Bluerock Review : May 2003

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Bluerock Review - May 2003 (362k)
Surviving in a harsh world - credit derivatives. " Custodians, what's next?
Keywords: credit derivatives, swaps, credit default swaps, CDS, custodian, custody, regulatory


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Custodians, whats next? For almost as long as the custody industry has existed many people have forecast it demise. Times have not changed and the old arguments are still being played out, but custodians are still here, still thriving and still delivering. So why haven't they died and what does the future hold for them? As always when looking forward it is best to start by looking backwards. This case is no exception to the rule, and might help see the future based on the old adage 'what goes around comes around'. Custodians started in the mid '70s as precisely that looking after the assets of buy and hold investors and their principal business was defined in terms of number of global markets served, income collection deadlines and other such measures of service competence. Over the next decade or so businesses grew with some consolidation of providers but principally through organic growth, helped by a healthy fee kicker thanks to several bull markets. The key to the future of custodians lies in what happened next, the addition of accounting as a new value added service was the catalyst for the expansion of custodians into new service areas based on holding the assets. Over the Eighties and early Nineties there was a significant growth across all of the custodian providers in new and diverse product areas. Custodians added new value added services such as securities lending and performance measurement. This rapid expansion also claimed some casualties amongst the smaller, local and second tier providers as they or their ultimate parent realised the cost of investing to stay in business was too high, particularly on the technology side. However there was a cloud on the horizon the growth in core custody, which was still a significant driver of profits, was coming from periods of sustained growth in underlying markets. When this growth dried up so did the significant stream of business growth from the bull markets which was helping to fund the significant investment needs. So where do we stand now? With markets significantly lower and likely to remain at these depressed levels for some time the prospect of significant asset growth is almost non-existent. Against this we have the backdrop of the consolidation in the European securities infrastructure, a heavy regulatory agenda and client base frantically grappling with operational costs. Times have never been tougher. Ironically it is custody that will be the driver of the future of custodians despite the fact that custody is increasingly a small part of what we do. Our business is driven by what our clients are both prepared to subcontract to an external provider and the products and services their clients require from them. As Europe moves towards a more retail based Multi manager environment pure asset management companies will have to behave increasingly like manufacturers, brand will be important as will relationships with distributors but fundamentally they will sell on consistency of performance, quality of service and value for money. It is here that the door opens for custodians as broad service providers. The major custodian providers have significantly valuable offerings in these three areas. Consistency of performance can be helped by traditional custodians services such as securities lending or cash management, the increasingly we've seen major custodians venture into the transaction cost analysis arena through outright purchase or joint ventures. Understanding the cost impact of trading on performance has proved to be a significant growth opportunity given lower market returns and regulatory pressure. As Europe has seen a growth in retail control of assets so quality of service has become much more important. In a Multi manager environment the problem becomes even greater in terms of delivering quality from third party asset management providers. Here again the door opens for custodians through their increasing focus on transfer agency and fund trading platforms as well as their traditional cash and banking products. Value for money is a much tougher proposition however as asset managers in the main have a fundamental mismatch as their earnings are principally based on value of assets managed and their traditional operations and administration is fixed cost. The European regulatory environment is helping significantly here as there are several new pieces of legislation all of which will cost money to implement in fund management back offices. It is the asset managers' struggle with this fixed variable problem that is opening the door for custodians to provide more services on a variable basis. The best example of this is a move amongst the larger custodians to provide outsourcing services on a bundled and component basis. The fundamental irony here is that the majority, if not all of these services are based on being custodian and holding the primary record. So whilst custody is not dead it is changing to be more of the utility and foundation on which a much wider suite of products are built. There are still clouds on our horizon, we are not immune to the financial pressures created by the lower markets, it will take a certain amount of courage to continue to invest. The consolidation in the European securities infrastructure if successful in delivering the types of savings that have been promised will alter the competitive landscape where a custodial firm is dependent in part on sub custodial services in Europe. The European regulatory burden with such upcoming challenges as UCITS III, the European savings directive and Basle II will all have their impact on our industry. So what of the next ten years? We will continue to see consolidation in the custody industry however there will be more joint venture deals done between larger global players and local providers. Many of these will be a prelude to an ultimate sale or exit from the business. The European securities infrastructure will consolidate if not physically it will do through increased connectivity and interoperability, this however will not matter to global custodians as business will be increasingly built on a much wider suite of products. Our client base will broaden to a point where we service product manufacturers and distributors in the widest sense. In