Fee falling

Asset managers have little choice but to try to minimise their expenditure on custody as they face a world of pressures.

By Charles Gubert
A consultant reflecting on the parlous state of the asset management world compared the pre- and post-crisis ambience of an after-party at an annual industry get-together. In 2005, attendees were treated to unlimited alcohol including champagne and well-aged spirits.

A decade later, the unfettered booze supply had morphed into carefully enforced, rationed beer and wine allocations. The budgets at asset managers are being constrained, but what impact is this having on the custody industry, and how is it responding?

Active management has a number of merits, but performance at many has not been in line with client return expectations. Low interest rates, volatile equities and irrational politics have been market drivers, making it hard for firms to produce returns based on the metrics that they are used to and most comfortable with. Many investors are also wondering why they are paying between 0.75% and 1% in management fees when numerous active firms have failed to beat their benchmarks. The alternative to spend just 0.1% or 0.2% in management fees to have exposure to an index tracking product or robo-advisor is therefore quite appealing. Many active managers have had little choice but to reduce fees to keep their clients.

Regulatory transparency drivers around cost breakdowns have also invigorated investors, many of whom have demanded more information about the fees they pay managers and their service providers. “Regulations like MiFID II are applying pressure on fee transparency.  Investors now know what managers are paying service providers, and they are benchmarking charges across different managers. If one manager is paying materially more for custody than someone else, the investor may ask ‘why?’” said a source at an asset manager.

The UK Financial Conduct Authority (FCA) has also intervened demanding answers as to why active management fees remain pre-set at what it believes are uncompetitive levels.  Potential fee models are being considered and one suggestion is for the imposition of an all-in-charge, something the FCA believes will wipe out hidden costs. Major asset managers including Vanguard and Old Mutual have hit back, warning some firms may inflate their trading costs to protect revenues.

Bad timing

Asset managers are worried that excess pressure on their fee models could wreak damage on their businesses. The costs of running operational processes at fund managers is no longer insignificant. Institutionalisation – at least in the alternatives world – has introduced new responsibilities and requirements. Institutional investors, having been admonished for their pitiful standards of operational due diligence post-Madoff, are demanding more information in greater detail than ever before. This comes at a cost to the manager.

New risks like cyber-security, something many firms previously discredited as an obscure threat – have to be taken seriously, and this requires thorough investment in technology. Corporate governance is no longer a process of appointing a perma-tanned, inexperienced director at limited expense, but an individual who takes their role seriously and one who is now subject to the Senior Managers & Certification Regime (SM&CR), at least in the UK.


The regulatory environment for managers is generally unfriendly, certainly in the EU. Many firms had assumed the worst of the regulation – such as the Alternative Investment Fund Managers Directive (AIFMD) – was behind them, only to realise MiFID II was being introduced in 2018, and this looks set to be the most challenging of the lot. Brexit is certainly front of mind at many UK asset managers, and some may be forced to make substantial adjustments and locate key personnel within the EU. All of this adds cost at a time when revenues are subsiding. Asset managers have little choice, but to minimise their overheads, and service provider fees – including custody – are feeling the strain.

“Fee pressure on custodians has been applied for some time now although it is not specific to asset managers but across all client segments,” says John Van Verre, head of global custody at HSBC Securities Services. “There is now increased pressure on the asset management community’s costs. Operating a regulated business brings regulatory costs, and this has impacted fund managers too. It is a logical development that asset managers evaluate their own service provider charges as a way to reduce their overall cost base.”

Unfortunately for the custodian banks, this is happening at a time when their own model is being challenged. Revenues at custodians have been falling since the financial crisis. The perpetually low interest rates imposed by Central Bankers globally have impeded their ability to generate margins off deposits. FX trades executed on behalf of institutional investors used to yield significant returns for custodian banks, but client and regulatory pressure on such profits have had adverse consequences.

Expectations rising

In addition, regulatory costs such as Basel III have rendered certain banking activities unsustainable. Fund managers may agonise over AIFMD and UCITS V depositary rules, but it also introduces huge costs and risks into the custody chain. Other regulatory pressures include criticism by the FCA that contracts between clients and custodians “are usually around 10 years in duration, creating barriers to switching,” adding terms are often more beneficial to the banks. This could be a precursor to regulatory action, although the FCA did acknowledge there was decent competition on custody fees.

To add to the challenge, the service levels demanded by asset managers of their custodians have not remained static, but actually increased. “Asset managers are demanding their custodians provide them with more data and reporting,” adds Van Verre. “This is having a significant impact on custodians’ operating models. The industry is reacting and has rationalised its platforms and increased efficiencies. This has been done through streamlining IT systems, offshoring operational processes to lower cost locations, and identifying new products and innovations.”

Some asset managers have told their global custodians to set up hot contingency networks in their markets, whereby two sub-custodians provide coverage at the same time.  However, such operations are not cheap for custodians, particularly in jurisdictions which adopt segregated account structures.  Asset managers are frequently reticent about paying for such services and custodians have little choice but to oblige, as fund managers have made it no secret they will switch providers if pricing is not competitive.


