Local Asian custodians not ready for IM phase five

Banks’ sluggish preparations for initial margin rules could hit buy-side clients

As firms in Asia look ahead to the final stage of non-cleared margin rules, due to take effect in September 2020, bankers are raising the alarm over the lack of preparations among local custodians to handle the anticipated uplift of collateral flow from smaller, regional clients.

“I don’t think there’s too many sub-custodians out there who can offer any form of initial margin segregation for these rules,” says a former Asian head of collateral at a global bank. “They may be able to offer margin segregation with regards to client money, cash and some of the stuff in Europe. But I’ve not seen anybody here [in Asia] who is offering substance on sub-custody, although some of the smaller custody agents are now thinking about this.”

Sub-custodians are domestic banks that offer custody services in local markets. Such banks are expected to play a more prominent role in settlement and collateral management as initial margin rules force smaller counterparties across Asia to post collateral against certain trades.

The former head adds that firms subject to initial margin in phase five need to begin discussions with potential custodians now. “Firms really need to make a decision [about which custodian to go with] in the fourth quarter this year,” the source says, pointing out that the onboarding process typically takes between four and six months.

Local custodians are also unable to offer the kind of tri-party service that global banks, which may be the counterparties to their buy-side clients, typically demand. Buy-side clients are unlikely to want to connect directly to a tri-party specialist, such as Euroclear in Asia, in addition to using a local custodian.

“The sell side typically uses tri-party infrastructure to post collateral, whilst many phase five buy-side firms have specific relationships with domestic or global custodians that they want to maintain. So the challenge is how we can manage these two different ecosystems,” says Fouad Estephan, director of product management for collateral services at Euroclear.

In response, Euroclear has proposed to allow local custodians to connect with the firm, and channel their client margin payments through to the tri-party system.

As smaller buy-side firms gear up for the new margin regime, some have asked the International Swaps and Derivatives Association to review certain custodians’ account control agreements. The former collateral head says up to 20 new custodians may be preparing to enter the market for initial margin segregation, and at least two custodians have gone through the “time-consuming process” of making sure that their legal documents meet minimum industry requirements.

One of the reasons buy-side firms are keen to preserve local custody arrangements is so they can continue to post collateral in domestic currencies, rather than switch to US dollars or another G4 currency that they wouldn’t normally keep on their balance sheet. In a number of Asian countries – India and China for example – domestic government securities cannot be held overseas, meaning firms would need to use a local custodian to be able to post this type of collateral.

“I’m not sure that a lot of thought has gone into the onshore/offshore issue yet,” says the former collateral head. “What will happen in phase five is that, because the collateral can’t go offshore, you will end up in a situation in which firms need to rely on a local custody agent. The sell side has to understand what that means and what countries are protected. The danger is that if countries don’t have [an IM-ready] custodian at present, they will need to create one if they don’t want assets to go offshore.”

Collateral conundrum

While posting local Asian securities may be more costly than posting equivalent securities in more liquid markets, buy-side firms are exploring the economics of using local securities instead of trying to maintain assets on their balance sheet that they don’t want. This may affect the type of collateral that their bank counterparties need to accept in order to remain competitive in the region.

“It’s up to the dealer community to be realistic about the access that clients have to collateral to satisfy the regulators and make sure that eligible collateral negotiation is a quick process by being reasonable,” says the former collateral head.

But any shift in collateral use will not be immediate. A custody manager at one large US institution says there is pressure to use local collateral – and therefore local custodians – but there are other more important issues to sort out first.

“My impression is that this would put another layer of complexity on a situation that is already very complex with respect to the migration into phase five of the non-cleared margin rules. What I think you’ll find is that market participants will initially be more conservative or restrictive in terms of the collateral they will use and prioritise collateral assets that are easy to transfer and hold on a consolidated basis,” the manager says.

A hybrid approach for clients might be for global custodians to link up with agent banks where local currency restrictions require. BNY Mellon is one global custodian that has begun this process.

“We are already plugged into the local custodians so our primary responsibility is to hold these margin assets which will be posted against bilateral trades of non-cleared over-the-counter derivatives. We will make sure we instruct movement of collateral to and from counterparties on behalf of the client,” says Mathew Kathayanat, head of product and strategy for Asia-Pacific at BNY Mellon.

But to be able to achieve the most efficient collateral management possible, BNY Mellon is being choosy about who it teams up with.

Kathayanat says: “We look for those [local custodians] that are capable of good connectivity. They should be Swift-enabled and understand global custody, because sometimes local custodians don’t understand global requirements and can be very inward-looking.”

Kathayanat says it is imperative to avoid a constant back-and-forth between global and local custodian, so it is better if the local custodian knows exactly what the clients want and can anticipate how to meet these needs in line with the global requirements.

The likes of HSBC and Citi are also waiting on the sidelines to offer local custody services: the pair are global names that have custodian operations in jurisdictions including China and India. Although BNY Mellon offers local custody services in some of the world’s markets, it doesn’t presently have any local custody operations in Asia, relying instead on a network of sub-custodians to deliver its custody and collateral services to clients in the region. 

“To a greater or lesser extent, HSBC is well prepared given our sub and global capabilities,” says Helen Baker, head of global custody product management at HSBC. “In anticipation of the increased volumes, we have developed a real-time market standard automated STP [straight-through processing] solution for the collateral movements with fully transparent reporting.”

Editing by Alex Krohn