Australian Firms Make Regional Processing Push
By Gary Maller
October 13, 2003 -
In a sector characterized by consolidation and compliance challenges, Australia-based firms like Berndale Securities and Fortis Clearing are seeking an edge over their Asia-Pacific processing rivals by offering regional custody-clearing solutions.
"From the point of view of providing a clearing and custody capability or an execution and clearing capability for large global players who want a full regional blue-print, we have some clients in Australia who are using us for custody and clearing, and would like us to do that for them in Tokyo, Singapore and Hong Kong," said Berndale Managing Director Craig Mason, declining to reveal the identity of Berndale's new global custody clients. Berndale is a wholly owned subsidiary of Merrill Lynch. Mason believes there is a regional clearing opportunity, in that super-fund managers can use Berndale to offer offshore back-office services for fund managers in Hong Kong, Tokyo and Singapore. "This would be the provision of clearing and settlement, and agency custody for Berndale clients across the region, but based in Australia," he said.
Berndale already provides international custody services out of Australia through Merrill Lynch's global network, Mason said, declining to elaborate.
Berndale is not alone in its regional ambitions. According to Managing Director Joost Becker, Fortis Clearing (a unit of the Netherlands' Fortis Group) also provides clearing and custody services out of Australia for markets throughout the Asia-Pacific realm. The firm is active in Singapore, Korea, Taiwan and Japan.
 Running a similar model to Berndale, Fortis has so far concentrated on clearing derivatives transactions for hedge funds and market-makers. "We clear 45 percent of the Australian derivatives market and 7 percent of equities, which provide the underlying security for the derivatives volumes," Becker said. Berndale claims around 15 percent of total equity volume in Australia.
In addition to building the custody-clearing services it provides to super-funds, Becker said his firm also intends to deploy a range of services to retail broker-dealers. Fortis is also set to extend its reach beyond derivatives processing to increase its share of equity volumes, he added.
Berndale also clears derivatives but Mason is wary of the volatility associated with that market. This stands in contrast with Fortis which, according to Becker, has built highly sophisticated, proprietary risk management tools that cater to that market.
Indeed, risk management rates high among the issues that have prevented Australian processing providers from moving beyond their home market. For example, risk management-related challenges remain the key impediment for correspondent clearing in Hong Kong (Securities Industry News, May 5). Currently in another round of consultations with industry participants, the Hong Kong Stock Exchange is expected to announce its findings by year-end. Custodians including Standard Charted Bank, Citibank, and HSBC have been pressing the HKSE for the introduction of agency and correspondent clearing as a means of further lowering back-office infrastructure costs for clients already using their custodial services.
However, Mason claims Berndale's regional model is not dependent on the adoption of clearing in Hong Kong or other specific markets.
For their part, global custodians such as the Bank of New York and Citibank consider the deployment of correspondent clearing in Australia a natural extension of their existing services (Securities Industry News, May 3). That's because, in addition to netting trades on their own books as clearing participants in Chess, Australia's central depository, they can perform settlement of cash and stock as well.
However, Chess' real-time, fully dematerialized settlement system has proven to be a barrier for global custodians and others seeking to clear in Australia. This is because for many, Australia's relatively small market still lacks the critical mass required to justify the cost of deploying a clearing interface to Chess.
 Specific business rules govern the functions the various types of Chess participants can perform. As non-broker participants (NBPs) in Chess, custodians act on behalf of clients to direct trades (as nominee) to an executing broker-dealer, effect post-trade allocations and manage corporate actions. But the actual settlement in Chess must be performed either by a registered self-clearing broker-dealer participant or a clearing-only participant. Different business rules and capital requirements apply to clearing participants than NBP custodians because the credit and settlement risk for the trade is carried on the clearing participant's balance sheet, not by the custodian.
According to Mason, Berndale--which is both a clearing and custody participant in Chess--can provide super-fund managers with more flexibility to re-balance portfolios. "The new service bypasses traditional custody offerings for super-funds because the executing broker gives up settlement to Berndale, who, in addition to assuming risk as clearer, also handles post-trade allocations and confirmations between funds," Mason said. "This means super-funds can place block trades without revealing the identity of the underlying fund manager clients to the executing broker."
According to Mason, the firm is targeting institutional correspondent broker-dealers who want to leverage the Berndale-Merrill Lynch balance sheet. "Their ability to do more and bigger tickets and deal more freely with institutions and fund management groups has freed up new opportunities for them," Mason said of that sector.
