous Risk Assessment (CRA). “The continuity planning arrangements that we key word in this title is continuous,” explains have in place. And, they are requesting Richard Barker. “Sub-custodian risk moni- comprehensive information regarding how toring is something that we do on a regular assets are held in the local market, how title and ongoing basis.” The CRA model is is transferred and whether they will retain applied across the 88 markets in which RBC access to those assets if a sub-custodian or Dexia supports and safeguards client assets infrastructure entity passes into insolvency.” In our mind, due diligence is something that happens every day. When we do conduct on-site due diligence, much of our analysis is a verification of the due diligence that we have been conducting, on a daily basis, throughout the year. and across approximately 130 sub-custodian Not only has the depth of questioning in- relationships. “The CRA model is undertaken creased within these risk reviews, but HSBC in many ways, including remote and on site has noted greater intensity in the follow due diligence,” he adds. “One of the cardinal up process. “In times past, often it was the rules around which our asset protection case that we would receive a due diligence methodology is built is that it is obligatory questionnaire or RFP, we would respond to for all providers to accept and agree with the those questions, and typically this would sat- CRA process.” The CRA model has six main isfy the requirements of the risk evaluation,” segments – namely legal, sub-custodian re- says Brooks. “Now, the depth of analysis lationships, market information, operations, and follow up has moved to a higher level.Financial Services Research Q4 2010 financial and risk management – and under- Clients are analysing our responses more lying these six headline categories there are carefully and they will come back to us for approximately 30 different risk criteria that detailed follow up driven by questions from are monitored on a continuing basis. the broad range of experts represented on the organisation’s risk committee.” In line with this methodology, RBC Dexia has taken the decision to expand its surveil- Broker-dealer customers have long been lance and to eventually bring all cash rela- rigorous in compiling a real-time view of the tionships and prime brokerage relationships exposure that they have to their counter- under the CRA model. As a result, these parts. This will include prompt and compre- business relationships will be monitored on hensive reporting relating to failed trades an ongoing basis according to the same and unmatched positions – thereby enabling risk assessment methodology applied for its them to maintain an accurate picture of42 securities services and funds businesses. their cash positions on an intra-day basis.
  8. 8. Sub-custodian risk HSBC has been able to support this demand audit, legal, risk and compliance and the through providing sophisticated cash fore- bank’s senior management. Hence, a casting for this client segment. very large number of people within the organisation are dependent on the data More broadly, Colin Brooks observes that emanating from the network management global custodian and global broker-dealer group in order to structure their risk evalua- customers are conducting more regular tions and to drive strategic decision making. due diligence visits to locations in which they employ HSBC as sub-custodian. This Shepherd contends that it is only when the increase in the frequency of site visits over bank can deliver a prompt and accurate list the past 12 months may reflect the fact that of its global counterparts, and a full list of many clients put due diligence visits on hold the accounts that it has with each of those during the financial crisis, when a tight cap counterparts, that compliance or credit are was placed on travel budgets and staffing able to ask the correct questions and to pressures limited the time that network quantify the risks to which the bank is ex- management staff could spend away from posed. In turn, the compliance division will the office. However, this is also indicative require that each one of these relationships, of a more rigorous risk assessment process, extending right down to account level, is whereby we are now starting to see more properly documented. For a large global frequent and detailed on-site inspections. institution, this is a major assignment. For some financial entities, it may take months Supporting technology and to collate the full list of documentation, Colin Brooks, Global Head of Sub-Custody data management and the corresponding audit trail, that the and Clearing, HSBC Securities To facilitate their risk monitoring commit- compliance division will require to support Services ments, MYRIAD’s Simon Shepherd observes this process. that one of the largest global custodians in the market is looking to adopt MYRIAD’s FSR asked Clearstream’s Mark Gem whether workflow technology in order to support a his organisation had restructured its tech- rolling sub-custodian review process. This nology and data management in order to technology will enable the organisation streamline how it pulls information from largely to dispense with service level agree- providers in its sub-custody network and ments. Using Web-based technology, the ensures that key personnel have prompt sub-custodian will report changes via the access to this data. “The answer is no,” Web portal each time