Operational risk in the global marketplace

Operational risk in the global marketplace
Understanding operational risk factors in international marketplaces.
By Geoff Pike, Director, Risk Management, Global Custody

Custodians add value to client relationships by leveraging their knowledge of and experience in global market places. This information, when it relates directly to the foreign markets, can be invaluable, particularly when it is communicated quickly and clearly.

Operational risk is inherent in global custody, because the business is process driven. Custodians receive instructions, which are passed through a number of manual and automated processing routines; transactions are settled and client reports are generated.

Now add in the myriad of different market settlement processes and clearing systems around the world and you begin to get a better idea of the complexities involved.

The level of inherent operational risk increases the further you move away from the global custodian. Strategies to address risk along this spectrum take into account the amount of direct control the global custodian has over processes and events. This is sometimes referred to as the Rule of Diminishing Control.

The relationship between the global custodian and subcustodian comes midway in the spectrum of diminished control of operational risk. While a global custodian doesn't have complete control over its subcustodians, it does exercise influence on their conduct and standards. Here the global custodian has to use a different set of tools to manage the operational risk aspect of investment around the world.

Your custodian can use both its size and understanding of client needs to select the best subcustodian for each market. Global custodians also exercise control and minimize the potential for operational risk through their selection process, consistent monitoring practices and making sure that the subcustodian delivers the services clients want.

In the lineup of diminishing control, depositories are farthest from the custodian in terms of ability to control the operational risk factors that depositories can represent to the global investor.

Since depositories have no competitors, there is a need for yet another strategy in the continuing effort to control and contain operational risk. In this case the potential risk resides in the possibility that external events will impact the settlement cycle.

Control factors available in dealing with depositories include providing information on their capabilities and limitations, in specific markets.

The dizzying speed of technological change and its accompanying regulatory environments has global custodians facing constant change with respect to international markets.

The global custodian acts as a shock absorber in respect of this change (Y2K, introduction of the euro and T+1 are examples) by:

* analyzing and interpreting the impact of the change(s);
* creating a bridge between the client and the change; and
* cushioning the technology spend required by the client to participate in the benefits of the change.

Clients gain a great deal of competitive advantage by understanding how global custodians identify and control operational risk. The global custodian helps the client to manage its own operational risk exposure in order to enhance the return on their investments.

It is possible to identify, limit and manage operational risk factors, but only at the price of vigilance and well-thought-out procedures and approaches to a world marketplace that offers opportunity, as well as danger for the unwary.

Contex Group