New fund rules in Saudi Arabia could open up the market for independent custodians, though some obstacles must still be overcome. George Mitton reports.
Among the planned revisions to the Saudi Arabian investment fund regulations, which some say could be passed into law in the coming weeks, one provision is of particular interest to custodian banks: a rule that says all fund companies must appoint an independent custodian for each of their funds.
This is a significant change because many of the companies providing funds in Saudi Arabia today, such as NCB Capital, Riyad Capital or Albilad Capital, are linked to banks which have their own custody departments. After the rule change, these players would presumably have to find a third-party custodian instead. The ensuing scramble could see significant business won by independent custodians. Among the global players, HSBC, Northern Trust and Deutsche Bank, which have custody licences in Saudi Arabia, might hope to gain.
Certainly, these players have reasons to be hopeful. They anticipate that many of the Saudi players will opt not to award custody to departments of rival Saudi banks, whom they might view as direct competitors, and will instead choose international firms. However, there are still obstacles to overcome before these firms can operate as custodians according to the same models they employ elsewhere in the world.
Although the draft investment fund rules from the Capital Market Authority (CMA) have yet to become law, there is evidence that the push towards independent custody is already happening in the market.
The CMA has contacted some fund providers in the country to encourage them to appoint a third-party custodian, even though the rules haven’t yet been published, says Nabil Issa, partner in the Middle East and Islamic Finance Group at law firm King & Spalding.
The encouragements have been met with a mixed response. On the one hand, many fund companies recognise the policy represents a move towards international best practices, which ought ultimately to benefit the end investor by ensuring assets are instead protected by a third party.
On the other hand, hiring an independent custodian often involves increased cost, which can add significantly to fund fees. Issa says he has seen custodians charging “hefty” amounts such as 0.1-0.2% of the fund’s net asset value.
Nevertheless, for the global players, this push towards third-party custody is encouraging, though there are still question marks. One issue is that global custodians typically have a global business model, in which certain functions are performed at central hubs. Yet, currently, the CMA requires that some fund administration functions must be carried out on the ground in Saudi Arabia.
Arindam Das, regional head for HSBC Securities Services, says his firm is required to do all the transfer agency functions – subscriptions, redemptions, maintenance of a fund’s investor database – in Saudi Arabia. If he could choose, he would prefer to “offshore” these processes, and have them done in a central location by an HSBC team that handles transfer agency for funds domiciled all over the world.
The issue, he says, is efficiency. By centralising key functions such as transfer agency, HSBC can deliver better value to clients. It is not just a question of technology. Fund administration, “is not an established industry in Saudi Arabia, developing the expertise is problematic”. And of course, like any business in Saudi Arabia, quotas to employ Saudi nationals are in place, which creates additional factors to consider.
“If they would open up, they should allow international operating models,” he says.
QUESTION OF TRUST
Another obstacle, Das goes on to warn about, is less a question of regulation but more about mindset. HSBC manages its own funds in Saudi Arabia, as it does in other domiciles.
For other fund companies to accept HSBC as a custodian for their funds, those companies need to be comfortable with the idea of the “Chinese wall” that separates HSBC’s fund business from its fund administration and custody business.
“Currently the issue is that another bank doesn’t give us their custody or admin mandate because they feel we are custodian and admin to our own funds, and we will share information, which we don’t do. These are not things you can change with regulation. Regulation can force you to accept some things, but the mindset remains.”
That said, the international players are optimistic about the draft rules from the CMA. According to Hammad Izz-e-Hamid, head of direct securities services, Deutsche Bank, the rules will “surely promote the concept and embed the role of a custodian in the kingdom”, a concept that has not been clearly defined so long as custody has been handled largely by the banks themselves.
Izz-e-Hamid says a greater role for independent custodians would increase transparency in the kingdom as well as boost expertise in the Saudi funds servicing industry. Although there are still question marks, he says the draft fund regulations are “a step in the right direction”.
Those remaining questions will need to be answered, though. One concerns fund administration, which is not specifically mentioned in the draft rules. Will fund companies be required to give their fund admin to a third party, as well as their custody? This, again, would bring the Saudi market in line with international best practices. However, Michael Slater, senior vice president, Northern Trust, who leads the company’s activities in Saudi Arabia, says the CMA has yet to produce any official guidance on this, despite apparently holding meetings to discuss the topic.
“We’re waiting to see if the CMA includes fund administration in the regulations, along with custody,” he says. “This would help the industry and provide more clarity to global companies like Northern Trust.”
One final point that might hinder the international players in their quest to gain custody assets is that for certain types of fund, there may be regulatory reasons for preferring a 100% Saudi owned custodian over an international player.
Although the CMA regulates the capital markets and issues custody licences, another department, the Saudi Arabian General Investment Authority (SAGIA), regulates foreign direct investment into the country.
Portfolio investments – into listed equities, for instance – are not included in SAGIA’s remit. However, a private, closed-ended real estate fund whose assets are a tower block and a mall in Riyadh, for example, may fall under SAGIA’s remit if the investors or the custodian are deemed to be foreign.
To avoid the headache of seeking specific approvals from SAGIA, these types of fund “want a custodian that is 100% Saudi-owned or at least 100% GCC-owned”, says Issa, of King & Spalding.
“Because there are only a handful that can do that, they feel justified in charging hefty fees.”
The international players are probably less interested in handling custody for these kind of real estate vehicles, since custody in such cases amounts to merely safekeeping property ownership papers, an activity where they may fail to offer a valuable service. If, however, it is perceived that the international players are also at a disadvantage when handling conventional mutual funds, this confusion could affect their ability to win new business.
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