there is a material de- responds Gem, “but the reasons for this velopment that will impact the service that it are interesting.” In early 2007, Clearstream offers to the global custodian – whether this took a decision to conduct a comprehensive be the appointment of a new relationship review of its risk procedures. It conducted manager, a movement in market deadline or scenario analysis across a range of different a change in operational practice at the CSD, situations, asking the question ‘what would clearing house or payments system. we do if X or Y happened’? “Having initi- ated this process, we recognised quicklyFinancial Services Research Q4 2010 The implications of this debate around that if we took a given counterparty in a sub-custodian risk monitoring extend well given scenario analysis, it was often difficult beyond the network management group. in advance to predict how many different Within any global investment bank or types of exposure we would have to this global custodian, the need for real-time risk counterpart at any time,” comments Gem. monitoring across the sub-custodian net- “Potentially, the entity might fulfil 25 or work will be shared by a number of other 30 distinct roles through which it had a divisions within the bank. In explaining this relationship with Clearstream: it might be scenario, Shepherd draws an analogy with a direct counterparty or a counterparty to a pebble being thrown into a still pond. one of our customers; it may be a securities The first ripple spreading outwards repre- issuer; it might be a depositary bank or a sents the network management team. The cash correspondent; it might be an account second ripple embraces the full operations operator; and so on. Thus, in understanding44 staff. The third ripple will include treasury, this complexity, and the multi-layered
  9. 9. Sub-custodian risk relationship we may have with any specific gether during a crisis scenario and how staff counterpart, we recognised that the human will access necessary information,” observes dimension is crucially important.” Gem. “But it is not advisable to consume considerable time and resource attempting On the basis of this analysis, Clearstream to predict exactly what will go wrong. It concluded that it would difficult to install a was unfeasible, for example, that a risk single system or technology package that committee would have predicted accurately would meet all of the organisation’s needs, many of the challenges presented by 9/11.” capturing the full range of exposures that Clearstream might have to another finan- JPMorgan’s Elizabeth Fortier reports cial institution. “We are confident in the similarly that her organisation has made technology that we have in place to support some minor enhancements to its internal our risk management personnel,” says systems in order to strengthen its ability to Gem. “All staff in this area are able to call pull key risk information together quickly. up a real-time profile of our risk exposures The network management group supportsNot only has the depth of questioning increased within risk reviews, we have noted greater intensityin the follow up process. In times past, often it was the case that we would receive a due diligencequestionnaire or RFP, we would respond to those questions, and typically this would satisfy therequirements of the risk evaluation. Now, the depth of analysis and follow up has moved to a higherlevel. within minutes and we have conducted rig- the activities of a range of business lines orous stress tests to ensure this is the case. within JPMorgan and, for this reason, it is But there is no integrated solution available important to collate key risk information on the market that would allow us, at a promptly, to identify areas where risk is keystroke, to call up all necessary risk data concentrated, and to share this informa- in a single consolidated report, tailored to tion with other teams within the bank that the specific risk situation in which we find contribute to the risk monitoring process ourselves.” (for instance, credit, operations, legal and compliance, treasury). Inevitably, credit risk Instead, notes Gem, the key to robust and monitoring is an important consideration in responsive risk management is to establish the current financial climate, for example, very short lines of command within the with JPMorgan’s credit team monitoring risk Financial Services Research Q4 2010 organisation and to support this with fast across financial counterparts and service access to information. With this in mind, partners on an intraday basis. Clearstream established a Credit Crisis Committee which allows decision-makers BBH’s Andrew Rand reinforces the point within the organisation to sit together with that in the current financial climate, credit those that have access to the data. risk assessment is paramount. Conse- quently, the bank directs close attention In conducting this review of its risk proce- to the financial results and credit position dures, Clearstream’s thinking was heavily of each of its sub-custodian partners and influenced by a fundamental lesson that it service counterparts. For sub-custodians, drew from 9/11 – namely, that we should BBH is committed to conducting at least never try to decide in advance what kind of two formal reviews every year, although crisis we are likely to have. “It is important Rand suggests that in practice its evalua- 45 as a team to plan how we will work to- tions are much more frequent.
