Senior representatives from custody banks discuss the changes taking place around the pricing of custody and related services against a backdrop of increasing regulatory risk. They also consider the evolution of outsourcing and changes in OTC derivatives processing. Edited by Nick Fitzpatrick.
Etienne Deniau (Société Générale Securities Services), Drew Douglas (HSBC Securities Services)
Frank Froud (BNY Mellon Asset Servicing), Jervis Smith (Citi)
Funds Europe: As of July 2011, how do you feel about the business outlook for asset management and asset servicing? And how do you compare it with one year ago?
Frank Froud, BNY Mellon: The asset management and asset servicing businesses are moving closer together. The risk-reward profile has changed hugely in the last eleven years. And looking towards 2015, once the 25 pieces of major Emea [Europe, the Middle East and Africa] legislation have been enacted, it will have changed fundamentally again.
Risks are getting riskier. Regulations are getting more difficult to understand. The value chain has got a value to it that the end investor is prepared to pay for, but I’m seeing increasing pressures for asset servicing providers to get involved in more fiduciary oversight of the value chain – and I’m not quite sure how we’re going to factor that risk and the cost of providing those services into the new business model that will evolve from 2015.
Jervis Smith, Citi: Clearly, both the asset management and asset servicing businesses have one thing in common: a lot of their revenues stem from assets under management [AuM], whether it’s assets under management of their clients in the case of asset servicing organisations, or pure assets under management.
In light of this, most people I talk to, or who respond to surveys, feel that the asset management business is at a fairly stable stage now in 2011 – perhaps in some respects more stable than it was a year ago.
However, it may be less positive in its outlook.
A year ago people were saying, ‘Well, the worst is over and now we should be going gang-busters’. But this year people are probably a little bit more balanced in their outlook.
Everybody is expecting single-figure growth in assets under management, which is a concern for asset managers as the growth is coming from market growth rather than inflows.
On the asset servicing side, in our business I think that the lack of volatility has an impact. When things are very stable we don’t see the same type of volumes in the broker-dealer business or on the bank side.
Drew Douglas, HSBC: I agree that asset management and asset servicing are coming closer together, and that it has implications for outsourcing. This closeness may well represent increased opportunity for fee revenue – but I think the outsourcing model is also going to change with more of a focus on standardisation.
On the point about regulation: it’s not just the mere 25 pieces that create a challenge, it’s also about the changing interpretation of existing regulations. I think that’s where there are big surprises in store for the asset servicers’ world. For example, exactly which derivatives are in scope in Dodd-Frank? [Wall Street Reform and Consumer Protection Act.] And there is the question of exactly how and when to segregate collateral.
There is no doubt there will be an overall increase in cost with all this regulatory change and the increased fiduciary obligation of asset managers and service providers combined. Whether a portion of this cost is transferred from the asset manager to the asset servicer through an outsource model which we are seeing more of, it will still hit the investor’s account at the end of the day.
Etienne Deniau, Société Générale: It is very clear that responsibilities have increased for asset servicers during the past two to three years, and they will increase even more over the next two years, too. But it is not clear how costs could be passed on to the funds themselves because funds have prospectuses that state rates and these cannot be increased. This means it is only new funds that could see any increases.
What I have noticed is that continental asset managers over the past year seem to have concentrated their asset management capabilities, so where they used to have many offices throughout Europe, they now gather in just a few offices. All the investment management staff are gathered in one or two offices. For example, the generic equity strategy is in one location, the bond team in another, or perhaps all are in one location. This is new.
The possible reason for this is that they may be trying to take advantage of the new European passport. This will make it easier to distribute funds in the coming years.
Smith: One of the interesting dilemmas for organisations that provide services to the asset management industry – whether investment banks or asset servicing organisations – is that flows into funds are increasingly concentrated on a small number of houses, so while you can look at the overall market and say, ‘Great! Everything is going up’, it depends on who your clients are and whether their increased funds under management actually translate into additional revenues. That’s an interesting dynamic that we probably didn’t see to this extent before the credit crunch.
Froud: I agree – if you’ve picked your clients carefully, they will be the ones doing well; if you haven’t, then you will see net outflows.
