Foreword

    In April 2017, HSBC published ‘Custody in 2025’, a ground-breaking and influential paper outlining the 10 key developments that we believed were likely to radically transform the entire post-trade operating model. Admittedly, some experts have questioned whether there will be any need for custodians in the future as new, disruptive technologies emerge, and acquire market share. Instead, we argued that the role of the custodian would simply evolve in line with market trends, and it is a view that is now widely held and accepted across the industry.

    Continuing on from ‘Custody in 2025’ publication, we are pleased to launch “Network Management in 2025”. This paper explores some of the core trends and changes that will impact the network management community at global custodians/ brokers. This paper aims to provide network managers with useful strategic insights about how they can remain relevant within their organisations and continue to create value for their businesses and end customers.

    Introduction

    We are living in an ever-changing world, the impact of which is being felt at businesses on a number of different levels. Network management is not going to be an exception, and will likely see its remit evolve dramatically over the next few years.

    Since the financial crisis, network managers’ focus has primarily been concentrated on agent selection for purposes of: risk management, regulatory/financial crime compliance, cost effectiveness, capabilities and market insights. However, material developments in the securities and cash markets (e.g. changes to market infrastructures, evolution of crypto-currencies/digital assets, growing importance and value of data, the push towards receiving globally consistent experiences, the transition from a static due diligence process towards a more dynamic model/approach) will all collectively have a lasting influence on the role of the network manager, which this paper will fully dissect.

    However, these industry-wide transformations will not dilute the responsibilities of network management. It could be argued network management will actually become even more important in time, especially as securities and cash markets are increasingly confronted by new and unpredictable challenges like cyber-crime. Whatever happens over the next few years, it is clear the network management function will be very different in 2025 to what it is like today.

    The purpose of network management

    Most experts would concur that the role of network management is to manage risk, capabilities and costs, all of which form the basis of agent selection. However, this merely states what network management is doing, not why it exists to begin with. The reason for network management’s existence is not solely about managing risk, capabilities and costs, but enabling our clients (global custodians, brokers, investors) to grow their businesses by providing global solutions covering all markets which underlying customers either want to access or receive a service from. This includes markets where the bank itself may not have a physical presence.

    Traditional responsibilities of network managers New responsibilities of network managers
    Risk management Internal coordinator
    Regulatory and financial crime compliance Knowledge provider
    Cost management Data integrator
    Capability assessment Management of partnerships
    Market information Driving new (technology enabled) solutions

    Are the new tasks really new?

    While some of these new briefs are obviously fairly novel, others are merely evolutions of existing responsibilities. In fact, many within the network management community would argue that they already perform some of these new tasks (i.e. Knowledge Provider, Internal Coordinator, Management of Partnerships). It is important to note that the traditional roles and duties of the network manager will not disappear, but could assume a far greater significance.

    New responsibilities of network managers

    Internal coordinator

    Increasingly, network management will be the internal function assigned with coordinating all of the different activities between the various business streams (e.g. legal, financial and regulatory compliance, risk, credit, operations, IT/Cyber) across banks who are utilising external and internal agents. It is critical that only one party (i.e. the network manager) has full visibility and oversight of these agents. Such centralisation will help mitigate the risk of separate stakeholders within (large) banks establishing their own bespoke network solutions, which could result in a superfluity of external agents, leading to overlaps, inefficiencies and unnecessary costs.

    In order to be effective and to help ensure networks are future-proofed, internal coordinators need to demonstrate the following traits:

    • Excellent communication skills
    • Forensic knowledge of the various businesses
    • In-depth understanding about new technologies and their potential

    Data integrator and knowledge provider

    The sheer volume of data in the world today has multiplied exponentially, and it is still growing. Data is often obtained from multiple counterparties and sources (i.e. agents, market infrastructures, technology providers, regulators) and it is delivered in different, inconsistent and fragmented formats, making it exceptionally difficult for internal stakeholders to accurately process the relevant information. It is here where network management teams could play a proactive role, assuming charge of data aggregation and integration, thereby becoming holistic sources of knowledge for their entire business.

    Consequentially, network managers – by collaborating with other business divisions (cash management, global banking and markets, securities services) inside their organisations – could become invaluable sources of information and increasingly important participants during the strategic development and implementation processes at banks, as well as at their own clients.

    Management of partnerships

    Network management has long been a relationship business, with agents often seen as partners as opposed to just plain service providers. The value of these engrained relationships should not be underestimated, not least because their strength and durability makes it easier for all parties involved to execute changes or resolve operational problems.

