Global custodians are experiencing strong growth and increasingly complex demands from their clients.
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Since its beginnings more than three decades ago when US legislation forced pension plan sponsors to separate investment management activities from the custody of the underlying assets, the global custody business has mushroomed to envelop all types of pension plans, hedge funds and, more recently, the bulging pockets of sovereign wealth funds from the Middle East and Asia.
This international business now lies largely in the hands of a half-dozen global custody, or processing, banks that use increasingly sophisticated technology to help clients track a dizzying array of financial instruments and keep pace with intricate regulations. In the meantime, investment managers can concentrate on making money as the global custody banks work with local sub-custody institutions around the globe to handle the sharply rising volumes of transactions.
“The industry has really blossomed in the last five years. The tipping point was the hedge fund industry and when institutions began investing in these funds, as well as the growth of alternative investments, such as derivatives,” says Joseph Antonellis, vice chairman at State Street Securities in Boston, Massachusetts.
James Palermo, co-chief executive officer of BNY Mellon Asset Servicing in New York City, agrees. “When hedge funds wanted to play in the international arena with institutions, they had to provide transparency for the investment committees of the institutions. Before, they were largely dealing with individuals,” he says.
These giant processing banks have by and large escaped the repercussions of the economic slowdown or global credit crunch as they garner fees by helping investment managers and securities issuers issue, move and safe-keep all types of securities. While a downturn in securities trading and equities value can cut into their revenue stream and new business slows as the financial industry contracts, custody banks continue to cull profits from greater market volatility and the jump in transaction volume. “[Global custody] is more independent from the health of the equity markets,” says Charles Rauch, managing director of financial institution ratings at Standard & Poor’s in New York City.
Industry leaders remain optimistic that the assets under custody and administration will continue to grow. Antonellis, for example, sees immediate growth slowing from the 20% annual hikes of the past two years, yet rebounding back to 20%, or even 50%, over the next three to five years. “Everyone is more active now in a global world,” says Peter Cherecwich, head of institutional strategy and product development at Northern Trust, a multi-bank holding company based in Chicago. “As long as people don’t put their money under their mattress, there will be more money available to grow the pie.”
Palermo, who estimates that the assets held under custody and administration totaled $93 trillion at the end of 2007, expects growth in North America to slow to the mid-single digits in the coming year as Europe and the United Kingdom register increases of 10% to 14%. At the same time, markets in Asia and the Middle East will continue to record 20% annual growth as the managers of sovereign wealth funds search for investments outside their borders and high-priced oil generates more wealth for the oil-producing countries.
Even mature markets such as North America will maintain growth as more companies, and even some state governments, shift from defined-benefit pension plans to defined-contribution plans. These co-mingled funds in the defined-contribution plans require more tracking by investment managers, as each employee holds an individual account with numerous investment options. “It used to be just some equities and bonds in these plans. People have many more choices today, and they can change their allocation frequently, even each day,” says Rauch.
Another factor behind the industry’s ongoing growth is the push for greater compliance, transparency and harmonization among government regulators and lawmakers. Asset managers increasingly depend on their custody banks for solid record-keeping as legislation, such as the US Sarbanes-Oxley Act of 2002, pushes them into a more complex and costly regulatory environment.
Across the Atlantic, investment managers—and their custody banks—are wrestling with the European Commission’s Markets in Financial Instruments Directive, also known as MiFID. An expansive reform of the European financial markets that officially replaced the Investment Service directive last November, MiFID is a crucial part of the European Union’s efforts to create a single, more competitive market in financial services.
The directive allows banks and investment firms to compete more directly with stock exchanges as it lets investment firms, banks and exchanges offer their services across the borders of each EU member country. In a move that will increase investors’ reliance on custody banks, the directive will require more stringent reporting requirements at the pre-trade and post-trade stages as well as regularly updated order execution policies. UK lawmakers made the relevant changes to their laws in early 2007, and the UK Financial Services Authority has virtually shifted the new law into its rule book.
“The harmonization in Europe is good news,” says Antonellis, explaining that it should help streamline the settlement process and make it less expensive. He notes that transaction costs are two to three times more expensive in Europe than in the United States.
“The impact of MiFID is more directly on broker-dealers but is an example of how custodians must continue evolving if they are to keep up with the market,” says Martin Kunz, product head, global custody, at BNP Paribas. “In much the same way that global custodians were appointed in the past to give access to a sub-custody network, so custodians now are acting as a conduit to the new multilateral trading facilities that are emerging.”
Rauch says it’s not only regulators who are demanding more information and record-keeping. “The pension funds and mutual funds want more information and analytics,” he notes. “The demand for more information is coming more from the customers.”
As the markets and their underlying instruments become more complex, the need for more sophisticated analysis and regular reporting of statistics, such as net asset value, is being demanded from all types of asset owners, Kunz says. “Clients are no longer concentrating all their assets with one single custodian, and therefore the ability to offer consolidated reporting and performance analytics across all activity is becoming increasingly critical to clients,” he adds.
“The back office is where we add value by creating tools that help the asset manager better manage all the data and by providing better risk analysis,” Cherecwich says. “Before, the clients had to do it themselves. We can do it less expensively with technology.”
Antonellis agrees that clients want more transparency in their portfolios and more analytical information so they can assess the performance of their securities and minimize their risk. “Clients’ needs are changing as we speak,” he adds. “It’s a reflection of the state of the world economy.”
Paula L. Green
