More than a compound noun

Iain Morse assesses trends in Germany's Depotbank and master KAG segments

Abwicklungsprovisionen, the practice of bundling charges for settlement and custody
fees, may not last much longer. These fees have traditionally been set as basis points of the value of assets under management but if this practice disappears, Germany will lose more than a compound noun. It supports an indigenous, country-specific industry of Depotbanken, between 60 and 65 in number, many owned by German banks, insurance companies and other institutions.

Depotbanks play a similar role to global custodians in relation to master KAG's - entities also specific to German jurisdiction. For decades this has been a niche industry but a handful of global custodians, such as State Street and BNP Paribas, now seek to rationalise this market.

Viewed from a cross-border financial centre like Luxembourg, the German financial services industry can look overprotected and old fashioned. Indeed, recent years have seen a huge increase in the sale of Luxembourg domiciled cross-border, retail investment products to Germany. But on the institutional side a different story emerges. "We have heard opinions that institutional business will go to Luxembourg, and that the days of master KAGs are numbered but the reverse seems to be the case," says Frank Herring, a partner at law firm Norton Rose.

German institutional investors have proved reluctant to go cross-border, and last year BaFIN, the German Banking Supervisory Authority, was instrumental in introducing new legislation that rendered master KAGs very competitive with their cross-border rivals. This is important, because master KAGs are under a regulatory obligation to use at least one, BaFIN regulated Depotbank.

"These changes make the master KAGs streamlined, low cost and very competitive," argues Thomas Paul, a partner at law firm Hengeler Mueller. To understand the full significance of this some history is required.

Since 1990, German Spezialfonds - Spezial-Sondervermogen - have been open to any institutional investor, a rubric extended in last year's Investment Act to include partnerships of private individuals. Investors choose Spezialfonds if they wish to retain some measure of control over the management of the fund assets; they determine the investment guidelines under which the fund is managed. The Spezialfonds, with a current net asset value of around €700bn, are traditionally established in contractual form on the basis of a framework (or tripartite) agreement between the investors, a KAG and one or more Depotbanks. This relationship can be very close; master KAG's require an investment committee and this may include a representative of the Depotbank.

The architecture of the master KAG/Depotbank relationship can capture a wide range of commercial considerations. Institutional investors, such as domestic insurance companies, may invest in their own master KAGs which are then serviced by their own Depotbank. In some cases there are ‘family' relationships between separate investors with their own master KAGs but still utilising one or other's Depotbank.

Variations on this interaction can be endless. But there are also a small but very significant group of independent master KAGs, without own-managed funds, whose core business is the provision of fund accounting and administration. Some of these are owned by non-German institutions such as BNP Paribas. Universal, the third largest master KAG is one example - German owned, with assets of €86bn. Behind these sit the stand-alone Depotbanks owned by global custodians, and competing with their in-house rivals and to some extent with the master KAGs.

German law does not include the notion of a trust arrangement as in Anglo-Saxon legal systems. Instead, master KAGs and Depotbanks duplicate functions, such as accounting and fund price valuation under the so-called ‘four-eyes' principle. Prices separately determined by each party must be compared with any differences reconciled. "This principle will not in my view be abandoned; it has served investors well," observes Paul.

The assets of the fund are effectively held in custody by the Depotbank. But there are other similarities between the regime for master KAGs and that for retail mutual funds. For instance, the Spezialfonds is set up under rules agreed by the investors within guidelines laid down by the German Investment Association (BVI) and is regulated by BaFIN but subject to compliance with the relevant statute law. Master KAGs do not need to publish annual reports or fund values; even the timing of valuations is subject to the investor's discretion.

This is a relatively opaque market but it seems as if the standalone master KAGs, which leave the investor to choose Depotbank and asset manager, now offer an increasingly preferred solution in this market.

Traditionally, German financial institutions have preferred a vertically-integrated business model capturing as many relevant service components as possible under common ownership, but this practice is now coming under critical appraisal. The reasons for this are simple: a demand from investors for reduced costs, better performance and improved risk management.

The context for this has been rapidly growing demand for portfolio diversification away from domestic bonds and equities. This is challenging the competence of some of the smaller, in-house Depotbanks. Hearsay evidence suggests that some master KAGs have had to look past their existing Depotbank when seeking to custodise more exotic assets - namely to those run by global custodians. There is also growing demand from investors for both master KAGs and Depotbanks to offer sophisticated risk management tools and portfolio analysis to their client investors.

Here Depotbanks have the advantage; it is their role to gather the primary data required for fund valuation and related processes such as the application of risk management tools to the relevant portfolios. Over the past decade we have seen something very similar in the US and UK; economies of scale tend to favour global custodians. Last year's act made very significant changes to the regulation of Spezialfonds which will only exacerbate this competition.

The overall intent behind these changes has been to make the Spezial fonds/master KAG/Depotbank system competitive with Luxembourg and other cross-border centres. Under the act, new asset classes were permitted for inclusion in Spezialfonds, including real estate, private equity partnerships, commodities, unsecuritised loans, and units in other investment funds.

Concentration limits have also been relaxed; up to 20% of a master KAG's assets can be held in private equity. Master KAGs can be segmented, built up out of component funds which may individually be 100% invested in one or another asset class, such as private equity or commodities. "This means that a €2bn master KAG can have up to €400m in private equity, a lot of money by any standard," says Paul. The outcome is intended to be very flexible and low cost. In this context, it is easy to see why the global custodians and master KAG providers should be predicting major change in this market.

Meanwhile, competition between the largest master KAGs and Depotbanks is also increasing around the provision of value-added services such as risk management, stock lending and cash management.

Insourcing by master KAGs from Depotbanks is already becoming more commonplace. "There is only room for four to five master KAG's in the German marketplace," says Jörg Ambrosius, senior vice-president and managing director at State Street Bank in Munich. There is no reliable market data on current levels of ‘Abwicklungsprovisionen', but these are known to be as low as two basis points of the value assets under management. "You can't live on these," adds Ambrosius. "The only way of doing so is to win market share."

The role of third-party consultants is also increasing in the German market. "We ask clients what they want in terms of reporting and advise on the choice of both master KAG and Depotbank,' adds Torsten Köpke, senior consultant at Watson Wyatt in Germany. In this situation there is little point in choosing two equally competent service providers. "The Depobank can provide a consolidated view of client assets whether held in or out of a master KAG. Custodians provide a wider range of services," he adds.

Rating the Depotbanks

BNP Paribas Securities Services is the first Depotbank to be rated under a new set of transparent rating criteria from Telos and Kommalpha Institutional Consulting, with a 1- rating. The Telos/Kommalpha rating system, compiled and published in an annual report, rates Depotbanks, Master KAGs, asset managers and other service providers in the German institutional market.

"This rating means a lot to us," assesses Gerald Noltsch, general manager of BNP Paribas Securities Services Germany. "We think that a transparent and consistent rating system like this should allow our clients and potential clients to make better-informed commercial judgements about which Depotbank they should select." The Telos/Kommalpha rating takes account of a wide range of factors including coverage, settlement and custody, fund services, quality of reporting, back office information technology systems and sale process.

Universal is meanwhile rated as the best Master KAG provider in the German market place. The firm is owned by five German private banking groups with €86bn under management and cash inflows for the year ending September 2008 of approximately €10bn. Its core business is in fund and securities administration but its rating also reflects its move into risk
management.