July 2007

CUSTODY PANEL: Talking about change

A trio of some of the industry’s top custodians were invited to comment on several key issues facing custodians and their clients. Topics include consolidation and profitability. By Nick Fitzpatrick.
A significant amount of consolidation has been seen in the US in recent months, particularly with Mellon/BoNY. When two global custodians merge/acquire, what advice can you give to a fund management business for best managing this event?
Simon Shapland, RBC Dexia Investor Services
07_07_shaplandOne of the fundamental supports to the relationship that you have should be a detailed and up to date service level agreement that you jointly monitor on a regular basis.  This should be accompanied by a log detailing day-to-day queries, which typically is an automated or internet tool, and for more substantive or ongoing matters, an issues log. This should set out the service levels that you receive regardless of any merger activity. You will already have a degree of assurance in the quality of your client service and relationship management interfaces and personnel.  Clearly as soon as practical you would expect to meet with the executive level of your custodian to understand what might arise from the proposed merger and what is the indicative timetable of events. Your contractual arrangements need reviewing to see whether there are any clauses triggered by the merger, either adverse or beneficial to you, or indeed your underlying clients. Change can be positive in both the short and long term and it is wise to carefully monitor what actual and predicted changes might occur and assess the impact to you.  Clearly your business will be affected and understanding the future changes will be important.  Here are some of the areas to question your custodian upon:
  • Future systems and operating model;
  • Location of the operations and your client service/relationship management interface;
  • Timing of changes;
  • Who will be the future contracting entity and their capital adequacy and ratings;
  • Who bears the cost of change and are your reasonable costs included;
  • Perceived benefits from the new organisation in terms of products and services.
From the early days of any merger news, to receiving concrete answers to your questions, could inevitably take time.  During this time, regular dialogue with your custodian is paramount to ensuring that you remain pro-active in managing such an event.   Sébastien Danloy, Société Générale Securities Services
07_07_danloyAny merger must not impact your activity, this is “business as usual”. In particular you have to make sure that you keep your business contacts with whom you are used to working with (eg, the relationship manager). Ask your provider about his intentions in terms of integration and changes in its IT platforms. This must be smooth and without any regression in the service. You should benefit from new and better products. Ask him what and when.   Timothy Caverly, State Street
07_07_caverlyConsolidation within the industry has been something of a constant for the past decade or so, as it becomes more and more challenging and costly for global custodians to maintain the level of investment required to stay ahead in this business. For investment managers, there are important questions to ask when faced with the consolidation of a provider. For example, “What strategic benefits can I gain from this consolidation?”  Providers need to ensure confidence that the consolidation will enable such benefits. For example, with State Street’s pending acquisition of Investors Financial Services Corporation, the combined companies will provide customers with economies of scale, ongoing capital investments in new technology, the ability to access global markets and an unmatched product scope.
Profitability in fund management and other financial sector firms has been huge in the last 12 months or so. What has profitability been like in the global custody sector?

The pricing of core custody services and the ancillary value added services is generally connected to the value of assets under administration or activity levels. Recent years of rising market value and associated activity levels quite clearly enable what in some cases is a low margin business to generate revenues which custodians are invariably re-investing back into the ever evolving support to fund managers. Such investment improves the efficiency and product breadth of custodians as well as ensuring control and risk mitigation.  With the globalisation of consumer investment and the increasing return of confidence to the markets, custodians have a responsibility to maintain this support. In such a dynamic environment, those custodians who innovate away from the lower margin core activities may well be able to charge a higher margin for certain value added products and services.  Such rewards are understood, accepted and indeed encouraged by those fund managers and their clients who see it as a key part in maintaining competitive suppliers to the administration world. Danloy: All actors in the fund industry benefit from the positive environment of the financial markets, the constant innovation in instruments (structured products, real estate funds, private equity…) and growing cross-border distribution. This results in increasing the cash inflows from investors and the required investments to manage these changes. Changes in the regulation and the markets have required significant investments (VAT rules, ESES, Target 2, MiFID,…) In conclusion, a healthy business but large investments to run the new clients’ activities and the regulatory changes keep margin under pressure. And those which did not invest are or will sell their activity. Caverly: The industry’s global custody sector has seen steady growth in profitability. Given the intensely competitive nature of the global investment environment, those custodians who are able to identify and position themselves to take advantage of key growth areas — whether by penetrating new geographic markets or by broadening their product scope — are less at risk of being impacted by a market downturn and are more likely to continue to achieve increased profitability.
How do you plan to increase your profitability and what type of business from fund managers do you need to support this? Is it still important to be able to cross-sell other services (eg, fund administration, stock lending) for your business to be profitable?

