20 Sep 2011, Custody Risk, Risk magazine
Handelsbanken Custody Services Jonas Modigh, Head of sales and client relationship management
Nordea Robert Mattsson Axén, Head of product development
SEB Ulf Noren, Global head of sub-custody
Custody Risk: How is the current financial uncertainty impacting the securities services business in the Nordics?
Ulf Noren: The Nordic markets have performed well in comparison to many other major western European and North American markets. The Nordic markets are well prepared to fight off any international slowdown, thanks to really good fundamentals. Looking at the securities industry, due to the global situation there has been an increased focus on risk management issues. We have, positively for sub-custody audiences, seen interest levels coming back being – although small – a source of income. We also think that the global crisis has contributed to our client base looking at suppliers again.
Robert Mattsson Axén: For securities services, the Nordic market is very well prepared, although assets under custody have dropped, which has affected us. But volatility is up and that is a positive for sub-custodians, so you have seen both the downside of the crisis and also an upside from the securities services side.
Jonas Modigh: We have seen an increased interest from our clients when choosing custodians in the Nordic region from anywhere in the world. But they are very much looking at risk issues. Before, it was ‘OK we’re looking at the long-term commitment of the custody business’, but now they also need to consider what is the risk with the custodian, and what’s the stability of the custodian. Those factors are more important for the global custodians nowadays, looking at the sub-custody risk. When you ask your clients ‘what are the main criteria when you choose a custodian?’, there is price and quality – those sorts of answers that have always been there, but now naturally they also mention risk.
Custody Risk: So do you see that as an opportunity?
Modigh: That depends on who you’re working for. None of the banks sitting here are in a troublesome position. For us at Handelsbanken, it’s an advantage because we have always been a very risk-averse bank with low risk.
Noren: If you do your European comparison, you’ll find the five large Nordic banks coming out really well in terms of capitalisation and how they are doing in the European stress tests. We can feel slightly more comfortable than our European peers. The only problem is that all the other banks in our region are also doing fine from a risk perspective, and that’s a neutralising thing.
Custody Risk: Overall, how do you think 2011 will work out in the Nordics?
Axén: The companies in the Nordic region are very focused on exports, and it hits them when there is a recession in different countries. Even if their results are fairly good now, they see the forecast as less promising. We have seen values at the exchanges drop because of that and, in this way, we are very affected in the Nordic region.
Noren: Some Nordic banks have exposures in Baltic countries that, at the beginning of the crisis, were classed in the same group as Iceland. But there has been a controlled and speedy recovery in the Baltic economies and we’re looking at 2012–2013 growth rates of between 5% and 6%, underpinned by a growing consumption appetite, with some public stimulus of the economy. The recovery happened surprisingly quickly, being well controlled. It has been a planned recovery that actually took place in a role-model manner. And that increase is why you feel comfortable with our particular region. We can withstand some global recession effects, they will affect us quickly, but we are well equipped to handle a normal recession rate globally.
Modigh: The Nordic countries have difficulty creating growth on their own because they are so internationalised – we need exports. It could be a troublesome situation if both the eurozone and North America do not solve their problems.
Custody Risk: But does more volatility create more transactions, which help your businesses?
Modigh: Yes, that’s the usual case with volatility – that the transaction volumes go up. But now the value-based fees from which we also source income from, have dropped substantially in recent months here.
Axén: A couple of years ago, this volatility would have gained us much more, but nowadays we have the central counterparties (CCPs) so the number of transactions doesn’t increase with the same numbers. Transaction volumes have dropped quite dramatically because of the introduction of CCPs.
Custody Risk: Has the launch of the CCP eased the competition from London-based multilateral training facilities (MTFs) for the incumbent exchanges?
Axén: There is still very big competition from the different MTF statuses popping up all the time, and we’ve also seen some fall outs. I would not say it has eased their competition, but without a CCP they would be in much worse shape.
Noren: Yes. There was a need to introduce it from both a functionality and risk management point of view. Looking at incumbent exchanges, they have held up pretty well and you see virtually no change in their absolute numbers of what they are conducting. But, as a relative proportion of their part of the pie, it is considerably lower, going from 100% down to 70% to 60%. Is that a success or a failure? I don’t know. But, as an absolute number, the total trading has been growing and, as soon as total trading grows, that’s a long-term positive for any market.
We still see inflationary tendencies owing to the number of MTFs coming around. There’s a dark pool announced virtually every week, and recent inflation in CCPs. The only market that has a local CCP in the Nordics is Norway, with Oslo clearing. The other three markets use the European Multilateral Clearing Facility (EMCF), which is a European CCP. But it helps, definitely.