    Technological disruption – namely DLT (distributed ledger technology), APIs (application programming interfaces), AI (artificial intelligence), the emergence of cryptocurrencies, the growth of data as a service (DaaS) along with evolutions in market practices – such as the rise of DLT-supported tri-party models facilitating direct access for global custodians and their clients to CSDs or standardisation of the AFME due diligence questionnaire – will all lead to major industry changes, but also new and unique risks, which network managers need to be alert to.

    As such, network managers’ deeply embedded relationships with their service providers will assume an even greater significance, especially as the industry becomes increasingly complicated and interconnected as a result of these transformations. It is no longer adequate for network managers to simply be “control owners” of their external agents. Instead, a network manager with a full “front-to-back” view of external agents will be pivotal if such changes are to be managed safely and effectively. A failure to monitor service providers on an enterprise-wide basis in this fast-evolving marketplace could lead to a build-up of counterparty risk for global custodian/broker-dealer clients.

    It is also critical to note that business strategies moving forward are likely to focus on consolidating external provider relationships so as to accumulate cost savings and achieve globally consistent solutions. For instance, some global custodians/broker-dealers may find it preferable to appoint sub-custodians on a regional basis instead of using them simply for individual markets.

    While consolidation creates increased counterparty risk for clients, it reduces operational risk; minimises overall costs and enables clients to receive a more consistent suite of services across their networks. However, cost should not be the sole factor behind agent selection. Global custodians and broker dealers need to choose providers who deliver meaningful strategic value through their networks, the benefits of which can be shared with underlying clients.

    However, there may still be a need for network managers to appoint specialist providers to support them with specific requirements in particular markets complementing the services of their existing general agents. Managing this hybrid model effectively will be key, especially in the context of the increasing importance of emerging markets and the growing possibility that new (i.e. triparty) models and partnerships could become more common. The trend among clients to reduce the number of agents for cost and operational risk reasons will therefore be balanced with the need to obtain solutions that support their individual requirements.

    Identifying partners who can provide globally consistent solutions will be a key criterion for network managers. Simultaneously, network managers need to ensure their service provider partners have sufficient funding and programmes/workstreams in place that support and future-proof their business strategies. It is clear there is now a transition happening as network managers increasingly focus on prioritising value-drivers over cost-drivers when selecting their providers so as to ensure they find the right balance.

    We are living in an ever-changing world, the impact of which is being felt at businesses on a number of different levels.

    The new challenges

    The network management function is poised to undergo a significant transitioning over the next few years. In this section, HSBC will take a look at some of these key changes including:

    • The move away from a static due diligence process to a more dynamic model
    • Changes in market infrastructures and how they drive new business models
    • The evolution of cryptocurrencies
    • The role of data as a new Asset

    Driving New (technology enabled) Solutions and achieving a more dynamic due diligence model

    The existing network management due diligence model is highly fragmented and inefficient for all individuals involved. In most circumstances, due diligences will typically entail network managers sending questionnaires over to their providers, before conducting a physical on-site visit. In addition, network manager due diligences are usually conducted in cycles (annual, bi-annual, three-yearly), meaning they do not have a real-time view of the risks at their providers. As the volume of regulation grows – in lockstep with various internal operational requirements – network managers are being forced to obtain more information from their agents.

    Nonetheless, the industry is attempting to rationalise the due diligence process. Take, for example, the questionnaires network managers send to providers. While these documents all share a common purpose, many of the questions are often inconsistent or duplicative. AFME sought to redress this matter by creating its own proprietary, standardised template to bring order to the whole due diligence questionnaire exercise. Despite AFME’s best intentions, the process is still far from harmonised (see chart below). This is because different network managers continue to insert their own tailored questions into the AFME template, making due diligences even more convoluted and time-consuming for impacted participants.

    A number of internal and external stakeholders want to obtain better insights into the performance of their agents on an ongoing basis. They will do this by shifting towards a “continuous monitoring model”, which can be achieved if network managers implement some internal changes. This would require network teams to develop data and analytical tools to produce internal control reports and manage exception handling.

    However, direct connectivity – enabled through APIs between network managers and their agents – would need to be created, allowing for real time monitoring of operational risk. Looking ahead, tools such as predictive analytics or behavioural analytics which leverage machine learning and AI could help network managers identify trends, allowing them to pre-empt problems at their agents. This suggests due diligence will shift away from the static model to a more dynamic approach.

    What is the percentage of additional due dilligence questions to AFME that you ask?


