Custody Report – A Conversation with Custodians

• J.B. (Bernie) Ward, director, corporate and group services, Canadian Western Trust
• François Gagnon, executive vice-president, custody services, Desjardins Trust
• Kevin Drynan, president and CEO, State Street Trust Company Canada
• David Linds, senior vice-president, business development and client relationship management, CIBC Mellon
• John Folk, senior vice-president and chief operating officer, The Northern Trust Company, Canada
• Scott R. MacDonald, head, pensions, financial institutions, client service, North America, RBC Dexia Investor Services

How did the custody industry fare in 2009, and what major trends do you expect for 2010?

WARD: Most plan sponsors stuck to their knitting despite hard economic times and trusted in their investment guidelines. As a result, their plans weathered the storm quite well. A major trend we are seeing is increasing recognition and concern about the shortcomings of defined contribution plans, for both the sponsors and the members.

GAGNON: Canada, in 2010, will benefit from the slow recovery initiated at the end of 2009. Equity markets will see a slight increase, although not as strong as in 2009. The custody business will face similar challenges in 2010 as in 2009. Interest rates continue to be low, which limits cash management and securities lending opportunities. Transparency, compliance and governance are at the centre of [plan sponsors’] preoccupations.

DRYNAN: We are certainly seeing signs of recovery; however, we are still operating in a fragile economic environment. Client assets have risen from the market lows, but it is still too soon to tell how close we are to the end of the tunnel….As part of their focus on risk management, clients are reviewing their operating models, which may indicate a renewed interest in outsourcing some investment servicing functions and, in some cases, in-sourcing some functions.

Given the events of 2008/09, have you noticed greater pressure from your clients for transparency and disclosure?

GAGNON: Definitely—thus the interest in compliance monitoring solutions. More specifically, in Quebec, Law 20 has heightened the importance of fiduciary responsibilities for pension committee members and suppliers. In light of this, custodians are more involved in assisting pension committees with the assessment of potential risks associated with counterparties, investment products, et cetera, by facilitating access to information and providing transaction execution transparency.

WARD: There is a trend afoot for transparency and full disclosure of fees. There is also a move toward self-directed RRSPs adopting a fee-for-service model when compared to the historical and traditional commission-based model.

More and more we are seeing individual investors wanting to see what it costs to run their self-directed plans, which is identical to the model that retirement plan sponsors have had the luxury of for years.

MACDONALD: Clients have been increasingly seeking a more detailed understanding of the dynamics of a custodian’s business and what they will be getting for their fees, and we expect that to continue in 2010. This includes the risk management processes and tools that custodians use to run their businesses, and clear communication of liability responsibilities….We have also noticed an increase in clients looking to consultants to help evaluate the performance, disclosure and transparency of their custodial partners, but they are still working out how to ensure defensible good governance in the selection of the consultants themselves, which we expect will be an increasing area of focus in 2010.

How has securities lending been affected in the last year?

LINDS: Overall, lending balances are lower since the turmoil in 2008. This lower demand is caused by various factors, including industry-wide de-leveraging in addition to lower stock prices and reduced dividends. The extra attention the market has paid to securities lending has helped to increase its profile over the year. This has provided us with many opportunities to address issues such as risk management in securities lending, and the benefits of short selling to the efficient functioning of financial markets.

Although risk is still an important consideration, our conversations are turning toward helping clients increase their returns through securities lending. This is fueling greater interest in lending against cash collateral, while encouraging clients to enter our program for the first time.

GAGNON: The Lehman situation has put stress on Canadian securities lending. It also demonstrated that the programs in Canada were in better shape…There is better awareness on both sides of the transaction of who the counterparties are and the importance of continued monitoring. The demonstration, on behalf of the custodian, that he or she can respond in a timely fashion to changes with counterparties and the markets is important. Lenders now understand that a lending program has a full range of embedded risk controls to minimize risks and that the agent lender has as much to lose as the client does.

