Renewed focus on the important role of custodians

Custodians are sometimes out of sight and out of mind, but as Damon Taylor writes, recent events have reinforced the vital role they play in the Australian superannuation industry.

As gatekeepers for both the superannuation and wider financial services industries, custodians have always played a vital role.

However, in the wake of the well-publicised collapses of Trio Capital and Opes Prime, it is perhaps inevitable that the role has received closer examination.

Reports such as that commissioned by the Australian Securities and Investments Commission (ASIC) into custodial and depository services have prompted dialogue discussing not just a custodian’s traditional duties, but also how those duties are evolving and for Paul Khoury, chief operating officer for State Street in Australia – such talks have already proven fruitful.

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“So the principal role of the custodian has always been to safe-keep assets, whether that’s shares, bonds or something else entirely,” he said.

“That remains the primary focus of the custodian and that’s really around reducing risk, providing a definitive book of records, and segregating assets away from other investment administrators or investment managers.

“What custodians are trying to do is make sure that transactions flow correctly so that we have an efficient market for trading securities,” continued Khoury.

“And what that does is provide separation of duty between the investment manager and the custodian so that there’s clear accountability and a clear ownership of the assets in the market.

“And again, that provides a risk-controlled environment for investors,” he said.

Yet with regard to the evolution that had taken place within the custody space, Khoury said that the key driver had been the provision of data.

“So for us, it’s about understanding firstly how we correctly record the assets and then, more importantly, how we provide that book of records back out to our clients and ultimately to the members,” he said.

“It’s that drive for information, that drive for timeliness and accuracy that’s so critical for the custodian.”

Seeing a similar line of progression in custodial services, Pierre Jond, Chair of the Australian Custodial Services Association (ACSA), said that on the back of customer demand, custodians had added a number of administration services to their traditional offering.

“Those will typically be administration and unit pricing, registry activities, and performance reporting,” he said.

“So while the basic role of the custodian hasn’t fundamentally changed, what has changed is the clients themselves.

“They’re investing in more complex products with more complex investment strategies and so the onus is on us as custodians to keep up-to-date with the evolution and changing needs of clients,” Jond said.

Of course, part of the custody evolution has come about solely on the basis of changing legislation, but for David Braga, managing director of JP Morgan Worldwide Securities Services, any participant in the financial services industry expects regulation to change over time.

“And that’s the right thing for regulators to do in terms of how they evaluate the market and ensure that the end consumer is appropriately protected,” he said.

“So yes, it’s changed but there’s no surprises there.

“However, part of what we think ASIC are looking to do, and this comes back to their idea of a gatekeeper and where they’ve gone with some of the whistleblower commentary, is look to make sure that the overall regime – particularly for a retail investor – is understood, transparent and safe to the greatest extent possible,” Braga added.

“It’s so some of these unfortunate events that have occurred are locked away, we learn from them and they are thus less likely to occur in the future.”

Braga pointed to the collapse of Trio Capital as a prime example.

“So what they’ve said is; you as custodians, you’re not the only gatekeeper, there are multiple gatekeepers through the investment cycle but the role you play as a custodian is an important one,” he said.

“And going back to the segregation and safekeeping of assets that we do as a matter of course, we acknowledge that.

“Where it’s getting a little bit unclear is, as a custodian, our contract is back to our clients and we’re licensed as a custodian to act on behalf of our clients in their capacity as trustees or responsible entities (REs),” Braga continued.

“That trustee or RE has a lot of the expectation and requirement to maintain the compliance of the fund, and the behaviour of the fund, but some of the dialogue we’re now having is around whether there are other ways we could highlight areas of a fund’s behaviour that may need further investigation.

“Now, at the moment, what we’re obligated to do by the regulation is clear and we’re all fulfilling that but the question is whether there’s additional reporting with respect to fund behaviour that we should also be doing,” he said.

Unfortunately, it is that very lack of clarity around custodians’ obligations versus trustees’ obligations that ASIC has raised as one of its chief concerns.

The possibility of an ‘expectation gap between what is legally required of custodians and what investors expect the custodian to be doing’ is hardly ideal, and yet it is not a concern shared by Khoury.