  10. 10. Sub-custodian risk In line with this commitment, BBH sched- Scheduling on-site visits ules a weekly management meeting – Within its CRA framework, RBC Dexia attended by each of the firm’s partners categorises markets into major, intermediate and often by the Head of Network Man- and minor, depending on the level of assets agement – which will discuss the bank’s under custody held on behalf of clients exposure to specific counterparties and the in those markets. This framework will, in credit status of these counterparties. Any turn, determine the frequency with which it concerns over how any counterpart is using conducts on-site service reviews in these lo- its credit facilities will be brought to the cations. Richard Barker explains that for the attention of this weekly meeting. Addition- minor markets, RBC Dexia has now stepped ally, BBH circulates a twice-weekly coun- up the frequency of on-site visits to at least terparty risk newsletter that will highlight once every two years. This marks an increase significant changes in the credit quality in the frequency of site visits when com- Andrew Rand, Global Head of Network of any of its counterparts, ensuring that pared with its standard practice before the Management, Brown Brothers staff are informed at an early point of any global financial crisis. “Historically, we might Harriman notable concerns. have conducted site visits once every three to five years for the smallest markets in our RBC Dexia network management has network,” he says. “For the major markets introduced selective changes to its tech- in our network, we will typically conduct an nology and data management to comple- on-site visit at least once every 12 months.” ment the changes that it has made to its regional model (see pp 41-2). Specifically, it JPMorgan’s Elizabeth Fortier indicates that has introduced a package called SharePoint when scheduling on-site visits to sub- in each of its global locations, providing custodians, the frequency of these visits will a facility through which information can typically be determined by the pace at which be shared accurately and on a timely basis market practice is changing in a location and between network managers and opera- the level of potential risk identified to clients’ tions staff based in these different offices. assets. “It is not necessarily the case that we Also, it has introduced enhancements to its visit most frequently the markets in which global market information product in order we have highest transaction volumes and as- to strengthen the quality of market infor- sets under custody,” comments Fortier. “For mation that it distributes to clients. A senior a large, established market in which there member of the network management have been few substantive changes and our department is responsible for co-ordinating service needs are being met effectively, we market newsflashes and for ensuring that may push this market to an 18 month cycle RBC Dexia clients are fully updated about for on-site visits. In contrast, in a smaller breaking developments at market level. market where a series of important changes are taking place, we may wish to visit this lo- Further, RBC Dexia has refined and cation much more frequently.” For example, upgraded the performance scorecard JPMorgan network management staff have technology that it employs within the made a series of visits to markets in sub-Financial Services Research Q4 2010 network management department. This Saharan Africa over the past 12 months is a quarterly scorecard review that the net- – even though AUC in these markets is work team has operated for many years. relatively low in global terms – owing to the All sub-custodians are scored against all high level of market reforms that are taking sections of agreed service level standards, place in those locations. including the standard and frequency of market information received from them, Having conducted a detailed review of its on a quarterly basis. This process, which risk monitoring procedures over the past two forms a major part of the CRA, allows the years, JPMorgan network management has network management group to evaluate made few specific changes to the content of the performance of its sub-custodians market review questionnaires. In cases where against the agreed SLS and in comparison it has made adjustments, typically this has in- with the rest of the sub-custodian network volved steps to tighten legal documentation46 (see box, p 47). or the content of an SLA. “We have been