Fortunately for custodian banks, a revenue stream that had once been extremely lucrative and subsequently fell off a cliff, has made a reappearance. Securities on loan, according to DataLend, surpassed the $2 trillion mark, and saw a $180 billion year-on-year increase. This is the biggest increase since DataLend began tracking the market in 2013. The return of securities lending is a positive development for the custodians and it has been driven by regulation of the over-the-counter (OTC) derivatives market. The Commodity Futures Trading Commission’s (CFTC) – as part of its Dodd-Frank mandate – phased in clearing for OTC instruments in 2013. Markets across Asia-Pacific (APAC) and Europe – through the European Market Infrastructure Regulation (EMIR) – have also introduced centralised clearing. 

New revenue generator
Clearing under EMIR has been applicable to Category one and Category two clearers since 2016, and it will be introduced throughout 2017 and 2018 for the remaining categories. In order to clear OTC products in a central counterparty clearing house (CCP), users need to post initial and variation margin, which must be best in class collateral. Un-cleared or bilateral OTCs will comprise of instruments that are very niche or risky, and will not be allowed to pass through CCPs. However, bilateral OTC transactions will be subject to firmer collateral rules as the Basel Committee on Banking Supervision (BCBS) and the International Organisation of Securities Commissions (IOSCO) have told national competent authorities to implement margining requirements on such trades.

Counterparties to bilateral OTC trades will have to post initial and variation margin, although as with centralised clearing, its introduction will be implemented in stages. Trading in any type of OTC instrument henceforth will have to be guaranteed with collateral. Financial institutions which are long cash or high quality bond instruments will find compliance with these rules fairly straightforward provided they have a coherent collateral management plan. For entities which do not have such assets at their disposal, it is much harder. These organisations need to identify cash or AAA government bond rich institutions to borrow from, in order to meet their OTC margining requirements.

Many custodians are therefore looking to lend out securities in exchange for a fee to institutions for their margining needs.  Collateral is a lucrative revenue generator as it is scarce. Quantitative Easing (QE) has eliminated a lot of the supply while banks and broker-dealers are being forced to sit on high quality liquid assets (HQLAs) for regulatory purposes. As such, this type of lending activity by banks could be a massive commercial windfall. “We have seen a huge demand for high quality collateral because CCP collateral eligibility criteria means many OTC counterparties do not have the required or eligible collateral themselves to post as margin. They are looking to service providers to perform collateral transformation upgrade trades, and such activity has helped the custodian banks generate revenues,” commented Van Verre.

Some believe the changes which the custody industry needs to make are more fundamental. Automation is an axiom for efficiency, and this is translating into significant investment in innovative technologies that could disintermediate costly components of the industry. A number of technologies are making headlines in the custody world. Blockchain – or Distributed Ledger Technology (DLT) – could automate manual recordkeeping and reporting processes, both of which are imbued with inefficiency.  Anyone who has had to perform a Know-Your-Client (KYC) or anti-money-laundering (AML) check will verify that. Corporate action processes are also in the Blockchain firing line. The risks in corporate action issuance – if it was done in real-time on a wholly transparent blockchain – would be eliminated.


Change of direction

Established market infrastructures such as CCPs and Central Securities Depositories (CSDs) could have their internal processes totally changed by blockchain. Transactions can be settled on a blockchain in T+0 meaning counterparty risk would be eroded, and possibly the need for market infrastructures and platforms like TARGET2Securities (T2S). In theory, this could threaten intermediaries such as custodians.  Van Verre highlights custodian banks were making innovative strides, and investing heavily in blockchain research and development (R&D). He added the technology was undergoing proof of concept trials at HSBC, where it was hoped it could help generate efficiencies in proxy voting processes, for example.

Others, however, are sceptical the industry is evolving. “There are still too few custodian banks doing too little to innovate,” says Nicholas Bone, founder and CEO at EquiChain, a London-based FinTech firm. “Perhaps it is cultural inertia, vested interests of individuals or a feeling that this FinTech ‘thing’ will soon blow over and custodians can get back to making money the tried and tested way.  The reality is that the custody business is a high cost, low margin game and with ever-increasing regulatory requirements to accommodate. Pricing models have not kept pace with the risk profile of the business. Custodians have only ever renegotiated pricing downwards with their clients.”

Bone added though that same custodians had become more proactive recently. The ultimate aim for custodians has to be automation and straight-through-processing (STP), and this could be achieved by emergent technologies such as blockchain, machine learning or AI. The latter is already being trained in performing repetitive functionalities in financial services. If there are fewer actors in the custody chain performing manual processes, costs will fall, and this will benefit asset managers and their end investors. Simultaneously, it will allow custodians to remove inefficiencies from their businesses, and focus their efforts on innovation.