Global Custody and Clearing Services (Finance and Capital Markets)

Global Custody and Clearing Services Ross McGill and Naren Patel

GLOBAL CUSTODY AND CLEARING SERVICES

Also by Ross McGill INTERNATIONAL WITHHOLDING TAX: A Practical Guide to Best Practice and Benchmarking RELIEF AT SOURCE: An Investor’s Guide to Minimising Internationally Withheld Tax THE NEW GLOBAL REGULATORY LANDSCAPE: Impacts on Finance and Investment SARBANES OXLEY: Building Working Strategies for Compliance

CHAPTER

Global Custody and Clearing Services

ROSS McGILL NAREN PATEL

© Ross K. McGill and Naren J. Patel 2008 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The views and opinions expressed in this book are solely those of the authors and do not necessarily reflect those of the institutions which have acted as co-publishers to the book. Although Palgrave has made every effort to ensure complete accuracy of the text, neither it, nor the authors, nor any co-publisher can accept any legal responsibility whatsoever for consequences that may arise from errors or omissions or any opinions or advice given. Nothing in this book is intended to constitute the provision of taxation or investment advice. Readers are strongly advised to take professional independent advice on such matters. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. First published in 2008 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y. 10010 Companies and representatives throughout the world. PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin’s Press, LLC and of Palgrave Macmillan Ltd. Macmillan® is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN 13: 978–0–230–00700–0 hardback ISBN 10: 0–230–00700–7 hardback This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. A catalogue record for this book is available from the British Library. A catalog record for this book is available from the Library of Congress. 10 9 8 7 6 5 4 3 2 1 17 16 15 14 13 12 11 10 09 08 Printed and bound in Great Britain by CPI Antony Rowe, Chippenham and Eastbourne

To our wives, families and friends without whose unfailing support this work would not have been possible

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Contents

List of Tables

ix

List of Figures

x

Preface

xii

About the Authors

xiii

Acknowledgements

xv

Who should Read this Book & Why

xvi

List of Abbreviations

xviii

PART 1 AN INTRODUCTION TO CUSTODY & CLEARING 1 A Brief History of Custody 2

Custody Today

3 12

3 Key Issues

28

4 Clearing & Settlement

43

PART 2

ASSET SERVICING

5 Asset Servicing Key Issues

61

6 Withholding Tax

85 vii

viii

CONTENTS

7 OTC Derivatives

113

8 Trustee & Fund Accounting Services

130

9 Securities Financing & Lending

140

PART 3

MANAGING RISK

10 Vendor Landscape

159

11 Corporate Governance

174

12 Network Management

202

PART 4

T E C H N O LO GY

13 Standards, Messaging & Mediation

219

14 Reconciliation

239

PA R T 5

THE FUTURE

15 The Future

261

Appendix I Example of Securities Service Level Agreement

270

Appendix II Example of a Service Level Standards Statement

276

Appendix III Standard Securities Lending Agreement

285

Bibliography

305

Index

307

List of Tables

1.1 2.1 2.2 2.3 2.4 2.5 4.1 4.2 5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8 6.1 6.2 7.1 7.2 10.1 10.2 11.1 11.2 14.1 14.2

Global custody survey Types of custodian Recent mergers and acquisitions Worldwide assets under custody Domestic assets under custody Cross border assets under custody Overview of principal financial market infrastructures in Europe Giovannini’s barriers Asset management firms by region Corporate actions growth by type Scaling of losses by AUM for funds managers in 5 European countries Potential ROI by size of firm Top UK fund managers Top North American fund managers Top European fund managers Types of corporate action Extant tax available for recovery Statutes and recovery times in the main markets Differences between exchange traded and OTC derivatives Challenges in OTC Derivatives Main corporate actions software vendors Comparison of vendor functionality Impact of MiFiD sections on IT Complaints filings box score Examples of reconciliation event types SWIFT ISO 15022 Reconciliation message types

4 14 16 19 20 21 51 53 62 66 67 68 72 73 74 80 89 94 114 125 164 165 179 199 245 254 ix

List of Figures

2.1 3.1 4.1 4.2 5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8 5.9 5.10 5.11 5.12 6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 6.9 6.10 7.1 7.2 x

The investment chain Outsourcing at both ends Comparison of securities to money markets Account structures of actors in clearing settlement & custody The corporate actions chain Common processing errors Geographic breakdown of AUM by region Market impact of corporate action type by region Losses due to CA failure Assets managed in the UK Equity allocation by country Equity allocation by sector Asset management globally by parent Client mandates of AUM Asset allocation across all categories Importance of automation to custodians Principle of withholding tax Factors affecting entitlements to withholding tax Effect of processing approach on performance The withholding tax principle Relief at source Remedial Reclaim Model Communication in tax processing Tax related issues for custodians Current Tax Processing Model Service Bureau Model for tax processing The place of OTC Derivatives in custody and clearing OTC Derivative trade process flow

14 29 46 48 64 64 66 67 67 69 70 70 71 71 72 79 86 88 93 97 98 99 100 102 107 109 116 119

LIST OF FIGURES

7.3 11.1 11.2 11.3 11.4 11.5 14.1 14.2

The future of OTC trade processes MiFiD and objective setting MiFiD and transparency MiFiD and record-keeping MiFiD and compliance Class actions filings 1996–2006 Reconciliations process flow Service levels of outsourced reconciliation

xi

128 182 183 184 185 200 243 252

Preface

Global Custody was conceived out of changes to United States pensions law in 1974 when the Employee Retirement Income Security Act (“ERISA”) forced US pension plan sponsors to segregate investment management and custody of their underlying assets. Today assets under management in global custody have exceeded $90 trillion and global custody is a flourishing business covering over 200 countries. Clearing and Settlement activities have similarly grown at a concomitant pace and both have, and will continue to see, enormous changes both in infrastructure and also in available products, delivered through convergence and development of standards and technology, overseen by regulation and good corporate governance. With holdings in cross border assets growing at 16% a year, trading activity has never been higher nor broader in its scope whether measured geographically or by asset class. Technology has given the markets the potential to realise enormous efficiencies in speed and cost and so clearing and settlement systems have grown to be highly complex in their fight to minimise risk. In this climate it is fundamentally in the interests of both investors and the financial institutions that serve them, to be clear about how custody and clearing works and the key issues that need to be understood and addressed. I believe that this book achieves those aims in a clear and concise way. The authors have called upon not just their own substantial experience in the industry, but on key players whose combined insights and experience make this book particularly important not just for the novice investor but also for the experienced professional.

xii

About the Authors

Ross McGill. Since graduating with an honours degree from Bath University in 1978, Ross has held key management posts with major international companies. He is CEO of an international consultancy practice helping financial services firms become more competitive and efficient. Ross has worked in the wholesale financial services sector since 1996 and was, until 2002, Group Managing Director of five software companies servicing the major banks on three continents. He is particularly well known in the industry for his public work with the Society for Worldwide Interbank Financial Telecommunications (“SWIFT”), the US Treasury, IRS and global custodians dealing with the practical effects of new regulatory structures. He is also director of marketing for GlobeTax, leading business process outsourcing of withholding tax processing in the UK and E.M.E.A. where he advises financial intermediaries on best practice in business process enhancement. Ross was co-chair of SWIFT Market Practice Group on United States Section 1441 NRA regulatory issues for ISO standard messaging and cochaired an Operational Impact group with the IRS, US Treasury and Deloitte & Touche LLP from 1999–2001. Ross also serves as the UK expert representing Service Bureaux on ISO 20022 Securities Evaluation Group (SEG) Committee TC68. Ross’s published works include: Published by Euromoney Books:
International Withholding Tax – A Practical Guide to Best Practice and Benchmarking (2003)


Relief at Source – An Investor’s Guide to Minimising Internationally Withheld Tax (2004) xiii

xiv

ABOUT THE AUTHORS

Published by Palgrave Macmillan:
The New Global Regulatory Landscape – co-authored with Terence Sheppey (2005)


Sarbanes Oxley – Building Working Strategies for Compliance – co- authored with Terence Sheppey (2006)

Naren Patel. With a BSc(Hons) Accountancy with Business Finance degree from Leicester University, membership of the International Securities Institute of the UK and an SFA Registered Representative, Naren is a Securities Industry practitioner with more than 20 years post-graduate experience. In recent years, he has held senior Director level position and been at the sharp end of strategic business development for leading software houses in the UK specialising in the areas of launching new products, PR, marketing, focusing on the complete trade life cycle from front to back including areas such as ETC, ETD and Corporate Actions Integration technology, standards based messaging and in general operations for asset managers and custodians over the last few years. Naren’s most recent role is Director, Securities Business Development at CheckFree Corporation and he was previously Director, Marketing and Business Development at Trace Group Plc. Prior to this he was a Senior Regional Account Manager at SWIFT where he helped develop SWIFT awareness within Custodians, Fund Managers and Broker Dealers. Naren was responsible for promoting the ISO 15022 implementation and deployment. He was Chair of the European Network Management Forum. Prior to working at SWIFT, Naren worked for over 10 years within the Royal Bank of Canada / Royal Trust Corporation of Canada most recently as Director Relationship Management & Business Development UK, Europe and the Middle East. He was also the Head of Client Services in Toronto for Canadian Sub Custody. Prior to moving in to the Custody area at RBC Naren was a senior manager for over 2 years in debt refinancing and restructuring. Naren also spent over 5 years with NatWest Bank in the Unit Trust Administration and Trustee area as divisional section head. Naren has been published in many trade journals providing concise thought leadership analyses of issues and future trends and frequently asked to provide press comments for custodians, Fund managers and Broker Dealers.

Acknowledgements

The authors would like to thank and gratefully acknowledge (in alphabetical order) the following for their contributions to the work of this book. Steve Bill, Head of Sales COR – STP Graham Bright, Managing Director, Financial Tradeware Bob Craddock David Dickenson, Director of Network Management, Thomas Murray Martin S. Foont, President Globe Tax Services Inc. Bob Fuller, CEO, Equiduct Hugh Gibson, Consultant to ISDA Wendy Gyngell, Marketing Manager, Equiduct Manoj Mistry, Royal Bank of Canada, Director Financial Institutions Simon Shepherd, CEO Myriad Group Technologies Limited Michael Simmons Stefan Sosnowski, Independent Consultant, Reconciliation Products Gary Wright, CEO, Biss Research

xv

Who should Read this Book & Why There are three categories of people for whom this book is intended to be useful:


Those responsible for strategy within custodian banks;




Those who run operational departments within custodian banks;




Those who use financial intermediaries to provide safe custody of their assets.

The primary reason for anyone to read this book should be to get some real insight into the drivers of the business, how it is likely to change in the future and what commercial re-alignments are likely. Will consolidation continue and to what end? These types of question are affected by factors within the industry as well as, increasingly, those outside it. For example, in the last decade, custody development was pretty much dictated by technology. The IT department was king because it was clearly the “big thing” that could affect business the most. So, major IT projects by the larger custodians created new advantages, drove down operating costs and pushed smaller custodians out of business or into the hands of the larger players. Where this didn’t happen, the market saw banks selling off their custody business to the larger players either because they couldn’t live with decreasing margins or because they couldn’t keep up with the spiralling investments that the large players were throwing at the area. Virtually every function in the business wanted to have projects based fundamentally on automation. As always, such automation led to massive downsizing or getting leaner and fitter as the euphemisms go, usually paraded by those not directly subject to them. It was common for projects from a wide variety of departments to be prioritised by the IT function in terms of their placing in the pecking order. xvi

WHO SHOULD READ THIS BOOK & WHY

xvii

In the current decade, even though most firms continue to spend massively on IT, it’s not the technology functions that control the spend nor the agenda anymore. It’s the compliance and legal functions which are driving the business with IT supplying the end product. Custodians are coming under a number of different pressures from a number of different sources, each with their own agenda and levels of influence. Regulators are driven to try to increase control over the banking industry because of a perceived lack of ability to self-regulate. Additional regulations act on behalf of investors to make processes and reporting more transparent. The natures of many of a custodian’s activities, particularly in corporate actions, are being increasingly scrutinised by regulators in all jurisdictions to comply with international attempts to minimise fraud, money laundering and terrorist activities. Geopolitical influences act with administrators increasingly concerned with ethics – ethical investment, carbon neutral funds as well as corporate governance ethics – good corporate financial behaviour. So, while automation is still viewed as the only real consistent strategy to deal with these issues, it’s the drivers of these governance stratagems, the lawyers, compliance and business leaders who are setting the agenda, the business and functional specifications if you will, for the continuing ability of custody banks to do what they do and still make a profit. So let’s take a closer look at what custody is today and how it came to look that way.

List of Abbreviations

AGM AML ASP AUM BAM BIS BOT BPM BPO BPR CCP CCF CDS CSD CSV CTM CUSIP DTCC DVP EAI ECSDA EGM ESB FCP FIX FSA FTE FTR xviii

Annual General Meeting Anti Money Laundering Applications Service Provider Assets Under Management Business Activity Management Bank of International Settlements Business Object Type Business Process Management Business Process Outsourcing Business Process Re-engineering Central Counter Party Common Contractual Fund Credit Default Swap. Also Canadian Depository for Securities dep. on context Central Securities Depository Comma Separated Values Central Trade Manager (Omgeo) Committee on Uniform Securities Identification Procedures Depository Trust & Clearing Delivery versus Payment Enterprise Application Integration European Central Securities Depository Association Extraordinary General Meeting Enterprise Service Bus Fund Commun de Placement Financial Information eXchange Financial Services Authority Full Time Equivalent Financial Transactions Reports

LIST OF ABBREVIATIONS

FX GL GSTPA ICSD IFRSA IRR IRS ISDA ISIN KYC LIBOR MDDL MiFiD NACK NAV NCSD NSCC OCC OTC PCA P/E PFPV RFP ROI SEPA SIA SLA SMPG SOA SOX SSS STC TQM TQI VCC WSDR XML

xix

Foreign eXchange General Ledger Global Straight Through Processing Association International Central Securities Depository International Financial Services Regulatory Authority Internal Rate of Return Interest Rate Swaps. Also US Internal Revenue Service dep. on context. International Swaps & Derivatives Association International Securities Identification Number Know Your Customer London InterBank Offer Rate Market Data Definition Language Markets in Financial instruments Directive Negative ACKnowledgement Net Asset Value National Central Securities Depository National Securities Clearing Corporation Options Clearing Corporation Over the Counter Principal Components Analysis Price Earnings Ratio Pension Fund Pooling Vehicle Request for Proposal Return On Investment Single European Payments Area Securities Industry Association Service Level Agreement Securities Market Practice Group Service Oriented Architecture Sarbanes Oxley Act 2002 Securities Settlement System Straight Through Processing Total Quality Management Total Quality Information Variable Capital Company Web Services Descriptor Language Extended Markup Language

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PART 1

An Introduction to Custody & Clearing

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CHAPTER 1

A Brief History of Custody We cannot go into the detail of custody and clearing services without giving first some sense of context and history to the subject matter. The industry has been formed by people not by theory and it is these characters that have brought us to the current position of the industry. Only a very few custodians have been able to achieve a consistently excellent level of service. And as the compilation of Global Investor’s survey results since 1988 in Table 1.1 shows, none has been better than BBH. When, in 1988, Global Investor launched its first global custody survey, the industry was very different. The scope of value-added services was still very limited, the size of the industry was small, and a large number of smaller players populated the market. Throughout the great consolidation spree of the 1990s, only four banks Chase, State Street, Citibank and Northern Trust appeared in every survey since 1988. Of the 15 banks that appear in the 1988 survey, only seven appear in the latest survey. Chase and Northern Trust, which between them dominated the survey in its early years, have both fallen dramatically down the rankings more recently. Indeed, very few custodians have managed to score consistently well, which makes Brown Brothers Harriman’s run since the early 1990s so remarkable. Since 1992, BBH has only fallen out of the top two places four times, and has never finished lower than fifth. What is it about the global custody business that attracts some of the finest minds in the banking industry and beyond? It’s not rocket science. It doesn’t save lives, and no one from the industry is going to win a Nobel Prize. Yet still they flock out of the world’s top business schools and universities to tackle issues such as pan-European transfer agency and net asset value calculations. The talent pool in the business has always been impressive, from the time Doug Bonnar started to assemble his team at Chase to meet the challenge set by the Ford Foundation. 3

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Table 1.1 Global custody survey Brown Brothers Harriman Northern Trust Chase/JPMorgan Chase Pictet Mitsubishi Bank of California/UBoC Royal Trust State Street Citibank Bankers Trust/Deutsche Morgan Stanley Bank of New York Mellon Investors Bank and Trust RBS JPMorgan Bank of Bermuda The Boston Company Midland/HSBC Harris Trust Bank of America Chemical Bank Manufacturers Hanover NatWest Lloyds Barclays Banque Scandinave en Suisse Banque Internationale a Luxembourg

1096.47 960.28 928.17 891.95 888.74 871.02 679.47 672.91 665.37 635.12 586.75 480.98 398.66 350.15 272.24 271.94 263.60 222.54 179.86 178.40 175.29 133.57 75.03 61.89 43.00 32.30 10.00

Chase became the finishing school for aspiring custodians, producing a seemingly endless stream of bright young things who dispersed across the globe to bring global custody to the great unwashed. Even the mighty State Street, when it looked for a replacement for the legendary Bill Edgerly, tapped Chase to find Marsh Carter. But other banks have produced their own roster of superstars, as shown by our list of legends and the roll of honour. Some of these were pioneers, who were in at the very start of the business and acted as pathfinders for others to follow. Others were transformational leaders, who took their firms on to the next level of the business, while a few came in from completely different industries and brought their unique experience to bear on the market.

A BRIEF HISTORY OF CUSTODY

5

There are also those who took on an ailing business and turned it around against all the odds. The dynamic duo of Gene Lockhart and Kerry Alberti achieved precisely that feat with the UK’s Midland Bank, keeping it afloat when the easier option might have been to turn off the life support machine. Today its successor, HSBC Global Investor Services, is in good health. When Marsh Carter was appointed as president and chief operating officer of State Street in 1991, he had a reputation as a problem-solver. At Chase, Carter had been drafted in by Mike Urkowitz, the head of Infoserv, the bank’s service products business, to restructure the custody operation. Both he and Urkowitz shared the same vision. They recognised that custody was an information business, not a transaction processing business. In the 10 years between 1991 and 2001 when Carter was chairman and CEO, the corporation’s market capitalisation went from $2.4 billion to $22 billion, while assets under custody rose from $1 trillion to more than $6 trillion and assets under management from $100 billion to $600 billion. Carter inherited a strong legacy from Bill Edgerly, the previous CEO who had reshaped the bank as an asset management and servicing business. He was also fortunate to be handed an early opportunity to make his mark. When the California Public Employees Retirement System (CalPERS) account came up for bid in 1992, State Street won. They bundled pricing and it won the business and set a trend for future deals. Success was sweeter when State Street went on to pick up the equally important Californian State Teachers Retirement System (CalSTERS). Having successfully repelled an unwanted bid from The Bank of New York, Marsh Carter eventually retired in 2001. He had delivered the global expansion that the board and stockholders had looked for, as well as maintaining sustainable earnings growth: 2001 was the 24th consecutive year of double-digit operating earnings per share growth. He also filled out the product line so successfully that, by the time he left, the top 1,000 clients were using an average of 6.5 State Street products, while the top 100 used 10. Few would dispute that, over the past 30 years, the outstanding global custodian in terms of service quality has been Brown Brothers Harriman. Consistent success in industry surveys and a blue-chip client list that includes many of the world’s largest mutual fund managers bear testament to its enduring qualities as one of the few custodians to understand the true value of long-term client relationships. Douglas Donahue, the Brown Brothers Harriman partner in charge of Investor Services, has been there from the start. Joining in 1976 from Harvard Business School, Donahue rapidly moved from his initial job in financial analysis to work for Stokley Towles, a partner who was keen to develop the custody business. Although Brown Brothers Harriman had no dedicated custody systems or operating model, it did at least have some history in the industry: it had

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GLOBAL CUSTODY & CLEARING SERVICES

won its first fund administration mandate in 1928. The real impetus for a global custody solution came from clients: Scudder, Putnam and Fidelity. This focus on clients, and a willingness to tackle complex challenges, have led to Brown Brothers Harriman’s dominant position with US mutual fund complexes: it counts Merrill Lynch, Vanguard, Capital, Alliance and CSAM among its clients. Fund managers have always looked for a trusted partner who knows what they are doing. The pioneering early work of developing a stable custody product eventually gave way to a greater focus on technology. In the past 10 years IT has become the big issue, especially in the area of client reporting and straight-through processing. BBH capitalised very quickly on the power of the internet, and were rewarded with positive reviews from users and industry awards. The key strengths of the firm, service and thoroughness, give it a unique edge. Bill Edgerly is also clearly fond of a challenge. When he became president and chief executive officer of State Street in 1975, the bank was far from healthy. Edgerly joined from Cabot Corporation, having already sat on the board of State Street for several years. What he found was a group of businesses that lacked integration and direction, and he took the best part of three years to turn things around. The rescue job complete, Edgerly and his senior management team wrote what they described as the ‘Bold Strategy’. This involved a much greater emphasis on securities processing, an area where they already had significant technical competence from their work with US mutual funds. Additionally, the bank realised that its personal trust business held the seed of an opportunity to manage institutional money, especially in index funds. The strategy may have been bold, but it was also perfectly timed and executed. During the boom years of the eighties, securities processing was the place to be. Edgerly oversaw the creation of a multicurrency accounting and processing platform, the introduction of 24-hour operations, expansion of the Quincy operations centre, and the development of overseas locations. In 1987, State Street won top spot in the inaugural Global Investor custody survey, further vindicating the strategy. Edgerly is widely credited with being the first bank chief executive officer to spot the potential of securities services as a strategic business, rather than simply another service product. But he also recognised that a further leap forward would be necessary and he started to assemble a fresh senior management team including his successor, Marsh Carter, Albert Petersen from Euroclear and Jacques-Philippe Marson from Cedel to inject a more global mindset into the corporation. If Douglas Bonnar, the man who invented the term ‘global custody’, could be described as its midwife, then Colin Grimsey, who worked for Bonnar at Chase, was both mother and father of the product.

A BRIEF HISTORY OF CUSTODY

7

Grimsey will always be remembered as the man who developed and nurtured global custody from its earliest days, transforming it into a multibillion dollar industry that truly spans the globe. Grimsey’s genius was to exploit a product that was both complex and labour-intensive, and to build a business in a market sector – US mutual funds – where Chase had little penetration. US investment regulations, especially the 1940 Investment Act, made it difficult for US mutual funds to administer overseas investments, yet Grimsey and his colleagues successfully lobbied the Securities & Exchange Commission for an exemption that allowed Chase to hold foreign assets in non-US bank branches on behalf of their clients. Grimsey himself would be the first to recognise that he was lucky to be surrounded by a group of highly talented individuals. Few other firms could boast the intellectual firepower of Chase on both sides of the Atlantic. Despite plenty of opportunities to move elsewhere, Grimsey remained loyal to the bank. To make your mark at one custodian is something of an achievement; but to do the whole thing all over again at another custodian requires an uncommon degree of talent. Robert Kay managed this feat, although his introduction to the custody business was hardly earth-shattering; he joined Chase in 1977 to work in their financial institutions group in London. That balance of power quickly changed. With Kay promoted to run the group, he oversaw the phenomenal growth of Chase’s global custody business. Mutual funds were the first US investors to diversify internationally, and then the effects of the 1974 Employee Retirement Income Security Act kicked in, with US pension plans following the same path. The momentum behind Chase carried it through to the mid-eighties, when Kay saw the potential of a new market, dealing with UK insurance companies. At one stage in the nineties, Chase had custody relationships with three-quarters of the top 20 UK insurance firms. From these relationships, Chase also carved out its market share of the UK unit trust business. Kay moved to Morgan Stanley in 1987 and set up its custody business. Based in New Jersey, Kay assembled a pugnacious team of managers with a common vision to re-engineer the way in which custody was bought and sold. Clients liked the approach, with names such as Henderson, Prudential in the US, Vanguard, Wells Fargo Nikko and Fidelity as clients. After leaving Morgan Stanley in 1990, Kay had a brief spell with Goldman Sachs before establishing his own business, Global Securities Consulting Services (GSCS), where he is still exercising his talents as a supremely shrewd reader of the custody markets. It is no small irony that the only genuine European global custodian should be run by a man who spent much of his previous career with US banks. Jacques-Philippe Marson, president and chief operating officer of BNP Paribas Securities Services, joined the French bank in 1998 after seven

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years at State Street, where he was initially given the task of re-engineering operations and ended up running the international business. Marson, who was born on a ship in international waters and has Luxembourg citizenship, started his career with Morgan Guaranty Trust Company in 1976. He stayed there for 12 years, and first got involved in the custody business during an assignment to Brussels, from where the Euroclear Operations Centre was run. He moved on to spend three years at Cedel (now Clearstream) as head of business development, operations and treasury before joining State Street in 1991. Under Marson’s watch, and with the enthusiastic support of Marsh Carter, the bank’s chief executive officer, the global profile of State Street grew exponentially. It took leadership positions in Canada and Australia and elbowed its way to a seat at the top table in the UK pension funds sector. Marson was keen to put local managers in place, and attributes much of his success to the strength of the people around him. In 1998 Marson was chosen by Paribas to create a major European player in global custody. Paribas had acquired JP Morgan’s clearing and custody business in Europe which became the base from which the project began. Although Marson’s dream of a pan-European custody bank alliance was stalled by the merger with Banque Nationale de Paris, the impetus behind the core businesses of clearing and investor services remained unchecked. Marson and his team have achieved exceptional results: coverage of European markets has grown from five to 12 countries, while transaction volumes have risen from 3 million to 26 million a year. Assets under custody have swelled from €500 billion to more than €2 trillion, with staff numbers rising from 500 in 1998 to over 3,500 today. Within Europe, industry surveys consistently rank the clearing and sub-custody business at the very top in terms of product and service. But Marson’s boldest move has undoubtedly been the 2002 acquisition of Cogent Investment Operations, giving the bank a major fund administration presence in the UK, as well as businesses in Dublin, Luxembourg and Australia. With this deal, Marson may well have created a tremendously powerful alternative to the US banks, which has been the objective since his first day in Paris. The future will tell. The late eighties saw American banks marauding across the UK, plundering custody mandates from UK banks that had been overwhelmed with retail investment volumes and had failed to plan for growth. In the unit trust (mutual fund) sector, Chase and Citibank led the way, their success underpinned by the strength of their corporate banking relationships with major British insurance companies. Citibank’s masterstroke was to hire John Morris from the UK’s Midland Bank, where he had been running the trustee business. Joining Citi in 1987, Morris was tasked with setting up Citibank’s trustee company and developing a major presence in the sector.

A BRIEF HISTORY OF CUSTODY

9

Although unit trust managers recognised that the service from UK banks left a lot to be desired, there was still a reluctance to move. There was a high threshold of pain among the managers, who didn’t want to switch to the US banks. Citibank’s first unit trust mandate was for the Baring UK Growth Trust, and other major clients including Perpetual, Norwich Union, Friends Provident and Commercial Union soon followed. The success of the trustee business led to a steady climb up the corporate ladder for Morris, who took on responsibility for sales and client management within Europe for the global securities services business. Under his leadership, Citibank established a commanding position in the Netherlands with local pension funds, as well as expanding relationships with UK insurance companies and developing a strong franchise in Edinburgh. Today, the early advances made by Morris and his European team are reflected in the fact that Citibank has the highest percentage of non-domestic assets of any of the top five custodians. Although it had been in business since 1865, it was the 1974 Employee Retirement Income Securities Act (ERISA) in the US that gave Boston Safe, its primary subsidiary, the opportunity to take a leading role in institutional trusteeship of ERISA-governed plans. Taken over by Shearson Lehman Brothers in 1981, The Boston Company carved out an enviable reputation for innovation and high-quality service, culminating in 1993 when it shared first place in the Global Investor custody survey, the same year as it was bought by Mellon Bank. One of the main architects of its success was Jim Palermo, who joined the firm in 1986 to run the marketing of custody and asset management after a career in the automotive sector that included a spell as a financial analyst with General Motors. Palermo, who became a vice chairman of Mellon Financial Corporation and president of its global securities services business, arrived at just the right time. By 1993, Boston Safe had some $200 billion in assets under custody and, following the takeover by Mellon, Palermo ran the tax-exempt clients for the combined group. After a two-year spell with Mellon Capital Management, he was appointed head of global securities services (GSS) in 1998. Palermo’s tenure at the helm of Mellon GSS has seen the business transformed from a niche player with service quality issues into a highly focused, client-driven operation that can more than hold its own against its larger competitors. The success of joint ventures such as ABN Amro Mellon, CIBC Mellon and Russell/Mellon Analytical Services has helped to attract clients that were previously beyond the bank’s reach. In parallel with this growth, there has been an unbroken record of service improvement. There is a pleasing symmetry to the fact that the architect of many of The Bank of New York’s most important acquisitions over the last decade, Tom Perna, was himself part of a business that BoNY bought in 1986. Perna,

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GLOBAL CUSTODY & CLEARING SERVICES

who was a senior executive vice president of BoNY, was previously with Fidata Corporation, a specialist investment administration firm, and he helped to integrate the business with BoNY’s operation. But it was only with the acquisition of Irving Trust in 1988 that BoNY’s securities processing business began to assume a much higher profile. Senior management realised the potential of fee-based businesses, and pulled together all the different operations after the Irving deal. Beyond the US, BoNY was probably best known for its American Depositary Receipt business, but the summer of 1995 changed all that. In May that year BoNY agreed to buy Bank of America’s custody business, with assets of almost $500 billion, and followed this up with the acquisition of JP Morgan’s global custody business, adding some $800 billion of assets and making it by far the largest global custodian. Perna was a key player in these transactions, as he was in the later unsuccessful attempts to buy State Street and Mellon. Of all the acquisitions in which Perna was involved, none was more painful than RBS Trust Bank in 1999. Service quality issues, product deficiencies and technological challenges all contributed to the problem, but Perna insists it was a good deal in the long run. More recently, BoNY acquired Pershing, a target it had been stalking for many years and recently announced the merger with Mellon Corporation. What all this says of course is that the world is getting more complex. Many of the delineators in the business have become grey areas. The expense incurred by custodians must be more than matched by a return on that investment. Many of the custodians, in creating products to meet their customers needs have perforce become more and more like their customers. Outsourcing in the investment management sector has increased this trend. Today we see many firms that provide custodial services to the investment management community also setting up their own investment management arms or, as described earlier, acquiring such businesses as the synergy between customer and supplier becomes more indistinct. It is in this environment that custody must struggle to keep its identity. Draw any kind of diagram representing the financial services and investment management chain and you will find that any individual firm can, if it’s being successful, wear several ‘hats’ depending on which direction you happen to come at them from. These then are the challenges for today’s custodian: 1. Invest enough to stay ahead and keep downward pressure on transaction costs; 2. Standardise enough to avoid replication of costs;

A BRIEF HISTORY OF CUSTODY

11

3. Get and keep assets under management at an optimum level to avoid acquisition; 4. Outsource non-core activities and use it to develop added value services; 5. Differentiate yourself. So, back to the question, what is custody? At this level we now know that custody can be a range of interactions with investors, other financial institutions and issuers. What the custody package contains can vary based on the needs of the market. Even its core elements of asset safekeeping can vary based on the scale and scope of the custodian’s reach into the market.

CHAPTER 2

Custody Today

In the “old days”, as we’ve seen, custody was predominantly about the core service of looking after the physical evidence of a client’s ownership in shares – the certificate – together with one or two added value services tacked on. Today, in the twenty first century, custody is a highly sophisticated product. With the dematerialisation of assets, the certificates have, for the most part, gone, replaced by electronic records managed by sophisticated technology which connects the shareholding to a large number of related events on the one hand and on the other connects the financial intermediary (custodian) to a wealth of information about investor interest and activity that can be used to stimulate further business. The odd added value product tacked on the side has now become a closely interwoven network of custody services and intermediaries that can span the globe in microseconds. So all is peace and light? Well, not quite. If you asked ten people to define custody, you’d probably still get ten different answers, although the core would probably be reasonably consistent. At a recent conference in the UK, this question was asked and the answer seemed to be rather like the question of what is pornography? I can’t define it, but I know it when I see it. The key seems to have been in the burgeoning development of the added value services which connect to an investor’s ownership of shares. The competitive market place being as it is, each “custodian” can define its own “product” based on what it is good at, what experience it can gain access to and how easily it can package it. Historically, this has flowed from the core custody product as a means to improve the woefully narrow profit margins “enjoyed” by traditional custodians. The added value services were designed just as much to add value to the custodian profitability statement as to the investor’s benefit. While dematerialisation was the key issue that really gave custody the opportunity to develop, its only in the last five years that the technology and 12

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13

more importantly the imagination of those in the business has managed to connect the dots to create truly global product platforms. In his book “Securities Operations” in 2002, Michael Simmons states that custody is predominantly about providing “greater efficiency and less risk in relation to trade settlement and the holding of securities in safe custody on behalf of the owner”. That would be just as valid a comment on the key issues covered in this book as it was then about his. So, what is the relationship between client and custodian? A Global Custodian is basically appointed by its client, who can be any legal person – individual or corporate entity, to facilitate trade settlement and the holding of securities and cash, by use of its existing worldwide network of sub-custodians, each of which is a member of the local central securities depository (CSD). The client will issue settlement instructions to the Global Custodian, which then directs its instruction to the appropriate sub-custodian which effects settlement in the local market on behalf of the global custodian. The exchange of cash and securities resulting from the trade executed occurs at the CSD, where the accounts of the sub-custodian representing the buyer and seller are debited or credited with securities and cash. In its narrow meaning, custody therefore refers to the safekeeping of assets. In its wider meaning, custody embraces all the other services provided by a custodian, ancillary to the safekeeping of assets. Specifically it is the range of agreed services outlined by the custody agreement between the client and the custodian. See Appendices I and II. The nature of these agreements may be domestic or global. As the name implies, domestic or local custody refers to custody arrangements concerning domestically held assets. However, global custody refers to custody arrangements concerning portfolios of assets that are held in more than one country. Global custody thus describes both a major international industry and a set of interrelated services relating to the administration of investments made outside the country where the investor is located. It plays a fundamental role in the success of the fund management industry. When properly managed, it can give investment managers the means of earning higher returns on a fund without the need to take on higher levels of risk. A trend in recent times has been the growth in securities lending which has contributed to the higher levels of performance. See chapter 9. Figure 2.1 shows however that custodians, of whatever flavour, do not act or behave in a vacuum. They are constrained by Issuers above them who are the generators of investment income, typically dividends and bonds and below them by the investors who are placing their money into the Issuers hands through the investment vehicles offered. A global custodian, as the name implies, operates globally and has presence in many markets worldwide, either directly, or through a network of sub-custodians. A sub-custodian may be a local branch or an affiliate of

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GLOBAL CUSTODY & CLEARING SERVICES

Issuers Global custodians Custodians & agent banks Depositories Brokers Funds Trustees Auditors Proxies Advisors Investors

Figure 2.1 The investment chain Source: Author’s own

Table 2.1

Types of custodian

Term

Description

Custodian

An organisation that holds securities and cash on its clients’ behalf and may effect settlement on its clients’ behalf.

Global custodian

As above, but has a network of local custodians that hold securities and cash and effect settlement of trades on behalf of the global custodian.

Local Custodian

A custodian which operates within a specific market.

Sub-custodian

A custodian within a global custodian’s network of custodians.

Central Securities Depositories (CSD)

An organisation that holds securities, normally in book entry form, usually the ultimate place of settlement, effected through book-entry transfer.

National Central Securities A CSD that handles domestic securities of the Depositories (NCSD) country in which it is located International Central Securities Depositories (ICSD)

A CSD that handles domestic and international securities.

Settlement agent

An organisation that effects the exchange of securities and cash on behalf of its clients.

Source: Author’s own

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the global custodian, but usually it is a local bank. The sub-custodian may also be a bank or banking group that acts as a regional custodian, providing local custody services in several countries within a geographical region e.g. Eastern Europe.

MARKET SIZE Service providers, both large and small, act for clients in many countries worldwide, handling assets across over 100 countries for investment. The range of services is ever more sophisticated. Measured by the value of assets held under custody, it is a multi trillion dollar industry. The top 50 Custodians worldwide assets under custody as at 2007 totalled in excess of $90 trillion. Key drivers in the growth of global custody over the years include:


in the 1970s, the introduction of floating exchange rates and – towards the end of the decade – lifting of exchange controls in many major economies resulted in rapid development of the market for international debt instruments;




in the 1980s, professional traders became prominent players and the practice of arbitrage increased;




also in the 1980s, a rise in specialist fund managers running dedicated portfolios of foreign equities;




through the last two decades, the opening up of markets in Eastern Europe and a gradual increase in investment in equities and in crossborder investments;




As a result of these investments the custodians gradually took on a highly active role in advising clients of the operational risks and pitfalls that confronted them in underdeveloped markets.

By the beginning of the nineties, several of the larger players had begun to expand their product range to such an extent that they were no longer talking about custody, but referring instead to securities services, investor services or global securities services. This reflected the diminishing importance of physical safekeeping services, as a result of dematerialisation or immobilisation of securities in the Central Securities Depositories (CSD). It also reflected the desire by the custodians to move the perception away from the limited meaning that the phrase “custody” implied. As the range of services expanded, so too did the cost of staying competitive. Technology costs escalated, as custodians began to assume a

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GLOBAL CUSTODY & CLEARING SERVICES

Table 2.2

Recent mergers and acquisitions

1996

Chase Manhattan Bank and Chemical Bank Merge

1999

Bank of New York buys Royal Bank of Scotland Custody Business

2000

JP Morgan and chase Manhattan Merge

2000

Ulster banks sells IFSC business to Northern Trust

2002

BNP Paribas Buys Cogent from AMP of Australia

2003

HSBC Agrees to buy The Bank of Bermuda

2004

Deutsche bank agrees to buy Custody operations from Dresdner Bank AG

2005

RBC and Dexia Bank announce creation of Joint Venture

2006

Bank of New York merges with Mellon Corporation to create worlds largest Custodian

greater role in collating, storing, and transmitting information. Many banks could not keep pace, so there was a rapid increase in mergers and acquisitions as custodians sought to consolidate their businesses in a bid to increase scale and offer new products and services to a wider breadth of informed customers. Table 2.2 shows just a few of the many mergers and acquisitions that took place in the decade between 1996 and 2006. This macro-economic cycle of mergers and acquisitions in turn put pressure on the profit margins of smaller custodians, unable to compete on the same cost/profit level. Falling profit margins in the traditional core custody services, forced many custodians to expand their services into more complex areas such as stock lending and active cash management where profit margins are higher. Recently there has been a trend to move in to servicing Hedge Funds as well as derivative trade settlements. The recent high growth rate is expected to continue, driven by a combination of global trends:


investors’ growing appetite for cross-border assets, for emerging and exotic markets and for a wider range of financial instruments;




investment managers’ and banks’ increasing use of global custodians to replace their own networks of local custodians;




in many countries, the state retreating from its role of primary pension provider, causing citizens to invest in defined contribution pensions and

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17

mutual funds in record numbers – with custody banks serving the pension funds and mutual funds, their money managers and the banks acting for high net worth individuals;


the increased scrutiny by regulators forced many institutional investors to decide that they should concentrate on their core business and let others worry about core custody and administration. European pension funds are following the US trends of separating custody and asset management;




the growth of the investment fund industry in both the US and Europe, particularly in mutual funds, has enabled individual and institutional investors to share economies of scale and benefit with greater levels of yield and lower risk through diversification;




aging populations and increasing use of funded schemes to reduce excessive state pension burdens.

Nowadays, only a handful of truly global players remain. Custodians are now seen as securities services providers moving well beyond their clients back offices. They are moving towards the front office to offer a range of products that cover everything from portfolio management, trade execution through to confirmation matching. Investment managers are increasingly willing to outsource functions that they had viewed as providing a competitive edge, but are now increasingly viewed as a cost and non-core. This trend to outsourcing to the custodian is increasingly viewed as an attractive way to displace cost. Custodians have some choice to decide in which market space they would like to operate. Smaller custodians are increasingly choosing to become specialists in specific areas while larger ones are consolidating. The new competitive threat for custodians is coming from the influential national and international central securities depositories who are increasingly after the core business of asset services, clearing and settlement.

MARKET TRENDS It took just four months to spring the $16.6 trillion deal and The Bank of New York Mellon Corporation was born. The prime rationale was the synergy i.e. where Bank of New York has weaknesses, Mellon has strengths, where Mellon may have been short on scale, Bank of New York has it in spades. Combined assets mean the new entity is one of the top 10 largest asset managers in the world and the largest asset service provider. Bank of

18

GLOBAL CUSTODY & CLEARING SERVICES

New York also now claims a spot in the list of top 10 wealth managers worldwide, with various operations in 37 countries, combined annual revenues of $12.5 billion, a combined pro-forma market cap of $43 billion, making it the 11th largest US financial institution. Mergers amongst custodians can bring bi-directional benefits – reductions in cost at the operational level as well as market advantage in the other. However, there are downsides and the fact of a merger or acquisition of a custody business does not automatically guarantee success. Apart from the regional one-off costs often associated with “reducing costs” aka losing people, there is a market negative impact often from the market as people lose their jobs in favour of a more “efficient” system. Such efficient systems must be chosen with care. They often include the takeover by one firm of the operating practices of the other and this can be long drawn out and is rarely as effective or as cost efficient as the initial estimates indicated. Other methods of consolidation can see both operational units being ditched as an opportune time to outsource non-core areas. Frequently this has occurred with “high maintenance” jobs; i.e. jobs that are expensive to fill and maintain due to high market salaries or local employment legislation being outsourced to low maintenance areas e.g. India or China. The market is still in flux within this cycle, although the lessons of the retail banking sector are being viewed carefully as call centres return to their origins due to negative reaction of the target market and, it has to be said, poor service and marketing, from the outsource providers. In short, it looks like an easy synergy in many cases, but investors who are informed of a bright new world from a custodian in merger, should always be careful to assess the impact on themselves and ask searching questions to determine any possible negative situations. As we’ve said, it’s not just about cutting cost – new entities formed from mergers need to be very, very careful about impacting customers and very thoughtful and deliberate in how the two companies integrate, so that customers benefit, and the new entity can continue to grow. Long-term success for custodians centres on two areas of expertise: asset servicing and asset management. The first is essentially about price and the second is about performance. For the first, bring on the volume. For the second, protect performance to grow assets under management. Asset servicing is a low-margin business, benefiting primarily from economies of scale. Asset servicing commands the greater portion of both companies’ investments. In addition, the asset servicing business provides a lot of the software required for wealthier customers, whose needs are becoming increasingly complicated to manage. But the main advantage, say analysts, is the protection asset servicing brings a company in slow or falling markets, and they like the two-thirds/one-third split between the two functions in the new entity.

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19

Table 2.3 below shows the top five global custodians ranked in numerical order of the value of total assets under custody which based on our previous argument, gives an indication of the systems expenditure of the firms involved at least on a pro-rata basis. Table 2.4 below, in contrast, shows the rankings in numerical order of the domestic assets under custody. Finally, Table 2.5 shows the same numerical rankings, this time however, the list is in order of cross border assets under custody. The issue here is not which custodian is at the top or even in what order they appear. The tables above will change with time as each global custodian amends and develops its own strategy. What is key from this is that investors need to get past the hype of any given custodian, global or otherwise, and figure out how that custodian’s strategy fits their own situation and expected growth. Custodians hold a range of assets on behalf of their customers. These include equities, government bonds, corporate bonds, other debt instruments, mutual fund investments, warrants and derivatives. Institutional investors, money managers and broker/dealers are among those who rely on custodians and other market participants for the efficient handling of these worldwide securities portfolios. Table 2.3

Ranking 1 2 3 4 5 6 7 8 9 10

Provider JP Morgan Bank of New York State Street Citigroup Mellon BNP Paribas HSBC UBS AG Northern Trust Societe Generale AGGREGATE OVER TOP 50

Worldwide assets under custody

Assets under custody, worldwide (in billion Managed US dollars) directly

Managed as sub-custodian

13903 13757

12801 13757

1102

11900 9142 4909 4760 3880 3377 3300 2986 91086

11900 1492 4709 2156

7650 200 2604

3300 1514

1472

Reference date Dec 31 2007 Mar 31 2007 Dec 31, 2006 Jun 1, 2006 Mar 31 2007 Dec 31, 2006 Mar 31 2007 Sep 30 2006 Sep 30 2006 Dec 31 2006

Source: © 2007 globalcustody.net No reproduction without consent. Extract from www. globalcustody.net used with permission. The extracts from globalcustody.net depict data as at November 1st 2007. Service providers can submit their figures in real-time, so please refer to globalcustody.net for the most up-to-date and comprehensive data

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GLOBAL CUSTODY & CLEARING SERVICES

Table 2.4

Ranking Provider 1 2 3 4 5 6 7 8 9 10

Domestic assets under custody

Assets under custody, domestic (in billion Managed US dollars) directly

JP Morgan The Bank of New York State Street Citigroup Mellon Group CACEIS I.S. Northern Trust Investors B & Trust SIS RBC Dexia I.S. TOTAL ACROSS TOP 23

9342 8729

9342 8729

8708 3149 2909 1991 1761 1580 1573 929

473 2909 1738 1761 1373 1573 929

Managed as Reference sub-custodian date Dec 31 2006 Mar 31 2007

2676 253 207

Dec 31, 2006 Jun 1, 2006 Mar 31 2007 Dec 31 2006 Sep 30 2006 Jun 30 2006 Jan 1 2006 Dec 31 2006

44117

Source: © 2007 globalcustody.net No reproduction without consent. Extract from www. globalcustody.net used with permission

BUYERS AND SELLERS The custody market is dominated by a small number of key players – comprising major banks and specialist providers. The participants within the global custody can be generally classified into two categories:


Those who supply custody services (the “Sell” side) and;




Those who demand or buy those services (the “Buy” side).

The Supply Side includes:


Custodians;




Sub-Custodians;




Central Securities Depositories (CSDs);




International Central Securities Depositories (ICSDs).

CUSTODY TODAY

Table 2.5

Ranking 1 2 3 4 5 6 7 8 9 10

Provider

Cross border assets under custody

Assets under custody, cross-border (in billion Managed US dollars) directly

Citigroup The Bank of New York JP Morgan BNP Paribas State Street Societe Generale Mellon Northern Trust BBH RBC Dexia I.S. TOTAL ACROSS TOP 22

21

Managed as sub-custodian

Reference date

5993 5028

1019 5028

4974

Jun 1, 2006 Mar 31 2007

4561 3858 3192 2986 2000 1539 1304 1071

3459 1254

1102 2604

1514 1800 1539 830 1071

1472 200

Dec 31 2006 Dec 31, 2006 Dec 31, 2006 Dec 31 2006 Mar 31 2007 Sep 30 2006 Dec 31 2006 Dec 31 2005

474

33909

Source: © 2007 globalcustody.net No reproduction without consent. Extract from www. globalcustody.net used with permission

There are also secondary suppliers that supply a range of services to the primary suppliers, for example:


Stockbrokers;




Derivative Clearing Houses;




Investment Managers;




Firms engaged in the supply of automation processes and data communications;




Firms engaged in the supply of outsourced processes (core and non core).

The Demand Side includes:


Trustees of Pension Funds;

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GLOBAL CUSTODY & CLEARING SERVICES




Self-Managed Pension Funds;




Mutual Funds;




Insurance Companies;




Local / Domestic Banks;




Stockbrokers.

DUTIES AND RESPONSIBILITIES Custodians effect settlement of trades (that is, completion of a transaction, where the seller transfers securities or financial instruments to the buyer and the buyer transfers money to the seller) and provide safekeeping of the assets on behalf of clients. The services also include:


Asset Safekeeping;




Securities Settlement;




Collection of income arising from the portfolios (dividends and interest payable);




Application of entitlements to reduced rates of withholding tax at source and reclaiming over-withheld taxes after-the-fact. See Chapter 6;




Notification and dealing with corporate actions (such as bonus issues, rights issues and takeovers);




Proxy Notification and Voting;




Foreign Exchange (FX) transactions.

A wide range of additional services fall under the umbrella term of ‘value added global custody’.


Cash Management;




Risk and Performance Measurement;

CUSTODY TODAY




Securities Lending. See Chapter 9;




Tax Withholding/Tax Reclaims/Relief at Source;




Accounting and Reporting;




Outsourcing for Investment Managers;




Counterparty Risk Management;




Commission re-capture;




Trading services.

23

A custodian may, for example, act as a fiduciary for a fund and monitor the fund to ensure that it is managed in accordance with its prospectus. If a custodian is appointed by the trustees of a pension fund for example, the custodian will typically advise the trustees of any activities that the trustees should be aware of. This, at times may cause conflict with the investment manager as the custodian can refuse to settle a trade if it conflicts with the stated investment policies of the fund. In providing a fiduciary service the custodian’s responsibilities are to:


carry out the instructions of the manager unless it is in conflict with the funds document of incorporation and regulations;




ensure that income is remitted to the fund on time;




at the fund year end they can enquire into the conduct of the manager to ensure that the fund has been managed in accordance to its constitutional documentation and regulation;




monitor the activities of the manager;




ensure that units are issued and distributed in accordance to the funds document of incorporation and regulation;




maintain service efficiency.

Some experts have long suggested that there is little or nothing to choose from between the global custodians – in other words, custody has become a commoditised product and all custodians do roughly the same job at the same price. Even though we all know that this is far from an accurate reflection, there is a perception that standardisation of processes, which is a key

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GLOBAL CUSTODY & CLEARING SERVICES

factor in improving operational efficiency, has inevitably led to standardisation of service. Yet industry surveys consistently demonstrate that there is a huge difference in service quality between the best and worst performers. What this tells us is that, in the minds of clients, there is a huge difference between the best custodian and the worst. What it also tells us is that custodians can and do differentiate themselves based on the quality of service, which is effectively the way in which they deliver their product. Some custodians whose technology is not as good as their peers’ can still differentiate themselves through effective relationship management. All custodians deliver products in a different way, even if they use similar technology, sub-custodians, depositories and staff. There are a number of ways custodians make “service” a true differentiator:


making it easy for customers to do business, giving them single contact points, user-friendly systems and flexible operating procedures;




making real efforts to understand their customer’s business and their challenges, developing solutions that meet their current and future requirements;




packaging solutions from different areas of the bank, like brokerage, treasury and credit, to add true value to their operations;




building better products to support what has become a hugely complex investment environment, incorporating new asset classes and markets as clients demand them;




deploying technology to give customers a competitive advantage, both in terms of cost and flexibility.

Differentiation – even in a market that is meant to be commoditised – is actually very easy. Everyone has the opportunity to take basic asset servicing and turn it into something better than the average. When this opportunity is taken proactively, customers recognise it – that’s why asset servicing mandates still move on a regular basis.

R E L AT I O N S H I P M A N A G E M E N T All investment services providers are now being challenged by two fundamental long term trends that are re-shaping the industry on two fronts.

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1. Alternative Investment Strategies; 2. Investment Operations Outsourcing. Providers, including custodians, are being asked to deal with increased complexity as well as taking on significantly greater risks and responsibilities for middle and back office operations. Research by Tower Group suggests that hedge fund assets will grow at an annualised rate of 15% between 2006 and 2008. Barclay Trading Group research substantiates this estimate. It is, quite simply, a market that is growing too quickly to be ignored. Similarly, outsourcing can no longer be dismissed as a passing fad. In the first quarter of 2007 alone there have been more than six new deals announced and more are in the pipeline. Interestingly, the US is finally catching up with the concept and reports suggest that there are plenty of major US money managers currently evaluating the opportunities. As providers, custodians have to ensure that they are well positioned to meet these challenges. One of the keys to long-term success is total clarity of strategic vision, purpose and direction. Providers have to be realistic about what they want to do, and with whom they want to do it. As the demands grow – both from a geographic and a product perspective – resource allocation becomes critical. A well-constructed strategy not only gives direction to the business, it also becomes a strong selling point. Prospective customers appreciate a service provider that knows where it wants to be and will not get diverted by transient fashions and temporary trends. As they assess the market for administration partners, clients are taking a very close look at long-term plans. An outsourcing contract, for example, is difficult, painful and expensive to break, so managers need to be sure that they pick the right partner. Buyers of investment services want a custodian who is in the business for the long term, who works with the customer to develop solutions, and who has a clear and realistic vision of current and future strategic challenges and opportunities. They need to be completely convinced that their provider understands their business, their problems and their challenges. When we look back over the last 30 years, we can see that the custodians that could not tick all these boxes are generally no longer in business. The customer bases of custodians also need to be completely reassured about the resilience of technology. After all, they don’t want to jump from one burning platform to another. The custodians who will prosper in the brave new world of investment servicing are those who have a clear-eyed technology strategy that is based around a common platform for the core service. Whilst there is no global solution that covers all instruments, investment styles and

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product lines, a single, central engine must be able to process the major part of the work.

S TA N D A R D S A N D F L E X I B I L I T Y Standardisation is so, so important. To make the economics add up, custodians have to standardise processes and operations, and clients understand this. But this does not mean that they [custodians] become inflexible about the service offered. Customisation should not be a dirty word, but in this industry tailor-made solutions are often characterised as obscenely expensive, both to build and maintain. In part, this view has its roots in the high-profile failure of a couple of outsourcing contracts, but it is also used as an excuse for inflexibility. Tailor-made solutions do not need to be expensive for clients. On the contrary, customers expect and demand customisation, especially when they are looking for value-added services, up to and including outsourcing and alternative investment administration. Flexibility is a vital part of the service offering, especially when it involves any client-facing activity, such as transfer agency or client reporting. Managers rightly require a high degree of customisation at these crucial touch points, and the custodian must respond accordingly. However, it is equally important to understand and accept that, while customisation is essential, it must also be reasonable. It is a poor strategy to develop client-specific solutions that can never be transferable to other clients. Tailoring gives a significant competitive advantage as long as it is cost efficient, scalable and replicable. In effect, what providers have to do is build up an inventory of bolt-on solutions that clients can pick and choose from, without incurring the huge cost of one-off fixes. All successful providers take on more clients, each of which has specific demands; they will be able to satisfy those requirements from a portfolio of solutions that they have developed for other clients. Ultimately, success or failure depends on the custodian’s ability to combine a package of standardised processes and customised solutions that works for both parties. As a provider, the custodian has to implement a completely different service model for outsourcing. It is important that the client and the provider work together to come up with a servicing solution that is practical, comprehensive and flexible. The custodian needs to ensure that they have the right people in the right positions, and that requires a considerable upgrade in client servicing capabilities. There has never been a more challenging time in the investment services industry. Clients are constantly demanding that their custodians do more – with alternative investments, outsourcing, front-office products, or

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collateral management, for example – and they need to deliver the right solutions at the right time. Successful providers will have that key characteristic, flexibility; hardwired into everything they do, and will use outstanding service as the basis of long term client relationships. Ironically, even successful providers do still fall foul of obvious mistakes. In many instances for example, SWIFT message types between custodians follow ISO 15022 standards. However, the structure of those standards allows for different interpretation of where any specific set of data appears in a message. The net result is that, even though there is a standard in place, the ability to interpret the standard leads to an impediment to automation and thus cost reduction. What one custodian is capable of sending in an MT566 confirmation can be different to what another is easily able to receive in a way that it can integrate into its back office systems. In addition, as we will see later, internal controls still create a fracture in what could otherwise be fully STP processes. This has led, within the ubiquitous SWIFT community, to a plethora of groups of members who in the commercial world, are direct counterparties. These groups agree between themselves a specific data layout within the standard and thus meet their business needs. But these “Closed User Groups” – CUGs, “Member Administered Closed User Groups” – MACUGs and “Message User Groups” – MUGs all evidence one thing – a standard that is not tight enough combined with a membership still intent on doing it their way as far as possible. Hopefully the new standard, ISO 20022 will make a difference, but there will still be a need to get the hearts and minds of the custody community bought into the concept of standards rather than being forced to accept it.

CHAPTER 3

Key Issues

In this chapter we will look at some of the key issues that have, are and will task all those involved in the custody, clearing and settlement industry. To do this we will use both presentational style and also some case studies which help to highlight the very real problems and solutions that many have already come across. One of the most prevalent of these is the issue of outsourcing which now sits at the centre of discussions as all parties seek to focus on core activities where they can reduce costs based on their own skills and unique business models. Outsourcing seeks to do the same thing, using the skill sets of others and is set to increase in the current economic cycle.

OUTSOURCING Outsourcing is one of those all encompassing terms that falls foul of frequent misinterpretation dependent on context. Custodians often outsource “non-core” functions to specialist third parties as a way of reducing costs and increasing performance (through use of a “best of breed” policy). This is often seen in the market as outsourcing of IT (hardware, software and /or management), but even this is a limited view. It’s understandable when viewed in context of the amounts spent by custodians on IT, but it is certainly not the only outsource situation. Many custodians are also outsourcing functional business areas, particularly in corporate actions where predominantly manual processing does not lend itself to automation e.g. tax processing. Aside from a custodian outsourcing some of its own functions, custodians are also, somewhat ironically, offering outsourcing as a solution to some of their client base at the same time. Increasingly, to the great benefit of the custodians, investment managers worldwide are reaping impressive benefits by outsourcing back-office 28

KEY ISSUES

29

I.T.

Market Services

Custodian

Back of funct fice ions

Figure 3.1 Outsourcing at both ends Source: Author’s own

functions to them. For pension plan sponsors and members, the end result can be improved plan performance and returns. The question is: how is outsourcing contributing to these results and what part is the custodian playing? The demands for faster delivery of information and more detailed reporting from regulators as well as stakeholders are placing growing pressure on investment managers. To be competitive, they need to contain costs and sharpen strategic focus. Custodians are among the solutions that investment managers are turning to. Over the past 12 years, as many as 50 investment managers in North America have been working on an outsourcing basis with custodians – and more are continuing to sign on. While traditionally, these organisations have provided trade duties such as settlements and safekeeping, they have the ability to do much more. As we’ve inferred, custodians have immense capital resources, scalable systems and extensive operational, technological and human resource capacity. While investment managers are primarily concerned with managing money and servicing clients, they have also had to assume many middleand back-office functions on behalf of clients and regulatory bodies, and for purposes of fund valuations, accounting records and auditing. These duties – often conducted with varying degrees of inflexibility, long timeframes and aging, inadequate technology – typically represent time and resourceconsuming operations and significant capital investments. Custodians have the ability to assist investment managers by bringing to the table the technology and providing trade instructions, reconciling security positions with other custodians, and preparing accounting and performance measurement reports, to name only some potential outsourced functions.

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CASE STUDIES Case study 1: Corporate actions The example used here is of a North American custodian who was faced with a corporate actions nightmare and not only did they research the various in-house and commercial solutions available, when implemented, their use of outsourcing rocketed them to the number one service provider status, for that function, for four years in a row (Source: Global Custody Review). To contextualise the issue, anyone in the investment management chain who manages or receives cross border income directly or indirectly will face the issue of withholding tax. Many clients are over-taxed often up to 35% and they (or their custodians) have limited time in which to recover their entitlements. Some estimates of the amount of tax entitlements that go unrecovered each year are up to $180 billion and the amount of extant tax (i.e. recoverable at any one point in time) is estimated to be $1.5 trillion (Source: GlobeTax). The recovery process is long, complex, error prone, requires extensive and constant research and close relationships with tax authorities to deliver value back to clients. It is a classic case for outsourcing to reduce costs and improve value.

Partner or supplier As with all custodians outsourcing proved to be a difficult concept. There were sensitive issues to be addressed including security and confidentiality as well as the more traditional cost issues. Addressing these issues is what defined, for them, the difference between a supplier and a partner (albeit not in the legal sense). A supplier acts strictly to the terms of a contract. A partner on the other hand is more motivated than a supplier and has a longer term relationship in mind. This allows the provider to remove the specialist function from the client, but still stay in contact with the business and its needs and contribute to the client’s business beyond that which would be expected of a supplier. The difference can be subtle because today everyone calls themselves a partner, it’s the “in-phrase”. Being one is different. Two issues separated the suppliers from the ultimately successful partner in this case study. First, was the degree to which the firm was prepared to put its reputation and skills where its mouth was. The second was the recognition of the value and quality of the service provided. In withholding tax outsourcing, specialisation, quality control and investment in IT must be so high that firms can provide services transactionally on a completely contingent basis. In other words, if they don’t get the client’s tax back, they don’t get paid. What better demonstration of belief is there? Value is

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demonstrated in pricing structures. Some analysts think of tax recovery as “data processing” – that it doesn’t matter whether the tax reclaim is for £100 or £100 million, it’s the same process. Wrong! Tax authorities are far more inquisitive and demanding today about high value reclaims than small ones so they do take much more effort to recover. Fixed price solutions may seem attractive but they reflect neither the real process nor the value and trust that outsourcing partners should demonstrate. They evidence a supplier mentality, not a partner mentality. In summary, this custodian’s advice was – think not only of what functions can reduce costs or create market advantage but think also about what really evidences your supposed outsourcing partner from actually being a supplier, and what that means for your business success. In this case, the custodian came up with what they called the six C’s of outsourcing. For a more detailed introduction to withholding tax, if needed, the reader is directed to Chapter 6. While these 6 C’s are shown here in context, they can also be applied to almost any business function as part of an outsourcing mandate.

Competency Best practice in tax requires relief at source, where available, to be obtained for the benefit of the client so he has maximum funds from day one. Some countries have “accelerated” recovery processes and failing to meet the deadline can result in a decade-long wait for client money. Some security types, such as ADRs have no direct reclaim possibility, only indirectly on the underlying shares and through the sponsoring bank. Some investment vehicles are transparent to tax authorities and reclaims may be missed if confidentiality keeps broker income streams and client identities separate. Some methodologies are transparent to tax authorities, so brokers who claim title to securities may think they are entitled to apply treaty rates, foreign tax authorities will disagree and penetrate title to beneficial ownership. All this demonstrates the need for extreme competency and deep knowledge. Outsourcing becomes logical because it’s the primary focus of the partner and all its expenditure is aimed at this one objective.

Complexity There are around 200 countries in the world, each may or may not have a treaty with other countries for the avoidance of double taxation. For each of these country pairs there are a number of types of investor and a number of types of income, any combination of which can result in a different rate of withheld tax and treaty entitlement. The date on which income is distributed also affects the entitlement and other factors increase the complexity

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further. The number of permutations is over 400,000. The in-house cost of recovery for any fund with multi-residence members or custodians with broad client bases will be prohibitive compared to the number of likely reclaims that will be generated. A good outsourcing firm succeeds because its business model leverages economies of scale across the whole process. In the last twelve months the largest outsourcing firm in this area processed over one million tax reclaims. At that level, the focus of research and investment buys a greater assurance of success compared to what they could deliver on their own.

Cost reduction The number one reason that firms consider outsourcing. However, while important, it’s not usually the number one concern of firms that understand the value of withholding tax. The big benefit that delivers cost reductions is in the removal of hidden internal processes. Even if the custodian has a software system, some significant proportion of the process is manual and, for financial services as we all know, manual is bad. Outsourcing allows firms to convert a costly, semi-manual error prone process into a Virtual Straight Through Processing function. In a well benchmarked V-STP environment, clients send a file one way and receive funds and reports electronically in the other direction. And from their viewpoint, that’s pretty much all there is to it. All the manual elements of the process, indeed, all the elements of the process, are opaque. Information flows one way, money flows the other way and that’s exactly what fund managers, custodians and investors like.

Compliance If you can’t produce an accurate assessment of a client’s recoverable tax or eligibility for relief at source correctly the first time and every time, you stand a good chance of falling foul of regulatory compliance. How many headlines have we seen in the last few years of heavy fines being issued for failure to keep and maintain accurate client records? It’s these very records that underpin the assessment of eligibility. The idea of outsourcing a function to minimise compliance risk may seem paradoxical. However, the number of regulations now in force that evidence some sort of extraterritorial jurisdiction gives corporate actions departments and compliance officers nightmares. Outsourcing, in a functionally selective way, can actually reduce the burden on compliance and operations departments by releasing them from some proportion of concern over whether they have their structures integrated and monitored. It then becomes the job of the outsource partner. The benefit is that the accuracy of

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the underlying data is critical to the outsourcer’s business, because it is its only focus.

Corporate governance Financial services firms face two corporate governance issues, not one; their own governance, usually overlooked by regulatory authorities, and the corporate governance of their clients. Investors are becoming increasingly activist and holding their investments long as the balance in yield strategies changes. The result is that more are receiving dividends and being overtaxed. Typically, two institutional investors with different residencies may be taxed, and therefore over-taxed differently. If the CFO of the invested company does not take action, his investors lose money. Similarly, if the custodian fails to act, the investors may lose money. The publication in 2003 of proxy voting policies on probity in withholding tax evidences the pressure on the investment management chain to demonstrate that everything possible has been done. Investor concerns should make custodians and fund managers consider outsourcing more strongly to demonstrate best efforts on behalf of their client’s underlying shareholders. See chapter 11.

Competitive advantage Most relationship managers would happily enter a pact with the devil if they could get a legitimate and clear service advantage in the market and withholding tax is one such. Unfortunately, when taken at the fund management or even custodian level the internal costs are so high that profitability is difficult to achieve so many either don’t address withholding tax at all, do so inconsistently or have policies which disenfranchise some clients. Outsourcing allows the creation of a profitable withholding tax service which is complete and inclusive for all clients and converts a fixed internal cost into an external, variable and contingent one.