Global custodians with genuine commitment to the market have seen over the years their core proposition evolve so that products and services that were once deemed innovative become part of the normal requirements. This leads to the challenge of continual evolvement and improvement. The creativity of the fund management industry continually presents challenges to custodians who need to work closely with their clients to predict, plan and deliver solutions. Such close working develops a common purpose that should include the sharing of future strategies. Diversity of products and services with differing profit margins is important to any supplier in any industry and custody is no different to that approach.  Cross sell should not just be about diversity of fee type, but as much about strengthening and deepening the relationship and corporate trust which becomes mutually beneficial to both parties. Danloy: Global custody is highly commoditised and subject to fierce competition. Straight-through processing (STP) is key to maintaining attractive prices and has already reached high levels. Fund managers are not ready to pay a blank cheque and they are expecting high quality service. They are requiring more services in addition to global custody, eg fund administration, transfer, paying and representative agency, performance and risk analysis, over-the-counter (OTC) derivatives/structured products  pricing, middle office outsourcing, and securities lending. Cross selling brings benefits to the clients; for instance lending its assets allow for offsetting the safekeeping fees. In addition providers have interfaced the different services (eg., fund administration with global custody and performance) ensuring STP, high quality at lower prices due to the important volumes. Caverly: To increase our profitability, we have to ensure that our customers are provided with value they simply cannot receive anywhere else. At State Street, our key competitive advantage is our focus on institutional investors. This focus is at the foundation of our ability to develop dynamic, long-term relationships with many of the world’s largest, most sophisticated investors. Because of this focus, our customers are confident that we are well positioned to grow with them and continue to meet their needs in the future. The confidence our customers have in us is reflected in the length and depth of our customer relationships. Our top 100 customers have been with us for an average of 14 years and use an average of 12.3 State Street products. Approximately 75% of our new revenue comes from expanding our relationships with existing customers. Given these points, cross-sell opportunities and focus are integral parts of our business strategy.
What challenges and opportunities are arising for custodians that extend from the ongoing diversification of assets by fund managers into areas such as structured products and property? Has this led to reduced fee income from traditional equity/fixed-income business and, if so, given that custody is a business that is dependent on economies of scale, what are the consequences for overall cost of delivery?

The growth of new asset types in recent years is a proper evolvement of fund management techniques that will benefit the global financial institution markets and custodians must actively support this.  Controlled and co-operative development with fund managers is fundamental in managing the operational support to such new products.  Systems development and automation may not always keep up with the creativity of new asset classes leading to higher production costs that the industry generally, and its consumers, will have to accept, certainly in the short term.  Innovation must be encouraged even if in the early stages of a new product coming to market they do not fit into the ‘scale’ side of the custodian’s business. Proper pricing of such products and services should enable the custodians to reinvest in the potential automation, which in turn will reduce the costs for the future.  In that way the industry has always progressed and absorbed the unusual into being the norm. Danloy: Fund managers are increasing their use of structured/complex products and property via specialised vehicles (such as hedge fund) and softening of on-shore regulations. Since these products are unique, tailor-made and not publicly valued there is a need for an independent pricing and for a M/O to capture the trades and process them in the most automatic way possible: the existing plain-vanilla M/O are not equipped.  The markets for structured products and property are specific and complex compared to the equity/fixed income business, thus the synergies are very limited. Caverly: Increasing complexity across the industry is one of the greatest challenges for custodians. At State Street, our experience in handling the most complex transactions and strategies has enabled us to view complexity as more of an opportunity than a challenge — it’s precisely what we do best. Meeting the changing needs of fund managers as they move into structured products and property, for example, is a natural extension of our traditional product offering, and not dissimilar from our entrance into the hedge funds market a few years ago. We are committed to innovation, even in times of down markets and financial results, as a means to developing the products and services that our customers seek.
What current or potential regulatory obstacles do you envisage for your business?

