Asset managers are forging more rigorous contracts with their custodians. Nick Fitzpatrick says the changes, which could affect prices, are revolutionary for an industry that’s three decades in the making...
Three decades after custody banks began to persuade pension funds and asset management businesses that their assets would be safer and more efficiently administered if custodians looked after them, the Lehman Brothers collapse of September 2008 and the more recent Bernard Madoff scandal have put these claims to the test.
Largely, the industry has proved itself, yet custody is nevertheless changing.
Apart from regulatory-led initiatives (see separate article, p40-42), clients are recasting contractual agreements themselves. Investors who were shaken by the impact of sub-prime-related chaos are much more rigorous about their custodians’ duties and obligations when it comes to keeping assets secure, custody executives report.
And a further change that some anticipate is that more onerous duties for custodians could increase the price of custody-related services.
The outcome for costs is still uncertain and not everyone sees an upward price move as inevitable. But what does appear certain is that clients are not waiting for regulators to tighten up the scope of a custodian’s responsibility. Instead they are taking steps themselves to make contracts watertight. There is a move by investors to try and contractually capture every main eventuality that the financial crisis has taught them about and to determine how liable their custodians are when things go badly wrong.
One topic is whether or not custodians should return assets – at their own expense – if a broker fails while those assets are in transit.
There is no consistency in European law about this, but France has firmly dealt with the issue – and not in favour of custody banks.
Following a 2009 legal case involving custodians RBC Dexia Investors Services and Société Générale Securities Services, together with asset managers Lafitte Capital, Delta Alternative Management and Day Trade Asset Management, a French court determined that a custodian must return all assets immediately – a so-called ‘absolute obligation’ – even if the assets are then only partially returned to the custodian when insolvency proceedings against the intermediary are finished.
The case was complicated and centred on assets used by prime brokers for collateral and rehypothecation. The ruling is a comfort for asset managers, but a problem for custodians. For the AMF, the French regulator, it can now boast a higher level of regulatory protection for fund shareholders.
Speaking about the broader market, Margaret Harwood-Jones, head of institutional investors at BNP Paribas Securities Services, says: “I can see some contractual agreements in the industry changing and new examples of best practices emerging.”
She says that another subject of contractual scrutiny, which also plays to the fears about counterparty failures that Lehman produced, is the extent to which custodians check the integrity of their sub-custodian network.
“Pre-crisis, it did not matter so much to clients of a global custodian which sub-custody banks they used. But network management is far more important to clients now,” says Harwood-Jones.
As an example, she says that clients want to know if a sub-custodian commingles client assets with its own assets, which could leave clients at risk if the custodian turns insolvent.
“Global custodians have to demonstrate that our sub-custodians have segregated third-party assets on a client-by-client basis and that there is no commingling,” Harwood-Jones says.
Another area of focus is the level of compensation offered by custodians.
Göran Fors, global head of custody at Nordic banking group SEB, says: “Clients want to see exactly how they will be indemnified. We see changes in the way institutions are evaluating new providers and the level of indemnification is a part of that criteria.”
But it could also be that the increased scrutiny of custodians is leading to a greater appreciation of the custodian’s job.
Daron Pearce, head of relationship management, Emea, at BNY Mellon Asset Servicing, says: “The custody market has been fundamentally shaken and it has brought home the fact that there is risk in custody.”
An example, and again related to commingling, is that when investors retreated from equities into cash as markets began to shake, they realised that their cash was held on the custodian’s balance sheet and not segregated in the way their equities generally were. Therefore clients might favour a bank with a strong credit rating to reduce risk in their cash holdings.
But they may also appreciate that stable custodians can charge a premium related to this stability, too. If the risks associated with custody and the manner in which custodians can control these risks are understood better, it may well give custodians a chance to revisit the risk-reward discussion without feeling too uncomfortable about it.
At least, this is the kind of argument custodians are edging towards. There is a lot of talk in the industry at present about repricing services in order to wean revenues off basis-point charges related to assets, and to reprice in accordance with risk.
Asked about this, Pearce says: “When we look at our own pricing there is more realism on behalf of buyers now. People accept custodians have to price for risk.”
He adds: “People thought custody was just a commodity. Now they recognise that the investment in technology we make, stability, and balance sheet strength are all important and differentiating factors.”
Given the court ruling in France, there is little wonder that the cost of French custody may increase. This was a view indicated in Funds Europe (May 2009) by François Marion, chairman of Caceis Group, a French banking firm that operates custody services.
“France is the European market where prices for custody, depositary and fund services are the lowest. Therefore, if it appears that the French market charges the lowest price but bears the higher risk, then an adjustment will be necessary,” he said at the time.
Harwood-Jones, at BNP Paribas, believes that increased automation in custody could offset upward pressure on costs. But there is still a pinch point. She says that the higher costs of borrowing money could impact clients’ pockets.
“There are credit risk-related elements that exist within the custody product where we advance money to clients. The cost of capital to all banks is much higher than it was before the financial crisis so all finance activity is experiencing significantly higher costs. If levels stay where they are, it’s easy to see that in some cases this may have to be shared with the client.”
A greater awareness of risk and the contractual measures used to deal with it have consequences for clients beyond cost, though.
Fors, at SEB, says that some custodians simply might not risk entering certain markets where financial instability is high due to substandard financial infrastructure – for example, lacking a strong central counterparty, or where laws around sub-custody do not require funds to be segregated.
“It will be difficult for custodians to take on all the risks that exist in specific markets,” says Fors.
Similarly, Bruno Prigent, deputy head of Société Générale Securities Services, says: “The Lehman Brothers and Madoff episodes helped us identify clearly the different risks that we have when we provide depositary services or fund administration services. Now we have to address these different risks by identifying the consequence for different services. This might mean increasing prices, or discontinuing a particular service.”
If the menu of services does shrink, although large custodians may continue to swing their leverage to offer a long list of custody-related functions, the shrinking menu may open up the market to niche players to fill the gaps where other custodians pull out or can’t compete.
Pearce, At BNY Mellon, says that in Q2 this year, activity in custody and related asset servicing picked up as asset managers returned to focus on operational issues, such as outsourcing back-office functions.
Custody has long-since matured and it is now rare to find a pension fund or asset manager that does not outsource its own custody operations.
But over the past ten years custody banks have sought to boost revenues and differentiate themselves by rolling out value-added services such as fund administration, fund accounting and performance measurement. More recently custodians have competed fiercely to provide services related to the newly popular alternative investments industry, such as the pricing, settlement and accounting for esoteric instruments and complex strategies.
These services are offered on a best-of-breed, or component, basis, or they are bundled together with traditional custody. Pearce says asset managers continue to consider both options.
Bundling has been criticised in the past for fuzzy pricing. But if custodians do price for risk, or offer more concentrated services in competition with specialist providers, it could be expected that pricing will become less opaque.
A combination of regulatory change, client scrutiny and custodian realism is threatening to force up custody costs. Custodians hope clients will be philosophical about this if it happens.
At least custodians have, by and large, demonstrated their value. Speaking of BNY Mellon, Nadine Chakar, head of Emea at BNY Mellon Asset Servicing, told Funds Europe last October: “This episode [Lehman Brothers] tested us and it tested our methods.”
Changes in the custody landscape will continue to unfold in the coming year. For an industry that’s been ticking along for 30 years or so, the changes to be seen in the next twelve months could constitute a revolution.
©2009 funds europe