  11. 11. Sub-custodian riskReinforcing a Continuous Risk Assessment approachRichard Barker, Senior Manager Network Services, Network Management, RBC Dexia InvestorServices, tells FSR that RBC Dexia network management has introduced selective changes toits technology and data management in order to complement the changes that it has made toits CRA methodologySpecifically, it has introduced a ment department to react rapidly, provided by external surveys. “Thus,package called SharePoint in each of should there be a deterioration in the if network management staff noticeits global locations, providing a facility financial status of any sub-custodian a deterioration in performance from athrough which information can be or counterpart. sub- custodian, we can compare withshared accurately and on a timely external reference points to identifybasis between network managers Performance scorecard whether this trend is in line withand operations staff based in these In parallel with this development, RBC observations from other sources,”different offices. RBC Dexia also uses Dexia has refined and upgraded the says Barker.intranet to support this transfer of performance scorecard technologyinformation between key staff within that it employs within the network Typically, the key results of thisthe organisation. management department. This is a performance scorecard process may quarterly scorecard review that the be summarised on a single A4 sheetAlso, RBC Dexia has introduced en- network team has operated for many and utilised by network staff as ahancements to its global market infor- years. All sub-custodians are scored starting point when they conduct duemation product in order to strengthen against all sections of agreed service diligence at market level.the quality of market information level standards, including the standardthat it distributes to clients. A senior and frequency of market information “To ensure timely input to this con-member of the network manage- received from them, on a quarterly tinuous risk evaluation process wement department is responsible for basis. This process, which forms a require our sub-custodian partners,co-ordinating market newsflashes and major part of the CRA, allows the net- as part of their SLS and legal agree-for ensuring that RBC Dexia clients are work management group to evaluate ment, to share with us key informa-fully updated about breaking develop- the performance of its sub-custodians tion that may impact our servicements at market level. Alongside this, against the agreed SLS and in compar- and legal relationship,” adds Barker.the bank has introduced Risks Uncov- ison with the rest of the sub-custodian “Under the remote CRA model, andered, a product that highlights the key network. “Performance results are in particular the comprehensive an-risks in each market globally in which provided to our sub-custodians with nual attestation process, we requestRBC Dexia is active, according to its an indication of where they fall below annual validation and confirmationsub-custodians. This information is or exceed requirements,” says Barker. on a number of areas including legal,available to clients through the bank’s “We conduct a service review with credit, insurance, local law changesGlobal Market Information web portal. any sub-custodian that does not meet etc. Furthermore we also request our expected service level, designed from our sub-custodians completionTo reinforce its capacity to monitor to provide relevant feedback and put of questionnaires and assessmentsthe financial status of sub-custodian a plan in place to ensure that these which relate to BCP assessments, pro- Financial Services Research Q4 2010partners and counterparts, the areas are improved prior to the next cedures to be followed in the instancenetwork management department quarter’s performance review.” of bankruptcy of a sub-custodian orhas established relationships with a key infrastructure entity, and so on.”number of external data vendors that RBC Dexia network management has In total, RBC Dexia network manage-specialise in providing credit alerts now extended this exercise to cover ment circulates to sub-custodiansand CDS ratings. Richard Barker notes RBC Dexia’s international wealth man- approximately 490 documents whichthat, by doing so, the objective is agement business, which is handled they must complete and return,not to compete with the high-quality out of the Channel Islands, along thereby providing a full list of currentcredit information assembled by RBC with a number of business lines that documentation, and correspondingDexia’s central credit evaluation team. report in to the Luxembourg office. audit trail, required internally by theRather, the intention is to ensure One additional step that it has taken network management, credit, legalaccess to timely and customised data is to align the quarterly scorecard and compliance teams, and externallythat will enable the network manage- reviews with some of the results by financial supervisors. 47
