Russia is probably the worst case, with no central regulator to supervise issuance, trading or clearing, according to respondents. No centralized stock exchange exists and there are no commercial or securities laws governing the marketplace. The Moscow Interbank Currency Exchange (which trades only in short-term government bonds) has put a custody and clearing system in place and the Central Bank recently produced a regulatory framework for the issuance of new shares in banks. But, the emergence of a well-regulated exchange backed by a viable clearing infrastructure appears to be some way off.
Taiwan has aggregate foreign ownership limits and quotas assigned to each foreign investor. This is preceded by an extensive application process. Additionally, there are limitations on repatriating capital. These present difficulties and challenges to clients, not to mention risks.
U.S. investors often are discriminated against when it comes to capital reorganizations, said one global custodian, although companies still are pleased to attract their investment. This applies particularly (but not exclusively) to the U.K. market, where U.S. institutional shareholders often cannot subscribe for new shares.
Venezuela has a particularly cumbersome physical settlement process, requiring a number of sign-offs and a huge paper trail that leads to a very long settlement period regardless of contractual settlement date. It also exposes the investor to substantial risk.
One custodian bank in Caracas with 17(f)5 qualification, a mutual fund requirement, has created a delivery vs. payment environment for foreign investors that is based on the presentation of a certified trasposo and a stock exchange transaction payment note. It also has set up procedures to reduce fails and, in a market where transactions settle on schedules ranging from T+0 to T+90, recommends investors negotiate a T+5 settlement cycle.
Whatever the investing institution's views on the subject, voting share holdings in foreign companies is a more complex process than in the United States. Apart from language problems (companies do not tend to routinely produce documents in English), the method of holding foreign securities - usually a nominee account - may not be acceptable proof of eligibility to vote in some markets (e.g. Sweden). And, registration into the investor's name may not be possible in time for the meeting. In addition, in some countries (such as Japan) companies tend to hold their annual meetings on or near the same date, making voting each holding impossible.
International proxy voting is an area of growing concern to U.S. institutional investors, in particular public pension funds. However, given the recent publication of a Department of Labor regulation warning private pension funds they, too, were required to vote their proxies - even international proxies - private pension funds will become more involved in this issue.
The global custodians in the survey reported proxy voting activity is growing between 15% and 30% a year. One custodian reported a four-fold increase in proxy voting activity between 1992 and 1993.
The problems most frequently mentioned by the global custodians are the lack of standards for corporate governance, language translation, registration of beneficial owner, difficult time schedules and the need for a physical presence to vote in certain countries.
Said Mr. Aprahamian of Barclay's: "The most immediate operational difficulties associated with proxy voting are: the interpretation, the language translation, and the delivery of information to the end beneficiary in a timely manner."
Another noted "standards are beginning to emerge. However, there still remains a great deal of confusion among investors with regard to ownership rights. In many markets where foreign ownership is restricted to a certain percentage, investors are able to acquire shares above the percentage limit but forsake their ownership and voting rights. Standards are evolving for corporate governance in emerging markets, but this evolution will be slow and will vary from market to market."
Several custodians echoed the sentiments of Bankers Trust's Ms. Smith, who said the biggest operational difficulty with voting proxies "continues to be the timeliness of information. Foreign institutions continue to ignore the U.S. shareholder, and only issue information in the local language. Through the stringent requirements that we have placed on our agent banks to translate and disburse the proxy information, we continue to disseminate the information to our clients quickly and accurately."
Said Mr. Mancuso of Investors Bank & Trust: "It is still very difficult to receive sufficient information concerning the proxy. We subscribe to several industry vendor sources and aggressively track announcements with our subcustodians. Unfortunately, there is a shortage of vendors who provide comprehensive information of proxies."
But Chemical's Mr. Bilbe argued the largest operational difficulty is the re-registration of holdings into clients' names, when necessary. "This usually affects unavailability of the stock together with large costs in some countries. As yet there does not seem to be any clearly defined standards in the emerging markets, but we are beginning to see a desire to evolve a series of standards for the governance of corporates. It is our view that this will occur over the next couple of years due to market pressure."
Other custodians noted several countries require an individual to attend the annual meeting in order to vote.
