A recent trip to our London clients focused on T2S strategies and the actions being taken by UniCredit and also the markets within its coverage model. But clients were eager, at the same time, to discuss the CSD operator model, mentioned in previous newsletters. The concept creates no issue for UniCredit and we operate a similar model for ICSDs in certain locations. On the clearing side, acting as an operator for a remote broker clearer is also a common option.
Operating as a remote member of a CSD does, though, pose a series of challenges, both for the CSD and the potential remote member. It is worth considering them all. But first of all we should recognise the drivers for the model. AIFMD and UCITS V will all change the liability structure of the EU market. Essentially, the global custodian will become liable for all losses incurred at a sub-custodian. And a sub-custodian includes any prime broker used by a hedge fund. To make matters worse, it appears that, irrespective of whether the hedge fund negotiated an agreement, such as allowing excess collateral to be held and re-hypothecated by the prime broker, the depository would be deemed to have condoned it, and protected the fund from loss, whether their approval was by positive agreement or even inaction.
It is clear that AIFMD and UCITS V will further increase the tensions that already exist between the administrator and depository on the one hand and prime brokers on the other. AIFMD compels funds to appoint a depository and few will agree to the traditionally quite remote arrangements that still exist between many depositories and prime brokers. That model is bound to change and the bank-based prime service or prime broker providers would appear to have a serious competitive advantage in the new world. One should also note, in this context, that prime brokers themselves are reviewing the operator model and the option of their funds being the direct member of the relevant CSDs.
The operator model will thus entail the global custodian or the prime broker, or one or more of their clients, becoming a direct participant in a CSD and then, through a power of attorney or similar instrument, appointing a local bank as their operator. As the operator is not in the ownership chain which flows from the CSD to the CSD participant and then on, as appropriate, to the beneficial owner of the relevant securities, sub-custodian risk is eliminated.
But the process is far from simple. On the cost side, the CSD participant is stand-alone and incurs fees on the basis of their portfolio in each market. They lose any scalebenefits that come from the sub-custodian’s total portfolio and, in markets permitting omnibus accounts, any benefits from internalisation. And it has to be remembered that total elimination of all sub-custodian risk will only arise where the operator model is used in all markets. The total resolution of the sub-custody liability challenge would be hugely costly from an administrative perspective; thus the likelihood is that most interested parties will look at this option only where they have extreme scale or a challenging local credit or legal environment.
The participant has to sign all agreements required with each local CSD and will be bound by local law, may have to accept documentation in the local language and will have to submit returns as required by the local CSD. Obviously the operator would assist in such submissions and could advise the participant of any issues. It should, though, be noted that some CSDs may require local incorporation for a direct participant to reduce the risk of contagion from a foreign court. Extraterritoriality is becoming a growing danger! CSDs may also have unique requirements to ensure they, and their participants, meet AML and other regulatory or legal obligations. It cannot be assumed that the current sub-custodian environment merely duplicates their needs in this area. And, finally, care has to be taken to ensure that there are no meaningful obligations that cannot be outsourced and that there are no notices that cannot be lodged with a third party. In other words, the operator may not legally be able to intermediate all flows and actions of a CSD, especially where there is a call for funds in the case of financial problems at a CSD.
And, if the participant operates a cash account at a local bank, they still incur correspondent banking risk. In T2S, the asset servicing model would allow flexibility to manage the risk for those markets that operate in the Euro. But that would only cover Austria, Slovakia and Slovenia in our region. And the direct participant, operating their own cash accounts, would need to ensure that they have facilities that allow them to put up any required liquidity during the settlement process to ensure efficient settlement.
Few markets currently run operator structures, although none appear to explicitly forbid them. Certain could well have capacity issues if such participation were at fund level. And some markets do insist that their participants have a local licence; thus eliminating the option for funds and many global custodians to be direct participants. Although, in theory, passports should help within the EU, it is not a given that the local CSDs will accept a bank or other entity as a participant, if it is not incorporated in their own jurisdiction. And there is a question as to the status of a participant within each local regulatory structure. If CSD direct participation is deemed to be an investment business, it is probable that returns would need to be made to the local regulators, and these may be at Group level rather than just at local entity. Care must also be taken to ensure that any new structure adopted does not result in tax liability; with the risk of this increasing if there is a requirement for the participant to be locally incorporated.
In the ideal world, the remote participant would sign a basic CSD agreement, with the operator advising them of any change in their liability and also monitoring the account to ensure they met all regulatory and other demands. Ideally membership could be remote from the home location of the fund or the global custodian. Remote membership would have no regulatory or fiscal ramifications and operators would be allowed to consolidate the accounts for which they are the operator in their family pricing at the relevant CSD.
Unfortunately, that is not the world we live in. The risk concept of the operator model is sound. UniCredit can intermediate as operator for the direct participant. But there are a series of financial, regulatory, fiscal and operational challenges that need to be overcome. And, bizarrely, the drive for the initiative is an attempt by European regulators to protect investors. The unintended consequences may mean that those investors incur greater costs and more unexpected risks!
John Gubert
Chairman
Global Securities Services Executive Committee