the approaching revolution in europe's fund industry

The approaching revolution in Europe’s fund industryOur view of upcoming infrastructure and distribution changes

Asset Management

Europe’s fund industry is on the brink of a change that will challenge many existing business models. New market infrastructure will make the industry’s value chain far more cost efficient and ease cross-border selling. And the combination of regulatory and market pressure is likely to make the retail distribution market steadily more competitive. Such changes will have an impact across the industry – from asset managers, to custodians, to distributors. For some they will create new opportunities; for others they will pose significant challenges.

Contents

Page

Introduction

T2S becomes a catalyst for consolidation

Pressures build for more open distribution

What the future might look like

Preparing for what lies ahead

Contacts

01

02

06

08

09

11

1 The approaching revolution in Europe’s fund industry | PricewaterhouseCoopers

Introduction

Europe’s fund industry is on the brink of a revolution that will lead to greater efficiency, less cost and a more open market.

From a cost perspective, creation of the TARGET 2 Securities (T2S) Eurozone settlement hub from 2013 will drive down the cost of settling trades, and may lead to further consolidation among both central securities depositaries (CSDs) and custodians.

In distribution, regulators and market participants alike are pushing for a more competitive market, in which banks and other intermediaries sell investors the best funds available. At a time when the UCITS IV directive will ease cross-border

marketing from mid-2011, this will intensify the fight for market share by opening national markets to the most ambitious and agile players.

Across the EU’s fund industry, the next 10 years will see nothing short of a transformation. The number of participants in clearing and settlement will shrink, as they will in custody. Asset managers will find it easier to market their funds across the EU, so creating greater competition. The direction of change is clear – as is the fact there will be both winners and losers.

“BNY Mellon will be able to connect directly to T2S in future and we are now evaluating whether to do so market by market. In each country we are looking at the services our sub-custodian performs, and asking whether we can perform them ourselves. Some sub-custodians will be disintermediated and we will see a huge compression of margins – probably in the region of 60-80%. My guess is the number of banks active in sub-custody will diminish. A lot of the local players will disappear. Those that are regional players will survive and be the winners. If, for example, a Spanish sub-custodian decides to leave the market we may be able to enter that country, so T2S will bring opportunities.”

Paul Bodart, Head Of Operations EMEA, BNY Mellon

2The approaching revolution in Europe’s fund industry | PricewaterhouseCoopers

T2S becomes a catalyst for consolidation

T2S is an IT platform that will support CSDs by providing core, borderless and not- for-profit settlement services from 2013.

The objective is to achieve harmonised and commoditised delivery-versus-payment settlement in central bank money in euros (and possibly other currencies) for most securities in Europe.

By intensifying competition among CSDs and enabling regional custodians to bypass sub-custodians, it is likely to become a catalyst for greater consolidation.

T2S drives down costs

T2S will provide core delivery-versus-payment settlement at far lower cost than is currently the case. Eurosystem, the euro area’s monetary authority which comprises the European Central Bank (ECB) and the national central banks, plans to have the T2S IT infrastructure up and running by 2013.

According to the ECB, domestic settlement costs in Europe are currently up to 10 times higher

than in the United States, with cross-border settlement far more expensive than settlement within national borders. Furthermore, the cost of EU cross-border transactions is between two and six times more than domestic transactions. T2S will drive costs down towards US levels, with an estimated 90%1

reduction in cross-border costs.

The system will settle both domestic and cross-border transactions in euros but with the ability to settle in other major currencies at a later date. All securities currently settled by existing CSDs will be eligible (including mutual funds, exchange-traded funds, hedge funds, real estate and pension funds).

The platform is a not-for-profit organisation that will have a strong corporate governance structure. This includes an advisory group comprising 42 representatives of the Eurozone’s national central banks, CSDs and commercial banks, plus advisers.

1 Source: Oxera, LSE, CEPS – presented by the ECB at the FESE convention in June 2007 // Draft working document on post-trading activities 23.05.2006.


Introducing CSD cross-border competition

Following introduction of T2S, CSDs will not only be able to handle transactions within their home countries but also transactions from across Europe. Furthermore, the actual process of settling will move to T2S, meaning that CSDs cannot continue to charge so much for cross-border transactions. CSDs will start to compete with each other and their profitability will suffer.

Europe’s CSDs have been moving towards closer integration for several years, forming links with the two big clearing and settlement operators – Euroclear and Clearstream. In 2009, both Euroclear and Clearstream introduced clearing and settlement platforms covering several markets. In order to maximise efficiency, they have high degrees of process automation through straight- through processing.

Euroclear launched its ESES (Euroclear Settlement of Euronext-zone Securities) platform covering

the three markets of Belgium, France and the Netherlands in January. The new platform processes all fixed-income, equity and fund transactions in multiple currencies on the same platform. Euroclear currently plans to add the remaining CSDs in its network (UK, Sweden and Finland), creating its so-called Single Platform.

Clearstream, meanwhile, launched its Link Up Markets platform in April, which joined up the national CSDs from Spain, Germany, Switzerland, Austria, Greece, Denmark and Norway.

