COVID-19 has sparked far-reaching disruption across financial services on multiple fronts. Financial institutions have had to review and recalibrate major priorities as a matter of urgency. Some of the most pressing include activating business continuity plans (BCP), managing balance sheet challenges, optimising operating procedures and staffing models, and managing digital distribution channels while protecting staff and customers. At the same time, lockdowns and safe distancing measures have spurred large-scale adoption of various digital platforms, giving rise to new cybersecurity risks that need to be assessed and addressed.
COVID-19 has also catalysed certain industry-wide developments already afoot prior to the pandemic. For example, virtual conferencing facilities and remote access options to market terminals were rolled out frictionlessly over the course of just a few days, when they would typically take years to implement under business-as-usual conditions.
In Securities Services, the conduct of physical or onsite due diligence has long been an essential part of how custodians select their agent banks. With COVID-19 curtailing global travel, borders closing, nations going into lockdown and safe distancing measures being enforced, the industry’s due diligence processes have been fundamentally impacted.
While there has been a gradual easing of lockdowns globally, many countries are re-imposing restrictions as they encounter new waves of infections. In the meantime, working from home continues as the ‘new norm’ in many markets.
But how long will this go on for? And how should industry players respond?
On 1 August 2020 – six months after declaring COVID-19 a public health emergency of international concern – the World Health Organisation (WHO) warned that the pandemic is likely to be ‘lengthy’, its global spread accelerating, and that its effects will be felt for decades to come.1
Bearing this in mind, network managers and agent banks need to recognise that waiting out the pandemic before resuming due diligence is simply not an option. Their traditional operating model requires an urgent overhaul, and this could well represent a new chapter in the network management playbook.
1 Coronavirus pandemic will be ‘lengthy’, World Health Organisation warns – The Independent, 2 August 2020
The industry is, understandably, still on a learning curve when it comes to virtual due diligence. “Through virtualisation, we can obtain a lot of valuable data and information. The question is whether the service providers are allowed to, capable of or willing to offer it. This is where the current discussion is focused,” says Beatriz Molina, head of global network management at BNY Mellon.
Having said that, however, regulators appear to be sympathetic to the challenges facing banks and brokers. “Some regulators understand that the current circumstances do not allow for on-site due diligence. They expect organisations to apply additional risk mitigants and to reinstate on-site visits once possible,” Molina noted.
Network managers are reconciling themselves to the fact that on-site due diligence visits will need to be virtualised for the time being. “From an on-site visit perspective, we are still working with providers to determine the best course of action, including considering virtual tours. Some providers have indicated that they are producing or have produced standard virtual tours which would be available to all clients, with bespoke reviews available if required. We are working with internal stakeholders to compare these offerings with our normal on-site agenda to identify any challenges,” says a network manager at a European global custodian.
Physical vault tours – although an irregular feature of modern-day due diligence since most markets having dematerialised physical securities – are an optimal candidate for virtualisation, especially if adherence to the 1m-2m social distancing measures cannot be observed.
In the few countries where securities are still held physically, Bogart Miheaye, head of sub-custody network management, W-EMEA and the Americas at BNP Paribas Securities Services. believes that the Association for Financial Markets in Europe (AFME) needs to come up with a framework clarifying how network managers can be given virtual access to the vaults. This could pose a major dilemma for agent banks though. By giving network managers virtual access to their vaults, there is a risk that highly sensitive security protocols could be revealed – whether inadvertently or deliberately – rendering the vaults potentially vulnerable to theft by sophisticated criminal groups.
Virtual tours of agent banks – at least in the immediate or near term – may be of limited value when most people are working from home.
Stephen Hart, director, network management at Standard Chartered is of the view that while some agent banks have given network managers operational tours via live video feeds, this may not be of much tangible benefit especially when so few people are actually working from the office.
However, the benefits of and necessity for virtual due diligence will need to be regularly reassessed, if challenges regarding on-site visits continue into next year’s due diligence cycle.
This is particularly so if network managers face growing pressure to travel less frequently due to budgetary constraints and/or corporate commitments to reduce travel carbon footprints as part of the increasingly important environment, social, governance (ESG) agenda.
