The profitability conundrum in today’s macroeconomic climate

Political, regulatory and macro risks are all to real for the securities services industry, so how will custodians prepare, asks John Gubert.

Stock markets have seen an incredible period of growth. Equities and bonds have been in the ascendency. Interest rates remain at an all-time low and equity valuations, on almost every historical measure, are at all-time highs. Our industry is still heavily dependent on the ad valorem charge, and, in a bear market, this could reduce substantially 

Risks are multiple. Political risk is acute. Capital formation may be on the decline. Markets are more vulnerable to mood swings, especially with the growth of tracker funds. Derivative influence continues to be high. Collateral availability is not automatic. And liquidity remains susceptible to the economic landscape.

Yet our custody, and fund management fees, are buoyed by a higher than budgeted ad valorem flow. This is an endowment benefit of being in the business rather than a management performance result. Margins, even allowing for the salutary buffer of variable bonuses, are less than healthy for a peak performance point in time. Yet, few would argue that the two drivers to historic market performance have been the fall in interest rates and the flood of money looking for superior returns in higher risk assets.

Political risk is real. Brexit will lead to pressure on corporate profit in the UK and parts of the EU even if the major stocks may be cushioned by their dependency on global income sources. Trumpism risks disturbing the flow of world trade with Asia, with especially China, Japan, Taiwan and Korea, being vulnerable to the erratic vagaries of US presidential directives. It is also far from clear whether the US deficit will benefit from the planned budget and fiscal strategy of the US administration or if we will see continued high deficit financing in the US, potentially alongside a policy of reversing quantitative easing. 

Bellicosity is on the increase with many potential conflicts over and beyond anything that could arise from the verbal diatribes pouring out around the stand-off in North Korea. And protectionism, whether under the banner of America or other countries first, is growing, as evidenced by US policy on NAFTA or TPP and signalled by the EU’s talk on capital flows whether by revising equivalence rules in the financial sector or supporting a Macron-style philosophy on preventing foreign takeovers. And we have the seeds of a possible fiscal war as the EU seeks to recalibrate their tax take, historic and future, from multinationals.

New capital formation is likely to decline, although the reversal of quantitative easing could counter that trend. There are traditionally two great sources of new capital formation. The one is government debt and the second is equity dominated new issuance. Both are under stress. On the government debt side, if the traditional major buyers of debt are out of the market, whether governments no longer hungry for their own paper or surplus nations with declining external balance sheets, interest rates will rise and capital values will fall. Mathematically the decline in the value of historic debt is not going to be countered by new issuance. Thus, the debt pool declines, hitting custodian, and especially ICSD, ad valorem fees. 

Debt values decline hitting fund fees and leading to further downstream pressure on suppliers. In this far from benign environment, equity issuance is likely to suffer and corporate buy back activity to deploy past accrued surplus reserves could well be a driver for a smaller equity pool. Traditionalists would expect that to support higher asset valuations, but any decline in current earnings in the more protectionist world would have a countervailing effect. And, in the event of lesser performance by world markets, there remains the spectre of ETF overhang for these funds, with a perhaps less than certain long-term investor base, are heavily invested in either the major world-market liquid stocks or derivative contracts with high to medium counterparty risk.

World markets also still face two almost ignored problems, namely liquidity and collateral availability. Liquid markets depend on two-way activity and any fall in the buy side demand can have magnified impacts on asset values. Market falls, in turn, generate short positions and those create demand for asset financing and collateral. One can appreciate the enhanced legal certainties around many of the new collateral management applications, but historical precedent supports the likelihood that any weakening of borrowing party balance sheets will cause the available collateral stock pool to decline. 

Taking the odd basis point of fee does not, in the minds of many lenders, justify a risk of non-repayment, or, more likely, in today’s markets, the risk of deferred repayment or return. Collateral margins, like CCP margins, work in normal markets but not as well in times of crisis when litigation risk as well as credit risk becomes a true key feature of investment strategy. Liquidity, at times of market tension, dries up and, although Central Banks could have a positive role once again, the appetite for a re-run of the last crisis is politically zero.

The reality is that we are in the good times and should be planning for downturns. Of all our costs two appear paramount for better management. Headcount is 60% of custodian costs and needs to be cut. The logic is to move, with urgency rather than the current lethargy, to greater automation, more shared service provision and elimination of redundant functions as technology advances and allows for process rationalisation. The second is regulation and the philosophy of regulation needs to change. It is too complex and it is too unmanageable.  The reality is that we need more judgemental regulation based on core principles and regulatory discretion in interpretation. Otherwise we will continue to have albatrosses around our necks such as, most recently, MiFID II with its 1.5 million paragraphs of regulation. 

The future could be bright, but not on current trends!