Survey - Global Custody: In for the long term: EMERGING MARKETS by Michael Peel: Despite recent turmoil, developing markets still offer unique long-term opportunities
Financial Times; Jul 9, 1999

The Bombay equity market can sting unwary investors. "I have heard of bundles of shares being delivered where the top few are certificates and the rest are blank sheets of paper," says one former operations director for a global custodian. "They are weighed rather than counted and then just banged into the vault".

The ruse, of a kind more readily associated with backstreet con-men than share dealers, is an extreme example of the peculiar hazards confronting those who put their money in emerging markets. Investors can be caught out by inadequate trading systems and documentation, long settlement times and less than transparent market rules.

The plethora of perils helps to justify the existence of custodians, many of which now make expertise in the emerging markets one of their chief selling points. Guarding investors against sucker punches and unfamiliar local regulatory practices is one of their key functions.

The demand from fund managers for emerging markets capabilities is growing as more nations develop liquid bourses, despite their severe underperformance over the last few years, particularly since the Asian currency devaluations in 1997.

Expertise in safeguarding and settlement in emerging markets is offered either by global custodians or by so-called sub-custodians, which offer country specific or regional services.

Global custody for emerging markets is dominated by the largest US custodians - Chase Manhattan, State Street and the Bank of New York - while Citigroup and HSBC have strong presences in Latin America and Asia respectively.

All are coy about the revenues they glean from less industrialised countries. James Cassidy, who works in Deutsche Bank's global institutional services division, estimates that emerging markets business accounts worldwide for less than 10 per cent of the bank's custody-related revenues and assets under management.

The relative importance of emerging markets has diminished as they have lagged other world bourses, with the benchmark IFC composite investables index underperforming the FT/ Standard & Poor's World Price index by about 50 per cent over the last four years.

"For a global custodian part of the fee schedules are charged on the value of the assets," says Mr Cassidy. "If the client loses part of the value of the assets, the custodian fee goes down."

While some custodians have responded to the decline by cutting back their operations, others have been reluctant to give up local knowledge and expertise that has proved hard to acquire. This has meant some companies have been incurring relatively high fixed staff costs in the hope that business will pick up as overseas investors return to the market.

Many say companies that have cut staff - by up to 45 per cent in some cases - may find themselves short-handed if demand turns around. "That could be a false economy," says one banker. "There could be problems for those who have downsized aggressively."

The reason for this, he argues, is that it generally takes a long time to train new staff to the standards required by global custodians. "There aren't people saying in (adverts in) newspapers: 'I have 10 years custody experience so hire me'," he says.

Custodians say the number of knowledgeable staff is increasing as bourses make technical and regulatory progress.

The countries that are most troublesome to investors now stand out because they are noticeably worse than elsewhere.

Of these, Russia remains the market that most perturbs custodians. Dealing reflects the chaos rife in many parts of the new market economy, with tortuous settlement and a high risk of fraud. India has traditionally been rated a difficult place to do business, with paper-based dealing causing settlement times to be long. Things are improving, however, as electronic trading takes hold.

Settlement has also proved problematic in Indonesia, where a lack of liquidity in the market left some local brokers short of cash to settle deals. "One of the key issues was making sure the key brokers had enough money before you handed over the shares," says David Hardman, senior vice president of custodial services at Standard Chartered Bank. "We were looking for payment before delivery."

Asian markets in general are cited as difficult because of the extensive documentation required by regulators. The region has also sprung surprises with sudden rule changes, such as the imposition of capital controls in Malaysia.

Against such setbacks, custodians point to technological improvements that have allowed several emerging markets to operate more efficiently than developed bourses. In some bourses, the dealing environment has become so refined that settlement has become too quick: there are stories of money moving from investors' accounts before the trade has been electronically credited to them.

The rapid pace of development is expected to continue as emerging markets draw on the experience of bourses in more industrialised nations. "It's like anything: you develop it later and you benefit from the experiences of people before you," says one custodian. "A lot of (emerging markets) are quite modern in their book keeping arrangements and legal structures, with quick settlement."

This trend is another important reason why most custodians want to remain in emerging markets despite the turbulence of the past few years. They argue that the increased transparency of dealing has eroded the competitive advantage that local custodians hold as a result of their greater experience of the trading environment. It is allowing global custodians to enjoy the benefits of their greater technical expertise and economies of scale. "When you look at the major surveys about who provides the best services in emerging markets, it is not very often the local players," says Deutsche Bank's Mr Cassidy. "The same old names come up again and again."

These dominant forces are already looking forward to better times, thanks to the rally emerging markets have enjoyed in recent months. The IFC investable index has outperformed the FT/S &P World Price index by about one third since September, and many emerging market strategists forecast years of superior returns ahead.

As these markets develop, custodians expect systemic problems to diminish, increasing the relative importance of their work as troubleshooters familiar with some of the more unusual local practices. "A lot of people were drawn into the Colombian market when the volume on the Medellin exchange exceeded that in Hong Kong," says the former operations director. "It was later discovered that it was the drug baron (Pablo) Escobar washing his money through."

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