Battlefield 2020: ETFs

The surge in uptake of passive investing has resulted in ETFs becoming one of the dominant asset classes for the buy-side, and could determine the next top global custodian.
By Joe Parsons

The custody market has gained a reputation of being one that does not entail a lot of change. The four big custody banks have dominated market share for a number of years, with BNY Mellon maintaining its position as the largest global custodian since 2015.

Assets under custody (AuC) have been steadily rising across the leading quartet, as new regulations and requirements for asset managers have placed increased importance on having a global custodian. In the third quarter, AuC at BNY Mellon hit a new record of $32.2 trillion, an increase of 6% year-on-year.

BNY Mellon’s dominance over the US mutual fund and asset manager market has enabled it to hold onto the top spot without any fear of being overtaken.

Until now, BNY Mellon’s position has never been so under threat in its three-year spell at the top of the league table, with its long-time rival State Street vying for the number one spot once again.

In the third quarter, State Street saw its AuC increase by an astonishing 10% to $32.1 trillion, reducing the gap with BNY Mellon from $1.3 trillion a year ago to just $100 billion. While you might be thinking ‘this isn’t exactly pocket change’, in the world of AuC this is a nominal amount.

The growth from State Street is correlated with the meteoric rise in the exchange traded fund (ETF) market, which has emerged as the next battleground for custodians to compete.

From 2008 when the first active ETF was issued, the market capitalisation has increased from $500 billion to $4.4 trillion at the end of September 2017. According to new research from EY, the market could eventually reach $7.6 trillion by the end of 2020.

State Street is the largest provider of custody services to ETFs. Its advantage can be attributed to the fact that its buy-side arm, State Street Global Advisors (SSGA), is one of the largest issuers of ETFs, and therefore relies on the bank for its asset servicing. However, its client base also includes BlackRock’s iShares, among others.

The potential dominant position State Street possesses in the ETF market could, therefore, propel it to the top of the custodian rankings by the end of 2017, according to analytics firm Trefis. Despite Global Custodian going to print shortly before the Q4 results were released, we do know however, that State Street has around $390 billion in asset servicing assets remaining to be installed in future quarters, according to its third quarter release.

Arms race

The industry-wide shift from active to passive investment strategies by many of the big buy-side players has caught the attention of the rest of the global custody industry who now see this asset class as the next key battleground.

“With over $4 trillion globally in assets, and the fact that ETFs are now larger than hedge funds, from a custodian standpoint it is a very important asset class,” says Jeff McCarthy, CEO exchange traded products, BNY Mellon. “We have increased our focus on ETF because of the flows of these assets and interest from global asset managers, asset owners and our overall clients.”

BNY Mellon’s new chief executive Charles Scharf has specifically highlighted ETFs as a key growth target for its asset servicing business.

“Our asset management and asset servicing flows today are clearing suffering from not having scale in ETFs,” Scharf said on the bank’s third quarter earnings call.

“When you look at our flows versus others you’re not going to see the same kind of low growth that we see elsewhere, and we do have the same issue in the asset servicing side where our competitor has a much more sizeable business themselves.”

The ETF market could be primed for further growth with the possibility of new entrants as issuers. According to Frank Koudelka, senior vice president for global ETF product specialist at State Street, the possibility of mutual funds entering the ETF space could present even more opportunities for the Boston-based custodian to beef up its capabilities.

“We do a large amount of business with mutual funds globally, and they too are coming into the ETF market. They are acquiring smaller ETF sponsors, hiring ETF talent to launch their own products and even partnering to enter the market. All of the firms we talk to have an ETF strategy whether they are investing in them or launching them,” says Koudelka.

Outside of the two top global custodians, JP Morgan and Citi have also sought to carve themselves a slice of the ETF pie.

JP Morgan Asset Management, another significant player in the space with $1.7 trillion in ETF assets under management, also relies on its investment bank for custody and fund services in the US. But it has not stopped the bank eyeing further growth in order to compete with its rivals.

