Making the non-mega custodians mega

Custodians outside of the mega players, like BNY Mellon and State Street, will need revolutionary thinking to remain competitive.

In a recent article, Joe Parsons questioned the impact that the new, external to the industry, CEO’s would have on three of the major industry players. These were the mega custodians, BNY Mellon and State Street Bank. There was also Northern Trust, which has similar characteristics to State Street in business mix but faces similar challenges to the other non-mega market players. In fact, all bar the top four or five players in the market have a major challenge. They need revolutionary thinking to avoid profit attrition, product degradation and a slow burn to oblivion.

So, what is the problem?  It is technology spend, people, buy-side dynamics, re-engineering of the business architecture and unseen competition. And the solutions? They must be different for the 15 or so non-mega players from those they are adopting. There will always be niche suppliers, perhaps geographic for specialised products, but being a mini-mega custodian is definitely not an option.

Technology spend by the mega players exceeds the gross revenues of many of the lesser ones. That is no automatic panacea as one can spend and deliver poor technology, but it is a major competitive advantage. The reality is that we appear to be on the cusp of a major re-engineering of IT architectures. At one level firms are moving to functional convergence; using the same platform in different business lines by focusing on the 90% which is comparable rather than the 10% which is different.

At another level, firms need to consider where they have competitive advantage or where they could outsource into utilities to achieve better performance. Furthermore, there is a need to consider using facilities managers, leveraging more cloud technologies, using artificial intelligence (AI) to better cost advantage and creating possible cooperatives with competitors to reduce the unit cost of investment. In effect, the future has to be more unified supply chains and greater automation. Technology is a barrier for most that budgets cannot overcome; sharing technologies is a solution that few will be able to avoid.

AI should be able to decimate the operational labour force and also some of the front-end information provider functions. You do not need people for 90% of settlement as it is automatic or logically iterative. You do not need people to pass information or explain data or information sent unless your delivery tools are sub-standard. You do need people to understand client needs, offer advice on enhancing client processes and being able to communicate these into requirements that can be met by the business. You do not need people to communicate or calculate the bulk of fund pricing or compliance with fund prospectuses as AI will do it better and faster. You may need less offshoring, quite simply because a large number of those roles are capable of being automated. In reality, you need less people but more skilled and more broadly trained; inevitably that also means better paid or costlier depending on your viewpoint.

Buy-side dynamics will also change. The OECD world is becoming more of a savings consumer than a savings accumulator. The emerging world population dynamics mean they lag the OECD world by around a quarter of a century. Governments and government bodies will continue to be split between the deficit and surplus nations although there will be changes in wealth dynamics as natural resources decline in importance for several currently mega-rich countries.

This will mean a continued shift to the East for savings and, unless people really believe in a permanent bull market, a sharp decline in index trackers, whether surrogate or not, and a shift to cash equivalents or, for the less risk averse, absolute return fund styles. There is also likely, in an electronic age with the millennials passing through middle-age, for savings in the OECD to become more personalised rather than single institution-based. This will lead to data challenges, service challenges, risk considerations and severe price competition from an impatient population with a desire for instant information and real time execution.

Market architectures will change. We need only to look at the change in the ICSD infrastructures over the last two decades as they moved from custodians of physical certificates to data powerhouses covering asset servicing, settlement, stock finance, collateral services and more. They are likely to have a fiduciary role in the inevitable single ledger environment. But they, and also entities such as SWIFT in the public-sector and various specialised service providers in the private-sector, are likely to become the facilitators for the shared services I already noted. However, this area of expansion will prove a battle ground with the mega players wanting to keep the space for themselves and possibly anti-infrastructure luddites preferring oblivion to compromise.

It would also be illogical to assume that competition will remain static. First, I suspect that technology will disintermediate some by offering niche solutions for services, especially if there is real progress over the coming decade or so in blockchain and other technologies. Technology has its limits as we can see from the tribulations of the self-drive automobile or the data challenges of Facebook. But our industry is still in the early industrialisation phase and we have a long way to go to hit those type of barriers. Second, I would expect the major banks in the Far East, especially in China, to move into the market in greater force and capture a large share of the indigenous, regional and inbound markets. And there is always the wild card, the disrupter that destroys the business model, although regulation is likely to temper that risk quite substantially.

So how should the market tackle the issues? For the non-mega players there is a need to recognise that go it alone is risky, costly and potentially ineffective. They need to think cooperation and outsourcing, especially in areas of zero or low level competitive advantage, which really straddles the whole of core processing and also traditional areas of perceived value added such as fund pricing, fund compliance or even areas of fund reporting. They need to have a sound people strategy in terms of recruitment, competencies, change ability and, above all, training. They have to gain internal alignment to ensure that they are not building multiple versions of essentially the same platforms and using excessive people to support those platforms.

They should plan for material reductions in returns, especially if the markets fall and they lose a decent percentage of their market appreciation endowment benefits. And knowing this is all likely to happen at a time of potentially increased competition, some of the mega players should consider platform sharing for they are not all rich enough to implement their likely investment plans if the market moves to a true bear market. After all, they need to retain shareholder loyalty which is inevitably geared to share price performance and return on equity. And with signs of growing pressure on corporate profitability, increased insularity in approaches to capital and trade flows as well as countries eying the corporate sector to satiate their appetite for new sources of revenue to accommodate their burgeoning social security programmes, that is no minor risk!