Axén: And the funny part is that Oslo, which has its own CCP, has lost less of its market share than Nasdaq OMX, which has the other Nordic markets. You will always see the incumbent exchange be one side of a trade as long as it has the auction as a starting point, so they even seem quite positive on MTFs, despite the strong competition.
Modigh: Considering it a success or not, for the local market we only need to think of how things would look if they hadn’t done it. So, in that sense, it is a success because it would have been much worse. It was a must in the market.
Custody Risk: And how do you see this affecting the smaller players within the market? Will there be more consolidation in CCPs and MTFs?
Modigh: Definitely, but also new ones are popping up all the time. Both trends
Noren: If you look at smaller players in the trading participation scene, they will experience a more complex and more expensive reality. So smaller traders will leave the direct membership arena and go for the direct market access (DMA) solutions and the likes. We are in heavy demand and need the consolidation of the CCP scene. Interoperability might ignite the consolidation fire.
Custody Risk: Do you have a time frame for this?
Noren: Yes, there is a time frame for inter-operability in the Nordic markets. EMCF says that it will be ready for interoperability under certain conditions by January 1, 2012. Nasdaq OMX has announced that competitive clearing with the addition of EuroCCP and SIX x-clear will happen during 2012, with a muted March/April 2012 timescale.
Norway has announced that it intends to interoperate with LCH.Clearnet, but there are a few hurdles. We will have the same kind of contentious debate in Norway that we had all over Europe with regulators coming in and probably starting their investigations from scratch. And we’ll find that they need to have Norwegian-speaking staff and be applied to Norwegian-language contracts, and things like that. So it will be interesting, and likely delayed.
Axén: We’ve seen several new broker firms trading in the Nordic markets, but maybe not always seen by us as sub-custodians because they go through general clearing members (GCMs). So the step into the Nordics has been easier even if there are debates ongoing in the Nordic region. If all of them are good for the market – and I’m thinking about the high-frequency trader – that is a discussion that is ongoing, at least in the Nordics.
Modigh: DMA trading has increased quite rapidly in the region and that has also enabled newer players to come in at a lower cost.
Axén: You will see that a somewhat traditional smaller player or local player will disappear or they will need to redo their whole business case or how they will do their business. So they have seen harder times since the introduction of the CCP.
Custody Risk: How has it affected sub-custodians?
Noren: We have lost a lot of transaction revenues. For example: the netting rate is enormous; it is a very efficient netting rate. When I looked at our own role as CCP during a fairly active month, we had six million transactions conducted in the GCM capacity, which was reduced to less than 50,000 settlements. That has an impact on your top-line revenue. It doesn’t necessarily do the same kind of damage to the bottom line, but top-line revenues are shrinking, definitely.
Axén: Looking at EMCF, they have at least 97–98% of netting effect in the trade versus settlement. So it has a major effect and we have seen at least 60% – possibly more than 60% – of our transaction volume disappear after the CCP. So it has hit us, and the problem for us as custodian is transactions that have disappeared had a very high straight-through processing rate. So we haven’t been able to reduce the cost as much as revenue in this case.
We have also seen another effect in the market that has been discussed over the last two years, and that is the settlement rate in each central securities depositary (CSD), which has dropped. Then of course it depends on how you calculate it. At least through the normal way that the CSD has calculated it, it has dropped. But that’s another discussion.
Custody Risk: Another challenge has been a decision by JP Morgan to in-source some of its sub-custody, which has sparked a debate. Should Nordic sub-custodians, particularly those with their own domestic institutional clients, be worried?
Modigh: We always face fierce competition nowadays from the global custodians, so I don’t think that creates something new. We need to prepare for this; I mean looking ahead to Target2-Securities (T2S) opens up the entire European landscape for competition among CSDs and the custodians. That is the world we live in now, so you need to focus on your costs to be able to run a cost-effective shop going forward. Then you can’t just hide from your competitors.
Custody Risk: Do you see it as a natural part of the competitive environment that you face?
Modigh: Yes. There’s no going back to the ‘good old days’, so to say.
Noren: There are two things. One is the drive from global custodians to set up full-service shops including sub-custody; to achieve that you need to have local presence and local expertise in place. There is very tough competition for staff, especially experienced staff. There is tough competition on the commercial side, which has made it very difficult for newcomers to enter the Nordic arena. Then, you also need to ask the question ‘what are the motives for doing this?’. And, if the global custody community says ‘I don’t trust any risk other than risk on my own institution’, you are suddenly in a situation where your risk, as a global custodian, doesn’t look that glorious.
