The Message From Warsaw - Charles Gubert, GTL Associates
4 July 2017
 
As The Network Forum Annual Meeting drew to a conclusion, one key message should be ringing loud and clear in the heads of all the delegates who joined the two-day conference.
 
The world as we know it is going to spectacularly evolve, and those who continue to dream about a reversion to past glories and bygone heydays, are going to find themselves stuck on the wrong side of history.  
 
Most people toasting their wine glasses on December 31, 2015 would probably have given short thrift to the notion that Donald Trump, a real-estate tycoon cum reality TV personality, would be President of the United States, or that the UK would turn its back on the European Union (EU) in a divisive referendum.
 
Even fewer probably thought that Jeremy Corbyn, a Labour leader and self-avowed anti-capitalist, would be a hair’s breadth away from being Prime Minister of one of the biggest financial centres in the world. The clear political risks – for now - are Trump and Brexit. Both are equally unpredictable, and neither is going away anytime soon.
 
As we can see, politics is changing; regulation is changing; technology is changing; clients are changing; risks are changing and markets are changing. Custody is going to have to change with it, and this may require organisations to make some uncomfortable or controversial decisions.
 
Brexit
 
A positive Brexit deal for the UK seems to be something of an oxymoron, mainly because the Conservative Party has a slender majority and its MPs are divided on Europe, with one panel expert doubting Theresa May will be in Downing Street by year-end.
 
The most imminent clash of heads on Brexit is likely to be a result of the EU’s renewed expectation that euro denominated clearing be located and supervised within the Single Market.
 
One panellist pointed out that repatriation of euro denominated clearing was a misnomer given it has always been based in London. Ill-thought out repatriation or forced relocation of euro denominated clearing is likely to lead to reduced liquidity and increased margin and collateral costs for OTC users.
 
The European Central Bank’s (ECB) power grab to oversee central counterparty clearing houses (CCPs) also risks putting it at odds with local central banks and regulators. That being said, some believe the Brexit risk to euro denominated clearing is being exaggerated, and cooperation will be realised eventually.
 
But why should we be optimistic? Mainly, because there are two truly systemically important CCPs in the EU – LCH in London and Eurex in Germany. “If the ECB demands direct oversight over LCH, then the Bank of England will request symmetrical oversight over Eurex,” said one panellist. As such, it is in neither the UK’s nor EU’s interest to enter negotiations on OTC clearing in bad faith.
 
Technology: Sink or Swim
 
Major industries, which individually employ hundreds of thousands of people, are being decimated by digital companies or platforms who may have a payroll totalling no more than a few hundred or low thousands, said one panellist. The ability to compete against nimble, cost effective and innovative providers who are often subject to lighter touch/no regulation is a problem for many established brands.
 
Banking needs to reform its technology, processes and systems otherwise it will find itself out of sync with changing consumer habits.  43% of banking systems are built using COBOL, whereby programmers are not so much retiring but actively dying of old age.  Reliance on systems which are this old needs to re-thought and addressed, if organisations are to hold their ground against disruptors.
 
The custody industry is heavily dependent on legacy systems, and it is true that a lot of this technology is hard to replace, at least in a way that is not disruptive. But just because something is difficult does not mean it should not be done.
 
Blockchain, distributed ledger technology and AI are all likely fits for the custody industry, and may be effective tools by which to transform and eliminate intermediation, duplication and repeat processes, at a time when costs are crippling and revenues are dropping. “The industry has not adapted to the post-Internet age. The industry made hay when the sun was shining, but the sun is no longer shining,” said one panellist.
 
Outsourcing or near-sourcing operational processes has long been considered a solution for cost control, but this may no longer be viable. The panellist warned the audience that the future competition to the custody industry was not in the room, and that it was crucial firms start to embrace technological change. “I do not need a correspondent bank to deliver market information, which I can easily access on Twitter,” the panellist added.
 
Industry adoption of technology is mixed. Admittedly, some organisations have got a technology strategy. Goldman Sachs famously said it was no longer a bank but a technology company with a banking license. Whether this translates into the custody world is another question. An audience poll found more than half of respondents believed custody and clearing industry would be “much the same as today.”
 
New Risks, New Responses
 
For a modest 10,000 euros, a cyber-criminal can acquire ransomware, which can be used to extort or blackmail major corporations by bringing their servers to a grinding halt. One cyber-expert said some of these criminal gangs were adopting traits typically associated with legitimate corporate enterprises. He said they were buying up office space and paying staff regular salaries. Some are even equipped with live chatrooms whereby victims are given instructions on how to pay ransoms.
 
Recent cyber-attacks have been notable for their severity and scale. “The software used in the latest hacks was developed by nation states. Many of the tools were then stolen or leaked, and have found themselves in the hands of criminals and hackers, who are adding variations to the software. This is a problem that is spreading like wildfire,” explained the cyber expert.
 
Custody is a global business with weak spots that are totally open to compromise by outside hackers. Another panellist said the continued use of legacy technology was a weakness that could easily be exploited by nefarious criminals. The Swift/Central Bank of Bangladesh attack was a truly watershed moment for this industry, and one expert said the response by Swift in implementing a robust security programme was due credit.
 
Cyber-security measures need to be strong enough to mitigate serious hacks, but people training is key, and this is an area where more work needs to be done. “From an industry point of view, there is not enough training. We spend our time teaching ourselves about ‘stranger danger’, but we do not do this in a virtualised environment. There is a human element of security too,” said the cyber expert.
 
Fortunately, network managers have clocked onto cyber risks, partly as a result of the liability risk they now take on under AIFMD and UCITS V. The DDQ unveiled by the Association for Markets in Europe (AFME) includes a section dedicated to cyber at sub-custodians, and this is an area where real progress has been made, at least in the due diligence process.
 
Attendees at the Network Forum are equally aware of the risks. 20% of the audience said in a session poll that cyber-crime was the most significant risk in the custody chain, putting it ahead of regulatory or legal risk, albeit behind operational risk.
 
Where to next?
 
The Network Forum will be holding its Americas Meeting in NYC on November 7, its Asia Meeting in HK on November 13, and its Africa Meeting in Cape Town wc/November 27.
 
 
 
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