How have contingency plans changed the industy?
If any lesson is to be ascertained from the 2008 financial crisis, it is that no institution can say with full confidence that it will not fail.
And as the industry absorbed this stark message, banks, asset managers and investors began to implement wholesale changes to their traditional counterparty risk management practices, building thorough protections and contingency plans into their operating model to minimise any disruption to their activities should a core service provider disappear or collapse.
This reform has been industry-wide. Clearing members composed frameworks prescribing how assets and collateral can be ported to solvent infrastructures should the primary CCP default. Meanwhile, asset managers devised protocols to shift business from failing banks to one(s) in sounder financial health. Global custodians have changed course as well, conscious that many risks (market volatility, freezing of credit, cyber-attack, etc.) could threaten the daily operations or existence of the sub-custodians or agent banks in their networks.
Changing provider is a job in itself
A sub-custodian failure can seriously encumber the operations at a global custodian or broker-dealer. Firstly, client assets in the local market(s) could be at risk of non-recovery/loss or at a de minimis being frozen for a prolonged period of time, especially if local bankruptcy laws and procedures are undeveloped, untested or incongruous. Onboarding a new agent bank – even in regular market conditions– is an intricate, long-winded exercise, requiring exhaustive due diligence and legal negotiations, while it is not uncommon for service level agreements (SLA) to be lengthy, detailed and complex.
Porting accounts to a new provider takes time, particularly when markets are behaving erratically or sub-optimally. A robust contingency plan enabling a custodian/broker-dealer to seamlessly move client assets from a defaulting agent bank to a solvent secondary provider is a pre-requisite, which is now demanded of by nearly all sophisticated institutional investors globally. Identifying a suitable contingency plan, however, is not a straightforward or standardised process, and requires enormous thought and analysis.
Finding the right contingency plan
Network contingency plans fall into three distinct and unique camps. A passive or cold contingency plan usually takes at least one month to properly implement but is considered to be the most cost-effective, which may appeal to some margin or balance sheet capital constrained banks. This approach is rudimentary in nature and will simply involve a global custodian notifying a secondary agent bank that they are the selected back-up provider in the market should the primary counterparty run into trouble. However, the custodian will not have SLAs or accounts in place at the secondary provider under this structure.
At the opposite end of the spectrum is what is referred to as an active or hot contingency plan, a framework whereby the custodian will have a back-up or reserve agent bank running and replicating dual or parallel operations alongside the primary provider. In theory, this should allow for any urgent transition to complete on a same-day basis assuming live settlements or standing settlement instructions can be accommodated in a timely fashion. While this structure requires the most work and is expensive, it is widely considered to be the most thorough approach to contingency planning.
Nestling in between hot and cold contingency plans is the aptly named warm contingency plan. Under this framework, SLAs and accounts will be in place at the back-up sub-custodian, but that provider will not duplicate existing operations. The typical service provider transition time for a warm contingency plan is anywhere between one week and three weeks. While hot contingency plans are considered to be the most prudent and effectual from a risk perspective, it is not always the correct option, particularly in less developed or illiquid markets where an acceptable secondary provider may not even exist.
Finding the right reserve agent-bank
A contingency plan needs to put the interests and requirements of the clients at its core by ensuring that the process is smooth, expedited and non-disruptive. A failure to do so could have serious, adverse and long-term ramifications on the custodians’ client relationships. It is also the responsibility of a diligent sub-custodian to have regularly tried and tested procedures in place ready to facilitate an effortless onboarding at a global custodian or broker-dealer with limited or zero scope for error during that transition.
As part of the selection process, global custodians will perform on-site due diligence exercises supplementing the AFME (Association for Markets in Europe) due diligence questionnaire (DDQ). It is critical any sub-custodian attempting to win these secondary mandates demonstrate that their operations, asset safekeeping arrangements, IT infrastructure, SWIFT and local market connectivity with key domestic infrastructures is strong and follows international best practices to the letter.
Regulators go on the offensive
Regulators have made clear to custodians that they expect them to have fully watertight contingency plans in place. The EU has pushed through a number of requirements putting greater emphasis on the issue, notably AIFMD (Alternative Investment Fund Managers Directive) and UCITS V, which both demand depositaries take on strict liability for assets held in custody and sub-custody, rendering them financially accountable if customer assets go missing or are stolen. A dereliction of duty will be costly and damaging to any provider, which is why many are investing time and effort into executing effective contingency plans.
The International Organisation of Securities Commissions (IOSCO) has also published comprehensive guidance strongly advising global custodians do their utmost to protect client assets. This must include having a proven contingency plan. The challenge for custodians is to develop a contingency plan, which has the full confidence of clients and backing of regulators. A failure to do so could result not just in a substantial loss of business, but regulatory intervention and possible censure.
The future of contingency plans
While industry best practice dictates hot contingency plans are the most exemplary defence mechanism against an agent bank default, there are very valid arguments against adopting it on a global basis. In an environment where securities services’ margins are shrinking, the notion of custodians operating hot contingency plans throughout their whole networks does not make economic sense as it would eat into a large slice of group revenues. The practice is also not logical in markets which utilise segregated account structures.
An alternative approach could be to incorporate hot contingency plans – wherever possible – into the high-risk markets or major jurisdictions where customer exposures are greatest. However, as competition for clients increases, a best of breed and clear contingency plan may be the difference for a global custodian between winning and losing customer business. Adjusting to this new counterparty risk paradigm will also require sub-custodians to be highly flexible if they are to retain market share as well.
Head of Global Sales & Relationship Management
UniCredit Global Securities Services
If any lesson is to be ascertained from the 2008 crisis, it is that no institution can say with full confidence that it will not fail.