By doing the first statement, the second statement means ‘I don’t deserve to manage this risk’, so you should look for other motives behind it. If there is a paradigm shift going on that entails global custody and sub-custody becoming one, which I don’t think there is, then it’s worth looking for. And I ask ‘is there a formula from the global custodian where you can take a global approach to compliance with the new regulatory environment, then it’s worth looking for and implementing’. Otherwise, I’m comfortable on the sub-custody side.
Axén: They have a different business model from our usual competition. Remember we have a Nordic market, which we believe is fairly good, but it’s four different markets. We are all revenue providers, it’s quite expensive to go into each individual of those four markets – there are four different currencies, basically four of everything. We believe it comes at a very high cost to win. We will see some direct custody, which we have already seen by global custodians, but they will go with their own client base. In terms of competition around other clients, I don’t see them in the short or medium term as a risk. But we risk losing them as clients, but I don’t see them as competition because then you are required more of a local presence with a high cost attached and it will take its time to build that local presence.
Modigh: The competition of global custody is not a new phenomenon.
Noren: On the global custody side, do we need to be worried? You have three strategies in the Nordics, which is selling off global custody entering partnerships, which is the route that Handelsbanken is taking, the DnB NOR is going the same way, Pohjola Bank and Swedbank are doing the same; and the third strategy is to keep your global custody operation, which is something that SEB has done and Danske Bank as well. You have all three strategies.
Custody Risk: How do you see your strategy changing over the next few years?
Modigh: For global custody, we are confident we have a good partnership with Northern Trust where we mutually work in the Nordic region. Looking further ahead for both global and sub-custody is pretty much all about T2S – when does it come into effect and how should we reshape our business to make the best out of that? And how do we reduce our costs, make use of T2S to reduce our costs further for cross-border trading and also find new revenues for when the sub-custody business declines – finding new services, new ways of charging, new products? There are many things we don’t get paid for today that are part of a package.
Axén: Should we see T2S as a threat or an opportunity? Working with product development, I see opportunities. Will the sub-custodians change? Yes, you need to change – 15 years ago sub-custody looked totally different. You will see unbundling of services, you need to look at new price models, etc. You will also see some clients exit or settle themselves in T2S. But that also means ‘can we take down our costs?’ There are opportunities in that area as well. We need to reshape but that is daily business and you need to work with that.
Custody Risk: So how important is T2S when looking at the future?
Axén: T2S will affect us in one way or another, even if none of the four Nordic markets will join T2S. Norway as an example, which has been outside of the European Union (EU), still needs to adapt to the EU’s landscape. We can see different options where one or two or three countries only join and one steps out. So we will see differences. It will affect us quite dramatically, in the short term but also the long term.
Noren: There’s an old Queen song, I Want It All, and the next line is “I want it now”, that is what the client base wants – they want it all and they want it now. T2S, together with the 12–14 under-regulatory initiatives, drive the development and it provides optionality there for clients. You can find six or seven main scenarios where the client wants it now and, if you are the typical large broker-dealer company or investment bank, four years ahead is a very long time. A top priority as a sub-custodian is to re-engineer your business so that you are in shape to deliver all of the T2S effects, notwithstanding T2S’s launch or not.
Custody Risk: How do you communicate to your customers about T2S?
Noren: There are various stages of readiness. Some think it’s beneficial to sit back a little bit and see how this is developing and are thereby saying ‘I am going to employ an asset scenario and use the same kind of strategic set-up that I have today’. The majority of the around 300 institutions that use sub-custody in the Nordics are further down the planning line, and they have their minds set on two or three of the main scenarios. And then you sit down and have that discussion, looking for what they want to achieve: ‘can you deliver that?’, ‘can you deliver that under conditions?’ and ‘how do you make sure that, if you go for part of the most extreme but also most likely solution, settlements always are separated from asset services, advocacy and advisory services, etc.?’. How do you eliminate the risk that you are going to support an even more complex asset servicing provision to your clients when you are not in full control of your settlements? How do you get that control? You need to involve your own product management area, the full array of business lines on the client side and also the respective securities depositories.
Modigh: It’s not 100% certain that all European custodians will hook up and go direct and bypass their current custodian. We receive mixed messages when we speak to clients. For some, it is in their mind, but some still consider having a regional custodian in the Nordics. Time will tell.
Axén: We need to adapt, whatever they do. Our clients have an opportunity to wait and see. They also have the opportunity to go directly, but they need to value now the risk of doing this. What about asset servicing? I also see a difference between remote brokers or brokers, or custodians or sub-custodians in the rest of Europe as well. They face the same problem as we do. So you see the readiness in those areas and the choice they need to make are different, but we as custodian need to be ready for all options.
Custody Risk: Which regulations are at the top of your agendas?
