Latin American Custody

Large global custodians working in Latin America are not having the best of times. The wider banking crisis has trickled down and affected even healthy custody businesses as parent banks have had to wield the axe across the board. Custodian clients are proving parsimonious, too, as they look to bring down costs that were considered peanuts in the glory days.

Custodians admit their clients are putting pressure on them and scrutinising their bills. “Significant pressure on fees is coming both through lower market valuation of assets and from clients themselves as they look to reduce their cost base in these difficult markets,” admits Drew Douglas, global head of custody at HSBC.

Given the squeeze, custodians need to carefully consider whether their core businesses are solid before they make any plans to grow their business in emerging markets. Already, many clients have been unhappy with the service that they have been getting and many are keen to change their custodian. “Many of our clients are extremely unhappy with their custodians. They have not been able to get basic services,” says Stacy Scapino, global director, Mercer Sentinel Group, which advises investors on asset servicing arrangements.

She says clients have expressed dissatisfaction in areas such as their service provider’s inability to reconcile positions, pricing and valuing of alternatives, typically less liquid assets; as well as practices in security lending programmes.

A wave of litigation is further complicating matters for custodians, making future strategic planning fraught with uncertainty and compelling them to increase the level of reserves in case of the unexpected.

Events at the global level are clouding the picture for their regional businesses and inducing a caution-above-all approach. Scapino says that given the lack of clarity surrounding the possible outcome of litigation on each particular institution, she is generally advising her clients to sit tight. Her best guess is that there will be more clarity by the end of 2010 on which institutions have come out the other end most strongly, allowing clients to pick new custodians with more confidence.

These global uncertainties are leading to a fortress, batten-down-the-hatches mentality and ensuring that what investments there are stay focused on improving existing services to clients, rather than opening up new fronts.

The global context means that Latin America is often on the back burner. Returns on investment are under the microscope and Latin America has to compete with more urgent projects such as improving the lousy service provided on over-the-counter (OTC) derivatives, says Scapino. She predicts that the gunpowder will be reserved for alternative investment platforms, which may represent a better return than regional plays.

Latin asset growth

The gloomy global backdrop for the custody business and the possibility for providers to bolt on complementary businesses comes at a time when a number of markets in Latin America are looking highly attractive. An improved regulatory environment for local funds, as well as more foreign investments heading into emerging markets, means fund managers can now look for more attractive returns.

The pattern of market growth is very uneven across the region with individual circumstances dictating how much interest investors have in each country. Some countries have even been going backwards, notes Mike Kalavritinos, managing director at BNY Mellon Asset Servicing in New York.

Interest in the equity and debt markets of Argentina, South America’s second largest economy, has ebbed quite substantially, for example, he says. Policies there, including the nationalisation of pension funds last year and the removal of the last Argentine stock from the MSCI Emerging Markets Indices, have accelerated the decline in foreign investor interest and Argentine equity markets are today considered frontier and irrelevant to all but intrepid foreign investors.

Equally, Venezuela, which used to be an attractive equity market, has also gone backwards. The privatisations of the early 1990s, including telecoms company CANTV, have been reversed under Hugo Chávez and his extensive nationalisation programme.

At the other end of the interest spectrum lies Chile. Long a magnet for foreign money, the government has sought to emphasise foreign direct investment over portfolio flows and has imposed many limitations on equity and fixed-income investment with strict rules covering vehicles for investment, notes Kalavritinos.

The positive news is that foreign money has flowed heavily into the markets of Peru and Brazil, which both provided sterling performances last year. That was down largely to more orthodox macro-economic policies than those practiced by Argentina and Venezuela. A decrease in interest rates has helped markets grow as investors seek higher returns. This is particularly marked in Brazil which is enjoying an interbank rate of 8.75%, a single-digit rate for the first time in many years.

The Brazilian fund market is already worth $700bn with some $200bn to $300bn in pension funds assets. Moreover, foreign investors already hold some BRL410bn in assets, bonds and equities in Brazil, according to the Brazilian Financial and Capital Markets Association (ANBIMA).

