A gloomy combination of lower fees and customers rushing out of emerging markets for the safety of US dollar investments has taken the wind out of many immediate plans for global custodians to expand services for clients investing in developing markets. In this lean era, custodians have to tred a delicate balance in the developing world, not wanting to be over-represented as clients flee markets, but keen to be still visible in regions that offer the best opportunities for indigenous client growth. They are also having to squeeze their sub-custodian networks on fees as just as clients push them to become faster and more responsive.
Global custodians are facing tough times after years of boom that saw them rapidly expand into new frontier emerging markets at their clients behest. The largest now offer custody almost universally. Northern Trust, for example, covers more than 90 markets and has clients in 43 countries, according to Tim Theriault president of corporate and institutional services. People want to be in developing markets early on and its our job to be there and educate them, he says.
The problem with this huge footprint of late is that clients have been deserting developing markets which have suffered higher volatility than the developing world in the downturn and which have been hard hit by aversion to risk and illiquid assets. The Russian equity RTS Index has fallen 73% while Indias benchmark Sensex is down 53% to the beginning of December, for example.
The race to the emerging market exit by asset management clients is irritating to custodians who, over the last several years, have been pushed to set up operations in smaller markets precisely to assuage client criticism that they were not moving fast enough in the developing world, pointed out Richard Hogsflesh, managing director at R & M Surveys, a specialist custody and securities servicing research company in the UK.
Today, instead of pushing custodians to expand, clients are showing a much livelier interest in the risks to which they are exposed. Demand for information and transparency has never been higher, said Theriault. Clients are re-visiting basics such as whether accounts are co-mingled or held in separate accounts and what would happen in the event of a bankruptcy.
In developing countries, demands are more specific. Clients are taking a much keener interest in counterparty and government risk as well as sovereign ratings risk in emerging markets, said Theriault. Pricing securities in such volatile markets, particularly the developing world, has become a top priority. When a market does not trade, it is more challenging, but pricing remains an essential function, he noted.
For more sophisticated asset manager clients, the new focus has been heavily on the sub-custodian network, particularly in developing markets, said Simon Walker, deputy head, global custody product management, at BNP Paribas in London. Clients want to know their global custodians precise contractual relations with sub-custodian networks and BNP has taken a fresh look at all these relations to ensure they are water-tight. The challenge in managing a network of agents is having risk reporting arrangements in place, he noted.
Were being asked about the selection of underlying agents and their financial strength, cash and securities lending and where assets are held and on which balance sheet, added Drew Douglas, Global Head of Custody at HSBC. The ability of sub-custodians to pass through information more quickly has become key in all markets while in the developing world, often with its smaller, physical, less efficient markets, stock availability pre-trade matching, settlement becomes more important, he notes. In these markets, clients need basics such as ensuring trades are taking place, he noted.
Clients have also been reviewing service providers much more closely over the last four to five months, says Douglas. There is a particular onus on operational risk with clients wanting greater transparency on how assets are held, transacted and settled: particularly whether assets are appropriately segregated and collateral is managed, he said.
Concerns about sub-custodian networks and the ability of agent banks to cope with extreme market conditions, such as trading freezes and defaults, are of course not confined to developing markets since the credit crisis rocked the foundations of the worlds largest financial institutions and, in the case of Iceland, even entire markets.
And while many emerging markets still have considerable infrastructure problems that need resolving, some of the bigger economies are addressing the issues as they attempt to attract foreign investment and build internal growth and wealth. There has been significant settlement system progress in India and Brazil, for example, points out Stacy Scapino, global director, Mercer Sentinel Group, which advises investors on asset servicing arrangements.
Developing in developing markets
A second issue stemming from the drop in foreign client demand and assets in the developing world and thus global custodian fees is what presence custodians need to maintain in the developing world and how fast they should grow.
Custodians will not likely leave markets they have recently entered, said Hogsflesh. He reasons that those that have already invested in emerging markets knew they needed to stay for the long-term. But expansion plans, dreamed up in easier times, will be hard to meet in current straitened circumstances, he added.