How to outsource This custodian has some clear advice. Spend your time finding out whether you can trust your potential partner and not whether you think his process is better or worse than yours. Trust is built up in a number of ways. What’s the financial position of your partner? Who uses them? Take up references and pay attention to the tone as well as the words used in references. That’s all “head”. Now add “heart”. What does your partner put back into the industry and into your business in particular? Is he looking after your interests and your clients or just processing data? How does he go the extra mile? Trust is the key that opens the door to successful outsourcing.

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Make sure your end result is as STP as possible by making it all about file transfer from your viewpoint. This can be achieved very quickly with good client IT support. How – because if, as in this case, your partner is processing over a million reclaims a year for example, it’s clearly their business to make the transition smooth and efficient. The result the client sees is electronic files out and money and electronic reports in.

When to outsource While withholding tax is a seasonal business, outsourcing of this functional kind takes only a few weeks to implement. Full transition (the big bang) can of course be done between dividend seasons to allow the same stabilising process, but given that the result is essentially a data feed out and account credits in, there is actually no reason why big bang cannot occur at any time. This is because of Statutes of Limitations. If initial analysis shows significant sums about to fall out of Statute, big bang is not only feasible it’s preferable to avoid potential liabilities later on. Whether big bang or phased introduction is selected, the Statutes typically give several years in which reclaims can be filed so whatever is handed over is not usually mission critical. Having said that, best practice benchmarks this activity at less than two weeks from notification of income to filing of tax reclaim. In summary: 1. Outsourcing is something everyone is already doing and has been doing for years. Outsourcing withholding tax is about a change of degree, not kind; 2. Outsource for several good and solid reasons; 3. Choose someone you can trust, that knows the difference between a partner and a supplier and can prove it; 4. Choose someone whose business volumes demonstrate the basic principle of outsourcing efficiency; 5. Choose someone whose reputation in the market stands testament to the fact they’ll still be there in ten years; 6. Check benchmarks. International benchmarks for withholding tax processing were published by Euromoney Institutional Investor in 2003; 7. Make it STP from your viewpoint; 8. There is no real timing sensitivity or seasonality to outsourcing withholding tax – how fast do you and your clients want to realise the benefits?

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Case study 2: investment manager A large U.S. investment manager whose clients are composed of mutual funds, managed funds and pension funds was experiencing difficulty producing, on a daily basis, comprehensive reporting and fund valuations for their sophisticated funds and products. Complicating matters, the manager, with US$30 billion in assets and 300 international accounts, relied on multiple global custodians, each of which provided vastly different levels of service. The result was inconsistent information delivery and inaccurate reporting. To begin resolving this challenge, the investment manager determined it was necessary to distinguish between core and non-core competencies. It was decided this would enable the organisation to focus on areas that provided a competitive advantage. The organisation identified product, client servicing, marketing and distribution, and money management as core competencies. The functions that were not core to the business were fund accounting and valuations, custodian management and trade communication with depositories. The organisation also discovered that these non-core competencies were consuming vast resources – both financial and human. The investment manager looked to outsourcing as a potential solution. The objective would be to work with a provider that could successfully manage custody and accounting data collected from multiple custodians while fulfilling reporting requirements for clients and plan sponsors. Back-office operations required substantial focus, energy, capital and resources – and represented 15% to 20% These day-to-day operational burdens added to the duties of the investment manager, while reducing its ability to focus attention on managing investments and to manufacture new products. The organisation found a compatible custodian, and was able to offload much of the responsibility – and some cost, about 3% – of back-office operational focus. At first glance, this scenario may give the impression the investment manager was “passing the buck” to the custodian. While it is true that the custodian or the investment manager produce essentially the same results, the custodian approached the “how to” in a completely different fashion. This is where the indirect benefits of outsourcing made their way to plan sponsors and members. Technology was also one of the largest cost allocations within the manager’s back-office operational expenses. Even prior to the burst of the technology bubble in 2000, many back-office technology platforms were already outdated. Just think of the new investment vehicle innovations that have evolved over the last few years – hedge funds, exotic derivatives funds and a vast increase in securities lending. With shrinking revenue and limits on spending and technology upgrades, the investment manager was unable or unwilling to make capital expenditures to keep back-office technology in line with new innovative investment products.

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The selected custodian, on the other hand, given their scale, had already layered in new technologies to meet the needs of today’s sophisticated investors. This meant the custodian had already invested in new technology. By outsourcing, the investment manager could invest in the development of new investment products – without having to bear the responsibility of enhancing the technology necessary to support it. This also meant that less management time and executive leadership was needed to facilitate these updates and develop client relationships. Lower fixed costs were another plus. The custodian had many clients using its technology platform. Thus, the platform was scalable and the fixed costs spread over a larger base; this enabled the custodian to provide the fixed-cost portion of outsourcing services to the investment manager at a discount. There was another cost advantage for the investment manager as a result of this relationship: high fixed costs shifted into a variable costing structure. The majority of a custodian’s fees are based on transaction volumes, which means they are variable in nature. For example, in our case study, the manager had significant investments in people, facilities and technology. As market valuations and transaction volumes fluctuated and client transitions occurred, fixed costs, such as rent and software licensing, remained constant. When the investment manager handed over back-office duties to the custodian, these expenses moved from fixed-only to a combination of fixed and variable costs. By outsourcing, the investment manager shifted from a fixed cost base to a variable cost base that could be managed more effectively relative to changes in transaction volume. This cost structure is an appealing advantage of outsourcing. However, it’s important to keep in mind that, just because a shift in cost structure transformed the investment manager’s expense stream, it did not produce immediate expense reductions. Because this is a long-term outsourcing relationship, the investment manager has the potential to realise savings only after the expenses involved in shifting back-office functions from internal operations to an outside source have been absorbed. Another cost area was also reduced as a result of this outsourcing partnership. While unions often protest at the displacement of employees as a consequence of outsourcing, in this case the back-office employees of the investment manager were skilled professionals whose jobs were transferred to the custodian. The custodian typically lifted out back-office functions as well as the employees who performed those functions – further reducing expenses for the investment manager. The positive effects of the custodian taking on the employees are the goodwill and the partnership evoked by the transaction. Both parties are being good corporate citizens. The direct benefit to the investment manager is that the lifted-out employees bring specific experience to the custodian. The investment manager has the comfort of knowing that the custodian staff is intimately familiar with its back-office operations.

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This case study points out just a few of the benefits of outsourcing investment management back-office operations. Here are some of the other benefits these proactive investment managers – and their clients – are realising. Custodians have developed comprehensive contingency arrangements for their technology infrastructures. So, if one or more platforms become inoperable, back-up platforms are available. This is why many investment managers that outsource have developed plans whereby their custodians will serve as the “operational hot site” in the event that their office’s physical location becomes inaccessible. As a matter of course, custodians have well-tested business resumption plans for all systems to ensure that financial transactions can be completed. Ultimately, this service further reduces the burden for the investment manager by eliminating the requirement to maintain a comprehensive recovery plan and “operational hot site” for the back office. Improved risk management is another outsourcing advantage. On any given day, investment managers may perform thousands of transactions for institutions, amounting to billions of dollars. They must also transact with and instruct their respective custodians. This poses technological constraints for investment managers who, typically, must communicate with up to five global custodians on a daily basis. Today, trade communications between investment managers and their custodians take many forms – from faxing, e-mails and phone calls, to sophisticated electronic trade delivery and secure dedicated straightthrough-processing. Many back offices still use manual trade entry processes to move data from the trade order management system or the portfolio management system to their custodian network. Settlement and market risks arise when each custodian uses different methods for trade notification, accounting and reporting communication. These risks can – and in many cases, have – cost institutions hundreds of thousands of dollars in losses when transactions are lost, misread or received late. To reduce such risks, all major custodian outsourcers have devised consistent, standardised, automated global information transfer processes. These facilitate the safe transfer of trade and portfolio information among custodians and investment managers in formats that are consistent and reliable. Despite the advantages of outsourcing back-office functions to custodians, many investment managers are hesitant to outsource these operations. There are a number of reasons. For example, many smaller boutiques and specialty managers require specialised procedures related to performance and accounting of their valuations and records – procedures only they can perform. Other investment managers may not have an asset base that is of sufficient size or scale to warrant outsourcing but can clearly benefit from outsourcing back office functions such as risk mitigation.

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For the most part, outsourcing could benefit the majority of the world’s large asset-based investment managers – say custodians. Perhaps most importantly, the advantages of outsourcing can flow to pension plan sponsors and members. With the back-office burden alleviated, the investment manager can allocate more time and resources to investing and client relationship building – the areas from which sponsors and members most benefit. While the experience of outsourcing is not without growing pains, most of the initial pains can be alleviated by allocating time for planning and dialogue. Clear expectations must be communicated at the onset. Each outsourcing deal is unique and all parties must focus time and energy upfront. Once the transition of technology, people and risks is complete, many investment managers may examine the benefits of outsourcing. Unhampered by the need to invest in new back-office technology, they have:


created innovative new investment products;




shifted high fixed costs to variable expenses;




re-engineered operations using timely and consistent data produced by the outsourcer;




more time to focus more attention on revenue-generating money management tasks;




reduced transactional risk; and




reduced the burden for maintaining back-office business continuity plans.

For pension plan sponsors and members, this should demonstrate why outsourcing is now popular in investment management. These two case studies exemplify the importance of outsourcing from two different directions. Custodians on the one hand are able to offer outsourcing as a product to their customers to create market advantage and secure long term relationships with clients which help offset the costs of developing such products and leveraging their existing technology and expertise. On the other hand, custodians gain benefit themselves from outsourcing some of their own functionality where there is a clearly better methodology in the market that leverages higher volumes and technology in the same way.

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SPECIALIST SUB-CUSTODIANS Next to outsourcing as a key issue, the network of sub-custodians that allow for global operations is a key issue for participants. Getting it to work and keeping it working is a complex environment. Markets are always trying to harmonise procedures, systems and regulations, whether through the industry’s efforts to overcome Giovannini barriers as an example or through the creation of cross-border exchanges and depositories. For an institution trading or investing in securities, these changes have gone hand in hand with easier and cheaper access to cross-border markets, and a greater choice of ways of organising its securities services in these markets. These developments have profoundly changed the competitive landscape for providers of securities services. It is no longer sufficient just to have the ability to settle or safekeep securities and to take care of any income payments and corporate actions. Nor is communication in accordance with SWIFT standards a distinguishing factor, nor the availability of an internet enquiry tool, nor a client services desk to respond to client queries. So where and how can a local market specialist provider add value in securities services? Securities services are a field of expertise in their own right. Securities services are not just a by-product that are offered alongside trade financing, brokerage or asset management. The service requires expertise, know-how, and commitment to be a “specialist” provider of securities services. Having an in-depth knowledge about how a certain corporate action works – for the simple reason that staff have processed the same stock’s corporate actions for many years – implies that fewer errors will be made and more flexibility can be offered when it comes to, for example, last minute position changes. A good example of a service where expertise is key is tax reclamation services. Having a good understanding of how double taxation treaties between the final beneficiary’s country and the country in which the income was paid work, is the basis for using any potential, revenue increasing, procedures for relief or reclamation of tax paid. Having an expert provider can therefore add value by making the most of available tax benefits and flexibility in, for example, corporate actions processing, while reducing operational risk. It is fair to say that the integration of market infrastructures harmonises entrance procedures and takes away some of the barriers for qualifying institutions and investors to opening their own accounts at depositories. Whether that is necessarily a wise move depends on the direct as well as hidden costs of establishing such a direct link. Being a direct member of a central securities depository requires, first of all, that you establish connectivity to the depository, but also that you commit to continue investing in changes the depository may make on an infrastructure level. A specialist

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provider of securities services, which is a direct participant of the securities infrastructure, will take care of these investments to present its clients with homogeneous service levels from which infrastructural peculiarities are largely filtered out. The specialist can be expected to be actively involved in market working groups, helping to shape the market in line with its (clients’) interests. From an operational perspective, operating a direct link requires a more hands-on approach to handling any settlements and corporate events, whereas a specialist provider can go to great lengths to design a customised service level. A direct membership will therefore require operational and IT resources that could be avoided using a specialist provider. Unless the direct membership is a core service in your business process, outsourcing this link to a specialist can therefore be the option that adds most value by maximising resources.

MAKING CROSS-BORDER MARKETS DOMESTIC In anticipation of a more integrated European securities market, there is already a very easy route available to process cross-border securities transactions in a harmonised way, under domestic terms and conditions. That is, by employing a specialist provider that has direct memberships to different securities infrastructures, but uses a single platform to process all market transactions. Going one step further, the real European specialist will not only support the basic clearing, settlement and custody services across multiple markets, but will also have access to those specific to each individual market. Eliminating the complexities and costs of cross-border securities transactions is therefore a highly effective method via which the specialist provider can add value in terms of efficient and cost effective market access to multiple markets.

M O V I N G U P A N D D O W N T H E VA L U E C H A I N : VA L U E - A D D E D S E R V I C E S A specialist securities services provider can simply add value by providing a better, more client-focused, and more flexible service than a less committed provider, or by covering a larger number of markets through an integrated set-up. Specialist providers, however, go a step further in adding value for their clients – that is by adding new modules to the suite of products as addons to the traditional clearing, settlement and custody services. By doing so, the “custodian” develops into a full-scale provider of securities and investor services, and offers trading, fund management support, and back-office

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administration outsourcing. This enables the investor or intermediary to consider for each step of their processes whether to do it themselves or whether it makes sense to “outsource”; to make or to buy.

ORDER MANAGEMENT SERVICES Clearing services to a broker/dealer client, which is a member of a stock exchange, typically start from the moment the trade has been executed – “post-trading”. However, the membership itself – the connection to the exchange’s trading infrastructure – is not necessarily a core service to the broker and could be part of the value chain to be taken care of more efficiently by an impartial securities services provider.

C R E D I T FA C I L I T I E S Although a credit facility may seem a standard part of a service offering, it can become a value-added service if the specialist provider is able to make the most of the available collateral and credit lines.

TREASURY SERVICES; CASH MANAGEMENT SUPPORT; SECURITIES BORROWING & LENDING An active securities borrowing & lending desk is a prime example enabling clients to save costs from failed settlements on the one hand, and maximise return on holdings on the other hand. An automatic securities borrowing facility, whereby the provider offers both a good availability of lendable stocks and a highly automated and efficient processing flow (including favourable deadlines for returning stock intra-day), enables the trading institution to minimise costs from, for example, non-settlement penalties or even buy-ins. Specialist providers distinguish themselves here by better access to lending portfolios (either matching clients’ long and short positions, or through excellent contact with external lenders) and tailored auto-borrowing solutions. Effective cash management support can equally eliminate opportunity losses.

RISK AND PERFORMANCE REPORTING; FUND ACCOUNTING Whether instigated by a stricter regulatory regime or simply as part of a move towards a higher level of efficiency and accountability investors and traders alike have a need for management information tools that enable

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them to analyse their performance, risk profile and investment options. The independent, specialist provider is ideally positioned for this task, having access to the clients’ transactions and holdings but being impartial to its investment decisions and trading patterns. For the institutional client base these providers offer the complete administrative activities in the field of investment administration, financial administration, daily NAV-calculation and administration of available premium savings schemes. The institutional investor and asset manager can fully outsource these administrative back-office duties, so they have time to fully focus on their core activities and responsibilities. This includes tailor-made reports and accounts on a daily, weekly, monthly, quarterly and annual basis. For broker clients, both gross and net profit and loss statements are available. In order to evaluate operational efficiency, settlement performance analyses and scorecards enable the client to update static data and fine tune their own operating flows.

S TAT I C D ATA M A N A G E M E N T A N D A D M I N I S T R AT I O N O U T S O U R C I N G SOLUTIONS The specialist provider that works in partnership with its client is probably the party that is best positioned to identify where benefits can be derived from further streamlining the settlement and administration process between client and provider. In the case of, for example, a broker/dealer wishing to keep its back-office as limited as possible, a completely integrated processing flow including order-routing, clearing, (net) settlement and onwards delivery to the broker’s client account may be the ideal solution. In a rapidly changing industry, buyers of securities services can benefit from the developments that providers and infrastructures are experiencing – with the choice between a commoditised service at infrastructural level, or a sophisticated, flexible service with the full range of value-added services provided by a local market specialist or Sub Custodian bank. So, we see that apart from the big issues such as outsourcing as a strategic method to organise one’s business functions and orient them to the market, global custodians must perforce work with specialists in sub-custody and functional operations to be able to offer their global service. The key issues flowing from this being operational efficiency, risk management, product value, data and fund management.

CHAPTER 4

Clearing & Settlement We move on now to clearing and settlement. Clearing, Settlement and Custody activity focuses on the clearing, settlement and custody functions by analysing how they work and the interaction between the organisations involved. There is an interdependency in the roles of clearing houses, central counterparties, central securities depositories and the custodians, as well as, assessing the impact on the workflow and procedures in the operations function at banks, brokers and institutions. Clearing, settlement and custody is at the heart of everything that happens in the financial markets. The evolution of clearing and settlement is one that is still happening and as such, it is impacting on the operations function through both new practices but also, increasingly, in terms of regulation, risk and reputation. In essence the efficient clearing and settlement operation is managing risk, not because it is a direct part of the process but more because it is a bi-product. The routine procedures relate to reconciliation and record keeping. If these are performed efficiently and accurately it will result in accurate records of activity and profit and loss. The settlement process is a key element in identifying and correcting errors made by dealers and traders. Failure to identify the error or act promptly will result in potentially serious financial loss, as well as worrying auditors and the regulators. In addition to these concerns the financial service sector is also undergoing a massive rationalisation of the structure of clearing and settlement and seeking the twin objectives of automation and shortening settlement cycles. The challenge for operations managers is considerable: manage costs, eradicate inefficiencies, create an environment to be competitive, and implement the procedures to meet future changes that will occur. 43

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W H AT I S C L E A R I N G A N D S E T T L E M E N T ? Clearing generally refers to processes for managing risks between a trade taking place and it being settled. These are undertaken by a clearing house or central counterparty (CCP). Counterparty risk is the risk that one of the parties to a trade fails and is unable to complete the transaction, leaving the other party exposed to changes in market prices since it carried out the trade. This risk is managed by a CCP which steps in between the buyer and the seller as soon as possible after the trade is executed. If one party fails subsequently, it is the responsibility of the CCP to complete the trade. The CCP covers itself against this risk by collecting margin from the two parties. The amount required is calculated according to an algorithm based on historical volatilities and correlations of the prices of the assets being traded. CCPs also frequently carry out netting of transactions. Thus, if a firm carries out many transactions in the same security or derivatives contract, these can all be netted to a single position, either delivering or receiving. Clearing has historically been very important in derivative markets, where contracts may remain open for months or even years. Eliminating counterparty risk becomes important in these circumstances. Many derivative contracts are settled through payment of the cash value of the position rather than through delivery of the underlying asset, which is facilitated through netting. Clearing has become more important in securities markets in Europe with the introduction of electronic trading systems, where the anonymity of the participants is important. Most of the firms that use clearing houses are either large trading firms themselves or firms, known as General Clearing Members, which provide access to the clearing house for smaller firms. As a result, there is relatively little direct contact between clearing houses and retail firms or end-investors. Settlement generally refers to the exchange of cash and assets between buyers and sellers following a trade. For securities, it normally takes place through a Central Securities Depository (CSD), also known as a Securities Settlement System (SSS). A CSD provides Delivery versus Payment (DVP). This means that the payment and transfer of ownership of the securities should be simultaneous, final and irrevocable. This eliminates the risk that one party could fail at a point when it is holding both cash and securities, leaving the other party out of pocket. CSDs also provide for the safekeeping of securities, generally in electronic form. As part of this service, they enable the holders of securities to receive the benefits of their holdings, such as income, and other entitlements, including the ability to take up rights issues and accept take-over offers.

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Because of their function providing for the safekeeping of securities, a much wider range of organisations has a direct relationship with a CSD than is the case with a clearing house. Although some investors may be direct participants in a CSD themselves, in most cases they use a custodian to do this. As a result, the role of CSDs is not limited to settling stock exchange transactions. For example, securities held in CSDs are used as collateral to support the provision of liquidity by central banks. Since in many cases a national CSD provides the ultimate record of ownership for a nation’s securities, each CSD has to operate within its country’s framework of laws governing property ownership, often with deep historical roots. There are two International Central Securities Depositories (ICSDs), Euroclear Bank and Clearstream International. Their specialist function is to provide for the safekeeping of international bonds, which are still issued as physical certificates. They are often direct or indirect members of national CSDs and in this respect offer similar services to custodian banks. With the dematerialisation of securities, this activity does not consist any more in the physical custody in vaults of tomes of “living” papers, but keeping the securities stock on an information support, so that any financial assets may be localised at any time. The intermediaries charged with the securities custody are of two types:


market intermediaries;




centralising intermediaries.

THE DOMESTIC ACTORS OF CUSTODY Intermediate custodians (local custodian) – The sub-custodian is the market intermediary which stores financial assets in informational systems, in a hierarchic framework, and “re-deposits” them to a central custodian. It carries on only the intermediate custody. On the other hand, starting from this activity, it proposes a range of purely commercial services, with a strong added value but distinct from the information storing activity. The central depositary (CSD, Central Securities Depositary) – The national CSD (Central Securities Depositary) stores all the securities issued on its territory and, therefore, it is a guaranty of the existence of securities. It ensures the custody of securities for the participants’ account and delivers securities on the participants’ or the clearing houses’ instructions. All the European countries have such a national central depositary.

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GLOBAL CUSTODY & CLEARING SERVICES

T H E R E L AT I O N S H I P S B E T W E E N SUB-CUSTODIANS AND CSD Starting from an analogy with the hierarchical organisation of the monetary system, we could characterise the links between the sub-custodians and CSD. Within the money payment system, the banks manage the deposit accounts of economic agents and they ensure, on their authority, the payment service for their account. Using Figure 4.1, a payment initiated by X for Y supposes an interbank settlement to be effective in central money by the registration in the central accounts opened by bank A and bank B in the books of the Central Bank. In the securities world, the same hierarchical and centralised organisation may occur: the custodians manage the securities accounts of agents X and Y and ensure the securities “transport service” from one to the other. The securities deposited by X to A are then “re-deposited” to the central depositary that ensures the custody of all securities issued on the “assets territory”. Therefore, the custodians are only the intermediate depositaries of the securities they “have on custody” for the account of their clients. As compared to money, securities refer to a different logic. While X has securities, it is their owner and can enjoy their features (interest, for interest bearing financial products, dividends, for share certificates). Also, the local custodian is only the depositary of the securities. It does not own the securities and it cannot lend them to other economic agents. This practice establishes the notion of “segregation of assets”.

Money

Securities

Central Bank

Securities Depository

Bank A

Bank B

Custodian A

Custodian B

Agent X

Agent Y

Agent X

Agent Y

Figure 4.1 Comparison of securities to money markets Source: Bob Craddock

CLEARING & SETTLEMENT

47

T H E D I S T I N C T I V E O B L I G AT I O N S O F T H E DOMESTIC CUSTODY ACTIVITY 1. The segregation of assets. A bank should clearly separate the securities owned for its own account and the assets for which it is the depositary for the third party’s account. The developing activity of lending securities between banks can be carried on only with securities owned for the bank’s own account. This difference between money and securities is important in the event of bankruptcy: the holders of securities accounts remain the securities’ holders in so far as the securities are subject to a deposit with the central depositary. 2. Reconcile securities under custody and issued securities. To the extent that banks may lend the funds they manage for the account of their depositors, they are not bound to re-deposit all these funds to the Central Bank. Only a tiny part is kept as compulsory reserves. On the other hand, for the securities there is a strict reconciliation between the securities number under custody and the number re-deposited to the central depositary. Therefore, there is no place for a “securities multiplier”. 3. Management of the corporate events. The third difference between securities and money is that the securities have a more eventful life than money. In fact, money brings an interest rate depending on the account features. Securities may be the object of dividends, bonus issues and other corporate events. They may also be subject to pledges, loans, speculation (in the event of selling out of money call-options), they may act as collaterals (under the pretence of complying with the “segregation of assets” principle). The account depositary and securities bookkeeper should manage all these movements and should accurately keep the accountancy, so that one knows exactly the status of every client’s account for every asset, at any time. The relations established within book-keeping by various actors are represented in Figure 4.2.

CUSTODIAN’S ROLE FOR CROSS-BORDER PROCESSING OF SECURITIES The activity of the securities intermediate custodians became a strategic axis of development for certain international institutions. By providing a global service, the global custodian undertakes to process the securities in an administrative manner within an environment of different jurisdictions, more often by subcontracting to local sub-custodians. As local custodians, or even regional custodians (for instance, the euro area) manage only the securities of an area, this evolution is related the internationalisation of investing activities and particularly related to the development of

48

GLOBAL CUSTODY & CLEARING SERVICES

Private Individual Keeps account and notifies

has a securities account

Bank Keeps account and notifies

has account Other Custodians National (CSD)

Subcontracts the custody to Intermediate or Local Custodian

Keeps account and notifies

has account

National Central Custodian CSD

Sets up relationship abroad with

ICSD 1

ICSD 2

Figure 4.2 Account structures of actors in clearing settlement & custody Source: Bob Craddock

institutional investment funds which multiply their cross-border operations and try to widen their asset portfolios. Currently, the custodians fit into a commercial type approach towards investors. Therefore, they are service providers for this custody activity going beyond the unique administrative and technical function. There are several service types provided to investors:


Communication supports relating to transaction outcome;




Detailed information on portfolios (pricing, reporting);




Technical information on the markets;




Fiscal formalities processing;




Securities borrowing-lending activity;




Foreign exchange services;




Risk analysis;




Proxy voting.

CLEARING & SETTLEMENT

49

T H E R E L AT I O N S H I P S B E T W E E N C S D s A N D I C S Ds I N E U R O P E Euroclear and Cedel, the two International Central Securities Depositaries (ICSDs), were launched at the end of the ‘60s. The domestic securities are listed to a CSD as national ultimate depositaries. In some countries, the ICSDs don’t have the right to have direct relationships with the CSD (for a long time, the banks refused this idea as they were often stockholders of the local CSD and they had no interest in seeing the development of these direct links). As a consequence, ICSDs don’t have accounts in every CSD. That is why they also develop relationships with local correspondents (bank’s intermediaries, sub-custodians). The securities are immobilised (locked-up) on behalf of Euroclear or of Clearstream in these banks. The sub-custodian banks have a direct access to a CSD of the country in which they are located and to the settlement-delivery systems managed by this CSD. The relationships between CSDs and ICSDs cross without any real separation for the moment. But when CSDs develop links between them or when ICSDs “buy” a local CSD, competition clearly appears. As the international exchanges are growing, this situation will be increasingly frequent: Within an “ideal” task distribution (mainly for the ICSD) 1. The relationship is untied by a CSD. In the case of a domestic security processed by domestic counterparties; 2. The relationship is untied by an ICSD: a. For a domestic security: when either party is not domestic; b. For an international security, regardless of the investors’ nationality. Thus, by merging with CSDs, ICSDs could monopolise all securities flow and position themselves really as international custodians.

T H E I M P O R TA N C E O F C L E A R I N G A N D SETTLEMENT TO EUROPE’S ECONOMY Capital markets play a vital role for society. They allocate financial savings to productive businesses. They reallocate risks from people who want to avoid them to people who are willing to take them. They do this through a process of constantly reassessing risks and opportunities and adjusting

50

GLOBAL CUSTODY & CLEARING SERVICES

prices accordingly. This process works most effectively when markets are liquid – when participants can trade easily and prices are constantly being refreshed. Post-trade processes – generally referred to as clearing and settlement are a key part of the working of capital markets. When they are low-cost and efficient they contribute to the effectiveness of the market. When they are expensive or inefficient they inhibit the development of efficient markets. The value of the assets means that the safety, soundness and reliability of the systems through which they are held and transferred are vital. Clearing and settlement in Europe shows its origins in a patchwork of national systems. At the national level, they are generally efficient, sound and reliable, but lack the scale to bring their costs down to the lowest international levels. For cross-border transactions, however, clearing and settlement in Europe is neither efficient nor cheap. This holds back development of a truly European capital market. Building a sound, efficient and integrated clearing and settlement infrastructure for Europe has been both an objective of market participants and of official policy makers for several years. In April 2004 the EU Commission published a communication setting out its objective as the “achievement of an efficient, integrated and safe market for securities clearing and settlement”. More recently, Commissioner McCreevy stated: “The time has now come for all interested actors to take their responsibilities and collectively put their foot on the gas. The Commission is taking a close look at the economic case for action. We will decide whether any European legislation, or other intervention, is necessary on that basis and in the light of developments in the market. The next 6 months are crucial. As far as I am concerned, the clock is ticking” Improving the effectiveness of clearing and settlement in Europe is therefore clearly high on the list of priorities. At the European level there have been company mergers. These have resulted in several groups that comprise clearing or settlement organisations in more than one country. Some clearing organisations operate across national boundaries – for example Eurex Clearing which serves the German, Swiss and Finnish derivatives markets. However, none of the mergers of CSDs has yet combined the systems of the different organisations to create a single system serving more than one national market. CREST, which was built from the outset as a single system providing settlement for both the United Kingdom and Irish markets, remains the only example of a single settlement system serving two countries. The cross-border groups have plans to develop integrated systems serving all their national markets, but these are complex and demanding projects.

Table 4.1

Derivative

Sweden

Finland

OMX

OMX

trading Cash

OMX

OMX

equities Clearing

Norway

UK

France

Nederlands

Switzerland

Germany

Italy

Spain

Euronext

Euronext

Eurex

Eurex

IDEM

MEFF

Euronext

Euronext

Oslo

Euronext

Bors

EDX

Oslo

LSE

Bors OMX

OMX

house

Settlement systems

Overview of principal financial market infrastructures in Europe

NCSD

VPS

Owned by users Source: Bob Craddock

NOS

LCH

LCH

LCH

Derivative only

Clearnet

Clearnet

Clearnet

VPS

Crest / Euroclear

Euroclear France

Euroclear Nederland

SWX Swiss

Deutsche

Borsa

Bolsas y

Exchange

Borse

Italiana

Espanoles

x-clear

Eurex Clearing

Casa di Compensaz ione e Garanzia

MEFFCLEAR

Monti Titoli

Iberclear

SIS Deutsche SegaIntersettle Borse

Owned by users but with plans to float

Publicly quoted companies

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GLOBAL CUSTODY & CLEARING SERVICES

EXAMPLES OF CROSS-BORDER MERGERS OF CLEARING AND SETTLEMENT O R G A N I S AT I O N S


Deutsche Börse acquired Cedel to merge it with the German CSD, Deutsche Kassenverein, to form Clearstream in 2000;




Euroclear Bank merged with Sicovam in France (2001), Necigef in the Netherlands (2002), CREST in the United Kingdom (2002) and CIK in Belgium (2005). The group is now organised with Euroclear SA as holding company and service provider, with the national CSDs and the ICSD as subsidiaries;




VPC in Sweden merged with APK, the Finnish CSD in 2004.

London Clearing House in the United Kingdom merged with Clearnet, the French clearing house, which had already merged with the Amsterdam clearing house to form LCH Clearnet in 2003. The key challenge that makes the development of integrated cross-border systems so difficult is the absence of harmonisation of market practices across Europe. Crucial differences exist in corporate action processing (e.g. giving owners the economic benefits of security ownership receiving income, being able to take up rights being able to accept take-over offers etc), in tax processing (i.e., the procedures for reclaiming over-withheld tax) and in legal structures for transfer of ownership (i.e., determining when a transfer is final and irrevocable). As long as these differences in market practice continue to exist, any integrated cross-border system must be capable of managing all the different practices of all the markets it is serving. One reason it was possible for CREST to be developed to serve both the United Kingdom and the Irish markets was that historically their market practices were quite similar. Even so, CREST had to be built to apply two different methodologies for the calculation and collection of Stamp Duty in the two countries. This is the cause of much of the inefficiency in the present system and makes system integration much harder to achieve. In 2001 the Giovannini Group identified 15 significant barriers to an integrated EU clearing and settlement environment.

OWNERSHIP OF CLEARING AND SETTLEMENT Two contrasting trends have been evident recently in the ownership of clearing and settlement organisations.

CLEARING & SETTLEMENT

Table 4.2

53

Giovannini’s barriers

Barrier

Necessary action

Responsible

Deadline

7

Operating hours and settlement deadlines should be harmonised.

ECSDA should take the lead in this initiative, in close cooperation with ESCB-CESR.

Within 2 years

1

National differences in the information technology and interfaces used by clearing and settlement providers should be eliminated via an EU-wide protocol.

Protocol should be defined by SWIFT and, once defined, should be immediately adopted by the Eurosystem in respect of its operations.

Within 2 years

4

Intra-day settlement finality in all links between settlement systems within the EU should be guaranteed.

ECSDA should co-ordinate necessary measures. These measures should be drawn up in close consultation with ESCB-CESR.

Within 2 years and 3 months

6

Settlement periods for all systems within the EU should be harmonised.

More study required on the costs of harmonisation versus the alternative of managing additional costs of this barrier.

Within 2 years and 3 months

3

National rules relating to corporate actions, beneficial ownership and custody should be harmonised.

Local agent banks, via ECSA, and ECSDA should co-ordinate private-sector proposals. National governments should coordinate their response via the relevant EU Council.

Within 2 years and 3 months

8

National differences in securities issuance practice should be eliminated.

IPMA and ANNA should draw up proposals to this end.

Within 2 years and 3 months

Continued

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GLOBAL CUSTODY & CLEARING SERVICES

Table 4.2

Continued

Barrier

Necessary action

Responsible

Deadline

11

All financial intermediaries established within the EU should be allowed to offer withholding agent services in all of the Member States so as to ensure a level playing field between local and foreign Intermediaries.

National governments should co-ordinate their actions via the relevant EU Council.

Within 2 years and 3 months

12

Any provisions requiring that taxes on securities transactions be collected via local systems should be removed to ensure a level playing field between domestic and foreign investors

National governments should co-ordinate their actions via the relevant EU Council.

Within 2 years and 3 months

13,14, 15

The EU Collateral Directive will remove much of the legal uncertainty relating to netting and the uneven application of conflict of laws. Member States should ensure the full implementation of this Directive by the scheduled date of 27 December 2003. While this should be enough to allow the lifting of the restrictions on holdings of securities and securities settlement, there remains a need for a legal framework across the EU under which,

An EU Securities Within Account Certainty 3 years project should be agreed upon by national governments. The objective of this Project should be to draft the target reform and adequate resources should be made available to meet this objective. This task should be completed within a period of three years.

Continued

CLEARING & SETTLEMENT

Table 4.2 Barrier

Necessary action

55

Continued

Responsible

Deadline

whenever securities are held using an intermediary, it is the accounts of that intermediary that establish ownership of those securities. 2,9

National restrictions on the location of clearing and settlement and on the location of securities should be removed, as an essential pre-condition for a market-led integration of the EU clearing clearing and settlement environment.

National governments should adopt the relevant elements on the location of clearing and settlement in the new Investment Services Directive as proposed by the Commission. National governments should then co-ordinate to remove restrictions on location of securities.

Within 3 years

5

Practical impediments to remote access to national clearing and settlement systems should be removed in order to ensure a level playing field.

National governments should draw up a set of conditions upon which remote access can be guaranteed across the EU. These conditions should be drawn up in conformity with the requirements of ESCB/CESR.

Within 3 years

10

Restrictions on the activity of primary dealers and market makers should be removed.

National governments should co-ordinate their actions via the relevant EU Council.

Within 3 years

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GLOBAL CUSTODY & CLEARING SERVICES

In some countries ownership of clearing and settlement has moved out of the control of exchanges. As a result, the exchange, the clearing house and the CSD are separate organisations, each with its own shareholders, directors and management, creating a structure that is described as being split “horizontally”. Examples of exchanges ceding control of clearing or settlement include:


CREST, a user-owned organisation, which replaced the Talisman system previously operated by the London Stock Exchange;




Euronext disposing of the majority of its shareholding in Clearnet to merge it with the London Clearing House to form LCH Clearnet; and disposing of Necigef, the Dutch CSD, to Euroclear; and




OMX selling APK, the Finnish CSD, to VPC, the Swedish CSD, to form the Nordic CSD.

In other countries, exchanges have taken control of clearing or settlement organisation to create “vertical” structures (also known as “silos”). Examples include:


In Italy, Monte Titoli became a subsidiary of Borsa Italiana in 2002;




In Spain, Iberclear became a subsidiary of BME in 2003;




In Germany, Deutsche Börse acquired Cedel in 2000, to combine it with the German domestic CSD, which it already owned.

Within these structures, the ultimate ownership of clearing and settlement organisations remains quite varied. Deutsche Börse is a quoted company and therefore has a diverse shareholder base and a commitment to generating shareholder value. Both Borsa Italiana and BME in Spain, while they have created vertical structures, continue to be largely owned by groups of national banks, although public listing remains a possibility. Where clearing and settlement organisations are not owned by stock exchanges, they are generally owned in some form by their users.

TRENDS IN TRADING ACTIVITY The most significant development in European securities markets during the past decade has been the move to electronic order-driven trading systems, particularly for equities. This has been significant in two important ways.

CLEARING & SETTLEMENT

57

First, this type of trading system gives participants anonymity both before and after executing a trade. This is crucial to their success, as it enables traders to follow a trading strategy with less risk of other traders being able to follow what they are doing. But it makes a central counterparty an essential complement to the trading system. Firms need to know their counterparties in order to manage their counterparty exposures; by the introduction of a central counterparty the firm can asses its risk whilst their trading counterparty remains anonymous. Second, the ability to generate trading instructions electronically and execute them in fractions of a second has made possible the development of increasingly sophisticated “black box” trading systems within investment banks and some of their clients. The purpose of the black boxes can be as simple as managing the flow of orders into the market so as to match the average price of a security during the day. They can also be used to execute complex trading strategies arbitraging between different securities or even across different markets. A consequence of these developments has been enormous growth in the number of trades on major exchanges. However, much of the arbitrage trading exploits very fine price differences. The profitability of the trade depends on the total cost of executing it – including direct and indirect costs of clearing and settlement. Thus, these costs can influence the level of trading activity. This is in contrast to patterns of trading in the past, where trading decisions were made on the basis of investment choices; the costs of clearing and settlement were overheads to be borne, but not factors that determined whether or not the trade took place. A reduction in clearing and settlement costs – both domestic and cross border – to the sort of levels found in the US would potentially produce very significant increases in black box trading activity in markets in which they are already used, and also stimulate their use in smaller markets in which they are not currently used. Overall that would result in a big increase in market liquidity in Europe. European commentators often look to the United States as a model for Europe. The reality is that there is both good and bad to be observed in the comparison. US markets benefit from having a single, huge domestic market, in contrast to the fragmentation along national boundaries found in Europe. However, the US infrastructure is fragmented in other ways. It is undeniable that in the securities markets, the US domestic market is far larger than the European equivalent. The impact of automated trading, together with low settlement costs and strong competition between exchanges and other trading venues may be part of the reason behind the stronger growth in equity trading in the US than in Europe over the past five years. The United States benefits from the sheer size of its domestic market, with no internal boundaries. However, its market infrastructure remains

58

GLOBAL CUSTODY & CLEARING SERVICES

inefficient in other ways. In securities markets there are separate settlement systems for corporate securities (DTCC) and for government bonds (Fedwire). In virtually all European countries these are now integrated in a single system. There is still extensive settlement using share certificates, which is slower and less efficient than in those few European markets where share certificates are still in circulation. The infrastructure for derivative markets in the United States is still more fragmented. Clearing houses for futures contracts tend to be aligned with individual exchanges, while there is a separate clearing house for options (the Options Clearing Corporation (OCC)), which serves all the options exchanges. Again, this is in contrast to European markets, where a single clearing house typically clears for related cash, futures and options markets. There are, however, lessons for Europe from the process of consolidation that has taken place in the United States. The securities clearing and settlement infrastructure was originally developed separately for each exchange. The process of consolidation was initiated as a matter of public policy by Congress, which passed the Securities Acts Amendments of 1975 to promote a unified national market in trading, clearing and settlement. Congress directed the Securities and Exchange Commission (SEC) to facilitate the establishment of a unified national system that would have five objectives: efficiency, competition, price transparency, best execution and order interaction. The SEC stimulated the consolidation of the three major central counterparties to form the National Securities Clearing Corporation (NSCC) in 1976, but consolidation of all the regional depositories into the Depository Trust Corporation (DTC) took until 1997. Thus, even in a single country, with a single currency and a single regulatory framework (albeit with 50 different state laws) the process of consolidation took 20 years. Patience is a pre-requisite for building a financial market infrastructure!

PART 2

Asset Servicing

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CHAPTER 5

Asset Servicing Key Issues The reader will have gathered by now that, even though modern custody contains many disparate elements, at its core is a fundamental product offering asset servicing.

INVESTMENT IN RESOURCES A recent Tower Group report estimated that approximately US$1 billion would be spent in the area of corporate actions over the next 5 years. 42% will be with 3rd Party Vendors and 58% will be in-house development with certain elements sourced from 3rd party suppliers. The total assets under management for all global investment management firms may give some indication of the overall volume of assets that could in theory be affected by corporate actions.


In terms of AUM, of the global total:


Pension assets account for approximately $17 trillion;




A further $18 trillion is invested in mutual funds;




$16 trillion is invested in insurance funds;




The Top 20 Custodians manage over $90 trillion AUM;


Automation of corporate actions is either being implemented or under review by around 60–70% of market practitioners currently. Whilst only approximately 10–15% have already completed some segment of that process very few, if any, have implemented end to end automated processes; 61

62

GLOBAL CUSTODY & CLEARING SERVICES


In the USA FTE costs associated with CA are estimated in excess of $50 billion. From a sample of the firms analysed representing 75% of all UK Assets Under Administration, 19,000 jobs were identified:

Fund Manager/Analyst


3874

Marketing/Sales/Client Service


5544

Compliance/Finance


1550

Fund Admin/Ops/IT


8032

Clearly the support costs associated with Fund Admin/Ops and IT is nearly 43% of the total staffing costs. Which if we assume £100,000 for a fully loaded FTE cost
£803,200,000;
Celent estimates that approximately US$988 million will be spent by the industry on corporate actions automation projects over the period 2006–2010. Importantly, Celent predicts a noticeable, albeit gradual, shift toward greater spending on external software and services providers as opposed to internal development. This is a meaningful uplift from 2004. They predict 45% of the expenditure will be on third party vendor applications, while 55% will be spent on in-house builds as well as implementation of third party vendor systems over this time period;
Using the figure of 45% being spent on third party apps, we can estimate that total spending on Corporate Action third party automaton software should be in the region of $80–$100million a year for the next four years.

Out of the Top Asset Management Firms in each region the following breakdowns are realised based on assumptions on assets under management.

Table 5.1 Region UK North America Europe Total

Asset management firms by region Tier 1

Tier 2

Tier 3

5

40

70

11

20

212

5

7

88

16

27

203

ASSET SERVICING KEY ISSUES

63

Although there are many types of corporate actions across international markets, for the most part they fall into the following three categories, each with its own potential for added expense, suboptimal trading decisions and inefficient corporate governance.


Compulsory Actions, such as cash dividend and interest payments, which require no discretionary action on the part of the investor/ intermediaries;




Compulsory Actions with Options, which, for example, may give shareholders the option to receive dividends as cash or as additional shares;




Voluntary Actions, where an investment decision (and corresponding action) is required on the part of the investor/agents.

Although there is little operational risk in the first category, which requires no action, there is ample scope for failure in the second two, due to the following issues:
Confusing Notification: Issuers have a legal obligation to notify the market via prospectus and tombstone advertising; however, with no standard medium or format for making announcements, and no single securities identification system that is universally accepted, the only predictable results are confusion and uncertainty;
Multiple and Redundant Intermediaries: An entire sub-industry has grown up around scrubbing and interpreting the data from issuers, their agents and supplementary information vendors, encouraging understandably risk averse fund managers to subscribe to multiple providers. As a result they are not only paying for redundant information, but also reducing a narrow decision window;
Incompatible Time frames: With intermediaries setting their own deadlines the window for the ultimate decision maker is often far too narrow.

Current Issues at the forefront of asset servicing include:


Lack of Standardisation/quality of Corporate Actions Information leading to high levels of manual intervention;




Multiple Parties and communication channels e.g., SWIFT, email, fax proprietary;




Internal legacy systems problems – lack of integration with many manual steps and a lot of re-keying taking place;

64

GLOBAL CUSTODY & CLEARING SERVICES




Volumes increasing with added complexity – manual process cannot keep pace and errors are costly with “write off” taking place regularly;




Growth of volumes is fuelled by the uptake in Hedge Fund, OTC and Securities Lending activity.

Announcement of events

Investment decisions Issuer/agent

Depository/exchange Little or no automation/ standardization Sub custodians

Information vendors

Global custodians

Standardization exists. Automation possible.

Shareholder/fund manager

Figure 5.1 The corporate actions chain Source: Author’s own

Pre-decision processing

Decision processing

Post-decision processing

} } }
Incorrect or miss-

ing information
No diary entry
Internal / external

position disagree
Entitlement

calculations incorrect


Missed deadlines
Stock borrows or

loan errors
Partially settled or

failed trades
Miscommunication

with decision maker


Host systems not

updated / updated incorrectly
Trade amendments

processed incorrectly
Allocations /

entitlements wrong
Tax impact not

captured / inaccurately calculated Figure 5.2 Common processing errors Source: Author’s own

ASSET SERVICING KEY ISSUES

65

Increased investment driven by desire to mitigate risk, reduce manual processing and address global regulation was the focus in a recent Tower Group’s Reference Data Survey. This survey found that data management projects are now rated as a top priority or a high priority for financial institutions across North America and Europe/UK. So, where is the Focus?

Multi-line banks and brokers


Larger Banks and Brokers that service retail, institutional, prime brokerage and other clients. Generally maintain their own corporate actions group although they may outsource the retail activities to clearing firms and focus on differentiating their institutional business and see Corporate Actions as part of their service offering.

Mono-line banks and brokers


Small to mid-size Banks and Brokers and Fund Managers. Maintain their own corporate actions group for processing events, but see the process as a cost of doing business.

Clearing firms


Provide services for Banks and Brokers that do not clear for themselves and some of the retail business that is outsourced by larger institutional firms;




Typically maintain their own corporate actions group for processing and see the process as a cost of doing business;




This group’s focus is also on reducing cost.

Custodians


Primarily provide services to the Buy-side community;




Provide corporate actions services to their clients as part of their overall custodial business service offering;




Appear to have similar processing requirements as the Core target group, but added complexity on instruction management;

66




GLOBAL CUSTODY & CLEARING SERVICES

Custodians are pioneers in automating end to end processing of CA from a 3rd party vendor.

Market size The following figures and tables give some context to the size of the asset servicing market.

Japan - 8.1%

Germany - 7.0% France - 6.6%

Switzerland - 8.8%

Other - 18.4%

UK - 10.0%

USA - 41.1%

Figure 5.3 Geographic breakdown of AUM by region Source: Author’s own

Table 5.2

2006

Take over/ mergers

Corporate actions growth by type

Stock splits

Equity offerings

Exchange offers

Total

UK

121

64

339

45

569

USA

357

1635

1055

1115

4162

UK

79

105

579

43

806

USA

522

2123

935

1018

4598

2005

ASSET SERVICING KEY ISSUES

67

% Type of CA

40 30 20 10 0 Cash dividend

Distributed Partial calls income

Full call

Meeting

Dividends omitted

RoE

Name changes

Voluntary

Types of CA impacted

Globally

North America

Europe

Asia

Figure 5.4 Market impact of corporate action type by region Source: Author’s own

Table 5.3 Scaling of losses by AUM for funds managers in 5 European countries Total AUM (Euro billion)

Loss due to CA failure (Euro million)

UK France Germany Netherlands Italy

3,241 1,683 1,272 756 725

27.1 14.1 10.6 6.3 6.1

Total

7,678

64.5

Country

600 400 200 0

12

34

Total number of firms

250

300

400

Loss due to CA failure (euro million)

89. 5

107. 4

143. 3

Figure 5.5 Losses due to CA failure Source: Author’s own

Table 5.4 Firm Size and Scope

Potential ROI by size of firm

Complexity

Staff

CA

of Corporate Actions (Cas)

Efficiency and Structure

Processing System

Third Party Vendor Software/ Solutions Considered

BPO ROI Potential

Small firm

Few CA types and

Staff small (1–25)

Internal, not

Additional

Low or negative

Small asset

low frequency, only

and efficient but

scalable, and not

headcount

management firm of brokerage

a few data sources

labor-intensive

entire transaction life cycle

training for existing employees

initial ROI; solutions expensive relative to need Potentially very

Medium-size firm

More CA types with

Staff efficient but

Internal, perhaps

Consider external

Small custodian

greater frequency,

strained (25–100),

some external

software, BPO, or

high ROI as

broker-dealer, or

possible cross-border

increasingly siloed

software in

internally

software eliminates

asset management

CA events, several

high manual

various

developed

need to add staff or

firm

data sources

intervention in complex CA events;

transaction areas or BPO

software; internal development

additional developers

some internal developers

likely to be only a temporary solution

Large firm

High frequency and

Siloed but efficient

Heavily dependent

Consider external

Medium to high ROI,

Global custodian, large

higher number of

staff, (100)

on external

software or BPO,

particularly if

asset management firm,

CA types, data

susceptible to

software

particularly around

solution is flexible

securities depository,

scrubbing, multitude

regulation and

for scale and

data; standardization

or broker-dealer

of investments covered, cross-

harmonization initiatives, internal

integration, CA viewed increasingly

offers opportunities; internal development

and scalable; however,

border issues,

developers strained

as part of the

can be phased out

foreign CAs

Source: Celent

entire transaction life cycle

reconciliation of disparate systems may be difficult

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We have researched the Overall Size, Asset Allocation and Costs. In the UK Assets totalled in excess of £2.16 trillion, with more than 20% held offshore. This group in global terms with their parents is responsible for assets around £7.87 trillion. 1. Market Share of top 5
28% and top 10
46 % 2. More than the 50% of the Asset Managers do not use soft commissions. Of those that do did so in terms of weighting on Assets Under Management, costs for information feeds made up more than 50% under soft commissions 3. In terms of Instrument types – 37% are in Bonds and 45% in Equities

Money market 9%

Equities 45% Bonds 37%

VC 3%

Property 6%

Figure 5.6 Assets managed in the UK Source: Author’s own

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Emerging markets 4% Japan 12%

other 5%

Europe 14%

UK 56%

North America 9%

Figure 5.7 Equity allocation by country Source: Author’s own Government 2%

Retail 13%

Other 9% Insurance 40%

Private client 1%

Pension funds 35%

Figure 5.8 Equity allocation by sector Source: Author’s own

Client types – 40% of assets are for Insurance Funds 35% of assets are Pension Funds Asset Managers commonly fall under the following groups:


Passive – tracks index;

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Customised Benchmarks – Monitor blend of indices;




Absolute Return – LIBOR  2%;




Peer group – tracks performance of comparable funds;




Specialists – Specific asset class or exposure geographically.

Retail 15% Investment bank 28%

Other inc custodian 16%

Pension funds 2% Insurance 21%

Fund manager 18%

Figure 5.9 Asset management globally by parent Source: Author’s own

Peer group 14%

Customised benchmarks 49%

Specialist 14%

Absolute return 0%

Passive 23%

Figure 5.10 Client mandates of AUM Source: Author’s own

71

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Asset Allocation was across the following categories: Equities – North America, UK, Europe, Japan, Emerging; Fixed Income – Government Debt, Investment Bonds, High Yield Bonds; Money Market – Cash and Money Market; Alternative – property, VC.

UK equities North American European Japan Emerging Govt debt Investment funds High yield bonds Cash/MM Property VC Other 0

5

10

15

20

25

30

Figure 5.11 Asset allocation across all categories Source: Author’s own

Table 5.5

Top UK fund managers

Top 10 fund managers in UK Fidelity Investment INVESCO Perpetual Threadneedle Investment Services Ltd Legal & General Investment Management Schroder Investment Management Halifax Investment Fund Managers Ltd Scottish Widows Unit Trusts Managers M & G Securities Ltd Henderson Global Investors Mellon Fund Managers Ltd Continued

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ASSET SERVICING KEY ISSUES

Table 5.5

Continued

0–100

100–300

300–600

600– 1000

1000– 10,000

10,000– 50,000

20

26

7

6

47

10

0.29

1.44

0.74

1.34

54.15

45

Top 10 fund managers in UK AUM (£mm’s) # Fund Managers % Market Share Source: Author’s own

Table 5.6

Top North American fund managers

Top 10 North American based fund managers Barclays Global Investor State Street Global Investor Fidelity Investments Capital Group JP Morgan Asset Management AXA Group Mellon Financial Corp Citigroup Asset Management Vanguard Group Northern Trust Global Investment AUM ($billions)

0–100

100–300

300–600

600– 1000

1000– 10,000

Out of 100 Fund Managers

47

22

20

2

9

% Market Share

9

18

28

5

40

Portfolio Mix Equities – Domestic Equities – Foreign Fixed Income – Domestic Fixed Income – Foreign Cash Alternative Investment TOTAL Source: Author’s own

AUM ($ Trillion) 9.9 4.0 7.7 1.8 4.5 1.2 29.1

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Table 5.7

Top European fund managers

Top 10 European based fund managers UBS Barclays Global Investor Allianz Group AXA Group Credit Suisse Group Deutsche Asset Management ING Group AVIVA IXIS Asset Management Credit Agricole Asset Management AUM 0–100 ($billions) Out of 54 100 Fund Managers % Market Share 15 Portfolio Mix

100–300

300–600 4

600– 1000 3

1000– 10,000 5

34

30

9

11

35

AUM ($ trillion)

Cash Alternative Investment Equities – European Equities – USA Equities – Other Fixed Income – European Fixed Income – USA Fixed Income – Other

0.92 0.88 4.21 1.26 1.75 14.3 0.70 0.84

TOTAL

18.8

Source: Author’s own

The level of processing and operations costs are linked to Assets Under Management as well as activity in the Market. In the USA large and growing volumes are being realised with respect to Corporate Actions.

C O R P O R AT E A C T I O N S A U T O M AT I O N As the vendor landscape matures financial institutions are spending more on corporate actions automation. Celent estimates that approximately $988

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million will be spent on corporate actions automation projects from 2006 to 2010, advancing automation from hype to reality. Corporate action automation has made strides. But a collective solution is necessary to achieve true automation. According to Celent, the primary concern today is the lack of uniform data standards for corporate actions. Data is often unreliable or incomplete, and many institutions get corporate actions data from numerous sources. Manual intervention is necessary to correct the data and make it uniform – a time-consuming process. STP rates for corporate actions processing will improve only with data standards. While competition is heating up, the good news for vendors is that overall spending on corporate actions automation will increase as a result of demand and a wider variety of vendor solutions. Leading corporate actions automation providers should benefit from the increase in spending and the move for more financial institutions to turn to third party providers rather than internal solutions. When the information flows associated with corporate actions are automated, the costs and risks associated with it are significantly reduced. Typically, corporate action processing time can be reduced by around 40 percent as a result of putting effective messaging and work management systems in place. Better still, firms can also realise tangible competitive advantage. For Custodians, this competitive advantage will lie in the ability to provide marked enhancements to customer service. For example, custodians should be able to pass on to clients some of the time savings achieved through automation. And providing information about forthcoming events more promptly allows clients a wider window for their decision-making. A well-designed corporate actions system will also make it easy to deliver information to end users via a number of channels, allowing clients more flexibility in where and how they manage their side of the process. This is the kind of competitive edge custodians need in today’s consolidating market. Fund Managers can spend less time chasing the data itself and more time analysing it, improving the quality of their decision-making and enhancing the return on investment across their portfolios, providing the right systems are in place. Broker/Dealers will be able to seize every arbitrage opportunity if corporate actions databases are in sync with portfolio and order management systems. These benefits are what should drive any STP project, and that is even truer when considering the automation of corporate actions. There is as yet not a single technological ‘silver bullet’, and it is clear that the debate about workflow vs. integration is ultimately without much value to the pragmatic buyer. There is a set of problems out there that dictate the blend of IT and business functions that need to be applied, and the skill of the solution provider is measured in the quality of the blend.

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Automation has become a top priority for many CA departments. There is increasing confidence that credible benefits are available to those departments that take advantage of the automation options now on offer. Factors such as increases in trading and event volumes, Basel II compliance and the implementation of SWIFT ISO 15022 messages all contribute to the gathering momentum. Standardisation of message exchanges (ISO 15022) and the work of market practice groups to define event lifecycles deliver the possibility of increased straight through processing for the CA department. There is a note of caution in that non-standard adoption of the Securities Market Practice Group (SMPG) recommendations could lead to variations in the usage of the most basic event type, thus complicating matters for the industry as a whole. If, on the other hand, standards are agreed that allow corporate actions to be processed efficiently then:


Brokers and custodians can reduce exposure to errors, charge for a better service and reduce the capital allocated under Basel II;




Fund managers will gain time to respond, obtain entitlements earlier, reduce the risk of missing events and cut back office costs;




A key area that will benefit will be the processing of withholding tax. By automating the core corporate actions processing a faster turnaround on the processing of withholding tax will be realised. This will in turn lead to a greatly improved performance of funds. These are all real benefits that are being realised by a few early adopters.

Corporate actions is often described as one of the last bastions of manual processing. This is a surprising situation given the inherent high cost and the high risk profile of the CA process, where a single error can, and for some institutions does, prove a huge liability. There is increasing confidence that credible benefits are on offer to those departments that take advantage of the automation options now on offer. Factors such as increases in trading and event volumes, Basel II and the implementation of SWIFT messages all contribute to the developing momentum. The conundrum is why more custodians have not already automated more of the corporate actions chain by now. ‘If it ain’t broke, don’t fix it.’ departments cope with the CA process today like they have done for years. New projects have difficulty getting the go-ahead and justifying a return on investment (ROI) has been a tough internal battle. Few CA departments were automated so there was no fear of being left behind. Lack of good successful ‘role models’ has contributed to a fear of failure (and there have been failures). Numerous vendors have ‘jumped on the bandwagon’ but only a handful have a proven offering with live client sites.

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D R I V E R S F O R A U T O M AT I O N SWIFT messaging: Processing based upon the receipt and creation of SWIFT messages (as opposed to telex or fax based communication) makes life impossible for a manually based department. Basel II (and III): Life for the manually driven department will be tough and considering the potential high value of the risk this could have significant financial impact on the amount of cover required. Availability of proven solutions: Today it is possible to purchase a CA system from a supplier that has an installed base and has staff that are familiar with the CA process. ROI: Reduction and control of operating costs is the number one priority of financial institutions. And coping with variable levels of event volumes with a given headcount is a key ingredient for success. Automation can deliver on both of these but those that remain in the manual world will have little room for manoeuvre. Complexity: Corporate actions solutions are much more sophisticated and can generally be expected to handle over 100 event types both mandatory and voluntary. Connectivity: Could involve supporting multiple protocols such as MQ, FTP, etc. The messaging support would ideally be XML based, whilst equally capable of handling non XML formats such as SWIFT, most legacy back office systems or proprietary market data feeds. Globalisation brings about changes in this context of “management”. Thus there will eventually be no such thing as the “German” or “French” market, but a borderless business domain which will have as its segments not product types or countries but global customers within supply chain structures, each having distinct characteristics. The customer or the supply chain becomes the market segment. What drives any particular player in the market will depend on their view of their business domain. Some will source components, some will require a path to complete subsystems, some will require something in between. The response will undoubtedly be a mix of product packages that could involve direct product supply from a global product supply function, local or international collaboration of best of bread suppliers. Taking the size of the market into account, financial services is, understandably, one of the most important sectors for IT companies. The main external factors driving the uptake of IT within the Financial Services sector are the historic role out of the Euro and the compliance to

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the Basel Accords (Operational Risk) and in 2007 / 2008 the implementation of the MiFiD directive. The financial services sector has been more willing to support and less risk averse to backing new technology financially and proto-typing, especially where it sees the opportunity for quantum leaps in services, cost savings or revenues. It has, in a word, been highly encouraging to innovation. Client satisfaction is also a great driver of business for most custodians. Coupled with a rationalisation in the market, more and more custodians moving in to more disparate service offerings from White-Labelled to Outsourcing, without necessarily having the required experience or the technological backbone to address and deliver to the needs of the client makes this an increasing complex world. Most large global players’ systems are legacy in nature, in house developed and some many years old. The challenge is how to address and engage a typical non-XML based technology in to a new world where most forms of communication will be based on XML or market driven standards such as SWIFT ISO 15022 / 20022. Reduction and control of operating costs is the number one priority of financial institutions. Coping with variable levels of event volumes with a given headcount exerts demands on the CA department. During business peaks, additional qualified staff are not readily available and trying to cope with existing staffing can lead to expensive mistakes. Automation is the only practical solution. Departments that remain in the manual world will have little room for manoeuvre and will be subject to significant business risk. It should also be borne in mind that any actual CA implementation project is likely to require the flexibility of operating both with the ‘official’ standards and the inevitable variants (as will be implemented by counterparties). The ability to cope with the ‘ideal world’ standard as well as the ‘real world’ pragmatic approach is an important consideration to bear in mind. Automation is the way forward and is inevitable. The fear of doing something will, in due course, be replaced by the fear of being left behind and unable to cope with the demands of SWIFT ISO 15022 messaging and Basel II controls. Key Differentiators in corporate actions automation:


Rapid Return on Investment – a solution that demonstrates quick implementation and delivers an immediate ROI;




Highly Scalable and Adaptable – a solution that proves to be data content independent and able to adapt to a customer’s unique needs;




Exploits Proven Industry Leading Technologies – a solution that exploits industry leading messaging standards;

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High Performance – a solution that has repeatedly demonstrated outperformance against competitive offerings;




Proven – a solution that is being used by a number of Global 2000 corporations to solve their integration and STP requirements;




Unique Consulting Expertise – professional services that provide deep business and technical competencies in broad-based networking, commercial messaging and information integration.

Categories

Figure 5.12 Importance of automation to custodians Source: Author’s own

End-to-end capability

Automated reconciliation

Position capture interfaces

Workflow for exception management

Data models

Entitlement notification

Automated decision capture

Instruction processing

Settlement interfaces

6 5 4 3 2 1 0 Interfaces to tax processing

Rating

Figure 5.12 clearly shows the importance of automating many areas of the process. Such findings have been backed up by specific targeting of firms as part of a market sizing paper as part of this exercise. A corporate action is defined as any action taken by the issuer of a security that affects the structure or financial status of the security. End-to-end corporate action processing involves data capture, event certification, entitlement determination, event notification, voluntary response tracking, settlement, and reconciliation. There are more than 150 different types of corporate action event, of which 68 have recognised ISO standards. It can be seen from Table 5.8, that dividend payments and income distributions are the most common types of corporate action worldwide (and in the three main financial regions, with the exception of income distribution in the Asia-Pacific region). All the other corporate actions in the top eight are of the mandatory type, which, by their nature, are relatively straightforward. Voluntary corporate actions (or mandatory actions with options) – which are more complex and hence involve greater risk – represent only about 10–15% of all corporate actions taking place. Nevertheless, globally, this translates into approximately 90,000–140,000 of such complex actions each year.

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Table 5.8 Types of corporate actions

Types of corporate action

Worldwide

North America

Europe

Asia Pacific

Cash Dividend Income Distribution Partial Call redemption Full Call Meeting Dividend omitted Return of Capital Name Change Other

26.9 16.4 14.6 12.5 7.1 2.7 2.0 1.8 16.0

27.7 23.8 17.7 18.1 0.6 0.8 1.6 0.8 8.9

23.0 2.6 12.6 1.7 18.7 3.5 3.7 5.2 29.0

33.1 0.0 0.1 0.3 18.4 18.7 0.5 1.3 27.6

All Corporate Actions

100

100

100

100

Source: Author’s own

Additional costs may be incurred based on the connectivity option between the parties when it comes to automating these actions – via SWIFT, Proprietary, FTP, Web, and Fax. Volume dependency on pricing is important as it is based on a proportion of Assets Under Management and since one event could result in hundreds of sub-account notifications, even with all the costs implications, it is reasonable to expect a ROI of 40% or more. Automation in Corporate Actions allows for:


Increased coverage. Multi-site, multi-market deployment with an exhaustive functionality covering full corporate action lifecycle in a global environment and catering to voluntary as well as mandatory corporate actions, supporting over a hundred corporate actions;




Higher productivity. Increased operational efficiency by 25%, and cost reductions by 30%. Reduced risk by eliminating redundant processes and errors due to manual intervention;




Process Convergence. Corporate actions processing consolidated and processed across geographies as a shared service, eliminating duplication of effort and reducing operating costs;




System Convergence. Allowing a single system servicing Trade and Corporate Actions processing end-to-end across multiple businesses and geographies;

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Improved customer servicing. Range of notifications through SWIFT, email, Web, Fax, automated reminders & response tracking and consolidated, integrated reporting to clients;




Meeting industry standards. Standardisation and harmonisation of SWIFT MT message usage, ISO 15022 compliant;




Straight Through Processing. STP engine supporting configuration, audit, scalability and integration with workflow. There should be views through dashboards for application administration, STP and Workflow;




Enhanced Workflow. Workflow enabled with aspects like organisation structure, rule/SLA based work item assignment, proactive notification;




External Security. External security support for integration with existing enterprise security infrastructure;




Investment Protection. A solution should be an open system architecture, high scalability to handle increased volumes and easy & flexible to interface with external systems. It’s a single system servicing corporate actions processing end-to-end across multiple entities leading to economies of scale and elimination of cost/effort of maintaining multiple systems.