The homogenisation of markets, with Europe being a key example, will continue to give global custodians a challenge in meeting regulatory requirements.  These are not obstacles, they are challenges that are designed to protect the confidence of the end consumer and in many environments encourage the transportability of investment monies to the most efficient and risk controlled geographies. The proper emergence of corporate governance transparency and the need for greater client reporting and management information has challenged custodians to extract and represent relevant data in a whole new way. Custodians have become much more pro-active in individually and collectively working with regulators across regions and borders to tackle common and wide-ranging issues.  The protection of consumer confidence is a key driver for the global regulators many of whom are moving towards a principle rather than rules based-approach.  This shows the confidence that the regulators have in working with major custodians over how the industry is governed going forward. Danloy: The EU is helping a lot the funds industry by launching key initiatives (adjustments of UCITS III, white paper, expert groups on real estate and private equity…) The interpretation and application of European directives are not the same across the member states and generate developments that limit the expected economies of scale Local regulatory restrictions slow down the development of the business. Caverly: There is no denying that we are operating in a changing regulatory environment. New regulations are designed to provide more transparency and more accountability, which is a good thing. Although regulatory requirements pose new challenges for the industry, experienced service providers can be valuable partners in helping firms navigate these changes, creating significant opportunities. Consider the Specialised Investment Funds (SIF) law adopted by the Luxembourg Parliament on 13 February, which opens the Luxembourg market to broader investment opportunities. SIF, like other regulatory requirements, opens the door to a wider investment spectrum with the potential for higher investment returns for investors, while presenting important opportunities for managers to develop new products and access a new marketplace. Service providers who have the experience in dealing with complex fund structures, coupled with local, on-the-ground resources to help navigate these changing regulations have an enormous opportunity to showcase their expertise.
A number of fund managers are showing a significant and longer-term interest in Eastern European markets. Do you have an Eastern European strategy and can you explain it?

Custodians have always been at the forefront of investigating and assessing the viability of administrative support in new markets. The opportunities in Eastern Europe are no different. The key to proper development in these markets is being aware, through regular dialogue with fund managers, of the countries that are being considered for investment.  Linking this likelihood with your sub-custodian network enables the custodian to evaluate the systemic risk, regulatory requirements and costs of supporting particular markets. Any custodian considered as a global player will have experienced entering new and emerging markets and Eastern Europe is clearly one that politically and economically is rapidly growing in importance. Custodians have a vital role to play in advising fund managers on the risks of safeguarding assets and securing entitlements in new markets. Danloy: Eastern Europe shows a strong growth versus the rest of Europe. SG is one of the main banking investors in this region with a significant presence in Albania, Bulgaria, Croatia, Cyprus, Czech Republic, Georgia, Greece, Moldova, Republic of Macedonia, Montenegro, Poland, Romania, Serbia, Slovakia, Slovenia.   We leverage this by building a unique SG custody service with on-site teams guaranteeing the safety of fund managers’ assets and services, homogeneous and in line with the high quality standards of SGSS. Caverly: Although Central and Eastern European markets are still relatively immature, they are growing at 15% to 20% annually, significantly outpacing more developed markets. In another five to ten years these countries could grow to be very attractive. To have a significant presence in Eastern Europe at that stage means investing in these markets now. To that end, State Street is looking at Poland as a processing centre for custodian operations in Eastern Europe. Poland is the sixth most populated member state of the European Union and one of the most successful examples of the transition from a partially state-capitalist market economy to a primarily privately owned market economy. The Baltic States, with their focus on the pension industry, is another area of interest in Eastern Europe that State Street is carefully monitoring. © fe July 2007

Executive Interviews

INTERVIEW: Put your money where your mouth is

Jun 10, 2016

At Kempen Capital Management, they believe portfolio managers should invest in their own funds. David Stevenson talks to Lars Dijkstra, CIO of the €42 billion manager.

EXECUTIVE INTERVIEW: ‘Volatility is the name of the game’

May 13, 2016

Axa Investment Managers chief executive officer, Andrea Rossi, talks to David Stevenson about bringing all his firm’s subsidiaries under one name and the opportunities that a difficult market...


ROUNDTABLE: Beyond the hype

Oct 13, 2016

The use of smart beta investing continues to grow. Our panel, made up of both providers and users, discusses what the strategy actually means, how it should be used and the kind of pitfalls that may arise when using this innovative investment technique.

MIFID II ROUNDTABLE: Following the direction of travel

Sep 07, 2016

Fund management firms Aberdeen and HSBC Global meet with specialist providers to speak about how the industry is evolving towards MiFID II.