  12. 12. Sub-custodian risk rigorous in reviewing this documentation by financial regulators before they take firm across our sub-custodian network from our decisions regarding their business and opera- smallest to our largest markets,” says Fortier. tional strategies,” says Duggan. Many groups are not waiting and are being forced by their As part of its Sub-custodian Monitoring Boards to beef up their network manage- service (see box p 49). Thomas Murray has ment activities and the quality of informa- made a commitment to conduct on-site tion available to their clients. Some global visits on a rolling 30-month programme for intermediaries have appointed Thomas all significant markets in which its banking Murray to support their sub- custodian risk and broking clients support significant trans- monitoring because they wish to be at the action volumes or assets under custody. leading edge of industry standards, ensuring Derek Duggan notes that this is complemen- that they support their risk evaluation with tary to a bank/brokers’ network team and quality data input and a robust method- can, for some network management teams, ology. Others may wait until they better feel provide an attractive option: limited travel the direction and push from their financial We are being asked to take on more and more risk, but we are being compensated less and less. This is an untenable situation, even in the medium-term. In turn, those sub-custodian banks that currently offer a parental guarantee may be inclined to reconsider whether they will do so in the future. Under Basel III, banks are required to put up higher levels of capital against the risks that they bear in their business activities - and, given the potential impact on their balance sheets, some have questioned their ability to offer a parental guarantee in times ahead. budget and the opportunity costs of having regulator before seeking assistance from an staff away from the office may constrain external specialist. “Whatever the outcome their ability to conduct on-site reviews be- of future regulations,” he observes, “cus- yond the largest markets in their network. todians and brokers need to demonstrate adequately to the asset owners that they are Duggan believes it likely that the larger taking pro-active steps to ensure the safety Tier 1 banks may continue to do much of their clients’ assets through a rigorous of this risk assessment internally. Other programme of monitoring.” network teams will continue to review the larger markets themselves. However they A transparent view for may seek to draw on Thomas Murray’s asset owners services to provide on-site assessment for In the aftermath of the Madoff scandal,Financial Services Research Q4 2010 lower-volume markets in their networks. the Lehman Brothers bankruptcy and other For brokers and smaller banks, it may shock events that have beset the industry make business sense to outsource a major over the past 2-3 years, many network share of their data collection and network management teams have observed nothing monitoring to an external specialist such as short of a tsunami of queries from clients Thomas Murray, thereby allowing in house regarding the security of their assets and network managers to concentrate on higher the procedures in place to safeguard this. value elements of the agent bank relation- These questions feature more prominently ship and operational issues. than ever before in the RFP process. BBH’s Andrew Rand reports, for example, that his “We feel that we are at a tipping point for network management team now spends the industry, whereby banks and brokers substantially more time in responding to will await clarification around the future due queries from asset owners than it did two48 diligence obligations that will be required years ago. Dedicated staff within this team
  13. 13. Sub-custodian risk are committed to reacting to client queries, inquiring about the methodology that RBC updating clients on changes in the market Dexia employs in its CRA procedures and in and explaining to them how that will attempting to understand potential risks to impact their risk profile and their invest- their assets held in safe custody. “Through ment strategy. “On balance, the questions our colleagues in Sales and Relationship that are being advanced by asset owner Management, we note a lot of additional customers are now more sophisticated than questions from asset owners relating to how they have been in the past,” says Rand. assets are held in the local market, whether “In terms of sub-custodian risk issues and in omnibus or segregated account structures, market risk issues, they are taking a deeper etc,” says Barker. “We also note greater dive than they did two or three years ago.” interest in the financial status and credit This relates to the stability of specific finan- worthiness of our sub-custodian partners.” cial institutions and infrastructure entities. In response, RBC Dexia has introduced a It also pertains to specific risks at market range of avenues through which it is making level, including concerns around sovereign this information transparent to its beneficial risk observed in recent months in (for in- owner customers: for example, through the stance) Greece, Ireland, Portugal and Spain. Risk Uncovered bulletin; through news up- dates posted via its Global Market Informa- RBC Dexia’s Richard Barker voices a similar tion portal; or through the CRA manual that sentiment, noting that clients have become provides an in-depth explanation of its risk more inquisitive since the financial trauma in assessment procedures.Thomas Murray Sub-custodian MonitoringHaving been the sole provider of CSDs’ risk ratings for 10 years, FSR asked Derek Duggan,Thomas Murray’s Director of Data Services, to comment on how Thomas Murray has refinedits sub-custodian monitoring procedures in line with the regulatory and