Expansion into targeted developing markets will be difficult. As custodians review their overall businesses, they will be looking at what is core. New expansion is an expensive proposition, agreed Scapino.
Custodians are naturally coy when talking about future plans for expansion in developing markets when there is so little certainty in global financial markets overall. Their plans and forecasts for expansion remain at the whim of decisions taken at senior management or board level.
But they are keen to be seen recognizing the importance of the developing world for future business. Paul Feeney, Head of International Distribution at BNY Mellon Asset Management, announced at a recent conference that: We are confident that emerging markets will continue to outperform developed markets over the next 5-10 years. Theriault agrees that continued economic growth means that there are still good opportunities and says his bank will look to expand according to client needs.
HSBCs premise is that it is focused on Asia and the Middle East, and the area is the key proposition in general custody, says Douglas. To service clients, the bank uses an extensive network of sub-custodians for which he is also responsible. We see this as one of our core businesses. Still, Drew adds that for most in the industry, investment will take place in core not in new markets: Expansion and investment into new target markets will be difficult for certain institutions, he noted.
Asia and the Middle East are most often cited as the priorities for development, perhaps not surprisingly. Many emerging markets dont have large pools of assets and legislation is hostile to overseas investments, points out Scapino. She notes that, for example, in Latin America, there are typically only five to 10 pension funds per country which dominate the institutional scene. It is hard to justify opening up in the region when pickings are so thin.
The Middle and Far East, in contrast, have a heady combination of sovereign wealth funds and Central Bank reserves, rapidly growing institutional funds and new opportunities with hedge fund clients. This density of assets makes sourcing new clients viable. I have long contended that the battleground for the global custody business for the next five to 10 years will be in Asia, said Scapino. But she warns that with the squeeze on costs, most banks will need to put ambitious plans on hold for now.
Custodians insist that plans have not been altered. BNPs Walker says expansion plans have not been put on hold. Our third quarter presentations showed clearly that none of our plans are diminished or reduced.
BNP didnt have a strong presence in Asian markets outside of the Antipodes until recently, noted Walker. Increasingly, the bank recognised that European clients needed custody in Asia and that the firm could tap into funds based there. The bank opened an office in Singapore in 2007 and has spent this year building a full service office and has appointed a head of sales for the region. Paribas has been winning some business from prime brokers in Asia. The latter have thrived, in part, on a willingness to lend. With global deleverage, coupled with heightened concerns over the security of assets, there is likely to be a shift of assets under custody from brokers to custodians.
The French bank has also been expanding in Europe in a minor way by opening offices in Hungary and Poland this year to start to offer custody.
Global custodians may have new competition too as banks in new markets, particularly Asia, eye up custody and conclude it is an attractive, stable source of revenue in hard times. Japanese banks may seek to use the current downturn to build a presence as the market has no indigenous provider of any significance, according to Hogsflesh. They may be interested in the Asian piece of a global custody network if one comes up for sale.
Deregulation is driving interest in global custody in other markets. BNPs Walker recently visited South Korea, where restrictions on asset managers overseas investments are to be partially lifted early next year. He found plenty of enthusiasm on the part of Korean banks to help their clients service these assets internationally by setting up global custody networks. Still, as custody is a new business in Korea, there is a lack of awareness of the complexities of sub-custodian networks and the possible costs involved in servicing local clients internationally, he pointed out. The Korean market is growing fast with the Korean Asset Management Association putting the number of funds at 8,731, the third largest by number of funds in the world. But each fund has an average of $31 million in equity each against $1.28 billion each in the US.
This crisis is shaking up old definitions about where risk and opportunity lie. This time round, emerging markets may be the salvation not the root of the problem, offering custodians valuable new clients to help make up for the drop in assets under custody thanks to weak market performance. And as markets continue to gyrate, no bets are off: will the US continue to be seen as flight to safety? wonders Theriault.