Custodian Banking and Know-Your-Customer Compliance

Todd Breeden

Custody Banking Market Overview

Understanding the Custody Banking Landscape to identify opportunities of investment to enhance

XXXX market position

What Is a Custodian Bank?

https://www.ecb.europa.eu/pub/pdf/scpops/ecbocp68.pdf?cd251dd1ed508e2b2a1b569c07609ede

Institution charged with handling safekeeping, servicing and settlement related to customer securities Settlement: When securities are bought and sold,

the custodian takes care of the delivery and receipt of securities against the agreed upon cash

Asset Servicing: Managing benefits, rights and obligations related to holding securities, such as dividends, voting, and other corporate actions

Securities Services OverviewCustody services as it fits into a landscape of

securities services provided by broker-dealers, clearing houses, central securities depositories and others

Role of a Custodian in Securities Settlement System

http://gendal.me/2014/01/05/a-simple-explanation-of-how-shares-move-around-the-securities-settlement-system/

Buyers and sellers of securities have their assets safeguarded and serviced from the operations of the broker.

Central Securities Depositories hold all of electronic securities on behalf of issuers, and facilitate the transfer of securities between custodians when a trade is cleared

Drivers of Custody Sector Growth

http://www.institutionalinvestor.com/article/3481359/asset-management-hedge-funds-and-alternatives/cautious-hedge-funds-spell-big-business-for-custody-banks.html#.Vnr5LcArJD0

2008 Failures

• Lehman Brothers / Madoff drove asset managers to custodian services to safeguard assets against counterparty failures

Increased Regulation

• Dodd-Frank and Europe’s Alternative Investment Fund Managers Directive require hedge funds to use third-party custodian

Institutional Investor

Requirements• More rigorous

transparency requirements and governance around asset allocation at investor level forcing hedge funds to adopt custodian services

Demand for Custodial Services Outpacing Growth of Total Financial Assets

Competitive LandscapeIncreased competition from market infrastructure services for the core custody product has negatively impacted pricing pushed custodians into adjacent fund services to differentiate

Declining Margins Affecting Top-LineDespite AUC increasing at 8% p.a from 2008-2013 for the largest custodians, fee compression has significantly impacted revenues of the custodian market – causing massive consolidation and concentration of assets in search of operational efficiency/synergy

Big 4 Dominate Market

http://www.trefis.com/stock/bk/articles/310610/q2-2015-u-s-banking-review-custody-banking-assets/2015-08-20

$25.1TR AUC

Avg Fee: 0.0142%25% of Overall

Revenue

$22.0TR AUC

Avg. Fee: 0.0182%50% of Overall

Revenue

$20.5TR AUC

Avg. Fee: 0.019%4% of

Overall Revenue

$15.5TR AUC

Average Fee:

0.015%3% of

Overall Revenue

AUC of Big 4 represent ~2/3 of Global Custody Industry

Custody Market: Conclusion

The commoditization of core custody services has increased the demand for

adjacent value added services. Providing these services will allow custodians to

increase AUC and market share v. competitors.

Know Your Customer (KYC) and Foreign Account Tax Compliance Act (FATCA)

Adjacent service to custody banking creating a massive market opportunity

Twin Regulations Driving a New MarketKYC (2003)

• Regulation requiring financial services to verify the identity of its clients

• Mandatory for all US banks as anti-money laundering (AML) compliance, as well as the prevention of financial fraud and terrorist financing

FATCA (2014)• Regulation requiring US

citizens to report non-US financial accounts and requires FFI’s (foreign financial institutions) to report assets and identities of US account holders to the treasury

• FFIs in agreement with IRS to search customer databases to identify suspected US account holders informationEstimated Ongoing Cost of Compliance ~$8bn/year (Forbes)

In 2014 – Financial Institutions paid over $12bn in reported AML related fines

Challenges to Remaining CompliantCustomer Due

Diligence• Each account holder

needs to be reviewed for US indicia , not previously required under KYC/AML rules

• Periodic reviews to accounts must be performed as the holders’ of accounts status is subject to change

Intergovernmental Agreements (IGAs)

• Country-by-country agreements to help financial institutions comply with FATCA, despite legal barriers to do so (i.e data privacy)