“If we can determine that a virtual due diligence offers us a similar value and insight to an on-site visit, we believe that we will continue to use them post-COVID-19, especially for locations where a visit might otherwise be challenging or lower priority,” says the network manager of a European global custodian.
The industry has, for the most part, demonstrated great resilience, fortitude and agility in their responses to the pandemic. Network managers have maintained constant and regular dialogue with their agent banks and local market infrastructures, and most agent banks have responded to the crisis promptly.
“Agent banks have not fallen over despite the volatility and the huge numbers of people now working from home. We have not received reports of increases in settlement failures or of corporate events being left unprocessed, for example. In fact, operational activities across our network have remained largely stable throughout this crisis,” says Hart.
Nevertheless, the post-pandemic new normal is likely to be different than before, and the due diligence process will continue to evolve over the medium to longer-term.
During the early stages of the pandemic, the questions that agent banks received from network manager clients tended to focus on the logistical aspects of BCP and off-site remote working arrangements. Subsequently, the focus has shifted towards the risk implications of these new ways of working which have emerged as a result of the pandemic.
“We have been able to continue with our remote due diligence reviews as normal with the support of our providers. We have changed the focus of the business continuity and disaster recovery questions to better focus on the new style of working. Previously, these had been designed to understand aspects such as the use of back-up locations, whereas we now have a greater focus on working from home and the impact on processes, controls and technology,” explains the network manager.
“Working from home creates a variety of new risks around control, and this needs to be integrated into the due diligence questionnaire,” observes Miheaye.
The focus has shifted towards the risk implications of these new ways of working which have emerged as a result of the pandemic.
These new industry-wide concerns will need to be reflected in the due diligence questionnaire developed by AFME, a standardised tool often used by network managers when conducting their service provider risk assessments. Industry players have since prevailed upon AFME to incorporate into its questionnaire a standardised set of BCP questions designed to elicit detailed responses that will adequately address their new risk concerns.
Resiliency has been a topic that regulators are keen to review. Mark Jolly, executive director, Conduct Advisory, Group Regulatory Affairs at Standard Chartered stresses global regulators have been questioning banks about their pandemic-preparedness, covering criteria such as operational continuity, client protection and cybersecurity.
As the methods of communication between agent bank providers and their clients evolve, regulatory experts highlight that so too must internal compliance regimes.
According to Jolly, many employees working in regulated roles will typically be obliged to have their telephone conversations recorded for compliance purposes. With online platforms such as Zoom and Blue Jeans becoming increasingly widespread, Jolly says banks need to ensure that proper record-keeping is maintained. This can be facilitated by recording virtual conversations, although Jolly observes there may be technology constraints that require alternative solutions to be considered.
In certain instances, virtual communications fall foul of internal compliance rules. “Some sub-custodians are not allowed to use virtual communication channels for some specific purposes, or are using channels we cannot accept,” says Molina.
COVID-19 has also rendered in-person communications challenging, as more governments and institutions make it mandatory for staff to wear masks or protective facial coverings in the office. “It is not always easy to communicate with a person talking behind a mask, across a screen,” noted Molina.
Swanepoel believes that the number of on-site visits is likely to decline post-pandemic. “Even before COVID-19, we noticed network managers were making fewer visits to some of our smaller, lower volume markets than what they were three to five years ago. There are several reasons for this. The first is cost. Secondly, a number of market infrastructures – especially in Africa – have evolved by becoming increasingly automated and by enhancing their risk management, most notably around asset safety, meaning network managers are more comfortable with local practices, so there are fewer reasons to visit. Instead of conducting on-site visits every year, I expect some network managers will visit every three years now,” she explains.
The idea that network managers will travel less post-pandemic is a contentious one, especially given the regulatory liabilities faced by global custodians and brokers.
“I do not believe travel will decline post-COVID-19. BNP Paribas Securities Services provides clients with depositary services, which means we are subject to UCITS V and AIFMD (Alternative Investment Fund Managers Directive). The liability costs of failing to look after client assets are huge relative to the costs of travel. If an agent bank failed, the depositary could potentially have to recompense all of the monies lost. As a result, we will continue to travel and visit banks on-site to ensure clients’ assets are protected,” contends Miheaye.