commercialpressures brought about post MadoffMost obviously, he responds, Thomas by specific reporting requirements im- ratings for a universe of more thanMurray has increased the range posed by the local financial regulator, 170 sub-custody providers world-of variables addressed through its by queries raised by an asset owner, wide. This is in addition to its existingsub-custodian monitoring process, or by a request for additional informa- 145 CSD risk rating assessments.extending its questionnaires from ap- tion from the client’s internal credit, These are rated on an AAA to Cproximately 200 questions in the past legal or treasury team. scale. Thomas Murray developedto more than 400 questions now. As these risk assessments initially as be-a result, it now provides a more com- Though, in times past, this level of spoke proprietary reports that wouldprehensive risk assessment in a wide detail might be required when a be commissioned by individual clients.range of areas – including the way sub-custodian responded to an RFP, Thomas Murray now shares the anal-that assets are held in market and the this was rarely expected in periodic ysis with each relevant sub-custodiandegree to which these assets will be sub-custodian monitoring. However, – employing an approach comparable Financial Services Research Q4 2010accessible in instance (for example) of following the Madoff fraud banks to that employed for Thomas Mur-the insolvency of a sub-custodian or owe a greater duty of care to the ray’s CSD risk ratings – such that theinfrastructure entity. protection of their clients’ assets and sub-custodian has full transparency so a greater responsibility has now regarding how it has been rated andIn addition to the broad risk issues al- been placed on global custodians and areas in which it can improve.ready addressed by Thomas Murray in broker-dealers to identify all points ofits risk questionnaires, its clients have risk and to inform financial supervi- In turn, these reports can be used byopportunity to add their own specific sors how they are working with their the banking and broking clients asquestions prior to these being circu- local agents to mitigate these risks. part of the sub-custodian risk assess-lated via Thomas Murray’s internet ment data that they must provide toRFP platform (SupplierSelect for Finan- Sub-custodian Risk Ratings financial regulators and which theycial Services). These supplementary On the basis of this process, Thomas may also wish to share with assetquestions may be driven, for example, Murray provides sub-custodian risk owners. 49
  14. 14. Sub-custodian risk Indeed, whereas in the past a beneficial global network during 2010. This included owner customer might seek simple reassur- markets in the West African Economic ance that its global custodian had robust and Monetary Union, the Palestinian due diligence procedures in place, now Autonomous Area, Uganda, and Trinidad many are asking for detailed information and Tobago. This interest is destined to regarding the risk monitoring procedures continue into 2011 and the network man- employed and the protection afforded to agement team are reviewing opportunities their client assets in different financial cir- to open new markets in coming months in cumstances. This interest, notes JPMorgan’s Africa, the Middle East and the Caribbean. Elizabeth Fortier, is not restricted to the largest asset owners but extends across HSBC’s Colin Brooks notes that some asset a broad constituency of investors. For ex- owners have, for many years, taken a close ample, a mutual fund may need to provide interest in how their assets are protected detailed information on its custody ar- at market level. A number of the largest rangements to its fund board. “In almost institutional investors may, in rare circum- all markets that we support worldwide, our stances, accompany their global custodian institutional investor clients are questioning on a due diligence visit; and, more fre- us on a day-to-day basis about safe custody quently, they may join their global custodian arrangements,” she says. “And this is in a conference call with a sub- custodian or reinforced by enhanced regulatory scrutiny infrastructure entity. But in most instances from financial supervisors, which are giving an asset owner will rely on the expertise In conducting a review of our risk procedures, our thinking was heavily influenced by a fundamental lesson that we drew from 9/11 - namely, that we should never try to decide in advance what kind of crisis we are likely to have. detailed attention to how assets are held in and information network of its global the local market and the degree to which custodian to report on developments at these are ring fenced, such that they can market level that may affect the protection be recovered in instance of insolvency of a given to client assets. In turn, this is often a sub-custodian or infrastructure entity.” preferred option from the global custodian’s standpoint. It may be cumbersome, from The bulk of questions received by JPMorgan an administrative viewpoint, to have each network management from investor asset owner