September 2008

CUSTODY: Factory model closes down

The latest economic downturn may lead to another wave of outsourcing for custodians. But the ‘factory’ model of recent years may be in decline as clients look for higher standards of processing, reports Nick Fitzpatrick  
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"The Best of Times, The Worst of Times" - a further article from Nick Fitzpatrick, who argues that the past year has been relatively kind to major players in the custody business. READ Statistical information
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      Custody banks know how to turn an economic slowdown to their advantage. In the bear market that followed the dotcom crash, custodian banks aggressively marketed their outsourcing capabilities by trying to persuade fund managers to let custodians look after their fiddly back and middle office operations alongside their traditional custody. By doing this, custodians said fund managers would gain greater control of their costs and see profit margins increase.

      The current downturn presents a renewed opportunity for custodians to do this, but their business model may have to be very different from the industrial-strength offerings that custodians have built in recent years.

      Michael Wagner, a partner at management consultancy Oliver Wyman, says that a custodian’s clients, such as fund managers, will look for solutions to specific problems rather than purely for the scale offered by the one-size-fits-all platforms developed in the past decade.

      “In the past, fund managers were about scale and they just needed more assets under management in order to be profitable. But then traditional managers saw huge competition come along from small alternativemanagers,” he notes. The point is that some of the asset managers that have done well in recent years are those that have launched smaller alternative fund platforms, says Wagner. But these platforms, with their special requirements that arise from the fact that their investment portfolios are often more complicated than straightforward equity or bond funds, are more difficult to outsource when it comes to the whole gamut of back and middle office operations, from clearing and settlement, to fund accounting. Custodians will have to offer more specialisation. Independent valuations
      One major area in which investors could benefit from a custodian bank is linked to this very same complexity. Investors could benefit from – and may be obliged to obtain – independent valuations for complicated instruments such as collateralised debt obligations. Pricing these things is a service that should be provided by the likes of ratings agencies, but their reputations have been battered by the sub-prime crisis.

      Yet so far custodians have not really stepped into the space, says Wagner. “They have not really done much in this field, but then no one has asked them to,” he says.

      Wagner continues: “Custodians could not do valuations for complex instruments at the moment. It is only the issuer that knows exactly what assets are in the instrument. Custodians would need to ask for the underlying information.”

      And this would be a huge investment, he notes, and the business opportunity created by this also comes with a further cost: liability. Wagner says: “As soon as you enter a derivative valuation, you are liable for it.”

      But there is also a price to be paid for not taking opportunities like these when they present themselves. Missing business opportunities has, along with other factors, destroyed an estimated e5bn in value in the outsourcing business, Wagner estimated in a recent report (The Future of Transaction Banking: Securities Servicing).

      However, if custodians have to some extent failed to provide a useful valuation service for fund managers, they can’t be blamed entirely. Another recent report – OTC Derivatives Processing: Life on the Edge (April 2008), by Aite Group – indicated there is a great deal of apathy from buyside asset managers in their over-the-counter (OTC) derivative dealings. Automation levels are low but managers tend to see this as more of a broker/dealer’s problem, the report noted.

      Challenging year
      If losses of the sort that Wagner has calculated continue for much longer, then there may be far fewer players in next year’s Funds Europe Custody Survey. On the whole, custodians have put in a good set of financial reports in the last few quarters. But responses to our survey indicate that custodians are expecting a challenging time in the months ahead as the slowdown continues. Falling asset prices coupled with lower volumes is a custodian’s worst scenario because income is dependent on a basis-points charge linked to the asset size. This scenario may be more likely if, or when, recession finally bites.

      Stephen Baker, head of custody services at Bank of Ireland Securities Services, says: “The coming year is going to be a challenge for many custodians in managing the relationship between income and cost. As stock market values suffer this has a negative impact on custodians’ income. Therefore cost containment to minimise the negative effects of falling income levels will be paramount.”

      José-Benjamin Longrée, managing director of CACEIS Bank Luxembourg, says: “Investment and custodian banks have tightened their budget belts but are likely to feel the pinch elsewhere as a war for talent becomes increasingly hard-fought. Hedge funds and private equity firms have weathered the recent financial turmoil better than most and have started to poach talented individuals from the banks, a trend which could open the floodgates for a stream of talent away from the banks.”

      This is not the best time, then, to have to be investing in new areas of business, but the move towards ‘component’ outsourcing and away from factory models seems unstoppable as more asset managers offer alternative products.

      Rob Wright, chief operating officer at RBC Dexia Investor Services, says: “One challenge has been the continuing mainstream shift away from relative, passive benchmark returns to alpha. Providers continue to witness increasing volumes from alternative asset managers and growth in the use of OTC derivatives. Some funds are combining strategies, bringing together 130/30, mixing bonds and equities and so on. This convergence of investment styles is leading to requirements for higher processing standards.”

      But just as pressure on custodians is increasing to offer a more customer-focused approach, customers in turn had better expect to be more yielding when it comes to price. “What has happened in the past is that securities servicers have responded to RFPs by competing on price. But the services that we will see outsourced now, which will be more middle office focused, such as providing data components or risk management and compliance, as well as accounting, are more complicated. A different approach is needed,” said one observer. ©  2008 funds europe

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