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How dual networks minimise counterparty risk
How dual networks minimise counterparty risk
Asset safety is the paramount objective of global custodians and their key obligation to clients. Maintaining rigorous oversight of assets and ensuring their safekeeping across networks of agent banks is now more important than ever to custodians, investors and regulators.
But how can global custodians reassure clients that their assets are in sound hands? Global custodians use different contingency solutions to enable them to deal with adverse market events or sudden shocks, such as a default or credit situation at an agent bank.
The first model, known as a ‘cold contingency’, entails a global custodian notifying a secondary agent bank in a given market that they are their back-up provider in the event of a problem at the primary provider. The second approach or ‘warm contingency’ plan is when the global custodian has accounts and sub-custody agreements with a secondary agent bank, allowing for assets to be ported in the event of a crisis at the primary provider. A ‘hot contingency’ plan or dual network is where the global custodian actively utilises two agent banks in a single market to minimise counterparty risk for clients.
Quintessence asked Dominique Ansiaux, Global Head of Network Management at BNP Paribas Securities Services, to explain the virtues of a dual network and the key considerations when selecting agent banks.
Asset safety is the most important criteria and a dual network facilitates this, particularly in a crisis situation, which may include insolvency, acts of god, adverse decisions from the authorities, or operational issues. Put simply, a dual network allows global custodians to port assets to a secondary provider in a timely fashion with minimal disruption to client business. Such diversification in any market is central to client requirements, as evidenced by large investors such as sovereign wealth funds increasingly demanding that their global custodians have a ‘hot contingency’ plan in place, such as dual networks.
There are other significant benefits of using a dual network as it can allow global custodians to benchmark service delivery, fees and market information continuously, creating opportunities for cost savings and efficiencies.
Recent regulation has indeed put asset safety in the front seat. The Alternative Investment Fund Managers Directive (AIFMD) and the UCITS V Directive impose strict responsibility on depositaries to make sure that client assets are protected in custody and sub-custody, and this includes devising contingency plans.
This means custodians are under enormous pressure to make sure assets are secure, especially in their network or markets which are higher risk, such as frontier markets. It is not just EU regulators who are pushing this issue: the Australian regulator (with Regulatory Guide 133) and the International Organization of Securities Commissions (IOSCO), for instance, are both doing so. IOSCO guidelines state that custodian institutions should maintain appropriate arrangements to safeguard the clients’ rights in client assets. A dual network goes well beyond compliance with the IOSCO guidelines or EU regulations, which simply advise global custodians to have contingency arrangements whereby assets can be recovered if the agent bank suffers a disruption of service. Similarly, a dual network set-up also goes beyond the requirements demanded by UCITS V and AIFMD.
Global custodians must conduct robust due diligence on secondary providers because of the new regulatory environment in which they operate. Due diligence on secondary providers ought to be carried out in parallel with primary provider selection and there should be no variation in terms of the scope and thoroughness of that due diligence process.
Typical due diligence on a secondary provider will entail sending a detailed and bespoke questionnaire asking them to outline in depth their regulatory compliance processes, business continuity planning and asset safety procedures, for example. This should be followed up by an on-site due diligence visit, when these processes are thoroughly reviewed and tested by the network managers. This may include on-site verification confirming the level of automation between the secondary providers and local market infrastructure, monitoring operational risk controls, or checking that assets can be traced throughout the entire custody chain back to the central securities depository (CSD). These stringent selection criteria are essential to help guarantee that client assets can be held safely. The same criteria are applied for the periodical reviews as part of the ongoing monitoring process.
Industry-wide efforts are being made to standardise the due diligence process of network managers on their agent banks through the creation of a Due Diligence Questionnaire (DDQ) by the Association for Financial Markets in Europe (AFME). This standardised DDQ will free up resources for the agent banks at a time when costs are getting ever higher. It will allow local custodians to refocus their resources on different aspects of the enhanced due diligence process, in particular to support the increased on-site due diligence control requirements. It will also help the global custodians and sub-custodians manage their workloads and monitor work as it will reduce duplication by consolidating all of the standard or static data points. Ultimately it will provide for a more streamlined network manager due diligence and selection process.
Dual networks can help minimise risk in all markets, which is an absolute prerequisite to satisfy not just clients but regulators under UCITS V and AIFMD who want clarity that assets can be migrated seamlessly between agent banks in a crisis scenario. Large institutional investors are increasingly scrutinising the operational set-ups, including business continuity plans, which global custodians have at their agent banks.
The dual network model supports asset safety in an adverse market situation. This enhanced risk management and focus on due diligence is not going to diminish and dual network set-ups are likely to proliferate as a result.