We live in dangerous times! Custodian profitability is coming under acute pressure. Historically custodians were used to 6-10% compound growth in stock exchange equity values; in the last five to ten years those returns have ranged from neutral to negative. In the past, market appreciation compensated custodians for the historic estimated average 7% compound decrease in nominal custodian fees. Unfortunately, at the same time as stock exchange values have failed to grow, fee attrition has climbed toward a compound 10% per annum level.
And, if that squeeze were not enough, custodian revenues have been hit by other adverse factors. There has been more industry consolidation, at fund and bank level, meaning fee reductions for scale, and, in a largely fixed-cost industry, this will not have been reflected fully in cost reductions. There has been a flight to safety following losses and potential lawsuits, especially in the collateral management and foreign exchange area. Using the yield curve to improve returns on cash collateral, using mortgage-backed securities as collateral investment vehicles, and alleged gouging on foreign exchange transactions have all cost custodians, or are likely to cost custodians, money. At the minimum, they are leading to more conservative approaches in these areas, and that translates into lower margins.
We also have had the emergence of the all-purpose mega custodian. Their complex corporate structures mean economies of scale are being replaced by the cost of complexity.
On the cost side, salary costs as wellcontinue to defy gravity with the industry struggling to find its pay niche between the different compensation policies of prime brokers, investment bankers, asset managers and commercial bankers. Compliance is becoming an added burden with the risk that fines and penalties will soon overtake the soaring cost of the compliance teams. And technology maintains its grip on anything up to 20% of a custodians cost base, with new reporting and new products requiring both renewal of IT architectures and an ever-wider interlinking of different product components.
The hedge fund industry still manages to charge high fees with the 2+20% fee structure being retained in many parts of the industry. But the relative performance of absolute value funds, as well as the blending of the traditional long-only and alternative sectors, means they will not defy logic forever. As fund fees decline, they push on their cost sources, and those include the prime broker, fund administrator or global custodian. In turn, these look for reciprocal fee reductions from their sub-custodians.
The final adverse factor must be capital. More capital will have to be allocated to the business given the risk attribution in the market, whether in the new UCITS or MiFID rules, AIFMD or CSD regulation. Intraday risks will undoubtedly be captured soon by the regulators handbook, leading to a requirement for ever more capital.
A white knight in the form of a bull market does not appear too close to the horizon. The industry must hope it can monetize fast some of its new products, see rapid further custodian consolidation (at least where that remains a panacea) or the hatchet will come down on the cost side. Could the next trend be a shrinking of scope and scale across the industry? Only time will tell.