Japan was identified as the country in which it was most difficult for a global custodian to vote proxies because all corporations hold their annual meetings on the same day.
Securities lending is an established part of international investing for both global custodians and institutional investors.
Securities lending involves an institution lending its securities to a broker, who needs to deliver unavailable securities to another client to avoid a failed transaction. The borrowed securities are initially collateralized at 102% and 105% of the market value of the securities plus accrued interest for U.S. and non-U.S., respectively.
Acceptable types of collateral are cash, government securities and irrevocable bank letters of credit. Each day the lending agent (global custodian bank) compares the value of securities on loan and collateral with respect to both the market and currency values. As the value falls below 102%/105% plus accrued interest, in de minimus amounts, loans are marked to market and additional collateral is requested from the borrower.
Other collateral can include short-term investment funds, repurchase agreements, U.S. and Eurodollar deposits and other quality money-market instruments.
The international securities lending business is growing dramatically because of the attractive returns. Two custodians reported growth of more than 60% in the past year, based on outstanding loans in the international markets.
According to one custodian, securities lending is a dynamic business, and the characteristics of the financial marketplace - including random volatility, the desire for high-volume, high-speed operations and the need for liquidity - will continue to support securities lending.
The survey found portfolio returns from international securities lending are not guaranteed to the customer by any global custodian.
Respondents listed France, Japan, Germany, Italy and Hong Kong as popular markets for lending equities. For fixed income, they listed Denmark, France, Germany, Italy and the United States.
Basis-point spreads varied by portfolio type, market and custodian. Some custodians offered clients a 50-50 split on rebates, and one custodian would negotiate a 60% or 70% split for the customer. The more attractive customer split specified fund manager requirements in the areas of technology, lender restrictions and collateral.
Citibank views the global securities lending marketplace as three distinct segments:
Mature: In the United States and the United Kingdom, margins are thin, but there is plenty of volume because of sheer market participation. In both countries, a well-established legal structure, stringent collateral regulations and rigorous procedures for monitoring and controlling credit risk have been tested and proven. So much so, that the only way a lender in this market will suffer financial loss in the event of a borrower default is, if at the same time, the market value of the security lent increases to such a degree the collateral held is insufficient.
In general, the risks are either small or irregular because of timing issues such as advance of fees earned or custody overdrafts, all of which are factors in the custody proposal. Strategies for reinvesting cash collateral have changed radically in the United States, and it is expected global strategies will develop in all of the major markets.
Developing: Although the business of securities lending is still relatively young in most of Europe and Asia, it is rapidly gaining in popularity. Big securities houses in these countries welcome securities lending as a cost-effective way to cover shorts and avoid fails. Smaller banks with modest credit ratings and limited access to the interbank market have begun to use it to finance their proprietary trading. Larger banking institutions, prodded by growing borrower demand, have instituted lending programs based in large part on the U.S. model.
Currently, the legal structure is unique to each country and, on a country-by-country basis, there are legal and tax aspects that have yet to be tested. Local practices vary as well; for instance, collateral requirements may vary from none to very liquid, depending on the creditworthiness of the borrower.
Emerging: The dramatic expansion of these markets is not surprising - where there is volatility, there is demand to borrow stock. And the benefits to the participants, no less than the improved liquidity of local money markets, are powerful incentives for continued growth.
The custodians agree international securities lending will provide a greater return than U.S. domestic lending, and even greater still will be returns on activity in the emerging markets.
The earning potential of a portfolio is influenced by many factors, including size of the loan, type of security, the marketplace, the urgency or need for the loan and the tax status of the client and dividend requirements in each market. Other factors are: size and names of the equities (e.g. blue chip vs. second tier); trading pattern of the client; type of collateral used; borrower restrictions; and changes in market regulations and restrictions.
In the major markets such as Japan, France, the United Kingdom and Germany, standard industry procedures regarding sales notifications are followed. In smaller markets, global custodians work closely with the investment managers, to whom detailed notification procedures are distributed. As more international markets become book entry, the need for securities lending as an aid to liquidity in these markets is increasing and lending is being accepted in many more countries.