The need for firms to make sure that their trading desks have direct access to accurate, timely data on corporate actions in order to execute proper trading strategies is increasingly becoming more important. Even routine corporate actions can have a significant impact on trading prices, trading volume and trade price volatility. Most of the effect occurs in a short period around the announcement of the action, or the event itself, as the market is absorbing the relevant information contained within that corporate action. These effects depend on the type of corporate action and the particular point in the corporate action processing cycle. Within the corporate action types such as takeovers, spin-offs, stock splits and rights issues appear to have the strongest effects, while exchange offers have only a limited impact. In general, the strongest effect is observed on the date when the corporate action is announced, although record dates and ex dates are also often associated with significant increases in share price volatility and trading activity. Often described as the last bastion of manual processing, with its inherent high costs and associated risk, the corporate actions area is now at the top of many firms priority to automate, where the operating cost is the biggest motivator. Increases in trading and event volumes are also forcing institutions to look to automation.

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Fear of failure to implement automated solutions still remains high even though many firms are willing to invest. Justifying to the business an immediate ROI is still the hardest internal battle to win. This is further compounded by the fact that there are only a handful of vendors who have a proven offering with live client sites. The Corporate actions solutions out there are more mature at handling most aspects of most events, and all the good systems will allow exception based manual intervention where necessary. They are being recognised as being more reliable and less susceptible to overload than their human counterparts. Where organisations have implemented systems the corporate actions clerks have been able to pay more attention to exceptions and proactive management of event lifecycle whilst the drudgery of the paper mountain has – if not been removed – at least been reduced. This is, after all, a complex implementation, with returns initially measured in terms of increased efficiency, fewer errors, measuring performance of counterparts etc all of which are intangible and difficult to quantify. The corporate actions area is also characterised by a bewildering diversity: procedures, message formats, national nuances, even basic terminology can all vary from market to market. A key for a successful implementation is planning and project management by the enterprise and the vendor. This is a real test of a true partnership, and needs both to pull together in the same direction. It has to be recognised right from the start that the automated process can be different from its manual equivalent and invariably will involve a cultural change across an organisation. Each implementation in our experience to date has been different since each firm’s priorities have differed due to the business model and current processes involved. A good and successful project consists of well defined phases with each one seen as a mini-project in the overall corporate actions strategy. Each stage should be achievable with realistic targets. This will help in estimating costs and quantifying ROI at the same time ensuring that the day-to-day disruptions are kept to a minimum. Projects that don’t deliver ROI simply don’t exist any more. Our experience to date suggests that a CA implementation will pay for itself within 12–18 months before moving in to profit. A classic business case will have the following ingredients: 1. The solution should be scalable in terms of increased volumes and static or reduced headcount. New instruments and markets can be added to increase trading income with ease; 2. Cost reduction by better resource deployment through peaks and troughs. The system should be able to facilitate centralisation in an enterprise and will handle the bulk of standard processing. Resources can then be deployed for exception processing, improving client servicing and communication with improved timelines both internally and externally;

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3. Risk reduction is one of the key drivers and benefits in automating corporate actions. However, eradicating risk is not going to be realistic, but identifying and documenting areas that generate risk is essential. If you can quantify this with figures that represents exposure then this will certainly help focus senior management mind time. Another area of risk which seems to be forgotten or even ignored is one of corporate risk when selecting a vendor. There are many to choose from but only a few with a track record, longevity, and strong balance sheet exist. This part of the due diligence process needs to be given more attention as the vendor that is selected will need staying power over a longer period. Recent consolidation in the middleware market should serve as a warning to all. The needs of corporate actions operations are pushing the bounds of technology even further. It goes without saying that any solution should be orientated around exception processing. Industrial strength workflow technology is a must to generate tasks proactively during the course of the corporate actions lifecycle. This would include user and departmental workflow diaries, with escalation, alerts and monitoring of deadlines both internal and external. Key advantages to using workflow are:


Workflow helps to present work to all users proactively.




Monitors that work has been completed to a specified deadline.




Alerts the user and their supervisors when work is not completed.




Allows for a tailored and customised solution.




Workflow practices clearly help aids during a phased implementation.

It is the standardisation of message exchanges delivered by ISO 15022 and the work of market practice groups to define the particular lifecycles that have brought corporate actions into a realm where automation is possible. The market is moving further ahead with the adoption of XML and MDDL which allows information in a more structured form to be captured in the areas of options and on voluntary events. However, there is a note of caution, in that the key to adopting SMPG recommendations universally depends on the level of enforcement introduced. Today, there is none and the lack of a regulatory, or an industry driven, body could lead to variants in the adoption of the most basic event type. Significantly, the Giovannini Group, ECSDA Working group 5 and in its report the ESF, also reiterated the need for the industry to make changes

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itself. Most neutrals recognise that corporate actions information should be presented and transmitted to SWIFT ISO 15022 standard. What matters now is not for further discussion but real implementation. SWIFT ISO 15022/20022 messages could be the catalyst required to accelerate the adoption of corporate actions automation. The aim and benefit of automation is to provide the fund management community and the trading desk a bigger window to make an investment decision. Until firms make the effort genuinely to introduce automated workflow into this area, they will continue to operate a set of fragmented and inefficient processes. It is obvious to most what everybody should do, but not what they will gain. Issuers and data vendors must standardise the information they disseminate, issuers can stop to underwrite. Custodians can reduce exposure to errors, charge for a better service and reduce the capital allocated under Basel II. Fund managers that adopt the messages will gain time to respond, obtain entitlements earlier, reduce risk of missing events and cut back office costs. These are all real benefits that can be realised. Systems are out there which allow the repetitive monotony of corporate actions processing to be heavily reduced and to leverage the skill of the existing staff in a pro-active exception processing environment. The solutions that will allow an immediate improvement in efficiency and more importantly – a reduction in risk, are out there ready to be used. In summary, the danger with not doing anything is that custodians will continually be faced with operational risk, the risk of failure, or near failure, of mission-critical business processes and their underlying operational systems and data, which can include failure of functions, systems, people or relationships internally or externally to the organisation. Automation is the way forward – but in a realistic and pragmatic manner. The results which can be demonstrated are out there – efficiency gains, reduction in risk, increased internal and external visibility, conformance to compliance issues, satisfied customers, and crucially an enhanced bottom line.

CHAPTER 6

Withholding Tax

In this book, as we’ve said, it would be impossible in the space to cover every aspect of custody in extreme detail. However, it is useful if we can choose one such area in order to highlight the principles and processes that do underpin the custody and clearing world. For this purpose, we have chosen a little known and even less understood area of corporate actions’ asset servicing – withholding tax. While a description of withholding tax in a book of this nature would normally take up two or three pages at most, here we are taking the subject to some depth in order to identify the issues that custodians and others face in the market. The reader should be aware therefore that issues raised here apply just as much to every other aspect of custody and clearing. The nature of the issues may vary but essentially the types of issues are the same:


How to reduce cost and risk through automation;




How to gain competitive advantage in the market through performance.

Of the corporate actions event the type that is currently rising up the agenda for both investors and for custodians is withholding tax. For many custodians tax is a necessary evil to deal with primarily because approximately 60% of the process remains inherently manual and paper based. A fact which conflicts strongly with the principles of most custodians. We will therefore spend some time detailing this particular corporate actions event, not just to highlight the issues themselves but also, by reference, to highlight the more general issues that need to be faced by custodians in all corporate actions processing:


Understanding the issue;




Dealing with the complexities; 85

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Minimising liability, risk and cost;




Optimising client value;




Creating and delivering an STP business model.

Figure 6.1 demonstrates the issue. While the diagram shows the model for dividend income, withholding tax can apply to many different kinds of income. For custodians, the combination of dividend and bond interest income represents at least 95% of all the corporate actions activity they are ever likely to encounter. Essentially withholding tax is a cross border issue. Investors, the clients of custodians, have key attributes of which their residency for tax purposes (e.g. France, UK, USA) and their legal status (e.g. individual, corporate) are the most important. The other players in this theatre are of course the Issuers, those corporates that, as a result of a general meeting, declare and distribute dividends. The structure of the financial services model is unfortunately complex and an investor whose custodian is the asset servicer of record may be only one in a chain of pooled or omnibus accounts between the investor and the issuer. At the time of the distribution therefore, neither the issuer nor their paying agent bank know anything about the attributes of the investor. The domestic law of the Issuer’s country will require the Issuer or their agent to withhold tax at the statutory rate for that country e.g. Switzerland 35%. So, the payment is

Tax authority Withheld tax

Gross income

Net income after tax

Figure 6.1 Principle of withholding tax

Net income after tax reclaim

WITHHOLDING TAX

87

made to the investor down a chain of financial intermediaries who will then usually be subject to tax on the income within their own country. Such double taxation is recognised as being not in the best interests of the free market nor the easy movement of investment capital. As a result, pairs of countries have entered into “Double Tax Agreements” (DTAs) sometimes also known as Double Tax Treaties. These DTAs provide for a treaty rate of tax on investment income from one treaty partner to another. Thus when the investor finally receives their dividend net of statutory rate tax, an entitlement is generated based on the treaty between the investor’s jurisdiction and the issuer’s jurisdiction. The differential between the statutory rate applied and the entitlement to a lower treaty rate of tax is called a tax reclaim. Since most investors, particularly institutional investors, employ custodians to maximise their investment performance, the value of a tax reclaim can significantly impact on the custodian’s performance in the eyes of the investor. The withholding tax scenario is still not as simple as it looks. There are two factors which impact custodians and investors alike – Statute and Process.

S TAT U T E & P R O C E S S Statutes or “time bars” provide investors and custodians alike with a fixed period of time in which to claim their entitlement back from a foreign tax authority. The statutes are in two broad forms. Those calculated as a time period ending at the end of a year in which a dividend was paid and those calculated as a time period from the actual pay date. There is a minor third, those calculated as a time period ending at the end of a tax year for the issuing country. The positive side of this is that there is usually a time, measured most often in years, during which the investor’s entitlement can be reclaimed from a foreign tax authority. So, while the process, as we will see, is predominantly manual, there is an extensive leeway given to undertake the process. While there may be an entitlement generated via the DTA, the process by which a custodian retrieves that value for his client, the investor, varies by market. Over 95% of the entitlements to withholding tax reclaims are currently generated from just 32 markets. So while emerging markets have some importance, the mature investment markets are the ones where most of the tax is recoverable. The processes for optimising the tax position of an investor fall into two broad categories – relief at source and remedial reclaim. There are some peripheral types such as “quick refund”; however, as these tend to be special variants of the former two categories, we will not address them here. The

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object of all the processes, as far as a foreign tax authority is concerned, is to receive acceptable evidence that the claimant (i) is who they say they are and (ii) is entitled to the benefit of a treaty rate of taxation. Essentially “Relief at Source” (RAS) establishes these proofs in advance of the payment being distributed to the custodian. Remedial reclaim establishes the proofs “after the fact”. While it may be a nice idea, neither the custodian nor the investor get any choice in this matter. The process applied by any given market is at the discretion of that country’s tax authority. The reason that this is one of the most difficult areas of custody operations is that anything and everything about withholding tax is variable and interlinked. A market which today uses remedial reclaim processes, may tomorrow change to using a relief at source model. It is important to understand the scale of this complexity. Figure 6.2 shows many, but not all of the factors which a custodian has to encompass in its operations to be able to deal with this issue effectively. As we can see, we have already mentioned statutes of limitation, beneficial owner status and residency. The figure also shows that there are several other factors to be accounted for which we will cover in more detail later. Processing by tax authorities is predominantly manual. The proofs that they require are hardcopy documents, usually originally signed by the claimant and also signed and stamped by the claimant’s own local domestic tax office. The forms on which these claims must be made are often, but not always, in English, are usually multi-part and, importantly, if you get the form wrong, the claim can be rejected. This manual processing leads us to one of the other key factors of particular interest for investors – recovery time. Clearly for those lucky enough to be investing in a market that permits Statutes of limitation BO structure

Market types

Residencies

Markets

Recovery time

Processes

BO status Forms Year of income Variations

Regulation Income type

Figure 6.2 Factors affecting entitlements to withholding tax Source: Author’s own

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relief at source, the recovery time is nil (presuming the documentation has been submitted according to the process rules). However, for many others the process is remedial reclaim. While the tax authorities provide statutes of limitation to investors at one end of the process, they also provide themselves with a similar mechanism at the other. Recovery time is, according to the most common benchmark, the time a tax authority takes, from receipt of the reclaim to making payment. Here is where the effect of manual processing is greatest because in many markets the recovery time can vary from weeks to years (e.g. Italy anything up to eight years).

MARKET SIZE All this would normally be treated as an inconsequential issue if it were not for the amounts involved. Table 6.1 shows a model to demonstrate the relative size of available entitlements based on the value of assets under management. Recent research indicates that the proportion of assets under management held cross border is increasing at a rate of 16% a year (Source Barclaygroup. com). In some fund circles, the advice is that as much as 50% of assets should be held cross border. It is clear therefore that the model above, as time goes by, will generate ever increasing amounts of recoverable tax. As the reader will quickly see, the annual entitlement i.e. that amount of tax that is recoverable based on income taxed at the statutory rate within a given year, is compounded by the statutes of limitations affecting most markets. What must also be accounted for is the “lost value of money” i.e. the investment effect that would have been available had the income been taxed correctly at the beginning or had been recovered in the most time-effective manner possible.

Table 6.1

Extant tax available for recovery Global Custody $88.4Tn

Assets under management Average proportion cross border Average long term yield Annual average entitlement (Withholding rate-Treaty rate) across 9 countries Extant Tax Inc. average Statute of Limitations across 9 countries Source: GlobeTax and globalcustody.net

globalcustody.net

(30%) 7% 15%

$28Tn (32%) $2Tn $300Bn

5.2 yrs

$1.5Tn

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Of the estimated $1.5Tn available to investors through either RAS or reclaim, less than 10% is ever actually recovered through reclaim. Custodians face an uphill battle not just on the processing front, but as variables change, the cost effort of doing the best job possible for one’s clients becomes less advantageous. In recent times, withholding tax processing has been one of the early areas to change from a bundled custody fee to a separated out added value service. This allows custodians to help investors “connect the dots” between the value of the service they provide and the complexity of that task aka cost.

RISK AND LIABILITY As with any process, there is risk and liability which custodians attempt to mitigate or eradicate. Withholding tax is a good example of how corporate actions generally will trend in the future. Process risk is usually mitigated by automation where the risk can be centralised on the data input (hence the increasing importance of market reference data) and the effectiveness of the automation. Withholding tax as a corporate actions event creates added levels of risk and liability for custodians not just because such a proportion of the process is manual, but because of the ever- changing nature of the variables and the way that they are interpreted. Risk and liability can be categorised as follows: Issuers: As the generators of income to investors, Issuers are coming under increasing pressure from activist investors, particularly the hedge fund community. That pressure requires both transparency and best practice. These are translated most usually via proxy voting policies which in turn are affected by the ratings agencies and custodian performance. From an investor’s perspective the issue is one of either awareness and/or facilitation. Investors expect Issuers to take on a far more proactive role in pursuing the best interests of shareholders. When one considers that the effect of withholding tax optimisation by a custodian has the capacity to add upwards of 150 basis points in performance to a fund’s cross border AUM, investors are requiring Issuers to at least make them aware of any significant issue that could affect their decision to invest or divest in a particular company. The typical example is two institutional shareholders from two different countries investing in the same company resident in a third country. The intent of the board in declaring and distributing a dividend is to reward its shareholders with the presumption that the only varying factor to the amount is the number of shares owned. The reality is that one of the shareholders in the example could receive the gross amount declared while the other may

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receive anything up to 35% less – for the same original investment. The days when Issuers could assert that the tax affairs of investors were, to coin a phrase, their problem, are gone. While still true in theory, in practice it will be a brave CFO who takes the risk of not doing, and being seen to be doing, everything possible to give shareholders the best deal and equal treatment. In this, we find ourselves in that classic interim phase between what is now seen as best practice and what will ultimately move in to regulation if the industry is not seen by investors to be doing the right thing. The risk, at present, inherent in this scenario is of divestment where investors are changing their investment tactics based on the degree to which they feel an Issuer is helping them maximise their investment. Digressing from our dividend based model briefly, this issue is current in the market with respect to Eurobonds. Historically tax exempt, some tax authorities are beginning to apply a statutory rate of tax despite inter-governmental agreement that they should be exempt. In other words, while governments can still assert that the instrument is exempt, the view of how this achieved is changing from “don’t tax in the first place” to “tax and let them claim their exemption”. The final result may be the same in theory, but as we saw with the lamentably low proportion of recovery in this market, the likelihood is that many Eurobond holders in receipt of coupon payments will find themselves taxed. Counterparties: We have said before that most investment is not processed on a one to one basis, but includes many counterparties in what can be a complex chain of intermediaries. This applies just as much to clearing and settlement as it does to corporate actions and withholding tax. Any given intermediary in the process can have one role defined by their position in the process as well as another role defined by what arrangements they have made directly with tax authorities as we’ll see a little later with the US Qualified Intermediary regulations. Clients/Investors: Clearly by far the most important group in the chain, there are some specifics that can affect risk and liability for custodians. They are: 1. Contractual duty; 2. Deemed expertise; 3. Service scope exceptions; 4. Benchmarks. As we have said, custodians have an unenviable task in processing this particular kind of corporate action. They must blend the highest degree of

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STP into a process that must perforce be manual to a large extent. As a result, the way in which different custodians choose to address the issue varies widely and therefore the degree of fit between a client’s needs and what is delivered can also vary widely. Custodians typically throw people at this issue more than technology, which creates its own set of risks. The primary risk is that any given client will miss out on an entitlement that would otherwise have increased their portfolio’s value. These are called Service Scope Exceptions. They could come about for a variety of reasons: Value of the reclaim is too small. Given the high manual elements of the process most custodians divide their costs by the number of reclaims they file and any reclaim that falls below this arbitrary level will not be processed because the cost of processing exceeds the value delivered. The consequent risk is created based on whether, having chosen not to process, the custodian makes the client whole;
The structure of the client account is too complex. Some custodians will only process reclaims if the ultimate beneficial owner (i.e. the entity with the actual entitlement) is a direct account holder of the custodian. Where omnibus accounts (multiple beneficial owners in one servicing account) are supported, there are custodians who will only process to certain degree of complexity;
The instrument delivering the income is not supported. Very common with depositary receipts (DRs) where the reclaim generally cannot be filed with a tax authority but only with the sponsor of the DR issue, plus DRs themselves represent a number of underlying ORD shares and the custodian must factor in the ratio to its calculations in order to process;
Expertise availability. With people the primary focus of knowledge and the fact that there are two main dividend “seasons” in the financial year it is common that custodians cannot, in that predominantly manual process, move enough of the created reclaims through the process in the time given. This results in backlogs which can run the risk of falling outside of time bars and losing the client’s entitlement.


The issues of risk and liability here are created not just by the factors themselves, but also by the degree to which the custodian has informed the client of the issue and its scale and scope. Most benchmarks in the industry are at a very high level and do not clarify any of the above risks. It is left to the client to figure it out for themselves. As for those original areas of risk, in the absence of detailed benchmarks it is fair to assume that clients engage custodians in the role of a deemed expert. While contracts sometimes clarify the degree to which withholding tax (and any other corporate actions process) is to be delivered, many do not. Even where they do, there is an increasing trend on the part of investors

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to question how those constraints are applied and to what extent they are “fair”. For example, if one investor finds that they are missing ten million dollars (not an uncommon amount) in recoverable tax and another client ten thousand from the same custodian who cites to both that they do not perform tax reclaims, the degree of risk is higher that one (guess which!) will try to establish that the degree of impact on their portfolio should be matched with the degree to which the communication and contractual text reflects the value – the principle of proportionality. In other words, a sub clause caveat may not be enough to mitigate the risk and the consequent liability. Here again we are in change territory currently being delivered by the market rather than by contract and “misses” by custodians are being “rectified” behind closed doors to preserve the intellectual capital of the custodians concerned. There’s no breach of law here, yet, just clients who are pressuring for a clear and fair playing field which, given its complexity for custodians, is very difficult to deliver. The net result is that the industry saw the publication for the first time in 2004, of a set of 22 benchmarks for withholding tax as a corporate action. While many have yet to deploy these benchmarks as a core process, market pressure to do so is increasing and the likelihood of an open legal action on a class action basis from disgruntled investors will do nothing for confidence in custody but will at least herald the use of consistent measurements. Figure 6.3, for instance, demonstrates one of these benchmarks, Processing Efficiency Pe. The number of inbound income events to a custodian during the two “seasons” is not matched by the capacity of the staff doing the processing. The gap horizontally between the two lines represents the time lag between the income event on the system and the event going into the reclaim process. This period can be very long because custodians typically resource for these peak periods with temporary staff who are less well trained and

Reclaims per day

Capacity Ic

Ir

Time

Figure 6.3 Effect of processing approach on performance

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who … make mistakes. Therefore controls need to be increased to avoid the risk of missing a critical event. That portion of the graph above the capacity line generates potential backlogs if the subsequent staffing levels are reduced between seasons. Remember that time to recovery was calculated from the end point of these graphs. So clients must typically be aware that real “time to recovery” is compounded of the market time to recovery PLUS the time taken by the custodian to get the event into a condition to file. Backlogs can be a serious issue. At best, they delay the process, which creates a risk and liability because the client had an expectation of efficient service. At worst, they make the process fall over because the custodian takes so long to get the event into a fileable condition that the statute of limitations runs out. It must be said that clients also create the same problem by being insufficiently aware of the importance of moving documentation effectively. We have seen backlogs at their worst with custodians reporting Table 6.2

Statutes and recovery times in the main markets

Country of issue

Deadline for filing claims

Australia Austria Belgium Canada Denmark Finland France Germany Ireland Italy

No Deadline 5 years from end of year div. Paid 3 years from end of year div. Paid 2 years from end of year div. was Paid 20 years from Pay Date 5 years from Pay Date 2 years from end of year div. was Paid 4 years from end of year div. was Paid 10 years from Pay Date 4 years from Pay Date for div. With record date after 7/1/99 prior div. 1 year from end of year div. was paid 2 years from Pay Date 5 years from Pay Date 3 years from end of year div. was Paid 8 Years from end of year div. was Paid 3yearsfrom Pay Date 2 years from Pay Date 5 years from Pay Date 3 years from end of year div. was Paid 6 years from end of tax year (ending April 5) that the div. was paid

Luxembourg Mexico Netherlands New Zealand Norway Spain Sweden Switzerland United Kingdom

Indicative times to recovery 9 Months 6 Months 2 Years 14 Months 3 Months 3 Months 1.25 Years 10 Months 6 Months 5 Years

6 Months 6 Months 2 Months 6 Months 2 Years 1.25 Years 3 Months 14 Months 6 Months

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over ten million dollars of recoverables over five years past the time at which funds should have been recovered. Finally to regulation as a source of custody risk in corporate actions: as stated in their book “The New Global Regulatory Landscape” (McGill & Sheppey Palgrave 2005), most corporate actions functions are covered by at least one and usually several regulatory structures. Its also true that the classical “silo” approach to processing by most custodians creates an avoidable risk that the overlap between the various regulations as they apply to, say withholding tax, will eventually result in a direct infringement. Types of regulation (used here in its broadest interpretation of “any set of rules governing the behaviour of an enterprise”):


Sarbanes Oxley;




EU Data Protection;




EU Savings Directive;




MiFiD;




DTAs;




US S.1441 NRA;




US Patriot Act;




Corrupt Foreign Practices Act;




AML.

… and many others. In a similar vein to the regulatory pressure, the ways in which the market seeks to optimise can sometimes leave it open to unwelcome scrutiny. It’s unfortunately true that the regulator is always generally behind the market. But when it eventually catches up on an issue, this can create its own risks. In the most recent past the IRS in the United States has been very focused on “harmful tax practices”. Similarly the idea of dividend or coupon washing aka treaty shopping. So, for a custodian the key strategic issues include:


Structure and Cost


Internal vs. external.

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Resource


Space.




IT













Hardware & software;




Maintenance & licensing.

HR


Research;




Relationship management (tax authorities, clients etc).

Efficiency


Coping with seasonal variations;




Maximising process efficiency;




Mitigating backlogs;




Meeting benchmarks.

Business


Managing client relations;




Using processing as a market advantage;




Mitigating risk and liability;




Achieving compliance to multiple regulations.

PRINCIPLES FOR CUSTODIAL EFFICIENCY Withholding tax is one of those areas of corporate actions processing that can actually result in a direct financial benefit to a custodian’s clients. Its therefore somewhat bemusing that, even up to today, the function has been

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woefully under-resourced by most custodians and equally under-recognised for its effects on competitive advantage in the market. Where front office trading clearing and settlement systems receive millions of dollars in support of STP, corporate actions generally and withholding tax in particular have received almost no attention whatsoever. In its most recent survey, SWIFT reported that less than 5% of messaging across its network was for corporate action event support. In the same survey however, there was a marked increase in the expected expenditure on corporate actions automation in the next few years. In this next section we look at the three principles, taxation, communication and reporting, that create the platform by means of which custodians can focus on strengths and weaknesses effectively and improve performance, thereby mitigating risk and liability as we saw in the previous section. Also known as “the money”, the taxation principle lays out the key elements of how tax entitlements are processed. We have already seen the first level of this principle at work in Figure 6.1. Figure 6.4 shows a more detailed view of this in operation. The figure is structured to show all the potential players, although in the withholding element, some of these players have no direct role. Essentially investors, either directly or via some pooling vehicle such as a fund, have invested in a foreign corporation. When that foreign corporation declares (1) a dividend (or indeed issues a bond coupon payment distribution) that dividend is distributed by a paying agent via a registrar (2) who may or may not also be the withholding agent for tax purposes. In the absence of any

1 Corporation

Registrar bank

2

Foreign withholding agent

3

Foreign tax authority

Country custodian 4

Investors

Fund manager

Figure 6.4 The withholding tax principle Source: Author’s own

Custodian

Local tax authority

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instructions or evidence to the contrary, the withholding agent will deduct tax at the statutory rate and remit the net (4) to the range of its clients, usually intermediary custodians for whom it maintains an omnibus account. The tax is remitted to the tax authority (3). This is the model that generates the entitlement. Because the custodian maintains an omnibus account with the withholding agent, where all assets of its customers are pooled, the withholding agent has no knowledge of the status or residency of the underlying beneficial owners, the investors and/or the funds who by reason of those factors may have been entitled to a lower “treaty” rate of taxation. The key to withholding tax is to recognise the separation of entitlement from process. In other words, the treaty between the investor’s country and that of the Issuer of the income, determines how an entitlement to a treaty rate of tax may arise. This is entirely different from the process by means of which the investor can realise that entitlement. Clearly, having established the principle of an entitlement, the most obvious way to have that entitlement delivered is to be taxed at the correct rate at the time the original payment is distributed. This is called Relief at Source or “RAS”. Figure 6.5 shows how this works. Essentially all forms of process for obtaining an entitlement revolve around documentation. Primarily, the investor or entitled entity must demonstrate their residency and legal status. The ways in which this is accepted varies for each market. In the RAS model, such documentation is provided to one of the intermediaries in the chain or the tax authority so that the withholding agent deducts

2 Corporation

Registrar bank

3

Foreign withholding agent

4

Foreign tax authority

Country custodian 4a

Investors

Fund manager

Figure 6.5 Relief at source Source: Author’s own

1b

Custodian

Local tax authority

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correctly. For custodians this usually means segregation of client assets into “treaty” and “non-treaty” omnibus accounts at the custodian. So, if a custodian has 10,000 customers holding a million shares of which 250,000 shares are held by clients with treaty entitlements, the two omnibus accounts at the withholding agent would contain 250,000 shares and 750,000 shares respectively so that the withholding agent can deduct tax on the dividends for each share in the right proportions. In more sophisticated RAS jurisdictions such as the US, segregated accounts can take on a much more complex structure being differentiated by the role played by the custodian (QI designated accounts) as well as the specific rate that applies to the account’s assets. In Figure 6.6 we see the primary alternative to RAS, remedial reclaims. RAS is only offered as a process in some markets and for some types of income, so custodians must spend effort in keeping abreast of which market offers which process – and they do change. The area of remedial reclaims is the one that tasks custodians the most. Once a dividend is declared (1), the registrar and withholding agent act (2) to remit the statutory tax to the tax authority (3) and the net to the custodian (4). So far, this process can be automated, although not all have. The custodian now has an iterative process to go through to document the residency and status of its clients (5) in order to determine entitlements. Before it is able to file a reclaim, it must obtain local verification of its client’s residency in many cases (6). Even when filings are actually made to the market, the route can vary (7) as some markets do not permit reclaims direct to tax authorities but require filings via an in-country agent bank.

1 Corporation

Registrar bank

Foreign withholding agent

2

Foreign tax authority

3

Country custodian

4 7

8

Investors

Fund manager

5

7a

Figure 6.6 Remedial Reclaim Model Source: Author’s own

Custodian

6

Local tax authority

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Even this model is a simplification as some financial instruments only partially follow this model. Depositary Receipts are a good example. As DRs represent a number of underlying ORD shares, many authorities don’t recognise the DR as a security, therefore the reclaim must be filed first to the sponsor of the DR. For American Depositary Receipts (ADRs) this will be one of four firms: BNY Mellon, Deutsche Bank, Citibank and JPMorganChase. Claimants (or their custodians) must therefore factor in not just the differential route of the reclaim in the market but also the ratio of the DR to the number of underlying shares on which the actual reclaim will be filed. Most investors have no clue just how difficult and expensive withholding tax processing is. Most custodians themselves because of a lack of attention to the issue have done little to automate the process where possible nor find a way to convert the process into a profit centre from what, for many, is currently a cost centre. So, now we know the tax principle. How it is calculated, where it goes and generally what models exist to optimise it. For custodians with an entirely manual process, it’s not uncommon to find the cost of processing reclaims at about the £100 mark and a processing efficiency of between 12 and 25 reclaims a day. For most custodians of any note this is simply not a sustainable business model and backlogs quickly develop creating a hidden risk and liability that, one day, clients will want their money back. The same issue viewed from a communications perspective also tasks custodians.

3 Pay MT202 1 Corporation

Registrar bank

2

Foreign withholding agent

Foreign tax authority

4a

Country custodian

4 Pre-notify

4b Pay MT566 6 Investors

TV or CTV

5 Fund manager

Statement

Custodian

Figure 6.7 Communication in tax processing Source: Author’s own

4c

Local tax authority

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One of the key ways in which custodians generate efficiencies and mitigate risk is by automating processes in an effort to get to the “utopia” of straight through processing (STP) where no hands touch the transaction. In the front office of clearing and settlements STP is much further advanced than in the back office of corporate actions. And of the corporate actions back office, the furthest retarded function for communications automation is withholding tax. The most ubiquitous technology available to assist is delivered by the Society for Worldwide Interbank Financial Telecommunications (SWIFT). SWIFT is at the same time the ISO appointed guardian of standards in financial messaging and also the operator of a global interbank computer network for the secure delivery of messages. However, even SWIFT has a long way to go before this particular part of corporate actions can be automated. The strategy upon which SWIFT is embarked, and thus the rest of the industry will follow, is one which will see the opportunity to automate develop. First, the players: until recently the only firms able to be members of SWIFT were the banks. However, SWIFT has already begun creating platforms and structures to allow corporates and funds to pass messages across its networks. It is therefore entirely feasible and predictable that, at some point, tax authorities will also join. From a messaging point of view, the current corporate actions messages have relatively few “codes” that facilitate the use of messages to support tax reclaims or relief at source. ISO 20022, the next generation of standard from the current ISO 15022 sees the development of “business processes” as the base method of development rather than the individual messages. What is required in the market is the combination of the standards approach based on the process together with the actors in the industry engaging with the standard. Even so, this is not enough. Within the ISO 15022 standard, custodians still have too much leeway to create differences. The message structures, particularly those with “multiple blocks”, i.e. where one message can contain data for several transactions, are interpreted by custodians differently. The result is that where an outsider might think that a standard gives an opportunity to automate, these differences, where one custodian puts data at one point in the message and another puts the same data at a different point, reduce that opportunity. Similarly, the failure of the rest of the custody business to move forward technologically at the same pace can, in some cases, destroy the concept that they are working to. We have seen custodians in receipt of an MT message, print the message out, take it to someone for authorisation, then, once authorised, take it to yet another group … … who proceed to re-key the entire message so that it can be sent out. So, STP in, STP out and manual in the middle! Amazing.

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The suite of standard messaging that applies to corporate actions includes:


MT564 Notification;




MT565 Instruction;




MT566 Confirmation;




MT567 Status & Processing Advice;




MT574 Documentation (W-8BEN and Beneficial owner list);




MT900 Confirmation of message receipt;




MT950 End of Day Summary.

Figure 6.8 repeated here for ease of reference, exemplifies the types of complexity that faces custodians when servicing assets. In order to even establish an entitlement to additional tax for a client or clients, the custodian must be aware of and take into account a veritable cats cradle of issues ranging from market driven – regulatory, process types and market types through to client issues such as legal status, residency and documentation. Statutes of limitation BO structure

Market types

Residencies

Markets

Recovery time Processes BO status Forms Year of income Variations Regulation Income type

Figure 6.8 Tax related issues for custodians Source: Author’s own

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It’s worth spending a little time here on one or two of these issues, particularly documentation and regulation. Where the IT function held sway ten years ago and effectively decided what got done and when in terms of moving the business forward, today the compliance and legal functions must be consulted before anything moves outside the business. The tools of compliance are regulation, controlling the inputs – what can or can’t be done, and documentation, which are the control processes to minimise risk. In withholding tax the primary “regulation”, to use it in its loosest sense is the Double Tax Agreements between pairs of countries. These set the basis for an entitlement. However as has been pointed out elsewhere (The New Global Regulatory Landscape McGill & Sheppey. Publ. Palgrave), these are not the only regulations that apply. EU Data Protections rules apply in many cases; US Sarbanes-Oxley (“SOX”) can apply either if the custodian trades their own shares in ADR form or indirectly if their position in the financial services network brings them into contact with firms directly subject to SOX as a supplier. From a withholding tax perspective there are other issue specific regulations that many are subject to, e.g. US Section 1441 NRA which affects any firm in receipt of US sourced income. These are generally termed Extraterritorial regulations as they are examples of regulations enacted by one government intended to apply to people or firms that are not otherwise subject to their jurisdiction. Finally, there are domestic regulations that apply, although increasingly these are usually subsets of more global regulation e.g. Anti-Money laundering (AML). It is very easy for custodians to meet the requirements of one set of regulation while breaching another. So, for example, a Swiss custodian is restricted under Swiss law from releasing personal information about a client outside the country’s borders. However, many Swiss custodians do file tax reclaims which can only be filed in the name of the ultimate beneficial owner, evidencing name, address, tax ID etc. Similarly, the EU data protection directive’s eighth principle prohibits the movement of personal data of EU residents outside the EU to “unsafe” jurisdictions such as India. Yet, as we all know from the newspapers, personal data is being bought and sold on the streets of Mumbai due to outsourcing of banking activities to India. Documentation is a major issue for most custodians, not least because we do not yet live in a world where electronic documentation and its security, have been effectively created. So, paper rules, and where paper rules, come cost, complexity, storage, retrieval and a whole host of other issues. Returning to the specific issue of withholding tax, efficiency is inextricably related to cost and complexity. For custodians, the complexity of the

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cats cradle in Figure 6.8 results in: Thresholds – limits on the value of a client’s entitlement below which the cost of recovering the entitlement is greater than the entitlement itself; Service Scale & Scope – other factors which reduce the number of occasions where a client has an entitlement but the custodian either chooses not to or cannot recover the client’s entitlement; Risk & liability – if the client does not know that a decision has been taken at some point not to recover an entitlement, the risk is that the custodian will be liable to make up the difference. Even where custodians do advise clients, it is often in a way that is not proportionate to the size of the entitlement. There are already firms from the class actions space researching the withholding tax space for the opportunity to help investor’s recover their entitlements from custodians who, as deemed experts, should have either made an effort to recover funds or failing that, have, in a proportionate manner, clearly advised the investor of their decision. In withholding tax, the scenario takes a turn, even at the end of the process cycle. Analogous to settlement cycles on the buy-side, once tax reclaims are filed it can take months, often years, before the money is finally received (refer to Table 6.2) – yet another comment on the fact that while the custody space is bristling with automation, typically tax authorities are not. This leads inevitably to the need for benchmarks. Withholding tax here is like many other areas of custody in that practitioners have taken a specifically process oriented approach yet have not implemented effective controls and benchmarks. Hence backlogs go unidentified, funds that should be recovered in a specific time frame go unrecovered for many years. Equally, the engine room, the function that through their efforts generates the recovered tax back into client accounts goes almost completely unrecognised in the sales and marketing department and opportunities for product development are lost. One such example is “Contractual Tax”. The principle is that the custodian will front up the value of a tax reclaim on pay date. So the investor gets the full value of their return in optimum time. The custodian goes on to reclaim the funds in order to make itself whole from effectively “lending” its client the value of the reclaim. Despite the fact that lending is what banks do and that, with sensitive pricing based on good statistical process knowledge (see Figure 6.9), as long as the cost of the product is outweighed by the reinvestment potential the client now has from having his full entitlement, this is an extremely viable product. Yet very few custodians offer it.

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R E L I E F AT S O U R C E – T H E FUTURE MODEL G30, a group of 30 custodians has reported that the most effective model to meet Giovannini’s objectives of removing barriers to trade, is relief at source in withholding tax processing. Clearly, this is the best methodology to optimise an investor’s tax position. However, many believe, inaccurately, that relief at source is the easier process to follow. Relief at source involves typically documenting a client’s entitlement to a treaty rate of taxation prior to paydate and informing the upstream paying agent either individually or in aggregate, to pay at treaty rate. G30 also seems to favour the US model for relief at source which, as regulatory systems go, is the most complex in the world at over 800 pages of direct regulation and over 1200 pages of indirect rules. Promulgated in 2001 after 20 years of development, the US withholding tax rules establish the US as a primary relief at source market with an option, not explicitly specified in the regulations, for remedial reclaims. These regulations are again an interesting example of what happens in other areas of the custody settlement and clearing world. They are extra-territorial in nature i.e. they are enacted as a US regulation, yet they apply, not to US entities, but to all non-US entities in receipt of US sourced income. Their principle is that US income distributed to a non-US person should be taxed at 30% unless there is valid documentation in place at the time of the payment to prove an entitlement to a lower rate. The original reason for the regulations was however to have a way for the IRS to identify any US person engaged in treaty shopping (setting up an account in a treaty country, funnelling their investments through it as a “resident” of that country and thereby gaining access to a lower rate of tax on investments than that to which they would otherwise be entitled). Their efforts to do this have resulted in the most controversial regulations in custody for many years, closely followed by MiFiD, SEPA. To police this regulation, the IRS established the concept of a “Qualified Intermediary” or QI – a financial institution that signs a contract with the IRS under which on the one hand it commits to hold and mange documentation correctly and process properly so that on the other hand, apart from its US customers, it does not have to divulge the identities of its clients. Any institution NOT signing up is, by definition a Non-Qualified Intermediary or NQI. These firms must release their client’s information either to a QI, a withholding agent in the US or to the IRS. To be sure that these QIs did their job properly, the IRS assessed many foreign jurisdictions in terms of the strength of their domestic KnowYour-Customer (KYC) rules so that only firms in “approved” jurisdictions could sign up to protect the identity of their customers from the IRS and/or their competitors.

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Here again, we come across one set of regulations that requires disclosure of investor personal information potentially across country borders which could create a breach of another set of regulations (data protection) under which custodians must operate. Penalties also exist for non-compliance, a situation also common elsewhere in custody. Importantly, as far as the US is concerned, the carrot of these regulations is that if the custodian does the job effectively, they can protect the identity of their non-US customers. The stick is that QIs must submit to regular audits in up to three phases. Failure, e.g. under-withholding, at Phase II of such an audit can result in fines calculated from a sample of the custodian’s accounts extrapolated all the way across the custodian’s designated accounts (those for which he acts as a QI). These are in addition to other more standard penalties for failure to file reports etc. Details of the QI regulations can be found elsewhere (Relief at Source – An investor’s Guide to minimising internationally withheld tax. McGill. Publ. Euromoney and International Withholding Tax – A Practical Guide to Best Practice & Benchmarking. McGill. Publ. Euromoney). Essentially, on the practical level, withholding tax is deposited by QIs or withholding agents, to the US Treasury on a regular basis (calculated by reference to the annual estimated deposit amount). The IRS on the other hands receives reports once a year from QIs and NQIs about payments made to their non-US clients (1042 series) and US clients (1099 series), the former at a pooled level to protect client identity. So returning to the principle that this method (relief at source) and that this particular implementation of that method (US S. 1441 NRA) is the best system for investors, we must look to the results of the first set of audits which reported that in 2005 over 90% of the 1042 reports filed by custodians were rejected. By 2006 this figure had dropped to a mere 75%. While clearly an effective system, we must remember that the reason these complex regulations exist is not to serve the optimisation objectives of investors but to police and control those who seek to subvert the more general tax system. For reference, at the other end of the spectrum, some countries use the Address Rule i.e. if you can as a custodian evidence a customer with a local address in a treaty country, you can apply relief at source payments to that customer automatically. Clearly, the QI regulations are over-complex and were not originally designed to make the market more efficient. Equally, Address Rule systems are overly simplistic and leave large opportunities open for treaty shopping, money laundering and other nefarious and questionable activities. Custodians therefore face some very complex and difficult issues in this area, which is only one example of back office corporate actions processing. Issues of equal complexity surround other areas, particularly proxy voting.

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What is needed is a new business process approach that is able to leverage the elements of processes already automated, improving them where necessary, and creating new connections in the market and new standardised processes to create a business process lifecycle. The issue for custodians is to take this new process and implement it to one standard, no variations, in order to create the future opportunity of real STP in corporate actions. It is likely that withholding tax will be that process (i) because the political and governance pressures are now at a peak to support it and (ii) because the business case for it is compelling and (iii) because investors are now aware of it – and they want their money.

SOLUTIONS Whichever process model comes out on top – relief at source, reclaim, combination, as we have said, custodians need to respond to increasing pressures to provide a more all-encompassing service. If they do not respond to original investor pressure, it is certain that those investors at the other end of the chain will create the need for regulation. Figure 6.9 shows the process model adopted by most custodians with a tax processing function. What is clear in this model is the degree of manual processing and the degree of complexity and centralisation of effort within a custodian. For clarity, a tax reclaim can only be filed by a beneficial owner (the recipient of the income). Tax authorities will accept an agent of the beneficial owner

Foreign Withholding Agent

Issuer

Payment of Withholding Tax

Mail:Submit

MT564 Event Notification

Custodian

Credit Client

Research

Submit

Calculate

Follow

Document

Reconcile

Validate

Queries

Tel/Mail Follow-up

Mail for validation

Mail for authorisation if no POA Client

Local Tax Authority

Client Acct

Figure 6.9 Current Tax Processing Model

Tax Repaid

Foreign Tax Authority or Local agent bank

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signing the reclaim form, but only if a supporting Power of Attorney (POA) is included in the submission. Hence in Figure 6.9, if the custodian does not have a POA, an extra step is included to send a completed form to the beneficial owner for signature. Both this step, (very common) and the requirement in many cases to have the forms additionally certified by the beneficial owner’s local domestic tax authority, create the first of many manual processes. The need to perform this commercially valuable service for clients, like other areas of custody, is usually addressed with a combination of people and IT. Common strategies include: 1. Buy – purchasing third party software to automate part of the process internally; 2. Build – add to legacy systems new functionality to automate the process; 3. Bureau – use third party specialists to buy-in elements of the process that you find difficult or too costly; 4. Outsource – engage a specialist to partner with who can provide the processing engine you need. This is the classic conundrum of custody and clearing services. What is so core to your activities and so unique to your firm as a custodian that its intellectual property must remain in your hands. What is merely processing that everyone must follow the same model (i.e. no unique models). Each of the options open to automate the process has advantages and disadvantages. Purchasing a third party application is costly in licensing, maintenance and integration. Most third parties are small hence inherently risky, yet they are able to bring together best practice from many players. Building a system falls foul of most of the bad side of IT projects – difficult to prioritise in the IT queue, project over-runs on budget and implementation, but they do give you an opportunity to build in to a system any unique features of your core product. Bureau is an increasingly popular method, using specialist providers for certain elements of the process is not uncommon in custody where agent bank networks are the norm for collecting market information. They suffer few downsides as long as the integration to existing systems is managed effectively and there is high confidence in the supplier’s “product”. Outsourcing is also increasingly popular, although the industry has suffered damage to its reputation from the two most common sectors IT outsourcing and data processing outsourcing. IT outsourcing is rife with difficulties, especially in the banking field, but this should not put custodians off the increasing trend to outsource small specialist areas such

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as withholding tax where solutions are giving an early “virtual” view of what a truly STP process will look like. Figure 6.10 shows an alternative model available in the market which fits into both the bureau and outsource methodologies. The elements of the process are individually available to custodians, hence the bureau model, but for those that select the entire series of processes, this effectively gives an outsource model. The important thing to recognise about this model is that, from the custodian’s perspective, the process has effectively become STP. So, given a partner that has sufficient credibility, experience and volume in the market, data received by the custodian in ISO 15022 form about a dividend distribution (MT566), for example, can be copied automatically to the service bureau where any manual processing is included within the broader context. Reports and receivables postings can equally be automated from the service bureau (MT598 & FileAct) into the custodian’s systems for integration to departmental screens and even offer the opportunity to embed such reports into secure client pages on the internet, a growing trend. Finally, any payments of recovered tax can also be credited to the client’s account at the custodian using ISO 15022 messaging (MT202). Such service bureaux also leverage their volumes into best practice by having much more detailed and effective controls and benchmarks than may be the case for any individual custodian.

Issuer

Foreign Withholding Agent

Foreign Tax Authority or Local agent bank

Payment of Withholding Tax

MT564 Event Notification

Service Bureau Research

MT566 (FileAct) Income File

Calculate SWIFT User Primary BIC

MT566 (FileAct) Receivables Posting FileAct Status Reports

Additional Destination BIC

Document Validate

Credit Instruction

Submit

Credit Client

Client Help-line

Follow Report Bank

Client Acct

Figure 6.10 Service Bureau Model for tax processing Source: GlobeTax

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TRENDS Its been widely reported that withholding tax will be a dead issue in less than a decade. Frankly most of the people we speak to have been hearing the same comment since the late eighties. Its true that there has been a convergence of statutory tax rates and a coincident convergence of treaty rates so that the differential entitlements on a global scale have been reducing. There have also been regulatory changes (usually referred to as harmonisation of tax) and there are legal issues, particularly in Europe, that have had the effect of levelling the playing field. However as at January 1st 2007 there were over thirty changes to tax issues for custodians. Below, to exemplify the degree to which tax is NOT becoming any easier, is a summary of the changes that came into effect on 1/1/07. Belgium. The new withholding tax rate is 0% for dividends paid to a parent company resident in a country with which Belgium has signed a tax treaty, as long as the parent company has held at least 15% of the shares of the subsidiary for an uninterrupted period of 12 months preceding the payment. Previously, the dividends were only exempt if paid to an EU parent company which had owned at least 20% of the shares in a Belgian subsidiary for an uninterrupted period of 12 months. The EU Directive on parentsubsidiary companies required Belgium to reduce the threshold to 15% on January 1st 2007, and to 10% on January 1st 2009. Estonia. The statutory withholding tax rate on dividends was reduced from 23% to 22%. Luxembourg. The statutory withholding tax rate on dividends was reduced from 20% to 15%. Netherlands. The statutory withholding tax rate on dividend was reduced from 25% to 15%. Norway. The Norwegian Government adopted the European Economic Area (EEA) agreement on withholding tax on dividends in November 2006. This agreement states that a country must apply the same statutory withholding tax rate to all EEA residents as it applies to its own residents. Therefore, the statutory dividend withholding rate in Norway of 0%, is the same rate that will be applied to dividends received, after January 1st 2007, by shareholders resident in the EEA. The government also accepted that inbound dividends from EEA markets should be exempt from tax. The Norwegian government also agreed to refund withholding taxes paid in 2003 and later years by European Union (EU) residents, provided claims are filed with the tax office prior to the

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following deadlines: 2003 December 31st, 2006 2004 December 31st, 2007 2005 December 31st, 2008 2006 December 31st, 2009 For a refund of Norwegian withholding tax paid wrongfully during the years 1994–2002, EU residents may file for a civil claim against the Norwegian tax office. It is not known at this time whether a one year or three year deadline will apply to claims filled on taxes withheld from 1994 to 2003. Slovenia. The statutory withholding rate on dividends and interest was reduced from 25% to 15%. South Korea. The statutory withholding tax rate on interest was reduced from 27.5% to 15.4%. Spain. A new law that increases the statutory withholding tax rate on dividend income from the present 15% to 18% was approved by the Spanish Parliament (Law 35/2006) on 28 November 2006. This reform became effective beginning January 1st 2007. U.K. The UK Real Estate Investment Trust withholding tax regime started. A UK-REIT is a company which has a property rental business. It must be resident in the UK and be listed on a recognised Stock Exchange. Under the UKREIT regime, a qualifying company pays no tax on its qualifying property income but must withhold tax at the basic rate of 22% when making a distribution to shareholders derived from its qualifying property income – a “property income dividend” (PID). A UK-REIT is obliged to distribute most [define most] of its profits as PIDs. One of the conditions to qualify for UK-REIT status is that no single shareholder can own 10% or more of the shares. Although the PID is treated as income from UK property, the Non-Resident Landlord Scheme does not apply to the income. There are two types of distribution paid from REITs: One type of distribution, which will be paid from tax-exempt property income or gains, will be a PID (Property Income Dividend) which will have a 22% withholding tax deduction at source. Effective January 1st 2007 these dividends (PID) will be subject to treaty rate entitlements under double tax treaties (DTTs) between the UK and other countries. A second type of distribution will be dividends paid from other profits that will be treated as normal dividends, i.e. a 10% tax credit will apply to

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these dividends. Like any other normal dividend with a tax credit attached, there is no reclaim allowed to non-residents on this tax credit. From January 1st 2007, new legislation gives qualifying non-residents the opportunity to claim repayment of some or all of the tax that is deducted from PIDs that are paid by UK-REITs. Some non-resident investors are able to claim repayment of tax that is deducted from a PID. The amount of relief that is available is dependent upon: 1. The terms of any double taxation treaty that is in force between the UK and the country of residence of the investor. Please note that the DTTs between the UK and France, US, Japan and Ireland specify that Pensions are exempt from withholding taxes. (Irish charities are also exempt); 2. If the investor is an individual living in a Commonwealth country or in an EU country, plus nationals of Iceland, Liechtenstein and Norway may also qualify to claim Personal Allowances to set against a PID (ICTA1988/ S278). These personal allowances are part of the normal income tax regime and are not part of a tax reclaim regime. These data were kindly supplied by GlobeTax Data Services from their e-TaxData Online product. What’s clear from this is that tax is by no means harmonised nor even showing signs of harmonising. Processes are changing at an equal pace and this type of scenario is common across other areas of custody and clearing. This chapter has been very specific and its timely to remind readers that the reason was both to explain the specific issues since they are a fundamental part of the custody product but also to use some of the issues raised to highlight some of the problems faced by custodians.

CHAPTER 7

OTC Derivatives

Over The Counter (OTC) Derivatives markets have witnessed phenomenal growth in the recent years, not only in terms of volume of transactions, but also in the universe of products that are traded and in the breadth of counterparties active in the market. The consequence of the rapid growth is reflected in the strained state of post trade infrastructure. With automation taking the top priority for market participants, it has fuelled many opportunities for service providers in the OTC Derivatives back-office. There are various service providers, who are rapidly rolling out services to Investment Managers, Hedge Funds and Broker Dealers, for addressing the upstream and downstream processing challenges in the OTC trade life cycle. Likewise, custodians also provide a range of post-trade settlement and collateral management services for Investment Managers. Custodians are challenged in OTC Derivatives Trade processing and the functions they perform, which inhibit their ability to serve the growing demands of their clients. Derivative securities, more appropriately termed as derivative contracts, are assets that confer on their owners certain rights or obligations. These contracts owe their existence to the presence of markets for an underlying asset or a portfolio of assets, on which the agreements are written. Derivative securities are either traded in Exchanges or in OTC markets. The major differences between the two are provided in Table 7.1. In recent years, a few IRS and CDS varieties have become standardised contracts based on Indices or Benchmarks and are traded electronically much like exchange traded instruments. CDS Index based products are used to hedge credit risk or to take position on a basket of credit entities. CDX and iTraxx are the two main families of CDS Indices. Based on the features of these derivative contracts, they can be classified as vanilla products and structured products. Vanilla products are run-of-themill contracts with no additional or unusual features. Structured products 113

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Table 7.1

Differences between exchange traded and OTC derivatives

Exchange traded derivatives

OTC derivatives

Standardised in nature

Customised in nature. They are tailored financial products

Traded via derivatives exchanges

Traded between two parties – bilateral over the counter

The counterparties are anonymous to each other as the exchange facilitates the trading and the trades are cleared through the clearing houses acting as Central Counter Party (CCP)

Being purely bilateral contracts the counter parties know each other and the contracts are settled bilaterally without the intervention of any Central Counter Party (CCP)

These are predominantly retail products, used and traded by retail entities

These are predominantly wholesale products, used and traded by large, sophisticated entities with large financial risks to manage

Futures, Options, Vanilla Swaps are examples of this type

Credit Default Swaps (CDS), Interest Rate Swaps (IRS), Forward Agreements are a few examples of this type

are customised products with additional features reflecting the financial risks of the individual entities of the deal. Special features of OTC derivatives are as follows:
They involve periodic cash payments made by one counterparty to the other or by both to each other based on the terms and conditions of the contract. A CDS contract would involve cash payment from one party to the counterparty on the occurrence of some event (like credit event in case of credit default swap), or payment on exchange of the deliverables by the counterparty on the day of maturity of the contract. In the case of IRS it could involve quarterly payments based on rate resets. In short, OTC derivatives may require payments throughout the life of the transactions or on maturity or both;
Both the parties to an OTC Derivative contract would agree to the terms of agreement based on the clauses mandated by the International Swaps and Derivatives Association (ISDA) Master Agreement. These master agreements provide for the legal framework of the contract. It also provides for specific terms of bilateral netting, close-out netting, definitions used by the market for ‘credit event’, and collateral arrangements.

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There has been very sharp growth in the OTC Derivatives market over the past 12 months. According to the Bank of International Settlements (BIS), the total outstanding notional amount was over US$298 trillion in 2005 and, according to an ISDA market survey in 2006, the notional amount outstanding of credit derivatives had grown by 52% in the first six months to $26.0 trillion from $17.1 trillion, that of interest rate derivatives by 18% to $250.8 trillion from $213.2 trillion and that of equity derivatives by 15% to $6.4 trillion from $5.5 trillion. Growing volumes of business have raised concerns about the processing of these contracts. The automation of trade execution and post-execution of OTC Derivatives has not been able to keep up with the pace with which the market is growing. This explosive growth has created a backlog of unconfirmed trades. Such backlogs have raised the regulatory concern about the situation. The Federal Reserve of the US called a meeting of major players to discuss the risk management measures for the growing CDS trades where they highlighted the need for urgent effort by market participants to clear the backlog of unconfirmed trades and update back office plumbing to deal with the complex new instruments. A subsequent ISDA Operational Benchmarking Survey has indicated an improvement in backlog of confirmations. Automation facilities like DTCC Deriv/Serv and SwapsWire have been able to improve the confirmation ratio to an extent by providing automated matching and confirmation services.

T H E P L AY E R S OTC Derivative markets have different types of players. They include:


Industry Participants;




Liquidity Pools;




Service Providers.

Figure 7.1 gives an overview of the key entities in the OTC Derivatives space and their respective roles.

I N D U S T R Y PA R T I C I PA N T S OTC Derivatives, being bilateral contracts, are customised in nature and may be unique, reflecting the specific financial risk-management needs of individual entities at a given moment. The players involved in these kinds of

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Participant

Liquidity Pools

Investment Manager Client / Hedge Fund

Creditex Trade Web MarketAxess

Participant: OTC Derivative Dealer Prime Broker

Messaging and Affirmation Infrastructure T-zero DTCC - Deriv/Serv Swaps Wire Market Trade Processing CreditXpress

Custodian

Confirmation & Life Cycle Management DTCC Deriv/Serv

Market Data Vendors Reuters etc.

Figure 7.1 The place of OTC Derivatives in custody and clearing Source: Stefan Sosnowski

deals are the asset/investment manager (one of the counterparties to the deal), the dealer (the other counterparty) and the global custodian – the custodian of the investment manager. The Investment Manager is typically a buy-side firm which is buying the contract to protect itself from credit risk of a reference entity. End users include Banks, Insurance Companies, Special Purpose Vehicles, Corporates, Re-insurers, Securitisation Companies, Third party asset managers and Hedge Funds. More recently, the growth in the usage of credit derivatives by hedge funds has had a marked impact on the overall credit derivatives market itself, where their share has increased to 58% over the year, according to research firm Greenwich Associates. Hedge funds have been regular users of CDS especially around the convertible arbitrage strategy. They have also been involved in many of the ‘fallen angel’ credits where they have been significant buyers of protection. Given their ability for leverage they have substantially increased their volume of CDS contracts traded, which in many cases has been disproportionate with their absolute size. OTC Derivative dealers are typically sell-side firms. In the case of CDSs such firms are ready to buy the credit risk of the reference entity. However, many deals could take place between dealers themselves trading on credit risk itself. The custodians are the ones who protect the interests of their clients who are predominantly the buy-side firms like investment manager, asset

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manager, hedge funds and so on. Custodians provide various services to their clients in terms of collecting the trade details, valuing the contract, participating in the reconciliation and settling the trade. Prime Brokers provide similar services to hedge funds.

LIQUIDITY POOLING There are however some initiatives taken up by the industry as a whole in providing dealer-to-client electronic trading platforms such as TradeWeb, MarketAxess and dealer-to-dealer – inter-dealer trading platforms such as CreditMatch, Creditex and so on.
The Creditex platform provides complete price, trade transparency and operational efficiencies, allowing traders to easily place live, actionable orders. Clients are also able to receive intraday and end-of-day electronic feeds of live index prices and trade confirmations, thus eliminating some of the risks associated with the trade reconciliation process;
TradeWeb’s dealer-to-customer online marketplace provides a view of the largest fixed-income markets in real time to the Leading Online Bond Trading at the marketplace;
MarketAxess provides an electronic trading platform which is a multi-dealer disclosed counter-party model, which allows institutional investors to view multiple bids and offers from broker-dealer clients. Apart from that it provides: online trade execution with the majority of the world’s leading dealers, commingled inventory of U.S. domestic corporate bonds, Yankees and Globals; approximately 3,000 line items of inventory, $40 billion in indicative bids and offers.

Service providers Various types of service providers have emerged in the market. The types of services they render are Trade Confirmation and Matching, Payment Matching and Reconciliation, Documentation Management, Valuations and other services.
Markit is the pre-eminent source of data and valuations in the credit, equity, OTC derivative and structured finance markets. Markit owns the benchmark Reference Entity Database (RED) used in the credit derivatives market. The company also offers a bespoke Portfolio Valuations service spanning all OTC derivatives products that meets investor requirements for best practice in independent valuations;

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SwapsWire is an electronic platform for capturing and agreeing swaps. It has created a single secure network and hub, using Financial Products Markup Language (FpML) as the data standard;
T-Zero enables financial professionals to affirm, allocate, novate and terminate trades with their counterparts in real time. When a trade is booked on a dealer system, it is collected by T-Zero, assigned a unique identifier for the life of the trade, and passed to the counterparty for affirmation;
DTCC Deriv/Serv is an important service offering by the industry utility to provide a strategic platform for market participants to avail themselves of the automated matching and confirmation services provided for all Credit Default Swaps. Interest rate swaps including swaptions, and equity derivatives (stock futures and options) and the automated payment matching and settlement services provided by it for credit default swaps;
TriOptima, a Swedish financial technology company, develops and delivers triReduce, the first and only multi-lateral mass termination service for the OTC derivatives market. The service currently targets IRS and CDS. The triReduce technology produces proposals to terminate a package of thousands of swaps;
CreditXpress connects dealers to hedge fund and institutional asset management clients to automate post-trade processing. The service affirms corporate bond and credit derivative trades, and allocates them to specified client accounts. Affirmed trades may be sent automatically to the DTCC’s Deriv/Serv and Omgeo TradeMatch platforms. Users may also track positions in real-time and send notifications of trade novations to counterparties using CreditXpress;
Markit Trade Processing enables fund managers and banks to affirm and confirm their OTC derivatives trades. Users may send notifications of novated or disputed trades through a secure instant messaging platform. Clients also use the platform to reconcile portfolios. It can pass STP trades on to the DTCC and SwapsWire automatically.

Growing volumes, increased regulatory attention and need for efficiency have resulted in various efforts by service providers in streamlining the OTC Derivative trade handling processes. Various service providers such as T-Zero, DTCC, SWIFT, and Omgeo have all come out with service offerings to meet the processing needs of OTC Derivatives products.

Typical trade life cycle Figure 7.2 shows the message flow between the players participating in a trade lifecycle in the OTC derivative market. Some of these boxes processes

Dealer

Investment Manager

5. IM sends the trade and confirmation details to custodian

1.New Trade Trade Capture

6. Cash Flow Details 7. Swap valuation details

Affirmation

8. Daily reconciliation with IM and Dealer Confirmation 9. Details regarding collateral to be accepted from the dealer or posted to the dealer from the IM 12. Credit event Notification

Liquidity Pools

Payment Matching

Trade Capture 2.Cancel or Amend

2.Cancel or Amend 3. Affirm

4.Confirm

1.New Trade

3.Affirm

Various Service Providers

10.Payment Match

4. Confirm

Affirmation

Confirmation

10.Payment Match

Payment Matching

13. Contingent payment details on the occurrence of a credit event.

Custodian

Figure 7.2

Settlement

OTC Derivative trade process flow

Source: Stefan Sosnowski

11. Periodic fixed Payment SWIFT

Settlement

OTC DERIVATIVES

11. Periodic fixed Payment

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where there is scope for further automation in the flow of information between the custodian, the investment manager and the dealer.

FUNCTIONS OF CUSTODY IN OTC Custodians provide various services to ensure the smooth settlement of OTC contracts in time. These functions are crucial for the success of the market considering the voluminous growth of these contracts in recent years. Custodians are however currently facing operational challenges to ensuring that they have right kind of information such as contract data in time to prepare for the settlement. Custodians perform some or all of the elements of:


Contract Maintenance;




Event Processing;




Valuation;




Payment and Settlement;




Collateral Management;




Reconciliation;




Account Maintenance;




Reporting.

Contract Maintenance involves maintaining the details of the contract throughout the various stages of the contract. The primary elements include:


Maintaining the trade details and confirmations sent by the client with respect to:


New Deals;




Deal Modification (Amendment, Notional increase etc.);




Assignment;




Exercise/Termination( partial or full) Investment Manager;

OTC DERIVATIVES







121

Sourcing the transaction details from the client/counterparty using:


Manual Receipt or Data Feed (in FpML Format);




Confirmations may continue to be in paper form and hence may require to be manually updated;




The trade data and confirmation may also be sourced from industry utilities such as DTCC, SwapsWire wherever transactions are matched by service providers;

Contract shredding: Cancellation of off setting contacts using TriOptima services.

Event Processing involves custodians managing the various events occurring throughout the life cycle of the contract. These events include:


Periodic rate resets for IRS, TRS, and so on;




Receiving credit event notices;




Triggering collection of contingent payment from the counterparty;




Triggering appropriate action contained in contract on default of a counter party (for instruments like IRS, TRS etc);




Processing corporate action events;




Processing requests like portfolio rebalancing, and tear-ups;




Processing of early termination and assignment events.

Valuation and Payment Calculations involve Custodians being responsible for the valuation of positions and collateral and calculation of the payment obligations throughout the life cycle of the contract. The various functions include:


Calculating payments due on periodic intervals and quarterly rolls;




Bilateral netting of payments to be effected;




Payment matching with DTCC Deriv/Serv;

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Valuing positions and collateral offered against each position for exposure monitoring.




Marking to market individual positions and collateral securities regularly, with previously agreed:


Valuation model and parameters;

Market data feeds (market prices for underlying assets and valuation for standardized Derivatives);







Sending these inputs to collateral manager group.