“ETFs in the next few years will probably grow around 18%, and alternatives [investments] around 9%. So they are fast growing asset classes, and we are investing heavily to improve our offering on that,” said Daniel Pinto, chief executive of JP Morgan’s Corporate and Investment Bank (CIB) at its investor day last year.

In addition Citi has provided custody and fund administration services for ETFs in the US, Latin America and Asia for a number of years, including BlackRock’s Brazilian and Mexico ETFs and the China Asset Management CSI 300 Index ETF.

The data difference

The custody and fund administration services needed for ETFs and mutual funds are more or less the same, focusing on the principles of safekeeping assets, fund accounting and valuation.

However, the main divergence for providing administration services to ETFs is around the ability to construct and calculate a basket on which the ETF is based on, as well as the data that is disseminated to investors.

“There are a lot of synergies between servicing mutual funds and ETFs, but the big fundamental difference is the basket process. After every day a basket is created and then disseminated to be put out in the market to market makers. That basket needs to be created the day before it is being traded, so you are not only valuing the funds but you are valuing the basket before it is traded,” says Koudelka.

“An ETF utilises core custody and fund accounting technology, but the basket process is unique. We leverage an ETF module in our core technology for the creation of the basket which allows us to apply the NAV, securities valuation, corporate actions, inflation / interest factors, etc. utilising a straight-through process for creating the baskets.”

Therefore in order to win business, advanced capabilities for custodians and fund administrators to handle and disseminate data daily are required.

“Most ETFs publish their portfolio data every day so market makers can see what is in the fund and are able to price the ETF during market trading hours. There is a lot more transparency over the fund and there is a lot more information going out to the market, so custodians have to provide ways to communicate this data to vendors and market makers,” says Kevin Grant, head of investment management group, Invesco Powershares.

“What we have found is that the services mentioned are the core offerings, and are the bare minimum for a custodian to be taken seriously. It is now about value added services they can offer. Ways they can differentiate are around market changing developments – being involved in industry forums and initiatives to help improve the European ETF market - for example the ability to settle ETFs in a central location and make the various ETF markets more accessible.”

Earlier this year BNY Mellon hired Rob Rushe, an executive for its European ETF segment and former EMEA head of ETF fund servicing at State Street, to precisely boost its data solutions within the sector and win clients.

Speaking to Global Custodian, Rushe says the fund servicing role has evolved to cater for more data elements and access points for investors.

“The initial focus was to provide certain data elements to authorised dealers that are creating liquidity in these products. From our conversations there are new data points that can assist these parties and provide greater access. We will continue to increase our role by sitting down with asset managers and liquidity providers on an advisory basis to help them to access this market,” says Rushe.

The battle for Europe

The US ETF market is a crowded one for the global custodians, as many of the issuers leading the way are both American-based and the fact that most are listed only on a handful of exchanges.

Meanwhile across the Atlantic, the European ETF market is still maturing. The pace of its evolution is accelerating significantly though. Over the year there has been a handful of new entrants to the European market, with Franklin Templeton, JP Morgan Asset Management and Fidelity Investments all listing their first products in Europe.

According to figures conducted by consultancy firm ETFGI, the European ETF market held over $680 billion in assets as of June 2017.

Where the European market differs from the US is the fact there are so many different exchanges and markets for ETF issuers, causing fragmentation and making settlement and other post-trade services more complicated.

“The reason for fragmentation is that most of the ETFs are locally listed and traded on different exchanges. All of these stock exchange transactions will be settled in a domestic central securities depository (CSD),” says Harold Defays, head of product development, investment fund services, Clearstream.

“An ETF that is domiciled in Ireland, for example, may be listed on a number of exchanges, such as in London, Frankfurt or Paris. The technical challenge is that, when a share of the ETF is bought in Germany, that unit is custodised with the German CSD. In order for that same unit to be sold in London, the back-end side has to find a way to move that unit from the German CSD and onto the British CSD. This has obviously a cost and impacts on the liquidity of these products as these realignments regularly cause settlement delays or fails.”