Smith: That’s particularly acute in the hedge fund space. There is a real movement towards certain houses and that means that hedge fund administrators who are dealing with lots of little hedge fund managers may encounter problems with their margins.
Douglas: This is why there have been a few more acquisitions of boutique outfits recently. Consolidation does mean a shift of assets and, in a way, what we have probably all seen is a concentration in all of our portfolios and a shrinking of stand-alone boutique managers. So with consolidation in asset management, there is going to be the same thing within our service environment as well.
The Alternative Investment Fund Managers (Aifm) Directive is pushing service provider consolidation. The interesting piece for me is that before the financial crisis it was about diversification of counterparty risk, yet regulation is putting and consolidating fiduciary counterparty risk into single depositories. So while managers will be forced to choose stronger financial institutions, regulators are still focusing any asset manager towards fewer players within the industry.
Funds Europe: It is perceived that custody banks will compensate themselves for lower revenues from less profitable clients by charging them less favourable FX fees or offering lower interest on cash balances compared to the terms offered to more profitable clients. In light of legal issues this has thrown up in the US, is it time to be more transparent in terms of these fees?
Deniau: Some asset managers are now requesting maximum spreads on their FX transactions. This means they want to know in advance the margin according to the currency that they trade. They want us to publish key performance indicators (KPIs) on FX, so they know exactly what our maximum revenues could be. More and more customers are requesting KPIs on FX.
Smith: Custody was underpriced for many years on the assumption that there were other aspects of the relationship that might subsidise the custody fee, but these have now come under more scrutiny, and quite rightly so. But that means that you then need to look at how you price your custody more realistically for the risks and the work that goes into running these businesses.
We discussed this with an advisory board of our clients recently and they’re all unanimous in saying that there should be more transparency around how custody is priced, but we would all welcome that because it means we can price our custody properly instead of it being assumed that it will somehow be subsidised by other activities. It’s a healthy thing for the industry but it is a difference of approach and it is client driven; it’s not that the custody banks have changed the way they did business, it’s the pressure they’re under from their clients.
Froud: European clients are much more sophisticated and understand what a ‘standing instruction’ foreign exchange is, and that it is at the low end of the market. Most of us around this table probably do not make money on 50% of those transactions and that’s the bulk of the FX business.
The really big-ticket items are negotiated, with traders asking brokers for the best prices. Standing instruction FX in support of the normal book of business is not as profitable.
Where our industry may not have done a good job is in explaining the difference between negotiated FX and standing instruction FX.
Douglas: I don’t believe there has ever been a desire to not be transparent about the differences between large-ticket items and high-volume-flow items. Nor do I think any bank has really had an issue in establishing the profitability of clients.
But I do think the issue comes down to the obligations of providing a custody service: what is the fiduciary obligation of the bank when providing global custody?
At the end of the day, when a bank provides a global custody service it is just one of many service providers to a client and the bank does not necessarily become responsible for the whole portfolio.
There is a clear distinction between being named as a depository or providing custody services to a fund. This has to be understood by the industry, and to what extent one is responsible for the entirety of the assets. These need to be separated out and appropriately priced. The first being a core custody service one would supply to any client, and the other being the fiduciary obligations attached to being a depository for a fund, which varies by jurisdiction and regulation around the globe.
Froud: Yes, and I feel that there is not enough clarity legally speaking about what those obligations are for different parts in the value chain, but we need it in order to understand the risks and price for them. These include operational risk and regulatory risk. And we also have to factor in the possibility that we are going to need much more highly-qualified people to support that degree of fiduciary oversight – people with actuarial-type skills, for example, and they are not cheap.
Deniau: The difference between global custody and the trustee depository aspects of the business are very important. Right now we are seeing movements related to this. For example, we are seeing many Cayman funds coming to the EU, in Dublin. We are seeing global custody customers establishing dedicated funds to make sure they benefit from trustee rules. We are seeing now more sovereign wealth fund portfolios being switched into dedicated funds that take advantage of a jurisdiction and its legal requirements around trustee laws. They want more safety for their assets.
Froud: I don’t think we’re in the custody business; I think we’re in the investment services business. We all represent companies that are in the intellectual property space if you look at the trust business in its wider sense.