Colombia and Mexico lie more in the middle. Colombia is attracting more foreign interest though not at the same furious pace as Brazil and Peru. The Mexican markets continue to interest foreigners because of their size but performance has suffered because of the proximity to the United States and the country’s inability to pursue macro-economic reforms.

Up for grabs?

Traditionally, custodians in the region have focused on the foreign portion of government funds, typically those of central bank and central securities depositories. These are still the core of custodians’ portfolios although currency and asset bases are undergoing significant diversification, explains Kalavritinos.

JPMorgan has been active in pursuing such clients and last year won the mandate tendered by Peru’s Central Securities Depository, Cavali, to provide custody and asset administration services. That win came hot on the heels of the US bank winning the custody business of the Central Securities Depository of El Salvador. “JPMorgan is well positioned to become the securities service partner of choice for Latin America,” says Chris Lynch, head of western hemisphere sales for JPMorgan Securities Company.

These funds are very conservatively invested, with very high allocations to fixed-income, Kalavritinos says. The interest rate environment is pushing them to diversify into higher yielding instruments while regulations are allowing them to look overseas, he notes.

Government funds are becoming more interesting thanks to wider investment mandates as well. Kalavritinos adds: “We are seeing segmentation of these funds’ portfolios. Regulatory changes that enable them to make more foreign investments are coming at the same time as the decline in interest rates. That is making diversification a necessity not a luxury.” Commodities and corporate bonds are two areas into which such funds are moving, he adds.

These funds are increasingly diversifying foreign currency holdings. Here, in the backyard of the US, the greenback has held sway of portfolios. The dominance of the US dollar has been eroding with long-term concerns over its store of value. The presence of European and Asian currencies is still small but growing.

Kalavritinos is beadily eyeing developments in Brazil. Royalties and taxes from the pre-salt oil discoveries, with estimated reserves between 25bn and 100bn barrels, are destined for a new fund, loosely modelled on Norway’s sovereign petroleum fund. Moreover, Brazil’s sovereign wealth fund, funded by the primary fiscal surplus, may get permission to invest outside the country in 2010, making part of its $8bn assets available for global custodians.

Other trends are underpinning the interest of custodians in Latin America. A liberalisation of regulations is increasing the pool of foreign assets in other fund types. The next stage of growth is set to be the battle for these new investors and their assets.

Kalavritinos is already working hard to win the global business of pension funds in the region and, in particular, would like to win insurance company business. The custodian is also looking for private client businesses and at independent asset managers that are looking to expand.

The strong performance out of the region would usually be triggering a wave of investments by global custodians. With caution as the watchword for most banks, there has been more retrenchment than commitments of new money, however.

Local custody trends

One area that continues to prove elusive is securing local custody. The rigidity of regulations and requirements for a bank charter and a physical presence have deterred banks from competing for this business. Regulations usually mean they have to front operations through a local presence, notes Scapino.

The need for a physical presence is a particular problem in heavily-regulated Brazil. “Brazilian regulators really promote the domestic business,” says Scapino. “They keep developed countries’ banks at arm’s length and only use them when needed. It’s a very consolidated market and the big family banks are very well connected, making it hard to get in.”

Given the general absence of custodians, local Brazilian banks are consolidating in their home market and starting to eye foreign clients. Itaú-Unibanco is vying to become a significant sub-custodian and Bradesco would like to build on its very large, local custody platform to woo foreign clients.

Not all foreign banks are waiting for the global environment to improve either. BNP Paribas is already custodian to its own funds and has some foreign clients. It is now keen to set up a business to provide services to other foreigners.

Even so, companies that are looking to grow are exceptions rather than the rule and most custodians are not spending substantially to build their presence in the region. The traditional approach to Latin America by banks and custodians has been gung-ho in the good times and they back away as the next crisis hits, an expensive and counter-productive approach. This time round, the opportunity may be missed altogether.

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