So where do the custodians and market infrastructure sit in this growing, yet fragmented, European market?

Invesco’s Grant believes the custodians that are able to offer an all-inclusive package will most likely be the ones to succeed in the European ETF servicing market.

“In Europe, the trend has been not to look for a custodian for individual functions but for an all-encompassing package which includes transfer agency, such as receiving subscription and redemption orders from banks and market makers that trade directly with ETF, custody and fund administration, valuation and accounting services, and providing oversight of the fund itself and its UCITS regulation to ensure it is compliant,” he says.

Those custodians that have achieved in Europe include State Street, BNY Mellon, Northern Trust and BBH, and others are planning to grow their ETF fund administration business in the region, including Citi.

“Citi today provides custody services to a large number of ETF investors and we are in the process of developing full ETF fund administration capability with an anticipated go live of mid-2018,” says Pervaiz Panjwani, EMEA head of custody and fund services for Citi.

“The service proposition we are looking to bring to market is a unique end-to-end offering that leverages our capital markets, full custody and fund administration capabilities, securities lending and common depository.”


Furthermore, issuers are leaning towards as international CSD (ICSD) model, whereby the asset manager uses either Clearstream or Euroclear’s ICSD structure to issue an ETF in order to overcome fragmentation. Franklin Templeton and BlackRock are among those buy-siders that have adopted this model for Europe.

While this is a step in the right direction, Clearstream’s Defays believes buy-siders still face difficulties issuing an ETF within the pan-European settlement platform, TARGET2 Securities (T2S).

“The issuance via the ICSD structure is particularly beneficial for products that are listed in multiple currencies across multiple national stock exchanges,” adds Defays. “Unfortunately, the ICSD model is not optimal in a T2S environment, but to be fully efficient the ETF needs to be issued by a T2S-authorised CSD. That is something we are working on, and are looking to launch version two of the ICSD model where the issuers are able to choose Clearstream or LuxCSD to issue their ETF.”

Clearstream has sought to address these issues and combat fragmentation by installing a new cross-border funds processing platform for multi-listed ETFs.

Race to zero

With the ETF market entrenched in the US, and steadily maturing in Europe, it is now time to assess where the market will go, especially with so much hype and so many new entrants coming in. 

Many industry experts have identified the move to smart beta and actively managed ETFs as the next phase for investing, which has now become 20% of the overall ETF market.  BNY Mellon’s Rushe believes it is going one step further to becoming a distribution mechanism.

“The market is moving beyond smart-beta and into the active space, and at the same time, it has become more than an asset class but also a distribution instrument. As the market expands into the active space, we may see some of those characteristics challenged. For the success of the distribution model, they may have to put in lower fees and intra-day tradability,” he explains.

With more asset managers transitioning to passive strategies and offering ETF products, being able to compete on pricing will become more important to win clients. “One of the challenges the market has is the race to zero,” adds BNY Mellon’s McCarthy. “One factor issuers are competing on is expense ratio, and pushing the ratio for these products down. To remain viable as an asset manager means managing the costs of these products. These include index licensing fees, exchange listing fees, data management etc.”

As a result, fees charged by custodians and fund administrators will be vital in determining where asset managers will send their business.

“The ETF market is very competitive with many issuers and a lot of people having similar products. Making sure you are competitively priced means you need someone that can review your costs on an ongoing basis. The custodians have to offer solutions that allow the ETF issuers to set their management fees at a level that is interesting to the market,” says Invesco’s Grant.

The ETF market could determine the most significant change to the global custody rankings since the mega mergers in the early 2000s. With so many asset managers entering the scene, both in the US and across Europe, the market is most definitely the next battlefield for custodians to compete on over the next five to 10 years.