The days when you can split these services up into discrete parts of the value chain and understand the risk and price them accordingly are gone. You have to look at the totality of the service in terms of investment services that we’re providing. I see people receptive to these discussions.
I was at the Fund Forum conference recently and this was a discussion I had with a number of people, whether they were consultants or clients, and they said they agreed with the principle and that they would have to watch how the fabric of the services business in Europe unwinds.
Smith: It is a massive opportunity in Europe – particularly as the landscape has been dominated by banks that have provided their subsidiary asset management companies with these types of services. As those subsidiaries’ demands increase for their providers to compete more with the competition, they will have to go to external providers. This means continued consolidation of the asset servicing business because those smaller European banks just won’t be able to compete on the basis of technology.
Funds Europe: Are asset managers any more realistic about the costs of outsourcing than they were five years ago? Do they accept the value of standardised processes over bespoke models? And where cost is important, can they accept the idea that cheaper costs may impact service quality?
Froud: I’ve had tangible, reassuring evidence when dealing with some of my clients recently that the debate has moved on from one about cost to one about who is better able to manage their risks for them. They are asking themselves if they really have the expertise to understand what all these changes to the industry mean.
We are spending a huge amount of money over the next three years making our systems capable of handling regulations such asTarget 2 Securities, Aifm, the RDR [retail distribution review] in the UK, and so people are talking to us about how best to manage these associated risks.
I pick my clients very carefully and we walk away from far more opportunities than we say yes to. I really need to understand the underlying reasons for a client to want to outsource, and if the reasons are good and if they are prepared to engage with us in almost a consultant-type fashion, then I think it will be successful relationship.
Deniau: People understand much better where their costs lie and their need now is to split up risk factor. They are ready to accept all investment risk, and usually execution risk, but they would like to get rid of the operational risk, which means outsourcing the back office and possibly the middle office.
Once they make an investment decision, and once the execution is done, they want to give everything else to a third party. They understand that there is then settlement risk, replacement risk and other risks, and that there could be difficulties in valuing these. They understand also that there can occasionally be a black-swan event, and they have to be priced too, which may not be easy. But my feeling is that they understand these issues now very well when we explain them.
Douglas: If there isn’t the desired shift to a standardised strategic architecture – which exists in different ways in all of our organisations – then a transition is not going to be as successful.
To a degree there is also a discussion around how to manage the transition to that kind of operating model. We believe that’s where our transition management skills as asset servicers needs to change. The issue is how we guide our clients through that path of conforming to a new model, as opposed to never getting there and running several fund platforms.
Smith: Another issue is the quality control of the service to the underlying clients on behalf of the asset management firms. Whether they are institutional or whether they are retail asset managers they have got clients who they have got to keep happy, so we discuss the price a client has got to achieve in terms of cost saving in order to justify losing that quality control.
Froud: One more point I would like to make is that asset managers are now much more aware of the cost to the potential suppliers of entering into an RFP [request for proposal] process. A really large process typically has ten to 15 workshops of 15 people bringing experts globally to a certain location; you can easily burn up significant calories doing that.
Funds Europe: To what extent are outsourcing decisions extending to the middle and front offices?
Smith: The immediate reaction is to ask why anybody would want to outsource their front office. It’s because asset management firms are becoming more specific about which asset classes they’re good at managing and firms are quite prepared to white label, to outsource, or to have funds of funds.
Where there is some outsourcing, although it may not be immediately defined as such, it is around managing asset classes like foreign exchange or index tracking, where you can outsource the trading desk and execution.
I wouldn’t say there’s a rush of people to outsource their execution desk but there are some thoughtful things, and I know some of our competitors have been beefing up on the execution side of the business. Of course, some of us have an investment bank alongside us that we can plug into for trade execution of foreign exchange or even equity.
Douglas: This raises the question of the definition of middle office, which is blurry. Even people within our own organisations will argue about where the cut-off line is. We definitely see this in the derivatives space: collateral management, for instance. Now is that front or middle office?
Some people put it in one pot and some people put it in the other, but definitely the outsourcing of and the creation of an efficient collateral management environment, especially with changing rates, is going to be something that people look to a service provider for.