Custodians are also responsible for processing of payment and settlement instructions received from their client. The primary functions include:





Effecting payment instructions with regard to:


Periodic cash flows and exchange of principal;




Collecting the contingent payment on the occurrence of a credit event;




Close-out netting in case of default by a counter party, premature termination of contract and so on;




Accepting the delivery of collateral amount or posting collateral amount on behalf of the client;

Interacting with organisation(s).

operations/back

office

personnel

in

client

Custodians also play a very important role in the OTC Derivative market by providing collateral management service throughout the life cycle of the contract. To provide this service, custodians have to perform the following functions:


Evaluate the terms of ISDA Credit Support Annex;




Check availability of Initial/appropriate commencement/during life of contract;




Exposure monitoring movement of value of collateral against position(s) held;

collateral

cover

at

OTC DERIVATIVES

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Act upon instances of under collateralisation or over collateralisation as per contract/master agreement between counter parties;




Process substitution of collateral securities by different (eligible) securities;




Place Margin call in instances of under collateralisation;




Release collateral in case of over collateralisation;




Monitor receipt/delivery of collateral;




Trigger default in case of breach of collateral conditions;




Coordinate with credit/risk management teams in client organisations.

Custodians also have to reconcile the cash/collateral movements throughout the lifecycle of the contract. The primary functions of reconciliations include:


Monitoring and reconciling;




Periodic cash flow booking;




Collateral receipt/substitution;




Collateral release.

The account maintenance function involves the maintenance of the client account starting from the negotiation through collateral management till the settlement of the trade including.





Maintaining the details of the ISDA master agreement and specific master agreements, if any, including, for example:


Details of steps to be taken on occurrence of specific events like partial termination and assignment;




Details of Credit Support Annex;




Outlining deviation from accepted practices; if any.

Executing bilateral/tri partite agreements with client regarding operation of accounts;

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Communicating with client regarding rights and responsibilities of client and custodian under different circumstances;




Maintaining cash and collateral accounts including:


Assigning collateral to different trade types/individual sub accounts;




Updating collateral positions based on;




Exposure calculations with each valuation:


Trades on position;




Create collateral with new counter party on assignment of positions;




Release collateral on expiry/stepping out of position.




Accepting the replacement of one set of collateral securities with another;




Booking periodic and contingent payments;




Effecting instructions received in the course of event processing;




Client reporting.

Custodians can also provide other miscellaneous services, not discussed in detail here such as:


Policy and process documentation;




Regulatory reporting.

As we have seen, the OTC derivatives market is growing by leaps and bounds. New and non-standard products are traded regularly. The market participants are facing operational challenges in the area of trade capture, timely confirmation, valuation and collateral management. Lack of standard language, lack of standardised processes and practices are adding to the inefficiencies in the processing. Even in 2007, many participants have yet to put in place suitable technology infrastructure to meet these challenges. The need for improved automation in the OTC markets in particular, has been emphasised by the results of a recent JP Morgan poll of 20 asset managers and institutional investors who cited data management and systems infrastructure issues as the biggest challenges they faced. Three quarters of

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respondents said that their current infrastructure provided limited and insufficient support for the pricing and processing of derivatives. Participants in the market face the challenge of exchanging documentation for confirming the trade as required under the standard ISDA agreement (see Appendix II). The documentation process needs to consider the product specific terms and conditions resulting in manual / semi automated processes. However, several firms have embarked on initiatives to automate the documentation process using standard documentation management tools such as Thunderhead. Custodians’ current processes have several gaps in terms of straight through processing of OTC Derivative trades. For example, communications to the custodians from investment managers have not yet been standardised – there is no SWIFT message that can be used for communicating to custodians for swaps. The challenges faced by the industry and custodians in particular can be classified on broad terms as relating to processes, standards and data. The challenges faced in these areas and the remedial measures and extent of readiness vary. While many industry initiatives will help in meeting the challenges on the data front, the processes are being addressed. However, a lot of work needs to be done in the area of standardisation. Table 7.2 Major areas of concern

Challenges in OTC Derivatives

Challenges

Remedial measures

Level of readiness in handling

Processes

Need for automation in the process of exchange of information between the client and the custodian

Developing interface with clients and third-party valuation service providers for accepting messages electronically

Though initiatives are taken up by the custodian, it’s yet to catch up with the growing volumes

Standards

Need for industry accepted standards for the data elements of the contracts for the ever-evolving structured products market

The industry has to take further steps in developing standards for data elements of the contract and messages for exchange for the evolving structured products market. Agreement on Best Practices would set the benchmark.

Low.

Continued

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Table 7.2 Major areas of concern Data

Challenges Difference in valuation models and data provided by multiple vendors

Continued

Remedial measures

Level of readiness in handling

Having a tripartite agreement on the valuation data and model to use and adapt industry initiatives taken up for providing infrastructure for maintaining trade details for the entire life cycle

Initiatives in providing infrastructure have been taken up by DTCC

Industry initiatives There have been many initiatives taken up to expedite the trade capture and post-trade settlement processes by eliminating the existing bottlenecks. These initiatives provide opportunities to various market players including custodians to improve their OTC Derivative trade processing capabilities. The following are the few important and latest initiatives taken up: DTCC Trade Warehouse: a trade database or “warehouse” where trade data is kept until maturity. The warehouse will take matched trade records and expand those into the cash-flow schedule in DTCC’s records. Where needed, the system will apply rate resets and calendars to generate those cash flows, which will automatically feed the payment system. This fully automated straight-through processing system will handle trades from execution through to settlement of the final maturity, lowering both cost and risk for participating firms;
T-Zero and DTCC Deriv/Serv Link: The T-Zero system electronically captures all trade details, assignments, allocations and other relevant details in the processing of credit derivatives, and allows counterparties to send affirmed trades to DTCC automatically for same-day (T
0) legal execution. Using T-Zero in conjunction with DTCC DERIV/Serv removes


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the entire drafting, checking and confirming functions for trades against counterparties who are also on the system;
Omgeo Connect Links with DTCC Deriv/Serv to automate processing of OTC Derivatives trades. In linking the two services, Omgeo Connect clients will be able to access Omgeo Central Trade ManagerSM (Omgeo CTM), Omgeo OASYS-TradeMatchSM and DTCC Deriv/Serv via a single hub. Omgeo Connect will extend its XML message specification to capture the data relevant to OTC derivatives, transform this data into industry standard FpML messages, and route these messages to DTCC Deriv/Serv via an MQ interface. Post matching, Omgeo Connect will receive status messages from DTCC Deriv/SERV, transform these messages, and pass them back to the investment manager via their Omgeo Connect interface;
SWIFT has also turned its attention to the post-trade OTC automation struggle, and entered into an agreement with the International Swaps and Derivatives Association (ISDA) to support FpML messaging services over SWIFTNet. The two organisations have agreed to create a SWIFT FpML Closed User Group.

New processes The various developments listed in the preceding section will change the way OTC Derivatives will get processed. This provides ample opportunities to market participants including custodians to revisit their current processes and system capabilities and to suitably change to the new scenario. Figure 7.3 depicts how the future OTC Trade process flow would appear. Given the crucial role of the custodians in the entire process and the growing volumes and importance of OTC Derivatives, it is imperative for the custodians to strengthen their infrastructure for handling the OTC Derivatives. Custodians have to adopt emerging standards and participate in connecting to the various industry facilities so that they can serve their clients ably and efficiently and minimise their operational risks. Increasing the automation of processes and adopting industry best practices would meet their strategic needs. Adopting the industry accepted FpML messaging standards and having a seamless interface with third-party information providers is going to help to improve the service levels and provide them an edge over competition. Building interfaces with client’s back office processes will also bridge the gap in straight through processing.

Custodian 2

Client/ Investment Manager

3 4 5

Contract Maintenance

Event Processing

Payment & Settlement

Valuation & Payment

OTC Derivatives Dealer

4 5

3. Final term sheet sent to custodian by the client 4. Reconciliation of valuation and payment details with client and dealer 5. Accepting the delivery of collateral from the dealer or posting collateral on behalf of the client 6. Market data feed useful for valuation 7. Payment matching done by Deriv/Serv before the payment due dates 8. Payment settlement processed by custodian on due dates for clients

Reconciliation Collateral Management Account Maintenance 1

Reporting

7

1

7

Deriv/Serv

Omgeo 1.1

1.1

1.1

SWIFT 8 2

3 2

4 3

SWIFT FpML CUG

5 4

2

3

4

5 Manual process automated process Future automated process

5 6 3rd Party Data providers

6

Figure 7.3

The future of OTC trade processes

Source: Stefan Sosnowski

1. Trade details between the two counterparties matching & confirmation via Deriv/Serv 1.1 Alternative way to exchange trade details via SWIFT-Deriv/Serv connectivity 2. Initial term sheet sent to custodian by client after matching and affirmation.

6

Possible alternate for sourcing trade details by custodian

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Finally, to give all this a sense of sustainability and confidence, custodians will also need to have well documented policies in place for handling the payment and settlement processes, regulatory reporting, client and internal reporting to support such initiatives. Building a robust processing architecture will open new opportunities to custodians to address the outsourcing opportunity of the difficult part of operations associated with OTC Derivative products. Custodians who take a lead in these could emerge as the OTC Derivative administrators.

CHAPTER 8

Trustee & Fund Accounting Services As part of a complete client offering we’ve seen that most top tier global custodians will provide an array of products and services, many of which come under the general class of “asset servicing”. The aim is to hook as much of the client needs through one provider to capture the opportunity to cross sell other services and over time increase their share over the available revenue stream from that institution. The cross-border regulated collective fund industry in Europe forms a considerable part of the asset pools of many major investment management houses. Local regulation requires an appointee who is independent of the fund manager to oversee the manager’s operation and take into safekeeping the assets on behalf of investors. During times of significant change within the industry it is essential that any appointee has the distinct cross-organisation attributes to partner effectively with investment managers. Fund managers, when selecting their preferred strategic partner, will consider the following:


Legal, regulatory and compliance breadth, commentary and support;




Depth of experience and knowledge of the professionals within the team;




Understanding of the unique requirements of differing collective products;




Systems and technology that provide automated solutions.

Most Global Custodians who offer Trustee services have significant experience in supporting a wide range of fund structures including:


Unit trusts;




Investment companies with variable capital (VCCs);

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Pension fund pooled vehicles;




Common Contractual Funds (CCF).

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Key services usually offered include:


Monitoring of the investment manager;




Monitoring of the administrator;




Reporting to shareholders and board of directors;




Liaison with the regulator.

FUND ACCOUNTING The largest Global Custodians provide pooled investment accounting and valuation services. Most meet the domestic and multicurrency accounting needs of their clients in all major markets around the world, in any fund cycle, legal structure or domicile – allowing them to stay focused on their core business. The top tier global custodians have in-depth experience in investor level accounting. They need to provide experience and understand the complex industry regulations and issues in administering a wide range of fund types – from basic bond and equity funds to complex multimanager/multi-class/multi-currency funds and money market funds. Custodians will also provide accounting services for a full range of private assets, derivatives (see chapter 7), cash and foreign exchange instruments.

P O R T F O L I O VA L U AT I O N Major global custodians offering portfolio valuations will price more than 25,000 securities daily across more than 500 portfolios. More than 95% of all those security positions will be priced on a fully automated basis. A wide range of investment instruments are usually valued daily:


Equities, bonds and money market instruments;




Complex securities: MBS, emerging market debt instruments, emerging market equities, Brady Bonds, fund of funds and derivatives.

They will also ensure pricing accuracy by a series of daily data quality verifications using a zero-tolerance standard.

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N AV C A L C U L AT I O N S Most large global custodians will deliver more than 8,000 NAVs (Net Asset Value) per month. Today, it is not uncommon to find 91% of funds are priced on a daily basis. Custodians will differentiate from each other through accounting expertise and automated system capabilities for complex vehicles: Multiclass and multi-currency funds – Systems are capable of processing up to 33 classes per individual fund, including base and nonbase share classes. This expertise spans all fund and asset types. More and more are supporting share class foreign exchange hedging. Typical accounting tools will record both the hedging instruments and the related realised and unrealised gains and losses to the specific hedged share classes.
Money market funds – A specialised money market unit is the key in servicing both stable NAV and accumulating funds in US$, EUR and Sterling. The money market unit is normally comprised of custody and fund accounting teams who work closely with clients to meet all the deadlines.


Key features of such services include:


Returns to ratings agencies (S&P weekly and Moody’s monthly);




Weekly reporting;




Weekly system-generated mark-to-market reviews;




Distributions paid daily, on redemption or at month end, with automatic reinvestment facility available;




Detailed statements available monthly and on demand;




Client and shareholder access to transfer agency recordkeeping via the proprietary web based product.


Multimanager funds – This option enables fund promoters to combine the talents of various investment advisors into one fund. The integrated custody and accounting platform allows for the set-up of multiple funds per advisors, and the consolidation of all the data into a composite fund. This structure allows investment advisors to view and interact as if they were managing a separate fund, while the fund promoter can receive a NAV and obtain reporting for the fund on an aggregated basis.

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Internal and external pooling – this pooling method increases efficiencies and reduces trading costs by having the investment manager handle only one portfolio. An extension is for both an intra-fund and extrafund pooling servicing capability, allowing portfolios from the same or from distinct legal entities to be pooled.
Fund of funds and master-feeder funds – A fully integrated custody and accounting platform allows global custodians to service fund of funds, master-feeder funds and fund of hedge funds.

Reporting, will allow clients to access and download portfolio data direct to their desktop and view it with a variety of commercial software packages. Some Global custodians also provide:


Trade date full accrual multicurrency accounting;




Customisable, flexible general ledger;




Real-time pricing;




Coverage in more than 100 markets;




Information access 24x7 from wherever you are via Internet.

F U N D A D M I N I S T R AT I O N Investment funds are subject to legal and tax regulations based on the structure of their portfolios. In Ireland, for example, all investment funds are authorised and supervised by the International Financial Services Regulatory Authority (IFSRA). Fund companies have to keep abreast of changing regulations and implement the regulations in a manner that is consistent with industry practices. If a fund company fails to comply with legal or tax regulations, it may suffer from legal and financial liabilities. As we’ve also seen, in chapter 6, those tax liabilities may be both domestic and international in nature. Global Custodians with a presence in 100 global markets have experienced fund administration teams who can provide local knowledge that helps clients increase their fund distribution opportunities and manage risk. The benefits to their clients include:


Reducing clients’ daily administrative burden by preparing financial statements, compliance and client reporting, reconciliations, legal filings and publications;




Ensuring compliance with regulatory requirements.

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Fund Compliance – Daily and monthly monitoring of investment restrictions (including regulatory, prospectus and investment manager mandates) are normally available from automated compliance monitoring systems. Reporting is usually done on an exception basis and the range of limits that can be monitored includes spread and concentration limits, efficient portfolio limits, approved markets and credit ratings. Custodians also prepare semi-annual and annual reports and provide company secretarial services including arranging board meetings, providing necessary materials, and taking and distributing meeting minutes.

ELECTRONIC TRADING & RESEARCH For investors managing complex relationships with multiple counterparties, which is not uncommon, and seeking to increase returns and operational efficiencies while reducing costs, an integrated trading network is imperative to achieve success. A real-time, fully-integrated, electronic currency and equity trading platform addresses investment managers’ needs by offering complete and integrated access to premier products and services from leading financial institutions, while supporting workflow and risk management throughout the entire investment process, It can help by automation of the execution of orders, generation of confirmation and affirmation, and matching of trades by utilising a straight-through processing approach. Research – Provides clients a unique window on the world by analysing proprietary data. Analytics – Delivers a range of analytical tools to help investors make strategic decisions based on up-to-date financial data. Daily information available includes: an assessment of benchmark movements, a measure of portfolio flows across world markets, and a comprehensive assessment of the market value of borrowings and the quantity of securities borrowed across asset classes and exchanges for all G-7 countries. Trade Management – Provides efficient order management and comprehensive real-time execution of trades for portfolio managers and traders as well as compliance and operations personnel. Order Confirmation and Reporting – Provides a comprehensive solution for the confirmation and processing of trade transactions. The service reduces processing problems to a minimum, enabling investors to concentrate on implementing an investment strategy.

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M U LT I N AT I O N A L P E N S I O N P O O L I N G Custodians are often challenged by the way in which new market structures can be created to benefit from advantages, such as tax, where other more traditional mechanisms would fail. An example is in pension fund pooling. Collective investment schemes or unitised vehicles are designed to help investors benefit from economies of scale, diversification of risk and exposure to specialised investment manager knowledge. However, any resulting income earned may incur withholding tax which may often discourage pension funds from investing through collective investment schemes. When pension schemes invest directly into securities, they typically are entitled to favourable withholding tax treatment on investment income. See chapter 6. In a bid to preserve the tax advantage of pension fund status, while enjoying the benefits of investment in unitised vehicles, pension schemes can consider an intermediary fund structure with an optimal tax status. Examples of these funds include the Common Contractual Fund (CCF) in Ireland, the Fund Commun de Placement (FCP) in Luxembourg and the Pension Fund Pooling Vehicle (PFPV) in the United Kingdom. From an operational standpoint, these types of funds carry complex reporting requirements. Dual reporting at the fund level for asset valuation purposes and the participant level for income and taxation purposes is needed. Virtual pooling, permitted under mutual fund regulations in Ireland and Luxembourg, is a way to combine assets with the same investment management mandate, while continuing to enable these assets to be legally, beneficially and directly owned by the pension fund participants in the asset pool. In a unitised structure, the pools would represent funds and the pension fund participants would hold units of the pools. With virtual pooling technology, the pension fund participants directly own the percentage ownership of the underlying securities of the pool. A key characteristic of virtual pooling is “asset segregation” whereby pension funds own securities rather than units of a pool. Because the pool is not a legal entity the securities are technically owned by the participant pension funds. Investors can combine investments in a variety of asset classes across different legal entities that are subject to common investment management. Technology to support virtual pooling offers pension fund investors:


A completely automated and integrated core accounting and custody system;




Downstream processing and reporting by pool and by fund;

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The ability to maintain independent decision-making policies at the pension fund level;




Potential for cash flow matching;




Economies of scale through larger pools resulting in reduced volumes of transactions and lower transaction costs;




Access to a broader range of investment managers.

Virtual pooling can be used by pension funds as a substitute for, or in conjunction with, investing through a tax advantageous collective investment vehicle.

INVESTMENT MANAGEMENT For institutional investors, the ability to successfully navigate today’s global marketplace is more difficult than ever and custodians are only too keen to help. Investment barriers continue to fall in markets all over the world – and new investment vehicles are emerging with compliance and regulatory requirements becoming increasingly complex. A key objective is achieving growth, while at the same time managing risk and improving operational efficiencies. Global investment expertise, state-of-the-art investment technology and flexible, low-cost implementation allow global custodians to tailor portfolios to satisfy virtually any investment objective and benchmark preference. An array of asset management solutions of which custodians must be aware and deploy if they are to be competitive, includes:
Passive Equity Strategies –The most cost-effective way to access this indexing expertise is through pooled funds.
Active Equity Strategies – Strategies range from enhanced to high performance. Hedge fund management is offered, including a long-short market-neutral European equity strategy.
Private Equity Strategies – Private equity investment pools invest in private companies through investment strategies managed by dedicated teams of investment specialists who take an active role in guiding, focusing or restructuring to optimise value.
Currency Management – managing both passive and active currency overlay strategies.
Equity and fixed income strategies are also available in passive, enhanced and active management styles, and can be targeted to any

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benchmark clients choose. Most important is that all investment vehicles provide investors with exposure to all major global markets.
The use of powerful analytics and rigorous portfolio management with the aim of consistently meeting performance objectives while at the same time controlling risk for clients – including pension funds, insurance companies, foundations, corporate investors, financial institutions, religious institutions and family offices.
Dedicated investment teams, in-depth indexing experience, unparalleled trading efficiencies and an ongoing commitment to technology development – including client/server technology.

P E R F O R M A N C E & A N A LY T I C S Custodians also assist investors’ decision-making process by showing them how their assets are performing from a return and risk perspective, relative to a similar benchmark across all asset class levels at intervals they select. Using audited data from the global custody and accounting platforms, analytical reports ensure the highest degree of timeliness, accuracy and relevance. Value-added services give clients the time, tools, flexibility and information they need to realise their ultimate objective: maximising returns within acceptable risk levels are also offered.


Performance calculation – Typically based on the Modified BAI method (IRR) for monthly performance and the daily valuation method for daily performance measurement, it compares plan and manager performance against a similar benchmark.




Performance attribution – This service offers a comprehensive way to view and evaluate performance results by identifying the value added from allocation, selection, currency and hedging for global portfolios. For fixed income portfolios, attribution by maturity, duration and rating is deliverable upon request.




Risk-adjusted returns – This service provides the most common risk adjusted return figures, such as Sharpe Ratio, Treynor Ratio and information ratio, as well as risk statistics like standard deviation, beta and tracking error.




Fixed income characteristics – The Fixed Income Characteristics Report illustrates the most common risk figures, including duration and

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convexity, as well as return figures such as yield to maturity compared to a benchmark.


Equity characteristic – This report provides fundamental data per security or portfolio compared to a benchmark like market cap, P/E ratio, P/B ratio, dividend yield, 5-year EPS growth.




T30 report – The T30 report shows the 30 largest invested securities within a portfolio or a total plan.




Fact sheet – This provides summarised information for a portfolio or total plan, such as asset allocation, top 10 holdings, performance and risk and currency allocation. Ancillary Products offered by custodians include:


Trading cost analysis – helps track the trading costs incurred by equity portfolios during daily activities. It breaks the trading costs into three cost elements: commission, fees and market impact. Each element is compared against its respective universe cost. The report compares costs by total fund, country, investment manager and broker, highlighting areas of highest/lowest cost.
Value-at-risk – calculates the maximum loss of a total plan within a given confidence level using a covariance/variance approach. By means of other interactive tools, e.g. VaR Calculator II, clients can adjust the asset allocation and policy to perform scenario analysis on their total plan which can be used for capital allocation purposes.
Investment review – normally a tailor-made report in presentation format that provides all relevant information for the investment committee. It includes asset allocation, performance and risk figures and top 10 holdings, using graphs, comments on market developments, performance attribution, value-at-risk and Trading Cost Analysis where applicable.
Yield book – Yield Book is a sophisticated fixed income analytics tool that provides information such as multi-factor attribution compared to a similar benchmark, as well as sector analysis, option-adjusted risk characteristics and scenario analysis.

SHAREHOLDER RECORDKEEPING SERVICES In today’s increasingly fast-paced global market the demands on investment fund managers have never been greater. The ability to leverage increasing

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cross-border investment opportunities is paramount to the success of a custodian’s clients. At the same time investors and distributors are also requiring up-to-themoment, comprehensive and customised investment information. As these operational and administrative issues become more difficult and costly to resolve institutional investors need the support of a service provider with the resources and expertise to let them focus on achieving their overarching objective – optimising investment returns. By choosing to partner with a Global Custodian investors can sometimes benefit from innovative, proven technology that enables them to better manage client accounts, conduct high-volume trades and stay compliant – all in one reliable, robust package – while helping them meet the demands of business in a timely, cost-effective manner. A comprehensive range of administration processes are often available, some of which cross the border between custody and settlement, including:


Client transaction processing;




Settlement and registration;




Reconciliation and control;




Shareholder and intermediary maintenance and reporting;




Distribution processing;




Internet servicing for investors, intermediaries and promoters;




Output services;




Regulator reporting and interaction;




Management information services;




Performance fee equalisation at the shareholder level.

Investors should be careful however to maintain total control of the development of their business, deciding how much of the daily shareholder recordkeeping administration process to outsource, and which elements are core to their client proposition – and therefore best managed internally.

CHAPTER 9

Securities Financing & Lending Securities lending is increasingly recognised as part of the investment management activity with an estimated $3 trillion or more of securities on loan at any given time. Securities Lending describes the market practice by which, for a fee, securities are transferred from one party (the Lender) to another (the Borrower). The borrower is obliged to return them either on demand or at the end of the agreed term. Securities lending provides liquidity to the equity, bond and money markets, placing it at the heart of today’s financial system. This increase in liquidity reduces the cost of trading, thereby increasing market efficiency and benefiting all. Securities lending markets allow market participants to sell securities that they do not own in the confidence that they can be borrowed prior to settlement. They are also used for financing, through the lending of securities against cash, forming an important part of the money markets. The ability to lend and borrow securities freely underpins the services that securities dealers offer their customers and the trading strategies of dealers, hedge funds and other asset managers. On the lending side, securities lending forms a growing part of the revenue of institutional investors, custodian banks and the prime brokerage arms of investment banks. Some important consequences arise from the nature of the securities lending transaction;


Absolute title over the lent and collateral securities passes between the parties. These securities can be onward lent or sold outright;




The new owner has certain rights – it can ‘on lent’, sell to another buyer and vote in AGMs;




The borrower is entitled to the economic benefits i.e. dividends, but the agreement with the lender will require the manufactured equivalent to be returned to the lender;

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The lender is exposed to the price movements of the securities since the borrower can return them at a pre agreed price.

There are differing views in the market place as to the exact meaning of the term Securities Lending. The word ‘lending’ is in some ways misleading. In law the transaction is, in fact, “an absolute transfer of title against an undertaking to return equivalent securities.” This results in some important consequences arising from the nature of securities lending transactions:


Absolute title over both lent and collateral securities passes between parties, meaning that these securities can be sold outright or “on lent”;




Once securities have been passed, the new owner of them has certain rights. For example they have the right to sell or lend them to another buyer and vote in the AGMs / EGMs if they are the holder at the record date;




The lender of equities no longer owns them and has no entitlement to vote. But they are still exposed to price movements on them since the economic exposure to owning those securities is not passed. Typically lenders reserve the right to recall equivalent securities from the borrower and must exercise this option if they wish to vote.

Borrowing shares for the purpose of acquiring the vote is inappropriate, as it gives a proportion of the vote to the borrower which has no relation to their economic stake in the company. This is particularly the case in takeover situations or where there are shareholder resolutions involving acquisitions or disposals. The potential to vote using borrowed shares means that there is a risk that decisions could be influenced by those that do not have an economic interest in the business. The Securities Borrowing and Lending Code of Guidance states: “there is consensus in the market that securities should not be borrowed solely for the purposes of exercising the voting rights at, for example, an AGM or EGM. Lenders should also consider their corporate governance responsibilities before lending stock over a period in which an AGM or EGM is expected to be held”. Similarly collateral held, which can be of equal or greater value than the shares lent, should not be voted. This is a clear position and one of which practitioners actively engaged in the business of securities lending are acutely aware. The supply of securities in to the lending market comes from the portfolios of beneficial owners, such as pension funds, mutual funds and insurance companies. The demand to borrow securities begins with trading activities of dealers and hedge funds.

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In the middle are a number of intermediaries. This reflects the fact that securities lending is a secondary activity. They provide services such as credit enhancement and a provision for liquidity but are willing to borrow securities on call and while lending them on term. They also benefit from economies of scale by providing significant investment in technology. Intermediaries involved in these processes include custodian banks and asset managers lending securities as agents. Agents will normally agree to split revenues with lenders and may offer indemnities against certain risks, such as borrower default. Another category is dealers acting as principals. Dealers are intermediates between lenders and borrowers, but they will also use the market to finance their own activity. The history of securities lending is inextricably linked with the custodian banks. Once they recognised the potential to act as agent intermediaries and began to market their services to their clients, they were able to mobilise a large pool of securities that were available for lending. This also contributed to the growth of the market. As agent intermediaries, together with Asset Managers and third party agents, most custodian banks whether they are regional, local or global have added securities lending to their core custody businesses. Their advantages include:


The existing banking relationship;




Their investment in technology and global coverage of markets;




The ability to pool assets from smaller portfolios, insulating the borrowers from dealing with multiple parties;




Provide borrowers with protection from recalls.

Being banks, they also have the capability to provide indemnities and manage cash collateral efficiently – two critical underlying factors for many underlying clients. The other level of operation for an intermediary is as a principal. There are three broad categories of principal intermediary:


Broker Dealers;




Specialist Intermediaries;




Prime brokers.

In contrast to the agent intermediaries principal intermediaries can assume principal risk, offer credit intermediation and take positions in the securities that they borrow.

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A further role of the intermediaries is to take on liquidity risk. Typically they will borrow from institutions on an open basis – giving them the option to recall the underlying securities. Principal intermediaries provide a service to the market in matching the supply of beneficial owners that have large stable portfolios with those that have a high borrowing requirement. They also distribute securities to a wider range of borrowers than underlying lenders, which may not have the resources to deal with a large number of counterparties. These activities leave the principal intermediaries exposed to liquidity risk if lenders recall securities that have been borrowed on a term basis. One way to mitigate this risk is to use in-house inventory where available. Borrowers, when acting as principals, have no obligation to tell lenders or their agents why they borrow securities. In fact they may not know especially if they are subsequently lending these to proprietary traders or hedge funds, which might be vague on their trading strategies. The most common reason to borrow securities is to cover a short position – using the borrowed securities to settle an outright sale. The short position is part of a larger trading strategy, typically designed to profit from perceived pricing discrepancies between related securities. Short positions also arise as a result of failed settlement and where dealers need to borrow securities in order to fill customers buy orders in securities where they quote two-way prices. Not all securities lending is motivated by short selling. Financing is also a driver where the lender is seeking to borrow cash against the lent securities, whether using repo, buy/sell backs or cash-collateralised securities lending. Other drivers which can work to the advantage of both the lender and borrower are;


The lender may be subject to withholding tax. Some borrowers are not and may receive the dividend free of tax and share this benefit with the lender by way of a fee or a large manufactured dividend;




Where the issuers offer the shareholders a choice of a cash dividend or scrip at a discount to the market. A borrower may choose the scrip and sell the share in the market and share the benefit with the lender.

TRADING AND SETTLEMENT The securities lending market is actually a hybrid between a relationship based market and an open, traded market. Settlement occurs on shorter timeframes than outright transactions, so that securities can be borrowed to

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cover a sale. In most settlement systems the securities loans are settled as ‘free of payment’ deliveries and the collateral taken is settled quite separately. This can give ‘daylight exposure’, a period in which the lent securities have been delivered but the collateral securities have not yet been received. To prevent this some lenders insist on a pre-collateralisation, so transferring the exposure to the borrower. They in turn need to ensure that they or their counterparts/agents act in accordance with the beneficial owner’s requirements. The counterparts or agents will include the following types of organisations:


Asset Managers;




Local Custodians;




Global Custodians;




Third Party Lending Specialists;




Proxy Voting Contractors e.g. ISS or ADP;




Broker Dealers.

It is the case that securities on loan cannot be used to vote by the lender. Should they wish to exercise their right to vote, they need to recall these securities by the pre-determined time i.e. record date. Notwithstanding the above, it is not the case that, in aggregate, all votes on lent shares are lost. Some shares that have been borrowed will be delivered into the market to settle sales and end up with buyers. These buyers will be oblivious to the fact that these shares have been borrowed and will view them as their property and choose to vote as they see fit. It is the case that there may be some loss of votes associated with collateral positions or positions sitting long in trading books because shares held as collateral or in trading books are not normally voted. The right to recall any security on loan is enshrined in the legal agreement underpinning this activity and typically the lender recalling securities must provide their agent or borrower with “standard settlement period notice.” Recalls are part and parcel of the securities lending business. However, borrowers seek to avoid recalls wherever possible and frequent recalls may discourage borrowers from accessing portfolios. In practice the lenders, or their agents, communicate the lender’s position with regards to voting to the borrowers to avoid any surprises. It is important for all parties that they understand the importance of this communication and the rights of the underlying client to recall their securities to vote. There are several

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positions that can be taken and these are driven by the owners of the assets made available for loan. At all times it is the owner who determines what can and cannot be done with their securities. The beneficial owners of these assets include the following types of organisations:


Pension Funds;




Mutual Funds;




Insurance Companies;




Unit Trusts;




Charities and Religious Institutions.

Beneficial owners need to consider additional factors of their own. These include the following:

Organisational characteristics


Management motivation – Some lend to offset custody and administration costs. Others seek a revenue stream;




Technology investment – Lenders vary in the level of investment to support securities lending;




Credit risk appetite – The lending market consists of organisations with a wide range of credit quality and collateral capabilities. A cautious approach to counterpart selection (AAA only) and a restrictive collateral guideline (G7 bonds) will limit lending volumes.

Portfolio characteristics


Size – borrowers prefer a large portfolio;




Holdings size – Loan transactions generally exceed $250,000. Holdings of less than this are best deployed through an agency programme, where they can be pooled with other inventories;




Investment strategy – active strategies are more likely for recalls and less attractive than passive portfolios;

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Diversification – Borrowers are looking for liquidity. A global portfolio is a better fit, however there are markets and certain borrowers that have an asset class focus;




Tax jurisdiction and position – Borrowers are responsible for making good any benefits of ownership as if the securities had not been lent. They must pay the economic value of dividends to the lender. An institution’s tax position compared to that of the other possible lenders is therefore an important consideration. If the overall cost is low then it will be in greater demand;




Inventory attractiveness – ‘Hot’ securities are those in high demand. So the hotter the portfolio the higher the return.

Route to market


Using an asset manger as agent – If the asset manager already operates a securities lending programme then this would be a fast route to market for the beneficial owner;




Using a custodian as agent – This is the least demanding option, since they will have already made a decision to select a custodian;




Using a third party specialist agent – If the beneficial owner has decided to outsource, this may involve getting to know the provider. The opportunity cost of this delay needs to be factored in;




Selecting on principal borrower – effectively a global franchise using their expertise and capital to generate spreads;




Lending to proprietary principals – These include broker dealers, market makers and hedge funds.

GENERAL SECURITIES LENDING MARKET PRACTICES Loan negotiation Traditionally securities loans have been negotiated between parties on the phone, followed up by written confirmation. Normally it’s the borrowers who initiate the call. However, proactive lenders may also call their approved counterparts’ securities that are in demand at the time.

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Today there is an increased level of bilateral or multilateral automated lending at an agreed price which facilitates automatic matching. Such a platform is provided, for example, by Equilend, which connects borrowers and lenders through a common set of protocols, to promote enhanced efficiency and speed and reduce cost and risk. SecFinex also offers a similar service in Europe.

Confirmations Written or electronic confirmations are issued when possible on the day of trade. Any material changes are advised between the parties. Examples include collateral changes, substitutions etc. Confirmation would normally include the following:


Contract and settlement date;




Details of loaned securities;




Identities of lender and borrower;




Acceptable collateral and margins;




Term and rates;




Bank and settlement account details for the lender and borrower.

Term of loan Loans may be either a specified term or open. Open loans are trades with no fixed maturity date. It is normal for the security loan to be open or ‘at call’, especially for equities as the lender would look to protect the underlying fund manager’s ability to sell at any time. Lenders can sell the securities whilst they are on loan since they can be recalled in time for settlement. Term trades are used to describe arrangements in the securities lending market. The parties have to agree whether the term of a loan is fixed for a definite period or whether this duration is merely indicative and the securities are callable. Securities subject to a fixed loan should not be sold while on loan. Where the term discussed is intended to be indicative, it usually means that the borrower has a long-term need for the securities, but the lender is unable to fix for term and retains the right to recall the securities if necessary.

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Putting securities “on hold” This is the practice where the lender will reserve securities at the request of a borrower to meet the borrowers need to borrow at a future date. This occurs when the borrower needs to know that the securities will be available before committing to a trade. Any price will be indicative and for the securities to be held only until the following day. The borrower can roll over the arrangement provided a call is placed before 9am, otherwise it terminates. A key aspect is that the lender will not receive a fee for reserving the security and may be challenged by another borrower making a firm bid. In this case the first borrower will have 30 minutes to decide to accept or release them. A variation is where the lender does receive a fee for putting the securities on hold; as such they are under agreement and cannot be challenged by another borrower.

Settlement Securities lenders need to settle trades on a shorter timeframe than the customary settlement period for the market. Settlement normally occurs through the lender’s custodian bank. The lender will normally have an agreed schedule of guaranteed settlement times for its securities lending activity. Prompt settlement is crucial to the efficient monitoring and control of the programme, with reports needed for both loans and collateral. In most systems the loans are settled ‘free of payment’ deliveries and the collateral is taken separately in a different payment and settlement system and maybe a different country and time zone. This can give rise to a ‘daylight exposure’, a period during which the loan is not covered as the lent securities have been delivered, but the collateral has not been received. To mitigate this risk some lenders insist on a pre-collateralisation, so transferring the exposure to the borrower. In the UK the CREST system for settling UK and Irish securities is an exception to the normal practice as collateral is available within the system; this enables the loans to be settled against cash intra-day and for the cash to be exchanged.

Termination of loan Open loans may be terminated by the borrower returning the securities or by the lender recalling them. The borrower will return the securities when it has filled its short position. Sometimes the borrower can fill this need by borrowing securities more cheaply elsewhere and returning the securities to the original lender. The borrower may give an opportunity to the original lender to reduce its fee.

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Redelivery, failed trades and legal remedies When deciding which markets and what size to lend in, securities lenders will consider how certain they will be of having their securities returned in a timely manner when called. They need to consider what remedies are available to them in the event of a failed return. Procedures for failed redelivery are normally covered under the agreement or agreed between the two parties. There may be a case for financial penalties for the lender. Costs incurred and covered include:


Direct Interest/or overdraft;




Costs incurred as a result of the borrowers failure;




Cost incurred for ‘buy in’ by the lender.

Costs that would usually be excluded are those arising from the transferee’s negligence or wilful default and any indirect consequential losses e.g. the non return of the loan causes an onward larger deal to fail.

I M PA C T O F C O R P O R AT E A C T I O N The basic premise underlying securities lending is to make the lender whole for any corporate action event – such as dividend, rights, or bonus shares – by putting the borrower under contractual obligation to make equivalent payments to the lender, for example by manufactured dividends. However the shareholder right to vote cannot be manufactured since the legal ownership passes to the borrower. Where the lenders have the right to recall they can exercise this to make their position whole. The onus will be on the borrower to find the securities by borrowing or purchasing them in the market. This can damage market liquidity, which is the risk that intermediaries manage. Stock lending is important in maintaining liquidity, but borrowing of shares for the purpose of voting is not appropriate. It is important that the beneficial owners are fully aware of the implications for voting if they agree to the share being lent especially if the resolution is contentious. The following positions are possible and there are securities lending programmes constructed to cater for each of them:


Voting (and therefore recalling) securities at every opportunity e.g. when the owner has a strong culture of voting and does not wish to miss an opportunity to demonstrate its position to the company This is quite a rare position to take and is often only made in a subset of markets that

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are very important to the owner e.g. A UK pension fund might wish to recall all UK securities to vote;


Voting (and therefore recalling) securities only when the vote is deemed important enough e.g. when a take over is being considered This is a more commonplace position and enables the owners to enjoy higher securities lending revenues whilst voting when they feel it is warranted. It is important to note that the beneficial owner determines when it is important to vote, not their agents or borrowers;




Not voting securities at all – there are still organisations that choose, for their own reasons, not to vote. However, should they change their mind and make an exception, they would have the capability to notify their agent or borrower and recall the securities in the normal way;




Maintaining a buffer of at least one share in all holdings – To ensure that the beneficial owner or asset manager receives direct advice regarding voting (and all other corporate actions) the retention of at least one share in their account is advisable. This has the advantage of ensuring the efficient and direct flow of information whilst retaining optimal lending returns. It is typical for there to be some retention or “buffer” of securities to be made in a lending programme and this level could be as low as one share or could be expressed as a percentage of the value of the holding.

R I S K R E G U L AT I O N S A N D MARKET OVERSIGHT Financial risks in securities lending are primarily managed through the use of collateral and netting. Collateral can be in the form of cash or securities. The market value of the collateral is greater that the value of the lent securities. This margin is required to protect the lender from loss and should reflect the cost of liquidating the collateral and repurchasing the underlying securities in an event of a default. Any profits made in the re-purchase of the lent portfolio are normally returned to the borrower.

Risks and risk management As this is a small sub-set of the securities lending scenario, we will deal with risk management for this area within this chapter rather than the next part, Managing Risk, which is oriented more on general market drivers and strategic issues.

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Taking cash as collateral – the lender needs to decide how best to use this form of collateral. The lender normally pay a rebate interest to the borrower, so the cash must be invested at a higher rate to make any return on the collateral. The lender needs to decide on an appropriate risk-return trade-off. Reinvesting in assets that carry one of the following risks can increase expected returns


a higher credit risk: a risk of loss in the event of defaults; or




a longer maturity in relation to the likely term of the loan.

Taking securities as collateral – Taking securities as collateral is a way of avoiding reinvestment risk. In addition to the risks of error, systems failure, and fraud always present in any market, problems then arise on the default of a borrower. In such cases the lender will seek to sell the collateral securities in order to raise the funds to replace the lent securities. Transactions collateralised with securities are exposed to a number of different risks:


Reaction and legal risk – lender experiences delays in selling or repurchasing the securities. It runs the risk that the value of the collateral will be lower than that of the loan. Typically, the longer the delay, the larger the risk.




Mispricing Risk – The lender is at risk if the collateral is over priced or the lent securities under priced, as the prices used to mark to market differ from prices that can actually be traded in the secondary market.




Liquidity risk – Illiquid securities are more likely to be realised at a lower price than the valuation used. Valuation ‘haircuts’ are used to mitigate risks. These depend upon:


The proportion of the total security issue held in the portfolio: the larger the position the larger the haircut;




The average daily traded volume of the security: The larger the position the larger the haircut;




The volatility of the security: the greater the volatility the greater the haircut;




Mismatch risk: In practice the lent and collateral portfolio are often different. The lenders risk is that the value of the lent securities rises

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and the value of the collateral falls. Provided that borrower does not default, the lender can ask for more collateral.

Netting Netting is an important element of risk management, given that many market participants will often have many outstanding trades with a counterpart. So instead of requiring the parties to deliver securities or collateral on each of their outstanding transactions gross, their respective obligations are valued and the value of the obligations of one party are set off against the value of the obligations of another party, it is the net balance that is then due in cash. This netting mechanism is a crucial part of the agreement. That is why there is so much more legal focus on it. Most regulators of financial firms expect legal opinions on the robustness of netting arrangements before they recognise the value of collateral in reducing credit exposure for capital adequacy purposes.

Transparency All stakeholders, not just securities lending professionals, e.g. fund managers and corporate governance professionals, should understand the following:


The established legal framework underpinning the lending arrangement;




Securities must be recalled to vote;




The exact notice required to recall the shares to vote – this may be different to normal market settlement periods depending on the lending agent being used;




Securities which are on loan;




How to access loan and/or governance information;




The potential effect of dividend record dates.

Some beneficial owners are already in receipt of detailed reporting from their lending agents, although it is fair to say that the frequency and distribution of this information varies. Best practice is to provide daily reports securely on the internet. The evidence suggests that lending is not one of the primary reasons why voting turnout is low. The value of a vote is determined by the owner of that

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vote – if they do not value it they may choose not to exercise their right, irrespective of their willingness to lend. As the law currently stands in the UK, borrowing securities in order to build up a holding in a company with the deliberate purpose of influencing a shareholder vote is not illegal. However, based on recent headlines and the work done by the International Corporate Governance Network, institutional lenders have recently become more aware of this possibility and tend not to see it as a legitimate use of securities borrowing. Since the demise of the borrowing purpose test, it is technically possible for someone to borrow securities to vote. However, it has been made very clear that this is not acceptable practice as the UK Annex to the Stock Borrowing and Lending Code, SLRC, 11 May 2004 makes clear. Should this activity become an issue of concern in the future, it would draw regulatory attention very quickly, with the widespread support of the securities lending industry. It is vital that beneficial owners are aware that when shares are lent the right to vote is also transferred. The SLRC Code of Guidance states that “agents should make it clear to clients that voting rights are transferred.” Going forward, a balance needs to be struck between voting securities and the benefits derived from lending securities. Quantifying these competing benefits is challenging. The income derived from securities lending can be explicitly measured but the value of a vote is perhaps less tangible – particularly now that most securities carry a vote and the majority of equity securities in publicly quoted companies rank pari passu (i.e. there are fewer companies that issue both voting and non voting shares that can be compared with one another). Beneficial owners need to ensure that any agents they have made responsible for their voting and stock lending act in a co-ordinated way. This may mean that portfolio managers need to receive reports regarding securities on loan so as to avoid any situation whereby votes that they intend to make are not possible. This should be straightforward as notification of a vote taking place is given well in advance and securities can easily be recalled if necessary.

T H E I M PA C T O F T H E C U S T O D I A L AGENCY MODEL It has been suggested in some quarters that securities lending – or, more precisely, agent lending is doomed, if indeed not already dead. The argument today is that no lenders or beneficial owners are unaware of the range of new options available to them, nor will they be able to resist them. In this brave new world, there is no need for agent lenders to intermediate within

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the lending process. It’s certainly true that there are now multiple avenues through which beneficial owners and fund managers can reach the market. However, some would argue that the opposite conclusion should be drawn from the evidence presented above – that in fact, this fragmentation and multiplicity of options is actually strengthening the agent lender’s hand. It comes down to economics and dynamics. With the economics of the business getting tighter, considerations such as size, specialisation, depth of infrastructure and risk management all make it imperative that the agent lender option is given serious consideration. The convergence of hedge funds and traditional asset managers is accelerating. This trend is actually driving the growth of the lending business. Perhaps more importantly, the evolution of the asset management business means going forward, lending will no longer be a stand-alone activity – rather, it will be part of a holistic, integrated service offering. It is agent lenders who are best positioned to provide such a bundled offering. This ‘mainstreaming’ of hedge fund strategies will fuel lending at an unprecedented rate. Indeed, it is fair to say we expect to see a genuine boom over the next few years. Borrowing, once largely the remit of the hedge funds, has become institutionalised. However, there is a great deal of contention at present around the path custodians should take. If they are to offer a truly end-to-end service, then several pieces of business must be brought together – custody, fund administration, investment analytics and securities borrowing. Some custodians maintain they would never consider going down this route. By making available direct securities borrowing, a custodian would be encroaching upon the territory of the prime brokers, who are traditionally borrowers in a custodial agency programme. The existing supply chain comprises the institutional lender, who lends through an agent, who lends to broker dealers / prime brokers, who in turn lend to hedge funds. By bringing the agent lenders directly into contact with the hedge funds or institutional investors holding short positions, the prime broker will be dis-intermediated. In such circumstances the prime broker will probably continue to borrow from the agent lender. At the end of the day, the prime broker must have access to the liquidity pool and that pool is primarily provided by the agents. Consequently, the agent lenders cannot be completely bypassed. Certainly, a prime broker may be able to offer an exclusive programme to a particular institution, but that is not going to satisfy their day-to-day needs, since any one prime broker is unlikely to control enough of the required liquidity to have a significant impact. On the other hand, the custodian has no real choice but to follow the dictates of the market. If the traditional fund managers (who use the custodian for fund administration) move to adopt hedge-like strategies, the custodian faces a choice: either offer them that facility directly, or refer them to a

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prime broker. However, if they choose the second option, that collateralised finance means assets are moved out to the prime broker, who then starts to take on the role of the custodian. For agent lenders, change is inevitable as traditional client pools start ‘hybridising’ through increased adoption of hedge fund or hedge fund-like strategies. The custodian either loses that business to the prime brokers, or it evolves along with those clients, extending its traditional offering to provide them with the additional services they require. Taking this a step further. A traditionally long-only client investigates adoption of hedge fund-like strategies and approaches the agent lender to borrow. At this point, against prevailing Biblical advice, a dichotomy appears. The relationship has evolved into that client utilising the agency programme as both borrower and lender. The agent can structure the client’s borrowing such that his fund accounting is holistic: the books covering his long positions, his loan positions and his borrowing positions are combined within one statement. If the client were then to go to a prime broker, which uses a different fund administration platform, part of the overall assets will have to be pulled out, and the client will then end up with three different sets of numbers. So a holistic, one-stop shopping for the lending process means that, from the client’s perspective, there is a single box that accounts for everything. One set of processes, one set of controls, one set service. This also enhances risk management, because all the client’s activity, his behaviour, is being monitored and authorised through a single point. Having a complete picture in one place means the likelihood of an error or incident that undermines the fund manager is minimised. By contrast, in an uncoordinated or disjointed environment, there is no means of validating the extent of exposures, the concentrations or diversification. Consequently, there is a very strong rational incentive to keep the whole process holistic. Why, then, is it natural for the custodian to offer such a service? The custodian has already put in place the most technologyintensive component within the process, which is basic custody. That is overlaid with fund accounting and a settlement process and when securities lending is added to the mix it is merely a matter of connecting those different pieces in a seamless fashion. More importantly, this integration allows the thread of risk management to carry through the entire process. It cannot be ignored that the adoption of Basel II New Capital Accord will force firms into a very structured risk management process. Institutional investors are looking for service providers who can partner with them on such significant infrastructure development. The custodian is the best-positioned market participant to provide this holistic service offering. Custodial services, fund accounting, lending and borrowing and the very important third party risk and compliance monitoring all under one roof. At the end of the day, whoever has the inventory can

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supply the liquidity – but if they do not possess that liquidity, all they can do is buy it. Agency lending has historically been an engine of growth in North America. In Europe, however, there has historically been a broad range of options and agents have not predominated. However, we are now seeing a clear move away from self-lending and very strong support of the custodial agency model. This change is being driven by economics as well as changing investment priorities. One of the key strengths of an agent is its ability to aggregate. The fragmented pieces beneficial owners hold in multiple markets, regardless of their size, will only generate the returns they expect when they are combined with other fragments from other clients. It is aggregation that makes lending a worthwhile undertaking in commercial terms. Securities lending is not a cottage industry. Securities lending and the pursuit of good corporate governance are not necessarily in conflict. Both activities can and do co-exist happily within the investment management mainstream. Today, many of the foremost proponents of good corporate governance successfully combine an active voting role with a successful securities lending role. The information flow and communication necessary to ensure that conflict is avoided are already in place but could be developed further. Those that are concerned about possible conflict need to discuss openly the issue with their securities lending counterparts and corporate governance colleagues. There is no need for anyone to feel that securities lending will disenfranchise them. At all times it should be remembered that the owner of the securities determines whether securities are either lent or voted.

PART 3

Managing Risk

Managing risk is a key component of custody clearing and settlement in the twenty first century. In this part of the book we will look at the three primary mitigators of risk – technology solutions, regulatory frameworks (although some still cite this as a creator of risk not a mitigator) and the role of network management. Regulators are increasingly making the presumption that technology exists to help financial services firms meet any of the constraints and stipulations of their regulations. The regulatory frameworks themselves come out of governmental edict i.e. political pressure, but also from the perceived bad practices of the market. “Bad”, in this context being a relative term. This is often exemplified in the tax area where governments are constantly changing the rules. Similarly, many financial services firms are affected by governance regulation e.g. Sarbanes-Oxley 2002 which requires both structured (SWIFT) and unstructured (email, fax etc) communications control. See “Sarbanes Oxley – Building Working Strategies for Compliance” McGill & Sheppey 2007. Publ. Palgrave.

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CHAPTER 10

Vendor Landscape

The range and complexity of solutions is such that, in any credible book on custody, it is now impossible to describe the market without addressing both the theory, as we have so far, as well as the practice. The growth in financial markets is to a certain extent determined by the technology available and importantly the new technologies and deployments that are being designed. The firms mentioned in this chapter are by no means the only ones in the space, but they are the key players and their products and strategies should be understood by practitioners in order to gain some context of the likely changes in the market over the next five years.

CLEARING & SETTLEMENT OMGEO Formed in 2001 as a joint venture of the Depository Trust & Clearing (DTCC) and Thomson Financial, Omgeo services the global post-trade arena. The company supplies three platforms for allocations and confirmations: Omgeo OASYS for US domestic trades, Omgeo OASYS Global for cross-border trades, and Omgeo Central Trade Manager (CTM), for crossborder and non-US domestic service. Omgeo CTM has its own matching and settlement notification engine, whereas OASYS-TradeMatch handles central matching for OASYS users. The main technology theme at Omgeo is to expand the product options to give clients more types of post-trade tools and flexibility of access to those tools. Omgeo developed OASYS first, and the platform represents a majority of its current client base. The latest version, OASYS 5.0, integrates the matching status from TradeMatch on the OASYS desktop. Omgeo also offers a local matching application for OASYS Global users in addition to its TradeMatch central matching capabilities. 159

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Another of Omgeo’s technology initiatives, asset class expansion, aligns with the vendor’s main theme of access to more post-trade products. This approach broadens support for existing securities and expands into new instruments. OASYS 5.0 added more fixed income features, supporting the processing of to-be-announced contracts for mortgage-backed securities and allowing custom securities identification (CUSIP numbers) for money market instruments. Due to the strong industry and regulatory interest in automating derivatives processing, derivatives will be the first security type supported by a new product, Omgeo Connect. Omgeo Connect provides a gateway for an institution to connect its internal applications to a messaging and matching hub and enables Omgeo to support the counterparty spokes in the post-trade process. Institutions can also use Connect to monitor internal post-trade processes across diverse systems. Asset managers want to choose how to conduct their post-trade operations, and Omgeo’s product initiatives give them options. The company’s experience with post-trade processing, global infrastructure, and strategic partnerships positioned it well to maintain its leadership status in the marketplace. Omgeo’s regulatory approval as an electronic trade confirmation provider adds to its standing. However, the company will need to continue trying to overcome two drawbacks that are concerns of the buy side. First, the downside of standardisation is lack of customisation. In particular, asset managers balk at a central matching model because it doesn’t give them as much control over matching criteria and workflows as they are used to in their local environment. The second concern involves Omgeo’s “for profit” status. Asset managers would prefer an industry-controlled, notfor-profit entity to provide post-trade services. In the absence of a utility, more commercial choices to increase competition would help alleviate this concern, as would continued effort by Omgeo to provide flexible and open solutions at a reasonable price.

SS&C SS&C started in 1986, went public in 1996, and returned to private ownership in 2005 after its acquisition by The Carlyle Group. The company offers technology products for money managers, insurance companies, municipalities, and real estate property managers. Applications for money managers cover portfolio management, order management, portfolio accounting, performance and attribution, and client reporting. Three months prior to its sale to The Carlyle Group, SS&C acquired Financial Models Company (FMC). One of the FMC products was FMCNet, which began in 1990 as a means for Canadian buy-side institutions to communicate with custodians. In addition to the network, FMCNet provides a middleware layer that facilitates local matching with user-defined

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match criteria and tolerances. An analysis of SS&C’s product offerings shows that the company meets many requirements of buy-side firms. The company launched its central matching utility (then called FMCNet2) in 2004 to complement FMCNet. Today, both platforms fall under the FMCNet product name, offering broad access to brokers and custodians, a free SSI database, choice of multiple message protocols, and support for equity and bond transactions.

SunGard SunGard’s post-trade solution includes offerings from the SunGard Transaction Network (STN) and Straight Through Enterprise Processing (STeP). STN began in 1999 to provide a platform to facilitate straightthrough processing of securities transactions. Today, STN connects asset managers, issuers, and broker-dealers for trading across multiple asset classes, including equities, fixed income, mutual funds, money market funds, and commercial paper. SunGard STeP provides products and services for financial messaging and integration, real-time transaction management and post-trade automation across an enterprise. These two solutions enable SunGard to offer a range of options to suit various clients’ preferences, from installed applications to an applications service provider (ASP) model. STN provides the connectivity and message processing services between counterparties, including FIX allocations, matching, processing confirmations and affirmations, and sending settlement notifications. The STeP suite incorporates a SWIFTNet platform as well as matching, reconciliation, and exception management. In particular, STeP Trade Management enables internal operations staff to view allocation, confirmation, and settlement activities on a single dashboard. Ease of implementation and integration is the overarching technology theme across STN and STeP. An important enhancement to STN as a posttrade messaging platform involves putting a matching engine in its hub. Clients could choose this option in lieu of performing trade matching inhouse and without drastic changes to their technology infrastructure. As an alternative, clients could choose STeP intelliSUITE for local matching across asset classes. STeP Trade management provides internal integration and business process monitoring and enables clients to connect with STN as well as with other post-trade platforms such as Omgeo’s OASYS and CTM. SunGard can provide components or a complete post-trade solution.

C O R P O R AT E A C T I O N S Automated Corporate action processing is the last great bastion of STP – but it is a complex and costly issue to automate. The costs and risks

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involved are large. Errors caused by a plethora of manual processes result in losses of millions of dollars a year for many firms. However, the entry level cost for automated software prohibits many smaller custodians from purchasing an automated solution. The cost benefit equation becomes vitally important, but of equal importance is the analysis of the cost of not automating – often firms fail to include such relative intangibles as “loss of market competitiveness or credibility”, “loss of reputation” etc. Two main factors have slowed firms from buying automated solutions; 1. The initial cost to set up for anything other than tier one and some tier two players is too expensive. 2. The complexity of implementation due in the main to the lack of standardisation in communication and formats. There has been a surge in interest for automated software in the last two years. Automation of corporate actions is either being implemented or under review by around 60–70% of market practitioners currently. Whilst only approximately 10–15% have already completed that process. Any firm that wants to reduce their cost and implementation time for automating corporate action processing can move faster with an ASP offering. New markets in tiers 2 and 3, with this type of solution, are suddenly achievable as costs can be spread over a period of time. A vendor can solve the main objections of firms and bring a multitude of further advantages to customers including: 1. Spread payment plans; 2. Many items pre-configured to reduce implementation times; 3. One stop deployment; 4. One stop connectivity and integration with the outside world; 5. Reduced risk of error by automated processes; 6. Consolidated data feeds resulting in reduced prices and less connection failure points for Customers; 7. A built network of peer firms helping to increase standardisation of processing and market practice.

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When looking at the competitive landscape there are a few things worth noting up front:


One of the main competitors will always be in-house builds and certainly many of the larger custodian firms have attempted to go this route;




Corporate action vendors tend to have clients on parts of their system or may even only attempt to solve part of the problem by being specialist in one or two areas. Thus it is hard to do a true like for like comparison in some instances.

The processing issues that all these vendors are trying to resolve are not dissimilar. Some state that they can solve everything, others will tend to stick to the specialist or niche area they know best. All firms though are trying to tackle the massive job of gathering, “scrubbing” and disseminating corporate actions information. DTCC, for example, is targeting new revenue streams with the roll-out of a centralised suite of corporate actions processing solutions – “GCA”. While it is too soon to apply labels, the commercial basis for success is clear. Last year alone DTCC handled more than 10,500 corporate reorganisation events, 250,000 bond redemptions and 3.2 million income payments valued at nearly $2 trillion. After a successful launch, the Global Corporate Actions (GCA) validation service is already attracting several large customers from outside the initial group of founders. Celent found that a handful of dominant vendors, such as Xcitek and TCS, are facing new competition from relative newcomers like CheckFree, SmartStream, GoldenSource and Information Mosaic. While competition is heating up, the good news for vendors is that overall spending on corporate actions automation will increase as a result of demand and a wider variety of vendor solutions. Leading corporate actions automation providers should benefit from the uplift in spending and the move for more financial institutions to turn to third party providers rather than internal solutions. According to Celent, Xcitek, now XSP, is the dominant, established provider based on customer base to date. Celent goes on to say that while Xcitek does not appear to have the software to fit every client’s needs or demands, the company has a deep support staff and relatively wide functionality and broad appeal. Challenging for leadership based on functionality and flexibility are CheckFree and SmartStream, however, the market consensus would point to Information Mosaic also. To this end the main participants are as follows, the estimates here for number of clients etc come from industry sources but cannot be claimed with total confidence and will vary with time.

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Table 10.1 Vendor Xcitek InformationMosaic Mondas Smartstream Tata Vermeg Trace Financial ADP Wilco CheckFree Others

Main corporate actions software vendors Clients

Mkt Share

ASP?

55 18 14 8 25 8 8 20 4 20

31 12 9 6 10 11 4 8 2 1

Yes Yes No No No Yes No Yes No

Employees 40 25 35 15 25 25 15 12 12

Source: own research

An example of how dangerous tables such as 10.2 can be, and how difficult it is to really assess competitive offerings on a like for like basis, is the tax capability line. Withholding tax as a corporate actions issue is massive in both its implications and its complexity. While most vendors tick the box for tax capabilities, the extent of that tax capability varies enormously and virtually without fail, does not come anywhere close to an acceptable STP solution nor do they reflect the complexity of the function within the product offering. In several cases the vendors who have recognised this problem have already announced alliances with specialist providers such as GlobeTax where the focus on STP can benefit both parties.

XCITEKSOLUTIONSPLUS Xcitek XSP is said to be the most-widely implemented corporate actions automation solution available on the market today. XSP facilitates corporate actions event response capture through its web-based module, eTRAN™, and entitlement processing into back-office systems, to handle the complete corporate actions lifecycle. Functionality includes: Full announcement-to-settlement automation capabilities


Robust announcement capture/scrubbing;




Automated workflow with customisable user views;




Full position capture interfaces and entitlements calculations;




Automated notification and decision-capture capabilities;




Full settlement STP.

VENDOR LANDSCAPE

CheckFree

Information Mosaic

Mondas

SmartStream

Tata

Vermeg

Xcitek

GoldenSource

Comparison of vendor functionality

ADP Wilco

Table 10.2

165

SWIFT ISO 15022-complaint




























Rules-based workflow with exception management




















































Capability

Data scrubbing/ normalization Reconciliation capabilities




























Diary/calendar function




























Manual inputs option




























Administration module for user modifications




























Entitlement calculations




























Elections processing




























Real-time updates




























Audit trail




























FX transaction capabilities

























Tax capabilities




























Source: Vendors

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Other key points


Headquarters: New York, NY;




UK offices in Birmingham and London;




Private;




Founded in 1986.

Revenues


$25m **Estimated 2006 by Financial Insights.

Architecture


Independent operating system;




Runs on most application servers;




Notification/decision capture management system is a separate browser delivered application (BDA) module.

Strengths


Dominant player in the market – leveraging reputation as corporate actions data provider;




Full end-to-end processing capabilities with configurable process and workflow;




Pre-set handling of over 30 corporate actions information feeds;




User-defined “Queues & Views” workflow UI for managing process and exceptions.

I N F O R M AT I O N M O S A I C Information Mosaic (IM) is based in Ireland and is a global provider of middle and back office solutions for the securities services industry. Information Mosaic now have an ASP offering for their core system called “converg-eTM”. From within this they can run their corporate actions module CAMATM. CAMA can also be implemented as a standalone application.

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167

The ASP solution is fully integrated investment management platform that supports multiple financial services offerings, for multiple international markets, from one central location. Their corporate actions specific application, CAMA offers:


‘Unique’ patented rules based templates that streamline and automate corporate action processes;




Intuitive Interfaces that are easy to use and that simplify corporate action tasks;




Workflow and monitoring that facilitate efficient allocation of operational resources;




Built in rules that can manage European, US and Asian Pac corporate actions;




Tax Liability functionality supporting both local and double taxation rates;




Client taxation and reclaim reporting;




A ‘unique’ set of reporting tools for management information, regulatory and performance analysis;




ISO 15022 compliant;




Web-based entitlements notification/decision-capture.

Other key points


Headquarters: Dublin, Ireland – with representation in NY, London, Boston, Lux and Sydney;




Private – Management owns 62% of firm;




Founded in 1997;




Partnered with GlobeTax to provide tax reclaim processing via GlobeTax’s service bureau.

Revenues


$25m **Estimated.

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Architecture


Database and platform agnostic – can install on any web server environment;




HTML based user interfaces;




Integration to existing IT environment flexible:







N-tier;




XML;




J2EE.

Benchmarked to 2.2m elections per day.

Strengths


Fully configurable business and workflow rules templates;




Fully configurable action announcement reconciliation and data comparison rules;




Web-based instruction management;




Robust security and access management;




Recognised as best in the market.

S M A R T S T R E A M T E C H N O LO G I E S T L M ® C O R P O R AT E A C T I O N S SmartStream Technologies is a market leading provider of Transaction Management solutions which gave it a great target list when selling their corporate actions solution. In transaction management, the company has a 37% market share and over 1,100 clients, including 75 of the world’s top 100 banks. SmartStream’s TLM® Corporate Actions solution has been designed to support operations groups that perform day to day processing and drive cost and process inefficiencies out of the business. The solution ensures that every possible precaution is taken to safeguard against missed, delayed or incorrect data entering the processing lifecycle.

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169

Key points


Headquarters: London, UK;




Private;




Founded in 2000;




Employees: 420.

Revenues


$50m **Estimated 2005 by Financial Insights.

Architecture


Operates on client/server, client/mainframe or Unix environments;




Provides web-based connectivity and analytics;




Full XML capabilities across all solutions.

Strengths


Strong reconciliation management functionality;




Integrated workflow management capabilities;




Integrated solution stacks for different business activities across capital markets firms.

TATA C O N S U LTA N C Y S E R V I C E S


Headquarters: Mumbai, India;




Public;




Bombay Stock Exchange – 532540;




National Stock Exchange – TCSEQ;




Part of the Tata Group;

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Founded in 1968;




Developed NCS in 1995;




Employees: 41,000 worldwide;




450 dedicated to NCS;




Clients (444 worldwide for TCS);




180 clients in Banking/Financial Services (BFS group);




12 clients for dedicated NCS Corporate Actions.

Revenues


Total $2.24Bn;




Revenue Sources (Global).

Architecture


Operating system and RDBMS agnostic;




Runs on any application server;




Primarily implemented on UNIX;




Repository based environment – Component based architecture;




Full customisation of interfaces at implementation;




J2EE compliant;




Web-based information inquiry.

Strengths


Leveraged development model provides cost advantages;




Strong capital markets/financial services expertise;




Offer multiple, integrated capital markets application solutions;

VENDOR LANDSCAPE




171

Strong services organisation to support planning, integration, customisation and implementation efforts.

VERMEG, MEGACOR Megacor offers end-to-end processing to monitor full CA life-cycle and includes full links to internal and client processing, and sub-custodian and CSD processing, the product includes fully integrated claims management functionality.