Among the comments from the global custodians:
"International securities lending faces many challenges, as different markets have different operational requirements. These challenges can be divided into two categories. First, restrictive practices, which may preclude or encumber lending activity. These practices range from restrictions or prohibitions on securities lending and short selling to transfer taxes or capital gains taxes, which may make some securities lending economically unattractive.
"The second category of practices relates to the different operational procedures practiced in each market such as securities settlement procedures and corporate action processing. These practices, for example short settlement time frames in the Far East markets, create operational challenges, but if effectively managed do not preclude lending activity."
"Borrowers continue to develop sophisticated trading techniques for developing markets which rely heavily on international securities which, in turn, facilitate these trading strategies. The combined expansion of lending portfolios and the growth of borrower requirements for securities has led to a rapid growth in the business of international securities lending."
"The U.K. lending market is very unattractive due to restrictions on who can borrow securities and limitations on the types of collateral that can be posted."
Foreign practices increase the risk of securities lending for both the lender and the borrower, global custodians noted. Among the concerns:
Automatic buy-ins for fails can cause market risk. This issue is magnified in short settlement markets.
Some countries limit foreign holders of certain categories of securities. This may make it difficult to re-register securities returned from loan.
Thailand recently has initiated regulations that have mismatched buy and sell settlement dates for foreign participants, thereby increasing the risk of fails.
Many countries either ban or discourage on-shore lending and short-selling.
In terms of the lender's legal right to liquidate collateral, the supporting legal structures in many of these countries leave lenders with the burden of interpreting local legislation that was not necessarily written to cover securities lending.
Registration difficulties and penalties for failing create difficulties in securities lending in some foreign markets, such as Singapore, Thailand and Malaysia.
Global custodians do not guarantee returns on international securities lending. "Income generated by a portfolio is dependent upon the portfolio structure, investment environment, client investment guidelines, interest rates, borrower needs, supply and demand, and current market activity. These variables make it difficult to 'guarantee' a specific revenue figure to any fund," said one survey respondent.
"Guaranteeing performance from securities lending is a challenging proposition, since no provider controls the factors that contribute to its flow," said another. "Further, it is important to consider that the dynamics of the market will affect securities lending volume and earnings potential. If the securities lending market is down or inactive, it is inappropriate to force securities lending activity to achieve a guarantee. If the securities lending market is up or active, you will benefit from the stronger opportunities available."
Investment of cash balances is problematic in countries where overnight investments are unavailable or insufficient and overdrafts in local currency are prohibited by law. These issues are compounded in particular countries with hyperinflation.
As for interest on currency balances, a number of options are available. Some custodians offer U.S. dollar short-term interest funds and sweep arrangements on foreign currency balances. Typically, investor requirements include a minimum balance on a tiered basis.
Assuming a conservative estimate of 3% of overseas investment is represented by cash operating balances - which money managers use to settle transactions and collect income - the difference between full call-rate interest on the full balance and tiered, poor rates can be very significant financially, said Mr. Bilbe.
Clients are vitally interested in the investment of any custody-related cash balances of their funds. The global custodians report a wide range of custody-linked investment vehicles available for the investor, and a wide range of related services.
However, the sophistication of the service, investment return, client choices, cut-off times and transaction costs vary considerably. The global investor would benefit from a pro-active cash management program. Still, the myriad of service offerings requires a thoughtful and on-going evaluation process.
Virtually all of the custodians surveyed reported automatic mechanisms to sweep local currency cash balances into interest-bearing accounts at the end of the day.
Said one custodian: "Any cash balances left in the client's account at the end of the day are automatically transferred into one of the interest-bearing accounts.
"There are no fees or transaction costs associated with interest-bearing accounts. No minimums are required. Movements of cash in or out of these accounts are subject to our normal cut-off times. Any currency balances remaining in the account, for which we do not maintain an interest-bearing account, are put on call for specific periods of time. The bank pays credit interest on 28 currencies."
Ralph Mastrangelo, managing director of J.P. Morgan, said: "Client balances are recorded using multicurrency demand deposit accounts that are domiciled in Morgan Brussels, and therefore benefit from the protection of the bank's credit standing. Our multicurrency demand deposit accounts may earn market-linked interest rates currently in 23 currencies."
