Custody and exciting are not often found in the same sentence

The evolving custody landscape

It’s not often that custody and exciting are found in the same sentence. There are a number of exciting, broad themes presenting themselves in the Asset Servicing arena. To name but the most obvious, Modernisation, Transformation, Digitisation, Efficiencies, Regulations, Cyber Security. Risk and liabilities in the digital asset space as indeed the entire digital asset evolution.

What is custody all about?

At the heart and the primary role of the custodian remains the enablement of an investor’s participation to the global investment markets and the facilitation of the investment objectives. This in a risk mitigated and controlled environment, providing settlement efficiencies and asset safety. Facilitating the participation to corporate actions, distributions and the protection and exercising of shareholder rights. In the first instance, are the assets safe – Safe keeping -, are they identifiable as individual client assets. Can the investor trade and move assets, is cash available to be transferred or re invested, in the markets defined in the complex investment strategies and allocations. The custodians role is to remove the complexity and improve the accessibility of global investing. Helping the investor to navigate the many nuances and complexities of today’s global markets, hiding complexities through service. It is with these precepts that we need to look at the evolving landscape.

Technology can transform Post Trade

Exciting emerging technology enabling, settlement compression to reduce risk and increase liquidity. Developments to bring the investor and issuer closer, better enabling ESG, SRD, SDR and shareholder engagement. An industry built on lengthy sequential communication paths is moving to a distributed multilateral data exchange providing better insights is shaping our future ecosystem. With cloud computing complementing highly efficient data processing, resilience and scalability. Cloud strategies will need to cover a hybrid multi-cloud environment, public and private providing appropriate capabilities to varying client demand in hosting and processing sensitive data. 

The global custody solution, founded on security and asset safety is adding a third dimension of data. The new custody ecosystem provides for a digitally enabled solution providing for connections between ecosystem participants from CSD and sub custodian with brokers and global custodian. Connecting the investor more directly with the issuer for corporate communications and the exercising of shareholder rights. The established norm of lengthy sequential communications flows of the traditional model are being redrawn into a distributed flow between all participants at the same time. Thus removing latency, miscommunications and potential for errors, further reducing the risks in the process and removing complexities.

Fintechs will still need Custodians and Custodians will still need Fintechs

Allowing for the free selection and appointment of best of breed component specialist this new ecosystem needs to be built on the foundations of interoperable, open architecture. Providing seamless integration and efficient data exchanges across the entire value chain. The emerging FINTECH platforms provide for component based building blocks requiring integration into the environment. The custodians role in this is providing the infrastructure connecting all component parts into one client specific user experience. Data transparency and transferability will require custodians to rethink and remodel the prevailing self-build disposition. Connecting a patchwork of aged behemoth IT environments with strictest controls to the agile and nimble FINTECH will require careful navigation. IT platforms require modernization and transformation leading to real time processing across the spectrum. All components, settlement, Corporate Actions, Income, FX, Securities Lending, cash require instant real time processing and data updated with all parties. 

Crises are required to improve an industry still relying on manual processes

The post financial crisis regulatory work has evolved into a world changed by the pandemic and the forced change to many practices and workflows. Although our industry has expended extensive resources to automate over the years, in asset servicing there are still many manual paper-based processes often still requiring wet customer signatures. Particularly in areas such as account opening and on boarding, corporate actions, voting and very much so in tax services. As a consequence of the pandemic the industry has been forced to look at all of these.

The pandemic has pushed the need to shorten the custody chain further, requiring the development of proactive operating models and more proactive engagement to reduce fails, overdrafts and other costly time critical operations.

We have witnessed a revolution in our method of communication, we have seen changing regulations allowing for digital tax services in some jurisdictions and the introduction of virtual AGM / EGM’s. Can the industry continue to push on these, or as we are seeing in some instance the temporary pandemic measures are being rolled back again. These will need to be addressed if the global investment process and participation is to continue its growth.

The drive by regulators on encouraging the growth of markets and market participation is increasingly focusing on asset servicing, seeking greater transparency for the investor. Although current geopolitical action might see this slowing and reducing the pace of efficiency gains. Globalisation has always been vulnerable to global shocks, as we have recently seen with the pandemic. A powerful economic logic drove our era of globalisation, and that logic remains valid today. However, we are seeing this logic challenged, protectionism is rising along with regulatory divergence with a negative impact on harmonized practices and standards.

With the move to T+1, are we swapping credit risk for operational risk?

