The uncertain solutions to custody & clearing risks

Banks are currently looking into outsourcing, blockchain technology, and cybersecurity but are wary of unproven results.

When The Network Forum Asia (TNF) meeting took place in Hong Kong in November 2017, a concern that troubled most banks in custody & clearing resurfaced: How can we lower the risk coming from multiple fronts? From stubbornly rising costs to the uncertainties surrounding blockchain and cybersecurity, banks are now facing challenges with solutions that are not so clear-cut. However, this has not stopped banks from trying to gain more clarity and control through experimentation.

There is the persistent concern on rising costs for instance. In an online post following the TNF, Deutsche Bank said many banks looking to control costs are assessing the viability of outsourcing parts of their middle and back office processes.

The bank cited an audience poll at the event, which found nearly half or 48% to be actively weighing outsourcing as a strategy to not only reduce costs but to transform their entire operating model. Around one-fourth of attendees or 24% acknowledged the potential of outsourcing to support product complexity and diversification into new asset classes or markets. On the contrary, 28% said they were not considering outsourcing.

“Outsourcing allows organisationsto eliminate structural costs enabling them to devote more resources to less commoditised processes and client servicing,” said Deutsche Bank. “People-heavy processes like reconciliations, know your customer (KYC), anti-money laundering (AML) and settlement are particularly ripe targets for outsourcing,” the bank added, whilst also citing expert warnings that banks remained responsible and accountable for these activities even if they have been assigned to third party providers.

In 2018, sell-side outsourcing will continue to be a key theme as banks get squeezed by higher costs. “Whilst the buy-side has already outsourced much of its back andmiddle office processing, the sell-side has remained more ‘in-house’ - although often relying on agents for clearing, custody and settlement,” said Bruno Campenon, head of financial intermediaries & corporates at BNP Paribas Securities Services. “However, the ever growing cost of technology and regulation is causing sell-side firms to look more closely at outsourcing once more.”

Campenon expects a major global investment bank to outsource its entire post-trade activity this year. He also foresees outsourcing becoming the accepted operating model for global sell-side firms. With more banks benefiting from the mutualisation of costs, profitability inthis industry should start to recover.

Blockchain is another area in which banks are keen to obtain greater clarity. Deutsche Bank noted the revolutionary potential of the technology, but also the sobering risks that have put banks on a curious-but-cautious stance.“The securities services industry is on the cusp of a transformational digitalisation, which has been enabled through rapid advancements in fields like blockchain,” thebank said. “The T+0 settlement finality of blockchain-supported transactions could heavily impact clearing and settlement, potentially disintermediating central clearing counterparties (CCPs) and central securities depositories (CSDs).”

Blockchain’s roadblocks
According to Deutsche Bank, trading, clearing and settlement could even be completed in a matter of seconds with the emergence of blockchain-enabled initial coin offerings, a cryptocurrency-based equity fundraising tool. If this takes off, it could raise questions on the future of CSDs and CCPs, eventually leading to an industry shakeup. "Under a blockchain set-up, the necessity of the continued existence of some of the intermediaries currently involved in post-tradeprocesses would come into question,” said Julius Baer Group. “Assuming that near-instantaneoussettlement poses no unforeseen operational or credit risk – as a blockchain would theoretically allow instant verification of participants’ cash balances and security holdings – CCPs would be hard-pressed to justify their continued participation. In effect, clearing houses could, in theory, be disintermediated entirely,” it added.

“Likewise, the current ‘doubling’ of custody and safekeeping roles between CSDs and custodians wouldalso be difficult to justify. One or the other would be able to offer the full range of post-trade services. Asimilar reasoning applies to registrars, which would also struggle to justify their services to issuers, if these could liaise directlywith, say, a blockchain operating CSD.”

Deutsche Bank observed that the testing of blockchain technology is now shifting towards real-life applications, with banks ushering blockchain tools to clients that want to improve efficiency in “antiquated, low-risk” processes such as corporate action issuances, proxy voting and reconciliations.

“Banks and market infrastructures are under no illusions about the disruptive nature of blockchain but there are clear concerns aboutabsorbing the technology into systemically important processes precipitately,” the bank said. “Financial institutions want to ensure the technology is fully understood and can co-exist with legacy systems, some of which are more than 20-years old, before any integrations can begin seriously,” it added.

Testing mode
Part of the waiting game is looking out for successful first-use cases, and which is why a lot of eyes turned to the Australian SecuritiesExchange (ASX) in December when it announced it would be the first global stock exchange to adopt distributed ledger technology (DTL) for clearing and settlement.

ASX’s DTL platform will be developed by Digital Asset. Having found to be superior upon a couple of years of testing, the DTL platform is envisioned to replace the Clearing House Electronic Subregister System introduced roughly two decades ago. “Blockchain’s broader adoption by the industry may well reside on ASX’s experiences with the technology,” said Deutsche Bank.

For PwC, whilst blockchain technology has been receiving a lot of excitement for several years already, it probably has a long way to go in maturing as an applied technology. “We still occasionally hear clients ask, ‘Does blockchain really matter?’ The uncertainty is understandable,” said the professional services firm, in a blog post discussing the potential of blockchain in financial services.

“In 2017, firms created plenty of functional, proof-of-concept projects using blockchain in applications such as internal payments, trade finance, and custody. Despite their potential, many of these projects aren’t yet ready for primetime.”

In 2018, PwC expects more clearinghouses and custody providers amongst others to consider what blockchain can bring to clearing, settlement, and other intermediated functions. “Look for blockchain use cases spreading into more mainstream financial market utilities.”

Cybersecurity vigilance
Another source of uncertainty and anxiety for banks is cybersecurity, especially following the $81m heistat the Central Bank of Bangladesh in 2016. These days, cybersecurity is given more attention due to its potential to bring the whole enterprise to its knees.

“Having long been siloed with IT, cybersecurity now occupies boardroom and C-suite conversations, and it is widely considered to be one of the biggest systemic riskscurrently facing the banking industry,” said Deutsche Bank. “In addition to having strong IT protections, many organisations are investing huge resources and efforts into educating staff about the warning signs of cyber-crime.”

The heightened vigilance amongst banks has been a result not only of new threats, but also of newtechnologies in their systems that need to be continually updated with protections against possible attacks. Deutsche Bank said the rise of cryptocurrencies, for instance, has opened up a wealth of investment opportunities, but it has alsobecome a target of criminals that have found vulnerabilities inherent to the their exchanges. Even the vaunted encryption-enabled security of blockchain may be cracked due to the emergence of quantum computing in the next five to 10 years, according to the bank, which further impresses the need to be prepared for any risk curveball that may be thrown at the new systems.