The role of the custodian today is far more complex than it was, but are clients paying them too much? By Angelique Ruzicka
Finding the best custodian to partner with was an easier job a few decades ago than it is now. Traditionally, a custodian’s job would entail safekeeping securities in various markets, processing transactions, and moving cash and securities; and it was relatively easy to compare the services of one with another. However, what a custodian has to offer today is far more complex. Indeed custodians have had to adapt because fund managers’ products have become more sophisticated as they branch out into alternative investments. “When I started in the business in the ‘80s there were four main products: custody, accounting, cash management and reporting. Today we have around 24 services, including transfer agency, cash processing, derivatives valuations, collateral management, securities lending and foreign exchange (FX). It’s a much broader set of capabilities that managers are looking for now,” says Francis Jackson, head of business development and relationship management for JPMorgan Worldwide Securities Services.
In this complex world and with services increasingly harder to compare is it still possible to get a good deal from a custodian? Custodians make money in a number of ways but mainly through headline fees (transaction charges and safekeeping charges), which are clear and can be benchmarked against other providers.
To find out if your partnership is an efficient and cost effective one it pays to review your contract between you and the custodian, especially if it hasn’t been reviewed recently. “Most custody contracts are structured as evergreen. They are in place until such time as you terminate the agreement or you renegotiate,” explains Joanne Parker, director of Thomas Murray Investor Services. “So some groups may still have the same fee schedule that they had five years ago or possibly even longer, while other groups may have more disciplined governance in place over their funds where, every year, they benchmark their fees or every three years conduct a market review.”
Headline custody fees have nosedived thanks mainly to the increase in competition in the UK and Europe. Another reason why fees have become more competitive is because the underlying market has become more efficient and cheaper and the price has been passed on to clients. Therefore there could be huge benefits to reviewing contracts. “If they haven’t been renegotiated for a number of years managers could see very significant drops of up to 70% in fees. Obviously, if you have been reviewing your contract regularly we would not expect that kind of change in fees,” adds Parker.
Sources of revenue
But it’s not one price fits all in this industry. There are different levels of pricing depending on the size of your business and the amount of services you hand over to the custodian. “With some custodians the costs on asset servicing depend on the size of stock that you place with them. If you have a large fund you generally get a good deal with custodians. A smaller fund, however, would need to put more services with the custodian in order to make it more attractive for them,” advises Parker.
The general consensus in the industry is that a request for a proposal (RFPs) should be conducted every three to five years, but anything more frequent may not make financial sense. “It is expensive to do searches for custodians. The internal cost of the man-hours spent writing up the RFP and evaluating it can amount to six-figure sums. We spent a few hundred thousand when we did a search a few years ago and that was just an internal cost,” says a pension fund administrator, who did not wish to be named. “So unless you are unhappy or you have a good reason to do a search it may not be beneficial. A lot of firms would just do a year-on-year extension because it’s painless. If you renegotiate you may be getting better fees but then again you are putting yourself through a six- to nine-month effort and spending hundreds of thousands on internal staff time.”
Custodians make their revenues in other ways too and these are often not as scrutinised according to Parker. “Depending on how the fund is managed they can make quite a bit of money from interest on balances, for example, if there is uninvested cash left with the custodian and the manager hasn’t secured good rates. Even if you leave just 1% of your fund in cash and you are not making any money, over time that is going to have drag on the fund.”
Conducting passive FX of deals on behalf of their clients can be a source of revenue for custodians as well. “Some managers won’t do the FX related to the trade they are making so will let the custodian do it and the custodian could make huge amounts of money on that because it’s often buried and difficult to see what FX rates have been used and difficult to understand what it actually costs compared to what a negotiated competitive FX trade would be,” says Parker.
The final money generator for custodians is dealing in securities lending. However, clients are more aware of the fees associated with securities lending, as they would have a percentage split of the revenue from each transaction. The deals to watch more closely would be the ones related to FX and cash, but in the long run this could all backfire, argues Parker. “Customers are waking up to the revenue leakage around FX and cash and they are putting the pressure on custodians. But this could mean that custody fees may be on the rise again at some stage.”
Custodians themselves advertise the fact that managers and pension fund trustees can save even more if they put the majority of their services with one party. Michael Walsh, a head of State Street’s investment servicing business in UKMEA, says: “Customers can pick and choose what they want but we do encourage them to take all of them as you get economies of scale from both sides and it can lead to a partnership type arrangement. We encourage that as we can understand their needs better and therefore service their needs better. Our top 25 customers from State Street take between 12 and 13 products from us on average, so it’s quite a range and it’s the norm rather than the exception.”
Key performance indicators
There are some benefits to having all services with one custodian and savings can be made. “If you take on more services from a custodian you have more leverage. So if, for example, you take fund accounting, performance measurement and perhaps use their derivatives servicing capabilities you will find overall that your fees will come down a little bit as there is an element of bundling,” says Parker.
Walsh is correct insofar as having more services with one provider can create more synergies and efficiency, but this is not always practical solution for funds. “We use a number of sources,” said a custody client. “If you have a complex portfolio you may have contracts with multiple parties. There are merits to the argument of one provider as you have economies of scale and simplicity but sometimes the decision is forced upon you because of your individual circumstances and you can’t give it all to one custodian.”
To ensure that a relationship is efficient and to ensure that a custodian delivers what it said it would do in the contract, it may help to include a number of service credits, also known as key performance indicators (KPIs) in the deal. KPIs can be beneficial to both partners. They can inflict penalties on the custodian if it doesn’t deliver on certain terms and conditions, but custodians in turn can negotiate to have rewards put in place if they deliver on or above the requirements. “You can have comfort that no service is slipping; it’s a way of keeping on top of the relationship,” explains Parker.
Having KPIs in the contract is not standard practice in the industry and there are some custodians that refuse to use them.
“Some custodians will overtly say ‘we’d rather not have it in place’, others say they don’t do it, but if you are a large enough client they will understand why you need to do it and will do it,” says Parker.
Including KPIs is a labour-intensive way of maintaining a relationship and end-users should think hard about whether or not to include them. “It does take some time to set up and there is always a question of whether you have the right KPIs or if you have set them too high or too low. If your portfolio or trading strategy changes, you have to think about whether your KPIs are still appropriate. It is a labour-intensive way of managing a relationship, but some groups have found it highly effective,” adds Parker.
Network within the industry
Industry commentators recommend instituting KPIs further down the track once the relationship with the custodian stabilises. When the dust settles a client can get a better idea of the kind of KPIs to put in place once they know the type of service they are getting.
Keeping on top of a custody contract and on top of a relationship with a custodian is vital. But custody prices can dip and rise and it’s difficult to get a grip on what the industry standard is. Therefore it is crucial to develop strong relationships with peers. “People like myself who choose and monitor custodians have to network within the industry to bounce ideas off each other. Cold calling and asking someone how much they are getting for certain services is not going to work – people guard those kinds of secrets,” said a commentator.
© fe December 2007 / January 2008