The Taboo Subjects of the Custody World

Ahead of the totemic NeMa conference, it is well worth considering some of the subjects that may be discussed in bars ahead of the witching hour when custodians’ minds turn to more ethereal matters.


Ahead of the totemic NeMa (Network Management) conference, it is well worth considering some of the subjects that may be discussed in bars ahead of the witching hour when custodians’ minds turn to more ethereal matters. These issues are banished from many conference sessions as being too controversial or, in some cases, impeded by lawyers concerned at the strictures of the competition authorities. Needless to say we have many other weighty matters to discuss at NeMA with a focus on risk issues, the future of the industry and the plethora of regulatory and infrastructure change in our global “plumbing” pipeline.

Most of us are concerned at our shrinking profit margins. But, for many, it would be taboo to admit they are shrinking or even to consider whether the downward trend is reversible.

And there is open opposition to the destructive aspects of some of today’s regulation. This is not really targeted at the lost battles of the unjust allocation of liability on depositories by the Alternative Investment Fund Managers Directive (AIFMD) or the much more justifiable likely capital adequacy rules for indemnified stock lending. It is inspired by issues such as the Financial Transaction Tax (FTT), the short selling directive, litigation on alleged gouging, especially on FX, by custodians and the total disappearance of caveat emptor from both the retail and wholesale markets.

The financial battle has been alleviated by the current bullish tone of markets. In the year to date, the FTSE World Index in dollar terms rose over 10%. Without it, the global custodian diaspora in NeMA Warsaw would be in a sorry state. The challenges are multiple. Fees have fallen sharply and pressure remains. Net interest income is a shadow of its former glory, especially in the sub custodian sector. FX spreads have been decimated by transparency. The growing demand for reporting is hard to monetize. Collateral management, identified as the salvation by many in NeMA Budapest last year, is in reality a major contributor for the ICSDs and a small subset of the top ten global custodians. Transition management is the latest source of litigation. Prime brokerage will need to ensure functional and hierarchical segregation of activities under EU regulation. And we also have to question if the scale game has been played out. How much more scale does a $10 trillion custodian require to gain true cost advantage?

There are opportunities in the growing role of derivatives in portfolios, perhaps in others adopting the imaginative Northern Trust “shadow administrator” deal with the $140 billion Bridgwater Fund, or in the capital market opportunities resulting from the average 150-200% leverage of the alternative sector. But any belief that the liability provisions of AIFMD or UCITS V will lead to a major upsurge in fees is illusory in an era of overcapacity.

The reality is that our services are under-priced. In an earlier blog, “Calculating the Capital Levels of Custodians”, I suggested that the market was pricing the capital needed to support a trillion dollar custody portfolio at $400 million. The regulators appear, using stress test conditions, to be pricing it at nearer $600 million. That implies prices relative to assets are around 0.3 basis points under water. That is a meaningful amount. For a State Street with $24 trillion of assets under custody, that equates to an added $720 million, or 7%, of revenues per annum!

And a second reality is that there will be further consolidation in the market. I would expect at least two of the top twenty players to exit or merge in the coming two years. Several smaller and higher cost local or regional players will fail to survive. Great savings need to be made; and they need to be brutal. Savings can logically come from two sources. Amalgamations and outsourcing will eliminate high cost services or service providers. Repairs to the broken securities transaction lifecycle, by more intelligent use of industry utilities and greater automation, will allow us to reduce headcount and improve service (with regulatory initiatives really needed in this area as I noted in another earlier blog, “Considering the Challenges of a Shorter Settlement Cycle”).

Paradoxically, this need for a focus on cost management comes at a time when regulatory pressures are leading to an explosion in costs. And potentially, they could lead also to a decimation of revenues, further exacerbating the fragile business environment of the sector.

The biggest scourge of them all, the proposed 11 European nation FTT, appears unlikely to come to life in its current genesis. It would, in the impacted countries, in that form, destroy the repo market, decimate any market dependent on short term collateral, emasculate liquidity in the commercial banking sector and undermine seriously the brokerage inventory financing model. But there remain risks that an eventual compromise could still do some of these, for the opponents of the tax in world financial markets punch less weight than the protagonists in the EU community or the hungry Exchequers in those countries which will remain net winners from the tax. But that is not the only challenge. The politicians’ nemesis of hedge funds, high frequency trading, short selling or tax efficiency, although often with a basis of reason, is taken to extremes that are destructive for our businesses and for our markets.

And the Courts have forgotten the principle of caveat emptor or “buyer beware”. There was some justification for their ire when the retail market was assaulted with highly volatile and inappropriate products; but the extension of that sentiment to the professionally managed institutional funds’ market appears unjustified. Many recent claims by institutions appear opportunistic. Data has been readily available and concerns on any possible malfeasance should have been raised much earlier by the accusers. One has to question if they have not been more influenced by the changed environment for bankers rather than by a belief in the injustice of their treatment? That does not justify any inappropriate pricing, but it is incredibly difficult, long after events, to judge fairly whether the apparent cost of a transaction was an unfair cost, a true cost, a prudent reaction to volatile markets by the risk takers in the transaction or simply the price at the point of execution in those markets on a turbulent day.

So, has the industry a future? Undoubtedly it has but some longer term trends will continue. The cost of risk will continue to be undercharged. The complexity of markets will continue to increase. The regulation of markets will remain ever more convoluted. The market will continue to consolidate. But I also expect necessity to force changes in market structures. In reality a new dialogue is needed between clients and infrastructure, whether extant or to be newly created, to increase automation and rationalize the incredibly duplicative global infrastructure. We also need to eliminate all those high cost duplicative processes within commercial firms that add no real opportunity for differentiation. And a further dialogue is needed with regulators to ensure greater rationalization in the collection and dissemination of data to eliminate that country centric approach that merely adds cost without benefit to the entire process.

The securities processing industry is a series of silos with multiple occasional points of connectivity. The post trade supply chain needs re-engineering for the cost reduction target per dollar of assets will have to be close to 20% if we are all to generate the right levels of revenues to achieve the requisite returns on our logical levels of risk capital.