Global custody: Seeking out opportunities

Lynn Strongin Dodds explains how custodians are wasting no time capitalising on investment trends across Europe

Harmonisation of financial services may be an ultimate goal for the European Union, but pension provision continues to be a local game. For now, schemes move in step to the rules of their local jurisdiction, although in the long
run defined contribution plans are likely to become the order of the day. The challenge for the custodian is to provide the bread and butter core services but also to keep pace with the larger pension funds which are making forays into alternative asset classes and more complex strategies.

While many of Europe’s heavyweight corporate pension funds have to comply with international accounting standards that require greater transparency, custodians typically carve Europe into different camps. There are countries such as the UK, the Netherlands and the Scandinavian states which, thanks to domestic regulation as well as accounting laws, are home to the more sophisticated and mature pension fund schemes. While there may be nuances in the different legislation, the common theme is the focus on valuing liabilities using market rates.

For example, in the Netherlands, under the Financieel Toetsingskader (FTK), which became effective earlier this year, pension schemes have to discount liabilities by market rates and not by the standard four per cent that had prevailed previously. In the UK, accounting standard FRS 17 has brought a pension’s surplus or deficit fully onto a company’s balance sheet.

Denmark and Sweden, on the other hand, both operate so called traffic light solvency systems, which also sharpen the focus on liabilities. Denmark debuted its traffic light system in 2001 while the Swedish version came out last year for its insurance industry. It uses the three signals – green, yellow and red – to help funds monitor their exposure to different classes of risk including share prices, exchange rates, Swedish and foreign interest rates.

As for Germany, the country seems to be a law onto itself with a host of strict rules and guidelines. The country is also home to structures and vehicles which do not appear in any other jurisdiction. These include both spezialfonds, which are geared to hold the investments of one or more institutions, and the kapitalanlagegesellschaft (KAG) which is the legal entity asset managers must establish in order to manage and sell funds. They do not apply for the selling of registered foreign funds into Germany. Five years ago, the Master-KAG or multi-manager funds came onto
the scene, which are now replacing the KAGs.

While things are slowly changing, Germany’s pension fund industry has lagged behind many of its North European peers. Leading lights such as ABP, PGGM, AP Fonden, UK’s Railways Pension Scheme and more recently the London Pensions Fund Authority have already broadened their asset class as well as geographical horizons to Asia, emerging Europe and the Middle East in search of returns. They have embraced new technology such as algorithmic trading and direct market access and are currently investigating using shorting strategies that have been the preserve of the hedge fund community.

Global custodians have wasted no time trying to capitalise on these investment themes. They have been busy strengthening their infrastructure, investing in the latest state of the art technology and enhancing their suite of services. While core custody offerings such as safekeeping, settlement, income collection, tax reclamation, corporate action and proxy voting are still important, it is not where the money will be made. Moreover, custodians have a better chance differentiating their brands, products and customer service at the higher margin businesses rather than at the commoditised end of the spectrum.

Penny Biggs, head of asset servicing, global sales, at Northern Trust, notes: “The Dutch and Nordic players are particularly progressive and adventurous which means they invest in increasingly more complex asset classes such as private equity, derivatives and hedge funds. For a custodian it has meant getting closer to the clients’ investment strategy. It is no longer just about the processing but offering value-added services such as independent valuations of derivatives, collateral management as well as performance measurement and risk management.”

Securities lending has also gained traction, according to Jervis Smith, managing director, financial institutions group, and head of managed funds at Citi. “Historically, pension funds were reluctant to short sell, but now they are much more aware of the additional returns that can be generated by securities lending. They also realise it can help cover the costs of custody.”

Other revenue generating products that have gained prominence in recent years include investment accounting, regulatory reporting, transition management, commission recapture and transaction cost analysis. Asset pooling and compliance monitoring, especially if a pension fund has a restricted mandate, are also moving higher up the agenda. Martin Kunz, head of global custody products management at BNP Paribas Securities Services, explains: “We are seeing multinational corporations looking more at tax efficient pooling vehicles for their different pension plans. From a custodial point of view, this requires both plain vanilla products as well as significantly enhanced tax, performance measurement and valuation services.”

As for compliance monitoring, Smith points out, “if a pension fund is not allowed to, for example, invest in alcohol or tobacco, we are seeing this compliance function increasingly being outsourced to the custodian. Overall, though, the main difference between the requirements of pension funds is down to the level of sophistication of the scheme.”

Currently, most of the custodial spotlight is turned on the UK and Northern Europe. This is because, on the whole, their Southern European counterparts have historically adopted a more conservative investment approach. Their custody needs are simpler but that is expected to change going forward. For instance, in Spain, where equities and fixed income dominate, the Directorate General of Insurance and Pension Funds is considering a proposal that would enable pension funds to put almost a third of their assets into non-listed investments, including private equity and hedge funds. In addition, draft legislation approved this past June would allow diversification of the country’s Social Security Reserve Fund, which is currently managed internally and invested in government bonds and bank deposits.

Meanwhile, in France, the €33bn French pensions reserve fund (FRR) is making inroads into infrastructure, real estate, commodity and private equity funds. The FRR’s original allocation comprised 60 per cent equities, 30 per cent bonds with the remainder in cash. Under the new investment allocation, ten per cent is being slotted into alternatives.

Looking ahead, the competition among custodians will only intensify on a local and global level. Italian, Spanish, German and French pension funds are required to use their local provider or depotbank, although this has not stopped the behemoth contenders from making inroads.

Bank of New York Mellon, for example, set up business in Germany as a local bank and provides the full gamut of custodial services for their clients. More recently, JP Morgan Worldwide Securities Services launched JPMorgan CustodyConnect, which provides technology and processing services for financial institutions that already offer custody and related services in their local and regional markets, but want to improve their offering. The first institution to sign up was Swedbank, the Swedish bank.

Benjie Fraser, head of the UK pensions and European pensions coordinator for JP Morgan Worldwide Securities Services, says: “We work locally with pension funds as their strategic partner where we can. While pension funds in certain markets have to choose a local custodian, more broadly it is increasingly the fact that pension funds chose custodians because of their capabilities (in thinking global and acting local) rather than ones of pure national interest. The bottom line is that they are looking for best of class in the industry.”

Nadine Chakar, executive vice president at BNY Mellon Asset Servicing, also believes that scale will win the day as the pension fund industry in Southern European and Germany evolves. “European banks may provide excellent service in their home markets but custody is not their bread and butter. By contrast, it is our main business. It may be difficult for a local provider to make the investments in both technology and intellectual capital needed to meet as well as stay at the cusp of what clients are doing next. I think in time market pressures will persuade regulators to change their mind and allow pension funds in certain countries to choose non-domestic providers.”

Written by Lynn Strongin Dodds, a freelance journalist