Escrow services have grown in prominence as the financial crisis underscored credit and counterparty risk.
As an effective means to reduce counterparty risk and segregate assets, which are held by a bank, to be released only when certain pre-agreed conditions have been met, escrow services are in greater demand than ever.
“The crisis has put counterparty risk at the forefront of people’s minds,” says Daire McCormack, global head of escrow solutions at Deutsche Bank. “In situations where clients were previously happy leaving assets with a counterparty, for example a hedge fund with its prime broker, many now want to segregate those assets with a third party.”
Adds Morgan Downey, global head of custody and agency services at Bank of America Merrill Lynch (BAML): “A big change we have seen in the past five years among corporate treasurers is a shift away from focusing on generating returns on capital, to ensuring that their capital is returned.”
Its growth is principally being driven by this defensive attitude among corporates. This has led to escrows popping up in a host of interesting new areas.
“Escrow has been increasingly used to resolve environmental disputes, and as a way of enabling projects which could have environmental implications,” says Faisal Ansari, escrow services global product executive at JPMorgan.
“This empowers regulators to ensure companies clean up after themselves when engaging in projects in their jurisdictions.”
An escrow is essentially a rainy day fund but one that incorporates legally binding segregation. With a rainy day fund a corporate is free to determine when the weather is sufficiently bad to dip into the fund.
However, with an escrow, certain, prearranged conditions must be met before the funds can be accessed, meaning the interests of third parties can be legally protected.
According to Swiss Re Economic Research & Consulting, between 2000 and 2012 there was an average of about 180 man-made disasters per year, compared with 148 for the 13-year period before that. In the 1970s and 1980s, the yearly average was around 75. In 2012, man-made disasters caused around $8 billion in damages.
Few examples illustrate the need to keep a rainy day fund as well as BP’s Deepwater Horizon oil spill in 2010. According to its Q1 financial report, the cumulative pre-tax charge for BP’s restoration efforts reached $42.2 billion, and this only factors in the charges that BP feels able to accurately measure. The eventual cost will therefore be even higher, demonstrating the magnitude of liability that can occur in extreme cases.
“The increasing complexity and sophistication of the processes used to extract energy resources from remote spots, such as ultra-deep underwater exploration, Arctic drilling and shale gas extraction, increases the environmental risks, as well as the clean-up costs at the end of the resource life,” says Ansari.
Opportunistic litigation also adds to the cost of doing business, even if it does not lead to damages being awarded.
As technology advances, the cost of mistakes seems to rise dramatically. Companies are therefore looking to manage this risk pre-emptively, rather than re-actively, by putting escrow arrangements in place in advance of operations.
In many places, this is a regulatory imperative: the US Environmental Protection Agency requires such arrangements for activities that will leave a scar on the environment.
Russia, Indonesia, Vietnam and Ghana are among other places with similar requirements, but even where it isn’t, multinationals often consider it in their interests to stay ahead of events.
However, not all banks are eager to take on this business, which might carry a reputational risk of being associated with notorious and unpopular business ventures, such as mining or running pipelines in environmentally sensitive locations.
Escrow for insurance
Another growing use of escrow is in the insurance sector, says Deutsche’s McCormack, capturing the broader market for disasters, of which man-made accidents constitute just a part.
In particular, catastrophe (cat) bonds and bilateral reinsurance agreements have taken off since the financial crisis, as insurance companies move away from more expensive letters of credit. These structures represent an uncorrelated risk to financial markets, so make interesting investment opportunities.
Deals are done on a collateralized basis between the insurance company and the investor, with the bank holding the capital in escrow for the term of the contract, typically three years for cat bonds, or for one-year rolling contracts for bilateral deals.
It’s principally a dollar business, though there is plenty of room for growth in other currencies. BAML, for example, is positioning itself to capture business in growing economies in Asia and Latin America, where there might be an increase of escrow services denominated in yuan, real and other currencies, says Downey.
It is especially appealing to corporates because money held in escrow can still be deployed to generate returns, in safe and liquid investments, such as money market funds or government bonds.
Alternatively, it can be held on the bank’s balance sheet where it can earn interest. If the client is willing to forgo the interest, the Federal Deposit Insurance Corporation in the US will also guarantee deposits up to $250,000.
The money can be put aside in a lump sum but will typically be funded over time from the profits of the venture, allowing the capital to build up over time.
Escrow services have a mixed impact for banks from a regulatory perspective. Money in escrow can be supremely sticky, being locked away, sometimes for decades, meaning it has the lowest cost treatment possible under Basel III.
However, not all escrows have such long durations and some have lives of only days or weeks, meaning, on the contrary, the capital treatment is not favourable for banks. Money that will be tied up for the long term in an escrow would receive equally favourable treatment if it were held in an operating account, says BAML’s Downey.
Banks should therefore be neutral from a regulatory perspective on growing their escrow businesses.
In any case, the pace of escrow growth should accelerate further once rates rise, which will make the account more attractive for banks, says McCormack. “It’s an option on interest rates,” he says, as they will earn greater interest on the deposits they hold.
Irrespective of the capital cost and benefit of an escrow account, the regulatory push and fears over counterparty risk should ensure the structural growth of the service.