servicing the distributor market we will see the first break with our heritage custody products into a market where we are retail service administrators with transfer agency and fund trading products. This break with our heritage custody products is the real key to the future of custodians. Up until now custodians have always seen themselves selling bundled products across a single value chain to their traditional client base. However, we now believe the future of investment industry is one of polarisation and specialisation, which will result in several discrete value chains which the custodians of the future will service. The financial services industry going forward will have the following key players: - Owners of client pools, these will essentially be retail client owners but will be not just banks but corporates via their employees and other client owning affinity groups. - Packagers, these groups will be the drivers of liability matching and will most likely be formed from benefits consultants and insurance companies. - Product manufacturers, these will be the traditional fund management groups slimmed down to focus on core competency. - Infrastructure providers, these will be outsourcers and industry utilities. Each one of these participants will have a separate value chain on which the old custodians will service them with multiple new products. Some groupings will be easier to deal with based on either their established relationship with existing custodians i.e. fund managers or the relative advanced point they have achieved in their evolution. In the future we will service the owners of client pools with a suite of products based around product access platforms and transactional administration. The packagers will require client level valuation tools, sophisticated performance measurement and commission monitoring and capturing products. The fund managers, the product providers, will outsource or delegate to custodians as infrastructure providers or industry utilities, they also buy front-end tools from custodians. The sort of tools used to both enhance performance and to better manage total fund management supply chain providers such as brokers and analysts. Lastly the infrastructure providers will in many cases be custodians themselves, they will also be the new consolidated securities businesses particularly in Europe formed from the old exchange and depositary business. This might seem at best a confusing if not schizophrenic future, but lifting the lid on any existing custodian will clearly demonstrate the misnomer that 'custodian' has now become, with less and less revenue coming directly from custody and more and more investment going into new non custody product. This view of the future is not without its downsides we could see a return to raging bull markets which would comfortably mask all the problems the industry has, or indeed a fundamental apathy amongst retail buyers resulting in governments biting the compulsion bullet. Whilst this is a possibility too much damage has already been done to prevent a substantial and radical change in the industry and custodians as providers. Is custody dead? No like any good parent it is investing in its offspring to provide for their independent future. Surviving in a Harsh World - Credit Derivatives While the prospect of a corporate default is horrifying, why is it that banks themselves are not defaulting? In 2002, more companies defaulted on more debt than at any time previously. According to Standard & Poor's, 234 companies defaulted on a combined $178bn of debt which is more than four times the default rate of 2000. And yet, there have been no major bank failures. Banks appear to have learnt lessons from the Latin America debt crisis and the collapse of the savings and loan industry. Credit risk has been a cause of much of these historic problems so to prevent the risk of bank defaults in the future, banks on both sides of the Atlantic have come up with the idea of credit derivatives. Since then, the credit derivatives market has grown rapidly allowing credit risk to be spread more widely throughout the banking industry. So, what is a credit derivative and how has it prevented major bank failure? A definition of credit derivatives Credit derivatives can be defined as arrangements that allow one party (protection buyer or originator) to transfer credit risk of a reference asset, which it may or may not own, to one or more other parties (the protection sellers). So, credit derivatives are financial contracts designed to reduce or eliminate credit risk exposure by providing insurance against losses suffered due to credit events. The credit event triggers a payout by the protection seller. It is not surprising therefore, that credit events need to be tightly defined in the credit derivative contractual agreement. Examples of credit events are: downgrade of a credit rating; financial or debt restructuring; bankruptcy or insolvency; default on payment obligations such as interest or bond coupons. Credit Default Swaps The most common credit derivative is a credit default swap (CDS). This is a bilateral contract in which a one-off or continuous fee is paid to the protection seller in return for which the seller will make a payment on the occurrence of a specified credit event. The fee is usually calculated as a number of basis points of the nominal value. The CDS either refers to a single asset (known as the reference asset) or to a basket of assets (such as a loan portfolio). The contractual agreement will specify how and when the default payment (or payout) is to be paid. It may be linked to the price of the reference asset or another specified asset, it may be fixed at a predetermined recovery rate or it may be in the form of actual delivery of the reference asset at a specified price. The diagram illustrates the basic mechanism of a CDS. How are CDSs used? CDSs are tradeable and so have allowed banks to trade credit risk on the secondary market. This brings with it a number of opportunities for banks to reduce their credit risk through either a direct reduction in credit exposure or through a strategy of credit risk diversification whereby banks purchase credit protection on one reference asset (or pool of assets) and simultaneously sell protection on another asset (or pool of assets). Conclusion Banks have protected themselves well against credit risk through the increased use of credit derivatives. Credit derivatives trading desks are therefore at the heart of the action to ensure bank protection against major defaults such as WorldCom, France Telecom and Vivendi.