“There is today already a consolidation with the custody industry. The implementation of T2S will oblige global custodians to analyse their current models and consider the needs of local sub-custodians to access the local CSD for the settlement of the transactions. Nevertheless, as T2S only manages the settlement of transactions and not the custody aspect like corporate actions / events, the presence of local sub-custodians might be still necessary in the future. In this context, global custodians will have to analyse and review their business models.”

Bruno Prigent, Deputy Head Of Securities Services, Société Générale

T2S becomes a catalyst for consolidation continued...


T2S is likely to reduce the number of CSDs from the more than 20 currently in existence. With the settlement function moving to T2S, the remaining CSDs will compete and concentrate on functions such as management of corporate actions, securities lending, collateral management, calculation of fees, tax assistance, distribution, marketing of financial instruments data and reporting services. These activities are likely to bring them into competition with their custodian clients.

Source: European Central Bank, Frankfurt am Main, Germany. www.ecb.int/paym/t2s/about/why/html/index.en.html


Sub-custodians become disintermediated

For banks in the sub-custody business, T2S poses a significant threat. By allowing all CSDs to settle trades in securities from any Eurozone country, the clearing and settlement utility potentially allows custodians to disintermediate their sub-custodians. Whether custodians can disintermediate their sub-custodians will vary from one country to another.

The large regional / global custodians will need to see whether they can execute the functions currently carried out by sub-custodians in each country, and whether they want to. They will need to consider functions such as handling corporate announcements, paying income, paying dividends, processing tax claims and voting shares at annual general meetings.

Where regional / global custodians decide they can handle all of the sub-custody functions within a country themselves, they are likely to end the sub-custody agreement. At a time when banks’ profitability is under pressure, and they are focusing more than ever on core businesses, some are likely to exit the sub-custody business. In these instances, the larger regional and global custodians may well become consolidators, acquiring sub- custody businesses in order to enter new markets.

In addition to consolidation, the custody sector as a whole faces challenges that require considerable investment. These issues include demand for more transparency, more due diligence, more handling of complex instruments and greater follow-up of corporate events. The need for greater investment will, once again, increase the momentum for consolidation and greater scale.

T2S becomes a catalyst for consolidation continued...


Pressures build for more open distribution

For many years, the competitiveness of fund distribution in Europe has been restricted by the vertically integrated banking model, where banks are manufacturers and distributors of funds.

While banks have been promoting the open architecture for some years, many have still tended to sell primarily in-house products. Meanwhile, independent financial advisers have often been suspected of selecting the products paying most commission. Now pressure is building from a variety of sources for change.

Regulations level the playing field

New regulations are playing their part in this fundamental shift in the distribution paradigm. Most explicitly, in the UK the Retail

Distribution Review will ban financial advisers from receiving commission payments from fund groups from 2012. Financial advisers will have to charge for their advice instead, so removing any commission bias.

Across the EU as a whole, the EC is proposing a packaged retail investments products directive, designed to level the playing field between mutual funds and structured products. The EC is also due to review the markets in financial instruments directive (MiFID) by November 2010, which would give it the opportunity to ensure that the rules on inducements were imposed more consistently across Europe.

“The introduction of the Retail Distribution Review in the UK and the abolition of commissions will put the adviser firmly on the side of the client. It will increase the distinction between the providers with lower quality and higher quality product and further increase the concentration of flows. I think it will also draw a greater distinction between low cost passive management and alpha generation. If you are generating alpha you will be rewarded. If you are generating low volatility returns through good asset allocation you will be rewarded. If you are simply hugging the index then the adviser will look to access that index at as low a price as possible.”

Gary Shaughnessy, Managing Director, UK DC and Retail, Fidelity International


These rules state that commission may only be paid if the objectivity of advice is not jeopardised.

At a time when UCITS IV is making it easier to market funds across borders – mainly through the improved notification process, the management company passport and master-feeder funds – regulatory change will make the market far more open.

Lobbying intensifies

Some of Europe’s large fund groups and trade associations are reportedly adding to the momentum for change by lobbying the EC to ensure that banks and financial advisers are offering clients the most suitable products for their needs.

With the EC seeking to increase the cost efficiency of the fund industry and to promote investor choice, such lobbying may be well received. Fund distribution accounts for the single biggest proportion of costs in the fund industry – ranging from 46% of total costs in France to 75% in Italy.2

Steady move towards ‘open architecture’

Other developments are steadily opening up the European market. Over time, banks have been increasingly adopting open architecture, although the current harsh environment has slowed the trend as some banks seek to protect profitability. In particular, private banks are finding that their wealthy clients increasingly want the best products on the market. And some of the large financial groups are being forced to divest their non-core businesses, including in-house fund groups. If a financial group no longer owns a fund manager it is far more likely to move to an open architecture fund distribution model.

Furthermore, fund platforms handle a small but growing volume of fund business. These platforms are powerful distributors in the UK and are likely to become more popular elsewhere. In Germany, the stock exchanges are emerging as fund distribution platforms, with Deutsche Börse offering more than 500 exchange-traded funds and 3,300 open-ended funds.

