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© Copyright 2000 Rogers Media. The following article first appeared in the February 2000 edition of
BENEFITS CANADA magazine.
Re-Defining Custody
Consolidation, emerging markets and information technologies are re-defining the custody business.
The 21st century custodian had better be all ears.
By Tim Houlahan
Over the last decade, custodians have evolved from being safekeepers and processors of post-trade,
paper-based securities transactions to being managers of electronic information and providers of a wide
range of value added services, supporting clients in all sectors of the investment process: pre-trade,
trade and post-trade. As the new millennium dawns, custodians are set to take on further challenges--from
conducting transactions in a Web-based environment and assuming greater responsibility for global risk
management on behalf of their clients to integrating core investment services with valuable information
products.
Custodians that have the intellectual, financial and technical resources to meet varied client needs have
discovered new ways to competitively leverage their technology and content businesses into real value-added
information services. The 21st century custodian will be the centre of an extended supply chain of
e-finance services based on outsourced data and value-added information for everyone, everywhere, anytime.
A CHANGING LANDSCAPE
Traditionally, clients expected only basic or vanilla services from their custodians, including
safekeeping of assets, post-trade control of securities transactions, income collection and financial and
regulatory reporting. Their information requirements were simple and were met mostly by periodic hard-copy
reports. In addition, the environment at the beginning of the 1990s was, by far, less dynamic. Trading
volumes were relatively low compared to today. Investors focused mainly on domestic markets as foreign
investing did not have the same appeal as currently. Emerging markets were just beginning to come to the
forefront of investing activities, and the range of available investment products was much narrower.
However, all of this changed substantially during the decade. The increasing integration of the global
economy led to a surge in cross-border investment activities, changing the world's financial markets
dramatically. As a result, foreign investments by institutional investors increased accordingly,
accentuated by the opening up of a plethora of emerging markets which enjoyed a steady flow of
institutional money.
Custodians have responded to this trend by setting up the requisite infrastructure to accommodate clients'
increasingly complex investment strategies and minimize their risks in a growing number of countries. They
have had to make expensive investments in technology, which turned out to be the main driver of industry
consolidation during the 1990s. The high cost of technology led many custodians to either merge or sell
their operations to more capable and committed providers. As a result, the number of global custodians has
dwindled sharply, both in Canada and in the global marketplace.
ADDED VALUE
Plan sponsors and institutional investors have long used their custodian as the primary infrastructure for
their back office operations. The outsourcing of core operational processing allowed them to operate at a
low marginal cost. The demands of these institutional clients pushed custodians to provide a host of
ancillary products and services, including unitholder recordkeeping, portfolio valuation, performance
measurement and attribution, cash and foreign exchange management and securities lending. Accordingly,
custody systems today have a high degree of flexibility and adaptability, especially because there is no
homogeneity in client demand. That means custodians must be prepared to offer a comprehensive mix of
services in order to keep all their clients satisfied.
The outsourcing of tasks formerly performed in-house by clients stems from the recognition that leveraging
the post-trade data relationship to bundle more services into the primary supplier relationship with the
custodian makes sense. The client gets integrated services at a lower total cost while the custodian
manages an integrated product package. Experience suggests that this is not an easy task. The pre-trade
decision support requirements of clients are different from their post-trade operational data requirements.
The information content is higher, more proprietary and less standardized. And it changes rapidly,
requiring that the information be provided in an interactive manner to the investment decision maker at the
time and place a decision is being made.
MEETING INFORMATION NEEDS
The consequence of this shift is that when investors outsourced their operations they also outsourced data
they originally controlled. Therefore, investors needed to arrange with custodians to send back data to
meet their informational requirements for reconciliation reports, holdings reports, etc. This resulted in
an amplification of demands on the custodian for information. In addition, institutional investors today
maintain increasingly complex portfolios of traditional assets. That's combined with international assets
and non-traditional assets, often with one or more layers of derivative overlay to manage currency risk,
credit risk and to provide transfers between markets. The need for more refined and timely information also
created new demands on the custodian.
To address these requirements, custodians today provide a seamless flow of real-time information directly
to desk-top client interfaces that are linked to core custody systems. Clients can access trading and
account information on an as-required basis, virtually eliminating the need for hard-copy reports. The
trading process has been automated through linkages of investment management, brokerage, custody and client
systems.
Today, most client access systems are not only compatible with back-office systems, they are designed with
open architecture to easily adapt to different client systems in existing or future formats, and to service
new clients with different technology. Clients can use desktop systems to view transaction activities,
receive electronic statements, reconcile security positions, view and respond to corporate transactions,
obtain cash positions for single or consolidated accounts, forecast cash balances, execute transactions,
review operating procedures, make inquiries and communicate with their custodians through e-mail.