Axén: Several. You can’t just pick one because they are dependent on each other. You could mention the Securities Law Directive, Basel III and then the Markets in Financial Instruments Directive (Mifid) II, which will affect us as well. Some of them are directing to the CSD or CCP interoperability, but of course that will also affect us. The problem we all face is that there are so many at the same time. It is uncertain how it will be implemented, whether or not it will be implemented and in what time frame? And some of them will probably not cost us anything in the end. Hopefully they will bring something good.
Custody Risk: How much time are you spending on regulation at the moment?
Noren: It’s a long time since it was a regular eight-hour working day, so quite a lot and you need to focus on all of them. They might provide more transparency, for example, on the CSD side, but could also provide more darkness, depending on which route Europe is taking. An important starting point is figuring out why the politicians and regulators do all of this, and the answer to that is that they never want to face public opinion again, and say ‘hey taxpayers, we need to bail out the banking system once again’.
I fear that, as you introduce the regulations and don’t align them completely to each other and to – for example – corporate law, consumer law, and so on, the risk of getting into a bail-out situation is becoming greater. So it’s a big part of risk management with all of those regulations interacting. It will lead to a situation where the average investor is going to pay more tomorrow than they pay today.
Custody Risk: Do you think single-market players are a dying breed within the Nordic region?
Noren: Yes I do, and I see that happening all over Europe with the exception of the UK and Switzerland and a niche market or two in Central and Eastern Europe.
Axén: The Nordic region is a very competitive landscape with tough price pressure. It is also a region that will be looking at a number of infrastructural changes in the coming years. Taking that into consideration, I believe you need a critical mass to be able to survive and single-market or small regional players will have a hard time.
Modigh: Single-market providers will face difficulties defending their business cases in the long run. You will continue facing demands for big investments in the product going forward, and it will be tough if you are only present in one market. Being a multi-market provider, with the need to invest for your internal business flow anyway, you can leverage on your investments and develop high-quality products at a lower cost. However, I am not sure whether there will be consolidations in the Nordic region in the near future.
Custody Risk: In a few years’ time, what kind of suppliers of sub-custody services do you see in the Nordic region?
Axén: Due to the large infrastructural changes that I believe will happen, the service offerings will change – either in the way they are packaged or offered. Therefore, you will see some new suppliers that will try to offer part of the traditional sub-custody service offering, but still very few suppliers that could still offer the total service offering across the region.
Modigh: Multi-market providers will have a better chance to survive, and there will probably be an evermore competitive market in a few years’ time. Focus will be on asset servicing and also clearing – and paying agent services, due to local currencies in the Nordic region, rather than settlement. This requires you to be able to run a cost-effective shop and find new products and services. If you consider a post-T2S environment, we receive different messages from our clients regarding their future set-up plans. Some are looking into entering the Nordic region themselves, but some are still anticipating the use of a regional custodian. You will have a mix, dependent on the size of the client and its future business plans.
Noren: Regionals only. Independent of T2S, suppliers have adapted to a T2S-like model with many service-level layers. Re-engineered operational models will change the client-facing service model. Suppliers that are present in all product areas and with significant investments made in collateral management and cross-margining products. Much more of a ‘can-do’ attitude. Suppliers embrace open debate climate, sharing and learning.
Custody Risk: What do you feel are going to be the driving themes for custodians in the Nordic region over the next 12 months?
Modigh: We need to focus on reducing our cost by having a cost-effective shop, total knowledge of IT costs and an effective IT platform. At Handelsbanken, we are focusing on these issues right now and investing heavily in the IT platform for our Nordic securities business. That makes us feel rather comfortable before going into T2S because, once they are in T2S, there are no free lunches. You need to have a very cost-effective shop to stay alive.
Axén: T2S and regulation will be under discussion. From Nordea’s perspective, we need to prepare our organisation for a fairly uncertain future. We need to be prepared, flexible and be able to quickly adjust.
Noren: One driving theme is the positioning in front of regulatory initiatives and T2S. Another is re-engineering the operation areas and the business lines because you will stand in front of a situation where the commercial value of a settlement transaction will, if not diminish, become very low. We will centralise most of our settlement activity to a regional operation centre in Riga (Latvia). We have moved Denmark, Finland, Sweden and Norway, in that order. So that’s a mega project. The results are encouraging.
We need to focus on the asset servicing part of the offering and on the unbundling of services and fees, an equally large project. We are putting more investments into measurement of risk and handling of collateral management and cross margining. We are spending more time on client dialogue, spending three, four, five hours with clients to gain an understanding of where they’re going. We are also improving the client relationship area – increasing seniority, increasing the quality, working to adopt Asian attitudes in that one. You need to have much more of a ‘can-do’ attitude.