DRYNAN: The renewed focus on risk and transparency has created a movement toward industry-wide standards for securities lending, which will transform the way portfolios are built and how risk is managed. This new emphasis will help the industry to develop better programs, more innovative products and, ultimately, stronger relationships between agent lenders and beneficial owners. Risk and transparency are now at the forefront of investors’ minds. The securities lending industry is returning to a back-to-basics approach, transforming everything from risk models and reporting to investment approaches and customer relationships.

Are you seeing a renewed interest in risk management? What are custodians doing to reduce risk?

MacDONALD: Risk management never stopped being a focus for our clients. Rather, due to the recent market environment, specific types of risk were receiving greater focus. Not surprising, investment and shortfall risk were the primary concerns. One way that we are helping our clients to better measure and manage this risk is by developing customized liability driven investment benchmarks to facilitate the risk-budgeting process.

FOLK: Clients are broadening their focus on transparency in their portfolio holdings and what they’re looking for in the analysis of their exposure. Asset liquidity, counterparty exposure and interest rate sensitivity are being viewed at an overall portfolio/plan level, and the requirement for flexibility and timely access to data is increasing accordingly. Custodians are responding with more automation to minimize operational risk, while at the same time helping clients to better understand and minimize their counterparty risk. Until recently, a 30-, 60- or 90-day cash forecast was the norm. But in today’s markets, and with more alternative investments in their portfolios, clients are looking for a view on liquidity that includes hedge fund investments and potential capital calls on private equity.

DRYNAN: There is no question that clients are very interested in risk management—more so now than ever before. They are concerned with two primary areas of risk: portfolio management risk and operational risk. Both areas will continue to be important to clients in 2010 and beyond. As custodians, it is our responsibility to ensure that we are transparent with clients about risk and providing them with tools to help manage it. Risk management is a dynamic
process, and the needs of each client are unique. As the regulatory and market environment continues to evolve, we remain focused on continually developing our risk management offerings so that our clients have access to the best tools and resources available.

Where do you see the biggest opportunity for custodians to grow their businesses or make up for lost revenue in 2010?

FOLK: Firms that are positioned to compete globally—and able to invest in and add functionality within a consistent global platform—will see many opportunities to expand with both existing and new clients. There is still plenty of room for growth in core custody and information reporting, with $160 trillion in assets invested globally. Beyond traditional custody, we see exciting opportunities in servicing the asset management segment and alternative asset classes.

LINDS: We see the greatest opportunities for growth in supporting institutional investors as they reduce their risk and reposition their asset allocation for the long term. This means, we will continue to focus on helping plans to stay up to date with respect to investment performance, risk and other portfolio analytics. As workloads grow with stricter governance standards, plans will look for enhanced flexibility and greater accuracy in this reporting. Investment managers are also facing close scrutiny, and funds will continue to take advantage of available compliance-monitoring tools. We are also looking to derivative-servicing opportunities that reduce operational and counterparty risks for investors.

MacDonald: The recent economic plight has forced pension plans to take a good hard look at all of their business relationships, custodians included. After a period of increased analysis…of all aspects of the business of running a pension plan, we expect a lot of opportunity will come from that increased knowledge and understanding of capabilities. Plan sponsors will gravitate toward those providers that demonstrated an ability to help them and their members, and [who were] able to demonstrate a strong local commitment, creditworthiness and conservative management during the crisis. New opportunities will also come from providing prudent programs like securities lending, as well as from the provision of established outsourcing services such as benefit payments and performance analytics that will allow plan sponsors to manage their risk and allocate their limited resources to core activities.

April Scott-Clarke is assistant editor of Benefits Canada.
april.scottclarke@rci.rogers.com

This interview is an extended version of Custody Rountable, published in the February 2010 issue of Benefits Canada.

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© Copyright 2010 Rogers Publishing Ltd. This article first appeared in the February 2010 edition of BENEFITS CANADA magazine.