Key points


Headquarters: Paris, France;




Private;




Founded in 1994;




Employees: 250.

Revenues


$35m Estimated 2005 by Financial Insights.

Architecture


N-tier J2EE;




Thin client interface over web browser;




Runs on any J2EE compliant applications server;




RDBMS independent.

Strengths


Megacor is an integrated component of a suite of capital markets automation solutions;




Capital markets automation suite proven in European sell-side and buyside institutions.

G LO B E TA X GlobeTax specialises in withholding tax processing, a niche area of corporate actions. The firm launch a SWIFT based service bureau in 2005

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allowing custodians to send and receive tax related data and make tax processing STP.

Key Points


Offices: New York, London;




Subsidiary GlobeTax Data Services specialises in market reference data tools;




Private;




Founded 1992;




Employees
40;




Benchmarks: Volume
1m reclaims p.a.; 0% fails.

Architecture


Format: ASCII, ISO 15022;




Transport: SWIFTNet, FileAct sftp, secure email.

Strengths


Company process over a million reclaims a year with a zero fail rate since 1992;




Electronic sign-up process allows users to leverage global operations from one hub;




They are already the processor of choice of all the ADR sponsoring banks;




Member of the SWIFT Data Distribution Service.

OTHERS Trace financial A wholly owned subsidiary of FTSE listed Trace Group plc. Trace Financial, is a specialist provider of application integration software, corporate actions processing, real time trading and advanced message transformation solutions for financial markets worldwide. Since 1998, Trace Financial has 9 years SWIFT Ready EAI Gold accreditation and a global

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173

customer base of many investment, commercial and retail banks, broker dealers, asset managers and pension funds. CAMS – configurable corporate actions management solution with several live sites. Transformer – pure java and XML based message transformation toolkit, incorporating advanced data typing and data dictionary technology. Cloverleaf®finance – non-invasive message integration, translation and routing toolkit. Real-time – scaleable, resilient, real-time electronic trading architecture delivering global order books and enterprise wide electronic trading 24x7.

ADP BROKERAGE SERVICES Key points


Headquarters: Jersey City, NJ;




Public:





Founded in 1963:





NYSE – ADP.

Purchased US Clearing Corp in 2004.

Employees: 32,000 globally across all business units.

Architecture


Fully outsourced solution.

Strengths


Integrated front-to-back corporate actions tracking and processing;




Multiple options for managing elections notification and decision capture;




Various ways to interface with corporate actions processing services.

CHAPTER 11

Corporate Governance In this chapter we look at four issues that are to a large extent inter-related, although at first glance they may not appear to be so. The management of risk is not just about the hard issues of making processes more efficient with technology, although that is a large element. Managing risk is also about “soft” issues, rather a misnomer, of the impact of external influences. Corporate Governance has increased in importance over recent years. Corporate governance deals with the rights and responsibilities of a company’s management, its board, shareholders and various stakeholders. How well companies are run affects market confidence as well as company performance. Good corporate governance is therefore essential for companies that want access to capital and for countries that want to stimulate private sector investment. If companies are well run, they will prosper. This, in turn, will enable them to attract investors whose support can help to finance faster growth. Poor corporate governance, on the other hand, weakens a company’s potential and, at worst, can pave the way for financial difficulties and even fraud. Exercising the right to vote is therefore an integral and important aspect of good corporate governance for institutional investors. To be more precise the exercising of a right to vote against management is the ultimate sanction that a shareholder has and can be seen as a major step in meaningful engagement with the company. For custodians and, inter alia, the clearing and settlement space, the relationship between the board of an issuer and its investors is critical. As we’ve seen in this part alone, custodians can choose to engage in a large number of activities that, individually and collectively, bring them into connectivity with both ends of the investment management chain. In our current global economy, we usually follow a model that begins with best practice, failures lead to “self regulation” usually interpreted as the first “shot across the bows” from the regulators. Continued failures 174

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eventually lead to the regulators stepping in directly to the market. We have seen this on a number of occasions. MiFid is tasking the industry at present and a growing realisation that Sarbanes-Oxley’s provisions for good corporate governance are actually being cloned in a number of markets (e.g. JSOX in Japan). The main thrust of much of this regulation is the requirement for good systems of internal control. As a commercial best practice this may be obvious, but the controls, logical in a commercial sense are increasingly not sufficient for the regulators. Underpinning all this is the fact that custody and clearing processes are essentially about information and information is underpinned by data. In the financial model the amount of data concerned is very large and very fragmented, hence the growth of the reference data community. Finally, in cases where even good reference data has supported a regulatory compliant business model, things can still go wrong. Securities class actions is a growing area of concern for both investors and custodians. So in this chapter we will take a look at the issues facing the market from each of these four perspectives.

R E G U L AT I O N Custodians are increasingly subject to regulation. An obvious statement one might say, but the degree of complexity involved is rarely well understood. At the last count, the typical custodian could expect any one of its operational processes to be impacted by anything up to twenty-four sets of different regulation. Typical examples would be: Data Protection

UCITS III

S.1441 NRA

AML

Sarbanes Oxley

Patriot Act

Gramm Leach Bliley

Freedom of Information

MiFiD Basel II

Safe Harbor IFRS

e-Commerce Directive SEPA

FTR ISO17799

… and many more. See The New Global Regulatory Landscape – Impacts on Finance & Investment McGill & Sheppey publ. Palgrave 2005. Some of these regulations relate to the custodian as a business in its own right and some apply to the business as a consequence of either its method of operation, the market it chooses to operate from or in or the types of customer it chooses to support. The primary impact of increased regulation is increased cost and for many custodians, the decision about whether to provide a particular custody

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product can often be driven by the perceived cost impact vs. the expectation of how much the market will bear these costs. This can drive custodians to limit their offering at best and, as has been seen in recent years, at worst selling off their entire custody business. Barings, Enron and Allied Irish Bank all serve as telling reminders that even the most seemingly secure of organisations can fall victim to undetected fraudulent trading. As history has witnessed, the penalties for mistakes are high – a loss of $700 million from a total of just fourteen fraudulent trades in the Allied Irish Bank instance – and few are immune. In the aftermath of these losses, more rigorous industry requirements to minimise the cost of capital adequacy and to provide more effective, timely, information have been instituted. In addition, the tragic events of September 11 have further focused industry attention on the need for effective operational risk management and comprehensive disaster recovery. Managing risk has therefore become a vital feature of best practice in modern financial markets with organisations beginning to examine their financial procedures and controls and reduce their exposure to operational risk. However, progress towards real-time transaction processing is currently slow. The majority of institutions today are only in the early stages of developing an operational risk measurement and monitoring framework. Most have some framework for managing operational risk on a daily basis, but few actively measure and report this risk. Much of the action taken by organisations to date has involved ensuring the replication of systems so that in the event of a disaster, recovery can be rapid. This choice of focus is understandable in the light of recent events, however, the Basel II and III Accords add impetus to the drive towards a more structured approach and the obligation to meet industry compliance requirements. The other extreme – impulsive deployment of costly specialist software and ‘rogue trader’ insurance to safeguard operations – is not the answer either. Instead, organisations must invest their money more wisely by implementing a mixture of tighter day-to-day operational controls and systems that are able to process transactions faster. The objective is absolute real-time. Banks recognise that they must equip themselves with both the technology and the mindset to deal with the pressures of the modern international banking world. There are many initiatives and technology solutions that profess to help banks address growing global competition, maturing customer demand, the threat of increased regulation and reduced trade-tosettlement times. But there are real dangers that banks are being pigeonholed and sold one-size-fits-all solutions when what they actually need is to consider what is right, practical and cost-effective for their own organisation.

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A case in point is the drive towards achieving T
1 and 100% Straight Through Processing (STP). The argument for T
1 has pretty much been won, and it’s no surprise when you look at the economic justifications. A study commissioned by the Securities Industry Association has estimated that compressing the trade settlement cycle to T
1 will save the US securities sector $2.7 billion a year. With current levels and existing settlement times requiring $1,250 million to fund failures the potential savings are high and escalating for Europe. As the daily numbers and size of cross border equity transactions continue to double, and values at risk quadruple, the cost of funding failure if the industry doesn’t improve its processing efficiency will hit $3,750 million in two years time (figures from the GSTPA). The consensus is that the key to achieving T
1 is to automate the tradeto-settlement process to achieve 100% electronic and automated transfer of all data and messages in the securities trading value chain. This will dramatically reduce the time it takes to confirm and settle trades, and eliminate the need for manual intervention, shortening trading cycles and providing less opportunity for human error. Operational Risk Management is the watchword on everyone’s lips at the moment. The events of 9/11, coupled with the industry-wide move towards T
1, have both increased senior level awareness of the importance of Operational Risk. Regulatory pressure from the Bank of England and the Basel II Accord seek to penalise banks if they fail to demonstrate adequate operational risk systems and procedures and add impetus to the drive towards a more structured, enterprise-wide approach. The challenge is to work faster, with tighter controls and less risk. The drivers for improved Operational Risk Management make sound business sense. However, the implementation of an effective Operational Risk Management strategy faces several hurdles. Firstly, the financial industry has witnessed a steady rise in the volume of transactions being processed. Attempts to apply the same manual control procedures and paper-based operations for 100,000 units as opposed to 1,000 units a day are no longer adequate. The time available to check transactions and resolve exceptions is also reducing due to increased volumes, progress towards real-time transaction processing and the move towards shorter settlement cycles. This presents a conflict for institutions – how do they increase the level of checks and controls as required by regulators while handling greater volumes in a shorter space of time? The second hurdle is legacy systems. Every institution has a major investment locked up in their existing processing systems and replacement is difficult to justify in today’s cost-conscious environment. However, these systems often fit poorly with the new requirements imposed by operational risk management policies. Legacy systems were designed for high volume processing, but in a transaction-by-transaction manner – as each deal is

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struck or as each payment is made on behalf of a customer. The steps involved are therefore predefined and rigid. Furthermore, there is no requirement to compare one type of activity or transaction with another or to compare today with last month or last year.

MiFiD The other major regulatory concern for the industry is the European Directive: The Markets in Financial instruments Directive (MiFiD). In early May 2005, the inaugural meeting of the joint working group of ISITC Europe, FIX Protocol, the Reference Data User Group and SIIA/FISD on the Markets in Financial Instruments Directive (MiFID) took place in London. The event was over-subscribed and played host to a lively debate about the technology implications of this massive directive: among the conclusions drawn was the assertion that MiFID is the biggest single issue facing the securities industry at the moment – but awareness of its impact is woefully lacking, particularly at senior management level within brokers, investment managers and banks. One potential stumbling block to MiFID preparations is the fact that much of the detail of the directive’s final requirements has still yet to be defined. Institutions cannot afford to wait any longer before beginning to act on compliance strategies and from a technology perspective this means making flexibility a key feature. Adopting a service oriented architecture approach will ensure you are able to make alterations later in the day to accommodate any changes made at a regulatory level. A key focus of the activity the MiFID joint working group undertakes on the industry’s behalf is standards: a standard protocol for communication and standardised terms for key reference data elements such as instrument and entity identifiers. Institutions seeking to ensure they are in good shape to comply with MiFID – and to reap increased STP and operational efficiency benefits – should participate in developing these standards via the key industry bodies mentioned above, as well as adopting a standards based approach in creating their technology architectures, otherwise their costs are likely to be higher than those of their peers. Massive as MiFID is, the size of the challenge it creates is exacerbated by the fact that it is only one of several key pieces of regulation with which industry participants must comply during the coming years. In order to smooth the process of both initial and ongoing compliance with regulatory requirements of all kinds, from MiFID to anti-money laundering to Basel II & III to SEPA to any European variant of Sarbanes-Oxley that is introduced, adopting a coherent business process integration, automation and monitoring strategy is vital.

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“Adopting a service oriented architecture approach is recognised as one of the best ways to ensure firms are able to make alterations late in the day to accommodate any changes made at a regulatory level.” MiFID is a major piece of regulatory activity in the European Financial Services Action Plan that, along with other directives such as the Risk Based Capital Directive (formerly Basel II), threatens to place enormous strain on the IT organisations of most financial institutions. While MiFID’s goals of harmonised regulation across the expanding EU and improved market integrity through best execution and increased transparency are laudable, and even desirable, the directive is extensive in both breadth of application and depth of detail. Many financial services firms will have to consider seriously the implications both to their businesses and to their operational procedures, but one thing is absolutely certain – MiFID is going to give IT organisations a major headache. The articles within MiFID can be arranged in three groups:


investor protection;




market integrity measures;




general provisions.

Table 11.1 shows the likely level of impact of the MiFID measures on IT. While MiFID will have a wide-reaching impact on the IT implementations of any financial services companies falling under its reach, the Table 11.1

Impact of MiFiD sections on IT

MiFID area of impact General Provisions Client Classification Agreements Conflicts of Interest

Extent of impact on IT

Medium Low

Investor Protection Information Disclosure (Outbound) Information Disclosure (Inbound) Best Execution Process Client Order Handling

High High High High

Market Integrity Transaction Reporting Pre-Trace Disclosure Post-Trace Disclosure Record-keeping

High High High High

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timeframe has been equally aggressive. The details of MiFID are still being finalised by the Committee for European Securities Regulators (CESR), after which the various European regulators will execute their own processes to formalise the changes required. In fact a number of Member States, having missed the January 2007 deadline to transpose MiFID into their local laws, may even have missed the November 2007 implementation date. As a result, the precise details of what will be required from investment companies and banks are highly unlikely to be fixed in time to take definitive action to comply. The implementation date has already been moved 18 months and is now immovable at November 2007, but even this new date still leaves far too little time from the finalisation of requirements for a major IT project to be completed. Many companies have realised that the only choice is to start implementation in parallel to the MiFID requirements definition process, starting immediately. This is a difficult exercise, of course, like trying to hit a moving target. In fact, the IT implementation to support MiFID is likely to become an increasingly major element of a custodian’s competitive differentiation. In essence, MiFID is about commoditisation of services. The directive spans the entire investment business process cycle, while going to a far greater level of detail than ever before, harmonising activities and levelling the playing field for all companies within the marketplace. As a result one of the few areas of competitive differentiation remaining will be how support is implemented and how efficient and effective the resultant systems are. In IT terms, a lot of the challenges of MiFID stem from the need to have integrated operations spanning the whole investment lifecycle which of course is a fundamental element of managing risk. MiFID makes demands on sharing information between different applications, integrating front, middle and back office operations internally and in particular on carrying out extended operations that cross national borders and involve other business entities. It is this area of integration that lies at the heart of the IT challenge, since integration is a complex and error-prone area. While specific details of implementations will obviously depend on the specific individual scenario, there are a few broad-brush recommendations that companies should consider in order to cope with MiFID, namely choosing the right approach and getting the right tools in place. The first point to make is that it would be most unwise for companies to attempt to implement MiFID support as one large project. Given the compressed timescales and the extent of changes, the best approach is likely to be to split the project up into a number of smaller ones. This has many benefits. It may be possible to get going on areas where details appear to be already ironed out and it reduces the likelihood of arriving at the implementation date with nothing completed. It also allows companies to select

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sub-projects that have a benefit regardless of MiFID. Some of the MiFID requirements would probably be sensible from a business perspective even if MiFID were to radically change, and tackling these ones first reduces the risk of investment being wasted. For example, the requirements on improved information disclosure between clients and investment companies might improve client satisfaction and reduce risk. One architectural development receiving a lot of attention currently is that of the Service Oriented Architecture (SOA). An SOA turns IT components into reusable ‘black-boxes’ that can be combined to deliver specific business services. These components and services can be invoked from anywhere across the business without any knowledge of where they will run or what technology and environment it uses. Once the approach has been set, it will be vital to ensure that the right tools and technologies are in place to deliver the required business functionality quickly, flexibly and with minimal risk. Again, as in the case of adopting an SOA, this is likely to provide benefits both within and outside a MiFID context. Three critical areas of functionality are:


Integration;




Business Process Management (BPM);




Business Activity Monitoring (BAM).

MiFID contains many requirements that need integration technology. Trade information will need to be gathered from numerous different exchanges and correlated to support best execution, new requirements on client communications will require information such as charges and commission details to be provided earlier in the relationship, client profiles must be put in place and maintained regularly and pre/post trade information will be more detailed. These changes will increase the need for applications to integrate with one another, making an SOA and associated integration suite vital. In order to improve flexibility even more, companies can move towards using a BPM tool. This enables operational processes to be modelled and automated as required by new regulations and requirements at a business level, removing some of the need to understand the IT implementation details underpinning them. As MiFID requirements are refined, modifying the existing operational processes, the BPM approach ensures that these changes can be implemented much more quickly. Finally, once processes can be understood and managed at a business level, it becomes possible to implement business-level monitoring capabilities through the use of BAM technology. This can be particularly useful

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from both a compliance and iterative process improvement perspective. Since MiFID will be part of the regulated financial services environment, it will be important to be able to demonstrate that compliance is being managed. Indeed, MiFID increases the focus on compliance with its requirement to ensure that the compliance department is completely separate from the operational side of the business. BAM provides a mechanism for a compliance team to be alerted if some aspect of MiFID is being transgressed. From a process refinement point of view BAM tools make it possible to constantly monitor the performance of the business in real time, for example against a set of key performance indicators. This enables management to take decisions to optimise operations on a continual basis, and provides the information needed to understand the causes in the event of the business performing unsatisfactorily. The following three examples provide scenarios of MiFID-related challenges and how they might be addressed. These examples are highly simplified, but serve to illustrate how these technologies can help in delivering MiFID support.

SERVICE ORIENTED ARCHITECTURE (SOA) MiFiD and objective setting As part of the investor protection section of MiFID, a signed agreement is required before portfolio management services can begin, specifying such things as the objectives of the investment, what instruments will be used and the reporting of losses above a certain amount or percentage. Part of the execution flow for portfolio management might be as follows:

Portfolio Evaluation

Porfolio Management System (UNIX-based)

Loss above threshold?

NO Continue

YES SOA-based intergration between systems Drive client Technology independence communication service Process flexibility Client communication service

Figure 11.1 MiFiD and objective setting Source: Bob Fuller

Client-facing System (Windows-based)

CORPORATE GOVERNANCE

Trading Service

Information disclosure service

BAM tool monitors operations Exception Detected

183

Continue

BAM tool enables drilldown Corrective action Process improvement

Monitor speed of post-trade disclosures against corporate policy

Figure 11.2 MiFiD and transparency Source: Bob Fuller

The key point to be drawn from this example is that an SOA-based integration environment makes it easy to update the operational flow to accommodate the regulatory change. Because SOA-based integration provides a clean, service-based interface to IT components with no need to understand their technology or platform environments, the change is easy to implement. In fact, if a BPM solution is also in place then the change does not require any programming at all, but can be achieved through manipulating a process flow diagram.

MiFiD and transparency One of the stipulations of the transparency rules within MiFID is that posttrade reporting of volume, price, time and venue of trade and other required information has to be carried out as close to real-time as possible. The right selection of integration tools and architecture can not only make this easier to achieve, but can also ensure that this key performance indicator can be monitored, measured and improved and that exceptions can be spotted and addressed. This illustration demonstrates how BAM technology can be used to manage business performance against corporate policy. It is important to note that this ‘management’ has three distinct parts:


Key performance indicators are monitored to provide the necessary information in the desired format for executives to gain a clear picture of business performance;




When an exception is spotted, the technology needs to provide the mechanisms to dig into the problem and identify what has happened, and to take corrective action;

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The BAM technology should be able to add value by ‘learning’ what collective events caused the exception with a view to being able to warn of a likely future occurrence before it actually happens. This last piece enables companies to continually improve operational efficiency and effectiveness.

MiFiD and record keeping Part of the market integrity drive involves a higher degree of regulation in the area of record-keeping. In the case of dealing, record-keeping requirements are more extensive than previously, including items such as execution venue and dealer identification. In addition, CESR is suggesting that for orders executed in tranches full details need to be presented on each tranche. Current operations usually do not require this for tranches executed within the same day. However this is quite a controversial measure and it remains to be seen whether this will indeed be a formal requirement. By implementing the SOA-based, service led, integration approach, companies can protect themselves to some extent from the uncertainty, as shown in Figure 11.3. Once the ‘Dealing report service’ is established within an SOA-based, integrated model, it becomes a relatively simple matter to switch the operational implementation to support the regulatory change if it indeed materialises. Using an SOA approach ensures that the service can be invoked transparently, while the integration technology enables the flow to be changed easily and connectivity to be established between the different computing environments.

MiFiD and compliance Compliance has a strong role within MiFID, particularly due to the MiFID flagship objectives of assuring market integrity and enhancing investor protection. One area that will be particularly important from a compliance

Tranche 1 Order Fulfilment

Tranche 2

Report aggregate deal information

Continue

Tranche 3 Change to report Dealing report service individual tranche information if needed

Figure 11.3 MiFiD and record-keeping Source: Bob Fuller

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Continue

Activity information Drilldown Discussions with trading management

BAM Tool Detect trader override of best execution Drilldown to identify trader Spot patterns if any Log occurrence Involve management as appropriate

Log violation Audit Service

Figure 11.4 MiFiD and compliance

perspective is that of ‘Best Execution’ trading. Investment companies will be required by MiFID to publish their policy on best execution, and then it will be up to the compliance department to monitor adherence to this policy and log any exceptions. Figure 11.4 illustrates how this might be achieved. The compliance officer is alerted by the BAM tool detecting that ‘best execution’ has not occurred, perhaps based on the trader choosing to override the process. The BAM software identifies the exception and alerts the compliance officer, providing enough information to allow the incident to be followed up. The lack of clarity and solidity surrounding MiFID combined with the aggressive time-frames means that much careful thought and positioning is needed to ensure successful implementation in time. By taking on board the powerful benefits of SOA-based integration, BPM and BAM technologies, financial services firms can ensure that they have the armoury to address the challenges and the flexibility to adapt to whatever else may come in the future.

R E F E R E N C E D ATA At firms grappling with data management on the vaunted enterprise wide scale, reference data issues are still pretty much front and centre and throughout the securities industry it remains a daunting challenge to bring it all together cleanly and reliably. But another category of data, sometimes viewed as a subset of reference data, is emerging from obscurity as a data management challenge. This problematic category “counterparty data” may, in its way, be more critical to getting data management right. While client counterparty data may be viewed as a lower priority than reference data, the risks of getting it wrong are much higher.

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Reference data comprises descriptive information about a security, whereas counterparty data generally refers to the entities with which a firm does business, such as trading partners and clients. Much of the impetus behind counterparty-data improvement comes from a wave of new regulations containing “know your customer” (KYC) requirements. The USA Patriot Act, for one, requires firms to track client information across asset classes, geographies and legal entities. U.K. anti-money-laundering (AML) regulations have corresponding provisions. Incorrect reference data can lead to failed transactions and operational risk; accuracy in this area is considered critical to straight-through processing and related efficiencies. But the damages from misidentifying a trading partner or client can have legal and other costly ramifications. To help securities firms meet KYC mandates, software vendors are offering software packages that automate the workflow of account opening and client enrolment, risk profiling and regulatory review. It is designed to help firms do customer due diligence. “With today’s compliance requirements, the process of new-client onboarding is completely different and much more burdensome. The much greater degree of due diligence required, the number of players in the process now and the consequences of getting it wrong are just a few of the reasons institutions are looking for ways to automate and organise the many tasks and workflows.” The Sarbanes-Oxley Act and the Basel II & III capital accords also carry substantial data management burdens. Basel II and III more directly affect counterparty data: One of the core requirements is that financial firms set aside sufficient regulatory capital to account for credit risk. There has been an underinvestment in systems, databases and processes that underlie the acquisition, maintenance and distribution of credit data. When systems are implemented, the tendency is to install them on a standalone basis and not as part of broader credit risk architecture. Furthermore, inconsistent data standards impede information transfer among the front office, operations and credit risk areas. Most financial institutions have advanced credit risk management capabilities, yet estimates show that 90 of the world’s top 100 banks are deficient in maintaining clean counterparty static data repositories, counterparty organisational hierarchies, netting and collateral agreements and common counterparty identifiers. A Fortune 100-size bank would need to spend up to $100 million to develop and build a fully integrated credit risk management system. Maintaining just the data could cost $5 million to $7 million annually and require a staff of up to 75. Under Basel II, which updates the global bank capital regime in place since 1988, financial institutions stand to benefit if they adapt a new internal ratings-based (IRB) approach instead of a standardised formula to measure

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credit risk. The IRB approach is more complex, but it allows companies to use their own data to determine risk weights. Many banks have a fairly good idea of what data is required and in fact have been collecting some of it on risk ratings, defaults and losses for several years. However, the quality, consistency and breadth of the data often fall short of the requirement to be externally auditable and verifiable.

DUAL WAREHOUSES Most companies always had a sense of the total exposure for a counterparty across a firm, but never to the full extent and detail that Basel II requires. Many organisations are looking to launch a data warehouse that will incorporate information from 40 different applications including a number of counterparty repositories for wholesale clients and for retail. Among the additional activities it should also cover are securities lending and the margin lending of any correspondent clearing subsidiaries. The ultimate objective is to derive general ledger proofing, regulatory reporting and credit risk analysis from the same data rather than using the nominal exposure for each counterparty, as is currently the case. While all counterparty data is now linked to credit ratings, the new data warehouse should capture the factors that contribute to the ratings assignment and store them along with historical exposure and ratings data. This will enable organisations to tie loan loss recovery and default data to the credit ratings data, which is critical to the Basel II validation process Ideally, firms should link counterparty data to reference instrument data. Not only do financial institutions maintain different databases for counterparty data and reference data, but there are multiple ones within different groups based on the type of financial instrument involved, the department receiving the information and the region completing the transaction. It is common to have more than a dozen databases storing counterparty data in incompatible formats. Such discrepancies create headaches for compliance departments, which must ensure that any counterparty’s associations are correctly identified, not linked to a terrorist watch list and not at risk of default. There are several keys to maintaining correct and complete counterparty data. First and foremost is to verify that the source of the data is reliable, but there is a dearth of product offerings in this area. The biggest challenge in the collection of accurate counterparty data is understanding the often complex registration and regulatory structures that exist across the multiple jurisdictions that financial institutions service. Determining a correct pedigree can be worth plenty. Any firm that held investments in Armstrong World Industries learned that the hard way when

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it went bankrupt in December 2000. Many players in the credit default swaps market could not recover millions of dollars in losses on contracts bearing that name as the reference entity the parties had relied on had changed its name to Armstrong Holdings, which did not guarantee any debt issued by Armstrong World Industries. The following year came the Enron blow-up: Without an organised data hierarchy of entities related to Enron, the connections among them were not immediately clear when Enron went bankrupt. The commonality between counterparty data used for both credit risk and compliance will drive convergence in the processes for creating and maintaining customer information. Losses attributable to credit derivatives transactions and fines from regulators for weak know-your-customer controls are spurring this process.

I N T E R N A L C O M P L I C AT I O N S Concerns about legal liability and ownership of data prompt many firms to rely on internal sources, but that isn’t a panacea. Firms often depend on their own disparate applications, but the problem is how to maintain the data clean. Key identifiers must be matched to reconcile data that is not entirely consistent, and each department viewing the data must be satisfied. Those include trading, risk management, customer service, compliance and more. It’s far more difficult to create a central repository for counterparty data than it is for reference data. There are far more discrepancies in counterparty data within a single firm than there are in reference data. Data from different sources may list the business and legal names in different ways. Then there is the challenge of data governance: Sales staff, credit risk, operations, trading and compliance executives all view the information differently, which can lead to internal disputes over how much information should be stored, in what form, and who should control it. Identifying a company’s relationship to sister corporations under the same parent may be ambiguous. For example, traders may want only the basics about a company-name and location – while sales managers may be interested whether a counterparty and its parent are over extending their lines of credit. Hence, it is difficult to satisfy all constituencies. Given the difficulties of creating a single repository, an alternative approach to keeping tabs on counterparty data is to map identifiers from disparate sources to a single counterparty identifier. This approach is quicker to implement and its cost is more manageable. Investment in a mapping process can be leveraged if and when a financial institution builds

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a new and more complex data warehouse. Getting the mapping figured out helps solve a critical risk management issue – exposure aggregation – before tackling tougher challenges such as implementing the data warehouse and a data governance system. Outsourcing the cleaning of data has won some converts in the reference data field; not so for counterparty data. There is a keen sense that the information is proprietary not only to the firm, but to each of the departments using it. Firms feel a proprietary data hierarchy sets them apart from their competitors.

CONTROL The establishment and maintenance of adequate systems of internal control are important responsibilities for management. After Sarbanes-Oxley, they are also now a regulatory requirement in law in many areas. Indeed, many firms that are subject directly or indirectly to SOX do not realise the fact e.g. non-US custodians that trade their shares in ADR form or that have clients that do so. See Sarbanes Oxley – Building Working Strategies for Compliance. McGill & Sheppey 2007 Publ. Palgrave. It is a misconception that the responsibility for implementing and administering the system of internal control belongs solely to financial officers, internal auditors, or executive management. A fundamental aspect of management’s stewardship responsibility is to provide all internal and externals stakeholders with assurances that resources are adequately controlled and financial statements are accurate and informative. An adequate system of internal control is necessary for the effective discharge of these responsibilities. Virtually all employees in financial services operations have a role in effecting control. They may produce information used in the internal control system or take other actions needed to effect control. All employees are responsible for communicating identified operational problems, deviations from established standards and violations of policy or law. Internal and external auditors contribute to the overall effectiveness of the system of internal control by periodically evaluating the effectiveness of controls within the system. This process provides the organisation with useful information for improving the system of internal control and is increasingly a regulatory requirement cf Sarbanes-Oxley. Generally, internal controls are methods and procedures used to safeguard assets and other resources and to ensure that those assets and resources are used as directed by management. A more formal definition is that internal control is made up of the plan of the organisation and all of the coordinated methods and measures adopted within an organisation to safeguard its assets.

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Controls can be characterised as either accounting or administrative processes or procedures.


Accounting controls – refer to procedures which ensure that assets are safeguarded and that financial records are accurate and reliable;




Administrative controls – include the plan of the organisation and methods that are concerned with operational efficiency and adherence to managerial policies and applicable laws.

An internal control can be detective, corrective, or preventive in nature.


Detective controls are designed to detect errors or irregularities that may already have occurred;




Corrective controls are designed to correct errors or irregularities that have been detected;




Preventive controls are designed to keep errors or irregularities from occurring in the first place.

Internal control for custodians consists of five interrelated components: the control environment, risk assessment, control activities, information and communications, and monitoring. Each of these components is an integral part of the management process and plays a specific role in departmental internal control procedures. Control Environment – the control environment sets the tone of the organisation, influencing the control consciousness of its people. It is the foundation for all other components of internal control, providing discipline and structure. Control environment factors include the integrity, ethical values, and competence of the organisation’s people; management’s philosophy and operating style; the way management assigns authority and responsibility and organises and develops its human resources; and the attention and direction provided by the board of visitors. Risk Assessment – every organisation faces a variety of risks from external and internal sources that must be assessed. A pre-condition to risk assessment is the establishment of objectives, linked at different levels and internally consistent. Risk assessment is the identification and analysis of relevant risks to the achievement of established objectives. Take a look at the departmental routines, activities, and personnel. Identify potential problem areas through direct inquiry. This in turn, allows management to form a basis for determining how the risks should be managed. Because economic, industry,

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regulatory, and operating conditions will continue to change, mechanisms are needed to identify and deal with the special risks associated with internal and external change that can affect the organisation. Control Activities – control activities are the policies and procedures that help ensure that management directives are carried out. They help ensure that necessary actions are taken to address any risks that threaten achievement of the organisation’s objectives. Control activities occur throughout the organisation, at all levels and in all functions. They include a range of activities as diverse as approvals, authorisations, verifications, reconciliations, reviews of operating performance, security of assets, and segregation of duties. Information and Communication – relevant information has to be identified, captured, and communicated in a form and timeframe that enables people to carry out their responsibilities. Under Sarbanes Oxley this will effectively be “real time”. Information systems produce reports containing operational, financial, and compliance related information that make it possible to run and control the organisation. They deal not only with internally generated data, but also information about external events, activities and conditions necessary for informed decision-making and external reporting. Effective communication also has to occur in a broader sense, flowing down, across, and up the organisational structure. Everyone has to receive a clear message from top management that control responsibilities must be taken seriously. They have to understand their own role in the internal control system, as well as how individual activities relate to the work of others. They have to have a means of communicating significant information upstream. The organisation must also effectively communicate with external parties, such as customers, suppliers, state officials, and legislators. Monitoring – internal control systems need to be monitored. Monitoring is a process that assesses the quality of the system’s performance over time. This is usually accomplished through ongoing monitoring activities, separate evaluations or a combination of the two. Ongoing monitoring includes regular management and supervisory activities, and other actions personnel take in performing their duties. The scope and frequency of separate evaluations will depend primarily on an assessment of risks and the effectiveness of ongoing monitoring procedures. Internal control deficiencies should be reported upstream, with serious matters reported to executive management and the board of visitors. No matter how well internal controls are designed, they can only provide “reasonable” assurance that objectives will be achieved. Some limitations are inherent in all internal control systems. Such limitations might

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include the following:


Human judgment – the effectiveness of controls will be limited by decisions made with human judgment under pressures to conduct business based on information at hand;




Breakdown of controls – even well designed internal controls can break down;




Employees sometimes misunderstand instructions or simply make mistakes. Errors can also result from new technology and the complexity of computerised information systems;




Management Override – high level personnel may be able to override prescribed policies or procedures for personal gain or advantage. This should not be confused with management intervention, which represents management actions to depart from prescribed policies and procedures for legitimate purposes;




Employee collusion – control systems can be circumvented by employee collusion. Individuals acting collectively can alter financial data or other management information in a manner that cannot be identified by control systems. In determining whether a particular control should be established, the risk of failure and the potential effect must be considered along with the cost of establishing the control. Excessive control is costly and counterproductive. Too little control presents undue risk. There should be a conscious effort made to achieve an appropriate balance.

Internal control objectives are desired aims or conditions for a specific event cycle which, if achieved, minimise the potential that waste, loss, unauthorised use or misappropriation will occur. They are the conditions that we want the system of internal control to satisfy. For a control objective to be effective, compliance with it must be measurable and observable. Internal audit evaluates the custodian’s system of internal control by accessing the ability of individual process controls to achieve seven predefined control objectives. The control objectives include: authorisation, completeness, accuracy, validity, physical safeguards and security, error handling, and segregation of duties. The Objectives:


Authorisation – to ensure that all transactions are approved by responsible personnel in accordance with their specific or general authority before the transaction is recorded;

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Completeness – to ensure that no valid transactions have been omitted from the accounting records;




Accuracy – to ensure that all valid transactions are accurate, consistent with the originating transaction data, and information is recorded in a timely manner;




Validity – to ensure that all recorded transactions fairly represent the economic events that actually occurred, are lawful in nature, and have been executed in accordance with management’s general authorisation;




Physical Safeguards and Security – to ensure that access to physical assets and information systems are controlled and properly restricted to authorised personnel;




Error Handling – to ensure that an error detected at any stage of processing receives prompt corrective action and is reported to the appropriate level of management;




Segregation of Duties – to ensure that duties are assigned to individuals in a manner that ensures that no one individual can control both the recording function and the procedures relative to processing a transaction.

When we recommend improving controls within a function, we often hear three basic arguments for not implementing our recommendations: there are not enough staff to have an adequate segregation of duties; it is too expensive; or the employees are trusted and controls are not necessary. These arguments represent pitfalls to unsuspecting management. Each argument is in itself a problem that needs to be resolved. In most cases, compensating controls can be implemented in situations where one person must do all of the business-related functions for a department. If implementing a recommended control seems too expensive, be sure to consider the full cost of a fraud that could occur because of the missing control. In addition to any funds that may be lost, consider the cost of time that would be spent by the department during an investigation of the matter, and the cost of hiring a new employee. Fraud is always expensive and the prevention of fraud is worth the cost. Finally, consider the issue of trust. Most employees are trustworthy and responsible and this is an important factor in employee relations and departmental operations. However, it is also the responsibility of management to remain objective. Experience shows that it is most often the trusted employees who are involved in committing frauds.

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We’ve looked at controls so far from a traditional management perspective. Let’s look at how the internal control environment is affected as business processes are re-engineered and management is decentralised. Dramatic changes are taking place in management practices throughout the world as organisations struggle to restructure and incorporate TQM and other management concepts. Command and control hierarchies are being replaced by flat organisations. Layers of autocratic managers and supervisors are generally being supplanted by self-directed work teams – at least in theory. Empowerment and integration are superseding limitation and segregation. Periodic external appraisal has given way to continuous improvement. These new management methods require new internal control models. The old paradigm that says that internal control is equal to management control is based on hierarchical organisations. Those at the top establish the need for controls by edicts commonly known as corporate policy. Everyone throughout the organisation is expected to abide fully and completely by corporate policies and procedures – and there are many supervisors, managers, controllers, and auditors to check and make sure they do. There are three basic management control models. The first two models reflect the traditional approaches to control and include the REACTIVE model and the PROACTIVE model. The third model, known as the COACTIVE model, is new and incorporates the concepts of self-directed work teams, empowerment and continuous improvement. In most custodians and in financial services in general, while new working practices are acknowledged, the inertia is such that moving to new methods is very slow, almost generational, to take effect. Typical financial services firms are highly “siloed” with only enough cross communication available to get the job done. Operations departments are particularly affected. However, even as the old City of London has moved to Canary Wharf, this exemplifies that new ways of doing things can make headway. In the reactive management model, controls are established in response to problems. Reactive management organisations operate in a continual damage control mode. Reactive management is typically slow to respond, and often the response is no longer appropriate because the problem has escalated. Proactive management attempts to avoid problem occurrence by frontending the reactive model with the identification of risks and subsequent establishment of control priorities and objectives. A weakness of this approach is that it requires that all potential problems be identified in advance. Sizable resources are required to perform adequate studies of business processes and systems so that risks can be identified and appropriate control mechanisms developed and implemented. Unfortunately,

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management usually doesn’t have the time to perform the extensive analysis required to identify all the potential problems that might occur. Another inherent fallacy in the proactive management model is that potential problems are never considered as important as the current problems that must be dealt with. The real purpose of internal control is not to control people but to control the business process. Coactive control brings the elements of people, empowerment, and process together in an efficient and productive relationship. People who hold power but are not involved in the process have little direct knowledge about the inner workings of the particular business process and, therefore, are not in a position to affect internal control. As a result, their contributions are limited to formulating directives, monitoring activities, and reward/punishment mechanisms. The traditional board of directors is a prime example. People who are involved in the process but without empowerment do what they are told to and are, in essence, controlled by the process. Their activities are controlled by directive and supervision. They are held responsible for doing their job and their job only. In the coactive model, the intersection of the empowered people and the process represents power relinquished to the process itself. This represents the bottom of the iceberg – the area where breakdowns occur and small problems grow to become large problems, and other unanticipated problems develop. Coactive control is people, with power, involved in the process. The key attributes of those in a coactive control organisation are commitment to group objectives; competence to fill the role they have assumed; collaboration with others to invoke synergy; and confidence in themselves and in those with whom they work. Coactive control is inherent internal control rather than imposed management control, shared inclusive commitment rather than indiscriminate functional compliance, and capability that is pervasive throughout the organisation, rather than isolated. The coactive model suggests that enlightened management can empower itself by sharing accountability for internal control with employees, customers, and suppliers. Based on the realisation that the most effective class of control is preventive and the most basic preventive control is commitment to a shared vision, future internal control efforts will focus first on those who are responsible for providing the vision rather than those who are supposed to follow the procedure. Internal control is more than a necessary evil required by auditors. It is good business, particularly acknowledging the complexities of custody and clearing systems. Internal control provides assurance that the custodian’s objectives are accomplished and that its (and its client’s) assets are protected.

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SECURITIES CLASS ACTIONS Securities class actions has, at the core, the principle of good corporate governance so we must remind ourselves of the basic principles of this before we move on to describe class actions and their impact on custody and clearing. Corporate governance refers to methods, laws and policies that direct, control and administers important functions of a corporation. That, in financial services, can apply equally to the Issuers of securities as well as the custodians, brokers and other intermediaries themselves. Typically, corporate governance is managed by the principal stakeholders in a corporation – mainly the shareholders, management and board of directors. Corporate governance is a broadly defined subject. It includes, and often focuses on, accountability and fiduciary duties, but also includes company performance duties, as well as duties to other stakeholders other than shareholders (mainly employees). The main objective of corporate governance is to ensure that the aims of the management of the corporation are in line with the aims of the other major stakeholders. This is important since those that manage a modern corporate organisation are typically not the same people as the shareholders of a corporation. By ensuring that objectives are aligned through a corporate governance system, other stakeholders are able to make sure that their rights are protected and that the corporation is working towards maximising shareholder value and fairness. The most common principles of good corporate governance include:


Rights and fair treatment of the shareholders, including proper communication;




Rights and fair treatment of the other stakeholders (including employees, customers, suppliers, banks, other lenders, the local community, the environment, and regulators);




Role and responsibilities of the board of directors, including full disclosure on how board members are nominated and selected;




Disclosure and accounting transparency, including information about the role of executives, board members, performance objectives and goals, and financial documentation;




Ethical behaviour and corporate integrity.

Recent events, especially those that came to light around major business failures such as Enron and WorldCom, have reinforced the need for greater

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corporate governance. Much of the drive for improved corporate governance is coming from stakeholders themselves (shareholders in a corporation definitely want to protect their investments), but some of these changes are coming about as a result of governmental level pressure. Governance describes the process of decision-making and the process by which decisions are implemented (or not implemented). Good governance accomplishes this in a manner essentially free of abuse and corruption, and with due regard for the rule of law. Good governance defines an ideal which is difficult to achieve in its totality. However, to ensure sustainable human development, actions must be taken to work towards this ideal. Major donors and international financial institutions, like the IMF or World Bank, are increasingly basing their aid and loans on the condition that reforms ensuring good governance are undertaken. Good governance can be understood as a set of 8 major characteristics: 1. participation; 2. rule of law; 3. transparency; 4. responsiveness; 5. consensus orientation; 6. equity and inclusiveness; 7. effectiveness and efficiency; and 8. accountability. The purported purpose of class action lawsuits is to give investors the ability to take on the largest corporate or private entities (who can afford the very best legal services) and have a chance of redressing the wrong done by these entities. It is important to remember that even though the actual damage or cost to the individual class member may be small, the illicit gain to the corporate entity can be huge if done to hundreds or even hundreds of thousands of class members. Corporate wrongdoing within companies worldwide (highlighted by high profile cases such as Enron, WorldCom, Royal Dutch Shell and more recently Parmalat), have resulted in serious losses for the underlying shareholders.

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The Private Securities Litigation Reform Act under US law, passed by US Congress in 1995, allows disadvantaged shareholders to recoup funds lost as a result of corporate wrongdoing with no financial outlay by using securities class actions. Whether it is the investor in the sometimes enviable position of being the person who first brings the suit to correct a wrong or the investor who just doesn’t want to get washed down the drain and go silently into the night, the first thing to do is engage competent legal council. Almost all class actions which have merit are taken on a contingency basis. Your attorney or attorneys are going to pick up and incur some very heavy expenses. From the custody and clearing perspective, these issues are important because the custodian is the safe-keeper of the assets (issuer’s shares) and, as we’ve seen in Chapter 8, sometimes also the administrator. So a pension fund for example, who believes that it has a case against an issuer, will need to use the custodian’s records of safe-keeping to underpin its case. There is also a dichotomy of course in that the same institution may, acting in the role of paying agent, be engaged by issuers who wish to raise capital in the market through bond issues for example. So this is an extremely sensitive issue for custodians. The Issuers are going to be looking to stop the outflow of time and cash and get some return and will be looking to settle the case. Investors who have received a notice that they are a class member often have a very limited period of time in which to find legal council and evaluate their position and once the “opt-out” date has passed, viable options are very limited. Investors should remember they don’t even have to receive notice of the class action to be bound by the “opt-out” date, the final settlement reached, etc. … Almost all securities class actions are brought on a contingent basis, which means that the attorneys only get paid out of any recovery amount they obtain. This system helps to ensure that many investors and consumers with small losses can easily afford to bring class actions to assert their rights. A securities class action case may be brought against a company whose actions have damaged many people in a similar way. If the case results in a successful recovery, either through settlement or trial, all class members receive their portion of the amount paid. It is common that after the action has been started for many other injured parties to join the class suit. Obtaining funds due to disadvantaged shareholders is nowadays no longer an issue. There are so many ways of obtaining funds from the guilty parties e.g. by suing the Directors or Officers of the company, their insurers, the company itself, the company’s insurers, the company auditors, their insurers etc. Every year hundreds of millions of dollars are lost simply because they go unclaimed. Many Global funds that are eligible to participate in

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securities class actions do not do so for various reasons:


A misconception that a lead plaintiff position is the only option available;




Unaware of the class action or difficulty in sourcing accurate and timely information of cases filed;




Time frames for participation are often limited




The paths available to legal representation are predominantly US based;




Lack of appropriately skilled resource with expertise/knowledge of securities class actions.

Ensuring that funds due to a client reach that client is a fiduciary responsibility. Investment managers, individuals, pension funds and charities etc. are not getting access to money that is rightfully theirs. Class action securities fraud filings plunged to a record low in 2006, a year characterised by a strong stock market that exhibited lower volatility and an increased focus on corporate controls. The 110 class actions filings in 2006 represent the smallest number of filings in a calendar year since the adoption of the US Public Securities Litigation Reform Act [“PSLRA”] in 1995. Filings are down by 38 percent from the 178 filed in 2005 and are 43 percent lower than the ten-year historical average of 193. The decline from historical average is statistically significant. This sharp decline in the number of companies sued in class action securities litigation began in the second half of 2005 and has now continued for 18 months. Class action lawsuits by investors such as pension funds etc. may offer a number of advantages because they aggregate a large number of individualised claims into one representational lawsuit.

Table 11.2

Complaints filings box score Average (1996–2005)

Class Action Filings Disclosure Dollar Loss ($ Billions) Maximum Dollar Loss ($ Billions) Source: D. Monks

193 $124 $680

2005 178 $93 $362

2006 110 $52 $294

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CAF IndexTM – Number of Class Action Filings 1996–2006 240 1996–2005 Average (193)

228 208

214

211 188

174

178

179

176 110

112

90

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

Note: 2005 and 2006 figures include options backdating cases (represented by shaded areas).

Figure 11.5 Class actions filings 1996–2006 Source: D. Monks

1. Aggregation may increase the efficiency of the legal process, and lower the costs of litigation. In cases with common questions of law and fact, aggregation of claims into a class action may avoid the necessity of repeating days of the same witnesses, exhibits and issues from trial to trial; 2. A class action overcomes the problem that small recoveries do not provide the incentive for any individual to bring a solo action prosecuting his or her rights. A class action solves this problem by aggregating the relatively paltry potential recoveries into something worth someone’s (usually an attorney’s) labour; 3. In “limited fund” cases, a class action ensures that all plaintiffs receive relief and that early-filing plaintiffs do not raid the fund (i.e., the defendant) of all its assets before other plaintiffs may be compensated; 4. A class action in such a situation centralises all claims into one venue where a court can equitably divide the assets amongst all the plaintiffs if they win the case.A class action avoids the situation where different court rulings could create “incompatible standards” of conduct for the defendant to follow. For example, a court might certify a case for class treatment where a number of individual bond-holders sue to determine whether they may convert their bonds to common stock. Refusing to litigate the case in one trial could result in different outcomes and inconsistent standards of conduct for the defendant corporation. Thus, courts will generally allow a class action in such a situation.

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Class-action lawsuits are an important and valuable part of the legal system when they permit the fair and efficient resolution of legitimate claims of numerous parties by allowing the claims to be aggregated into a single action against a defendant that has allegedly caused harm. There are however several criticisms of class action lawsuits. The preamble to the US Class Action Fairness Act stated that class actions harmed class members with legitimate claims and defendants that have acted responsibly; adversely affected interstate commerce; and undermined public respect for the country’s judicial system. Class members often receive little or no benefit from class actions. Examples cited for this include large fees for the attorneys, while leaving class members with coupons or other awards of little or no value; unjustified awards are made to certain plaintiffs at the expense of other class members; and confusing notices are published that prevent class members from being able to fully understand and effectively exercise their rights. These comments of course are oriented to the consumer market. In financial services the situation is relative. While the legal costs involved in class actions may be very large, the investors, particularly institutional investors such as hedge or pension funds are no small-time entities themselves. Still, the pack mentality of class actions can give them a benefit. Similarly, for custodians, the complexity of the trade and settlement process as well as all the complexities evidenced in this book in asset servicing, all serve to highlight that class actions have applicability, even when the defendants are major institutions.

CHAPTER 12

Network Management The third key way in which the risks associated with custody on an international basis can be mitigated is through good relationships between partners with specialist knowledge and expertise. So-called network management therefore is aimed at creating a robust and clear set of guidelines by which different parties can contribute to the common objective of both extending value added services to clients and also mitigating the cost and associated risk of having to be a specialist in every area.

KEY ISSUES FOR DELIVERY The primary document which helps achieve these objectives is the custody agreement. As well as the usual suspects – compliance, law and operations, it is good practice to engage a network manager in the process as there needs to be someone in the process who can have an holistic viewpoint and ensure that, while meeting the specialists’ needs, the business needs are not forgotten. In course of negotiating the custody agreements, the network manager should seek independent legal advice where appropriate. Nowadays, however, there are standard agreements which have consolidated many legal advisor’s views. Some best practice guidelines are given below which should be considered in line with the sample custody agreement in Appendix III:


Ensure that the length of time that is acceptable from the time a trade has been executed in the market to the valid instruction being received is specified;




The agreement should specify the type of instruction that is acceptable i.e. SWIFT etc. The use of fax or any non standard instruction should be

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discouraged. It is now normal practice to be charged to receive instructions that will be handled manually;


The Agreement should list the markets;




The custodian should be liable for any loss suffered by the client as a result of negligence, willful default or fraud in its part;




The custodian generally does not take responsibility for any losses due to late or insufficient notice;




It will be the responsibility of the sub-custodian to inform the client of any corporate action events as soon as the sub-custodian receives notification on them. Necessary systems should be in place to ensure that the clients get timely, accurate and complete details of corporate actions. The agreement should specify the extent to which the custodian accepts liability for any loss;




It is normal that the sub-custodian is indemnified against all claims or costs in the event of proper execution of the instructions;




The sub-custodian should guarantee to maintain the confidentiality of the account;




The basis for charging should be clearly detailed and any securities lending activity should only take place providing the beneficial owner agrees to this;




The ability of the agent to use other agents should be specified, as should the extent of liability of losses;




In the US the custodian must supply a report on the market’s non-performance that the fund may be invested into. This should cover legal, credit and risk issues;




The sub-custodian should not be expected to accept responsibility for broker risk;




The sub-custodian is required to provide a full audit trail for money and securities managed under the agreement. These records should be made available for inspection by third parties;




All settlement should be on a delivery against payment basis. Where this is not practical the extent of liability should be defined. It is normal that the custodians will not accept liability for market risk;

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Provisions for termination of the agreement should be outlined. Normally this is within 90 days notice;




The agreement should outline whether or not it is acceptable for the fund to overdraw its cash account and what action the custodian will take;




The agreement should set out reasonable out of pocket expenses incurred in performing the work on behalf of its client;




The custodian should ensure that it has proper safeguards in place to protect itself from interest claims arising from failed trades and correspondingly pursue interest claims against counterparties that fail to settle on time;




The agreement should specify the jurisdiction that applies in case of dispute.

The following services are generally regarded as the core custodial services and should be covered by the agreement.

Safekeeping Assets under custody must be protected in a secure environment regardless of whether they are held physically or in book entry at the local CSD. Securities held physically are generally kept in a vault at the sub-custodian. The depository does not record the interest of each investor, but instead records the interest of the intermediary. Therefore the interest of the investor only appears on the books of the intermediary.

Trade settlement When an investment manager executes a trade with a broker, the investment manager sends a settlement instruction to the custodian. The instruction will have the details of the trade and the counterparty. The instruction will normally be either a DVP or a RVP. If a trade is in one of the sub-custodians markets, the custodian is responsible for instructing the sub-custodian to settle the trade. It is the sub-custodian that actually arranges the movements in the local depository or clearing agencies, in accordance with the local settlement practices.

Income collection One of the main responsibilities for a custodian is the timely crediting of income due to the client from investments held in the client’s portfolio. An

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example is the receipt of a cash dividend or interest income received. Custodians need to be aware of any income events affecting securities under their care. This is often accomplished by contracting for the services of various data vendors. They will provide information regarding the terms of the issue, income schedule and dividend announcements. An investor with a diverse portfolio spread over many markets may experience difficulty in reconciling income. Many dividends may not be received for days after announcement of payment date. This hinders cash flow management and projection. To overcome this many custodian offer a service which is called contractual income, where the custodian contracts to credit the client’s account for any dividends on payment date, regardless of whether the custodian has actually received cash. The custodian reserves the right to reverse the payment should the company default on their dividend payment. Contractual income is normally only offered in well developed and regulated markets. In emerging markets income is paid on actual receipt. Income in this case can also include income from entitlements to over-withheld tax, although this is not often seen as core and is offered as an extra chargeable item, so-called “contractual tax”.

Corporate action, notifications and processing A corporate action can have significant impact on the value of the security and therefore on the value of the portfolio. Monitoring and accurately processing corporate actions on the securities held under custody is one of the key responsibilities of the custodian. The custodian must be aware of any pending action, and as a result have contracted with a number of news services and data vendor feeds in order to receive daily information regarding corporate actions. Additional information may also be obtained from depositories, sub-custodians or even issuers. There may be restrictions on who can participate in a corporate action such as residential or territorial restrictions which may apply to the registered holder or underlying beneficial owner.

Proxy notification and voting A proxy is the authority or instrument that transfers a shareholder’s voting rights to an agent of the shareholder. Proxy may mean a person empowered to act as an agent in place of the shareholder. The custodian will act as a proxy when clients choose to exercise voting rights stemming from their holdings in companies. Securities that are lent lose their voting entitlements. There are specific voting rules relating to each market and the network manager and the custodian must be fully aware of them. Proxy voting rules can block the trading and settlement of shares while voting takes place or while shares are out for registration. Market rules stipulate that the votes be

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cast in a certain way i.e. in person, by mail, or electronically which is increasingly becoming a trend especially in the mature markets. In some markets, once a vote is lodged, the holding at the registrar is frozen and cannot move until after the shareholders’ meeting. Some examples: Austria – Shares are blocked from the date of pledge until the day after the AGM; Belgium – Shares are blocked 3–6 days prior to the meeting; Germany – Shares can be blocked by the custodian, but not on the market; Ireland – Share not blocked; Italy, France – shares are blocked 5 days prior to the AGM; Japan – Only registered shares can vote – this can take 1 month.

Foreign Exchange The custodian, acting as principal, can be engaged to provide currency conversions into or out of the client base currency. Often standing instruction engages the custodian to convert income received into the base currency. Many custodians charge an extra fee for FX transactions that are carried out with a third party in order to cover the extra costs and risks associated with this type of transaction. To ensure settlement on time all FX trades executed should be advised within one hour of execution.

VA L U E A D D E D S E R V I C E S Cash management This refers to the short term investment of cash to allow the fund to earn a return on cash that has not been invested. Custodians need to provide real time updates on account activity so as to effectively monitor non-invested cash. The need to ensure options is provided for investing cash that is not invested. This could include overnight deposit sweep facilities for balances that remain in accounts. This may involve off balance sheet transactions.

Risk and performance measurement This involves the use of technology based products, which re-package the information. This can include products that measure risk or volatility and can provide comparisons with industry performance benchmarks.

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Securities lending This involves the lending of client assets to borrowers for a fee. See chapter 9. The investment of cash collateral is the primary source of revenue for securities lending activities. Industry practice is to require collateral in excess of the market value of the securities loaned. Collateral margins vary by markets, and by type of collateral provided. Generally for domestic loans the collateral requirement is 102% and for cross border loans its 105%. The excess collateral serves as a safeguard against counterparty credit risk. The lending agent, i.e. the custodian, agrees to pay interest known as rebate to the borrower for the use of cash collateral. The higher the demand is for the security the lower the rebate that will be paid. Cash collateral is then invested by the custodian in accordance with the custodian’s investment guidelines. The objective is to generate a higher yield on the reinvestment of cash collateral than the rebate rate. The earnings generated above the rebate rate, the “the lending spread”, represent the profit which is then split between the custodian and the client.

Withholding tax/tax reclaim In many markets, dividend income and interest on bonds is subject to withholding tax and various other local charges. See chapter 6. Increasingly, investors have placed a great deal of emphasis on efficient tax management. With double taxation agreements in place between many countries, it is possible to gain relief from withholding tax so as to avoid the investor being double taxed, or to avoid the expense of having to reclaim withholding tax. Typically the custodians provide a tax reclamation service that offers investors the following:


Accurate assessment of the tax situation;




Exploring all tax benefits relevant to the clients situation;




Arranging tax relief at source, by ensuring that the required tax forms are completed in advance of dividend or interest payment. It may also involve the completion of the necessary local documentation.

Accounting/reporting This may involve the pricing of the securities in the portfolio on a daily, weekly or monthly basis. It may involve keeping track of expense accruals and payments, capital purchases, contributions and disbursements. It will involve the calculation of the net asset value (NAV) of the portfolio.

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Custodians may provide trustees and investment managers with products which facilitate the compliance monitoring, testing and reporting. Some custodians will draw the distinction between the customers that only require the core services and those that require the additional value added services. They see themselves as acting as pure custodians for the former and as master custodians for the later. Custodians are constantly developing new added value services and moreover, value added services are gradually being re-classed as core services to enhance their competitiveness. The Network Manager, when choosing the supplier of services, will need to decide upon the service or combination of services that suits its specific needs. In making such a decision, the network manager will need to consider the nature and structure of the underlying clients in terms of assets under management. The network manager will need to factor in the ability of the supplier to adapt and evolve to future changing needs.

ROLE OF NETWORK MANAGEMENT The main role a network manager will have is to ensure that the detail of the custody agreement has been complied with and all fiduciary responsibilities that they have are carried out in full to protect the client bests interest and in particular their assets. The organisations may put in place a Service Level Agreement to reflect the buyer’s (Network Manager) and the seller’s (agent bank) requirements. The network manager’s role is increasingly focused on managing the risk profile of the market and of the chosen supplier – the sub-custodian. Clearly the process is complex and an important aspect to consider is the risk associated with the custodian’s role. From the account holder’s perspective, the areas that a sub-custodian needs to pay attention to include:


the holding of securities and cash;




act upon the settlement instructions received by the sub custodian, and to ensure that this has been sent by the account holder;




the delivery and receipt of any physical securities and cash;




the management of corporate events and provide a regular point of reconciliation of activity.

A failure to comply with the above points by the sub custodian introduces the risk of loss from the beneficial client and the global custodians perspective.

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The global custodian and the sub custodian need to remain vigilant regarding the authenticity of the settlement instruction. The responsibility for acting upon this instruction is typically detailed within the agent bank agreement. There is a choice as to whether to set up a network of agents or whether to set up direct relationships with the local CSD. This is where the network manager is responsible for ensuring a detailed due diligence has been done on the local market and the providers available to them. One area of consideration is cost. In some circumstances, it may be cheaper to set up and operate direct relationship with the CSDs or a local custodian rather than using a global custodian. In some cases the premium that the global custodian may charge may be appealing due to the value added services they may provide. Other areas that the Network Manager will need to factor in include:


The credit rating of the custodian;




Past performance;




Levels and efficiency of services;




STP rates;




Fail Rates;




Ability to process multi-asset classes e.g. equities, fixed income;




Effective cash management;




Interest on cash balances;




Overdraft facilities;




Methods of processing corporate actions.

The cost of operating these services normally includes components of the following:


Cost of securities holdings;




Cost per settlement;




Cost depending on whether its DVP;




Cost for cross border settlement;

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Cost for non STP;




Any discounts for higher volume;




Group discounts and any reciprocity;




Ability to process multiple currencies.

In the UK and European markets the task of evaluating, selecting and monitoring global custodians and related service providers is increasingly being enshrined in legislation and best market practice guidelines. The FSA, recognising the risk associated with custody in 2001, published the Conduct of Business Rules. This requires that the regulated firm must “establish and maintain a system for assessing the appropriateness of its selection of the custodian and to continually assess this appointment”. For those US firms listed on NYSE or NASDAQ and also non-US firms that list via ADRs, the terms of Sarbanes-Oxley may also apply. These rules now seen as best practice may be adopted in other markets. Clearly Singapore and Australia have rules that are similar in place already. A structured benchmark is required to ensure that the client fiduciary responsibilities and regulatory obligations have been met. Regular Health Checks are recommended. These review the existing arrangement and examine three key critical areas of the relationship with the provider.


Service Level Agreement;




Custody Agreement;




Fees and other commercial arrangements.

Service level agreements Clearly the SLA will define the high level description of what services are available, but does not always address the commitments that are normally required by both parties. Increasing client pressure is now requiring that the SLA does address all aspects of the service, from overall consistency of the relationship management staff, through to disaster recovery plans.

Custody agreement This provides the main overall focus as to the assets’ safety and any risk mitigation provisions and the extent to which the custodian will take the

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responsibility for losses and protect the client from risks in the market. Often contracts present a variety of risk evasive clauses and many have over the top protection in favour of the service provider.

Fees and other commercial arrangements Institutions often find that they have been disadvantaged by the fees in such agreements. Normally the ancillary cost items such as interest spreads, FX margins and securities lending splits have been ignored, and when taken in to account make a significant difference to the total cost of the custodian relationship. Many custodians will say off the record that over 50% of their income comes from non-headline fees. This means that the core custody processing and operations may be running at a loss. In more recent times, high value, high maintenance areas such as tax reclaims have been unbundled from the custody fee structure so that the custodian, and the client, can more accurately identify costs and benefits. Increasingly the findings from the heath check are so bad that they trigger a full review of the overall arrangements. Usually, when this happens the incumbent supplier makes strong competitive proposals to retain customers, however the relationship is, too often, beyond repair. They do say that it takes 7 yrs to win the business back once it’s lost. To complicate matters, any other competitive suppliers in the market will try to induce the move away by bundling additional services at a lower fee. In either case the incumbent custodian has lost. It will loose the business altogether or retain it with a reduced revenue stream attached to the relationship. While reviews are time consuming and costly, the pay back in terms of improved services, access to new technology, reducing risk further by improvements in STP and overall increased asset safekeeping provisions make it compelling to revisit the market on a regular basis. The rule of thumb is between 3–5 yrs. It has become a compliance driven obligation to demonstrate fiduciary responsibility.

Custodian benchmarking Benchmarking service against a stated SLA is and should be a mandated activity. However, obtaining universal data to ensure that service levels do not slip is difficult. Further regulatory interest will certainly help drive best market practice in this area. If the custodian knows that they are employing knowledgeable, experienced third party solutions to monitor the service delivery, it is more likely that the custodian will provide a superior service. Foreign exchange benchmarking will identify the effectiveness or otherwise of the currency execution received from the custodian.

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Securities Lending activity can be monitored to ensure that performance and return and the risks associated are clearly measured and monitored. Tax processing activity can be monitored using a variety of benchmarks some of which are internal and some useful as marketing benchmarks externally. See International Withholding Tax – A Practical Guide to Best Practice and Benchmarking. McGill 2004 Publ. Euromoney. As portfolio values increase and custodian competition for mandates accelerates, investors are well advised to put in place a process for evaluation, selection and monitoring tools. The costs of implementing such a framework could be high and may require executive approval. Failure to do anything may result in the CEO or CIO’s job retention being challenged by informed clients.

MAIN TYPES OF RISK Business Risk – is the risk of losing a client’s business due to pressure on margins, innovation, new laws etc. The network manager needs to be aware of clients won and lost annually. What looks like good value today may be expensive in the future should the provider exit. The network manager should ensure that they are dealing with a AA
custodian. Cash Flow – The custodian agreement should specify how cash flow is to be advised and credited to ensure that it is invested into the market properly and in a timely manner. It is good practice to advise the custodian of any new funding requirements. Agent Risk – The risk that the agent fails to settle its obligations for full value at any time, and the risk that such failure will trigger a chain reaction. This risk occurs when a participant is unable to meet its financial liabilities. The agent should be approved annually and it should be clearly established what risks are to be carried by both parties. Country Risk – this is the risk connected with holding assets in a foreign country e.g. political, economic, fiscal and legal changes or gaps in coverage. Investments in debt related securities have for many years been governed by country risk and investment rankings such as Moody’s and Standard and Poor’s which reflect economic, political, legal, financial performance and stability. Credit Risk – This is the risk that a counterparty will fail to deliver or pay in full on due date and be liquidated or go bankrupt. Foreign Exchange (FX) Risk – consists of two elements, pre-settlement or market risk, and settlement risk. With continuous linked settlement (CLS), the settlement risk is completely eliminated and all that remains is the market risk.

