Much has been publicly discussed about the impact of T2S on the post-trade infrastructure landscape and in particular business and operating models of custodian banks. However, little attention has been paid to how T2S will change the service buying behaviours of the bank and broker communities.
Although the pan-European settlement landscape has fundamentally changed, custodians continue to operate on the basic premise that even in the new T2S environment, client service needs to remain practically the same. The T2S services and products that have emerged from custodians over the past 18 to 24 months have focussed primarily on the technical aspects of T2S – connectivity to T2S, providing a single access point to multiple markets, and asset servicing outsourcing solutions.
These all have their merits as technical solutions for the larger banks and brokers who are considering their future strategic T2S models to optimise operational and cost efficiencies as well as respond to regulatory change such as CSDR, Basel III, CRD IV, AIFMD and EMIR. But is the technical infrastructure and associated costs the main or only challenge faced by banks and brokers?
T2S needs to be placed in a wider context and assessed as an enabler and facilitator. Custodians need to understand key factors and their impact to ensure that their products and services continue to meet the current and future needs of sell-side clients.
As a consequence of regulatory and industry reforms, banks and brokers are being forced to reconsider their business and operating models, particularly collateral, capital and balance sheet management. Demand on collateral is expected to increase substantially following the introduction of central clearing of vanilla OTC derivatives and more stringent collateral requirements for non-vanilla OTC derivatives (EMIR and Dodd Frank, and global regulation such as BCBS261). The anticipated expansion of the central clearing model to securities financing and cash fixed income transactions post MiFID II is also expected to have an impact here.
Banks and brokers will need smarter approaches to the consolidation and optimisation of their collateral pools. They also need to develop strategies that enable access to deeper collateral pools and enhanced mobility that meets growing global collateral demands. Therefore, banks and brokers will need to consider their collateral management needs when deciding on the best venue or custodian bank to safe-keep their assets and how they gain access to other collateral pools.
Another key factor is liquidity management and costs. This is often overlooked, particularly in markets where access to commercial bank money is readily available and relatively cheap under favourable terms from the larger correspondent banks. However, in 2018, higher capitalisation ratios (80%) of intra-day credit under Basel III will change this picture not only for the correspondent banks but also for their clients. The cost of providing intra-day credit in commercial bank money is likely to increase and this may prove unsustainable for both correspondent banks and clients. This potentially drives future demand for access to central bank money.
It is debatable whether large scale banks and brokers need to retain the services of custodians for CCP clearing and settlement. Many of these organisations, already have the operational infrastructure and market infrastructure relationships in place to consolidate and internalise their CCP clearing and settlement flows leveraging economies of scale to achieve cost and operational efficiency. However, demand is likely to remain for value-add, complex and local market-specific services such as asset servicing and tax.
Service choice and flexibility will also drive future buying behaviour as custodian banks directly compete with CSDs offering value add services including collateral management, asset servicing and tax. The demand for bundled services will be challenged by the internalisation of CCP clearing and settlement flows as previously mentioned and the focus will shift towards value-add services to close out capability and infrastructure gaps through a service partner model.
Whilst operationally it may be desirable to centralise services into a single provider this introduces concentration risk. Such models are becoming less acceptable to risk managers, particularly, in a regulatory environment that has become more sensitive to counterparty and systemic risk and the potential contagion impact. Some custodian banks may want to consider how they regionalise their offerings giving banks and brokers the opportunity to rationalise and consolidate without introducing unnecessary concentration risk.
The demand for the traditional custody model will not disappear altogether and this will likely come from domestic and smaller cross-border banks and brokers who do not have the capital, investment appetite or capability to directly connect to T2S or an investor CSD. However, they may wish to replicate some or all of the T2S model through their custodian to optimise operational, cost, capital and liquidity efficiencies. There are two core choices of model: direct access where sell-side firms settle directly with the CSD(s) and indirect access where firms continue to use custodian banks. The likelihood is that most larger firms will opt for a hybrid model using direct access for high volume markets and custodians for lower volume markets and value add services.
The future of custodians will be determined by their ability to understand and adapt to client business challenges and service needs and how they can utilise T2S to help their clients achieve their wider objectives.
For the buyers of custody related services there is a real opportunity over the next two years to leverage T2S to re-shape their post-trade market infrastructure models and so reduce operational costs and complexity and drive significant liquidity, collateral and capital efficiencies. The financial and operational benefits from this approach over the two year horizon are more realistic goals than considering outsourced utilities or emerging fintech solutions.
Alan Philpot is a Managing Principal within the Capital Markets practice at Capco. He has over 25 years’ experience in managing and delivering large global programmes across all post trade functions, including in Tier 1 investment banks and as European CEO of an outsourcing service provider.
The content and opinions posted on this blog and any corresponding comments are the personal opinions of the original authors, not those of Capco.