The consolidation story in recent months has been driven by the likes of BNY Mellon and State Street. Both made acquisitions to give their alternative asset businesses more scale.
The risk theme is maintained by the proposed Alternative Investment Fund Managers (AIFM) Directive, which continues to be kicked and punched as it crawls through Europe.
AIFM could ultimately impose a stricter liability on custodians, meaning that if client assets were lost in cases like counterparty failures and fraud, or even a sovereign debt event, a custodian would have to stump up compensation even though blameless.
For the time being the custody business remains a scale game, with custodians much more likely to put the emphasis on the number of assets they keep under safekeeping, or the range of geographies and instruments they cover, while the smaller players might focus on their specialties. These factors are reflected in surveys such as ours.
But with AIFM, everything could change.
“This could change the dynamics of the industry. Right now it’s about scale, operational abilities and efficiencies, and about networks. It’s not about risk-based pricing. This would be a fundamental change,” says Andrew Gelb, Emea head of securities and funds services at Citi.
The emphasis could change from putting assets under custody in the spotlight, to a focus on the balance sheet strength of custodian banks and the financial stability of underlying sub-custodian networks. Custodians will need to demonstrate that they can effectively insure client portfolios when countries default or when urbane billionaire money managers are revealed to be common crooks.
|Strengthening the system
“If a custody bank is to be a shield against fat-tail events, like sovereign defaults or another Lehman Brothers, it will have to put up more capital. Today, most custodians run small balance sheets. But if the industry ends up underwriting fat-tail risk, then more capital may have to be deployed.,” says Gelb.Beyond Europe and into emerging markets, it is Citi and HSBC who are almost certainly the most self-supporting banks in terms of sub-custody.
The focus in sub-custody will be on strong representative banks in countries, especially emerging markets, where global custodians support their fund manager clients. Certain custodians have, or could build, their own proprietary networks and those that can will almost certainly claim this to be a competitive advantage.
Our survey & directory, which focuses on Europe, shows that Citi is virtually its own sub-custodian in many European markets. HSBC Securities Services has reasonable self-provision in Europe, and BNP Paribas Securities Services has considerable coverage.
Notably, in the case of Greece – a situation that would have strongly tested a custodian’s nerve over the past year if the strict liability rule proposed under AIFM had been in place – each of these three banks has self-coverage.
“We probably have one of the largest sub-custody networks in Asia and the Middle East. As a business, we have grown from east to west, rather than in the other direction,” says Drew Douglas, co-CEO of HSBC Securities Services. “We do not outsource components of our sub-custody and provide this service from the ground only where the HSBC Group has a presence. I believe global custodians will value this more and more.”
But there is still a big question about how workable the ‘strict liability’ requirement under AIFM is.
“The more liability a custodian takes on, the greater the need to commit additional capital and pass on these costs to clients,” says Douglas. “This could also drive the need to put certain assets on to the balance sheet from a contingent liability perspective. Of course, this is somewhat counterintuitive as a core component of a sound custody model is to segregate or secure client assets from the balance sheets of banks.”
All this will only really matter if the AIFM Directive comes into force in its present form, and many people, like David Curtin, assistant general counsel for Northern Trust, are hopeful that policymakers in Europe are realising the impact of AIFM on business models.
“Fewer and fewer countries are toeing the line now over this issue. It seems to be coming back as a real concern,” he says.
A STEADY INCOME IN UNCERTAIN TIMES
HSBC returned to double-digit profitability recently, but what part did global custody play?
HSBC Group’s interim results, received with great fanfare in August, showed a return to double-digit profit. Since 2006, two years before the collapse of Lehman Brothers, HSBC’s pre-tax interim profits went from $12.51bn (€8.12bn), down to $5.01bn in 2009, and back up to $11.10bn in the first half of this year.
Meanwhile, income from custody services has swung much less dramatically, remaining fairly level since 2006. In the first half of that year, net fee income was $423m. It peaked in the first half of 2008 with a $757m contribution, while its latest interim report shows $439m in net fees were made.
Global custody’s contribution to group net fee income so far this year stands at just over 5%.
The figures may not raise the roof at Canary Wharf, but doesn’t the fairly smooth journey for custody fees demonstrate the benefit to universal banks of running a securities services business, namely a stable, annuity-like income?
“Yes,” says Drew Douglas, co-head of HSBC Securities Service. “We have several legs to our business: global custody, sub-custody, fund services, corporate trust and loan agency. Where one business might be affected by market trends, the others may not be. For example, sub-custody does not involve agency lending, so this business was not subject to the problems created from reduced lending that global custody businesses were subject to.”
This year’s interim results were affected by low interest rates, which hinder custody banks in general. “Spread compression” is cited in the interim report as a drag on custody fees.
Says Douglas: “Almost all businesses have been affected to some degree by the economic downturn, most significantly on the net interest and FX side. This is why annuity income from securities services is so attractive.
“Consequently, we have been quite focused on maintaining and increasing market share over the recent period which also explains part of our positive results.”
Since 2006 the unit has remained, on average, as the seventh best contributor in net fees out of 16 business lines, which includes credit cards and broking income.