Current and historical information is available on both domestic and global accounts and in multiple
currencies. Clients can download formatted electronic reports, consolidate information from various sources
into a single report, cut and paste information, if necessary, and transfer information to their own
internal systems. The key is flexibility, especially for clients who use specific elements of information
to create ad-hoc management reports.
EMERGING MARKETS
The rapid growth of emerging market investing has also added to the technology requirements of custodians
who must be able to execute security transactions and maintain account records in a growing range of
markets that have different legal, regulatory, investment and language characteristics. Global custodians
are expected to facilitate reporting of investment policy and risk exposure and provide clients with market
changes and information.
For instance, the recent market meltdown in Asia and Russia presented enormous challenges to custodians who
had to deal with liquidity issues, unusual volatility, currency devaluations and counterparty risk as these
markets collapsed. The probability of a broker or sub-custodian failing was among the many challenges that
emerged. Such an eventuality could have resulted in significant financial risk to both custodians and
clients. As events unfolded, clients turned to their custodians for timely information to support their
decision-making in these markets and to protect the value of their investments. And custodians had to be
prepared to offer information amidst the turmoil. The proliferation of Value at Risk (see "VaR," page 45)
tools and methodologies is an example of the change in product offering from the traditional custodian.
Although custodians have always provided risk management services to their clients (by offering reliable
infrastructure and processes while serving as the primary repository of their clients' portfolio data),
they are now expanding this role, especially in emerging markets. In the new global capital market, the
biggest contribution a custodian can make is providing investment managers with sophisticated information
and risk management tools.
INTERNET ACCESS
The advent of the Internet presents new challenges for custodians. The perceived security risk of using the
Internet to conduct transactions and post confidential client information is, at present, high.
Accordingly, custodians cautiously offer limited services through the Internet while they iron out security
issues. As custodians gear up to eliminate the risk, it is only a matter of time before plan sponsors begin
to access a wider range of services through the Internet. Information access and management is then
expected to become even more efficient.
The result of such increased reliance on operational outsourcing is that the custodian can free
institutional investors and professional investment managers to function as elements of a complex supply
chain of relationships and services, regardless of geographic relationship, size and company
infrastructure. This chain could be viewed as a prototype for e-finance--with custodians providing shared
networks for transactions, data and services.
As they consolidate globally and face a more complex world of regulations, investment managers will
increasingly decide that what they are best at is managing money. They'll realize that administrative
operations can be done better and cheaper by external service providers. Globalization of the investment
management industry will drive back-office outsourcing into the hands of a small number of large and truly
global custodians.
The key to success in the custody business today is not how many assets custodians service, but the range
and quality of services that they provide to the sponsors.
With the help of initiatives to improve trading infrastructure--like T+1 (see "T+1," page 44) and straight,
through processing--and new tools like the Internet and Value at Risk measurement, the essential value that
custodians can provide plan sponsors will continue to migrate from traditional post-trade custody and
reporting, to market trading tools and pre-trade platforms for analysis and strategic modeling.
Tim Houlahan is vice-president, director sales and marketing at State Street Trust Company Canada in
Toronto.
*** ***
T+1
The impending move to T+1 (trade date plus one day) in developed markets means that non-money market
securities will settle one day following trade date. Currently, these securities settle three days after
trade date (T+3). The last time the settlement cycle was shortened in Canada was in June 1995, when it was
reduced from T+5 to T+3. A shorter settlement cycle reduces credit and liquidity risks and improves market
efficiency. By settling securities in a shorter time frame, there is less risk that unsettled trades will
deteriorate in value, thus allowing market participants to potentially default on any such transactions in
the event of a market correction.
In order to accommodate T+1, many custodians are aiming to achieve global straight through processing
(GSTP). This will allow for a seamless flow of automated information, from trade execution to settlement
reporting, regardless of the counterparties or settlement agents involved.To achieve GSTP, the industry
must invest heavily in technology.
With T+1 and GSTP scheduled for implementation within the next two years, the custody business will be
further transformed, setting new standards for the flow of information.
*** ***
VaR
The Value at Risk (VaR) of a fund quantifies the maximum amount the fund could lose over a particular time
horizon, with a given level of confidence. VaR provides a consistent approach for examining risk across all
asset classes globally. It incorporates the effect of diversification, allowing for more informed asset
allocation decisions. Three main methods can be used to estimate a portfolio's VaR: Monte Carlo value at
risk, historical simulation and parametric.
While intended primarily to assist asset managers to measure risk, VaR is becoming a tool for enhancing
performance and decision making. One sector in which VaR is particularly useful is the securities lending
industry. It can be used to alert managers or plan sponsors to an approaching level of risk that may be
undesirable in a securities lending portfolio.
One drawback according to some industry practitioners is that the use of VaR as a risk management tool
ignores the human dynamic in risk management efforts. Additionally, it doesn't account for extraordinary
events that can have an impact on investments. As well, practitioners caution that risk models should not
be viewed as a magic number, but considered in the context of the assumptions used.
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