Most of the respondents offered call accounts, time deposits and short-term investment funds.
The global custodians reported varying cut-off times for investments, depending on a number of factors:
The mode of the client's notification of an asset movement to a bank, such as standing instruction, automatic sweep, SWIFT notification, telephone.
The type of related transaction that may be a securities delivery, cash movement, income collection item, etc. Both the mode of notification and the underlying transaction type may affect the cut-off time for making the chosen investment.
The country of the underlying currency.
The global custodian. For example, one bank has a "15: 00 (3 p.m.) value date -1" (one day prior to value date) SWIFT cut-off for French francs (14: 30 if notified manually, not electronically); another bank has a "08: 00 value date -1" for the same transaction. Other banks were much earlier "15: 30 value date - 2."
Mr. Mancuso of Investors Bank & Trust commented: "Currency for Euroclear trades with proper instructions does not need to be in the account until settlement date. Due to the lower interest rates paid on balances in Euroclear, we recommend that our clients invest idle currency balances in other vehicles or accounts until the required move to Euroclear on settlement date. This will maximize the benefits of our client's cash management as well as the efficiencies of the Euroclear system."
Counterparty risk is a touchy subject with custodians and clients. It can arise in many parts of the process of investing in non-U.S. markets. In most situations, the custodians say the client "owns" or is responsible for the counterparty risk.
All global custodians agreed counterparty risk for their agents in foreign countries is their responsibility, as these network components are typically subject to a due diligence process.
Investors should expect the custodian to define its responsibility. Most custodians will limit responsibility to prudent selection of subcustodians (not a financial guarantee), adhering to local practice in custody operations (not a U.S. or other standard), and their own negligence plus that of subcustodians. They generally will not cover political, regulatory, exchange or investment control, liquidity, economic, information, market or systemic (how the local system functions) risks. In addition, they generally don't pick or evaluate brokers, exchanges or clearinghouses. "These have to be accepted by the investor as part of the investment risk, the price of being there and enjoying the opportunity of high returns," said one custody bank executive.
Typical of the responses from the custodians was this one: "Counterparty risk should always be a part of a fund's overall analysis and planning process, prior to investing. The fund should understand all pertinent markets, trading methodology and counterparty risk prior to investing. This entire process should then be supported by the custodian, who should continue to educate the investor."
Another custodian said: " We offer clients the choice between a program that indemnifies them against the borrower's failure to return securities and a program that does not offer this indemnity. All clients benefit from a sale/fail policy that offsets trade settlement risk. As is true throughout the industry, collateral investment risk continues to be carried by the client, with the bank offering a variety of investment options to help them address this risk. "
One custodian noted that as a principal in any transaction, whether it is securities lending, derivatives transactions or the buying and selling of traditional securities, the investor is exposed to counterparty risk. "Common sense would seem to dictate the primary defenses are to know your borrower and spread your risk."
Counterparty risk arises not only from failure to return lent securities, but also from brokers' failure to deliver. The global custodians noted investors should try to do business only with the most reputable brokers in a particular market.
However, as one noted, in many countries very few local players are deemed creditworthy by general market analysts or the standards of major capital markets' analysts.
"Counterparty risk exposure is properly the responsibility of the investment manager," said one global custodian. "From a custody perspective, we make every effort to protect our clients' investments by conducting an extensive and thorough subcustodian selection and review process."
Another custodian commented: "An investor's decision to trade with a local counterparty squarely places counterparty risk with the investor."
Some custodians may provide the investor with assistance in selecting a local counterparty. Trading with well-capitalized, reputable counterparties is recommended. One custodian with a presence in Sao Paulo performed credit evaluations of the major brokers in the Brazilian investment community. When clients trade with a broker on the custodian's approved list, "we will take the counterparty risk by giving our clients value for sales proceeds on settlement date, even though these proceeds are received by check, which does not clear until the next day."
The bank "reviews and approves all direct credit, counterparty, and agency relationships, and takes appropriate action where any concerns arise regarding the credit quality or viability of any institution. Our fiduciary and securities processing relationship extends beyond our subcustodians."