If travel is cut back and oversights then emerge in the midst of these virtual due diligences, network managers may need to think more laterally about how they perform their role moving forward.
Madeleine Senior, Managing Director and Head of Securities Services Financial Markets for Europe and the UK at Standard Chartered, believes one way to tackle this would be for network managers to appoint outside consultants or domestic auditors to supplement their remote due diligences and ongoing provider reviews.
Although on-site visits may become more infrequent, there is general consensus among network managers that they are unlikely to disappear altogether especially when they are considering entering new markets or undertaking RFPs, as they believe on-site visits could occasionally yield vital insights that would not be available on a virtual due diligence.
Although a handful of network managers have delayed RFPs because of COVID-19, Senior points out that the pandemic and subsequent market volatility has exposed glaring weaknesses at some providers, particularly in emerging and frontier economies. This, says Senior, is prompting a number of network managers to prioritise reviewing alternative agent banks in these markets. “Some providers have come out of this crisis better than others. As certain frontier markets face credit downgrades, clients want confirmation that their sub-custodian banks are in sound financial health. Large international providers with gold plated credit ratings, such as Standard Chartered, deliver a consistent commitment and service across all markets, which is why we continue to invest heavily into innovative API development, technology and innovation.”
In addition to clients increasingly consolidating agent bank relationships, Senior believes the crisis could test the commitment of certain providers in some markets. “Over recent years, we have seen a number of major banks exit large markets in Europe and elsewhere. Standard Chartered is 100% committed to its emerging and frontier markets,” she says, adding that “it is clear some providers have spread themselves too thinly globally, and they may use the crisis as a reason to pull out of certain markets which they view as not being strategically important." Moving forward, network managers would do well to get clarification from agent banks if they intend to exit key markets.
If anything emerges from this crisis, it is that the power of technology and innovation should not be underestimated, as many banks have learnt.
Senior says Standard Chartered is working tirelessly to ensure clients net the benefits of STP (straight through processing) and have access to accurate data. “Data has never been more important to our clients, which is why we are increasing our investments into API development. The crisis has been a catalyst for digital change as organisations are looking to reduce manual communications and transactions,” she says.
With physical interactions on pause, a number of emerging markets – which have traditionally been entirely reliant on paper-based processing – have been forced to implement structural reforms.
“Markets such as Nigeria and Botswana transitioned from paper-based trading and processing very quickly. A number of CSDs (central securities depositories) which used terminal connections had to put in place systems to ensure people could access their terminals from home,” says Swanepoel.
Improvements are visible elsewhere. Although CSDs in some emerging markets – including Nigeria, Kenya and Botswana – were in the process of gradually adopting SWIFT connectivity, Swanepoel anticipates that COVID-19 will accelerate the trend towards automation even further. Moreover, proxy voting and AGMs are also increasingly being conducted online, although experts caution countries against regressing once the situation stabilises. “I hope markets do not revert to the old manual ways of doing business post-COVID-19, and this is something we will lobby against,” adds Swanepoel.
Few industries have been left unscathed by COVID-19. The entire business model of network management needs to be reviewed, especially as wider macro challenges will cause budgets to be badly squeezed.
A hybrid structure of due diligence will likely emerge in the long-term with network managers visiting their agent banks for only essential reasons, with the remainder of business being conducted digitally.
Agent banks will need to adapt and ensure that their engagement with clients during virtual due diligence is of a comparable or even higher standard than that of a physical visit
In fact, some network managers believe the changes will be positive. “If we successfully implement this virtual process, there is a high likelihood that organisations will continue using it. The virtual process requires easier planning and it is more flexible in some areas. It also allows for a larger number of participants. However, this does not mean that virtual replaces on site. I think both models can coexist and be complementary to each other. Virtual might not be possible in all jurisdictions, nor through all providers and it might not cover all needs or be the most suitable tool. Enlarging the scope of virtual due diligence can allow the onsite process to be focused on more defined aspects or expanded across other aspects of market due diligence,” says Molina.
The crisis has given the securities industry a blank canvas to work with, and this rare opportunity for market participants to implement wholesale, radical reform is something that ought not be missed.
