Changing of the guard: custody in a post-crisis world

Global custodians have not had an easy time over the past few years. Value added businesses such as foreign exchange, securities lending and cash management are relative shadows of their former selves plus regulators are shining an ever brighter light into their business models. Firms have been busy re-structuring their operations but those that have the deepest pockets and scaleable businesses are the most likely to survive.

“Clients understand that this regulatory change will have a material impact on the custodian and the conversations are about the right price for the right level of risk.”

Hani Kablawi

In fact, a report published last year by Celent shows that it will only get harder to break into the magic circle of 10 who together control 91% of the market with the three largest contenders – BNY Mellon, JP Morgan and State Street – accounting for a 67% chunk.

As Stuart Catt, senior associate of Mercer Sentinel puts it: “There is no doubt that it is a difficult environment and the role of the custodian is changing. We are not moving away from zero interest rates any time soon, once profitable businesses remain repressed and it is difficult to see where the revenues will come from. I do not expect there to be a eureka moment and a new source to emerge but instead revenue growth is likely to be incremental.”

To compound matters, the squeezing of margins has coincided with a spate of litigation concerning among other things, price gauging. For example, State Street admitted in a statement last November that, “in a limited number of instances, we charged commissions on transition management mandates that were not consistent with our contractual agreements”. These allegedly included several high-profile investors such as the Kuwait Investment Authority, the UK’s Royal Mail Pension Fund, Sainsbury and Ireland’s National Treasury Management Agency.

The US custodian also came under fire in 2009 when the then California Attorney General Jerry Brown brought a $200m lawsuit against the firm for allegedly overcharging two state pension funds in foreign exchange transactions. Similar charges were brought against rival BNY Mellon by Virginia’s Attorney General Ken Cuccinelli two years ago.

This as well as the controversy and lack of transparency over securities lending pricing has led to a number of investigations. In the UK alone, the Kay Review of UK equity markets is calling for all income from stock lending to be rebated to investors as well as disclosed to them while the UK’s Financial Conduct Authority (FCA), formerly the Financial Services Authority, recently launched a wide-ranging review of the financial service industry which covers transition management, custody, securities lending, foreign exchange, collateral management, derivatives clearing and data analytics.

John Campbell, head of State Street Global Services in the UK, Middle East and Africa, believes that the major challenges stem from continued market uncertainty and complexity, including ongoing regulatory reform.

“While changes were undoubtedly needed in response to the financial crisis, policy makers need to recognise that regulation is not a silver bullet. New rules need to be based on stringent and thorough impact assessments but it is also important for industry participants to develop a culture of governance that enhances our operating models alongside the requirement of our regulators. Such a balanced and realistic approach to regulation and the development of our operating models is important given the low-growth environment, to avoid creating additional burdens on investment returns.”

A sharper edge

However, Campbell notes that despite the hurdles, the post-financial crisis world also enables custodians to sharpen their edge.

“Costs are being scrutinised like never before, the gap between winners and losers will widen, and the current period is an opportunity for organisations to differentiate themselves by being innovative and delivering what investors need,” he says. “Clients are increasingly looking to review their operating models to take out fixed costs and improve their agility. They recognise it is vital to be able to adapt to the available opportunities and they are looking for their asset servicing partners to provide insight and support on the options.”

Outsourcing back in vogue

Today’s deals may not resemble the back office lift-outs of yesteryear but buy and sell side clients are increasingly offloading noncore functions in a compartmentalised fashion. This is especially true in areas such as collateral management, valuation, risk analytics and performance measurement to meet more onerous demands of the European Market Infrastructure Regulation (EMIR) and Dodd Frank.