• IGAs provide relief to allow more types of documents to be used to classify if an account holder is a US person, increasing the complexity of customer due diligence• PWC’s “Quick” Ref

erence Guide to Global KYC/AML Laws is 583 pages…

Process & Technology Coordination

• All information collected as a part of KYC/AML process must be made available to the IRS, in order to verify authenticity of data, complicating the on-boarding of customers

• Disjointed technology processes and technology silos that store relevant customer data in front, middle, and back office operations often do not rely on the same or harmonious data sources, complicating reporting

Failure to uphold compliance and maintain program governance results in a 30% withholding tax on income from the US

Global Banking Segments Affected

http://www.mindtree.com/solutions/fatca-compliance-solution

Customer Demand is Real Over 80% of surveyed financial institutions

ranked AML & KYC management overhaul a priority in the coming years, while over 90% cited the biggest challenges to management is access to internal data and expertise

http://www.oracle.com/us/corporate/analystreports/chartis-financial-crime-risk-2541655.pdf (Chartis)

Costly / Difficult Implementations Despite high demand for KYC/AML

management, only 12% of 2015 surveyed respondents felt they had a fully integrated system

Incumbent Vendor LandscapeAML and Transaction

Monitoring KYC and Client Onboarding

http://www.oracle.com/us/corporate/analystreports/chartis-financial-crime-risk-2541655.pdf (Chartis)

Most major consultancy practices (PwC, E+Y, IBM, Mindtree, KPMG to name a few) offer implementation services for vendors on the above landscape, or build custom solutions for financial services clients

Investment Thesis

Given the tremendous ongoing cost burdens of maintaining FATCA and KYC compliant, as well as the fines/withheld income for compliance failures, financial institutions and investment groups able to manage compliance efficiently at a low cost will begin to generate alpha for their customers in the form of cost-savings,

providing excess net returns over peer groups invested in similar products

Emerging Technology Vendors

Examples of investible opportunities compiled from Crunchbase, LinkedIn, and other publically

available sources

Company SpotlightSector: RegTechProduct: Automated collection, verification and secure storage of customer due diligence (CDD) data and documentation.Target Market: “SMB” and up

Company Pitch: Viewable Here

Traction: Partnered with Accenture’s FinTech LabThesis: Automated data refreshing and auditing deployed in an API protocol that can be easily integrated (under 1 day) into an existing KYC/AML compliance enviornment reduces sales cycle concerns and lengthy implementations

PassfortHQ: London, UKFounded: 2015Investors: Accenture, Entrepreneur FirstFTE – 15 (LinkedIn)Capital Raised: [undisclosed

Company SpotlightSector: RegTechProduct: Customer On-boarding and due diligence product making KYC processes more efficientTarget Market: Financial Institutions and Regulated EntitiesMajor Customers: KPMG

Traction: Early days

Thesis: Consumer-driven KYC environment frees up resources at FI/RE level to generate operational efficiencies and cost-savings across the KYC/AML stack

TrunomiHQ: San Jose, CAFounded: 2013Investors: KPMG, Visionnovation, Saturn Partners, Persistent Ventures, SenaHill PartnersFTE – ~10 (LinkedIn)Capital Raised: $5.3M

Company SpotlightSector: Fraud ManagementProduct: Risk management and anti-fraud services for enterprise

Target Market: E-commerce ecosystem: Acquiring Banks, Payment Processors and Gateways, Payment Service Providers (PSP/ISO/MSP,IPSP), and Online MerchantsTraction: FinTech Forward Company to Watch 2015 / CIO 20 Most Promising Compliance SolutionsThesis: AML solution helps Money Service Businesses (MSB’s) including Money Transmitters and Bitcoin Exchanges by issuing alerts based on suspicious activity related to the movement of funds

IdentityMind GlobalHQ: Palo Alto, CAFounded: 2013Investors: Benhamou Global, Cybernaut, SBT Venture CapitalFTE – 37(LinkedIn)Capital Raised: $12.6M

Company SpotlightSector: RegTechProduct: Online identity verification services, powering fraud and compliance systems worldwide.Target Market: Enterprises and Financial Services Partners: LexisNexis, Experian, IDology, CallCredit, AvokaMarket Traction: As of Oct. – KYC/AML API covers 4 billion identities worldwideThesis: Next-gen verification designed for cross-border transactions to aid businesses complying with AML and KYC rules

TruliooHQ: Vancouver, BCFounded: 2010Investors: Blumberg, BDC Venture, Amex, TenforeFTE – 34 (Linkedin)Capital Raised: $23.3M