joining due diligence visits and customers falls broadly into two main teleconferencing directly. categories. Asset owners are requesting greater detail regarding the level of protec- Significantly, Brooks notes that in a fewFinancial Services Research Q4 2010 tion afforded to assets held in custody with instances asset owners have approached JPMorgan. And, secondly, a specialist group HSBC directly with an interest in estab- of investors is keen to talk to JPMorgan lishing a direct custody relationship with about the bank’s capacity to support invest- HSBC as sub-custodian. “Though we have ment opportunities in frontier markets. not solicited these enquiries ourselves – we “This reveals an interesting contrast across do not actively market to our clients’clients our investor base,” says Fortier. “Though – this is a reflection of the greater interest many institutional investors are looking that some asset owners are taking in moni- to limit risk, we have an active group of toring and managing custody risk across frontier market investors that are pushing their global investments,” he says. strongly to invest in new market oppor- tunities worldwide.” In response to this Regulatory push demand, JPMorgan network manage- We have noted that, in the wake of the50 ment opened 10 new markets across its global financial crisis, regulators in many
  15. 15. Sub-custodian riskjurisdictions are demanding that risk moni- tions in order to protect the domestic securi-toring across sub-custodian networks and ties infrastructure against perceived threatscash correspondents is reinforced and that posed by the cross-border investment activi-risk reviews are conducted more frequently. ties of foreign institutional investors. OneIn the United States, for example, Foreign example is the Irrevocable Payment Commit-Bank Account Reporting (FBAR) legisla- ment that the Reserve Bank of India has in-tion demands that financial organisations troduced during 2010 – whereby custodiansreport to the regulator full details of all active in the Indian market will need to askforeign bank accounts that they maintain their clients to pre-fund trades prior to set-with all business counterparts globally. tlement or else book the credit exposure forMYRIAD’s Simon Shepherd observes that settlements committed on behalf of clients.for some large global banks and brokers, The intention is to help insulate the do-this creates a major compliance obligation mestic market from cross-border problems.and one that they are struggling to fulfilusing their existing labour-intensive pro- The European Commission’s proposal for ancedures. “The response in many instances Alternative Investment Fund Managementwas to have staff attempting to collate this Directive has raised questions about theinformation manually,” says Shepherd. For future responsibilities to be borne by funda global investment bank, custodian or depositories and the associated liabilitiesasset management house, this represents they may bear. Though there is wide ac-a time- consuming operation – creating ad- ceptance that fund custodians should takeministrative delays such that the nature and appropriate measures to protect clientmagnitude of the risk may have changed assets that are held in direct safekeeping,substantially between when a report is or with sub-custodians that they have ap-called for and when it is delivered. pointed, custodian banks have voiced con- cerns that this directive increasingly requiresIn this context, Shepherd believes that the them to stand as insurer of their clients’automated and systematic approach that assets, requiring the bank to compensateMYRIAD can bring to this process repre- the customer for potential losses that aresents an important step forward. “There largely beyond its control and in no way areis no doubt that a number of firms are the result of direct negligence by the bankpoorly set up currently to monitor and itself. On a positive note, through concertedmanage sub-custodian risk,” he says. “But activity with industry peers, including lob-by automating these procedures through bying efforts on the part of the Associa-use of appropriate technology, these risks tion of Global Custodians (AGC), custodianand inefficiencies can be eliminated rela- banks have been able to push collectivelytively simply. Interestingly it is the less well for positive changes to this AIFM directive.organised teams who are often the mostresistant to change. The better organised More broadly, global custodians have airedteams understand and want to stay ahead concerns about the higher levels of risk thatof the game.” are being thrust in their direction at a time Financial Services Research Q4 2010 when there is still unprecedented down-HSBC’s Colin Brooks notes that, in general ward pressure on the fees that they receiveterms, regulators are demanding greater from asset owner customers. “We aretransparency around asset ownership – being asked to take on more and more risk,which may, over time, translate into a push but we are being compensated less andfrom omnibus towards segregated account less,” states BBH’s Rand. “This is an unten-structures. Beyond this, financial supervi- able situation, even in the medium-term.”sors are also working through the implica- In turn, those sub-custodian banks thattions of any potential threat to financial currently offer a parental guarantee may beinfrastructure or insolvency on the part of a inclined to reconsider whether they will dofinancial institution. so in the future. Under Basel III, banks are required to put up higher levels of capitalIn some jurisdictions, we have seen the against the risks that they bear in their 51financial authorities introduce new regula- business activities – and, given the potential
