As the profitability of pure custody services continues to decline, global custodians are realizing their dreams of moving up the corporate value chain.
The bear market has been tough for global custodians, putting pressure on costs as asset management revenues have shrunk. But the leading global custodians have not rested on their laurels. Instead, they have innovated and, without exception, are attempting to move up the value chain.
The past 18 months have been a difficult period for both clients and custodians, notes Dave Phillips, managing director at Citigroup Global Transaction Services. Consequently, there has been significant change in clients demands and the services offered. The down market put pressure on clients to reduce expense; that means the pressure has been put on us to do the same.
But while fees have been affected by the downturn in the equity marketsmuch of custodians fee income derives from the volume of trade and the value of assetsthe downturn has also created opportunities. Fund managers are looking at their accounting and other back- and middle-office services and asking themselves if it makes sense to continue doing them in-house, says Tom Swayne, executive vice president at JPMorgan Investor Services. The decision to outsource will continue as profitability improves. We are seeing a growing trend toward incremental outsourcing rather than taking the big-bang approach.
Outsourcing is certainly the buzzword in custody right now. With much of custody essentially a commodity business, the spotlight has shifted to value-added services with higher margins. Mellon can offer value to investment managers who are developing new products for different markets and dont want to build the infrastructure for these new products, says James Flannery, sales and marketing manager, US trust services, at Mellon. We act as a partner that can provide the infrastructure on an outsourced basis.
The vast technology investment required to keep up with regulatory, economic and industry change has brought outsourcing into focus for clients. Do I buy or lease? is the big question, says Flannery, and increasingly people are answering, Lease.
The result is that custody as an individual business is disappearing. Custody is no longer a product that you can make money out of as a stand-alone service, says Phillips. Historically there has been continual price decay, and we see no reason for that to stop.
Similarly, Jeff Conway, managing director, investor services UK, at State Street, says that State Street does not use the custodian tag anymore: We are an enabler of broader value through the administration of assets. Its about a whole gamut of solutions. People need to know how their custody service will complement their execution strategy or their transaction management.
Fund accounting, trade execution and order routing are the sorts of services that custodians are moving into, according to Phillips. Being a custodian offers great opportunities to cross-sell cash management and trade servicesall of which are scale business. Ultimately, much of our business will be the provision of information.
Financial pressure on clients has not been the only driver of change. On the servicing side things are getting more complex, says State Streets Conway. For instance, the move toward direct-contribution pensions rather than direct-benefit plans means that clients now have to offer a multi-fund environment with daily pricing. Those sorts of developments put strain on clients to keep pace.
Global Clients Need Global Custodians
More clients want a global relationship so that they can leverage value from it, notes Conway. The ability to have consistent service standards and be able to access data from any desktop in the organization is becoming critical.
Does this mean the end for regional players? Mellons Flannery says that in Europe the growing number of multinational companies, increased deregulation and the advent of the euro have put pressure on regional players to provide more value-added services. Many regional players are unlikely to be able to invest enough in technology to keep up. Swayne at JPMorgan says that the evolution of the financial services industry in Europe is also prompting change: As investors in Europe and elsewhere diversify more into global equities and away from country-specific equities, the focus will switch to those centers where there is most volumethe major trading centers and exchanges. Country-specific custody will become less important to clients.
But could any of these regional players develop a global business? BNP Paribas purports to be building a global custody business, but the large global playersState Street, Bank of New York, JPMorgan, Citibank and Mellonbelieve a strong regional player could emerge, though its unlikely due to the scale of investment required. As Citigroups Phillips notes, Outside of the potential of the existing European providers, the competition on the horizon is Euroclear and Clearstream, and at the moment they dont even operate in the global custody business.
Consolidation and Joint Ventures
Industry consolidation is a constant in custody. As Conway notes of State Streets acquisition of Deutsche Banks Global Securities Services, it brings immediate benefits of scale and new market penetration: The value of the Deutsche acquisition is principally its people, the Depotbank business in Germany, Italy, Austria and Luxembourg, and [performance measurement business] WM Company. The fixed-income securities lending business of Deutsche also complements our strength in equity securities lending.
Triumph in Adversity
Three consecutive years of down stock markets and interest rates at 40-year lows have made life tough for global custodians clients. But that doesnt mean all custodians have also suffered. Northern Trust, for one, was able to end the second quarter of 2003 with record levels of custody assets$1.8 trillionand funds under management$423 billion. Steve Fradkin, executive vice president of Northern Trust, says, Its because people have been interested in the solutions weve been creating. When clients have cost pressures, they become more interested in new ideas for productivity improvement, service enhancement and capabilities delivering revenue-generating opportunities like securities lending and commission recapture.
But acquisitions are not without their pitfalls. Conway says that State Streets target was to retain 90% of the business and that they are on course to meet that. Industry observers believe that is an overly ambitious figure. If their model was based on retaining 90% of clients, then they will come up short, says one industry player. He notes that State Street has lost the Federal Home Loans account to Citigroup. Thats about 10% of assets. A lot of Deutsche clients were Bankers Trust clients; this is their second move, and many are not happy about it.
One alternative way that some of the large players have expanded their global presence has been though the use of joint ventures with investment banks. Mellon teamed up with ABN AMRO and has now formalized the arrangement. Similarly, Bank of New York now has a joint venture with ING Bank.
Not everyone agrees joint ventures are the way forward. One market observer, who declined to be identified, notes: Can you think of a JV that has worked? Both sides have to stay fully aligned, and that is next to impossible. Mellon is not a JV anymore but is now a separate company. But in the middle of the formation of that company, Mellon bid separately for Deutsches assets. What message would that send to you if you were their prospective partner?
What Clients Want
Fortunately for clients seeking to differentiate between global custodians, those to whom Global Finance spoke each believed clients had differentthough not mutually exclusivepriorities.
Swayne says that contingency planning, in the wake of 9/11 and the recent power outages in the US, has become a major issue ranking alongside pricing and reliability for clients. It has become crucial in mandate decisions, he says.
Citigroups Phillips puts the emphasis on customer service: This is a transaction servicethings can go wrongso its important that you have a relationship there to sustain you when that happens. After-sales service is now the most important issue for customers; they want to know how we will react to their concerns and inquiries.
Price is always part of the equation when clients select a custodian, believes Flannery, but it is not the primary driver. Ultimately quality is the driver, he says.