Also, in the mechanics around trading in derivatives, there’s always a question of how to value derivatives. There’s certainly a desire to take a lot of the valuation components that we would use in a fund administration environment and make them more accessible to clients and as close to their front office as possible.
Froud: The willingness is there. We are seeing this in Germany where we did a deal to buy BHF’s asset servicing business a year ago. We’ve got quite a long line of small, medium-sized KAG [a type of German fund structure] functions that are coming to us, and we are picking the ones that we want to do business with. They’re not necessarily the biggest in terms of revenue, but they’re the ones that have the business model that is appropriate for us and ones that we can implement relatively quickly and cleanly. I think the answer is yes, there is a willingness to look at these functions.
Funds Europe: Eighty per cent of OTC derivatives will have to go on exchange by the end of the year as a result of Dodd-Frank and similar European regulation. How will this affect risk management, collateral management and stock lending? More broadly, how is the industry coping with increased regulation?
Deniau: This [OTC clearing] is a very complex subject. We are already seeing anonymous trading on MTS for bonds. When you are trading there, you don’t know if the bond is going to be cleared or settled. If the other counterparty is cleared and you are cleared, it will be cleared; but if your counterparty is not cleared it can only be settled, so you are not getting the same risk. Thus I am sceptical about anonymous OTC trading.
On the second layer we are seeing collateral management exploding. We are already 9% of tri-party repo in Europe and it is growing. It’s a huge, huge shift to tri-party repo.
Then on the CCP [central counterparty] we are facing the real question of systemic risk. Some CCPs with indefinite liabilities may create a huge domino effect, and CCP with liability limited to a given number might not be large enough according to the traded volumes, so something a bit more dynamic about the liability of the CCPs need to be found.
Froud: We could talk about Ucits IV, Target 2 Securities (T2S) or any of the 25 pieces of legislation, but it’s the totality of these things that matters. The solution to T2S might be in direct contrast to what is needed from an infrastructure perspective for Ucits IV.
It is understanding the net impact of all these things and making sure that you don’t put a solution in place for one which makes services for another one that much more difficult to deliver.
In the UK, you have to take a guess at some of these things. For the RDR, because of the lead time for putting in place the system fixes, you have to prepare twelve to 18 months beforehand. We’ve got to make an interpretation, find a solution for what we think it will be and then put it into the hopper and start building. Then, at the end of that process in 12 months’ time, we’ll say, ‘Here is your solution for RDR’.
It’s hugely expensive and I think the organisations around this table will be spending hundreds of millions of dollars getting their systems up to speed.
Douglas: I agree with you that it’s about infrastructure, but what’s interesting is all of our institutions are going to have a different view on T2S. Some of us have bricks and mortar on the ground and some of us are using supplier relationships, which certainly changes one’s focus. Some see it as an opportunity to enter Europe on a more cost-effective basis on behalf of our clients.
The two that I would add are the Aifm directive and Fatca [Foreign Account Tax Compliance Act].
Deniau: Fatca is the big one, for both asset managers and asset servicers. Aifm is the open door to Europe for non-European funds.
Douglas: Fatca is a big one for all of us. We believe it has significant potential to allow us to bring added value to our asset management community. One of our differentiators in the future will be around who the best service providers to the distribution platforms of our clients are, and getting Fatca right will be critical for our clients.
Froud: They’re going to look to us for support in order to provide the solution.
Douglas: Exactly, and what solutions are we bringing to the table? We have to move fast, because the deadline is right around the corner when you look at the amount of change that needs to take place.
Smith: Regulation has changed our role to be more of a strategic adviser as opposed to a back-office organisation. This is where the resources that our organisations can tap into take us into a different league from the more local and even regional providers, which just don’t have the resources. It has changed the relationship we have with our clients.
Froud: Clients are coming to us now seeking consultancy advisory services and saying, ‘Please interpret these things on our behalf’, and that’s unusual. They’re prepared to pay for that in some circumstances because the big global players are uniquely placed to explain what these things mean from a supply side and a buy side and to offer a market perspective. This is a trend that’s going to continue in the next five years or so.
Smith: The big change in our business has been the type of people that we have to recruit to take into account all of these changes. If you’re dealing in the middle office or the front office of an asset management company, you can’t put a custody guy in front of those people, they’re talking different languages. You have to go out and hire top-quality asset management operations people to discuss those matters.