The main development in the global custody space is the continuing objective to reduce risk through shortening or condensing the settlement cycle. We are seeing this in the US, Canada, India and others. Is the move to T1 the precursor to T0, the instant or atomic settlement. The speed of adoption will no doubt very much depend on the liquidity and the FX processing of the underlying settlement currency. Accessing liquidity and managing cash positions will be a major challenge. Reducing settlement cycles from T+7 to T+5 to T+2 required improving efficiency and STP. It still allowed time to correct mismatches and errors, with T+1or T0 there is no time, the data flow has to be correct from the outset. This will require the provision of straight through 24-hours global processing at scale that delivers real time insights from custody into the integrated ecosystem environment. Imagine a securities sale, with the position on loan and a corporate action pending. The requirements on all components and all parties to be aligned on the same data is exponentially higher than is currently witnessed. Moving from SWIFT MT to MX and using data to further drive STP is facilitating some of this development. Instant replication of critical information integrated into all parties across the ecosystem’s respective processes is required. Instant updates to compliance and risk systems or other controls and solutions will require updating. Credit control or credit management, moving overnight lines to daylight lines with instant recalculations.

Do the operation risks of this push for incremental settlement risk reduction and freeing up of capital outweigh the potential benefits? Are we swapping credit risk for operational risk? Will we see more failed trades, contra to the CSDR objectives, and more costly cash position errors? There remains a major question if the loss of netting benefits enjoyed in today’s environment and the major cash and securities prepositioning burden imposed by the instant settlement is practical under the current market infrastructures.

It is time for the industry to review the way they operate

All drives to more technology and greater automation, and yet, our industry remains inextricably tied to manual processes, faxes, spreadsheets, with a lack of harmonization across global markets. We continue to rely on paper and email in outdated processes covering account opening, tax services, physical securities and many more.

It was back in 2001 when Alberto Giovannini and his EU working group brought to light the non-standard issuer communication practices. Some progress has been made, though little direct regulatory actions to remove these differences or to harmonise them has been seen. We have diverging definitions across the globe from account structures, to naming conventions to identifying shareholders based on local corporate law. Regulations and market structure has not yet pushed us far enough. The pandemic has highlighted the need to continue the dematerialisation and automation of these processes. Much of this requires digitization to enable STP and integration into the ecosystem.

In order to achieve our collective objectives of reduced risk, reduced costs and improved outcomes, regulation harmonization along with collaboration between old and new is most certainly required.

Correctness and timeliness of Data will be key

Data delivering useful insights will help in the management of assets and reducing the associated risks. Data is the facilitator of the new global ecosystem where shortened decision windows do not allow for current established legacy processes with the built in inherent delays to the flow of information. Integrated open architecture will enable the removal of the latency in the custody chain.

DLT activity is visible and accelerating, though currently this appears restricted to niche areas and pilot or proof of concept activity. Most PoC are on private chains, how will private chains link to public chains? What are the security challenges, how are chains linked? Settling a bond which is then REPO’d or lent, or pledged as collateral, moving across chains presents many questions yet to be concluded. Do we know what these questions are and how to solve? There is some uncertainty as to its suitability and capability in very large-scale securities settlement environment. The digitisation of assets, introduction of coins or tokenisation and fractionalisation, will continue to evolve and become another asset class to be held in custody. The tokenisation or fractionlisation will assist in adding market liquidity, mainly in currently illiquid asset classes in the Private Markets.

Digitisation refers not only to the development of new asset classes but also to the modernisation of the end-to-end process chain. A digital transformation strengthening core capabilities at scale with resilience and establishing the infrastructure for the new era is essential. Digitisation of process requires operational reengineering where using data will drive the creation of the much-needed efficiencies. Technology with data as the backbone providing transparency and lineage. Real time data – information – delivered via API, CHATBOTS or other protocols, connected across the ecosystem. Adopting to the new ecosystem requires reorientation of working practices and internal platforms towards efficient data consumption using machine learning to make better use of the data.

Conclusion

Disruption with new technology should be viewed as an opportunity to allow the industry collectively to evolve. Custody services are predicated on banking principles, credit and balance sheet strength, risk intermediation and management with a strict control environment. Emerging nimble technology allows for targeted, specific aspects to be optimised. These will be integrated throughout the digital ecosystem. Whilst custody remains heavily regulated, concerned with consumer protection and requiring significant balance sheet, it is unlikely that the FINTECH will replace the custodian in delivering core custody services.

The changing dynamic is the need to bridge and to cooperate across the participants in the entire ecosystem. How do we bridge the gap between the heavily regulated, custody banking requirements and the exciting fast-moving evolving new technology? Technology extends a means to an end; technology is the means to enable the needed changes required to meet our objective of increasing market participation whilst reducing risk and costs.

At The Good Guys Company (TGGC), we are excited to shape, and to be part of, this journey for our clients.