A recent surge in Australian Stock Exchange (ASX) retail volumes--which currently account for 25 percent of market volume--and increased options trading have driven Berndale's volumes further. "Seventy-two percent of the combined Merrill-Berndale volumes are externally applied [i.e., are volumes from correspondent firms]," Mason said. "We have four new clients coming on between now and January, and some of these are major wins for our new custody-clearing service."
Mason believes more rigorous licensing requirements (mandated by the Financial Services Reform Act), which go into effect in March 2004 and specify more robust business continuity systems, is an additional driver. "It's pushing those smaller to medium organizations to look very seriously at their obligations in clearing and business continuity capabilities, which we provide as part of our infrastructure jointly managed by our clearing technology partner, GBST," he said.
 Mark Morris, managing director of AOT (a subsidiary of Holland AOT NV, a top 10 broker-dealer, and a correspondent of Berndale and Fortis) agrees. "There has probably been an overreaction by the industry in Australia to world events because so far, we have had very few problems here. But re-licensing for FSRA and a whole lot of other issues have made the cost of operating in this market a lot higher and to bear these costs, it's very hard to run a small operation. You need to be an operation of size."
New FSRA requirements will further tighten the compliance regime for custodians, according to John Gall, executive director of the Australian Custodian Services Association, the Australian custodian industry body that represents members holding some $670 billion in assets under custody and administration.
"The trend for fund managers over the past two years to outsource their administration to master custodians-where the fund manager gives the custodian a contract to look after all multi-currency reporting and attribution analysis and a whole package of services over the past two years-is a key driver," Gall said. "Many institutions are now outsourcing part but perhaps not all of their funds management. Benefits are derived from scale, but you can't walk away from your legal liability."
According to Gall, the new compliance rules have not yet clarified the obligations that will exist between master custodians and their fund manager clients. "If you have a custodian agreement, they provide you with all the information and processing, but the legal responsibility remains with the fund manager and they have to actively supervise it. This may not limit outsourcing to custodians, but fund managers will still need to have control as they will carry the legal risk," Gall said.
Should this compliance regime for custody eventuate, the result would be similar to the risk model applied to agency clearing on the sell side of the market-where the executing broker-dealer outsources back-office processing but not the legal, credit or settlement risk. And this may augur well for the custody-clearing model that Berndale and Fortis provide.
Neither firm provides outsourced fund management services, but their ability as a custodian and clearer to provide outsourced settlement risk may encourage fund managers (or custodians themselves) to direct the post-trade side of their business to Berndale, while still retaining their executing broker and outsourced fund administrator of choice.
"Master custodians are offering quite a deal of variable product and allow the client the flexibility to choose which services they will use," Gall said. "They also outsource and reciprocate specialist services between each other."
Market regulations that limit a correspondent broker-dealer's ability to outsource settlement to a single clearer also restricts corresponding clearing in Australia, according to AOT's Morris. "AOT has had to establish two separate business entities and hold separate participant numbers in Chess, simply because we deal with Fortis for our institutional business and Berndale for retail," Morris said. A strong advocate for new business rules allowing multiple clearers, Morris said the Australian Stock Exchange is reviewing new business rules that would extend the number of clearers a correspondent can use from one to two. A decision is expected by year-end. The ASX was not available for comment on the matter.
This proposed deregulation is a key issue for Fortis, Becker said. "It will make it easier for broker-dealers to split their institutional and private-client business and benefit from our specialist institutional broker-dealer services."
Morris believes that despite providing the advantages of moving the back office from a fixed to a variable cost, the outsourcing of processing services will likely be driven by new entrants in Australia, as entrenched attitudes prevent many of Australia's more established broker-dealers from jumping on the bandwagon.
Achieving a top-10 broker-dealer ranking just three years from start-up, AOT depended heavily on outsourcing. "The decision was based on a philosophy of only doing those things that you do best and go to best-of-breed partners for outside services like clearing and research," Morris said. "Our expertise is broking--not necessarily clearing. Similarly, not everyone can be a top-10 research analyst. We had the luxury of starting from a blank sheet of paper of how a firm should go into the future and how we could use technology to our best advantage. If you're starting up something new, you can avoid legacy systems and established staffing practices."
"It's a generational thing, plus a bit of ego," Morris added. "Some [conservative broker-dealers] think that just as to be a country you have to have an airline and an army, to be a stockbroker you have to have a research department and a back office. But with the technology available today, that may not always be the best way forward."
Copyright 2003 Thomson Media Inc. All Rights Reserved.
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