“I think broadly trustees have a good understanding of the role of the custodian, particularly the trustees of the larger, more sophisticated superannuation funds and the responsible entities that we service in the investment manager space,” he said.

“But I think what we need to do as an industry association, as a group of custodian administrators, is provide more education as to what the role is and, more importantly, what the role is not.

“So we have no authority to provide guidance on the investment process itself, for instance,” Khoury continued.

“Our role is to effectively ensure that, once the investment decisions are made, we execute correctly for the client and provide that route for the transaction to flow through to the different stakeholders.”

Offering a similar perspective, Braga said that while he didn’t believe there was any sort of gap between trustee expectations and the services custodians were delivering, communications were a two-way street.

“From what we can see, REs and trustees are well informed and work really hard to put in place the right compliance regimes around their funds,” he said.

“And at JP Morgan, we look to work just as hard with our clients around those aspects to ensure that there is no ambiguity and that they’re getting the information they need.

“So as an example, we’ll often host our clients for due diligence and oversight sessions where they’ll come in on a regular basis and do half-day/full-day style workshops to go through the overall operating environment and make sure that they’ve understood it,” Braga said.

Braga said that a number of clients also exercised deliberate oversight of custody activities to increase their level of assurance.

“There might be additional reporting that they require from us to be able to drive their own confidence over the service, that it’s in place and that it’s working the way they expect it to,” he said.

“They’ll also follow up when there are issues in the service.

“None of us are error free; things do go wrong from time to time and when that happens, there’s very clear communication that comes to and fro about what’s happened, where things have gone wrong and what can be done to fix whatever it is that has been found from a particular incident,” Braga added.

“And, again, that’s something that we take very seriously to help our clients fulfil their oversight obligations.”

Of course with regard to service error, administrators and custodians are in a unique position with respect to how integral they are to the day-to-day running of a fund. When all goes to plan, their services fade into the background and yet when an error does occur, it inevitably draws the spotlight.

So for Jond, though custodians continually strive to be error free, the key is picking the issue up quickly.

“From past experience, common issues can be simple to pick up and are picked up immediately,” he said.

“More complex issues may go undetected for a while longer, however, all custodians have the control frameworks in place to ensure that their impact is kept to a minimum.

“So with respect to response and remediation, it starts by stopping the leak,” Jond continued.

“One of the great principles of any custodians is to make sure you’re avoiding any snowball effects.

“An error never gets better over time, so the first step is making sure that the situation is being addressed short-term, making sure that if the fund has a risk, you’re basically chopping down that risk exposure ASAP.”

Outlining similar response mechanisms, Braga said all custodians had robust control environments that had driven error rates down immensely.

“We tend to deliver our service rates on a 99.9/99.8 per cent accuracy basis and, generally speaking, the errors are on the margin,” he said. “So we hold ourselves to a very tight standard and expect to be held to a tight standard.

“When things do go wrong, and they do from time to time, we have an embedded process which is run by a segregated team called Operations Control Management,” Braga continued.

“They sit outside of the core, day-to-day operations staff to give them some independence and they do an internal review, look through the facts of what’s happened and also look through how we may improve end-to-end – sometimes including improvements to be asked of our clients to tighten that particular aspect down.

“They’ll also look horizontally to say what does this particular incident tell us about the overall environment, is there something wider that we need to consider as well or is this an isolated event?” he said.

Going back over previous incidents, Braga said that the vast majority had come about as a result of miscommunication.

“It’s very rarely a core process deficiency per se, and I think that plays to the observation that we do have strong operational control practices,” he said.

“It’s more around misunderstood instructions or duplicated instructions, that type of a trigger that then causes issues.”

Giving some indication of the level of understanding that did, in fact, exist between custodians and their clients, Ian Martin, senior vice president and head of State Street Global Services, South Asia and Pacific, said that every one of a custodian’s customers understood and expected that errors might take place.

“It’s inevitable in a relationship where we’re processing such a vast number of transactions,” he said.

“So given that they understand that this will happen at some point – though obviously we’d rather it didn’t – they’re really much more concerned about how we go about resolving the problem, what we learn from it, and what we’re going to do to ensure that whatever problem has arisen doesn’t arise again.

“And that’s what makes the (response and remediation) process so important,” Martin added.