    Findings from a survey conducted at The Network Forum Conference in Athens in June 2019

    If the industry were to also migrate towards a DLT infrastructure, the due diligence process could be significantly expedited as well. As DLT provides a single version of the truth, agents could simply upload the necessary information onto the DLT, and provide network managers with permissioned access to it as and when it is required. Furthermore, DLT would allow providers to make changes to the information in real-time. This could also prompt calls to further standardise industry protocols and create a centralised utility where providers and network managers can share information accordingly. By adopting new technologies like big data analytics, AI, machine learning and DLT in the due diligence process, network management teams could potentially net enormous cost and risk mitigation benefits.

    Changes in market infrastructures drive new business models

    Market infrastructures (CSDs, CCPs, exchanges) – in particular – are likely to undergo a massive business model transformation as a result of rapidly changing technologies. Market infrastructures are widely expected to engineer systems whereby custodians (or even clients) become nodes in a DLT, allowing end customers to become direct market participants. This would be supported by APIs facilitating easier data sharing and connectivity between all market users. It is also probable that new tri-party models will need to be developed in order to create an integrated solution between the client, the CSD and their custodian banks.

    While some speculate this triparty ecosystem could disintermediate traditional banks, this is not a widely accepted view. In addition to providing asset protection, liquidity, FX solutions and meeting the various regulatory capital obligations, a trusted bank counterparty will still be required to consolidate the diverging data streams, by managing the underlying network of agents providing all of this information. This will enable clients to receive accurate data in real-time or near-real time. Network management will also likely be entrusted with ensuring and validating that assets are safe-kept properly in this multi-party business structure.

    Leveraging DLT could improve existing settlement processes too, in theory supporting the roll-out of instantaneous (i.e. t+0) settlement cycles, thereby removing the need to have intermediaries involved in the entire transactional lifecycle. Even though DLT supported settlements could hypothetically eliminate counterparty risk, it will require transactions to be pre-funded, meaning there would be heightened FX risk and less netting benefits.

    These challenges will have to be overcome if DLT solutions are to be rolled out more widely and successfully. While such innovations have huge potential to usher in a new generation of operating models across market infrastructures, it is crucial to note these technologies are in the very early stages of development. As a result, there is still ambiguity about the impact these developments will have.

    The evolution of crypto currencies

    The cash world is evolving, most notably with the emergence of digital currencies backed by Central Banks. It is still early days but such dynamics could change or even completely remove the need for external settlements. Instead, these will become book transfers in a central ledger. The concept of ‘one version of the truth’ will make the reconciliation process much easier as well. Significant efficiencies could be realised conditional on regulators allowing banks to use such a ledger as a trusted source, and that this can be utilised as their own book of records.

    In the long-term, the nature of FX transactions could be radically altered if Central Bank-backed cryptocurrencies can be held on a DLT by parties in other countries. This will dramatically change the way banks provide services to their clients. Similar to the transformations underway at CSDs and custodians, network managers will also have to evaluate the role they play in this new world of cash.

    Data as a new asset

    For clients to receive a globally consistent user experience, they need harmonious and reliable data. This is not always straightforward, mainly because a lot of data is sourced from multiple intermediaries (e.g. agents, exchanges, CCPs, CSDs, etc.) who will have their own bespoke processes when collecting, collating and analysing information. Nowadays, clients want access to consolidated and normalised data through APIs, something agents will need to facilitate.

    The securities services industry is exploring a number of innovative approaches aimed at enhancing data management. For instance, some organisations are working on ways by which to transform physical documentation into a digital format. This pivot towards digitalisation should not be misconstrued with dematerialisation though. Instead, providers envisage an operating environment whereby physical documents (e.g. private placements) are scanned into a digital format giving clients a joined-up view of their entire portfolios through a digital vault. Such tools will help network managers carry out their duties more efficiently moving forward.

    The importance of the traditional Network Management functions

    Network managers play an essential role in monitoring risk management, regulatory and financial crime compliance, cost effectiveness, capabilities and the delivery of market insights. This is not going to change. However, technological innovation and evolving risk dynamics will have a direct effect on the traditional activities of network managers. In response, the industry needs to acquire a deeper understanding about new technologies like crypto-currencies/digital assets and DLT while simultaneously getting to grips with threats like cyber-crime.

    Increasingly, network managers will find themselves thrust into the centre, acting as coordinators and data aggregators across multiple business streams within banking groups. As a result, network managers – owing to their unique position within the industry – are expected to play a critical and more influential role when helping banks achieve their various strategic objectives.

    Disclosure and disclaimer

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