Investors can reduce counterparty risk in the emerging markets by relying on their global custodian and their custodian's local correspondent to perform all movements related to their securities transactions. Consolidating movements with the custodian reduces the number of counterparties to which the investor may be exposed, as well as increases the chances for a smooth settlement because the local custodian can better monitor cash movements in conjunction with securities.
Among the comments from global custodians:
"Coverage of local market trends and credit factors are maintained on an in-depth, continuous basis to minimize investor exposure. Any deterioration in the creditworthiness of any subcustodian or other agent ... results in an immediate re-evaluation of business done and (a) scale back of activity and exposure, if appropriate. Our clients would promptly be notified of our review."
"We strive to reduce counterparty risk exposure in emerging markets by ensuring that we thoroughly understand the workings of each market and, in turn relaying this information to our clients, so that they completely understand the logistics of each market in which they are investing."
"We do not accept any counterparty risk in any market. Operating through a network of subcustodians, we endeavor to minimize operational risk, assess market infrastructure and process documentation satisfying legal and regulatory requirements. By exercising due diligence in the subcustodian selection process, we can ensure that the subcustodian acts in accordance with best local market practice."
"We do not attempt to control which counterparties our customers deal with and therefore accept no responsibility for this risk. The investor is protected to the extent that we are diligent in our subcustodian selection process and require that a custodian meet a series of stringent standards prior to entering an agreement."
"We protect all clients from exposure to our agent banks, but we do not purport to insulate the investor from broker or market risk."
"A custodian's toughest problem is the constant changing of laws and regulations in each country and their effects on the tax reclamation structure." A global custodian.
"Perhaps the most daunting problem for a custodian with regard to tax reclaims is the sheer complexity of the fiscal legislation multiplied by the number of markets in which clients are investing." Mr. Mastrangelo of J.P. Morgan.
The survey uncovered the following key points:
Guaranteed payments for tax reclaims may be offered by global custodians in the near future.
France and Italy receive honorable mention for the biggest tax reclaim headache.
Tax reclaims are an industry problem that needs industry attention.
Only one custodian claimed "to negotiate guaranteed payment schedules on a client-by-client basis."
The other custodians are at various stages of exploring the issue. For example, another custodian is starting a pilot of a guaranteed tax reclaim payment schedule. Three others fit this comment: "In an effort to better assist and service clients, (we are) currently addressing the issues associated with guaranteed payment schedules, and will offer a like schedule to clients in the near future."
And still another custodian hedged the bet: "Currently, we do not offer a guaranteed payment schedule for tax reclaims. As foreign markets evolve and stabilize, we could investigate this issue with our clients."
A tax reclaim guarantee is an important consideration when investing in emerging markets. Investors should pursue recent offerings and developments by the global custodian community.
What's the complication with tax reclaims?
According to the custodians, the greatest difficulties are receiving comprehensive updates from the local authorities when the foreign tax offices dictate changes, and obtaining the appropriate documentation to satisfy these changes on an on-going basis.
An example is the change that prohibited U.S. tax-exempt entities from receiving avoir fiscal in the reclaim process in France.
Another problem is there are no guaranteed time frames for payment in the foreign countries. Many tax authorities still take considerably longer than six months to honor claims, and provisions for penalty interest paid on late refunds are rare.
In addition, some tax authorities are unable to correspond in anything other than their local language. Further, they will not correspond with an agent in any case - dealing only with the ultimate beneficiary.
The most frequently mentioned countries with unruly tax problems are France and Italy.
Said one global custodian: " An investor is most likely to experience problems with tax reclaims in France, due to changing governmental laws and regulations, and emerging markets, where market inadequacies have not been overcome."
A recent interpretation of the 1972 U.S./France tax treaty seriously has threatened the position of U.S. pension funds and non-profit institutions, according to Citibank. When the treaty was negotiated, the Internal Revenue Service interpretation was that all entities including pension funds and charities were eligible for tax relief. The French tax authorities did not concur - even though French tax-exempt funds qualified and even though tax treaties are founded on harmonization and non-discrimination. In June 1993, the French tax authorities issued a press release stating they no longer would honor claims for avoir fiscal by U.S. non-taxable entities.
The issue is being negotiated between the IRS and French tax authorities.