“It needs to be extremely transparent for all stakeholders, depending on the nature of the particular problem, and we think we’re pretty good at ensuring that when we deal with these issues.”

Yet one side of custody provision not often addressed, and one particularly significant with respect to incidents of error, is what impact may arise from changing and uncertain investment markets.

For Braga, volatility drives clients’ desire for increased transparency, better reporting and improved data even further, and so custodians must be ready to respond.

“So something like the APRA holdings disclosure regime that may be coming in next year is part of it as well, to say to the funds what’s their holdings in the fund, but not only that, what’s the holding on a look-through basis,” he said.

“So where they are using unlisted vehicles, to see inside those, to see what the underlying direct assets are of every fund.

“That’s the type of request that’s coming about because of the volatility in investments markets,” Braga said.

Looking deeper into the issue, Martin said that no matter what form it took, custodians had to be able to support their clients through change.

“Anything that our customers do that’s different, obviously we need to be able to support that, whether that’s a new asset class or even a new market,” he said.

“So there’s an evolution and if you look at a typical super fund client from 10 or 15 years ago, a fund that was invested primarily in domestic market stocks and bonds, as opposed to what they might look like now with an array of unlisted unit trusts across property, infrastructure, hedge.

“All of those things have evolved significantly,” Martin added.

“Now, if you then overlay what amounts to high volatility or high risk in markets, we have to be very cognisant of our responsibilities there as well.”

Pointing out contemporary issues such as events in the Euro zone and certain markets’ negative interest rates, Khoury said that super funds were now faced with new and complex challenges that they had not necessarily faced previously.

“So all of those things will require the custodian to be extremely well prepared, to be a trusted advisor and to make sure that those assets are appropriately managed and continue to be custodially held and secure,” he said.

“But within that, there is also opportunity and I think it’s an opportunity for custodians to help their clients understand the nature of those risks, be able describe them effectively, and provide reporting around them.

“So we’ve seen an increased demand around our risk products, we’re seeing increased demand around things like our entity exposure reporting where we can understand where the specific exposures are by entity type,” Khoury continued.

“And all of that helps trustees provide a more transparent reporting back to their regulators and back to their members.

“That’s the role that custodians are uniquely suited to playing now,” he said.

So as super funds continue to grapple with both changing investment markets and Stronger Super reforms that will redefine much of the industry’s landscape, it is clear that custodians are ready and able to play a supporting role.

Indeed, for Braga, custodians could not help but be aware of what focus Stronger Super would bring.

“We’re very conscious of the intent around making costs more transparent,” he said.

“And so we’re working with clients to ensure that the products they’re buying are lined up in a way that makes it easy to attribute the right costs to the right funds and then through to the underlying members.

“But at a general level, we also see Stronger Super driving requests for more information from a fund’s custodian administrator,” Braga said.

“So, in many respects, that’s number one for us.”

It’s why we’re doing so much work around our delivery of information and data to our clients, to make that easier for them to consume and get right to where they want to go,” he said.

For his part, Khoury said that the Stronger Super challenge undoubtedly had a number of limbs to it.

“But the spaces that we’re looking at are the MySuper space, the SuperStream space and if you look at what the heart of that is, it’s around efficiency and cost,” he said.

“It’s (a), making sure that we can effectively transmit and transact across the industry and (b), ensuring we can look for ways to both mitigate risk and reduce cost.

“And from a custodian’s perspective, that really continues to be at the heart of what we do,” Khoury continued.

“It’s about identifying ways to reduce risk, ways to reduce cost and become more efficient in the process.

“So we look at those two particular aspects and focus on how we can allow our clients to structure their products in a low cost environment and how we can look to create that sort of efficiency internally to facilitate that,” he said.

Speaking to custody more broadly, Khoury reiterated that recent dialogue between ASIC and ACSA had already been helpful.

“I think anything we can do to help regulators get a better sense of our industry and how we operate has to be beneficial,” he said.

“But it’s also about globalising the theme so that we’re not simply focused on Australia.

“We want to provide information back to regulators that allows them to set regulation which is more meaningful not just in the Australian context but at the global level as well,” Khoury added.

“Because at the end of the day, we play in a global environment. That’s what we do.”