Collateral management
One major driver of change in the technology space is going to be regulatory. The Dodd-Frank Act in the U.S. and the European Market Infrastructure Regulation directive mandate that over-the-counter (OTC) derivatives—securities that trade via a dealer network as opposed to on a centralized exchange—must be cleared through a CCP.
With no central securities regulator in Canada, Sharma says it’s likely that each provincial regulator will eventually adopt concepts similar to the U.S. regulatory reform, but there have been no specific timelines yet. And, she adds, with the majority of OTC derivatives in Canada written by U.S. or European counterparties, investors will feel the impact of the regulatory changes.
One area where the custodian comes in is helping the investor to optimize its collateral usage. “The problem with OTC derivatives is that some of them may require as much as 10% of notional as margin,” says Reucroft. “I’ve got a swap that’s got a notional of $100 million, then I’ve got to find $10 million in margin to put up at the CCP. Where does the $10 million come from?” Unless the investor has that amount available, it usually means “moving the collateral (as margin) between CCPs on an intraday basis as margins change and positions change,” he explains.
“People will have to put together some pretty funky technology to do all that. It’s going to be quite complicated, and there aren’t going to be many who can do it,” Reucroft adds.
“I don’t think the global custodians have even started to spend on this, but when this kicks in at the end of the year to meet G20 requirements, then it’s going to be a mad scramble, with a lot of long hours to sort it out and make it happen,” says Reucroft.
Bernard agrees, saying that a number of firms are paying attention to the issue. However, “when we’ve asked for updates from custodians on what they’re doing, a lot say they’re waiting to see, once everything is final, what they need to do.”
Considering the alternatives
Another way that technology is driving the custody industry is through investment in alternatives. As pension plans increasingly make allocations to more complex investments—hedge funds, private equity, infrastructure and real estate, for example—they expect the technology provided by their custodians to meet that demand.
“We’ve invested significantly in alternatives over the past several years,” says Baillie, “as we’ve seen a significant trend toward more adoption of all kinds of alternatives.”
However, technology is not the only part of this process; there’s a people factor, too. Northern Trust has 300 employees in operations alone dedicated to alternatives. “They’re working behind the scenes to make sure we’re handling instructions appropriately and processing and reporting correctly,” says Baillie.
One of the toughest assets for plan sponsors and custodians is private equity, which is very labour-intensive. Forecast-ing a capital call (the legal right of an investment firm to demand part of the money promised to it by an investor) is an administrative challenge because it’s difficult to predict when the next capital call will occur, and the investor doesn’t always have the necessary cash available. Northern Trust has developed a tool that will give clients insights into when a capital call is coming, which allows clients to make the arrangement in advance; otherwise, it can be a bit of a scramble to raise the cash, says Baillie.
Northern Trust’s system will also image and process limited partnership statements (a statement from a partner whose liability is limited to the extent of its share in ownership), essentially creating a “paperless” process for an asset class that generates significant amounts of paper. It also automates a number of controls in the processing. “We have added intelligent software to an asset class that is very hard to automate.” For example, it will tell us if the capital call has been issued appropriately for all of our clients invested in that particular partnership, Baillie adds.