Back to July 2019

Coming to the forefront

By Paul Mackintosh  
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Regulatory changes make securities servicing a key issue in asset management

Securities servicing may not be the front line, or storefront, of the financial services industry. But it’s the kind of back-office area that has a way of pushing to the front of senior executives’ minds, not least because of regulatory change, a slew of which have come from Europe.

The European Union’s new Markets in Financial Instruments Directive, known as MiFID II, which was rolled out in January 2018 and builds on the original 2007 directive, is the kind of development that drives securities servicing issues up the agenda of institutions and asset managers. Then there is the EU Benchmarks Regulation which debuted concurrently and which affects, among other things, all asset allocation calculations of a portfolio.

Even more topical is the EU Shareholder Rights Directive II or SRD II, which became effective this June. These new regulations may only affect the EU, but their scope and the size of that market, let alone the obligations they impose on outside participants, will drive change in asset servicing worldwide. Besides, they parallel regulatory developments in many other regions.

With this kind of regulatory impetus, expectations of change and development in securities servicing remain high. “Over the next five years, the global securities services industry will face more change than it has over the preceding ten - or even 20 - years,” according to a March 2018 report from McKinsey & Co.

Although the back-office functions grouped under the securities servicing umbrella, including clearing and settlement, custody, and services to securities issuers, are supposed to be unobtrusive execution aspects of financial services, the new regulations, coupled with the new technologies available to implement and comply with them, increase the onus on financial services firms to make informed and prescient decisions.

Trends and developments

Demi Derem, general manager of Investor Communication Solutions International at Broadridge Financial Solutions, says one key development is increased outsourcing in the technology and operations aspects of asset servicing as investor teams become more comfortable working with specialist outside vendors.

“The anticipated pace of change over the next five years is putting securities servicing entities in a position where they need help to counteract the combined pressures of large-scale regulatory change, while simultaneously seeking to drive efficiency and optimise operational processes,” he says, citing in particular the need to replace legacy technology and adopt new ones.

Ian Martin, head of Asia Pacific at State Street, sees cost concerns and customer expectations as among the major drivers of change in securities servicing. ”Regulation, technology and investment complexity are driving up costs, yet fee compression is challenging revenue models. Investors’ laser focus on fees is creating challenges for both active and passive asset managers,” he says.

Despite the implementation challenges, Mr. Derem describes SRD II as “a real opportunity for those focused on investor communications to use this as a springboard for collaboration to build a better process for all participants”. He believes the new rights and obligations introduced by SRD II, such as issuers’ rights to know who their shareholders are, will create new product and business opportunities for those positioned to capitalise on them.

Change is afoot in the securities servicing field in more directions than these, though, and for any number of reasons. BNP Paribas Securities Services’s predictions this January for the year ahead include the outsourcing of post-trade processing and third-party clearance as major trends.

In Europe, particularly, the drag effect of one-country organisation is leading many banks and finance houses to look at standardising their operational models both across borders and across sub-sector boundaries within the financial services industry.

“More than ever, financial institutions cannot simply justify their business practices by their bottom line,” Mr. Martin says. “New regulatory reforms are prompting a cultural shift towards risk management, community values and regulatory compliance that puts investor trust at the forefront.”

But this may not be an easy task. He says many global investment organisations are struggling to find the technologies that will enable them to meet the pressure for greater transparency across borders and jurisdictions, while still being able to operate their business.

According to Mr. Derem, SRD II is one of the key applications of the new emphasis on transparency and governance. “Widely regarded as the most comprehensive change to European corporate governance standards for many years, SRD II was introduced to drive greater transparency in corporate governance and improved shareholder engagement,” he says.

He adds that many larger banks and asset managers are working very hard to try to digest and implement the new obligations and requisite systems, and enable that information transmission. But many smaller institutions have not even got that far and are only at the early stages of regulatory impact analysis.

BNP Paribas Securities Services puts it very succinctly: “Custodians will have to improve the transmission of information to facilitate the exercise of shareholder rights.”

Mr. Martin warns of higher compliance costs resulting from the new regulations, and precautionary measures around liquidity concerns leading to “higher investments in risk, data and reporting infrastructure”. Asset managers are also being driven to invest in technology and data analytics purely because of the sheer complexity of the data handling required to comply with the regulations.

Key technologies

Technology is important in developments within securities servicing in ways that go far beyond just new tools for current purposes. Artificial intelligence (AI), blockchain, cloud and digital technologies are the so-called ABCDs of innovation, Mr. Derem says.

According to Mr. Martin, distributed ledger technologies and tokenisation are “vital in enhancing financial processes and have the potential to make a real change to the asset servicing industry”. But he believes this change will be “evolutionary rather than revolutionary”.

Another area of technologically-driven change, through one where technology is creating a problem as much as an opportunity, is the explosion of big data.