  16. 16. Sub-custodian risk impact on their balance sheets, some have tional arrangements through which assets questioned their ability to offer a parental placed as collateral with a prime broker guarantee in times ahead. are re-hypothecated. A second was the due diligence procedures applied by feeder So too, concerns have been raised regarding fund structures that invested into Madoff the implications of the April 2008 Paris funds. However, beyond these specific Court of Appeal decision which bound fund cases – none of which had a direct link to custodians to full and immediate restitution Clearstream’s core activities – Gem suggests to clients of assets frozen in the Lehman ad- we can be encouraged by the stability of the ministration process. EU member states have core securities processing infrastructure and adopted a variety of ways of integrating into by the generally high levels of protection national law provisions – relating to UCITS afforded to client assets held in safekeeping. and alternative investment funds – guiding “Looking ahead, it seems likely that re-hy- the liability that a fund custodian bears pothecation is here to stay but that market when assets are held with a sub-custodian practice, steered in part by the European within its custody network or by a “third- Market Infrastructure Regulation and by party custodian” such as a prime broker. Basel III, will require that this operates in a substantially different way,” he says. “In Commenting on this issue, Clearstream’s particular, we are likely to see more trans- Mark Gem notes that the restitution parent cost analysis and reporting obliga- obligation applied to fund custodians by tions surrounding the re-use of collateralised the French courts in the wake of Lehman assets than we have done in the past.” Brothers’ insolvency is undoubtedly a con- cern. However, there is a well established In highlighting deficiencies in the sub- body of legislation that governs securi- custodian risk evaluation procedures applied ties transactions in Europe, including the by global custodian and investment banking Geneva Convention and the Securities Law customers, MYRIAD’s Simon Shepherd Directive. This is clear in specifying that the believes it will be interesting to revisit these restitution commitment born by custodians concerns in five or ten years’ time in order is a significant, but ultimately limited, ob- to review how far network management ligation. The overarching principle applied groups have been able to eliminate inef- in this European legislation, notes Gem, is ficiencies through adoption of suitable tech- that custodians will be required to restore nology and data management. Currently, assets to clients in instances where they this remains a hugely under-resourced area have been negligent; but where they can of the banking world. In the investment demonstrate sound procedures for selecting banking arena, for example, the front office sub-custodians and monitoring risk to client continues to consume a major share of bank assets over time, the custodian is unlikely expenditure. Middle and back office tend to to be required to compensate a client for be allocated a limited share of budget in rel- losses that the custodian cannot directly ative terms, despite their key role in shaping control. Thus, the Paris court decision, how assets are traded, settled and held inFinancial Services Research Q4 2010 which requires the restitution of assets on custody. In this context, Shepherd believes, an absolute basis, appears to be out of line some network management groups are with the tenor of the Securities Law Direc- simply not managing risk in as efficient and tive and the Geneva Convention. transparent a way as they maintain. Some are relying on multiple databases to compile Amid all the turmoil generated by the recent key information – and poor interfacing be- financial crisis, Gem believes it encouraging tween these databases dictates that key risk for the securities industry that its financial information cannot be compiled promptly infrastructure, and wider arrangements for during times of crisis. Though network providing custody of clients’ assets, did not management groups typically maintain that falter. It cannot be denied that a number they are fully in control of risk mitigation, of alarm bells were sounded in neigh- privately there needs to be more realistic bouring rooms. One area of concern, as appraisal of these shortcomings and the52 we have noted, was the legal and opera- steps necessary to remedy them.