Similarly, the regulatory dialogue means we’ve now got lawyers in our front office who are going out to see clients to talk about these issues, because it’s not the right thing to have a sales guy who’s selling middle-office outsourcing going in to talk about regulatory development. We’ve now got a cadre of lawyers and are using them specifically for this educational and advisory context.
There’s a total change of talent in the industry now. You’ve got investment bankers running our businesses, we’ve got corporate bankers running our relationships with clients. It’s got to be good for the industry to have that diversity and experience.
Froud: The other bit of regulation we should discuss is Solvency II. We’re getting a lot of interest around this for a variety of different reasons, not least because a lot of these large insurance companies are amalgams of small insurance companies. It’s a bit like where the asset management industry was ten or 15 years ago. They have a distributed set of platforms and what they need is a data aggregator, and as investment services people we have the ability to do that. That’s an interesting development in creating opportunities for the industry.
Smith: We talked about unintended consequences of regulation, and particularly as it pertains to cost, but Solvency II is a classic example which could actually completely backfire in terms of providing for pensions across Europe. If you make it unattractive to invest in equities from a regulatory point of view, from a capital point of view that’s going to lead to a drop in performance over a period of time.
This could lead to pensioners getting less to retire on as an unintended result of some very well meaning regulations about how insurance companies should be better capitalised. The fact that we haven’t seen too many insurance companies go bust historically means that perhaps people need to weigh up the risk and reward of that regulation a little bit more carefully than they have been doing.
Funds Europe: What new trends and products and services are you experiencing, and what new demands do you expect in the coming year?
Douglas: The amount we’re investing in what I would term ‘market intelligence’ and those individuals that can bring that value to the table has increased significantly, including technical, legal and regulatory expertise. We’re pulling all that together under a market intelligence focus. More and more we’re being asked as service providers, ‘What is your position? Where do you believe the industry is going? And does that align with the investments you’re making?’ Our clients want to know whether our view and investment strategy aligns with their business strategy.
And then automation of operations, we are still going to be under price pressure. How efficiently can you run your shop and how can you share that efficiency with me as an asset management company? How can your process add value to me, whether it be STP [straight-through processing] or data provision into our asset management? Whether that be through valuation or reconciliations and the rest of it? That’s the major technology investment we’re making and the people investment is around that market intelligence and thought leadership.
Deniau: I am seeing innovation in three different fields. One is risk management. We are seeing a huge demand on clearing and OTC clearing, and also on independent OTC product valuation. We have customers buying products from investment banks and they want us to compute independently the collateral management or re-compute the pricing because they don’t want to do that.
On the cost side, I see a lot of centralisation of asset management teams, because they are reshaping their portfolio of activities. Some want to outsource their back office because it’s not in their core strategy, or one wants to keep a highly specialised back office like a special situation corporate event management team because it’s crucial to the asset management operation.
In terms of the optimisation of revenue, I see that in distribution, finding new networks of distribution and finding new investors is key. What they require from us is a different approach. If there’s a new regulation, they want to discuss that regulation and see what solution we can build with them.
Froud: Just to reinforce what Etienne said, I think they’re looking for leadership from us. We’ve seen ourselves as a service provider or a business, I think we’re going to have to transform ourselves into a profession and provide leadership in the industry. People will willingly follow, but they’re looking for us to get it right.
Smith: We’ve picked up three trends. The first is globalisation. For instance, the movement of Asian asset managers coming to the West to distribute their products.
Then there’s urbanisation. The populations of the world are gradually going to live in cities, some of which we’ve never heard of but which have 20 million people, and the pressure that puts on the public sector. We’re seeing a lot of interesting demand from public sector organisations that previously haven’t been on our radar, and we see that on the cash management side as well as the securities side.
And last, the digitisation of the industry. The huge demand for data and people beginning to realise the value of the partnership with organisations that have the data. But also, how do you manage that data? Because it’s all very well the FSA wanting all these reports but have they got the capacity on their computers to store it, never mind to analyse it? Digitisation is going to be a very interesting trend in the next five years in our industry.
©2011 funds europe