Survival of the Fittest

The New Year is always an excellent time for forecasters. Never has custody and its related businesses operated in such a fluid environment as we have today. Anyone who thinks it is business as usual is heading the way of the dinosaurs. Anyone who believes their role will not change is living in an unbelievable parallel universe.

Regulation is leading to dramatic changes in the post-trade infrastructure. The ICSD model will inevitably change, with some bifurcationhopefully legally and not operationallyof their banking and notary functions. The CSDs will change with the emasculation of their service provision in the eurozone, as they outsource their core settlement competence to the ECB, and become, at best, a switching mechanism in that process. CCPs are on a growth trend with regulatory demand that the OTC markets move to a more uniform and cleared model. New structures are appearing, be they data depositories, stock lending-related netting vehicles or collateral highways and freeways.

Competition remains acute as bankers scramble for substitute revenues to replace the drag on their profitability, resulting from their mandatory deleveraging exercises and their retreat, in many cases, to a greater focus on home markets. Fee-earning revenue has become king! But investment-banking fees are harder to come by with lower levels of corporate M&A, greater transparency on foreign exchanges and the decline of the OTC market. Continued economic malaise across much of the world makes many question if the improvement in bad and doubtful debt performance across most OECD banks is the calm before the storm. In this world, transaction banking becomes the king of kings and expansion strategies are in fashion, although these do not increase the pool of value in the business. They merely reduce it through added competition and finer prices. Traditionally, in the custody field, taking fees close to cost worked as re-pricing was a triennial plus exercise and markets, as well as cross-border asset allocations, were rising at a giddy rate. Given the decline in appetite for equity investment and the strictures of regulation such as AIFMD and UCITS, the hopes of those who yearn for a return to the glory days of growth of the 80s and 90s, are likely to be dashed.

So what will happen in the market? The answer is that we are more likely to see the industry muddling through in 2013 as it is a year of transition, but not the critical year of implementation. However, as we move into 2014-15, I suspect changes will be more dramatic. The cost of infrastructure change will hit everyone. Profits will decline in the commercial sector. Risk attribution will continue to migrate from end investor through to custodian and administrator. Investment will be needed in technology, training and re-engineering. Consider the likely increased demand for CCP-related services, such as margin management, collateral management, asset financing and on-market fund pricing. Imagine how soon some of those Excel-based spreadsheets, used in low-volume environments, will need replacing by sophisticated applications. Consider whether service providers can move up that learning curve and evidence an equal knowledge level, in this brave new world, to that of their current dividend and corporate-action skills.

In this environment, we can expect three vital trends. The first is consolidation of the CSD infrastructure, with micro or even mid-size CSDs, especially in Europe, becoming a historical anachronism. At the same time, infrastructures will group more along the prevailing DTCC model, aligning CSD, CCP and data depositories, or the German model with trading venues, CSDs, ICSDs and CCPs all in one collective. The second is industry consolidation with global players surviving because they succeed in positioning their business as part of a broader client proposition, as in large Swiss private banks, major trust companies or quasi-infrastructures servicing a material part of their indigenous investor population in countries or regions with the requisite scale of business. And the third trend will be regulatory, for with consolidation comes concentration risk and an even more challenging too big to fail syndrome. Regulation is going to become more dirigiste, more exacting and more costly.

This does not mean the immediate end of all single-market custodians, smaller players or even all the small CSDs. But it does mean that scale will help, although, even for scale players, maintaining service standards across their entire franchises and meeting the inevitable, eventual capital adequacy rules will become a major challenge. The small players have to be agile to survive. Their model must have unique features that genuinely meet key critical needs of the buyer community. This could be proximity to market, power of influence, risk mitigation, local currency liquidity, specialized services or distribution capacity. But they need to provide world-class service in the smaller markets, on which larger players will not focus expensive key resources. The reality is, though, that in this demanding environment such a niche will be occupied only by a few.

At least the resultant consolidation should mean some fees for the harried investment-banking arms of our organizations. It will be the survival of the fittest. Now we just need to judge who those will be!