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Free Delivery Risk – At times the investment manager may enter in to an agreement with the broker to sell a stock and deliver it without receipt of cash proceeds on an undertaking from the broker that cash proceeds will be paid separately. Liquidity Risk – This is the risk that insufficient securities and / or funds are available to meet commitments; with obligation being covered sometime later. This occurs where, for certain technical reasons (stock out on loan, or in the process of registration etc), one or both parties to the trade have a shortfall in the amount of funds or stock to meet settlement obligations. These shortfalls may lead to settlement “fails” but do not normally lead to a default. Market Risk – This risk arises from market price fluctuations of securities and currencies, from trade execution to eventual settlement. Operational Risk – this is the risk of clerical errors, organisational deficiencies, delays, fraud and system failure. These are both internal and external factors that affect the safe operation of the depository. Seizure of Assets – In the event of the liquidator being appointed it is essential that the client’s assets are segregated from the assets of the custodians. Delay in the release of the client’s assets may prove costly. Settlement Risk – This is the risk that a party will default on one or more delivery or payment obligation to its counterparties or a settlement agent. Regulators are pushing for shorter settlement cycles in order to reduce the time parties are exposed to this risk. Systemic Risk – This is the risk that the inability of one institution to meet its obligations when due will cause other participants or financial firms to be unable to meet their obligations when due. Withholding Tax Risk – there may be markets or assets that do not permit the withholding tax to be reclaimed. There can be substantial loss to the client when tax is not recoverable. In addition, the degree to which the custodian limits their activity or places thresholds below which reclaims are not filed creates risk if the client is not explicitly made aware of the limitations and subsequently sues the custodian to be made whole. If large numbers of clients are affected, there is also a significant risk of a class action against the custodian. Asset Commitment Risk – is the risk associated with the period of time when either cash or securities are frozen, pending settlement of a trade. Following initial settlement the risk period is extended until the transfer of funds and stock becomes irrevocable. A few would argue that Network Management and indeed any ‘backoffice’ function is not as glamourous as pretty much any function in the front-office. But whilst the back and middle-offices cannot make vast

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profits on the back of trading success, equally they cannot make the losses. In addition they have the ability to create market advantage, if properly benchmarked, for the custodian and to generate customer loyalty. Network Management reduces the costs associated with trading and payments functions so that the bottom line impact of running a network is as small as possible. This means being well organised, efficient and informed and leveraging the masses of information, supposedly at their fingertips, to make sure that these costs are kept as low as possible. Without networks, banks could not exist. The wherewithal to trade, match, settle and clear would largely be meaningless if a bank engaging in such activity had no means of looking after its trading assets and those of its clients in a safe, economically efficient and ultimately reusable manner. The point should be absolutely clear, that Network Management is the embodiment of all that banks were ever set up to do: act as a safe store for goods of value, including cash, that would generate an economic rate of return until drawn down for re-use by the rightful owner at some stage in the future. The information required by a Network Manager to do their job includes both static and dynamic data. In the initial stages of a new relationship accounts need to be opened, documents drafted and reviewed both internally and externally and records need to be kept. Once an account (as the embodiment of a relationship) has been opened, plenty of dynamic data can then be passed across that account, assuming that a suitable home can be found for that data to reside in. So much for the theory, what of the practice? It is rare for all relationships to be fully documented. Even if each relationship has been fully documented in the past, it is likely that not all documents will be referenceable. It is unusual for relationships to be reviewed and reviewed in a consistent, recordable manner. Indeed, the tools of a modern Network Manager – an Access database (possibly), libraries of Word documents and a multitude of Excel spreadsheets do not co-exist in single platforms and therefore do not easily facilitate day-to-day activities. Because of the lack of investment in legacy tools, many of these ‘solutions’ actually build in inefficiency and cost. Because of the manual nature of checking and validation processes across multiple components, these processes are labour intensive and error prone. Furthermore, the lack of integration means that future re-use is an almost impossibility with the same processes being followed month after month. It has been suggested that if the front-office has taken 90% of I.T. budgets in the last 20 years, and the back-office has taken the equivalent of 10% of that, then the balance – all 1% of it – has gone into middleoffice systems. This imbalance is even starker if we consider that, after

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personnel, the second biggest cost to Banks is that involved in running their Network. But times and attitudes are changing. External pressure in the form of a raft of regulation and directives (Basel II, MiFID, SEPA, and SarbanesOxley among others) means that the middle-office is coming under increasing scrutiny, as Legal and Compliance Departments have to demonstrate complete control of their in-house operations. Internally, business pressure from all sides to cut costs or manage business critical processes more effectively is in turn bearing down in these areas. The problem for the Banks is that they are unable to track and therefore manage their costs in this area with either a high degree of accuracy or confidence. Current thinking is developing along parallel lines: at a business line level the detailed information that should be available to Network Managers needs to be better organised and presented. At a corporate level it makes sense to bring together often disparate Network Management teams so that this new detailed level of information can be leveraged across all business lines, to the benefit of the bank as a whole. There is therefore a greater desire to convert information into intelligence and to leverage this intelligence into commercial negotiations. To manage effectively, the banks need to be able to measure both cost and performance; to measure, they need to organise and rationalise their data better, to position themselves appropriately and to facilitate ongoing measurement of their relationships. This will in turn enable a move away from the prevailing ‘silo’ mentality towards that of the provision of a ‘utility’ style of service across a Custodian or Group as a whole and this is a key concept for the Custodians going forwards. The adoption of solutions or applications which therefore fill these criteria for better information management will be critical for the Custodians in the coming years. It is not untypical for Network Managers to be using tools that are outdated, un-integrated and costly to maintain. A typical Network Management team probably relies on an Access database, a library of Word documents in both hard copy and electronic formats, together with multiple spreadsheets, some of which have proprietary macros embedded in them, that are fit only for specific purposes or special situations. A further examination of the processes followed by Network Management teams is or can be equally startling: heavy manual processing of dynamic data, error-prone processes leading to significant re-keying of data; a lack of transparency or ease of access to basic information, including documents, that causes delays and promotes inefficiency; all of these are traits of ‘modern’ Network Management operations. These problems are further exacerbated by short-termism on behalf of the people responsible for positioning their teams better to be able to cope

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with new and enlarged responsibilities. There has been a prevailing attitude of ‘make do and mend’ which has meant very little structural change has taken place in the functionality used by Network Managers. So, while network management has a key role to play, as evidenced both in the best practices and documentary controls necessary to provide a good service, the tools available to achieve high levels of efficiency are basically missing. This has tended to be because network management is not viewed as a function in its own right, therefore does not attract IT resource or strategic management time. It is seen more as a necessary evil to ensure risk is mitigated.

PART 4

Technology

Technology has become and will continue to beat at the heart of modern custody and clearing systems. The modern financial world can no longer exist, even momentarily, without massive and continuing investment in IT. Equally any exposition of technology management in financial services would be a book in its own right. See Technology Management in Financial Services. McGill publ Palgrave. So at best, in the limited space available here, we must focus on key areas that affect custodians and the clearing and settlement system. There are three fundamentals of processing for any part of the market; standards, messaging and reconciliation.

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CHAPTER 13

Standards, Messaging & Mediation In this chapter we look at messaging and standards. In order to have consistency across the industry, we need standards for the types of communication that are used. The body that oversees those standards is ISO. The current messaging standard is ISO 15022 and the next standards release will be ISO 20022. There are two key implementers of standards – FIX and SWIFT. SWIFT is an industry-owned co-operative that is now over 30 years old, which supplies secure standardised messaging and interface software to clients who are typically fund managers, custodians, broker/dealers, stock exchanges, CSDs and ICSDs. SWIFT is also already tapping into the insurance and corporate market. Currently, the organisation has established connections for 8,100 institutions in 207 countries, and aims to have 30,000 institutions connected by 2010. SWIFT’s IP messaging platform, SWIFTNet, was launched in 2002. It is this IP network that will extend the number of users by boosting the number of services that the organisation will extend its reach in to. New services that can be provided over SWIFTNet include CLS, Euroclear, Crest, FIX, OMGEO, FUNDS and direct connection to a growing number of CSDs and ICSDs. Clearly, this is an attractive proposition from a user’s point of view, when one considers that if the users are active in multiple businesses, then by doing more business, the lower will be the unit costs of messaging. If we look at the current FIN volumes, Europe is by far the largest market. It is in Europe where the opportunity is the greatest – and, at the same time, this region also presents the greatest challenge. Consolidation of players, markets and standards, while on the surface providing a logical way forward, in practice creates complex problems in itself. Taking a typical custodian as an example, only a few years ago the main form of external communication to it would be telephone, telex, fax and SWIFT ISO 15022. Today, this communication may involve a combination of email, fax, telex, telephone, internet, proprietary systems and 219

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formats, SWIFT ISO 15022 and now ISO 20022, FIX, ETC, Funds native and XML, FpML, RIXML and other ML’s. We are only scratching the surface here, however. All of the above (and more) need to be accommodated, not only for the custodian to differentiate itself from its peer group, but also to develop an increasingly commoditised market for the sake of remaining competitive and improving levels of operational efficiency and client services. Client satisfaction is a greater challenge. Coupled with a rationalisation in the market, more and more custodians are developing increasingly disparate service offerings, from white-labelled products to outsourcing, without necessarily having the required experience, or the technological backbone, to address and deliver to the increasingly complex needs of the client. Most custodian systems are legacy in nature, developed in-house, and are sometimes many years old. The challenge is how to address and engage a typical non-XML based technology in a new world, where most forms of communication will be based on XML. The companies that move the fastest will have a head start on the competition. Financial institutions involved in global trading over the next decade will be challenged by their ability to collaborate and integrate via messaging standards that will be complex and constantly evolving. The key technology issue will not be networks, protocols or connectivity. Rather, it will be the ability to transform data and to permit effective dialogue with disparate institutions and services, implementing new best-of-breed solutions while, at the same time, protecting legacy investments. Message transformation is the key to successful STP. Message transformation is also the key to implementing an enterprise-wide data dictionary. Message transformation solutions are the silver bullet for solving the issues that arise where business meets technology. A typical custody transformation checklist would look like this:


Rapid time to market, with minimum ongoing operational overheads;




A non-invasive solution that will not disrupt existing legacy systems;




Allow business experts to take a driving seat in transformation, without becoming programmers;




Recognise data as business information, rather than simply strings of characters;




Full support for ISO 15022 and data dictionary approaches;




The option between mapping via an enterprise data dictionary, or mapping point-to-point;

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Support legacy & proprietary message standards, as well as XML etc, with a common interface;




The capacity to solve tactical messaging issues, as well as supporting strategic directions;




In-built support for industry standards, such as SWIFT, FIX, OMGEO, Euroclear.

In addition to the above, custodians must maintain:


The ability to support multiple versions of given standards as institutions ‘borrow’ and adapt standards to suit their mutual needs;




The assurance that annual migrations and upgrades to new messaging standards can be handled with minimum risk and minimum effort;




The ability to work within industry standard environments, J2EE and networked computing;




The capacity to handle any message structure, avoiding inefficient work-around;




An ability to protect investments and future-proof projects by re-using definitions and mappings, as well as built-in regression testing tools;




A commitment to minimising risk and errors by managing test and development, as well as production versions.

The financial services community is finding it hard to keep up with the integration projects that they face over the next couple of years. New product roll-outs, and changes in message format from SWIFT and similar organisations, are coinciding with regulatory demands such as SarbanesOxley, to create a tidal wave of work to be done. In a world where cost reduction still tops the agenda and IT teams are smaller than in the past, the Chief Information Officer (CIO) has to deliver complex integration projects quickly. A more flexible approach to integration is needed that reduces costs by allowing on-going change to be factored in more easily. Financial institutions involved in global trading over the next decade will be challenged by their ability to collaborate and integrate via messaging standards that will be complex and constantly evolving. The business drivers for using and adopting IP Networks such as SWIFTNet as a single window, for example, are clear – to drive down costs, increase revenue and

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grow market share. In order to reap these benefits, we feel that organisations need to make sure that they have thought about the related issues of sizing, resilience, security, fail-over, recovery of message/file loss and ongoing maintenance. If these issues are not considered, adding new applications, writing new interfaces and begging for more budgets could be a problem. The ideal solution would be a combination of IP connectivity with a proven, robust, extensible message broker layer, which does not force organisations to decide now what their future connectivity will look like. STP and process automation are the functions which have most positive impact on business continuity. Improvements in STP can be achieved in many ways – through greater standardisation of processes and formats, by automating workflow, using central databases of information and integrating disparate systems. Financial infrastructures such as SWIFT’s SWIFTNet focus on standards deployment and interoperability. All these initiatives will help to improve STP rates, but they are still only part of the solution. What they cannot do yet is achieve total end-to-end processing. The key technology issue will not be networks, protocols or connectivity but the ability to transform data and permit effective dialogue with disparate institutions and services, implementing new best-of-breed solutions whilst, at the same time, protecting legacy investments. Message transformation is the key to successful STP. An effective message transformation solution is the Holy Grail for solving the issues that arise where business meets technology. The benefits of moving to a single messaging standard are clear for the financial services industry and further endorsed by the number of initiatives to facilitate the industry-wide adoption of a single standard utilising ISO 15022, ISO 20022, FIX and XML. However, even with the standard in place, legacy systems will continue to generate and expect to receive proprietary messaging for a long time to come and will remain a barrier to achieving broader levels of STP. One key concept aimed at easing the adoption of the new standards and achieving interoperability with proprietary standards and STP is that of decoupling the business meaning of messages from their physical format representation, by definition via a data dictionary. Key components that are essential in the STP process include: Viewing of the Message Lifecycle: The Messaging Monitor should be a configurable, web-browser based GUI that allows instant viewing of message status. Customisation of the interface can be profiled according to the user’s log-in, making available only those actions that are permissible and displayed in a tailored environment. Message Validation: Messages can be syntactically validated to ensure their structure is correct, and that the test / live data will successfully parse (be broken up into individual fields) into the message structure.

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Network Validation: Certain networks, e.g. SWIFT, have a further level of message validation. This is termed ‘network validation’ and can only be performed once the message has been fully constructed. Non-xml: Non-XML systems / standards are not excluded from participating in an XML world. Any sophisticated tool should provide an instant XML representation of data that has originated from a non-XML environment, e.g. legacy systems, SWIFT 7775, 15022 etc. Co-existence of Message Standards: Being able to cope with the coexistence of such a vast array of different message standards (and also different versions of the same standards) is of paramount business benefit. Clients want flexibility, not dictatorship as to which messaging standards and particular versions of those standards they can and cannot use. Employing a data dictionary approach empowers custodians to offer such co-existence services. Message Testing & Impact Analysis: Not only does the business analyst require an intuitive interface to define the message transformations / enrichments, but they also require a testing facility to instantly view the results of their work. Mapping & Rules Testing: The same testing harness can also be used to test the mapping and rules actions that have been defined by the business analyst through the interface. Again, the results of these mappings and rules can instantly be viewed. Business Services / Web Services / SOA: Technology will help custodians to expand into a business services, web services, and SOA world. The underlying principle of each of these approaches is to encourage re-use of business functionality by way of IT services. This can be automated to the point where the technology automatically generates the descriptor language necessary to deploy into a J2EE environment, e.g. IBM WebSphere, BEA WebLogic, SUN etc. Transformation / Enrichment Service: Technology should be designed to be deployed in a ‘service’ environment. This could consist of anything from simply calling it as a standalone piece of Java functionality, right through to automatically generating the necessary Web Services Descriptor Language (WSDL) wrapper to deploy into a J2EE enabled Services Oriented Architecture (SOA) environment. Such services could be anything you choose, e.g. message transformation, message enrichment etc. Message mediation technology should be based upon a data dictionary approach to message representation. That is, business object types (BOTs), components, and component types are all used as building blocks to represent messages as part of a data dictionary. One common theme that runs throughout each of the points above is that solutions should be designed with ‘future-proofing’ in mind. That is, not

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only should the technology be extensible to the point where ‘plugged in’ functionality appears part of the overall product, but also clients have a common code base, i.e. not individual releases specific to each client. Any software updates should also be designed and tested to be backwardly compatible. Only a handful can honestly say that they have achieved this to any extent and few have achieved any sustained levels of STP across the board. The ongoing effort to develop and promote standards in the domain of financial messaging creates new opportunities for business efficiency through automation. At the same time, the diversity of existing and emerging standards results in complexities that must somehow be accommodated within IT architecture. Consider the variety of message standards that may be involved. On top of any bespoke and proprietary standards in use, a financial organisation may also need to process standards such as SWIFT ISO 15022, ISO 20022, FIX, FIXML, FpML, RIXML, MDDL, Omgeo amongst many others. The introduction of technology based standards built using XML provides a degree of conformity in approach, but not necessarily in implementation, meaning that XML of itself does not provide a solution to the diversity that must be incorporated. As standards mature, older versions of a standard supported by production systems must coexist with new releases while migration tasks are performed. The need for coexistence can be for long periods of time affecting multiple systems.

M E S S A G E M E D I AT I O N Critical to the success of any financial organisation seeking to maintain competitive advantage and continually introduce new efficiencies is the ability to manage the complexity created though these diverse message standards. Central to the ability to do this is a need for a message mediation capability that can be used to bring conformity to handling otherwise irreconcilable standards. Such a capability must be incorporated into the IT architecture and be part of the IT strategic vision and so aligned to business objectives. Message mediation is consequently an architectural building block that can support a number of architectural initiatives including the establishment of a Service Oriented Architecture (SOA). Message mediation introduces an architectural ability to address the problem of interface mismatch both at run-time and build-time – right through to analysis and design. Such a mediated architecture, in contrast to its predecessors, provides a means to perform run-time resolution of mediation actions based on build-time design activities. This yields a number of benefits:


True de-coupling between disparate systems operating to incompatible standards;

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Greatly improved opportunities for re-use;




Perhaps most significantly the possibility to move design of a given mediation scenario into the hands of a business analyst rather than exclusively being the domain of an application developer.

A message mediation service must provide a number of features to claim a key role in enterprise architecture. Message Structure Definition. There are a number of facets to message definition with the essential point being the need to capture all the information that is in the message definition documentation. For example, all the detail in the various SWIFT User Handbooks, the FIX Specifications (4.0, 4.1, 4.2, 4.3, 4.4), TRAX specifications and so on. The detailed technical specification must be captured in a common manner across all message sets rather than risk different representations for different message sets. Importantly this information should be maintained in such a way that a business analyst can work with it. Message Data Definition. Messages are made up of data in defined formats and arranged according to structure using a particular syntax. Often there may be additional processing rules to be taken into account (e.g The ‘ExchangeRate’ is present if and only if the ‘OtherCcy’ is present). These messages definitions must be stored so that they can be subsequently used. To improve manageability and maintenance such storage is improved by building from basic data types and business components as defined in 15022 ISO standard (not forgetting other non-ISO definitions). Assuming data can be represented in this way then these “business objects” should be used across multiple messages to represent ‘common’ business objects. An example underlines the merit of this approach. ‘Parties’ must be defined in a common way within, say, SWIFT ISO 15022 messages, yet in a different way than in FIX 4.3, which is different again from FIX 4.4. However it is important to identify the ‘Buyer’ or ‘Seller’ regardless of whether the data is formatted for SWIFT, FIX 4.3, 4.4 or whatever message set being dealt with. The importance of this approach is that the technical issues of format and syntax can be ignored, instead allowing focus on the business role. Rather than working with data and formats attention is on business objects understandable by business analysts. Rules processing. The final ingredient of the definition phase is to capture rules or conditions that are necessary to ensure the validity of the messages. To be expected second on any list of such features is transformation between different message structures. Transformation can be further

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sub-divided to consider differences between agreed standards and the more traditional challenges of incompatible representations. The building blocks for any transformation are functional tasks, examples include: Mapping tasks: copying fields from input to output formats. This may include mapping one-to-many, many-to one and many to many. Copy actions can be augmented by performing manipulation tasks on the data being mapped. These will include string manipulations (e.g. truncating a field to a given length), numeric functions (e.g. calculating the sum of two fields for an output field), date and time handling to reformat fields between different representations. Conditional logic constructs will be used to handle more complex transformations. Custodians are challenged and concerned with the necessity to be able to transform between otherwise incompatible financial messaging standards. A mediation service should provide methods to handle diversity standards such as:


SWIFT 20022;




SWIFT 15022;




FIX;




Omgeo CTM (Central Trade Manager);




FpML (Financial products Markup Language);




MDDL (Market Data Definition Language);




FIXML.

This problem is more complex than simply understanding these formats. Within each standard there is scope for incompatibilities between different versions that must be handled consistently. For example there should be compatibility between the ever expanding versions of FIX (4.0, 4.1, 4.2, 4.3, and 4.4) as well as the coexistence of different SWIFT formats. Transformation challenges will demand greater flexibility than handling just standard message formats. For example it is common for legacy systems not to support industry standards having opted for a bespoke or

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otherwise proprietary format. These systems exhibit greater interface mismatches than message structure alone requiring the transformation service to provide features such as:


Bi-directional transform capability between XML and non-XML data structures;




Data structure changes (e.g. csv into XML);




Data type changes (e.g. numeric to string);




Representation (e.g. fixed length data field into XML).

Message mediation has introduced the concept of message transformation – changing the structure of a message in flight. Message enrichment extends this capability to add additional data to the message that was not included by the originating application at message creation time. Sources for this data are typically found in relational databases, such as Oracle, IBM DB2 and MS SQL Server, though other sources could range from a file system though to a Web Service invocation or even another message. Mediation technology should not constrain these choices, though good design practices and operational factors are likely to influence how enrichment is performed and particularly where the data used is sourced. Before a message can be transformed it must first be parsed to make it understandable to the mediation service – so called “Parsing”. A common approach to this task is to implement an internal representation of message data that can be manipulated programmatically by the mediation service. This approach is successful because it allows the mediation service to make no assumptions about the incoming or outbound message formats. In essence the mediation service can operate on the “logical” message without concern for “physical” message. This approach is necessary because of the diversity of message formats that must be handled. The mediation service first parses the inbound message according to rules established at build-time and converts it to the internal format in use. Parsing therefore describes the process of deconstructing the message based on some predetermined criteria. This requires that first the message can be recognised in some way, and then to select and apply the correct set of rules. Messages can be identified using a number of approaches, for example:


Based on their inbound location to the mediation service – for example in a message queuing environment a message on a particular queue could be easily associated with a specific format;

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Control data may be appended to a message as an independent header to be used by the mediation service;




The message itself may maintain a unique identification in the body of the message;




Some combination of all these approaches.

Optimally the architecture will seek to achieve the maximum decoupling of all message producers and consumers using the most noninvasive manner possible. For these reasons XML is increasingly popular for representing message structures. The XML meta data can provide a suitable mechanism for message identification. Further, the nature of XML means that it need not of necessity be associated with a known message definition. Instead, if need be, the message structure can be traversed at runtime and processed programmatically in the mediation service. Such an approach underlines one of the appeals of XML – it is easily interpreted – and for mediation processing this can help development of a high performance solution. However, even for XML messages, to successfully process diverse message formats with strict processing rules it is necessary to predefine the message structures to the message mediation service and use these during parse tasks. Message identification is therefore the first step to allow parsing to a specific message standard. While this task can be easier for XML messages the diversity of standards dictates that the mediation service must be capable of processing both XML and other, traditional, proprietary formats. To recognise and subsequently parse a message to a known standard the mediation service must incorporate or access a message dictionary capability. A message dictionary is similar in concept to a data dictionary and, as would be expected, contains descriptions of message standards – formats, structures, legitimate values, ranges and such like. The dictionary content itself is likely to be independent of any actual message encoding as it must incorporate message definitions for many different format types. The dictionary should provide methods to create and maintain definitions through manual creation of a format and using import tools. The Import process should be able to handle general purpose industry standards such as XML schemas and programming language constructs (COBOL copybooks and C header files for example). To address the specific challenges of financial standards the dictionary should be supplied with, or have available for purchase with subsequent maintenance, key message standards, such as SWIFT and FIX. This avoids the labour associated with setting up complex message formats and builds a shield from the annual changes to standards.

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All the various messaging standards are now defined in a common way regardless of whether we are dealing with SWIFT, FIX, OMGEO, TRAX, XML, Proprietary back office and so on. The message dictionary should support export functions to allow creation of message definitions of formats suitable for use by other applications. For example the dictionary should be capable of exporting XML Schema and DTD definitions. A further feature to consider is support for multiple message dictionaries. This could allow a runtime process to resolve a message definition based on some context information and select, for example, an enterprise dictionary or a departmental one. The value of the message dictionary concept is very high and can provide significant benefits. An Enterprise-wide message dictionary provides a single authoritative source of message standards in use. It acts as a point of control facilitating improved opportunities for managing change and achieving re-use. Once a message is identified it can be parsed so that other mediation activities can be performed against it. For clarity it is worth restating that while XML messages need not necessarily be parsed based on a message dictionary format, the complex nature of financial message standards combined with many being encoded in formats other than XML indicates that they will be parsed by use of such a dictionary. Parsing functions must be able to handle “simple” structures, such as Comma Separated Values (CSV) and repeating groups, through to “compound” structures such as messages built from business objects. Clearly XML constructs must be fully supported. The mediation service approach to parsing should allow for programmatic extensions to the parsing process, either though introduction of additional parsers or by over-riding parsing actions with custom code. Failure to properly validate messages against standards specifications prior to further processing can result in increased costs. In an ideal scenario the applications producing messages could be certain to generate accurate message structure on all occasions, in reality this is often not the case due to the complexity and ongoing evolution of the messaging standards themselves. Strictly, validation can be considered as an optional task in contrast to parsing, though often validation will prove necessary. While parsing is concerned with the syntax of a message – is it correctly structured – validation adds a further level of message inspection that confirms the semantic content is correct. A useful analogy here is to consider frequencies used for radio stations as a syntactical construct whilst the broadcast programmes represent the semantic content. In this analogy any device that can tune to the frequency can receive (parse) the content, but may still not be able to understand (validate) it if it is broadcast in another language. A parsing process, for example, may confirm that an element exists to contain a postcode. Validation could inspect the contents of this element to confirm that it is

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indeed a postcode rather than some other value, and that it is present if the message specification requires it. Performing message validation adds additional processing overheads that must be borne by the mediation service. The negative cost – that of not performing message validation – can often be easily measured so the benefits of thorough validation can be evaluated and justified. For example, SWIFT charges for any messages that have been negated (NACK) through syntax or network validation errors. The validation process allows control of the degree of validation performed. It may not be necessary to validate an entire message, nor perform all types of validation. Again, using SWIFT as an example, the message could be validated for structural correctness, next for inclusions of all mandatory elements, and finally that all included data elements conform to the SWIFT definition in terms of lengths etc. This multi-layered approach allows a compromise to be found between processing overheads and risks to data quality. Architecturally there are benefits to placing validation in a separate mediation service rather than implementing it in the applications generating such messages. A core principal of software architecture is the aim to achieve a “separation of concerns”. Here the concern is to perform high quality message validation against current message standards. Instead of replicating this functionality across all applications, the solution is to identify and encapsulate the necessary processing and implement it as a reusable service – this allows a more effective decomposition of the software under development and improvements to the operation of the deployed system. The net result is that applications can be developed without the additional overhead of implementing and, perhaps of higher impact, maintaining a validation capability. Their objective remains to produce high quality messages, but now the mediation service intercepts these messages and validates them against current standards prior to transmission for downstream processing. Thus the maintenance effort to ensure all validation is accurate and up to date can be focused on the mediation service rather than many application instances. This fosters reuse of common services implemented by the mediation service. The mediation service therefore must provide a high quality validation capability that can flag errors and suspend further downstream processing of an errant message prior to cost being incurred or inappropriate processing initiated. The validation service should sensibly share the same message dictionary used for parsing operations. There are a number of common approaches to consider for handing validation exceptions. One option could be to invoke a transformation that corrects the error. This strategy will be successful when errors are easily identified, such as a mismatch between message format versions, and can be resolved through restructure of the available message data. Such an approach will not be viable if additional data is required to complete the

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message structure, though message enrichment could help. If it is not possible to resolve the message errors in the mediation service itself then the condition must be escalated in some way to either the originating application or some other architectural component responsible for further processing the errant message. All the elements we’ve described here – message definitions, transformations, validations and so on – can be managed by the mediation service to maximise the opportunities for reuse. The functionality provided by a mediation service must be readily accessible and manageable. For development this means more than providing a rich environment for developing transformations and such like, though this is required. It is essential that the mediation services provide tools that can accelerate the use of the service and increase understanding between business analysts and development teams. Ideally the tool should allow the analyst to build standards based transformations that can be used directly by the mediation service without the need for an intermediary stage where the analyst’s designs are translated into transformation code by a developer for subsequent deployment. At the same time the tool must support operational controls and allow IT specialists to extend the business analyst’s work with optimisations and other technology specific functions. This means that while the mediation service is a highly technical component of the IT architecture, the tools used to create and maintain the message flows processed by the service should be highly intuitive and focus on the business requirements and not the technical implementation. Contrast this approach to a more traditional process of analysts documenting their requirements in some way, perhaps using spreadsheets, and passing these to a separate team for coding. This introduces a further layer of interpretation and delay in implementing change. A recurring problem for IT based solutions is performing reliable testing as changes are required. Incorporating diverse and evolving financial messaging standards requires that a testing capability be incorporated into the mediation service development environment. Such test facilities should maintain test data and allow management of that data, for example comparing test outcomes to previous tests with the same data. Testing should allow for activities such as impact analysis and regression tests as well as performance and unit testing for changes as they are developed. In summary, the development tools are able to exploit the features of the mediation service considered here. Of particular note is the reuse of message definitions captured from the volumes of User Handbooks and other specifications. The analyst is automatically guided through what is valid and what is not in a way that allows testing of a specific message to ensure it complies with the published specification. The business analyst,

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best positioned to appreciate the business implications, now has a powerful quality assurance (QA) tool. The criticality of the messages processed by a mediation service dictates that it must be capable of participating in transactions. The non-invasive nature of the mediation service means that a common design approach is to intercept messages as they flow between different applications. It would be unacceptable for the service to fail to honour at least the same level of transactionality and data integrity implemented by the applications passing messages. A mediation service must be capable of operating with the various levels of security required in the enterprise. These services can be implemented in a variety of ways with considerable scope for subtlety. For example, consider a multi-part message, where each part may have different security needs and could be encrypted using different keys. The mediation service must be able to decrypt and re-encrypt the message parts in order to transform them. ISO Defined Security Services:


Identification – who do you say you are?




Authentication – can you prove that?




Authorisation – what can you do?




Integrity – whatever data is sent has not been changed or corrupted in some way;




Confidentiality – data cannot be seen be unauthorised entities;




Auditing – activities are recorded for subsequent review;




Non-repudiation – providing proof of message transmission.

The extent to which security is implemented will depend on a number of operational considerations. It is important that security is catered for without becoming a processing burden. The critical nature of mediation services requires that they provide a high performance and highly scalable solution. Message transformations should be deployed and managed using some form of version control – this could be implemented as part of the service itself or built using development tool interfaces to external version control tools. In general terms it is also desirable to seek:


Broad platform support;




Wide support for technologies such as J2EE, ideally the mediation service can be embedded within applications as well as providing standalone implementation choices;

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Support for distributed deployments and subsequent operational control;




Management support and planning information.

When we considered message dictionaries the need to provide support for financial massaging standards was noted. In addition to messaging standards a mediation service should support technology standards wherever appropriate. Examples include, and are mentioned elsewhere in this paper, J2EE, Web Services and XML initiatives amongst many others. Message mediation provides key capabilities that when combined establish a means to intercept messages, identify, parse, validate, transform, enrich and return them into the process flow. The mediation service can therefore be considered a core architectural component of an enterprise’s IT architecture. Operating as a core architectural component indicates that a mediation service should be considered in conjunction with other architectural components. The mediation service has specific capabilities which can be used either in isolation – to handle particular tactical requirements – or in tandem with other components in support of strategic objectives. The value of the mediation service for isolated, discrete usages is often more easily defined. When a mediation service takes a strategic role, its value is greater, but can be harder to quantify – it becomes a case of “the whole being greater than the sum of the parts”. In this scenario the various architectural artefacts cooperate to produce a combined effect greater then that of their separate effects – that is, they operate in synergy. Any form of architectural synergy requires careful planning – the overarching need is to ensure that IT supports business strategy. The discussion of validation processing earlier presented the architectural principal of “separating concerns” between different software artefacts. In the case of validation the possible merit of a validation capability for financial messages implemented as a separate service from multiple application instances was explored. This “separation of concerns” allows software design to be more effectively performed through decomposition of otherwise complex systems into comprehensible components. The mediation service itself can be considered a coarser grained artefact than the validation services it incorporates. Viewing the mediation service in its full architectural context opens up new synergistic opportunities for its use in tandem with other architectural components. The compelling architectural design that incorporates mediation services is the Enterprise Service Bus (ESB), commonly deployed in a Service Oriented Architecture (SOA). An ESB is generally recognised as a design pattern that addresses the need for advanced inter-application communications. The ESB provides a

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highly functional communications backbone rich in services such as mediation and transformation, routing, security, operational and management control, built to support standards and boasting many application interfaces. An ESB provides an excellent example of the synergistic benefits possible through implementation of a number of architectural building blocks to a well defined design and strategy.

ESB Characteristics ESB enables inter-application communication (the bus). Supports many communications models built on asynchronous messaging, e.g.


Fire and forget;




Publish/subscribe;




Request/reply;




Broadcast, etc;




Extensive interface connectivity;




Frameworks: .NET and J2EE;




Application suites (ERP, CRM, etc.);




Technologies (databases, transaction managers, etc.);




Language bindings (Java, C# etc.);




Sophisticated routing, providing features like location transparency and infrastructure agility;




Transactional integrity – Built to support industry standards, particularly: Web Services;




XML;




Business process models (e.g. OASIS) and languages (BPEL – Business Process Execution Language);




Event driven processing;

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Message mediation (transformation, enrichment, etc.);




Security (authentication, authorisation and so on);




Development environments (.NET, Eclipse and others);




Operations and systems management.

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A high profile feature of the ESB concept is the ability to perform realtime in flight mediations. Such facilities assist in development and control of solutions such as Straight Through Processing (STP). While an ESB provides an architected design for inter-application communications, a related architecture provides a backbone to support business activities – the Service Oriented Architecture, or SOA. With service orientation there is a formal definition of how a service is implemented and how it can be used – this provides a high degree of de-coupling and so introduces greater agility into the IT environment. Services can be accessed without application “knowledge” of where they are located or how they are implemented. Multiple services can be invoked in sequence to support business processes. A popular technology for definition and access to such services is Web services. However SOA neither predicates the use of Web Services nor is it true that a solution built to Web Service standards is necessarily adhering to an SOA.

ESB AND SOA CONTRASTED The ESB and SOA appear to have jointly become the most widely discussed concepts in IT architecture at this time. It has been suggested that implementation of an ESB results in realisation of an SOA – though this is not strictly the case. The ESB represents the maturing of many technologies, both standards based and proprietary, which have been in mainstream use over the last decade or so. This has been particularly true in the last few years as standards have formalised around these technologies. Likewise, the SOA is far from a new concept, though contemporary technologies lend themselves to development of solutions that implement SOA principles. The ESB provides the “plumbing” that links together disparate and otherwise incompatible applications. This can be achieved through a service oriented approach or techniques associated with Enterprise Application Integration. Service orientation changes the way applications are built and accessed – it is something more than connectivity and communications and requires an organisation to approach development of IT assets in a fresh style. An area for confusion is found in the use of common technologies such as Web Service standards and Message Oriented Middleware to implement

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the ESB and an SOA. This says much for the value of such technologies in IT architecture, but it does not mean that if you have an ESB you have an SOA. Many organisations will have some form of ESB, even if it is not named such, which has evolved from early initiatives to address application integration challenges. Implementation of an SOA ultimately requires a shift in perspective within the organisation to develop services rather than traditional applications aligned to business units. To be successful an SOA strategy will encompass creation of an ESB, or be built to exploit an established ESB – the current standard of ESB technologies provides the bedrock on which to pursue service orientation elsewhere in the Enterprise IT architecture. A simple, high-level view of some architectural layers shows how the ESB enables connectivity between applications and data and also supports the SOA. Thus the ESB and its core mediation capability is an essential architectural layer in support of not only resolving the challenge of diverse financial message standards but also facilitating increased agility in the enterprise. Having reviewed the functional attributes of a mediation service and placed it in an architectural context all that remains is to explain how to approach selection of a mediation service. Historically these questions might have started with a “buy versus build” discussion. Today the market is well catered for so competitive pricing is the first factor to influence strongly the buy decision. Perhaps more significant is the complexity of the mediation service itself, the development and subsequent maintenance effort costs – essential in order to maintain pace with continually developing standards – are simply too high to be a justifiable project in most organisations. This final point underlines the merit of buying a mediation service – development effort should be directed at building solutions that are aligned to business strategy, not IT strategy. Wherever practical it is sensible to buy technology and build business solutions with it. The alternative – to first attempt to build the technology – is sure to restrict IT to business alignment. Choosing to purchase mediation technology requires assessment of commercial offerings and vendor suitability. Additionally the vendor qualities should be considered in terms of stability, strategy, financial sector experience and support services capabilities. A proven track record with case studies available for reference is assistance, though this can only inform rather than decide the final decision. When considering a commercial solution to support financial messaging solutions it is essential to seek out a vendor that actively supports financial message standards in their products and is appropriately certified by standards bodies; for example SWIFT accreditation for compatibility to the SWIFT network. For the selected product to deliver the architectural benefits considered in the section “Message Mediation – Architectural Role” it must maintain a high degree of integration with mainstream technologies and standards as well as extensibility to enable support for non-standard applications.

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In these respects any mediation service should support a prevalent application framework such as J2EE or Microsoft .Net, and ideally both in some capacity. At the same time it should not predicate use of either framework. Ideally the mediation service should be deployable as part of such a framework if desired, as part of an infrastructure capability, or standalone based on architectural designs and objectives. Using J2EE as a reference, the mediation service should be accessible using EJB and MDB, but equally it should be possible to use the mediation service from a Java application not hosted in an Application Server. A desirable deployment option to consider would be the possibility of “embedding” the mediation service in another architecture component. Such an approach will provide additional flexibility when developing architectural alternatives. In terms of extensibility the mediation service should provide opportunities for customisation though well designed exits along with the possibility to include code to perform custom functions during message transformations, parsing and validation. The mediation service needs to support other mainstream commercial technologies that will be used along side it in the IT architecture. Due to their popularity in the financial sector IBM’s WebSphere MQ is an obvious candidate for compatibility, but any transport and integration technologies must be supported, where they are included in the architecture. The capabilities of a mediation service provide an essential architectural building block to address the challenges experienced by financial organisations seeking to manage many message standards. This is particularly so when the mediation service is implemented within a Service Oriented Architecture that improves IT agility and business alignment. Mediation services therefore offer a number of significant advantages to the financial organisation seeking to manage a diverse number of message formats:


Improved corporate agility – reduce time to market;




Capability to resolve message format mismatches between disparate applications in a non-invasive style;




Solutions that allows business analysts to be an active participant in the creation of mediation solutions along with traditional IT roles;




Out of the box standards support including message formats (e.g. SWIFT, OMGEO etc) and technologies (e.g. Web Services);




A common approach to all mediation activities, treating legacy applications in the same way as contemporary standards based applications;




Extensive opportunities for re-use, incorporating features like the message dictionary to further such imperatives.

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These capabilities are essential in order to address the challenge of diversity in financial message formats. When viewed in the context of an architectural strategy that exploits the mediation service deployed as part of an ESB underpinning an SOA then the potential return of the mediation strategy is further increased. Change is constant, so an IT architecture designed to support change is necessary to eliminate the brittleness that has caused IT solutions to become a constraint to agility. The mediation service is a critical component of this architecture and provides a foundation for long-term business benefits through greatly increased corporate agility.

CHAPTER 14

Reconciliation

In this chapter, we look at what could easily be viewed as the fourth major risk mitigation strategy. Where failures occur for whatever reason, reconciliation provides the methodology to identify the problem and remediate it out of the system allowing both custody and clearing to have a back-stop process. Reconciliation traditionally involves matching cash or securities between two parties, which in the buy side equates to an investment manager and its custodians and brokers. Cash reconciliation involves matching the investment manager’s cash balance versus the custodian’s cash balance. Securities reconciliation involves matching the investment manager’s holdings data versus the custodian’s and in some cases also matching transactions records. Depending on the institution’s architecture and requirements, reconciliation may also include comparing a general ledger (rollup) to a sub-ledger (discrete, line-item activity) for consistency, prior to comparing the general ledger data to a custodian’s data. Reconciliations may take place daily, weekly, or monthly depending on the institution. Typically, cash balances are reconciled daily and holdings less frequently (weekly or monthly), while transactions are reconciled either daily or weekly. Reconciliation is the process of identifying, investigating, and resolving differences between the balances in a company’s books and a third party’s records. Reconciliations should also include positions and transactions on internal system control/wash or suspense accounts, or cash balances arising from postings to these accounts. The absence or failure of key control activities can lead to substantial regulatory, business, market and reputational risk. An integrated, generic, flexible, robust and scalable platform for carrying out reconciliations, with the capacity to automate exception management processes, is key to managing certain components of enterprise-wide 239

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operational risk. In general these systems are considered reliable and contain similar feature sets, especially in terms of matching functionality. This similarity recently caused relatively fierce competition among vendors, largely on the basis of price. Banks and financial institutions are required by regulators to have an effective system of controls that are consistent with the nature, scale, complexity and risk of their on- and off-balance sheet activities. They must also consider the diversity of their operations including geographical diversity, the volume and size of their transactions, and the degree of risk associated with each area of their operation. The Basle II Capital Accord specifically addresses operational risk. It requires organisations to review their enterprise-wide operational risk and operational control processes and capabilities. The boards of directors and senior management of these organisations are responsible for the development and ongoing maintenance of appropriate systems and controls. Organisations could incur increased capital charges if they use unsuitable and inappropriate reconciliation and exception management processes. The ownership of the reconciliation production processes, and subsequent breaks enforcement, in many organisations has traditionally been decentralised – distributed among settlement groups, payments departments, accounting and finance groups. However, the continual needs to eliminate costs and to reduce and monitor enterprise-wide operational risks within organisations has, over the last couple of years, resulted in the creation of regional and even global centralised groups within so-called “operations control” or “neutral control” divisions. Reconciliations are now viewed as a core competence for these departments. There is a business need, and consequently growing pressure on these groups, to lower the cost of providing this vital control function by considering the outsourcing of parts of the reconciliation production process and even the exception management processes. In addition, traditionally highly automated business groups, such as futures and options brokers and clearers who used to perform reconciliation processes in their back-office systems, are finding that they too must turn to specific reconciliation and exception management technology to effectively control their businesses. Transaction volumes and derived exceptions are now too large to control. These new control divisions and the newer, more complex, client requirements issuing from various derivatives shops have made functionality and scalability priorities for reconciliation system vendors. Reconciliation systems have become a central part of enterprise-wide operational risk and business efficiency and control initiatives. This is true for investment banks, asset managers, brokers, retail banks, credit card companies, corporates and retail organisations alike. The global economic

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climate has dramatically changed over the last two years. The industry driven T
1 initiative has slipped away. The new straight-through processing (STP) initiatives have not enjoyed the same significant boost in transaction volumes that resulted from the dot-com boom, nor have they been substantially spurred by ongoing developments in cross border trading and associated settlements. STP is primarily being driven by the immediate need to reduce business costs substantially while simultaneously reducing and monitoring enterprise-wide operational risk. Operational efficiency and process improvement can only be increased through real-time analysis of exposures and trends. The abilities to focus on potential losses and to reduce the opportunities for fraud also matter. In the securities industry, traditional post-settlement trade and cash reconciliation processes are being replaced. Reconciliation and related exception management processes are now expected to cover the complete transaction life cycle (order, execution, allocation, confirmation, matching, settlement, accounting, corporate actions, income, etc.) of all business transactions regardless of type. The capabilities of these reconciliation systems have expanded over the years from essentially fixed format message reconciliations with limited matching capabilities to complex data transformation and generic reconciliations with unlimited matching capabilities and semi-automated exception management capabilities. Firms can now track an entire life cycle of STP, effectively identifying each individual process step within a transaction. When a step does not occur in accordance with the expected life cycle, alerts can be created, the root cause of an error can be identified in real time, and the error can be rectified. The ability to perform real-time or so-called “near-time” processing is now de rigueur. Other requisite features for today’s reconciliation systems include data capture, data normalisation and mapping, data matching and reconciliation, identification of exceptions and breaks, investigation and clearance, management information, reporting, and data archiving. Reconciliation now involves more than matching data between an institution and its custodians and brokers; it involves managing exceptions from discovery to investigation and to final resolution. Technological advances made in vendor solutions are enabling institutions to expand the scope of their reconciliation systems beyond reconciling cash and securities to matching more complex data sets. This “generic matching” or “generic reconciliation” is accomplished by loosening the constraints in the matching engine’s logic and thinking beyond the traditional logic required to match cash and securities activity. A growing trend in the marketplace for third-party reconciliation services is the extension of outsourcing to data acquisition and in some cases data matching and exception identification.

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As the global regulatory noose tightens, institutions are requiring that all technology applications be able to keep a robust audit trail, a capability that is especially important for a reconciliation system. Determining whether to centralise reconciliation or align it by product or asset class depends on the number of third parties involved and the complexity of the reconciliations required. Cash and securities reconciliation, the process of matching internal balances, transactions, and holdings with the external records of brokers and custodians has traditionally been the deepest of back-office functions for investment management firms. But the modern capabilities of thirdparty solutions are enabling reconciliation technology to emerge as the investment management industry’s “problem solver.” Reconciliation software is moving out of the back office and into the spotlight as firms use reconciliation systems not only to support reconciling cash and securities but also to support reconciling internal subsystems, matching orders and confirmations, and comparing security identifiers, among other things. Broadening the reconciliation system to cover other processes yields significant improvements in operational efficiency. Comparisons previously performed manually by loading data into Excel spreadsheets or Access databases can be automated from data acquisition through to basic matching, and user-friendly interfaces present the appropriate user with exceptions for investigation and resolution. Integrated business process management (BPM) and business activity monitoring (BAM) tools monitor trades from execution to matching to custody. These tools also can monitor a trade’s progress through management dashboards that allow supervisors and managers to watch for potential problems and resolve them proactively before any costly trade error occurs. The tools and dashboards should also offer a level of intelligence, alerting users to trends or patterns in the data and prompting them to create new matching rules to alleviate future repetition. Generic reconciliations will become the norm, as will the ability for the system to perform multiway reconciliations, matching sequentially to three, four, or more sources but presenting only one exception alert to the user(s). Matching engines and business logic accessible through Web services will allow the system to look at data where it resides, on an application’s database, rather than require that the data be physically loaded into the system before it can be examined. Being able to look at data directly improves the system’s efficiency and may lessen the burden of mapping new external data files. As investment management firms continue to expand globally, they will increasingly choose thin-client interfaces deployed in a Web browser with no footprint on the desktop. This deployment not only minimises demands on the institution’s IT staff but also enables collaborative interaction between internal reconciliation staff and external business partners. In this

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model, the reconciliation system alerts a user of an exception and may allow the user to generate an e-mail directly to an external party (broker or custodian) that invites the recipient into the system (securely) to enrich or correct the data and to attach comments and/or documents directly to the exception.

T H E R E C O N C I L I AT I O N P R O C E S S Reconciliation requires matching two or more data sources for the purpose of identifying any exceptions or breaks in the positions or transactions contained within those data sources. This process usually involves reconciling positions or individual events contained within a ledger (internal) against a statement (external). Naturally, ledger-to-ledger and statement-to-statement matching also occurs, depending on the sources of data being reconciled and the need to allow for transaction amendments and cancellations within systems. Reconciliation boils down to four main steps:


data capture and normalisation;




data comparison;




exception management;




archival. Receive

Normalize

Common Template

SWIFT

Compare

Manage

Archive

Pass Y

Acct id XML

Parse data

time

Alert

Resolve

Track

N

Sec ID units

Web/ email

location

2

1 System acquire data from multiple external and internal sources by variety of methods

System normalizes and compares data, focusing on key items

3 Matched data passes while mismatches trigger user-defined business logic to generate exceptions

Figure 14.1 Reconciliations process flow Source: Stefan Sosnowski

4 Staff investigates exceptions and processes changes. System tracks all activity for audit purposes and then archives final reconciliation date for future requirements

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None of these steps are simple, given that each process involves multiple sub-processes, tasks, resources, and audit points.

Step 1: data capture The data required to complete a reconciliation may be delivered in a variety of ways: a manual statement, a spreadsheet, an electronic statement, or a SWIFT format statement. These data need to be delivered on a timely basis (when required) from internal and external systems. Traditionally, these data would be loaded from files generated during the company’s close-ofbusiness batch processing. Increasingly, the source data capture can be performed in real time, utilising enterprise application integration (EAI) and middleware tools. Data may also be entered manually into a system if the data are unavailable in electronic format. Most systems have a manual input data mask that can be used if necessary. Data capture involves the receipt or active retrieval of data sets from external and internal sources. These may be in an industry standard format such as a SWIFT statement of holdings, or they may be in a custodian’s proprietary format, an Extensible Markup Language (XML)-based format, or a vendor’s proprietary format. Further complicating matters is the fact that each file may be captured via disparate transmission methods, such as FTP (push or pull), SWIFTNet, e-mail, and downloading from an Internet site.

Step 2: data normalisation Each data set then must be normalised by parsing its contents into a common data model, or template, which will serve as the basis for comparison. An example is translating one file’s description of the number of shares held into the common template’s appropriate data field for shares or units held. Normalisation may involve reading not only field contents but also related descriptive fields advising on use of the data (e.g., a multiplier for the share amount shown). Once the data sets are parsed into the common data model, the data can be compared. Originally, reconciliation systems could perform comparisons only between two data sets. However, the industry is now demanding threeway, four-way, and more reconciliations, for example comparing sub-ledgers to the general ledger to a custodial balance all in one step. The challenge is to portray this step in a simple fashion to the client as if it were a standard two-way reconciliation and, if necessary, to present a single exception. All reconciliation systems require business rules and logic that define the matching rules (the “if,” “and,” and “then”) and indicate whether there is a tolerance that should be applied (for example, a tolerance specifying whether holdings should match to the penny or to the whole dollar).

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The data to be matched may be in different formats. There are literally thousands of different data formats. Data could originate from different uniquely configured systems. In financial services, the SWIFT message format is undoubtedly the most readily used. Data are loaded into the system via data re-formatters or schemas. Currently, systems are sold with industry-standard re-formatters or message adapters (CREST, BACS, CHAPS, etc.) as well as a generic mapping capability to handle data from any unusual sources. This transformation enables optimum performance of the reconciliation system. Most of the systems reviewed in this report claim to have between 35 to 50 standard database tables that may be populated. Some vendors claim that their systems also offer unlimited database tables that can be effectively created on demand. A few of the biggest investment banks and asset managers have developed an interesting initiative to enhance the utility and usability of data from multiple systems within the enterprise. To this end, these organisations have begun normalising data input and output files into SWIFT and FIX message formats. All event and transaction data may be exported from any systems in FIX and SWIFT formats.

Table 14.1 Business Data Type

Examples of reconciliation event types Matchable Data Elements

Account Details

Event Types

Event Dates

Cash

Account or sub-account number, trading book, etc.

Currency, amount, counterparty

Transaction date, Security code if value date linked. Transaction references derived from internal or external systems

Securities Position

Account or sub-account number, trading book, etc.

Securities code, security name, security unit price, nominal – position, position type – settled or traded

Position date

Securities Account or Transaction sub-account number, trading book, etc.

Source: SWIFT, Celent

Event Reference

None

Securities code, Trade date, Transaction securities name, value date references buy/sell, number of (settlement date) derived from securities traded or internal or settled, trade external systems transaction types – free delivery, free receipt, DVP, RVP, collateral, stock loan/borrow, corporate actions, etc.

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Once the data have been loaded, data validation rules are then applied to the incoming data. Individual statements are checked to ensure that duplicates have not been loaded or that multiple copies of the same pages have been loaded. The systems also normally attempt to validate opening and closing balances against values that have been loaded into the system to date (i.e., closing balance day 1  beginning balance day 2) and to ensure that the control totals in the message match the value of the items contained in the message. In most systems, a message that fails the validation process is placed in a repair queue so that it does not compromise system integrity. In addition, some systems are able to calculate an expected balance and verify that the imported balance matches this total.

Step 3: exception management Data that matches between sets receives a passing grade and is either erased or moved into storage. Data that does not match is flagged as an exception and presented to the user for investigation and resolution. This is where automated exception management comes into play. Business rules that the firm has pre-established in the reconciliation system determine the next steps based on the nature of the exception. These rules decide whether the system should apply an automated routine to solve the problem or generate an alert calling for manual intervention. The system may produce a report that identifies exceptions, or it may generate e-mail(s) to users to prompt them to initiate problem resolution. Automated exception management should be a proactive means of identifying potential problem spots and avoiding costly errors. Innovative solutions on the market today can recognise patterns in exceptions and alert users that they need to input new business logic and rules to prevent the same types of exception from occurring again. Tracking of the various steps and any manual interventions (to record who intervened, when, and why) is a critical component of a reconciliation and exception management system because a full audit trail is a requirement for institutions looking to improve their operation risk and compliance. As the regulatory noose continues to tighten, institutions will require that all of their applications have robust audit trail capabilities. Throughout the process, systems monitor the steps of the procedure and report statistics via management dashboards. More systems now holistically apply trade life-cycle management, capturing the trade from execution to trade matching to ongoing reconciliation versus custodial data. Reports and dashboards show the status of trades and provide “aging” reports to indicate which trades are approaching settlement but have not yet undergone critical steps in the process. Dashboards can also compare the operational performance against user-defined benchmarks, reporting these metrics in real time or near real time.

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Once the data have been normalised and validated, the matching process can commence. Accounts may be configured so the matching process starts as soon as the required data have been loaded, or the process may be manually triggered. As the programs run, the data may be subject to the following types of matching possibilities: One-to-one matching – matches items in a “one-to-one” manner. Aggregate matching – matches items in a “one-to-many,” “many-to-one,” or “many-to-many” manner. In addition, some systems continually try to add items to an “aggregate” match group until that group is resolved (debits  credits). Aggregate matching is ideal for situations in which the receipt of items may be spread over several days. Tolerance matching – utilising a pre-determined date, currency amount and/or percentage variance for matching purposes. Tolerance matching is an ideal solution to address so-called “nuisance” items associated with accounts. Tolerances are usually needed due to inconsistent data rounding methodologies used across multiple systems. Most systems can be configured to enable the creation of accounting journals for these differences or tolerances, which may then be booked into primary accounting systems. Multiple-pass matching – the system will attempt to match items based on user-defined criteria until it tries all designated sets of matched passes. Interactive matching – the ability to match or un-match items online, utilising system inquiry capabilities including access to full transaction histories. For items that do not match automatically, an exception or break will be created. The industry-accepted term for one of these events is a “case.” A reconciliation system or its associated investigations system deals with cases in a number of different ways. A “position” account that is reconciled when there are differences will generate transaction breaks. These breaks will be treated as “cases” by the system. As a position reconciliation effectively takes a snapshot of data at a particular moment, a position case cannot be cleared by the creation of any new data. The case will stay open for that value/event date until it is resolved. Once it has been investigated and the root cause found, the operator can send the case to “history.” This process changes the system status so that the system knows that it should no longer consider the case outstanding. A “transaction” account, whether a cash- or securities-type of event, that is reconciled when there are differences will also generate transaction breaks. Again, these breaks will be treated as “cases” by the system. As a transaction reconciliation effectively lists all transactions for an account,

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these cases may be cleared by the generation of new data. These cases will stay open until they are closed by being matched against other transactions. Multiple transactions may also be grouped to create what is called a “net” item. These net items are effectively system-generated transactions and are normally created by users who, although they have identified the reason for many unmatched items, want to remove a substantial number of items from the reconciliation before the real matching item is posted. When the matching item appears, it is matched against the net. The cases will then be closed and sent to history. Because some of the vendors’ systems do not allow searches against items when a net item exists, net items should be very carefully monitored and controlled. Within most systems, the position of transaction cases generated from the reconciliation process can be automatically allocated to specific workgroups or individuals for further investigation. The vendors refer to this as “workflow.” The allocation methodology can usually be configured by account, by transaction type, by break type and even by a calculated currency amount. These cases are usually presented as lists with a specific case identifier (“ID”). The “owner” of the case is then obliged to review the reconciliation system to see if any further matches are possible; otherwise, he or she must interrogate the enterprise’s systems in order to determine why a break has occurred. One significant requirement of these systems is the ability to relate position cases to transaction cases. As positions or balances are usually created by individual transactions, investigation of a position case requires an investigation of all of the actual transactions for that account. The customary business transaction processes matched by reconciliation processes include: electronic trade confirmation; status of transactions; cash and general ledger; and securities position balances. A position reconciliation entails reconciling an internal settled securities balance derived from the settlements system(s) against an external custodian’s statement. Internal system positions can also be reconciled in the same manner. Physical vault holdings could also be reconciled against a client’s position balance derived from the settlements system(s). The process is usually moderately automated. Stock reconciliations have traditionally been performed on a weekly or monthly basis depending on the underlying volume of transactions and size of the positions. Any breaks will be identified on the reconciliation as a net long or short position in a number of securities. To rectify breaks, it is necessary to analyse individual settled transactions, open and failing trades, stock loan/borrows and any pending corporate action bookings. A key issue is the accuracy and harmonisation of securities’ static data codes (ISIN/SEDOL/CUSIP, etc.) across various systems. Similar in style to a cash-type reconciliation, securities transaction reconciliations entail reconciling an internal statement of transactions derived

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from the settlements system(s) with an external custodian statement of transactions. Matching ledger-to-ledger items and statement-to-statement items will also be necessary due to transaction cancellations and amendments. This process is either not done or is highly automated. Custodians with low transaction volumes would probably not consider automating this reconciliation. Those with large transaction volumes that focus on automating transaction reconciliations gain considerably, however, as the individual transaction breaks are immediately identified, therefore establishing the cause for any position breaks. These companies generally reconcile events on a “one-to-one” basis. Any breaks will be highlighted as open items in the reconciliation.

Step 4: data archiving Archiving is another critical piece of a reconciliation system. Data have to be stored and archived in accordance with regulatory and corporate record-keeping requirements. The performance of some of the systems can be severely compromised by overfull databases. Automatically matched items will usually be sent to “history” immediately. This means that they are removed from the data tables of outstanding items. Some of the systems also enable the user to roll back the reconciliation process in order to reverse the matching process if things go wrong or errors are made. The motivators for investing in an integrated reconciliation and exception management platform are fairly basic.

R E D U C I N G O P E R AT I O N A L R I S K A N D C O S T S Investing in a robust vendor solution will improve operational risk for institutions currently managing reconciliations in a home-grown application that may be nothing more than a large-scale workaround that mixes partially automated system routines with Excel or Access presentations. Better management of exceptions in a timelier manner leads to fewer failed trades, fewer missed payments, and the like. By automating perhaps 95% of reconciliation activities and focusing only on the investigation and resolution of the 5% that are exceptions, institutions can significantly improve the speed with which their reconciliation staff solve the highestrisk problems. By integrating management dashboards tying in metrics and analytics regarding failed trade rates and other operational “hot spots,” the institution will also be better able to manage its brokers and custodians and eventually solve problems at the source.

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I M P R O V I N G O P E R AT I O N A L E F F I C I E N C Y Investing in a modern reconciliation system with all of the features detailed above may also allow the institution to focus less time and effort on the data itself. Configuring the system to map external and internal data files into the system’s common template once during implementation shifts the focus of the daily, weekly, or monthly reconciliation process from equal parts data and exceptions almost entirely to the exceptions. This allows the institution to become more proactive in recognising patterns in exceptions and applying new business logic that will improve the overall automation of the system. A large investment management firm typically assigns 50 or more personnel as users of its reconciliation system (either full time or part time) for reconciliation and exception resolution. Improvements in data capture and business logic and ultimately in overall automation of the reconciliation process will result in reductions of dedicated headcount or redeployment of personnel. Obviously, redeploying personnel to more strategic activities can improve the bottom line.

I M P R O V I N G R E G U L AT O R Y C O M P L I A N C E As global regulations become stricter, institutions are keenly focused on implementing systems with critical audit trail capabilities. A substandard home-grown solution is very unlikely to include any audit trail. Nor is it likely to be able to attach documents to exceptions or to better manage exceptions, alert appropriate users when a break occurs, or provide a management-level overview of the trade life-cycle. All of these features may be available in a vendor solution and will no doubt help the institution’s chief risk and compliance officers sleep better at night. This is not to say that some firms have not built robust proprietary solutions; however, such firms are rare.

M O V I N G R E C O N C I L I AT I O N F R O M P O S TSETTLEMENT TO NEAR REAL TIME Most reconciliation systems are first implemented for post-settlement reconciliation. But once such a system is in place, institutions can realise tremendous additional benefits from automated matching and generic reconciliations and can improve their operational efficiency overall in ways they may not have anticipated. Applying a holistic view to the trade lifecycle from execution to matching, settlement, and ongoing custody, allows

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an institution to apply more event-driven and near-real-time reconciliation and thereby catch potential exceptions before they become a material issue. Being more proactive toward trade breaks in this way allows the institution to focus on addressing the sources and causes of recurring trade breaks to further improve pass rates. The core function performed by the technology is not complex. Matching two data sets and reporting on any items that do not match is not the challenge. Many institutions have been able to accomplish this level of automation quite handily with home-grown solutions. What makes this process a challenge is the complexity of the IT architecture of today’s investment management firm and the lack of standardisation of the external data that must be acquired, interpreted, and mapped for managing exceptions through to resolution. Financial services institutions are complex organisations, and buy-side firms are no exception. Dealing with operational silos and a spaghettidiagram of applications and databases makes any implementation a challenge. For reconciliation systems the complexity is multiplied because the subledgers of multiple internal systems must first be reconciled versus the institution’s general ledger (GL) before the system can perform reconciliation versus the custodian(s) records. The challenge most widely cited by investment managers interviewed by TowerGroup in regard to reconciliation is data acquisition. If we were to conduct an informal survey of investment managers and ask them what percentage of their reconciliation efforts are focused on data acquisition and what percentage on matching and exception resolution, we believe that responses would be equally balanced between the two, if not leaning toward data acquisition. Arising from this challenge is the marketplace for outsourced data acquisition. A growing number of service providers are looking to leverage across multiple clients the interfaces that they’ve already built with custodians and brokers. In North America, adoption of SWIFT data standards is high only among top-tier investment managers and global custodians. Investment managers not currently using SWIFT to communicate with their custodians may find it challenging to switch to SWIFT’s format from their current formats. Institutions not well versed in SWIFT file formats, data tables, and codes may initially struggle to implement them. Buy-side firms often refer to the challenge of “interpreting the data standards” because each of their custodians may present them with a slightly different flavour of a “standard” data file. As the broad trend of business process outsourcing (BPO) continues in the investment management industry, service providers are naturally extending their solutions upstream to better serve their clients and gain

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Increasing Value

Application Hosting Third party provides outsourced hardware and software hosting and maintenance In traditional application service provider (ASP) model

Data Acquisition

Data Acquisition & Exception Investigation

Provider manages the acquisition of the client’s external data and the integration in to the reconciliation platform

Provider not only acquires the external data but runs basic matching and passes all exceptions back to client for investigation and resolution

Data Acquisition & Exception Resolution Provider acquires the external data, runs basic matching and investigates and resolves all but the most complex exceptions, which are passed back to client for investigation and resolution

Figure 14.2 Service levels of outsourced reconciliation Source: Stefan Sosnowski

potential revenues. A growing trend is for vendors to extend their services to data acquisition for clients and in some cases to the matching and exception identification stages. In this model, a vendor builds on its existing base of custodial and broker data links to acquire specific data on behalf of the investment manager. For an added fee, the vendor may also normalise the data and load it into the reconciliation system and may even perform the basic reconciliation process and the identification of exceptions. Within the last few years, several back-office and middle-office BPO providers have launched outsourced reconciliation services, which offer the investment manager the opportunity to outsource fully reconciliation from data acquisition to exception resolution. In essence, these services are a product of the providers’ excess processing capacity and therefore provide an ideal revenue source for the providers. A key question that some investment managers are struggling with is whether or not to centralise reconciliation in their organisations. It may seem to make sense to centralise similar services that can share a technology platform and skilled human resources, but the complexities involved may make it too difficult to centralise reconciliation to a single unit. Complicating reconciliation are specific reconciliation processes, the knowledge of the source data that may be required, the business logic to be applied, the participants involved (e.g., a particular custodian or broker), and the appropriate investigation techniques. Top-tier and large investment managers generally favour a centralised model, closely aligning reconciliation with fund accounting. This model creates a staff that is skilled in the reconciliation system and the process and that is agile enough to adapt as the business requires. Because of the size and complexity of the portfolios involved and the number of third parties involved (a large investment manager may deal with 100 or more custodians globally), one-to-one relationships and knowledge of the third parties may not be

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feasible. However, in midsize and smaller investment managers, decentralised reconciliation by product or asset class may make more sense. With fewer third parties to deal with and a smaller number of portfolios and transactions to reconcile, specific skill and knowledge at the staff level may prove beneficial, yielding more efficient reconciliation and speedy exception resolution. Pricing for the various solutions is based on several factors including: the number of modules to be implemented, the number of users on the system, the number of database licenses required, and the costs associated with geographic or global deployments. Most solutions are on-premise installations and range to over one million dollars or more on a license basis. Customisation and integration costs can quickly double, if not triple, those of the base licensing fees. Implementation times vary depending on the number of modules to be implemented and the amount of customisation and integration with existing front- and back-office systems. Vendors also offer a choice of one-off licenses, perpetual licenses, or software rentals. Some also have additional charges that relate to the volumes of transactions processed in the system and accounts opened in the system. User licenses tend to be charged for the number of concurrent users logged on to the database. Maintenance is sometimes included in the rental fee or can be in addition to a perpetual license price. Annual maintenance of approximately 17.5% is normal. Standard consultancy rates usually apply among all of the vendors. Automation of basic cash reconciliation can be implemented within one week to three months. In contrast, a more comprehensive solution that handles cash, securities positions, securities transactions and other generic reconciliation processes can take six months or more. Some of the newer, generic types of solutions are proving difficult to implement. Some of their generic capability is effectively still in development. In addition, their generic nature means that more time and resources are required to configure the system properly for each business line. We feel that the costs of implementing these systems should be identified and agreed upon in advance as the customers would appear to be bearing the real development costs of these systems for the vendors. Electronic reconciliation processes have traditionally depended on SWIFT message formats. The ISO 15022 and the previous ISO 7775 standards set the principles necessary to provide different communities of users with the tools to design message types to support their particular information flows. These tools consist of a set of syntax and message design rules, a dictionary of data fields, and a catalogue for present and future messages built by the industry with the afore-mentioned fields and rules. These structured messages now cover most event types: positions, transactions, and statements. They also include versions designed to deal with confirmations, amendments, cancellations and inquiries.

