Reading the Global Custodian article on the race for $50 trillion of assets in the industry made me reflect on the growth of assets and the collapse of margins over the last decade or so. In that period, assets on average grew around three-fold and gross revenues in many cases by less than 50%. And bottom lines will not have kept up with gross revenues.
The reasons for these trends are self-evident. Assets under custody across the industry are a function of not only market appreciation but also new issuance and outsourcing. After all the S&P 500 since 2010 showed a stellar return of around 400%.
The Baa average US bond yield is pretty unchanged during the period though and thus bond portfolio growth has been more a reflection of issuance at times of low yields rather than the sharp value appreciation we saw in the period prior to 2010.
And, although new outsourcing opportunities have led to much debate over the last decade, the market looks more like having restacked the deckchairs than massively changed the slow burn trend to date to outsource. In effect, unsurprisingly, the biggest growth source across the custody business continues to be firstly market appreciation and new issuance, secondly M&A and finally net new business.
The risk and cost profiles have changed dramatically. Although the portfolio configuration of most custodians, with a growth of higher priced alternative and, more recently, private assets, has led to gross margins falling less than they otherwise would, the reality is the portfolio risk of custodians has increased whilst the portfolio priced risk has fallen.
Ad valorem fees, whether through the administrator or the custody areas, are still the major source of revenues. The balance, primarily transaction fees, lending income, foreign exchange spreads and net interest income are the other main contributors.
In a normally efficient market with high levels of STP, the fully loaded cost of asset servicing is likely to be in the 50-70% range of ad valorem fees and that assumes a reasonable level of technology spend. The residual figure is the risk premium for asset safety. I have to admit that is the cheapest insurance in the marketplace and I challenge readers to find a reputable reinsurer who would give them a meaningful stop loss package within those rates.
Non-ad valorem fees make a further contribution to the bottom line and most have a direct bank capital allocation requirement and it may be argued that their contribution increases on a portfolio basis the headroom for other risk absorption. But one also needs to leave room for an economic return from the business!
Costs in our industry are heavily weighted to headcount, both within the business and for many through recharges for shared services. Although automation is leading to reductions in headcount, we will continue to see higher per capita costs as the skill base of our people needs to increase.
Technology will also be ever more costly with further Fintech custody initiatives but this could be mitigated through cloud usage and other shared services. And we need to one day sort out the elephant in the room for legacy remains and it will need more than clever APIs and other interfaces to resolve.
To flourish, the industry needs volumes and a growth in available assets. The reality is that the most profitable periods in markets are in bull phases or when there is a sharp fall. We are at a risky juncture with most indicators suggesting that, although some individual markets remain under-priced relative to their peers, markets as a whole are fully valued.
A bear market adds pressure on clients to cut costs, leading to lost income from ad valorem and less activity translates into lower transaction fees, associated foreign exchange and lending revenues, although NII may hold up on higher rates on reduced balances.
When I was in the saddle at my former firms, I considered a 70% cost to income ratio at peak markets as the absolute minimum acceptable in any location to avoid a bear market loss for the business in a downturn given that asset servicing revenues are quite indexed to market levels while only around 20% of costs can be eliminated in a bear market and these relate primarily to sub agent custody fees.
The market is now more fragile than a decade ago from a revenue perspective but more manageable from a cost angle. I have often commented on the problems of scale, primarily around customer service. In the past customer service was heavily operational, it is now hugely value added and specialised.
Added assets do not lead to a linear increase in day-to-day service management. Portfolio diversification will lead to demand for new skills, which in turn may lead to more people. But many of those skills are also inherent in the financial institutions and treasury groups, now closely aligned to the business, and as such are easier to manage in a more cost-effective way.
Allied to this we can expect further detailed changes in regulation with more granular and all- embracing reporting as well as a step change in the regulation of digital assets. Hopefully, those who have invested in managing their data will be able to accommodate such changes far better than in the early days of client and market reporting.
In this environment, scale becomes a greater value than in the past and the planned acquisition of BBH by State Street Bank is a case in point. It is a clever acquisition because it is less of a material product extension in the footsteps of deals such as Charles River although it takes State Street into sub-custody in a meaningful way. It does add scale in areas where cost can be shed on a like-for-like basis. It also provides product growth potential through cross sales and a larger balance sheet. It looks a sound template for others to follow.
But what of the custodians who remain for we have seen both global and niche regional custodians shedding unattractive or unprofitable businesses? There will always be niches but they are fast disappearing for the business remains global, is adopting more and more universal standards, and scale works.
The biggest danger is in the “squeezed middle” but who are they? If they are the sub $10 trillion asset holders, that is no big issue but if one goes further up the chain, concentration risk becomes an issue both for clients and regulators.
European consolidation would appear easier than global consolidation given North American top players are either too big or may face regulatory challenges if they aim high.
One thing is certain as we cross the $50 trillion barrier, M&A will be a lead agenda item of many strategy meetings in the days ahead.