Why HSBC dared to extend its sub-custody network to the United States
HSBC has added the United States to its network of markets in which the bank clears and custodies the assets of its clients directly. HSBC has done all this, with varying degrees of difficulty, in dozens of markets around the world. But doing it in the United States is far from being a case of business-as-usual. It in fact marks a major break with the past. The question is why.
In November last year HSBC Securities Services started pilot-testing with selected internal clients a direct custody and clearing service in the United States. By the end of the second quarter, the bank will have shifted all of its business to its internal platform, including the business of its global custody clients. The creation of HSBC’s US Direct Custody will be the culmination of 18 months of work to add the largest market in the world to one of the largest sub-custodian networks in the world.
At one level, HSBC Securities Services opening a new market could scarcely be a more everyday event. The bank has a well-honed process for securing regulatory approvals. Accounts were opened successfully at Fedwire, the real-time gross settlement (RTGS) payments system operated by the Federal Reserve, and at the Depositary Trust and Clearing Corporation (DTCC), the American central securities depository (CSD). Internally, staff were hired and systems installed.
Chief among several reasons for this launch is a change in client understanding of the risks custodians are running. Two pieces of European regulatory legislation - the Alternative Investment Fund Managers Directive (AIFMD) and the fifth iteration of the Undertakings for Collective Investments in Transferable Securities Directive (UCITS V) - have between them transformed the risk-reward ratio in the custody business.
UCITS V in particular has imposed strict liability on custodians for virtually any losses incurred by investors, and its impact is being felt far beyond the immediate environs of the European mutual fund industry. There is a growing recognition among custodians that clients everywhere are likely to insist that strict liability become the contractual norm in custody agreements. At HSBC Bank USA client cash will be held on the HSBC balance sheet, while securities will be held in segregated accounts at the DTCC and the Federal Reserve.
"Clients now want a provider who cannot only back the liability they assume with a strong balance sheet, but control the process from end to end as well," explains John Van Verre, global head of custody and treasury at HSBC Securities Services. "Clients understand that, if you control the process from an operational perspective, it gives them an improved level of security in terms of asset safety. This is to some extent a matter of perception - after all, if the securities are properly ring-fenced they are not at risk even in an event of default - but clients still prefer to work with banks which can bring the entire process under their control."
Any client serious about in-house control of their assets also recognises that the United States accounts for two fifths of the market capitalisation of the globe. "Clients are asking themselves, 'What percentage of my assets does my custodian control within their own network?'" says Van Verre. "It is a question that comes up more and more in discussions with clients, and increasingly in RFPs as well."
Counterintuitively, these changes in client sentiment are reinforced by a shift in portfolio flows from North America to Asia, and from Asia to North America. "We are obviously well established as a regional custodian in Asia, so we custody the assets of major American global custodians on behalf of the fund managers and institutional investors they service," says Van Verre. "But thanks to economic growth, demographic trends, wealth accumulation and the relaxation of capital controls, there is an increasing outflow of savings from Asia to North America as well. By providing direct custody services in the United States, we actually benefit from the trends in both directions."
This makes sense. The clients of HSBC as a custodian in the United States consist of investment managers, insurance companies, sovereign wealth funds and a smattering of pension funds, drawn mainly from Asia, the Middle East and Europe. "We did not set up US direct custody to start competing for domestic US assets with the global custodians in the US," says Van Verre. "That was never our strategy and it has not changed; it is not what we are after. This is really to complement our global custody offering."
The sell-side firms that make up the classic direct custody and clearing clientele of HSBC in Asia - a few small prime brokerage firms servicing buy-side clients apart - are noticeable by their absence from the roster in the United States. "We are not looking to compete in the domestic broker-dealer space," adds Van Verre. "It is really the buy-side clients that we are targeting."
This can be construed as making a virtue of necessity - all the major banks and broker-dealers self-clear in New York - but the first client to transition to the new service will, as it happens, be a sell-side client: the New York operations of HSBC Markets. This is not merely because it helps to subsidise a start-up with internal business. The investment bank was self-clearing in the United States, and it is the back office staff of HSBC Markets that are providing the foundation of the sub-custody operation.
HSBC‘s US Direct Custody operation will be led on a day-to-day basis by Frank Primavera, Head of US Custody Operations. Overseeing this is Alexis Meissner, regional head of securities services for the Americas, who joined HSBC from BNY Mellon in December 2014.
The business the entire HSBC group placed with other custodians - and it used all four of the major providers in the United States across the various parts of its business around the world - will follow by the end of the second quarter of this this year. By the time the transition is complete, the proportion of business which is external to HSBC will rise to 80 per cent of the whole.
HSBC’s external clients will have high expectations of the service. Pressure for real-time access to information has increased in recent years and there is an understandable assumption that custodians which control assets without intermediation can deliver data faster than those that still make use of sub-custodians. "If you have an extra party in the chain you always need more time," agrees Van Verre. "Giving clients faster access to information which is meaningful to them is not specific to the US, but it is certainly a benefit of internalising the custody of assets."
HSBC will have expectations of its own. Custody is seen by the bank as a gateway into servicing the other needs of clients active in the United States, such as payments, foreign exchange and cash management. Although the size of the HSBC sub-custody network will remain unchanged at 39 markets, the addition of the United States is offset by the closure of Palestine - the ambition of the bank is to integrate the provision of these services to clients on a global scale.
"We are now actively marketing the United States as part of our global network through our regional business development teams in Asia, Middle East, Europe and the Americas," says Van Verre. "They are making clients aware of the fact we can support them directly in North America."