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Table 14.2

SWIFT ISO 15022 Reconciliation message types

SWIFT Message Types

SWIFT Ready Label Requirement

SWIFT Category

MT 100

Cash

MT 103 MT 192 MT 200

Cash Cash Cash

Gold

MT 202 MT 210 MT 292 MT 300 MT 320 MT 340

Cash Cash Cash FX Loans FRA

Gold Gold

MT 341

FRA

MT 900 MT 910 MT 940 MT 942 MT 950 MT 970 MT 972 MT 535 MT 536 MT 537

Cash Cash Cash Cash Cash Cash Cash Securities Securities Securities

Gold/Silver Gold/Silver Gold

MT 538 MT 540 MT 541 MT 542 MT 543 MT 544 MT 545

Securities Securities Securities Securities Securities Securities Securities

Gold Gold Gold Gold Gold Gold Gold

MT 546 MT 547

Securities Securities

Gold Gold

Gold Gold Gold/Silver Gold Gold/Silver

SWIFT Message Title Customer transfer, soon to be replaced with MT 103 Single customer credit transfer Request for cancellation Financial institution transfer for its own account Generic financial institution transfer Notice to receive Request for cancellation Foreign exchange confirmation Fixed loan deposit confirmation Forward rate agreement confirmation Forward rate agreement settlement confirmation Confirmation of debit Confirmation of credit Statement of customer message Interim transaction report Statement message Netting statement Netting interim statement Statement of holdings Statement of transactions Statement of pending transactions Statement of intra-position advices Receive free Receive against payment Deliver free Deliver against payment Receive free confirmation Receive against payment confirmation Deliver free confirmation Deliver against payment confirmation Continued

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Table 14.2

Continued

SWIFT Message Types

SWIFT Category

SWIFT Ready Label Requirement

MT 548

Securities

Gold

MT 549 MT 564 MT 565 MT 566 MT 575

Securities Securities Securities Securities Securities

Gold

MT n95

Investigation Gold messages Investigation Gold messages Investigation Gold messages

MT n96 MT n99

Gold

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SWIFT Message Title Settlement status and processing advice Request for statement/status advice Corporate actions notification Corporate actions instruction Corporate actions confirmation Report of combined activity – cash and securities Queries – where n is 1,2,3,5 exception management messages Answers – where n is 1,2,3,5 exception management messages Free format messsage – where n is 1,2,3,5 exception management messages

Source: SWIFT

Some of the current reconciliation systems still require all data to be normalised and effectively loaded as specific SWIFT format messages. These systems were only designed to match specific fields within these SWIFT messages. According to SWIFT, all of its users are now ISO 15022 compliant. While this means that these institutions are capable of sending and receiving these messages, what is really key here is how these messages are actually populated with data by legacy front-office, back-office and payments systems. For optimum STP to take place, firms need to be able to identify a transaction and its related events using unique internal and external transaction references. These references could be generated by exchanges, or they could be generated internally from in-house systems by clearing houses and central securities depositories (CSD). Many of the older core systems simply do not have the fields available or indeed the capability for transactions to be enriched with all the necessary references. Ensuring that these unique references stay intact throughout messaging among multiple systems and counterparties during the life cycle of a transaction is one of the keys to achieving STP.

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For a specific securities account, firms would usually receive two distinct statements, one for the cash-related transactions, the other for securities transactions. Naturally, most of the transactions on both statements are actually related. SWIFT created the MT575 Report of Combined Activity for Cash and Securities. This was developed because of a perceived need to create a message that integrated the cash and securities worlds. Surprisingly, this message has actually not become very popular. While it is very useful, because of the complexity of the message, most systems are actually unable to process it accurately. Several factors continue to motivate investment management firms to pursue projects with tangible operational efficiency results. Among them is the desire to mitigate operational risks, reduce or control costs, and improve the agility of the workforce. Add to these factors today’s regulatory environment, which is constantly challenging firms to improve their internal processes, improve the accuracy of their books and records, and maintain a tight audit trail, and the result is continued high interest in automated reconciliation and exception management systems. There are two approaches to reconciliation among buy-side firms: Some firms align reconciliation in a centralised team, while others align reconciliation by product or asset class. Each alignment has its benefits. Centralised alignment allows a firm to develop expertise in the intricacies of reconciliation, which may then allow the firm to redeploy staff to “hot spots” as the business demands. Aligning reconciliation by product or asset class fosters among the reconciliation staff a strong understanding of the securities and counterparties involved. There’s no one correct alignment and determining how to align reconciliation depends on the complexity of the reconciliation processes involved and the number of brokers and custodians involved. As buy-side firms look to move from a basic reconciliation system to a more robust platform integrating exception management tools and more generic reconciliation capabilities, we expect to see a continued high level of activity in this marketplace with a double-digit growth trajectory. The ability to generate real-time, near real-time, and intra-day data, to maintain and enrich transaction references across multiple systems, and to automate the resolution of exceptions will become key to controlling business. Batch processing-dependent reconciliation processes are becoming inadequate. Companies will need to understand the huge advantage of using one platform to cover transaction matching, reconciliations, exception processing and liquidity. Developments in the settlements world are leading to an environment in which counterparty netting and net settlement are commonplace, one where many thousands of transactions may ultimately result in one movement across a nostro account. Back-office departments supporting foreign exchange settlement activities through CLS, and in particular those

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supporting third party services, will need to be able to reconcile multiple trade amounts against one or more payments and also one or more receipts against multiple trade amounts. These higher volumes and more complex matching procedures will require reconciliation system users to use their system’s full functionality. Cash reconciliation processes have changed from reconciling end-of-day statements to intraday and so-called “value-time” checks, analysing cleared funds and O/D interest, invoicing business lines, and short-term cash forecasting and funding. Securities position reconciliation processes have also changed from a list of breaks to break-histories with related transactions, audit trails of notes and issues, and workflow reports showing risk exposures and outstanding queries. Reconciliation systems with generic data capture, normalisation and reconciliation capabilities are now the de facto standard. The older systems that rely on SWIFT cash messages still have a place as they have become optimised for specific data and message types and activities. But their limited matching and exception management capabilities may now be unsuitable if required to deal with further reconciliation challenges such as system-to-system reconciliations. The following eight observations highlight this further: 1. Organisations looking to upgrade their current reconciliation systems should, first of all, review their current processes, data sources, data formats, system configurations, matching rules and exception management requirements before rushing out to buy a new system. They just may be surprised to find that their current system is fine. Some companies have upgraded their reconciliation systems only to find the matching rates in the new system are approximately the same as their old system; 2. The exception management capabilities of these systems still need to be extended and require attention if these vendors are to succeed in their objective of being seen as STP champions, as the automatic resolution of exceptions is, after all, the goal; 3. The reward for establishing high-performance trade matching, enterprise-wide reconciliation and exception management is significant. A direct correlation exists between the installation of such systems and the ability to redeploy full-time employees in other core competency areas; 4. Reconciliation systems are part of the overall operational risk environment. However, contrary to vendors’ advertising and marketing, at this stage they cannot be considered operational risk management systems per se;

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5. There will be greater price competition among the players. We expect larger players with newer systems to discount their older but still capable systems in a bid to take out a few of the up-and-coming companies; 6. We shortly expect some cross-sector and geographic mergers and takeovers as the larger players seek to extend their market coverage; 7. All systems will ideally be capable of handling the new SWIFTNet XML message types when introduced; 8. Reconciliation production and investigation staff will initially need to be highly trained across multiple products and at each phase of an enterprise’s business transaction life cycle. The ongoing development of rulebased processing technology within these systems will ultimately reduce this dependency. Risk management policies within an organisation can only be as good as the data on which they are based. This is as true for operational risk as it is for other forms of risk. One aspect of operational risk is the increasing regulatory requirements for analysis and capital allocation. But perhaps more important are the sound business practices required to identify, assess, monitor, control and mitigate all operational risk factors and embed risk policies into daily operations. Operational controls, such as those implemented for reconciliation and exception management, used to be viewed by most senior management as necessary but otherwise unworthy of further interest. But now, in combination with workflow and business intelligence tools, they are increasingly viewed as providing the bedrock on which to build operational risk management structures. Reconciliation and exception management both deal with data from across the enterprise on a day-to-day basis, forming an excellent focal point for the application of operational risk controls and policies. A framework that combines automated solutions in these areas with systems and processes for workflow management and business intelligence can improve the quality of information available to senior management to formulate company policies and meet regulatory reporting requirements. By helping the organisation achieve the right balance between risk and efficiency it can also improve straight-through processing (STP) rates, reduce exposure to fraud and minimise internal losses by preventing potential losses from becoming actual. In today’s fast moving financial marketplace, 24 hours is a long time. In fact, it can spell disaster if you are unwittingly subject to poor operational risk management.

PART 5

The Future

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CHAPTER 15

The Future

P O S T-T R A D E A U T O M AT I O N Profitability and scalability are the two key business drivers facing the securities industry worldwide. Trading volumes are increasing, and so are the range and complexity of asset classes being traded. Organisations need solutions that help them grow their business while containing operational costs. In the next few years, organisations will have to replace the many manual processes that exist in their post-trade environments. They will need to further embrace automation and establish better internal and external integration to cope with increasingly global trading across asset classes. The industry is seeing an increase in order volume across all asset classes in particular over-the-counter (OTC) derivatives. This is creating a need to manage post-trade processing more accurately and efficiently than ever before. Significant volume growth has particularly been seen in credit derivatives. The notional amount of outstanding credit defaults swaps (CDS), for example, has doubled each year since 2001 and stood at $26 trillion in mid 2006. This is likely to continue as the use of derivatives becomes increasingly common as part of multi-asset class trading strategies by traditional asset managers and hedge funds. But as volumes of complex OTC derivatives have grown, so have the confirmation backlogs and potential settlement failures. One of the main reasons for these inefficiencies is that most organisations still rely excessively on manual processes to handle post-trade confirmation and payments processing. As volumes have grown, organisations have looked to increase headcount to cope with demand. But this approach is not sustainable – adding more people to the process does not resolve the issue of operational risk. Staffing and operational costs are important but the key issue is the 261

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finite pool of qualified and experienced people to work with these highly sophisticated financial instruments. Regulators and the International Swaps & Derivatives Association (ISDA) have been putting pressure on market participants to address the current problem of over-reliance on manual processing and settlement for these instruments. This has driven investment in the trade support and confirmation areas that has already started to reduce backlogs. Greater adoption of platforms such as DTCC’s Deriv SERV and “SWAPS wire” are also playing a part in offering standardised solutions for post-trade processing of vanilla OTC Derivatives. The 14 major dealers working with ISDA have met their targets for reducing confirmations backlogs in 2006. However, further investment is required if they, and the wider industry, are to further streamline operational processes to bring OTC derivatives more in line with other frequently traded asset classes – and ensure this a sustainable improvement. By 2008, industry analysts expect IT expenditure on credit derivatives trading and post-trade technologies to have increased by more than 50 per cent from 2005 levels. Organisations investing in securities processing technology to help them improve post-trade automation for credit derivatives should also be considering other asset classes as part of the same solution. If organisations can reduce confirmation backlogs and settlement risk for OTC derivatives on a common platform alongside equities, fixed income, foreign exchange and money markets, they stand to benefit from better support for multi-asset class trading strategies and further cost savings. The market is also becoming more and more integrated globally, with cross-market and cross-asset trading capabilities no longer the sole domain of the largest investment banks. Tier 1 financial institutions are increasingly operating in a seamless global environment rather than stand-alone entities in each market. This applies to investment banks, large buy-side firms and funds administrators. Geographic location no longer dictates the business that organisations take on and where they process it. Alternatively, firms are increasingly working through partnership and distribution agreements to operate in a global model, or outsourcing activities to focus on core competencies within the trading and settlement lifecycle. This globalisation is driving organisations to seek multi-asset, transaction process management systems that operate consistently across different markets, whether they are based in Europe, North America, the Middle East or Asia Pacific. The need to manage post-trade processing more efficiently is being driven by increases in trade volumes across all instrument types – including fixed income, equities, foreign exchange (FX), and over-thecounter (OTC) derivatives.

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Furthermore, equities-based firms are reinventing themselves and the retail space is being invigorated by a focus on wealth management. The pursuit of performance and client demand is taking organisations into alternative asset classes and new markets respectively. These new trading strategies are putting increased pressure on operations to support and service these activities. Cross-asset class trading is becoming a reality. There are now electronic execution venues for multiple asset classes and the financial information exchange (FIX) protocol is becoming reliable enough to support more than just equities. To date, the bulk of requests for cross-asset class trading services is originating from hedge funds. However, larger buy-side firms are also expected to invest in solutions that give them this capability. For larger organisations, the greatest challenge is linking trading desks and liquidity pools, which are usually separated. Away from the front-office more progress has been made. The technology exists today to process multi-asset class transactions in one central system. The more advanced buy side firms are leading the way in this regard. They are creating single systems to undertake the processing of all of their asset classes, whereas many dealers – while moving in that direction – are still using silo-based systems.

C O R P O R AT E A C T I O N S P R O C E S S I N G Profitability, performance and scalability are key business drivers facing the securities industry worldwide. With the industry striving for greater efficiencies at all stages of the trading life cycle, corporate actions has been identified as a key area for improvement Corporate actions processing has been identified as an area which involves significant risk – and one which is not simply confined to the ‘back-office’. It has an impact throughout the entire organisation, from front office trading strategies to risk, compliance and the efficiency of capital markets globally. The need for automation is driven by greater workloads, ever more stringent regulatory requirements, internal audit requirements and the growing adoption of electronic messaging (ISO 15022 & ISO 20022). However, CA automation brings additional business & technical challenges. Industry wide adoption of corporate action ISO 15022 standards is increasing, however there is still the need to be compliant when migrating to standard messaging formats and adhering to specific SMPG recommendations. The Securities Market Practice Group (SMPG) and the European Central Securities Depository Association (ECSDA) have been campaigning

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to improve standardisation by ensuring more consistent usage of the ISO 15022-based corporate actions messages. As organisations look to trusted partners to provide technology and services, more and more organisations will increase automation from standardised, workflow oriented, processing of corporate actions. The combined challenge for the corporate actions function is to process higher transaction volumes with increasing complexity characterised by a diverse range of asset classes, procedures, internal and external message formats and market specific nuances. At the same time, there is a need to introduce tighter controls, reduce costs, satisfy customers, maintain reputation and improve profits. It should also be borne in mind that any actual CA implementation project is likely to require the flexibility of operating both with the ‘official’ standards and the inevitable variants (as will be implemented by counterparties). The ability to cope with the ‘ideal world’ standard as well as the ‘real world’ pragmatic approach is an important consideration to bear in mind. The world of withholding tax remains remains a classic exemplifier of the corporate actions problem. Multiple counterparties, 30% automation in place and no sign on the horizon that tax authorities will join the automation band-wagon. Increasingly complex agreements between countries, changing reference data (tax rates) and variable processes mean that, for custodians, the new paradigm is virtual STP – outsourcing the function to a specialist using automation to create the secure pathways. Automation is the way forward and is inevitable. The fear of doing something will, in due course, be replaced by the fear of being left behind and unable to cope with the demands of SWIFT ISO 15022/20022 messaging and Basel II controls. There are numerous demonstrable benefits to embracing the inevitable: efficiency gains, reduction in risk, increased internal and external visibility, conformance to compliance issues, satisfied customers and, crucially, an enhanced bottom line.

R E G U L AT O R Y P R E S S U R E S The combination of market and regulatory pressures is creating a new interest in post-trade transaction process management systems. The Federal Reserve is demanding that dealing banks eliminate the voice, paper, and facsimile model in favour of electronic trading and automated processing – with algorithmic trading models across assets forcing the pace of change. Regulations such as the Sarbanes-Oxley Act, EU Data Protection Directives, Basel II & III and MiFiD are placing further pressures on global securities firms to prove the efficiency and resilience of operations, as well as the integrity and accuracy of transaction data. As a result organisations

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are increasingly looking to measure, monitor and manage all transactions post-execution, regardless of asset class, within a single architecture. Other regulations that might not directly impact post-trade functions will still have an impact. For example, the Markets in Financial Instruments Directive (MiFID) in Europe and the SEC’s new Regulation National Market System (Reg NMS) in the US both increase the frontoffice’s responsibilities to transparently demonstrate best execution. As organisations seek to comply with these regulations they will likely be processing more trades with more counterparties – further compounding the challenges of trading volume growth for the back-office, post-trade environment.

GROWING DEMAND FOR SINGLE P O S T-T R A D E A R C H I T E C T U R E Organisations are increasingly looking to manage post-trade processes in a single architecture regardless of asset class. Industry research published by Gartner forecasts that by 2008 four-fifths of investment services firms that trade in OTC derivatives will have automated and integrated their OTC derivatives systems so they can confirm trades the next business day. Gartner comments that the principal differentiator between competing OTC derivatives systems will be the capability for post-trade transaction process management and exception management – as well as the benefits of straight-through processing (STP) and integration. Successful institutions will be those that adopt industry standards to improve collaboration with other institutions for clearing, settlement and other commoditised posttrade processes. This observation from Gartner applies equally to post-trade process management systems across any asset class. Advanced workflow and exception management capabilities are required by organisations if they are to generate valuable ‘operational intelligence’ from their systems. This enables organisations to gather and analyse key information from across the organisation and ensure it is disseminated to the right people, at the right time, in the right format.

CONNECTIVITY AND MESSAGE S TA N D A R D S In response to the major challenges facing the securities industry, global institutions are increasingly interested in the concept of a post-trade

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gateway to help them:


Manage connections to multiple post-trade platforms;




Deal with multiple message standards;




Meet local and central matching requirements.

The complexity of a firm’s own technology infrastructure can sometimes make connecting to counterparties and post-trade utilities a major challenge. At a basic level, post-trade gateways address this by handling a certain level of internal integration, message transformation, monitoring and connectivity to external networks, utilities and counterparties. They do this without requiring the organisation to replace or upgrade existing technology assets. As the more innovative organisations have identified, moving to realtime transaction process management requires more than just a relatively simple gateway. It requires the ability to:


Model business processes at implementation and be able to configure them easily to reflect changes;




Encapsulate workflows, international securities market practice and local market practices;




Streamline and integrate exception management into these processes;




Provide internal and external integration to perform data enrichment at required stages.

Some of the leading investment managers with significant multi-asset class trading volumes have begun to use advanced techniques to allocate trades electronically – to their broker counterparties around the world – and automatically identify exceptions as they arise. They use solutions that do more than just bridge internal systems and external post-trade messaging platforms. They deploy configurable workflows and operational intelligence dashboards that help operations staff monitor all transactions and prioritise, investigate and resolve exceptions. By using these operational intelligence capabilities, they can gain a more accurate and timely overview of post-trade processing. They can further support industry efficiency by moving to same-day confirmation for the majority of transactions. Furthermore, they can identify what has been traded and allocated correctly, and which exceptions need greater scrutiny, on an intra-day basis.

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The central, global transaction process management solution is also a rich source of operational intelligence that organisations can use to analyse where, how, and why exceptions occurred. This intelligence can be used to make internal and external improvements and create an opportunity to strengthen internal processes and relationships with counterparties.

RISK WEIGHTING A number of organisations have taken operational risk management to the next level by risk weighting trades by instrument type, counterparty, currency, country of origin, and other parameters as they enter the transaction process management system. By front-loading every trade with a risk weighting it is much easier for operations staff to prioritise which exceptions receive their attention first and also to monitor problematic trades. Operational intelligence derived from historical reporting can be used to update this risk weighting. For example, data might reveal that more trades fail in one country than another and higher costs are incurred if trades fail in fixed income than equities. Therefore, the risk weighting of each trade type can be adjusted appropriately. Taking this a step further, a more sophisticated approach could use principal components analysis (PCA), a technique for simplifying a dataset by reducing multi-dimensional datasets to lower dimensions for analysis. Presentation of all exception information is crucial if it is going to be used to maximum effect. A configurable dashboard approach will enable an operations manager to act on the operational intelligence provided by a transaction process management solution. For example, they could filter all exceptions to focus on those that are time bound – first of all those settling that day, and then within that subset, those that have the highest value or risk weighting. A scoring system could inform an operations manager that any exceptions scored more than seven out of 10 will have to be resolved as a priority.

CROSS-ASSET PROCESSING EFFICIENCIES The organisations that are today handling multiple asset classes such as FX and equities on a common post-trade transaction process management system are benefiting from better workload management and reduced operational costs. For example, many organisations now deploy a single team to handle exceptions across multiple asset classes using the same system. If money markets exceptions have to be cleared by midday, the organisation can then

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redeploy the same staff onto equities and fixed-income exceptions in the afternoon. A Europe-based organisation would then be able to coordinate with its US operation and benefit from an extended working day for exception management.

LINKING TO FRONT OFFICE INVENTORIES The single view of exceptions across asset classes is being used by a number of trade support groups to effectively manage operational workload. However, this exception management information has not yet been linked back to the front office, which is the next logical step. Having an automated transaction process management system in place could also be a foundation for linking post-trade information back to front-office inventories. There are a number of ways organisations could benefit from this. For example, if an equity swap has associated corporate actions, it has implications for the cash flows relating to the OTC derivative. Today, no organisation has achieved this, despite the information and technology being available. Until the recent rise of multi-asset class trading strategies it may not have seemed a worthwhile initiative. However, in the next two to five years it is likely that the leading market participants will see the benefit of trade support groups providing the front office with this kind of information.

G R E AT E R I N T E G R AT I O N W I T H O T H E R P O S T-T R A D E S Y S T E M S Looking further ahead, it is likely that organisations will want to achieve greater integration between their transaction process management, corporate actions processing and post-trade reconciliation solutions. With an effective transaction process management system in place, there will be fewer breaks in the reconciliation process. But with closer integration, those that do emerge could be more quickly and efficiently resolved. For example, if an investment manager had a reconciliation break on a stockholding, they could easily link back to their corporate actions solution to see if an underlying stock split was the cause. Valuation of the underlying securities is particularly important for OTC. Where differences occur it could be due to corporate events on the underlying securities, from a rights issue or a dividend.

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In short, closer integration between these systems enables securities firms to take trades from an order management system and process them through the entire post-trade process through to settlement. They can then:


Address today’s pain points where lack of automation is hindering operations – whether it’s FX or OTC derivatives, but with an eye to using the same solution to eventually deal with multiple asset classes;




Look for more than just gateway functionality when scoping a new system. Most of the long-term value from investing in post-trade automation comes from being able to model workflows and integrate exception management into post-trade processes;




Ensure that workflows and the presentation of operational intelligence through a dashboard can be easily configured to meet your changing needs;




Consider some of the more advanced applications of post-trade operational intelligence to your business. Could your front-office benefit from a more real-time view of exceptions and inventory? If the answer is yes, but not yet, ensure that any changes to systems made today don’t inhibit this eventuality;




Investigate the possibilities of a unified exception management environment that minimises exceptions throughout the post-trade cycle and reconciliation processes, and makes it easier and faster to resolve the exceptions that do still emerge.

CONCLUSION The reality is that any extensive or exhaustive work on global custody and clearing would of necessity be a much very larger tome than this one and equally out of date before it ever hit the streets. We hope however, in the space available, to have given the reader a concise overview of what custody and clearing services are, how they interact with each other, the main issues that are tasking the industry and the drivers for change that will ensure that custody and clearing in five years – will probably need a completely different book to describe it.

APPENDIX I

Example of Securities Service Level Agreement The text sets out the minimum standards for CLIENT SLA and has been provided courtesy and with permission of Thomas Murray. The Service Level Agreement is divided into functional areas.

Settlement The settlement of securities transactions in all instruments where a client invests, according to the client’s settlement instructions. This service may include bulk settlement, where an asset manager block deals with brokers on behalf of its different clients/portfolios. Actual settlement is where a client’s account is credited/debited with cash or securities on the date settlement actually takes place. Contractual settlement service* is where a [CUSTODIAN] conditionally commits to credit cash proceeds to a client’s account on an agreed due date in freely available (i.e. cleared) funds. Provision of a contractual service will be contingent on [CUSTODIAN] receiving ‘clean’ trade instructions (i.e. complete, properly formatted and authenticated instructions), before pre-specified cut-off times. Related services provided by [CUSTODIAN]’s include trade affirmation and matching, failed trade notification (by type of fail) and resolution.

Key control objectives


All settlement instructions received are properly authenticated;




All authorised settlement transactions are recorded and processed completely, accurately and on a timely basis;




All transactions, including failed trades, should be dealt with on a timely basis;




All settlement transactions are pre-matched prior to settlement date.

Control objective: All authorised settlement transactions are recorded and processed completely, accurately and on a timely basis.

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Activity: Contractual settlement date accounting for securities purchases and sales Description of [CLIENT]’s requirements: To receive contractual settlement date accounting in all markets where [CLIENT] invests. The service should cover cash debits and credits related to all bonds and equities. Accounting and memorandum entries must be properly posted by [CUSTODIAN] to reflect contractual settlement.

[CUSTODIAN]’s service commitment

[CLIENT]’s service commitment

1. All settlement instructions are properly authorised and authenticated and sent by the agreed method of communication.

1. To instruct [CUSTODIAN] of purchases and sales within agreed deadlines

2. To pass all cash debits and credits related to all transactions on the contractual settlement date, provided that: i. [CUSTODIAN] receives instructions before the stated cut-off times and, ii. There are no external impediments in settling the transactions. 3. [CUSTODIAN] reserves the right to reverse cash proceeds should the trade not settle however, the bank will give [CLIENT] written confirmation of not less than 5 days. 4. If [CLIENT]’s trade instructions are received after [CUSTODIAN]’s timeframes, [CUSTODIAN] will apply CSDA should their sub-custodian achieve settlement for the contracted date. In such instances [CLIENT] will send notification to [CUSTODIAN] advising the specific trade(s) to which this should be applied. 5. To provide [CLIENT] with a trade settlement confirmation message MT54X on settlement date with the original transaction reference number (TRN) allocated by [CLIENT]. To advise immediately by telephone of any settlement confirmation sent to [CLIENT] in error.

2. To use the agreed method of delivering instructions. 3. For sales the securities will be available for delivery and cleared funds in settlement currency available for purchases.

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Activity: Trade amendments Description of [CLIENT]’s requirements: To receive contractual settlement date accounting on the stated value date where there are amendments – for example, where a failed trade requires amendment.

[CUSTODIAN]’s service commitment

[CLIENT]’s service commitment

1. Not to change the value date in markets where contractual settlement is applied.

1. If a failing trade requires an amendment to facilitate settlement, [CLIENT] will communicate the amendment to [CUSTODIAN] via SWIFT, proprietary link, or any other method to the Client Service Administrator, when it is close to the agreed deadline.

2. To action within the same day all amendments received within the agreed deadlines delivered by the agreed method of communication.

Control objective: All authorised settlement transactions are recorded and processed completely, accurately and on a timely basis.

Activity: Actual settlement of securities purchases and sales Description of [CLIENT]’s requirements: To receive actual settlement where [CLIENT] elects to receive actual settlement rather than contractual or where contractual settlement is unavailable. The service should cover all cash debits and credits related to all transactions. [CUSTODIAN]’s service commitment

[CLIENT]’s service commitment

1. To debit purchase costs on the expected settlement date, and credit sale proceeds within [24] hours of receiving confirmation of the receipt of funds from [CUSTODIAN]’s agent with good value.

1. To instruct [CUSTODIAN] of purchases and sales in accordance with agreed deadlines and delivered by the agreed method of communication.

2. To credit and debit [CLIENT]’s ledgers with [CUSTODIAN]’s transaction reference to reflect purchased and sold securities within 24 hours of settlement. 3. To report trade status information showing different codes for settlement and failing trades. 4. To clearly flag the day before that proceeds are due from a sale, through the cash projection/pending trade report. 5. To provide [CLIENT] with a trade settlement confirmation message MT54X on settlement date with the original transaction reference number (TRN) allocated by [CLIENT]. 6. To advise immediately by telephone of any settlement confirmation sent to [CLIENT] in error.

2. [CLIENT] should ensure that cleared funds are made available by value date to cover purchases. Actual settlement date accounting sale proceeds should not be utilised or remitted until the proceeds are confirmed on [CLIENT]’s account.

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Control objective: Settlement transactions are pre-matched prior to settlement date.

Activity: Matching trades, and on-line reporting of matched and un-matched trades. Description of [CLIENT]’s requirements: To receive up-to-date, on-line reports of the status of trades, including confirmed trades, outstanding trades, failed trades and reasons for failed trades. [CUSTODIAN]’s service commitment

[CLIENT]’s service commitment

1. On receipt [CUSTODIAN] will pre-match all trade instructions with [CLIENT]’s broker’s clearing agent, in accordance with local market practices.

1. No responsibility exists for [CLIENT] to contact [CUSTODIAN] about status of unsettled trades.

2. A pre-matching report will be sent daily to [CLIENT] by SWIFT MT54X, showing the standard SWIFT reason codes for the mismatch in field 23 for all unmatched transactions that are likely to fail unless remedial action is taken. CSA will verbally advise [CLIENT] in addition to any prematching report. 3. [CUSTODIAN] will notify [CLIENT] immediately by telephone if a matching problem is detected that requires immediate attention or is a large value transaction. 4. Settled trade details will be updated within 24 hours of settlement. 5. Any transactions alleged against [CLIENT] for which no instruction has been sent will be immediately reported by e-mail or telephone. This is in instances where counterparty has provided client details to [CUSTODIAN]’s sub custodian, thus identifying [CLIENT]. 6. [CUSTODIAN] will match all instructions without reference to [CLIENT] with cash differences within the standard market tolerances. 7. [CLIENT] will be advised immediately of settlement date of all failed trades by the agreed method of communication. 8. [CUSTODIAN] will only act on verbal instructions from mandated personnel for against payment transactions where such an instruction is followed up with an authorised instruction.

2. To contact counterparties to resolve unmatched trades when requested by [CUSTODIAN] to do so.

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Control objective: All transactions, including failed trades, should be settled on a timely basis.

Activity: Failed trade procedures Description of [CLIENT]’s requirements: To be informed by [CUSTODIAN], of actions required to complete a failed trade, as soon as [CUSTODIAN] becomes aware of a potential settlement difficulty. [CUSTODIAN]’s service commitment

[CLIENT]’s service commitment

1. To advise [CLIENT] of unmatched instructions for trades prior to value date, as well as those that have reached, and remain outstanding after value date.

1. To liaise with the counterparty to gather the information needed to complete the trade.

2. To take full responsibility for following up all unmatched trades on [CUSTODIAN]’s system after 24 hours, and seek resolution before contractual settlement date. 3. To inform [CLIENT] of the actions required to complete a failed trade.





Critical items will be referred to [CLIENT] immediately. Trades that are not due to settle for several days are referred no later than 24 hours after [CUSTODIAN] becomes aware of the potential settlement difficulty.

4. To resolve all interest claims on late settlement with the counterparties/brokers. 5. Covered under GCA.

2. To settle any interest claim or market fine caused as a result of the fault of [CLIENT].

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Activity: Daily reporting on the progress of failed trades Description of [CLIENT]’s requirements: To be up-dated, on a daily basis, of the progress of failed trades. [CUSTODIAN]’s service commitment

[CLIENT]’s service commitment

1. In addition to verbal communication, all trades that fail to settle on value date will be listed on the ‘outstanding trades’ report MT54X within 24 hours of the value date. This report will include standard reason codes in field 23 and will be updated on a daily basis until the trade has settled.

1. To take any reasonable action necessary to resolve failed trades, as requested by [CUSTODIAN].

2. To ensure that no outstanding transaction is overlooked by [CUSTODIAN]’s agents 3. To send [CLIENT] daily reports on the situation until it is resolved. 4. To provide a reason for each failed trade to alert [CLIENT]’s staff as to the original reason and current status. 5. [CUSTODIAN] will report any potential buy-in situations as a result of a filed trade at least 24 hours prior to execution of a buy-in and also on the day of the buy-in.

APPENDIX II

Example of a Service Level Standards Statement Category

Description

Performance standard

1

General

Business hours

Sub-Custodian will be operative from Monday to Friday from 7:30 a.m. to 5:00 p.m. EST (Eastern Standard Time). Closed on weekends and on market statutory holidays.

2

Account administration

Account opening

Sub-Custodian will open the following types of securities accounts: a single omnibus account an omnibus account for each tax status/treaty rate/tax pool an individual account for each client Title(s) of securities account(s) are to be in the name of the client and are linked to an individual/single cash account. Sub-Custodian will confirm the opening of a securities account by SWIFT MT 599 within 1 business day after receipt of instruction to open the account, providing the new account name(s) and number(s). Sub-Custodian will maintain a cash account which is linked to its securities account(s).

3

Client Services

Inquiries

Sub-Custodian will provide either an acknowledgement of receipt or a response within 24 hours of receipt of the inquiry. Where no complete response can be sent an explanation with an estimated time frame will be provided. Continued

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4

5

Category

Description

Performance standard

Client services

Market update

Sub-Custodian will notify Network Management department via fax, e-mail or telephone of any material changes impacting Sub-Custodian’s performance under the terms of the Sub-Custodian Agreement and this Service Level Standard

Client services

Market update

Sub-Custodian will send notices of market events, identified below, via e-mail or fax to the Network Management department within 24 hours of receipt as it pertains to the service provided: any changes in local market practices, settlement procedures, registration processes and local market changes any changes in regulations affecting foreign investment any changes in foreign exchange regulations and/or general banking practices any market participant which in the opinion of Sub-Custodian could affect the holdings of the Clients’, or the local securities market in general any significant political, economic or civic event that may, in the opinion of Sub-Custodian affect local financial markets

6

Safekeeping of securities

Asset statement

Sub-Custodian will send a statement of holdings via SWIFT MT535, identifying all assets which include the security description, availability of shares and market value (if available). The statement is sent overnight after close of business.

7

Settlement services

Cancellation

Sub-Custodian will accept cancellation of instructions via SWIFT MT54X. SubCustodian will provide confirmation of cancellation via SWIFT MT548 (realtime). Please note that automated cancellation via qualified MT54X is not possible at any point after the trade has been confirmed/matched or already settled at the depository.

8

Settlement services

Settlement confirmation

Sub-Custodian will report confirmation of settlement results real time using SWIFT MT54X. Please refer to the Sub-Custodian ISO 15022 Reference Guide. Continued

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Category

Description

Performance standard

9

Settlement services

Settlement status

Sub-Custodian will report failing/pending trades via SWIFT MT548 (real-time). (Please note that all code words will be received in Field Tag 25D or Tag 24B of the MT548)

10

Settlement services

Buy-in

Sub-Custodian will inform of potential buy-ins and will provide all necessary assistance to expedite the transaction. If Sub-Custodian receives notification of a buy-in, Sub-Custodian will communicate immediately the details, including all penalty charges incurred. The telephone conversation is confirmed via a SWIFT MT599, email or fax.

11

Income collection and redemptions

Entitlement confirmation

On declaration date, ex date, record date or books-closed date, whichever is applicable, Sub-Custodian will send a notice of entitlement via SWIFT MT564 identifying the account(s) (with their entitled position) eligible to participate in the income or redemption distribution.

12

Income collection and redemptions

Income confirmation

Sub-Custodian will provide the following details, on pay date – 5 business days, via SWIFT MT564 (for income) or maturity date – 3 business days, via MT566 (for redemption), upon crediting income: account name and number full security description (incl. ISIN code) pay date dividend or interest rate gross amount payable total collected amount of tax withheld Sub-Custodian will pay income based on the currency of income, i.e. USD or CAD. If a USD account has not been opened with Sub-Custodian, Sub-Custodian will automatically convert to CAD. For foreign income and redemptions, Sub-Custodian will credit Client’s account upon receipt of funds.

13

Income collection and redemptions

Income claims and adjustments

Sub-Custodian will debit Client’s cash account on 3rd business day after advising all legitimised claims against Client’s entitlement.

14

Corporate actions

Preliminary notice of

Preliminary notices are communicated within 24 hours of receipt of information Continued

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Category

15

Corporate actions

Description

Performance standard

corporate actions entitlements

and Official notices are based on record date holdings and are communicated within 24 hours (record date
1). Sub-Custodian will send a notice of entitlement via SWIFT MT564 identifying the account(s) (with their entitled position) eligible to participate in the corporate action as well as the nature of the action.

Corporate action – notification requirement

Sub-Custodian will provide the following information on all notifications within 1 business day of receipt of the official publication via SWIFT MT564 for mandatory corporate actions and voluntary corporate actions: security name and security identifier account name, account number and holdings corporate action type relevant dates: announcement date, ex date, record date, effective date, debit date, payment/debit amount, subcustodian and market deadlines, expected receivable date (if any), expire date security identifier all options available (in case of elective events) foreign investor restrictions fees related to corporate actions, commission and tax details (when applicable)

16

Corporate actions

Rights offering

For subscription rights offerings, SubCustodian will provide the following via MT564: subscription period and price the first day on which the rights become available trading period rights allotment ratio new entitlement ratio upon request Sub-Custodian will send any original documents received from the companies (e.g. allotment letters) within 1 business day of receipt. Corporate action notices will identify whether Solicitation fees are applicable on specific issues.

17

Corporate actions

Responses to voluntary corporate actions

Sub-Custodian’s deadline for response to voluntary corporate actions for securities held in book-based form at CDS is 10:00 am (EST) on the (CDS) market Depository for Securities’ deadline. Continued

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Category

Description

Performance standard The response deadlines for all other securities are as stated in the corporate action notification. Standard communication of corporate actions instructions is via SWIFT MT565. SubCustodian will acknowledge receipt of instructions via SWIFT MT567 (same day). Sub-Custodian will accept faxed instructions sent to the attention of Corporate Action Department at (416–955–3031), in urgent situations as well as for contingency purposes. Two authorised signatures are required on faxed instructions. Both signatures must be included in the Authorised Signatures list.

18

Corporate actions

Reminders

Sub-Custodian will monitor the receipt of client instructions required for voluntary events and will attempt to follow up when instructions have not been received. Earlier Reminder: Response Deadline Date – 3 Reminder Notice: Response Deadline Date – 1 Final Reminder: Legal Expiry ——-REMINDER NOTICE——SUB-CUSTODIAN HAS NOT RECEIVED YOUR INSTRUCTIONS IN RESPECT TO THE ABOVE CORPORATE ACTION. IF WE RECEIVE YOUR INSTRUCTION IT WILL BE PROCESSED WITHOUT LIABILITY ON THE PART OF SUB-CUSTODIAN AND WITHOUT THE GUARANTEE OF SUCCESSFUL COMPLETION. Instructions received after sub-custodian’s response deadlines are processed on a best efforts basis. It is not possible to guarantee successful completion of the action.

19

Corporate actions

Corporate action related entries and reporting

Sub-Custodian will book all relevant entries in the cash and custody account(s) with same-day value on payment, credit, distribution or settlement date, notifying by means of the appropriate detailed SWIFT advice. Cash advices provided and will have sufficient detail and/or reference to a security transaction. If a security received as a result of a corporate action is not immediately Continued

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Category

Description

Performance standard tradeable (e.g. new shares out for registration), Sub-Custodian will credit the shares upon receipt, clearly mentioning on the credit advice that the shares are unavailable for sale. As soon as they become tradeable, notification is sent via SWIFT MT508.

20

Corporate actions

Corporate actions client services entitlement protection

Corporate Action inquiries can be directed to Sub-Custodian’s hotline during business hours Monday to Friday, between 7:00 a.m. – 6:00 p.m. at (XXX) XXX XXXX or by e-mail. Sub-Custodian will respond to all inquiries within 24 hours or will provide an acknowledgement of receipt and estimated completion time within 24 hours.

21

Taxes

Tax withholding/ relief at source

Sub-Custodian will provide the withholding of tax with respect to the crediting of interest and dividends to the account which will depend on the accuracy of the beneficial owner’s residency, nationality and tax status provided to SubCustodian. The amount of tax withheld can be located on the income confirmation sent via MT566. Withholding tax information can be obtained in the Sub-Custodian Global Services market Withholding Tax Guide, which is available through the client’s account representative or the subCustodian’s website.

22

Fees and expenses

Invoicing and payment process

Sub-Custodian will provide Transaction and Custody fees calculated by the 7th business day and will send by email or mail. Fees are debited on the date agreed upon with the client. The fee invoice contains the following: A summary cover page containing the following information: sender and addressee name invoice number contact name, telephone and fax account number for which the charges apply invoice period covered subtotals by fee category (transactions, safekeeping, money transfer, others) subtotals by sub-accounts Continued

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APPENDIX II

Category

Description

Performance standard

Cash account administration

Account opening

Sub-Custodian will provide clients with the necessary forms and instructions to complete for identify verification and other due diligence requirements. New accounts will be opened within two Business Days after required information and documentation are received.

24

Cash account administration

Account maintenance

Sub-Custodian will implement changes, such as changes to signing officers, address and existing arrangements, within 48 hours of receiving such instructions

25

Cash account administration

Back valuation and interest statements

Sub-Custodian will dispatch Back Valuation and Interest statements by the 4th business day of each month. The statement will outline daily account balances, any value date adjustments made, applicable interest rates plus interest charges and payments.

26

Reporting

MT940/MT950 statement

Sub-Custodian will transmit MT940 or MT950 “Early Bird” statements by 22:00 hrs EST on date of transaction and the regular MT940 or MT950 statement by 5:30 hrs EST on the day following transaction date. The MT904/MT950 “Early Bird” statements will list all electronic transactions in increasing amount order (not chronologically) with debits followed by credits and opening and closing balances. The regular MT940/MT950 will include additional transactions such as cheques and internal debits.

27

Reporting

Confirmation of debits/credits MT900/MT910

Sub-Custodian will upon request transmit MT900/MT910 on a “real” time basis.

28

Payment processing

Cut-off times for payments

Sub-Custodian will process payments on value dates when received by the following cut-off times: Payments to a market bank with a bank/non-bank as ultimate beneficiary: Fully qualified – 17:30 hours Unqualified – 17:00 hours USD payments to a market bank (including Sub-Custodian) with a non-bank as ultimate beneficiary: Fully qualified – 17:00 hours Unqualified – 16:30 hours Continued

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Category

Description

283

Performance standard USD payments to a beneficiary in the USA: Fully qualified – 17:00 hours Unqualified – 16:30 hours Payments for credit to an account with Sub-Custodian’s bank (book transfers): Qualified or Unqualified – 19:00 hours Instructions received after cut-off times will be handled on a best-effort basis. In the event Sub-Custodian is unable to process a payment instruction due to lack of or insufficient instructions, SubCustodian will notify the client by SWIFT before the end of the business day.

29

Payment processing

Cut-off times amendments & cancellations

Sub-Custodian will process requests for same day amendment and cancellation by established cut-off times as follows: Same day cancellation of payments that have not yet been processed providing the instructions are: sent via MT295, MT292, MT299 or MT199 sent to “BICXXXXXXXX” received by Sub-Custodian before 02:00 hours EST on value date Process requests for same-day amendment/cancellation received at BICXXXXXXX after 02:00 hours EST on value date on a best-efforts basis. Process requests for same day amendment or cancellation of payments that have already been executed only if the beneficiary agrees. Process requests for amendment and cancellation for future value payments sent to Sub-Custodian SWIFT BIC other than BICXXXXXXXX before 17:30 EST one day prior to value date

30

Payment processing

Payment repairs

Sub-Custodian will make every effort to repair unqualified payment instructions and advise by SWIFT 299 on the following business day, of incorrectly formatted payments that have been successfully repaired. Where repairs cannot be completed, SubCustodian will contact the client for further instructions. Continued

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Category

Description

Performance standard

Payment processing

Investigations

Sub-Custodian will reply to all “in-house” investigations (i.e. where Sub-Custodian does not need information from outside sources) within 24 hours of receipt. Where information is required from a nonSub-Custodian source or is off-premises, Sub-Custodian will acknowledge receipt of the investigation within 24 hrs and follow-up and report on pending files every 5 business days. Sub-Custodian will upon request provide with notification of Sub-Custodian Prime rate change via MT935 within 24 hours of such rate change.

Interest rate

Rate changes

APPENDIX III

Standard Securities Lending Agreement Reproduced with permission of ISLA. Please note: inter-paragraph references have been removed and some re-formatting performed to assist the objective of providing the reader with a summary view of the contents of a securities lending agreement.

AGREEMENT BETWEEN: A & B APPLICABILITY From time to time the parties may enter into transactions in which one party (“Lender”) will transfer to the other (“Borrower”) securities and financial instruments (“Securities”) against the transfer of Collateral with a simultaneous agreement by Borrower to transfer to Lender Securities equivalent to such Securities on a fixed date or on demand against the transfer to Borrower by Lender of assets equivalent to such Collateral. Each such transaction shall be referred to in this Agreement as a “Loan” and shall be governed by the terms of this Agreement, including the supplemental terms and conditions contained in the Schedule and any Addenda or Annexes attached hereto, unless otherwise agreed in writing. Either party may perform its obligations under this Agreement either directly or through a Nominee.

I N T E R P R E TAT I O N In this Agreement: “Act of Insolvency” means in relation to either Party


It is making a general assignment for the benefit of, or entering into a reorganisation, arrangement, or composition with creditors; or




It is stating in writing that it is unable to pay its debts as they become due; or




It is seeking, consenting to or acquiescing in the appointment of any trustee, administrator, receiver or liquidator or analogous officer of it or any material part of its property; or




the presentation or filing of a petition in respect of it (other than by the other Party to this Agreement in respect of any obligation under this Agreement) in any court or before any agency alleging or for the bankruptcy, winding-up or insolvency of such Party (or any 285

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analogous proceeding) or seeking any reorganisation, arrangement, composition, re-adjustment, administration, liquidation, dissolution or similar relief under any present or future statute, law or regulation, such petition not having been stayed or dismissed within 30 days of its filing (except in the case of a petition for winding-up or any analogous proceeding in respect of which no such 30 day period shall apply); or


the appointment of a receiver, administrator, liquidator or trustee or analogous officer of such Party over all or any material part of such Party’s property; or




the convening of any meeting of its creditors for the purpose of considering a voluntary arrangement as referred to in Section 3 of the Insolvency Act 1986 (or any analogous proceeding).

“Alternative Collateral” means Collateral having a Market Value equal to the Collateral delivered and provided by way of substitution; “Base Currency” means the currency indicated in paragraph 2 of the Schedule; “Business Day” means a day other than a Saturday or a Sunday on which banks and securities markets are open for business generally in each place stated in paragraph 3 of the Schedule and, in relation to the delivery or redelivery of any of the following in relation to any Loan, in the place(s) where the relevant Securities, Equivalent Securities, Collateral or Equivalent Collateral are to be delivered; “Cash Collateral” means Collateral that takes the form of a transfer of currency; “Close of Business” means the time at which the relevant banks, securities exchanges or depositaries close in the business centre in which payment is to be made or Securities or Collateral is to be delivered; “Collateral” means such securities or financial instruments or transfers of currency as are referred to in the table set out under paragraph 1 of the Schedule as being acceptable or any combination thereof as agreed between the Parties in relation to any particular Loan and which are delivered by Borrower to Lender in accordance with this Agreement and shall include Alternative Collateral; “Defaulting Party” shall have the meaning given in paragraph 0; “Designated Office” means the branch or office of a Party which is specified as such in paragraph 4 of the Schedule or such other branch or office as may be agreed to in writing by the Parties; “Equivalent” or “equivalent to” in relation to any Securities or Collateral provided under this Agreement means securities, together with cash or other property (in the case of Collateral) as the case may be, of an identical type, nominal value, description and amount to particular Securities or Collateral, as the case may be, so provided. If and to the extent that such Securities or Collateral, as the case may be, consists of securities that are partly paid or have been converted, subdivided, consolidated, made the subject of a takeover, rights of pre-emption, rights to receive securities or a certificate which may at a future date be exchanged for securities, the expression shall include such securities or other assets to which Lender or Borrower, as the case may be, is entitled following the occurrence of the relevant event, and, if appropriate, the giving of the relevant notice in accordance with paragraph 6.4 and provided that Lender or Borrower, as the case may be, has paid to the other Party all and any sums due in respect thereof. In the event that such Securities or Collateral, as the case may be, have been redeemed, are partly paid, are the subject of a capitalisation issue or are subject to an event similar to any of the foregoing events described in this paragraph, the expression shall have the following meanings:


in the case of redemption, a sum of money equivalent to the proceeds of the redemption;




in the case of a call on partly paid securities, securities equivalent to the relevant Loaned Securities or Collateral, as the case may be, provided that Lender shall have paid Borrower, in respect of Loaned Securities, and Borrower shall have paid to Lender, in respect of Collateral, an amount of money equal to the sum due in respect of the call;




in the case of a capitalisation issue, securities equivalent to the relevant Loaned Securities or Collateral, as the case may be, together with the securities allotted by way of bonus thereon;




in the case of any event similar to any of the foregoing events described in this paragraph, securities equivalent to the Loaned Securities or the relevant Collateral, as the case may be, together with or replaced by a sum of money or securities or other property equivalent to that received in respect of such Loaned Securities or Collateral, as the case may be, resulting from such event;

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“Income” means any interest, dividends or other distributions of any kind whatsoever with respect to any Securities or Collateral; “Income Payment Date”, with respect to any Securities or Collateral means the date on which Income is paid in respect of such Securities or Collateral, or, in the case of registered Securities or Collateral, the date by reference to which particular registered holders are identified as being entitled to payment of Income; “Letter of Credit” means an irrevocable, non-negotiable, letter of credit in a form, and from a bank, acceptable to Lender; “Loaned Securities” means Securities which are the subject of an outstanding Loan; “Margin” shall have the meaning specified in paragraph 1 of the Schedule with reference to the table set out therein. “Market Value” means: in relation to the valuation of Securities, Equivalent Securities, Collateral or Equivalent Collateral (other than Cash Collateral or a Letter of Credit):


such price as is equal to the market quotation for the bid price of such Securities, Equivalent Securities, Collateral and/or Equivalent Collateral as derived from a reputable pricing information service reasonably chosen in good faith by Lender; or




if unavailable the market value thereof as derived from the prices or rates bid by a reputable dealer for the relevant instrument reasonably chosen in good faith by Lender.

in each case at Close of Business on the previous Business Day or, at the option of either Party where in its reasonable opinion there has been an exceptional movement in the price of the asset in question since such time, the latest available price; plus (in each case) the aggregate amount of Income which has accrued but not yet been paid in respect of the Securities, Equivalent Securities, Collateral or Equivalent Collateral concerned to the extent not included in such price, (provided that the price of Securities, Equivalent Securities, Collateral or Equivalent Collateral that are suspended shall (for the purposes of paragraph 0) be nil unless the Parties otherwise agree and (for all other purposes) shall be the price of such Securities, Equivalent Securities, Collateral or Equivalent Collateral, as the case may be, as of Close of Business on the dealing day in the relevant market last preceding the date of suspension or a commercially reasonable price agreed between the Parties); in relation to a Letter of Credit the face or stated amount of such Letter of Credit; and in relation to Cash Collateral the amount of the currency concerned; “Nominee” means an agent or a nominee appointed by either Party to accept delivery of, hold or deliver Securities, Equivalent Securities, Collateral and/or Equivalent Collateral or to receive or make payments on its behalf; “Non-Defaulting Party” shall have the meaning given in paragraph 0; “Parties” means Lender and Borrower and “Party” shall be construed accordingly; “Posted Collateral” has the meaning given in paragraph 5.4; “Required Collateral Value” shall have the meaning given in paragraph 5.4; “Settlement Date” means the date upon which Securities are transferred to Borrower in accordance with this Agreement.

HEADINGS All headings appear for convenience only and shall not affect the interpretation of this Agreement.

Market terminology Notwithstanding the use of expressions such as “borrow”, “lend”, “Collateral”, “Margin”, “redeliver” etc. which are used to reflect terminology used in the market for transactions of the kind

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provided for in this Agreement, title to Securities “borrowed” or “lent” and “Collateral” provided in accordance with this Agreement shall pass from one Party to another as provided for in this Agreement, the Party obtaining such title being obliged to redeliver Equivalent Securities or Equivalent Collateral as the case may be.

CURRENCY CONVERSIONS For the purposes of determining any prices, sums or values (including Market Value, Required Collateral Value, Relevant Value, Bid Value and Offer Value of this Agreement) prices, sums or values stated in currencies other than the Base Currency shall be converted into the Base Currency at the latest available spot rate of exchange quoted by a bank selected by Lender (or if an Event of Default has occurred in relation to Lender, by Borrower) in the London interbank market for the purchase of the Base Currency with the currency concerned on the day on which the calculation is to be made or, if that day is not a Business Day the spot rate of exchange quoted at Close of Business on the immediately preceding Business Day. The parties confirm that introduction of and/or substitution (in place of an existing currency) of a new currency as the lawful currency of a country shall not have the effect of altering, or discharging, or excusing performance under, any term of the Agreement or any Loan thereunder, nor give a party the right unilaterally to alter or terminate the Agreement or any Loan thereunder. Securities will for the purposes of this Agreement be regarded as equivalent to other securities notwithstanding that as a result of such introduction and/or substitution those securities have been redenominated into the new currency or the nominal value of the securities has changed in connection with such redenomination.

M O D I F I C AT I O N S E T C . T O L E G I S L AT I O N Any reference in this Agreement to an act, regulation or other legislation shall include a reference to any statutory modification or re-enactment thereof for the time being in force.

LO A N S O F S E C U R I T I E S Lender will lend Securities to Borrower, and Borrower will borrow Securities from Lender in accordance with the terms and conditions of this Agreement. The terms of each Loan shall be agreed prior to the commencement of the relevant Loan either orally or in writing (including any agreed form of electronic communication) and confirmed in such form and on such basis as shall be agreed between the Parties. Any confirmation produced by a Party shall not supersede or prevail over the prior oral, written or electronic communication (as the case may be).

DELIVERY Delivery of Securities on commencement of Loan Lender shall procure the delivery of Securities to Borrower or deliver such Securities in accordance with this Agreement and the terms of the relevant Loan. Such Securities shall be deemed to have been delivered by Lender to Borrower on delivery to Borrower or as it shall direct of the relevant instruments of transfer, or in the case of Securities held by an agent or within a clearing or settlement system on the effective instructions to such agent or the operator of such system which result in such Securities being held by the operator of the clearing system for the account of the Borrower or as it shall direct, or by such other means as may be agreed.

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Requirements to effect delivery The Parties shall execute and deliver all necessary documents and give all necessary instructions to procure that all right, title and interest in:


any Securities borrowed;




any Equivalent Securities redelivered;




any Collateral delivered;




any Equivalent Collateral redelivered.

shall pass from one Party to the other subject to the terms and conditions set out in this Agreement, on delivery or redelivery of the same in accordance with this Agreement with full title guarantee, free from all liens, charges and encumbrances. In the case of Securities, Collateral, Equivalent Securities or Equivalent Collateral title to which is registered in a computer based system which provides for the recording and transfer of title to the same by way of book entries, delivery and transfer of title shall take place in accordance with the rules and procedures of such system as in force from time to time. The Party acquiring such right, title and interest shall have no obligation to return or redeliver any of the assets so acquired but, in so far as any Securities are borrowed or any Collateral is delivered to such Party, such Party shall be obliged, subject to the terms of this Agreement, to redeliver Equivalent Securities or Equivalent Collateral as appropriate.

Deliveries to be simultaneous unless otherwise agreed Where under the terms of this Agreement a Party is not obliged to make a delivery unless simultaneously a delivery is made to it, subject to and without prejudice to its rights under paragraph 8.6 such Party may from time to time in accordance with market practice and in recognition of the practical difficulties in arranging simultaneous delivery of Securities, Collateral and cash transfers waive its right under this Agreement in respect of simultaneous delivery and/or payment provided that no such waiver (whether by course of conduct or otherwise) in respect of one transaction shall bind it in respect of any other transaction.

Deliveries of Income In respect of Income being paid in relation to any Loaned Securities or Collateral, Borrower in the case of Income being paid in respect of Loaned Securities and Lender in the case of Income being paid in respect of Collateral shall provide to the other Party, as the case may be, any endorsements or assignments as shall be customary and appropriate to effect the delivery of money or property equivalent to the type and amount of such Income to Lender, irrespective of whether Borrower received the same in respect of any Loaned Securities or to Borrower, irrespective of whether Lender received the same in respect of any Collateral.

C O L L AT E R A L Delivery of Collateral on commencement of Loan Subject to the other provisions of this paragraph 0, Borrower undertakes to deliver to or deposit with Lender (or in accordance with Lender’s instructions) Collateral simultaneously with delivery of the Securities to which the Loan relates and in any event no later than Close of Business on the Settlement Date. In respect of Collateral comprising securities, such Collateral shall be deemed to have been delivered by Borrower to Lender on delivery to Lender or as it shall direct of the relevant instruments of

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transfer, or in the case of such securities being held by an agent or within a clearing or settlement system, on the effective instructions to such agent or the operator of such system, which result in such securities being held by the operator of the clearing system for the account of the Lender or as it shall direct, or by such other means as may be agreed.

Deliveries through payment systems generating automatic payments Unless otherwise agreed between the Parties, where any Securities, Equivalent Securities, Collateral or Equivalent Collateral (in the form of securities) are transferred through a book entry transfer or settlement system which automatically generates a payment or delivery, or obligation to pay or deliver, against the transfer of such securities, then:such automatically generated payment, delivery or obligation shall be treated as a payment or delivery by the transferee to the transferor, and except to the extent that it is applied to discharge an obligation of the transferee to effect payment or delivery, such payment or delivery, or obligation to pay or deliver, shall be deemed to be a transfer of Collateral or redelivery of Equivalent Collateral, as the case may be, made by the transferee until such time as the Collateral or Equivalent Collateral is substituted with other Collateral or Equivalent Collateral if an obligation to deliver other Collateral or redeliver Equivalent Collateral existed immediately prior to the transfer of Securities, Equivalent Securities, Collateral or Equivalent Collateral; and the party receiving such substituted Collateral or Equivalent Collateral, or if no obligation to deliver other Collateral or redeliver Equivalent Collateral existed immediately prior to the transfer of Securities, Equivalent Securities, Collateral or Equivalent Collateral, the party receiving the deemed transfer of Collateral or redelivery of Equivalent Collateral, as the case may be, shall cause to be made to the other party for value the same day either, where such transfer is a payment, an irrevocable payment in the amount of such transfer or, where such transfer is a delivery, an irrevocable delivery of securities (or other property, as the case may be) equivalent to such property.

Substitutions of Collateral Borrower may from time to time call for the repayment of Cash Collateral or the redelivery of Collateral equivalent to any Collateral delivered to Lender prior to the date on which the same would otherwise have been repayable or redeliverable provided that at the time of such repayment or redelivery Borrower shall have delivered or delivers Alternative Collateral acceptable to Lender and Borrower is in compliance with paragraph 0 or paragraph 5.5, as applicable.

Marking to Market of Collateral during the currency of a Loan on aggregated basis Unless otherwise agreed between the Parties:
the aggregate Market Value of the Collateral delivered to or deposited with Lender (excluding any Equivalent Collateral repaid or redelivered under Paragraphs 5.4(ii) or 5.5(ii) (as the case may be)) (“Posted Collateral”) in respect of all Loans outstanding under this Agreement shall equal the aggregate of the Market Value of the Loaned Securities and the applicable Margin (the “Required Collateral Value”) in respect of such Loans;
if at any time on any Business Day the aggregate Market Value of the Posted Collateral in respect of all Loans outstanding under this Agreement exceeds the aggregate of the Required Collateral Values in respect of such Loans, Lender shall (on demand) repay and/or redeliver, as the case may be, to Borrower such Equivalent Collateral as will eliminate the excess;

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if at any time on any Business Day the aggregate Market Value of the Posted Collateral in respect of all Loans outstanding under this Agreement falls below the aggregate of Required Collateral Values in respect of all such Loans, Borrower shall (on demand) provide such further Collateral to Lender as will eliminate the deficiency.

Marking to Market of Collateral during the currency of a Loan on a Loan by Loan basis The Posted Collateral in respect of any Loan shall bear from day to day and at any time the same proportion to the Market Value of the Loaned Securities as the Posted Collateral bore at the commencement of such Loan. Accordingly:


the Market Value of the Posted Collateral to be delivered or deposited while the Loan continues shall be equal to the Required Collateral Value;




if at any time on any Business Day the Market Value of the Posted Collateral in respect of any Loan exceeds the Required Collateral Value in respect of such Loan, Lender shall (on demand) repay and/or redeliver, as the case may be, to Borrower such Equivalent Collateral as will eliminate the excess; and




if at any time on any Business Day the Market Value of the Posted Collateral falls below the Required Collateral Value, Borrower shall (on demand) provide such further Collateral to Lender as will eliminate the deficiency.

Requirements to redeliver excess Collateral If a Party (the “first Party”) would be required to provide further Collateral or redeliver Equivalent Collateral in circumstances where the other Party (the “second Party”) would be required to provide Collateral or redeliver Equivalent Collateral, then the Market Value of the Collateral or Equivalent Collateral deliverable by the first Party (“X”) shall be set-off against the Market Value of the Collateral or Equivalent Collateral deliverable by the second Party (“Y”) and the only obligation of the Parties shall be, where X exceeds Y, an obligation of the first Party, or where Y exceeds X, an obligation of the second Party to repay and/or (as the case may be) redeliver Equivalent Collateral or to deliver further Collateral having a Market Value equal to the difference between X and Y. Where Equivalent Collateral is repaid or redelivered (as the case may be) or further Collateral is provided by a Party, the Parties shall agree to which Loan or Loans such repayment, redelivery or further provision is to be attributed and failing agreement it shall be attributed, as determined by the Party making such repayment, redelivery or further provision to the earliest outstanding Loan and, in the case of a repayment or redelivery up to the point at which the Market Value of Collateral in respect of such Loan equals the Required Collateral Value in respect of such Loan, and then to the next earliest outstanding Loan up to the similar point and so on.

Timing of repayments of excess Collateral or deliveries of further Collateral Where any Equivalent Collateral falls to be repaid or redelivered (as the case may be) or further Collateral is to be provided, unless otherwise agreed between the Parties, it shall be delivered on the same Business Day as the relevant demand. Equivalent Collateral comprising securities shall be deemed to have been delivered by Lender to Borrower on delivery to Borrower or as it shall direct of the relevant instruments of transfer, or in the case of such securities being held by an agent or within a clearing or settlement system on the effective instructions to such agent or the operator of such system which result in such securities being held by the operator of the clearing system for the account of the Borrower or as it shall direct or by such other means as may be agreed.

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Substitutions and extensions of Letters of Credit Where Collateral is a Letter of Credit, Lender may by notice to Borrower require that Borrower, on the Business Day following the date of delivery of such notice, substitute Collateral consisting of cash or other Collateral acceptable to Lender for the Letter of Credit. Prior to the expiration of any Letter of Credit supporting Borrower’s obligations hereunder, Borrower shall, no later than 10.30a.m. UK time on the second Business Day prior to the date such Letter of Credit expires, obtain an extension of the expiration of such Letter of Credit or replace such Letter of Credit by providing Lender with a substitute Letter of Credit in an amount at least equal to the amount of the Letter of Credit for which it is substituted.

D I S T R I B U T I O N S A N D C O R P O R AT E ACTIONS Manufactured Payments Where Income is paid in relation to any Loaned Securities or Collateral (other than Cash Collateral) on or by reference to an Income Payment Date, Borrower, in the case of Loaned Securities, and Lender, in the case of Collateral, shall, on the date of the payment of such Income, or on such other date as the Parties may from time to time agree, (the “Relevant Payment Date”) pay and deliver a sum of money or property equivalent to the type and amount of such Income that, in the case of Loaned Securities, Lender would have been entitled to receive had such Securities not been loaned to Borrower and had been retained by Lender on the Income Payment Date, and, in the case of Collateral, Borrower would have been entitled to receive had such Collateral not been provided to Lender and had been retained by Borrower on the Income Payment Date unless a different sum is agreed between the Parties.

