Just over a decade ago, I left HSBC after almost 15 years at the helm of a business that grew tenfold, in that period of benign market conditions, to annual revenues of around $1.6 billion. Looking back over that decade, with the benefit of hindsight, I sense my departure, just before Lehman, was well timed! We have, over the last 10 years, seen a precipitous fall in the revenues to assets ratio, a sharp squeeze on operating margins and an exponential growth in the risk profile of the business.
The fall in revenue per dollar of assets has been driven by two factors. First basic custody fees have been cut sharply in almost all markets, severely reducing the profitability of the sub and domestic custody business line. In many cases, this is an inevitable result of the greater harmonisation of markets, the clearer codification of process, digital advances and thus the reduction in the cost of doing business. Exchange controls have been reduced or simplified. Foreign Investor documentation has been streamlined and the approval process has been rationalised. Record dates have become more the norm. In most markets corporate governance and investor protection have improved. And, although inefficiencies abound, they are exceptions, market-by-market, rather than the norm.
But, above all the squeeze in revenues is caused by continued overcapacity on the supply side. And it is further exacerbated by a fee squeeze on the buy side, and thus tougher than ever fee negotiations. The squeeze in operating margins is not going to cease in the near term. In the alternative fund space the traditional 2% plus 20% charge on assets and profits is becoming a thing of the past. The downward trend is likely to continue. Revenue risk for fund managers, and potentially their downstream partners, could increase for fees could become much more absolute return-based for a wide range of strategies and not just for alternative funds. Alpha and beta may still command differential fees for asset managers but, developments such as smart beta are leading down the returns earned per dollar of assets under management. Regulation is squeezing manager margins as soft pricing is banned and costs, such as research, are allocated to the manager rather than to the fund. In the pension market, money purchase schemes are replacing final salary ones and, in many areas, funds are amalgamating to gain scale benefits. Sub custody is no longer the licence to print money of the last millennium; risk and cost are driving the big sub custody buyers into self-clearing or vicious honing of fees aligned to greater service and risk assumption from suppliers.
Exponential growth in risk allocated is likely to increase rather than reduce. There are signs of serious likely future market divergence with the EU at the forefront of formal risk allocation and the US and much of the developing world potentially being more opaque. In Europe, only fantasists can believe that custodians are not liable for asset safety, pretty well irrespective of cause, at least for mutual and alternative assets. It is inevitable that we will have another Lehman moment in markets, where a market or infrastructure will fail, or, more likely, where an intermediary will fall and asset safety assumptions at a time of default will prove to be fundamentally flawed. At that time of mega losses or serious market disruption, the markets will question the reason for an almost total absence of allocated risk capital for this business line, whilst top management in many entities will panic and press the eject button for their post trade commercial offering. Scale will also come under threat for the supply side by an inevitable twin attack by regulators on concentration risk and contingency demands.
Will these trends continue in the future? I suspect that headline fees are fairly close to their nadir per dollar of assets, albeit I expect the discount curve for volume to widen and thus overall revenue per dollar of assets to continue to fall. Furthermore, the changing profile of invested assets by sector will have a material impact on fee earnings in the future with increases in cash and bond assets on the one hand and unlisted investments on the other. The bull market in bonds must now be over and, although I would not be rash enough to forecast equities, we are unlikely to see inflation friendly market appreciation in the near future. I suspect revenue growth in the future will be driven less by new fund creations or organic growth but more by industry consolidation and, eventually, a fair allocation of cost for risks assumed.
For, I cannot see the risk profile reducing. I suspect that asset safety rules will, most likely on the back of another Lehman type scare, over time, be extended by geography and fund type. I expect certain risks to increase exponentially, especially liquidity risk for fund redemptions in the face of tighter market trading conditions, solvency risk for leveraged funds as the new generation inevitably forget the trials and tribulations of the past, and structural risk with ETF’s and Private Equity perhaps becoming, or remaining dependent on one’s view, the most risky sectors. On the operational front, technology risk will increase and, as markets tighten their deadlines, outage risk becomes ever greater. Irrespective of the claimed technical robustness of developments such as Blockchain, operational failure will remain and cyber security, as well as basic physical IT security, will become increasingly dangerous potential points of failure of the business.
The reality is that we have a flawed process. Moral hazard is increasing, driven by government and regulatory desire to ensure that deep pockets prevail in the process as the bailers out of last resort. Risk management is deteriorating, due to corporate trends to stakeholder management, and thus liability falls on individuals erroneously seeking refuge behind the cover of shared accountabilities. The returns on the business are inadequate and so we need consolidation, despite the regulatory fears over concentration risk. But we also need some of our best, bravest and brightest to start allocating true capital to asset safety and operational risk, both at fund manager and downstream, so that returns can move into sensible territory and cover not just direct cost but also the growing contingency shadow that overhangs the business.