Over the past three decades, the global custody and investors’ services industry has facilitated some of the most dramatic and far-reaching changes in the global financial services landscape.
More than 30 years ago Chase Manhattan bank in the United States coined the term “global custody.” With the creation of different benefit plans in the US market and the flow of capital becoming bigger than what domestic markets could cope with, custodians suddenly found themselves not only servicing investment managers’ domestic needs, but also back-office processing activity in foreign markets. “The concept of a ‘master custodian’ representing different investment managers and acting as a guardian of a global book of investment was born,” says Jacques-Philippe Marson, CEO of BNP Paribas Securities Services. “Once custodians started going cross-border, they started servicing domestic clients outside of their home market. The first to do that were the Swiss banks, British banks, the Dutch and then US banks in the 1970s.”
Since then, the custody business has become even more global in nature. As investment managers sought higher portfolio returns outside their domestic markets, global custodians expanded with them, extending their networks to service new emerging markets. According to GlobalCustody.net, the total market for custodial services now exceeds $90 trillion (based on data from 50 service providers). Five years ago a similar survey produced a figure close to $40 trillion (with data corresponding to the largest 29 service providers at that time).
As custodians looked outside their own domestic markets for growth, scale became increasingly important. The more assets under custody, the greater the bank’s ability to deliver economies of scale and invest in sophisticated technology platforms to support their ever-expanding global customer base. It comes as no surprise then that, in the quest for scale, consolidation has remained a constant theme for the past 20 years.
The first major wave of consolidation in custody dates back to the late 1980s after the British government’s abrupt deregulation of the London Stock Exchange—commonly known as the “Big Bang”—exposed the UK’s financial services market to international competition. US banks seized on it as an opportunity to enter the local custody market, buying up custody arms of providers such as Barclays and Royal Bank of Scotland, which exited the business. Then 2003 saw the largest cross-border acquisition to date, with State Street acquiring the global custody business of Deutsche Bank. “The Deutsche Bank acquisition doubled our market share in Europe,” says Joseph Antonellis, executive vice president and chief information officer of State Street.
In the past 12 to 18 months, consolidation has shown no signs of abating, and last year saw a number of major deals concluded. In order to expand its Asia-Pacific network, HSBC Securities Services acquired the custody business of Westpac Bank in Australia. Last year Société Générale bought UniCredit’s securities services business, bringing its total assets under custody to €2 trillion, and toward the end of 2005 Canada’s RBC set up a joint venture with Dexia, which enhanced its exposure to the European market.
In recent months French custodian BNP Paribas, which prides itself on being a “true” pan-European securities services provider, bolstered its position with the acquisition of the third-party securities clearing and settlement activity of Bankhaus Carl F. Plump in Germany. It also recently acquired RBS International Securities Services, which provides securities services in UK offshore markets, and in Spain it acquired Exelbank, the securities services subsidiary of Banco Sabadell. In its quest to become a truly global custody provider, BNP Paribas does not rule out further acquisitions, particularly as smaller domestic providers such as Sabadell decide to exit the business. But the deal of all deals has to be last December’s announcement that the Bank of New York and Mellon would merge, creating one of the largest custody providers, with $16.6 trillion in assets under custody.
Looking ahead, a number of custodians believe that the custody business eventually will be concentrated in fewer hands as smaller custodians sell off or outsource their custody business to larger providers. “At the end of the day there will be three global custodians—probably two US firms, and the third being a European,” says Marson. Raj Shah, head of global custody at JPMorgan Securities Services, says there will be a “mega-merger” among the top eight to 10 global custodians in the next three to five years, and he anticipates further consolidation among regional players. “In this business, scale is important,” he says. “Clients are demanding greater efficiencies and for us to bring down costs.” But achieving that scale costs a great deal. “Last year we invested $600 million in our securities platforms, which shows you the scale of investment required,” Shah adds.
Bodman: Investment managers want help with alternatives
Technology’s Growing Role
“Technology, specifically the ability to accommodate change in technology, was more important than firms realized. That is the reason why there are so few firms left in the global custody business,” says Taylor Bodman, a partner at Brown Brothers Harriman (BBH) and CEO of BBH Infomediary, the bank’s platform for helping investment managers streamline their multi-party communications. Although BBH may not have the size of some other custody providers, Bodman says that its investment in technology, including its Infomediary platform, has enabled it to differentiate itself and thrive in a consolidating market.
While the largest providers paint a picture of a rapidly declining number of truly global custody providers, Bodman believes those firms that have “one amazing capability,” whether it is a state-of-the art risk mitigation or corporate actions processing solution, will still have room to shine. “Such providers will target pieces of the custody business as we define it today. As the world flattens, the idea of a one-stop shop will be really challenged,” he says. And although there may be fewer bigger names in the business than there were 15 or even five years ago, Bodman says there are still several hundred custody providers: “Through Infomediary we help investment managers connect with over 600 financial institutions providing custody services as an accessory to some other value proposition. So there is room for further consolidation, innovation and re-definition of what it means to be a custodian.”