Income in the form of Securities Where Income, in the form of securities, is paid in relation to any Loaned Securities or Collateral, such securities shall be added to such Loaned Securities or Collateral (and shall constitute Loaned Securities or Collateral, as the case may be, and be part of the relevant Loan) and will not be delivered to Lender, in the case of Loaned Securities, or to Borrower, in the case of Collateral, until the end of the relevant Loan, provided that the Lender or Borrower (as the case may be) fulfils their obligations with respect to the additional Loaned Securities or Collateral, as the case may be.

Exercise of voting rights Where any voting rights fall to be exercised in relation to any Loaned Securities or Collateral, neither Borrower, in the case of Equivalent Securities, nor Lender, in the case of Equivalent Collateral, shall have any obligation to arrange for voting rights of that kind to be exercised in accordance with the instructions of the other Party in relation to the Securities borrowed by it or transferred to it by way of Collateral, as the case may be, unless otherwise agreed between the Parties.

Corporate actions Where, in respect of any Loaned Securities or any Collateral, any rights relating to conversion, subdivision, consolidation, pre-emption, rights arising under a takeover offer, rights to receive securities or

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a certificate which may at a future date be exchanged for securities or other rights, including those requiring election by the holder for the time being of such Securities or Collateral, become exercisable prior to the redelivery of Equivalent Securities or Equivalent Collateral, then Lender or Borrower, as the case may be, may, within a reasonable time before the latest time for the exercise of the right or option give written notice to the other Party that on redelivery of Equivalent Securities or Equivalent Collateral, as the case may be, it wishes to receive Equivalent Securities or Equivalent Collateral in such form as will arise if the right is exercised or, in the case of a right which may be exercised in more than one manner, is exercised as is specified in such written notice.

Rates applicable to loaned securities and cash collateral Rates in respect of Loaned Securities In respect of each Loan, Borrower shall pay to Lender, in the manner prescribed, sums calculated by applying such rate, as shall be agreed between the Parties from time to time, to the daily Market Value of the Loaned Securities.

Rates in respect of Cash Collateral Where Cash Collateral is deposited with Lender in respect of any Loan, Lender shall pay to Borrower sums calculated by applying such rates as shall be agreed between the Parties from time to time to the amount of such Cash Collateral. Any such payment due to Borrower may be set-off against any payment due to Lender.

Payment of rates In respect of each Loan, the payments shall accrue daily in respect of the period commencing on and inclusive of the Settlement Date and terminating on and exclusive of the Business Day upon which Equivalent Securities are redelivered or Cash Collateral is repaid. Unless otherwise agreed, the sums so accruing in respect of each calendar month shall be paid in arrear by the relevant Party not later than the Business Day which is one week after the last Business Day of the calendar month to which such payments relate or such other date as the Parties shall from time to time agree.

Redelivery of Equivalent Securities Delivery of Equivalent Securities on termination of a Loan Borrower shall procure the redelivery of Equivalent Securities to Lender or redeliver Equivalent Securities in accordance with this Agreement and the terms of the relevant Loan on termination of the Loan. Such Equivalent Securities shall be deemed to have been delivered by Borrower to Lender on delivery to Lender or as it shall direct of the relevant instruments of transfer, or in the case of Equivalent Securities held by an agent or within a clearing or settlement system on the effective instructions to such agent or the operator of such system which result in such Equivalent Securities being held by the operator of the clearing system for the account of the Lender or as it shall direct, or by such other means as may be agreed. For the avoidance of doubt any reference in this Agreement or in any other agreement or communication between the Parties (howsoever expressed) to an obligation to redeliver or account for or act in relation to Loaned Securities shall accordingly be construed as a reference to an obligation to redeliver or account for or act in relation to Equivalent Securities.

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Lender’s right to terminate a Loan Lender shall be entitled to terminate a Loan and to call for the redelivery of all or any Equivalent Securities at any time by giving notice on any Business Day of not less than the standard settlement time for such Equivalent Securities on the exchange or in the clearing organisation through which the Loaned Securities were originally delivered. Borrower shall redeliver such Equivalent Securities not later than the expiry of such notice in accordance with Lender’s instructions.

Borrower’s right to terminate a Loan Subject to the terms of the relevant Loan, Borrower shall be entitled at any time to terminate a Loan and to redeliver all and any Equivalent Securities due and outstanding to Lender in accordance with Lender’s instructions and Lender shall accept such redelivery.

Redelivery of Equivalent Collateral on termination of a Loan On the date and time that Equivalent Securities are required to be redelivered by Borrower on the termination of a Loan, Lender shall simultaneously repay to Borrower any Cash Collateral or, as the case may be, redeliver Collateral equivalent to the Collateral provided by Borrower in respect of such Loan. For the avoidance of doubt any reference in this Agreement or in any other agreement or communication between the Parties (however expressed) to an obligation to redeliver or account for or act in relation to Collateral shall accordingly be construed as a reference to an obligation to redeliver or account for or act in relation to Equivalent Collateral.

Redelivery of Letters of Credit Where a Letter of Credit is provided by way of Collateral, the obligation to redeliver Equivalent Collateral is satisfied by Lender redelivering for cancellation the Letter of Credit so provided, or where the Letter of Credit is provided in respect of more than one Loan, by Lender consenting to a reduction in the value of the Letter of Credit.

Redelivery obligations to be reciprocal Neither Party shall be obliged to make delivery (or make a payment as the case may be) to the other unless it is satisfied that the other Party will make such delivery (or make an appropriate payment as the case may be) to it. If it is not so satisfied (whether because an Event of Default has occurred in respect of the other Party or otherwise) it shall notify the other party and unless that other Party has made arrangements which are sufficient to assure full delivery (or the appropriate payment as the case may be) to the notifying Party, the notifying Party shall (provided it is itself in a position, and willing, to perform its own obligations) be entitled to withhold delivery (or payment, as the case may be) to the other Party.

Failure to redeliver Borrower’s failure to redeliver Equivalent Securities If Borrower does not redeliver Equivalent Securities, Lender may elect to continue the Loan provided that if Lender does not elect to continue the Loan, Lender may either by written notice to Borrower terminate the Loan forthwith and the Parties’ delivery and payment obligations in respect thereof (in which case sub-paragraph (ii) below shall apply) or serve a notice of an Event of Default.

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Upon service of a notice to terminate the relevant Loan:


there shall be set-off against the Market Value of the Equivalent Securities concerned such amount of Posted Collateral chosen by Lender (calculated at its Market Value) as is equal thereto;




the Parties delivery and payment obligations in relation to such assets which are set-off shall terminate;




in the event that the Market Value of the Posted Collateral set-off is less than the Market Value of the Equivalent Securities concerned Borrower shall account to Lender for the shortfall; and




Borrower shall account to Lender for the total costs and expenses incurred by Lender as a result thereof as set out in paragraphs 9.3 and 9.4 from the time the notice is effective.

Lender’s failure to Redeliver Equivalent Collateral If Lender does not redeliver Equivalent Collateral, Borrower may either by written notice to Lender terminate the Loan forthwith and the Parties’ delivery and payment obligations in respect thereof or serve a notice of an Event of Default. Upon service of a notice to terminate the relevant Loan pursuant to paragraph 9.2(i):


there shall be set-off against the Market Value of the Equivalent Collateral concerned the Market Value of the Loaned Securities;




the Parties’ delivery and payment obligations in relation to such assets which are set-off shall terminate;




in the event that the Market Value of the Loaned Securities held by Borrower is less than the Market Value of the Equivalent Collateral concerned Lender shall account to Borrower for the shortfall; and




Lender shall account to Borrower for the total costs and expenses incurred by Borrower as a result thereof from the time the notice is effective.

Failure by either Party to redeliver This provision applies in the event that a Party (the “Transferor”) fails to meet a redelivery obligation within the standard settlement time for the asset concerned on the exchange or in the clearing organisation through which the asset equivalent to the asset concerned was originally delivered or within such other period as may be agreed between the Parties. In such situation, in addition to the Parties’ rights under the general law and this Agreement where the other Party (the “Transferee”) incurs interest, overdraft or similar costs and expenses the Transferor agrees to pay on demand and hold harmless the Transferee with respect to all such costs and expenses which arise directly from such failure excluding (i) such costs and expenses which arise from the negligence or wilful default of the Transferee and (ii) any indirect or consequential losses. It is agreed by the Parties that any costs reasonably and properly incurred by a Party arising in respect of the failure of a Party to meet its obligations under a transaction to sell or deliver securities resulting from the failure of the Transferor to fulfil its redelivery obligations is to be treated as a direct cost or expense for the purposes of this paragraph.

Exercise of buy-in on failure to redeliver In the event that as a result of the failure of the Transferor to fulfil its redelivery obligations a “buy-in” is exercised against the Transferee, then the Transferor shall account to the Transferee for the total costs and expenses reasonably incurred by the Transferee as a result of such “buy-in”.

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Set-Off etc. In this paragraph: “Bid Price” in relation to Equivalent Securities or Equivalent Collateral means the best available bid price on the most appropriate market in a standard size; “Bid Value” means:
in relation to Collateral equivalent to Collateral in the form of a Letter of Credit zero and in relation to Cash Collateral the amount of the currency concerned; and
in relation to Equivalent Securities or Collateral equivalent to all other types of Collateral the amount which would be received on a sale of such Equivalent Securities or Equivalent Collateral at the Bid Price at Close of Business on the relevant Business Day less all costs, fees and expenses that would be incurred in connection therewith, calculated on the assumption that the aggregate thereof is the least that could reasonably be expected to be paid in order to carry out such sale or realisation and adding thereto the amount of any interest, dividends, distributions or other amounts, in the case of Equivalent Securities, paid to Borrower and in respect of which equivalent amounts have not been paid to Lender and in the case of Equivalent Collateral, paid to Lender and in respect of which equivalent amounts have not been paid to Borrower, prior to such time in respect of such Equivalent Securities, Equivalent Collateral or the original Securities or Collateral held, gross of all and any tax deducted or paid in respect thereof;

“Offer Price” in relation to Equivalent Securities or Equivalent Collateral means the best available offer price on the most appropriate market in a standard size; “Offer Value” means:
in relation to Collateral equivalent to Collateral in the form of a Letter of Credit zero and in relation to Cash Collateral the amount of the currency concerned; and
in relation to Equivalent Securities or Collateral equivalent to all other types of Collateral the amount it would cost to buy such Equivalent Securities or Equivalent Collateral at the Offer Price at Close of Business on the relevant Business Day together with all costs, fees and expenses that would be incurred in connection therewith, calculated on the assumption that the aggregate thereof is the least that could reasonably be expected to be paid in order to carry out the transaction and adding thereto the amount of any interest, dividends, distributions or other amounts, in the case of Equivalent Securities, paid to Borrower and in respect of which equivalent amounts have not been paid to Lender and in the case of Equivalent Collateral, paid to Lender and in respect of which equivalent amounts have not been paid to Borrower, prior to such time in respect of such Equivalent Securities, Equivalent Collateral or the original Securities or Collateral held, gross of all and any tax deducted or paid in respect thereof.

Termination of delivery obligations upon Event of Default If an Event of Default occurs in relation to either Party, the Parties’ delivery and payment obligations (and any other obligations they have under this Agreement) shall be accelerated so as to require performance thereof at the time such Event of Default occurs (the date of which shall be the “Termination Date” for the purposes of this clause) so that performance of such delivery and payment obligations shall be effected only in accordance with the following provisions: the Relevant Value of the securities which would have been required to be delivered but for such termination (or payment to be made, as the case may be) by each Party shall be established; and on the basis of the Relevant Values so established, an account shall be taken (as at the Termination Date) of what is due from each Party to the other and (on the basis that each Party’s claim against the other in respect of delivery of Equivalent Securities or Equivalent Collateral or any cash payment equals the Relevant Value thereof) the sums due from one Party shall be set-off against the sums due from the

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other and only the balance of the account shall be payable (by the Party having the claim valued at the lower amount pursuant to the foregoing) and such balance shall be payable on the Termination Date. If the Bid Value is greater than the Offer Value, and the Non-Defaulting Party had delivered to the Defaulting Party a Letter of Credit, the Defaulting Party shall draw on the Letter of Credit to the extent of the balance due and shall subsequently redeliver for cancellation the Letter of Credit so provided. If the Offer Value is greater than the Bid Value, and the Defaulting Party had delivered to the NonDefaulting Party a Letter of Credit, the Non-Defaulting Party shall draw on the Letter of Credit to the extent of the balance due and shall subsequently redeliver for cancellation the Letter of Credit so provided. In all other circumstances, where a Letter of Credit has been provided to a Party, such Party shall redeliver for cancellation the Letter of Credit so provided.

Determination of delivery values upon Event of Default “Relevant Value”:


of any securities to be delivered by the Defaulting Party shall equal the Offer Value of such securities; and




of any securities to be delivered to the Defaulting Party shall equal the Bid Value of such securities.

The Bid Value and Offer Value of any securities shall be calculated for securities of the relevant description (as determined by the Non-Defaulting Party) as of the first Business Day following the Termination Date, or if the relevant Event of Default occurs outside the normal business hours of such market, on the second Business Day following the Termination Date (the “Default Valuation Time”); Where the Non-Defaulting Party has following the occurrence of an Event of Default but prior to the close of business on the fifth Business Day following the Termination Date purchased securities forming part of the same issue and being of an identical type and description to those to be delivered by the Defaulting Party or sold securities forming part of the same issue and being of an identical type and description to those to be delivered by him to the Defaulting Party, the cost of such purchase or the proceeds of such sale, as the case may be, (taking into account all reasonable costs, fees and expenses that would be incurred in connection therewith) shall be treated as the Offer Value or Bid Value, as the case may be, of the amount of securities to be delivered which is equivalent to the amount of the securities so bought or sold, as the case may be, so that where the amount of securities to be delivered is more than the amount so bought or sold as the case may be, the Offer Value or Bid Value as the case may be, of the balance shall be valued. Any reference in this paragraph to securities shall include any asset other than cash provided by way of Collateral.

Other costs, expenses and interest payable in consequence of an Event of Default The Defaulting Party shall be liable to the Non-Defaulting Party for the amount of all reasonable legal and other professional expenses incurred by the Non-Defaulting Party in connection with or as a consequence of an Event of Default, together with interest thereon at the one-month London Inter Bank Offered Rate as quoted on a reputable financial information service (“LIBOR”) as of 11.00 am, London Time, on the date on which it is to be determined or, in the case of an expense attributable to a particular transaction and where the parties have previously agreed a rate of interest for the transaction, that rate of interest if it is greater than LIBOR. The rate of LIBOR applicable to each month or part thereof that any sum payable remains outstanding is the rate of LIBOR determined on the first Business Day of any such period of one month or any part thereof. Interest will accrue daily on a compound basis and will be calculated according to the actual number of days elapsed.

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Transfer taxes Borrower hereby undertakes promptly to pay and account for any transfer or similar duties or taxes chargeable in connection with any transaction effected pursuant to or contemplated by this Agreement, and shall indemnify and keep indemnified Lender against any liability arising as a result of Borrower’s failure to do so.

Lender’s Warranties Each Party hereby warrants and undertakes to the other on a continuing basis to the intent that such warranties shall survive the completion of any transaction contemplated herein that, where acting as a Lender: it is duly authorised and empowered to perform its duties and obligations under this Agreement; it is not restricted under the terms of its constitution or in any other manner from lending Securities in accordance with this Agreement or from otherwise performing its obligations hereunder; it is absolutely entitled to pass full legal and beneficial ownership of all Securities provided by it hereunder to Borrower free from all liens, charges and encumbrances; and it is acting as principal in respect of this Agreement or as agent and the conditions will be fulfilled in respect of any Loan which it makes as agent.

Borrower’s Warranties Each Party hereby warrants and undertakes to the other on a continuing basis to the intent that such warranties shall survive the completion of any transaction contemplated herein that, where acting as a Borrower:


it has all necessary licenses and approvals, and is duly authorised and empowered, to perform its duties and obligations under this Agreement and will do nothing prejudicial to the continuation of such authorisation, licences or approvals;




it is not restricted under the terms of its constitution or in any other manner from borrowing Securities in accordance with this Agreement or from otherwise performing its obligations hereunder;




it is absolutely entitled to pass full legal and beneficial ownership of all Collateral provided by it hereunder to Lender free from all liens, charges and encumbrances; and




it is acting as principal in respect of this Agreement.

Events of Default Each of the following events occurring in relation to either Party (the “Defaulting Party”, the other Party being the “Non-Defaulting Party”) shall be an Event of Default but only where the Non-Defaulting Party serves written notice on the Defaulting Party:


Borrower or Lender failing to pay or repay Cash Collateral or deliver Collateral or redeliver Equivalent Collateral or Lender failing to deliver Securities upon the due date;




Lender or Borrower failing to comply with its obligations;




Borrower failing to comply with its obligations to deliver Equivalent Securities;




an Act of Insolvency occurring with respect to Lender or Borrower, an Act of Insolvency which is the presentation of a petition for winding up or any analogous proceeding or the appointment of a liquidator or analogous officer of the Defaulting Party not requiring the Non-Defaulting Party to serve written notice on the Defaulting Party;

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any representation or warranty made by Lender or Borrower being incorrect or untrue in any material respect when made or repeated or deemed to have been made or repeated;




Lender or Borrower admitting to the other that it is unable to, or it intends not to, perform any of its obligations under this Agreement and/or in respect of any Loan;




Lender (if applicable) or Borrower being declared in default or being suspended or expelled from membership of or participation in, any securities exchange or association or suspended or prohibited from dealing in securities by any regulatory authority;




any of the assets of Lender or Borrower or the assets of investors held by or to the order of Lender or Borrower being transferred or ordered to be transferred to a trustee (or a person exercising similar functions) by a regulatory authority pursuant to any securities regulating legislation; or




Lender or Borrower failing to perform any other of its obligations under this Agreement and not remedying such failure within 30 days after the Non-Defaulting Party serves written notice requiring it to remedy such failure.

Each Party shall notify the other (in writing) if an Event of Default or an event which, with the passage of time and/or upon the serving of a written notice as referred to above, would be an Event of Default, occurs in relation to it. The provisions of this Agreement constitute a complete statement of the remedies available to each Party in respect of any Event of Default. Neither Party may claim any sum by way of consequential loss or damage in the event of failure by the other party to perform any of its obligations under this Agreement.

Interest on Outstanding Payments In the event of either Party failing to remit sums in accordance with this Agreement such Party hereby undertakes to pay to the other Party upon demand interest (before as well as after judgment) on the net balance due and outstanding, for the period commencing on and inclusive of the original due date for payment to (but excluding) the date of actual payment, in the same currency as the principal sum. Interest will accrue daily on a compound basis and will be calculated according to the actual number of days elapsed.

Transactions Entered Into As Agent Power for Lender to enter into Loans as agent Subject to the following provisions of this paragraph, Lender may (if so indicated in paragraph 6 of the Schedule) enter into Loans as agent (in such capacity, the “Agent”) for a third person (a “Principal”), whether as custodian or investment manager or otherwise (a Loan so entered into being referred to in this paragraph as an “Agency Transaction”).

Conditions for agency loan A Lender may enter into an Agency Transaction if, but only if:


it specifies that Loan as an Agency Transaction at the time when it enters into it;




it enters into that Loan on behalf of a single Principal whose identity is disclosed to Borrower (whether by name or by reference to a code or identifier which the Parties have agreed will be used to refer to a specified Principal) at the time when it enters into the Loan or as otherwise agreed between the Parties; and

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it has at the time when the Loan is entered into actual authority to enter into the Loan and to perform on behalf of that Principal all of that Principal’s obligations under the agreement.

Notification by Lender of certain events affecting the principal Lender undertakes that, if it enters as agent into an Agency Transaction, forthwith upon becoming aware:


of any event which constitutes an Act of Insolvency with respect to the relevant Principal; or




of any breach of any of the warranties given in paragraph 0 or of any event or circumstance which has the result that any such warranty would be untrue if repeated by reference to the then current facts;




it will inform Borrower of that fact and will, if so required by Borrower, furnish it with such additional information as it may reasonably request.

Status of agency transaction Each Agency Transaction shall be a transaction between the relevant Principal and Borrower and no person other than the relevant Principal and Borrower shall be a party to or have any rights or obligations under an Agency Transaction. Without limiting the foregoing, Lender shall not be liable as principal for the performance of an Agency Transaction, but this is without prejudice to any liability of Lender under any other provision of this clause; and all the provisions of the Agreement shall apply separately as between Borrower and each Principal for whom the Agent has entered into an Agency transaction or Agency Transactions as if each such Principal were a party to a separate agreement with Borrower in all respects identical with this Agreement other than this paragraph and as if the Principal were Lender in respect of that agreement; PROVIDED THAT
if there occurs in relation to the Agent an Event of Default or an event which would constitute an Event of Default if Borrower served written notice, Borrower shall be entitled by giving written notice to the Principal to declare that by reason of that event an Event of Default is to be treated as occurring in relation to the Principal. If Borrower gives such a notice then an Event of Default shall be treated as occurring in relation to the Principal at the time when the notice is deemed to be given; and
if the Principal is neither incorporated in nor has established a place of business in Great Britain, the Principal shall for the purposes of the agreement be deemed to have appointed as its agent to receive on its behalf service of process in the courts of England the Agent, or if the Agent is neither incorporated nor has established a place of business in Great Britain, the person appointed by the Agent for the purposes of this Agreement, or such other person as the Principal may from time to time specify in a written notice given to the other Party.

The foregoing provisions of this paragraph do not affect the operation of the Agreement as between Borrower and Lender in respect of any transactions into which Lender may enter on its own account as principal.

Warranty of authority by Lender acting as agent Lender warrants to Borrower that it will, on every occasion on which it enters or purports to enter into a transaction as an Agency Transaction, have been duly authorised to enter into that Loan and perform the obligations arising under such transaction on behalf of the person whom it specifies as the Principal in respect of that transaction and to perform on behalf of that person all the obligations of that person under the agreement.

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Termination of this agreement Each Party shall have the right to terminate this Agreement by giving not less than 15 Business Days’ notice in writing to the other Party (which notice shall specify the date of termination) subject to an obligation to ensure that all Loans which have been entered into but not discharged at the time such notice is given are duly discharged in accordance with this Agreement.

Single Agreement Each Party acknowledges that, and has entered into this Agreement and will enter into each Loan in consideration of and in reliance upon the fact that, all Loans constitute a single business and contractual relationship and are made in consideration of each other. Accordingly, each Party agrees:


to perform all of its obligations in respect of each Loan, and that a default in the performance of any such obligations shall constitute a default by it in respect of all Loans; and




that payments, deliveries and other transfers made by either of them in respect of any Loan shall be deemed to have been made in consideration of payments, deliveries and other transfers in respect of any other Loan.

Severance If any provision of this Agreement is declared by any judicial or other competent authority to be void or otherwise unenforceable, that provision shall be severed from the Agreement and the remaining provisions of this Agreement shall remain in full force and effect. The Agreement shall, however, thereafter be amended by the Parties in such reasonable manner so as to achieve as far as possible, without illegality, the intention of the Parties with respect to that severed provision.

Specific Performance Each Party agrees that in relation to legal proceedings it will not seek specific performance of the other Party’s obligation to deliver or redeliver Securities, Equivalent Securities, Collateral or Equivalent Collateral but without prejudice to any other rights it may have.

Notices Any notice or other communication in respect of this Agreement may be given in any manner set forth below to the address or number or in accordance with the electronic messaging system details set out in paragraph 4 of the Schedule and will be deemed effective as indicated:


if in writing and delivered in person or by courier, on the date it is delivered;




if sent by telex, on the date the recipient’s answerback is received;




if sent by facsimile transmission, on the date that transmission is received by a responsible employee of the recipient in legible form (it being agreed that the burden of proving receipt will be on the sender and will not be met by a transmission report generated by the sender’s facsimile machine); if sent by certified or registered mail (airmail, if overseas) or the equivalent (return receipt requested), on the date that mail is delivered or its delivery is attempted; or







if sent by electronic messaging system, on the date that electronic message is received;




unless the date of that delivery (or attempted delivery) or the receipt, as applicable, is not a Business Day or that communication is delivered (or attempted) or received, as applicable, after the Close of

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Business on a Business Day, in which case that communication shall be deemed given and effective on the first following day that is a Business Day. Either party may by notice to the other change the address, telex or facsimile number or electronic messaging system details at which notices or other communications are to be given to it.

Assignment Neither Party may charge assign or transfer all or any of its rights or obligations hereunder without the prior consent of the other Party.

Non-Waiver No failure or delay by either Party (whether by course of conduct or otherwise) to exercise any right, power or privilege hereunder shall operate as a waiver thereof nor shall any single or partial exercise of any right, power or privilege preclude any other or further exercise thereof or the exercise of any other right, power or privilege as herein provided.

Governing Law and Jurisdiction This Agreement is governed by, and shall be construed in accordance with, English law. The courts of England have exclusive jurisdiction to hear and decide any suit, action or proceedings, and to settle any disputes, which may arise out of or in connection with this Agreement (respectively, “Proceedings” and “Disputes”) and, for these purposes, each party irrevocably submits to the jurisdiction of the courts of England. Each party irrevocably waives any objection, which it might at any time have, to the courts of England being nominated as the forum to hear and decide any Proceedings and to settle any Disputes and agrees not to claim that the courts of England are not a convenient or appropriate forum. Each of Party A and Party B hereby respectively appoints the person identified in paragraph 5 of the Schedule pertaining to the relevant Party as its agent to receive on its behalf service of process in the courts of England. If such an agent ceases to be an agent of Party A or party B, as the case may be, the relevant Party shall promptly appoint, and notify the other Party of the identity of, its new agent in England.

Time Time shall be of the essence of the Agreement.

Recording The Parties agree that each may record all telephone conversations between them.

Waiver of Immunity Each Party hereby waives all immunity (whether on the basis of sovereignty or otherwise) from jurisdiction, attachment (both before and after judgement) and execution to which it might otherwise be entitled in any action or proceeding in the courts of England or of any other country or jurisdiction relating in any way to this Agreement and agrees that it will not raise, claim or cause to be pleaded any such immunity at or in respect of any such action or proceeding.

Miscellaneous This Agreement constitutes the entire agreement and understanding of the Parties with respect to its subject matter and supersedes all oral communication and prior writings with respect thereto.

APPENDIX III

303

The Party (the “Relevant Party”) who has prepared the text of this Agreement for execution (as indicated in paragraph 7 of the Schedule) warrants and undertakes to the other Party that such text conforms exactly to the text of the standard form Global Master Securities Lending Agreement posted by the International Securities Lenders Association on its website on 7 May 2000 except as notified by the Relevant Party to the other Party in writing prior to the execution of this Agreement. No amendment in respect of this Agreement will be effective unless in writing (including a writing evidenced by a facsimile transmission) and executed by each of the Parties or confirmed by an exchange of telexes or electronic messages on an electronic messaging system. The obligations of the Parties under this Agreement will survive the termination of any Loan. The warranties contained in paragraphs 0, 0, 16 and 28.2 will survive termination of this Agreement for so long as any obligations of either of the Parties pursuant to this Agreement remain outstanding. Except as provided in this Agreement, the rights, powers, remedies and privileges provided in this Agreement are cumulative and not exclusive of any rights, powers, remedies and privileges provided by law. This Agreement (and each amendment in respect of it) may be executed and delivered in counterparts (including by facsimile transmission), each of which will be deemed an original. A person who is not a party to this Agreement has no right under the Contracts (Rights of Third Parties) Act 1999 to enforce any terms of this Agreement, but this does not affect any right or remedy of a third party which exists or is available apart from that Act. EXECUTED by the PARTIES

Schedule Collateral The securities, financial instruments and deposits of currency set out in the table below with a cross marked next to them are acceptable forms of Collateral under this Agreement. Unless otherwise agreed between the Parties, the Market Value of the Collateral delivered by Borrower to Lender under the terms and conditions of this Agreement shall on each Business Day represent not less than the Market Value of the Loaned Securities together with the percentage contained in the row of the table below corresponding to the particular form of Collateral, referred to in this Agreement as the “Margin”.

Security/Financial Instrument/Deposit of Currency

Mark “X” if acceptable form of collateral

Basis of Margin Maintenance: Aggregation shall not apply*



Aggregation applies unless the box is ticked. Netting of obligations to deliver Collateral and redeliver Equivalent Collateral shall not apply* Netting applies unless the box is ticked.



Margin (%)

304

APPENDIX III

Base Currency The Base Currency applicable to this Agreement is

Places of Business (See definition of Business Day.)

Designated Office and Address for Notices (A) Designated office of Party A: Address for notices or communications to Party A: Address: Attention: Facsimile No: Telephone No: Electronic Messaging System Details: (B) Designated office of Party B: Address for notices or communications to Party B: Address: Attention: Facsimile No: Telephone No: Electronic Messaging System Details: (A) Agent of Party A for Service of Process Name: Address: (B) Agent of Party B for Service of Process Name: Address:

Bibliography

Simmons, Michael, Securities Operations – A Guide to Trade & Position Management, John Wiley & Sons Ltd McGill & Sheppey, Global Regulatory Landscape – Impacts on Finance & Investment, Palgrave Macmillan 2005 McGill, Ross, International Withholding Tax – A Practical Guide to Best Practice & Benchmarking, Euromoney Books 2004 McGill & Sheppey, Sarbanes-Oxley – Building Working Strategies for Compliance, Palgrave 2007

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Index

.NET Microsoft Corporation, 23AQ4, 235 Access Microsoft Access, 136, 214, 215, 243, 250 account transaction, 248 administration processes, 139 ADP. See ADP Brokerage Services ADP Brokerage Services, 144, 164, 173 ADR. See American Depositary Receipts agency lending growth in, 156 agent ability to aggregate, 156 network, 209 AGM, 140, 141, 206 algorithmic trading models, 265 Allied Irish Bank, 176 Alternative Investment Strategies as a long term trend, 25 American Depositary Receipts, 31, 103, 172, 189, 210 AML. See anti-money laundering Ancillary Products offered by custodians, 138 ANNA, 53 Annex to the Stock Borrowing and Lending Code, 153 anti-money laundering, 95, 103, 175, 186 applications service provider, 161, 164, 166, 167, 253 and automated corporate actions, 162 ASP. See applications service provider ASCII, 172

asset management firms, 62, 73, 74 asset managers, 116, 140, 160, 173, 241, 246, 262 and hedge fund convergence, 154 and STN, 161 as intermediaries, 142 asset servicing, 18, 24, 61, 63, 85, 130 complexities in, 201 market size, 66 assets safekeeping, 22 seizure of, 8, 19, 20, 21, 62, 69, 74, 80, 89, 213 under custody, 204 Assets Under Management, 61, 67, 71, 73, 74, 80, 90 geographic breakdown, 66 audit, 43, 81, 106, 244 and reconciliation, 243 internal, 192, 264 sub-custodian, 203 trail, for exception management, 247 audit trail, 257, 258 for regulation, 251 AUM. See Assets Under Management Australia, 8, 16, 94, 210 Austria, 94, 206 automation, 82, 130 as the way forward, 265 software, entry level costs, 162 adverse factors of, 162 trading, 57 backlogs creating risk, 94 back-office, 28, 29, 35–42, 113, 164, 213, 214, 241, 243, 253–256, 264, 266

307

308

INDEX

BAI, 137 BAM. See business activity monitoring Bank of England, 177 Bank of New York, 4, 9, 16, 17, 100 banks, 22, 65, 116, 176, 215 and controls, 241 Barclaygroup, 89 Barings (UK Growth Trust), 9 See also trading, fraudulent Basel Accords, 78 Basel II, 76, 77, 78, 84, 155, 175, 177, 178, 179, 186, 187, 215, 241, 265 and III Accords, 176 controls, 265 exposure requirement, 187 BBH. See Brown Brothers Harriman BDA. See browser delivered application Belgium, 52, 94, 110, 206 benchmarking, 106, 115 custodian, 211 Foreign Exchange, 211 international for withholding tax, 34 user-defined, 247 beneficial owner, 92, 98, 102, 103, 107, 141, 143, 144, 149, 150, 152–154, 203, 205 and outsourcing, 146 other influential factors, 145 types of, 145 bilateral agreements, 123 BOT. See business object types BPEL. See business process execution language BPM. See businss process management. BPO. See business process outsourcing. Brady Bonds, 131 Brown Brothers Harriman, 3, 6, 21 browser delivered application, 166 business key drivers, 262 business activity monitoring, 181 exception notification, 185 strategy and mediation, 236 supported by IT, 233 business activity monitoring, 181–185, 243 business object types, 223 business process execution language, 234 management, 181 outsourcing, 252 buyers custody market, 20 CA, 62, 66, 67, 76, 77, 78, 171, 264, 265 and payback period, 82 California Public Employees Retirement System, 5 Californian State Teachers Retirement System, 5

CalPERS. See California Public Employees Retirement System CalSTERS. See Californian State Teachers Retirement System CAMA. See information mosaic Capital Accord. See Basel II capital markets, 49, 171 cash balances, and reconciliation, 239 flow, 212 management, 22 CCF. See common contractual funds CCP. See central counterparty CDS. See credit default swaps CDX, 113 Cedel, 6, 8, 49, 52, 56 central counterparty, 44 central securities depositories, 13, 14, 15, 20, 44, 49, 52, 56, 171, 204, 209, 256 central and national, 45 CESR. See committee for european securities regulators Chase (Manhattan), 3, 4, 5, 6, 7, 8, 16 CheckFree, 163, 164 checks value-time, 258 chief information officer, 212, 221 CIO. See chief information officer Citibank, 3, 4, 8, 9, 100 Citigroup, 19, 20, 21, 73 class trading, cross-asset, 264 Class Action Fairness Act, 201 class actions, 104, 196, 198, 199 and class members, 201 filings, 200 securities, 198 class member, 197, 198 clearing, 1, 3, 8, 17, 40–43, 50, 52–56, 85, 97, 101, 105, 108, 112–116, 175, 187, 195, 198, 239, 256 defined, 44 derivative clearing houses, 21 electronic trading, 44 european securities specialist, 40 firms, 65 house, 44 managing risk, 43, 157 retail activities, 65 technology, 217 development in the US, 58 EU Commission (2004), 50 local depository, 204 separate house in the US, 58 and settlement in Europe, national systems, 50

INDEX

Clearstream, 52 closed user group, 27 CLS. See continuous linked settlement COBOL, 228 collateral, 27, 41, 45, 113, 114, 121–124, 140–145, 147, 186, 207, 246 and securities, 148 as revenue for securities, 207 cash as, 151 for managing risks in securities lending, 150 requirements, 207 securities as, 151 comma separated value, 229 commission recapture, 23 committee for european securities regulators, 180 common contractual funds, 131 competency, 31 complexity, and withholding tax, 31 compliance, 32, 62, 157, 306 departments, 215 fund, 134 regulatory, and reconciliation, 251 and recoverable tax, 32 conduct of business rules, 210 confirmations, 115, 117, 120, 159, 243, 254, 263 processing, 161 written or electronic, 147 contingency arrangements, 37 continuous linked settlement, 212 contract maintenance, 120 control, 30, 56, 77, 78, 103, 106, 139, 148, 154, 157, 160, 177, 188, 189, 190, 192, 235 proactive, 194 security objectives, 192 controls, 15, 27, 78, 94, 104, 109, 155, 175, 176, 177, 188, 189, 190 activities, 191 administrative, 190 and validation process, 230 Basel II, 265 classs action focus, 199 coactive, 195 costs, 257 costs of, 193 deficiencies, 191 demonstrated, 215 design limitations, 191 documentation, 216 environment, 190 internal, and reconciliation, 239 management models, 194 objectives, 271 operational, 233 and neutral divisions, 241 process, 192

309

resources and, 193 version, 232 corporate policy, 194 corporate actions, 75–86, 91–92, 95–97, 101 activity chain, 64 advice to asset manager, 150 automated processing, 97,161 and CAMA, 167 and reconciliation, 242 and regulatory structures, 95 and withholding tax, 171 and Xcitek, 164 automation, 74, 84, 162 spending and demand, 163 common types, 79 configurable, CAMS, 173 cost and risk, 76 custodian services, 65 disseminating information, 163 diversity of, 82 front-to-back, 173 lack of standards, 75 lager banks and brokers, 65 mandatory, 80 manual, 81 numbers worldwide, 80 processing, 205, 264 routine, 81 small to mid-size firms, 65 types of, 22, 28, 30, 32, 39, 53, 61–65, 85, 101, 107, 203 vendors, 164 voluntary, 79 withhoding tax as a, 90 workflow, 265 corporate governance, 33, 156, 174–75, 196–197 international network, 153 principles of, 196 corrupt foreign practices act, 95 cost reduction and outsourcing, 32 costs fixed, 36 for failed returns, 149 counterparty and SWIFT, 27 data, 185–189 risk defined, 44 counterparts, 82, 118, 146, 156 types of, 144 command and control, 194 credit facilities, 41 credit default swaps, 113–116, 118, 120, 262 credit derivatives, 116, 263 Creditex. See trading platforms

310

INDEX

CreditMatch. See trading platforms CreditXpress, 116, 118 CREST, 50, 52, 56, 148, 246 cross border assets, under custody, 21 european regulated industry, 130 systems, challenge for, 52 CSD. See central securities depositories CSV. See comma separated value CUG. See closed user group currency, 246 management, 136 CUSIP. See custom securities identification custodial agency model, 153 custodian, 3–5, 9, 10–19, 28–29, 37–38, 42–43, 47, 49, 64, 76, 79, 85, 91–92, 96–112, 116, 121–122, 125–133, 154, 172, 196, 203–208, 211, 221, 226, 250, 265 accounting services, 92, 131 as a fiduciary, 23 as intermediate depositaries, 46 as providers, 25 banks, 45 and securities lending, 142 as intermediaries, 142 cash management, 206 duties and responsibilities, 22 fees, variable nature of, 36 functions, 15, 17–20, 29, 37–38, 48, 61, 65–66, 75, 84, 90, 92, 106, 113, 117, 120–127, 129–134, 175, 208 G30 group, 105 global, 23, 39, 252, 144 institutional investors, service types, 48 non-US, 189 outsourcing models, 26, 28 payment and settlement, 122 reconciliation, 239 regulation, offering limited by, 176 standardisation, 26 SWIFT, 27 tailored portfolios, 136 technology, 217 withholding tax, 30, 86 custody, 3–21, 40, 43, 45, 47, 53, 85, 89, 101, 104–106, 108, 112, 116, 133, 145, 159, 175, 198, 205, 239. See also global custody impact of regulation, 176 agreement, 210, 220 as an information business, 5 and European securities specialist, 40 and regulation, 95 and standards, 27 and technology, 217 as a product, 23 as a technological process, 155

business, and securities lending, advantages, 142 domestic obligations, 47 fund administration, 154 risks, mitigated, 202 software tools, 243 sub-custody, 42 transformation checklist, 220 worldwide assets, 19 custom securities identification, 160, 249 customisation and transferability, 26 dashboard, 81, 243, 250 and trade status, 247 configurable, 268 management, 247 operational intelligence, 267 data, 21, 27, 31–38, 42, 63, 65, 75, 77–81, 84, 90, 101, 103, 106, 108, 109, 112, 117–127, 131–138, 162, 166, 168, 172–173, 175, 177, 185–193, 205, 211, 214–215, 220, 222–225, 226, 227, 228, 230–232, 236, 239, 242–245, 248, 259 archiving, 250 acquisition vendors, 253 common model, 245 control, 228 counterparty, 185 custodial, 247 dictionary, 173, 220–223, 254 and message dictionary, 228 and message representation, 223 format diversity, 246 item tables, 250 liability, ownership, 188 matching, types, 248 normalisation, 245 reconciling, 188 repositories, 186 static codes, 249 validation rules, 247 warehouse, 187 data protection, 103, 106 data scrubbing, 165 datasets, 268 dealers, 19, 43, 55, 116, 117, 118, 140, 141, 146, 264 as principals, 142 borrowed securities, 143 broker, 173 major players, 263 dealer-to-dealer. See trading platforms delivery versus payment, 44 demand side members, 21

INDEX

deposit accounts, 46 depository receipts, 92 depository trust and clearing, 115, 118, 121, 126–127, 159, 163, 263 US settlement systems, 58 depository trust corporation consolidation of US depositories, 58 derivative contracts, 113 defined, 113 derivatives, 19, 35, 44, 114, 117–118, 124–127, 131, 241, 262–263, 266 credit, 115 credit transactions, 188 regulatory interest in, 160 US markets, 58 Deutsche Bank, 100 Deutsche Börse, 52, 56 Deutsche Kassenverein German CSD, 52 dividend, 34, 63, 67, 79, 86–92, 95, 97, 99, 109, 110–112, 138, 143, 149, 152, 205, 207, 269 double taxation agreements, 87, 103 treaties, 39 Doug Bonnar, 3 DR. See depository receipts DTA. See double tax agreement DTC. See depository trust corporation DTCC. See depository trust and clearing dual warehouses, 187 DVP. See delivery versus payment EAI. See enterprise application integration e-Commerce Directive, 175 ECSDA. See european central securities depositories association EEA. See european economic area EGM. See extraordinary general meeting EJB. See enterprise javabeans email, 63, 81, 157, 244, 279 and messaging standards, 219 secure, 172 Enron, 188, 196, 197. See also trading, fraudulent enterprise application integration, 245 enterprise javabeans, 237 enterprise service bus, 233 characteristics, 234 contrasted with SOA, 235 functional aspects of, 233 entitlements, 22, 64, 76, 84, 88, 97, 99, 104, 110–111 to withholding tax, 87 web-based, 167 withheld, 30 environment

311

regulatory, 257 equilend. See also lending, automated equity active, strategies, 136 allocation by country, 70 allocation by sector, 66, 70 strategies fixed income, 136 passive, 136 private, 136 ESCB-CESR. See ECB and the committee of european securities regulators ECB and the committee of european securities regulators, 53 Estonia, 110 EU. See european union Eurex Clearing, 50 Eurobond, 91 Euroclear, 6, 8, 45, 49, 52, 56, 219, 221 bank, as an ICSD, 45 european central securities depositories association, 53, 83, 264 european union data protection, 95 savings directive, 95 european economic area, 110 event processing, 121 Excel Microsoft Excel, 214, 243, 250 exception automated management, 247 management, 239, 244 processing, 82, 84 execution, 17, 58, 115, 117, 126, 134, 179, 181–185, 203, 206, 211, 213, 242–243, 247, 251 electronic, 264 expert provider, 39 extraordinary general meeting, 141 failed return, 149 FCP. See fund commun de placement, federal reserve, 115, 265 Fedwire and US government bonds, 58 file transfer protocol, 77, 80, 245 financial models company, 160 financial information exchange, 161, 178, 219, 220–226, 228, 229, 264 and normalisation, 246 financial information exchange markup language, 224, 226 financial products markup language, 118 financial services action plan and MiFID, 179 financial services authority, 210

312

INDEX

firms, 4, 7, 10, 19, 30–33, 44, 61–62, 65, 67, 75, 79, 81–84, 100, 101, 103–105, 116, 125, 126, 152, 155, 157, 159, 161–163, 169, 179, 185–189, 194, 210, 213, 243, 251–252, 256, 257, 263 buy-side, 264 equities-based, 264 global securities, 265 investment, 266 securities, 270 FIX. See financial information exchange fixed income characteristics, 137 FIXML FMC. See financial models company Ford foundation, 3 foreign exchange, 22, 206, 212 benchmarking, 211 FpML. See financial products markup language fraud, 151, 174–176, 193, 203, 213, 242 and class action securities filings, 199 exposure to, 259 front-office, 26, 213–214, 256, 264, 270 exception information, 269 inventories, 269 FSA. See financial services authority FTE, 62 FTP. See file transfer protocol FTR, 175 fund accounting, 41, 131 fund commun de placement, 135 fund managers European, 74 UK, 72 US, 73 funds, 6–9, 17, 23, 31–32, 35, 47–48, 61, 67, 70–72, 76, 95, 98, 101, 104, 116–117, 131 administrators, 263 and asset segregation, 135 cleared, 258 eligible for class actions, 198 fund of, 131 in a unitised structure, 135 investment, 133 master-feeder, 133 multimanager, 132 pension, and class actions, 173, 199 recouped through legislation, 198 recovering, 198 reporting requirements, 135 responsiblities for, 199 supply of securities, 141 FX. See foreign exchange G30, 105 G7, 145 GCA. See global corporate actions

general ledger, 252 Giovannini Group, 39, 83 and significant barriers to integration, 52 GL. See general ledger global corporate actions validation service, 163 global securities, 9, 15 GlobeTax, 30, 89, 109, 112, 164, 167, 171, 172 GoldenSource, 163 governance, 33, 63, 107 and custodians, 33 and regulation, 157 and transparency, 152 as an ideal, 197 corporate, 33, 141 data, 188 securities lending, 156 good, eight characteristics of, 197 harmonisation, 53, 81, 110 of securities, 249 lack of, in Europe, 52 Harvard Business School, 5 hedge funds, 35, 116–117, 133, 143, 146, 154, 262, 264 and asset management convergence, 154 securities borrowed, 141 lending markets, 140 hedge funds, 16, 113, 116 HSBC, 4, 5, 16, 19 IBM DB2, 227 ICSD. See international central securities depository and CSDs, 49 ID as case identifier, 249 IFRS, 175 IFSRA. See international financial services regulatory authority IM. See Information Mosaic income from portfolios, 22 income collection custodian responsibility, 204 India, 18, 103, 169 information, 5, 12, 16, 29, 35, 37, 45, 48, 53, 63–64, 69, 75, 79, 81, 83, 84, 103, 105–106, 108, 120, 125, 127, 134, 137–139, 150, 152, 156, 163, 166–167, 170, 175, 176, 180, 181–193, 196, 199, 205, 206, 214–215, 225, 269 and business data, 220 and central databases, 222

INDEX

information – continued as intelligence, 215 lack of access to, 215 management support for, 233 quality of, business intelligence, 259 information management, 215 information mosaic, 163, 166 institutional investor, 17, 33, 42, 87, 117, 124, 136, 139, 154 voting rights, 174 institutional lenders, 153 instrument (financial), 91, 92, 178, 187, 205 types, 263 integration and standards, 220 inter-dealer. See trading platforms intermediaries, 12, 41, 45, 54, 55, 63, 87, 91, 98, 139, 142, 143, 149, 196, 204 and mediation service, 231 as sub-custodian, 45 multiple and redundant, 63 principal, categories, 142 types of, 45 internal control, 175, 192 accountability, 195 administration, responsibility, 189 and auditing, 189 and business re-engineering, 194 and processes, 195 employee responsibility, 189 monitoring systems, 191 systems of, 189 types of, 190 international central securities depository, 14, 20, 52, 45 eEuroclear and Cedel, 49 international financial services regulatory authority, 133 international swaps and derivatives association, 263 internet, 6, 109, 152, 219 as enquiry tool, 39 investment vehicles, 31 banks, 140, 241, 246, 263 companies with variable capital, 130 investment manager, 10, 13, 16, 21, 23, 28–30, 33, 37–38, 61, 113, 116, 120, 125, 130, 135–136, 140, 156, 167, 174, 178, 208, 243, 251, 253, 267 buy-side firm, 116 outsourcing with custodians, 29 and global expansion, 243 and the challenge of reconciliation, 252 beneficial developments, 37 mid-size and small, 254

313

mitigating transaction risks, 37 partnering with, 130 top-tier, 252 investment strategy, 145 adopion of, 221 IRB (internal ratings), 186, 187 Ireland, 94, 112, 133, 135, 166–167, 206 IRS, 95, 105, 106, 113–114, 118, 121 ISDA, 114–115, 122–125, 127, 263 ISITC, 178 ISO 15022, 27, 76, 78, 81–84, 101, 109, 167, 172, 219, 220, 222, 224, 225, 254, 256, 265 messaging standards, 219 ISO 20022, 27, 101, 220, 222, 224 ISO 17799, 175 issuers, 13, 63, 84, 86, 90–91, 196, 198 and risk, 90 IT protocols MQ, FTP, and XML, 77 Italy, 56, 67, 89, 94, 206 items, 117, 162, 184, 211, 244, 247–250 ledger-to-ledger, 250 open, 250 statement-to-statement, 250 iTraxx, 113 J2EE, 168, 170, 171, 223, 233–234, 237 and other standards, 221 mediation service support, 232 Japan, 66, 70, 72, 112, 175, 206 java, 173, 223, 234, 237 JPMorgan, 4, 100, 124 JSOX, 175 key performance indicators, 183 know-your-customer, 105 KYC. See know-your-customer LCH Clearnet merger (2003), 52 ledger-to-ledger items, 250 legal remedies, 149 lending exposure in securities markets, 141 automated, 147 LIBOR, 71, 298 licenses vendor, types of, 254 liquidity, 45, 57, 140, 156, 257 affected by lender recall, 149 borrowers, 146 intermediaries, 142 prime broker access to, 154 and trade desks, 264 risk, and intermediaries, 143

314

INDEX

loans, 47, 144, 146, 148 domestic, 207 specified or open, 147 termination of, 148 the IMF and good governance, 197 logic constructs, 226 Luxembourg, 4, 8, 94, 110, 135 MACUG. See member administered closed user groups management information tools, 41 margin and lender protection, 150 market, 3–7, 11–20, 24–25, 28, 31, 33–40, 42, 44–45, 55–58, 61, 63, 69, 75–83, 85, 87, 88–91, 93–102, 105, 106, 107, 109, 113–118, 120–127, 131–132, 134–136, 138, 140–142, 150, 159, 161, 163 advantages of, 237 and FIN, 219 and fraud, 151 and regulatory pressure, 265 and SWIFT, 219 bond, 140 bad practices, 157 consumer, 201 costs of regulation, 176 custodian’s report on, 203 hybrid nature of, 143 integration, global, 263 IT fundamentals, 217 lending, 145 makers, 146 money, instruments, 160 practice, 267 in securities lending, 146 route to, 146 securities, and term trades, 147 service provided by intermediaries, 143 settlement periods, 152 swaps, 188 time to, 220 voting rules of, 205 MarketAxess. See trading platforms market data definition language, 83, 224, 226 markets in financial instruments directive, 78, 95, 105, 175, 178–182, 215, 265, 266 and objective setting, 182 and record keeping, 184 and transparency, 183 articles, 179 as part of regulated environment, 182 compliance, 184 demands on IT integration, 180

impact on IT, 179 implementation issues, 185 investment companies, 185 investor protection, 182 size of challenge, 178 MDDL. See market data definition langauge mediation, 219 technology, 227 mediation service, 227, 228, 229, 230, 231, 233, 236, 237, 238 and security, encryption, 232 as part of IT architecture, 233 embedded, 237 managing definitions, 231 standards handling methods, 226 testing facilities, 231 Megacor. See Vermeg Megacor Mellon Financial, 9, 73, 100 member administered closed user groups, 27 message data definition, 225 definitions, reuse, 231 dictionary, 228, 237 and validation service, 230 functions, 229 enrichment, 227 formats, 254 identifying, 227 lifecycle, 222 logical and physical, 227 standards co-exist, 223 structure, 225 testing, 223 validation, 222 message mediation, 224, 228 features of, 225 message transformation, 173, 222, 223, 227, 267 and STP, 220 message user groups, 27 messaging, 75, 77–79, 97, 101, 109, 118, 127, 160–161, 217, 219, 226, 229, 233 and SWIFT, 219 asynchronous, 234 challenges of, 220 electronic, 264 financial, 224 formats, 264 post-trade, 267 single standard, 222 standards, 102 tactical, 221 upgrades and migration, 221 meta-data, 228 methodologies, 31, 52, 109, 248 middle-office, 215, 253

INDEX

middleware, 245 and FMCNet, 160 message oriented, 235 MiFID. See markets in financial instruments directive MS SQL Server, 227 MT599, 277 MT535, 278 MT564, MT565, MT566, MT567. See also messaging standards MT574, 102 MT575, 257 MT900, MT950. See also messaging standards MUG. See message user groups mutual funds, 22, 145 national register of archives, 95, 103, 106, 175 national securities clearing corporation and the SEC, 58 NAV, 42, 132, 207 calculations, 42, 132 near-real-time reconciliation, 252 Netherlands, 9, 52, 94, 110 netting, 44, 54, 114, 121, 122, 150, 152, 186, 255, 257 and risk management, 152 legal focus on, 152 of transactions, 44 network management, 157, 213–215 defined, 202 factors, 209 significance of, 216 network manager, 202, 208–209, 212 and custody agreements, 202 primary role, 208 New Capital Accord. See Basel II non-qualified intermediary, 105 non-XML, 223 Northern Trust, 3, 4, 16, 19–21, 73 Norway, 94, 110, 112 nostro, 257 notification corporate actions, 22 proxy, 22 NQI. See non-qualified intermediary NRA. See national register of archives NSCC. See national securities clearing corporation OASIS. See organization for the advancement of structured information standards OCC. See options clearing corporation Omgeo, 118, 127, 159, 161, 224, 226 options for asset managers, 160 omgeo central trade manager

315

Omgeo CTM. See omgeo central trade manager one-stop shopping and the lending process, 155 operational controls, 259 risk management strategy, 177 options, clearing corporation, 58 Oracle, 227 order management, 41 system, 270 organization for the advancement of structured information standards, 234 OTC. See over the counter outsourcing outsourcing, 10, 23, 29, 78, 108 and STP. See straight through processing administration, 42 and regulation, 32 as a growth service, 25 as a custodian solution, 28 back-office functions, 28 contract, 25 competitive advantage of, 33 data cleansing, 189 defined, 28 investment operations, 25 value for withholding tax, 31 over the counter, 113–115, 120 derivatives challenges, 125 industry participants, 115 ownership of clearing and settlement, 52 Parmalat, 197 parsing, 229 partner, custodian, 30 partnership, 36, 42, 82, 263 patriot act, 95, 175, 186 PCA. See principal components analysis pension fund pooling vehicle, 135 pension funds self-managed, 22 trustees, 21 performance, 22, 79, 281 attribution, 137 calculations, 137 PFPV. See pension fund pooling vehicle PID. See property income dividend POA. See power of attorney policy, corporate, 194 pooling, 97 internal and external, 133 pension fund, 135 pension, multinational, 135 virtual, 135

316

INDEX

portfolios, 13, 15, 19, 22, 41, 48, 75, 118, 131, 133, 136, 137, 138, 141, 142, 143, 145 access discouraged, 144 size and complexity, 253 valuation, 131 position account, 248 post-settlement, 251 post-trade, 113, 118, 126, 127, 159, 160, 161, 183, 262–263, 265–266, 269 and foreign exchange, 268 gateway, 266 integration with other systems, 269 messaging, 267 operational intelligence, 270 processes, 266 transaction and exception management, 266 utilities, connecting to, 267 power of attorney, 108 primary suppliers of services, 21 prime broker, 154 principal components analysis, 268 private securities litigation reform act, 198 products, 5, 10, 16, 17, 24, 26, 35, 36, 38, 40, 113, 114, 117, 118, 124, 130, 160, 226 and STeP, 161 CDX, 113 innovative investment, 35 investment, 38 post-trade, 160 vendor solutions, 159 white-label, 220 property income dividend, 111 proxy, 33, 90, 106 and shareholder voting, 205 and withholding tax, 33 PSLRA. See private securities litigation reform act QA. See quality assurance QI. See qualified intermediary qualified intermediary, 91, 105 quality assurance, 232 RAS. See relief at source RDBMS, 170, 171 real-time, 118, 133–134, 165, 173, 257 and MiFID, 183 and operatinal efficiency, 242 as objective for transactions, 176 front-office view of, 270 regulatory requirements, 191 transaction management, 161 transaction processing, 176

recall, 141, 143, 144 avoiding, 144 lender rights of recall, 149 rights, 144, 147 reconciliation, 43, 47, 79, 117, 161, 168, 169, 208, 217, 239, 248, 250–251, 259 and audit trails, 243 and custodians and brokers, 239 and data archiving, 250 and exception management, 247 and net items, 249 and outsourcing, 241 and exception management, 242 automated, exception systems, 257 buy-side approaches, 257 cash and securities, 243 challenge for investment managers, 252 complexity of, 252 data capture and normalisation, 242 event types, 246 inappropriate, consequences of, 241 integrated, 250 ledger comparisons, 239 message types, 255 multi-way, 245 near-real-time, 251 normalisation, 253 outsourced, service levels, 253 process batch, 257 business rules and logic, 245 collaboration, 243 electronic, 254 explained, 244 manual intervention, 247 ownership, 241 post-settlement trade, 242 post-trade systems, 269 software and systems, 243 types of, 249 securities, 239 staff allocation to, 251 technological advances, 242 third party trends, 242 recordkeeping services shareholder, 138 records external, 243 RED. See reference entity database reference entity database, 117 reference data, 90, 172, 175, 178, 185–188, 265 Reg NMS. See regulation national market system regulation, 175, 251, 266 regulation national market system, 266 regulatory reporting, 129, 187, 259

INDEX

relationship management, 24 relief at source, 23, 31, 32, 87, 101, 105–107, 207 recovery time, 89 report reporting historical, 268 report of combined activity, 257 representation, 227 research information exchange markup language, 220, 224 rights issue, 269 risk, 22, 48, 78, 83, 90, 104, 157 and illiquid securities, 151 adjusted returns, 137 and performance measurement, 206 and liquidity through intermediaries, 143 and regulatory frameworks, 157 and vendor selection, 83 assessment, and internal controls, 190 credit, 212 counterparty, 23 enterprise, 241 liquidity, 213 market, 213 management, 150 mispricing, 151 mitigation strategy, 239 operational, and reconciliation, 213, 250, 258 profile, 208 reputation, 239 settlement, 212, 213 systemic, 213 transactional, 38 types of, 212 weighting, 268 withholding tax, 213 risk based capital directive, 179 risk management as outsourcing advantage, 37 operational, 177 policies, 259 RIXML. See research information exchange markup language Rules processing, 225 S&P. See standard and poor’s S.1441, 175 Safe Harbor, 175 Sarbanes-Oxley, 95, 157, 175, 191 and messaging standards, 221 SEC. See securities and exchange commission SecFinex. See also automated lending secondary suppliers of services, 21

317

securities class actions, 196 cross-border transactions, 40 multiplier, 47 on hold, 148 services as specialist services, 39 settlement, 22, 44 securities acts amendments passed in US by congress (1975), 58 securities and exchange commission, 58 securities borrowing and lending code of guidance, 141 securities industry association, 177 securities lending, 23, 64, 156, 207 and corporate governance, 156 and liquidity, 140 defined, 141 monitored, 212 part of investment management, 140 transaction consequences, 140–141 securities market practice group, 76, 83, 264 securities settlement system, 44 securitisation companies, 116 segregation of assets, 46 defined, 47 segregation of duties, 193 sellers custody market, 20 SEPA. See single euro payments area service custodian, 22 providers, 252 as partners for institutional investors, 155 types of, 117 utility style of, 215 service level agreement, 208, 210, 271 service oriented architecture and transparency, 184 contrasted with ESB, 235 and J2EE, 223 service scope exceptions, 92 settlement, 13, 14, 17, 22, 28, 40–43, 48, 49, 50, 52–58, 91, 97, 104–105, 113, 118, 120–123, 126, 129, 139, 140, 143, 144, 147, 204, 206 and class actions, 198 and loans, 148 and managing risk, 157 and securities, 148 automation, 164 cross border, 209 defined, 44 interbank, 46 instructions, 208 manula, reliance on, 263

318

INDEX

settlement – continued net, 257 of shares, 205 Omgeo CTM notification engine, 159 post, and reconciliation, 242 pre-settlement risk, 212 recovery, 198 sending, 161 shorter cycles, 177 trade, 204 trade-to-settlement, 176 SFTP. See simple file transfer protocol shares, 12, 31, 63, 90–92, 99–100, 103, 110–111, 153, 189 and normalisation, 245 borrowing for voting, 141 custodian as safe-keeper of, 198 voting notice, 152 short position, 143, 148, 249 Sicovam, 52 simple file transfer protocol, 172 SIIA\fISD. See software & information industry association/financial information services division Singapore, 210 single euro payments area, 75, 105, 178, 215 SLA. See service level agreement Slovenia, 111 SmartStream, 163, 168 SMPG. See securities market practice group SOA. See service oriented architecture society for worldwide interbank financial telecommunications, 27, 39, 53, 63, 76–78, 84, 97, 101, 109, 118, 125, 127, 157, 171–172, 202, 219, 220- 230, 237, 245–246, 252, 254, 256–257, 265 accreditation, 236 and counterparties, 27 and normalisation, 246 software & information industry association\financial information services division, 178 South Korea, 111 SOX. See Sarbanes-Oxley Spain, 56, 94, 111 specialist provider, 20, 108 independent, 42 vendor alliances, 164 specialist securities services in the value chain, 40 splits, 66, 81, 211 spreads interest, 146, 211 SS&C technologies, 160, 161

SSS. See securities settlement system standard and poor’s, 132, 212 standardisation, 76, 81 of operations, 23 and flexibility, 26 lack of, 63 standards, 27, 39, 75–79, 81, 101, 125, 127, 178, 186, 189, 200, 217, 219, 221, 224, 226, 228–230, 233–237, 252, 254 agreed, 226 and market consolidation, 219 diversity of, 228 incompatible, 224 legacy and proprietary, 221 managing the complexity of, 224 multiple versions, 221 promotion of, 224 state street, 3–6, 8, 19–21, 73 statement-to-statement items, 250 static data management, 42 statute of limitations, 34 STeP. See straight through enterprise processing STN. See SunGard transaction network Stockbrokers, 21, 22 STP. See straight through processing straight through enterprise processing, 161 straight through processing, 27, 32 positive market impact, 222 sub-custodian, 20, 204, 205 and CSD, 46 duties for corporate actions, 203 Virtual, 264 SUN, 223 SunGard transaction network, 161 supply chain, 154 supply side, 20 suspense accounts and reconciliation, 239 swaps, 118, 125, 188, 262 SwapsWire, 115, 118, 121, 263 as market platform, 118 SWIFT. See society for worldwide interbank financial telecommunications SWIFTNet, 127, 161, 172, 219, 221, 245, 259 Switzerland, 66, 86, 94 T 1, 177, 242 trade settlement cycle, 177 T30, 138 tata consultancy services, 163, 170, 169 Tata Group. See tata consultancy services tax, 9, 28, 30–34, 39, 52, 76, 85–92, 99, 103, 109 advantage of pension fund status, 135 authorities, 265

INDEX

tax – continued contractual, 205 deduction, 99 domestic, 108 general, 106 institutional position, 146 investment funds, 133 investor’s, 105 rates, 265 reclaim, 93, 167, 211 service, 39, 207 recovered, 93, 104, 109 relief at source, 207 statutory, 99 treaty rate, 98 TCS. See tata consultancy services technology custodian investments in, 36 as a cost, 35 term, of loan, 147 tools management information, 41 TQM, 194 trace financial, 164, 172 trade failed, 149 life-cycle, 251 settlement, 204 warehouse, 126 TradeWeb. See trading platforms trading and settlement, 143 cost analysis, 138 fraudulent, 176 integrated network, 134 trading platforms, 117 trading systems and central counterparty, 57 electronic, 56 transactions, 10, 22, 37, 40, 42, 50, 101, 113–114, 121, 161, 188, 206, 242, 244, 256–257, 288 equity, 177 harmonised, 40 increase in volume, 177 individual, 249 loan, 145 mediation service, 232 netted for CCPs, 44 positions in reconciliation, 239 protection of, 192 risks from securities, 151 stock exchange, 45 volume and size of, 241 transparency, 152, 184

319

TRAX, 225, 229 treasury services, 41 TriOptima, 118, 121 Trust and outsourcing, 33 Trustees, pension funds, 21 T-Zero, 118, 126 UK, 111, 186 ub custodian bank, 42 UCITS, 175 UK-REIT, 111 Unit Trusts, 72, 130, 145 managers, 9 UNIX, 170, 182 unstructured communications, 157 US markets, 57 US Patriot Act. See patriot act US S.1441, 95 variable capital companies, 130 validation, 107, 163, 187, 214, 222–223, 229, 230, 237 and parsing, 229 exceptions, 230 of data, 247 valuation and payment, 121 value-at-risk, 138 VCC. See variable capital companies vendor, 162 Vermeg Megacor, 171 virtual pooling as substitute for investing, 136 virtual-STP, 264 vote blocked shares, 206 voting rights, 140 web services, 223, 227, 233, 234, 235, 237 web services descriptor language, 223 WebLogic BEA, 223 WebSphere IBM, 223 white-label, 78 withholding tax, 22–23, 30–31, 76, 85, 88, 91, 93, 97–101, 103–104, 106–107, 109–111, 135, 143 agent, 54, 98–99, 105 and corporate actions, 265 and outsourcing, quality, 30 GlobeTax, 171 impact on custodians and investors, 87 over-withheld, 205 principle of, 86 proxy voting, 33 reclaim, 207

320

INDEX

withholding tax – continued relief at source, future model, 105 rules, 105 Word, Microsoft, 214, 215 workflow, 43, 75, 81, 83, 134, 165, 259, 266 advantages of, 83 as transactions in workgroups, 249 automated, 84, 164, 222 automated software, 186 configurable, 168 integrated, 169 technology, 83

WorldCom, 196, 197 WSDL. See web services descriptor language Xcitek, 163, 164 XML, 77–78, 83, 127, 168–169, 173, 220–224, 227, 228–229, 233–234, 245, 259 and non-XML technologies, 220 bi-directional capability, 227 common interface, 221 schema, 229 yield book, 138