The prospect of mounting competition

For fund groups, a more open market would also mean a more competitive market. The fund groups offering better value to investors would prosper in such a market. They would have an opportunity to build market share across much of Europe.

Pressures build for more open distribution continued...

2 European Commission White paper on enhancing the single market framework for investment funds, 15.11.2006.


What the future might look like

During the next decade, the shape of Europe’s fund industry will change significantly. The industry’s value chain will become far simpler and more cost efficient, with greater specialisation.

Fund groups will find barriers to distribution steadily fall and open architecture increases. The retail investor will start to get greater choice and more objective advice.

There will be opportunities for both custodians and fund groups. The large custodians will be able to achieve still greater economies of scale and to enter new markets by acquiring sub-custodians. Fund groups will be able to distribute more easily across the EU and the best will win market share.

Not all parties will be winners. The number of CSDs is likely to shrink, as is the number of

custodians. Furthermore, the vertically integrated banking / asset management model will come under pressure, with some banks choosing to sell their fund groups.

Of course, in spite of the strides towards a more perfect single market described in this paper, there will always remain differences between the EU’s national tax systems and market practices. Such differences mean that achieving a truly seamless single fund market may always be beyond reach.

Yet the changes currently underway are bringing the EU closer to being a unified, efficient fund market.


Preparing for what lies ahead

In order to prepare for tomorrow’s landscape, it is necessary first to have a clear idea of what it will look like, of its likely cost structure and of your firm’s true points of difference. Only then can market participants decide whether it presents them with opportunities or challenges.

Such are the intricacies of the EU fund marketplace, and the complexities of the different changes taking place, that all parties in the asset management value chain need to analyse carefully how they will be affected. When determining their business goals, they need to conduct holistic analyses that take into account confirmed changes to regulations and market infrastructure, as well as likely future changes and important trends, and the context of their existing business structures.

Fund groups seeking to market more widely across the EU, for example, should consider the UCITS IV directive’s potential, the custody infrastructure they need and possible future distribution opportunities. They might also want to consider gaining market access and economies of scale through acquisition.

For custodians, only a careful analysis of each market will reveal where it is possible to operate without sub-custodians. At the same time, however, the custody

business is facing such a wide range of challenges that some groups may wish to examine their entire models – from the guiding business principles and business service model at the highest level, down to specifics such as the required processes and technical architecture.

PricewaterhouseCoopers experts can support asset managers and custodians by reviewing current positions, defining blueprints of desired future states and providing guidance about how best to achieve desired objectives.

Such an exercise would analyse the following:

Current situation: where •you are now

Future situation: what your market •may look like in three years’ time

The road to follow: how to •take the best road to avoid pitfalls and leverage on business opportunities


Clients would then be able to consider the following strategic options / business opportunities:

Consolidation to gain •synergies and reduce cost

Definition of a new distribution •model via a centralised global custodian hub (with or without sub-custodian network) and access via CSD to the T2S European platform

Reorganisation of custodial •service processes on either a shared or utility basis. These centres of excellence can be located according to business preferences – to take advantage of lower costs, to ensure proximity to key markets and to be close to pools of available talent

Innovation in terms of new •product distribution into a new geographic area or distribution model through a regulated market

Guiding business principles

Business servicemodel

Functionalmodel

Processmodel

Technicalarchitecture

Governance & organisational

models

Locationmodel

Interactionmodel

The guiding principles set out how the blueprint will be defined, operated and implemented

The interaction model depicts the inter-relationships, dependencies and linkages between the custody business, its business partners and other stakeholders

Locations of the functions are determined within the context of the sourcing decisions for the business

The technology and high-level data architecture are aligned to the service delivery needs, the required STP levels and the interactions with various partners

The business service delivery model defines who the business partners (‘customers’) and stakeholders of the custody business are and what service they require

The functional model outlines the functions that will be required within the custody business to deliver the services

The processes are mapped, with controls embedded within the process long with accompanying narrative

Roles and responsibilities are defined within a clear organisational structure, which is overlaid with the governance model for wider decision-making


If you like to discuss any of the areas covered in this paper or the implication on your business, please speak with your local PricewaterhouseCoopers contact or one of our T2S specialists listed below:

Olivier Mortelmans Asset Management Advisory Leader, Europe, Middle East & Africa PricewaterhouseCoopers (Luxembourg)

T: + 352 49 48 48 4012 E: [email protected]

Laurent Collet PricewaterhouseCoopers (Luxembourg)

T: + 352 49 48 48 4104 E: [email protected]

Andrew O’Callaghan PricewaterhouseCoopers (Ireland)

T: + 353 1 792 6247 E: [email protected]

Steve Crosby PricewaterhouseCoopers (USA)


Sally Cosgrove PricewaterhouseCoopers (UK)


Contacts

This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PricewaterhouseCoopers does not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

© 2009 PricewaterhouseCoopers. All rights reserved. ‘PricewaterhouseCoopers’ refers to the network of member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity.

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