“Our clients are wrestling with an avalanche of data,” Mr. Martin says. “Five years ago, the top data concerns of the industry were related to accuracy and timeliness. Today, it’s the lack of integration between data sources and the explosion in data volume that keep investment professionals up at night.”

A further, equally problematic, industry area closely involved in these key technological developments is securities servicing for crypto assets.

Cryptocurrencies are one of the main beneficiaries of blockchain technology, and their proliferation has spilled over into the asset management industry. A report from the International Securities Services Association (ISSA) in October 2018 says players in the crypto asset markets “should be seen as a target market by major participants in the securities services industry”.

According to the report, “post-trade infrastructure must catch up with developments in pre-trade and trade before mass market adoption of crypto assets can truly occur”. Whether that mass market adoption is a worthwhile goal or not, the ISSA says that at least securities service providers could create a “safer and more efficient post-trade environment”.

Corporate actions are another area where AI and automation are having immediate impact, driving operational efficiencies and the development of new products. The products and solutions are “starting to become industrialised and are now better able to cope with sourcing data, calculating entitlements and collecting elections”, Mr. Derem says.

The Asian angle

Macro changes such as technology and cost pressures will have wide ranging impact, and Asia Pacific is going to be in the front line. The extraterritorial nature of the new legislative measures in Europe and elsewhere will also drive change deep into Asia Pacific.

Piecemeal changes are under way. At the end of last year, the Singapore Exchange launched its new T+2 securities settlement framework for settlement of trades within two market days, aligning the city state with Hong Kong, Australia and most Western markets.

The Australian Securities Exchange is busy replacing its legacy system with a blockchain-backed platform amid an extensive consultation procedure to bring the financial sector up to speed on the developments. The Hong Kong Exchanges and Clearing is managing a staggered implementation of its new post-trade system with the initial release going live this May.

While these developments are often about local technological efficiency rather than regional regulatory harmonisation, the trend towards convergence is clear and probably irresistible. BNP Paribas Securities Services points to Asia as a key region for third-party clearance and outsourcing, as the various local markets push to upgrade and enhance their trading infrastructures in an increasingly competitive environment. Third-party clearance may be the kind of option that enables the regional operations to leapfrog more mature markets in technological development, while keeping costs down.

The Asian Region Funds Passport (ARFP) initiative which came into operation this February should be the kind of region-wide regulatory advance that truly brings the asset servicing industry across Asia closer together. The current signatories, Australia, Japan, New Zealand, South Korea and Thailand, are some of the region’s most advanced economies and deepest pools of assets. But it does not seem to have triggered major flows, which is perhaps because the region’s giant markets, China and India, are not part of the initiative.

Last year, the Australian Custodial Services Association noted “that other major fund centres around the world have benefitted from the efficiency and lower operating risks that flow from higher levels of standardisation, simple structures and automation,” and warned that such moves are necessary before Australia can benefit fully from the ARFP.

The ten-nation Association of Southeast Asian Nations grouping has had its own collective investment scheme framework in operation since 2014, although participation levels have been lacklustre.

China is a high frontier in asset servicing, with regulators’ efforts to attract foreign capital driving new servicing and compliance needs and opportunities, according to Mr. Martin. He expects significant flows from China’s State Administration of Foreign Exchange’s announcement this January that it will double the quota under the Qualified Foreign Institutional Investor scheme to US$300 billion. In addition, the inclusion of Chinese bonds into the Bloomberg-Barclays Global Aggregate Index may bring “$300-$400 billion in foreign investment assets to the world’s third largest bond market by 2030”, Mr. Martin says.

Mr. Derem identifies margin pressure as well as regulatory and market changes as among the key drivers of new securities servicing developments. “Issuers should have improved access to timely shareholder information, and it would not be surprising to see those benefits extended to issuers throughout the [Asia Pacific] region,” he says. He expects voting services in particular to see improvement, driven by the general pressure for better corporate governance in Asia and elsewhere.

Overall, the indications are that Asia Pacific is likely to remain critical for the securities servicing industry.

Australia and Japan have “a lot of addressable assets”, which offer “near-term opportunities for custodian banks”, Mr. Martin says. He points to trends in superannuation reform and rising contribution rates in Australia, and increasingly complex and more diverse asset management products in Japan, including offshore funds, especially Cayman funds, “which are very important to Japanese investors”.

There is also the growing wealth management and middle class asset appetite in China. “The desire to bring global market best practice to China will open opportunities for global securities servicing providers,” Mr. Martin says.

According to the McKinsey & Co report, Asia Pacific delivered over 75% of industry-wide revenue growth for securities servicing over the 2010-16 period. With that kind of growth, the region is likely to remain in the securities servicing industry’s crosshairs for the foreseeable future.