And while technology has always been important to stay in the game, Bodman says the focus of that technology has shifted. “In the late 1970s and 1980s we developed proprietary systems to allow investors to automate paper and time intensive processes, such as affirming trades online,” he notes. However, by the late 1980s and into the 1990s, he says the technology focus extended beyond automation towards giving the client greater visibility and control over their expanding securities business. Today, technology has evolved towards providing investment managers with business process connectivity across multiple providers, geographies and new types of asset classes. Bodman says BBH’s Infomediary platform is the industry’s exemplar of this new kind of technology capability, which was initially pioneered for the bank’s internal use before being rolled out to customers in 2002.
Infomediary is a good example of how custodians have evolved from being just safekeepers of securities to technology providers helping customers automate as many parts of their business as possible, a role that has become increasingly important as investment managers’ portfolios have increased in complexity. And as much as consolidation in the custody business has been about acquiring scale and the ability to continue to invest in technology, a number of acquisitions in recent years have also been about acquiring value-added capabilities to service investment managers’ increasingly sophisticated needs.
Bodman: Investment managers want help with alternatives
For example, in February this year, in a stock deal valued at $4.5 billion, State Street acquired Boston-based Investors Financial Services, which provides mutual fund, offshore and hedge fund servicing. Upon closing of the transaction, State Street not only will have boosted its assets under custody to more than $14 trillion, but it also will have enhanced its position as a worldwide service provider of fund accounting to the mutual fund industry and shored up its leadership in servicing for hedge and offshore funds.
Antonellis says the acquisition will build on State Street’s offshore hedge fund capabilities as well as middle-office outsourcing and private equity accounting. Enhancing its hedge fund processing capabilities was also behind State Street’s 2002 acquisition of International Fund Services (IFS), which Antonellis describes as “the Cadillac” of hedge fund servicing in terms of its hedge fund accounting and administration capabilities as well as trade support and middle-office services for alternative investments.
But what has hedge fund administration got to do with the settlement and safekeeping of equities and bonds, the back-office processing capabilities that have been synonymous with custody since the 1970s? In today’s lexicon the term “custody” has been usurped by “asset servicing,” which is a reflection of the portfolio diversification strategies of investors that are investing not only in “vanilla” instruments such as equities and bonds but in alternatives such as hedge funds, exchange-traded funds, derivatives, private equity and property funds.
“Our clients have become more sophisticated,” says Anne-Lise Winge, head of business development, EMEA, at Northern Trust. The quest for “alpha” or higher returns is drawing investors into alternative asset classes. “As custodians we have had to follow them,” Winge continues. “It is not just straightforward custody anymore.”
In order to service this broader array of investments, managers are asking for more and more services from their custodians—services that are not just confined to back-office functions such as settlement and safekeeping but also encompass middle- and front-office capabilities including fund administration and accounting and performance analytics. “Investment managers want help with alternatives and entering new markets, and the foundations of what is considered to be core custody will continue to evolve,” says Bodman.
For example, investing in derivatives is becoming so mainstream that most custodians now consider it to be core to their service offering. Shah of JPMorgan says in the space of just a year the number of derivatives contracts it manages has tripled. “As clients move into different asset classes, we need to be able to service that portfolio holistically,” he says. “The biggest change in the business has been regulatory intervention around what you can and cannot invest in. That is why the business has increased in complexity.”
“Every portfolio is investing in derivatives in some way, shape or form,” says Antonellis of State Street. In order to service investors’ increasing appetite for derivatives, State Street is leveraging existing capabilities plus those it acquired by doing “lift-outs” for firms such as Pimco. Lift-outs are large-scale outsourcing deals where investment managers “lift out” staff and systems, which are then managed by the custodian, allowing fund managers to focus on the more strategic aspects of the business. At the start of the millennium, there was a spate of high-profile lift-outs announced by major investment management firms such as Schroders, Scottish Widows, Aberdeen Asset Management and Legg Mason. In the case of State Street, lift-outs allowed it to enter the derivatives processing business and to broaden its asset management capabilities. However, as the securities services outsourcing model has evolved, the focus now appears to be on outsourcing a process rather than a whole back-office or middle-office function. “As we have understood how to leverage services for others, we are moving much more into a component-based approach,” says Antonellis.
Referring to the large-scale distribution networks of top-tier custody providers, which allow firms to leverage a custodian’s technology to run their book of business, Marson says the term “global custodian” is no longer relevant in 2007. “[Custody] is not even a transaction banking type activity anymore,” he says. “It has become an outsourcing business as custodians use their technology to manage the processes of others,” he says.
But what does this mean for good old-fashioned core custody? Is the settlement and safekeeping of securities still fundamental to the business, or has it become commoditized? Arguments over this will continue to rage for years, but while custody now encompasses a wider range of services, custodians still believe that getting core custody right is essential if they are to move into new areas such as hedge funds and alternatives. “If you are to stay in the business, you have to get core custody right. But market interest is moving heavily towards alternative investments,” says Winge.
Although the focus has shifted to alternative assets, Shah of JPMorgan says that does not mean core custody no longer requires investment. “We are investing as much in our core custody platform and capabilities as ever,” he says. “We don’t want to have a ‘rotten’ core. Otherwise we won’t be able to sell the product.”