GC Friday Interview: State Street’s Paul Fleming on the Growth of Enhanced Custody

Approximately five years ago, State Street developed what it calls Enhanced Custody, where the bank offers securities financing directly to funds, rather than going through a prime broker. State Street’s development of the platform has led to significant growth in securities lending, where revenue rose 12% year over year during the second quarter of 2014. Paul Fleming, senior managing director and global head of enhanced custody at State Street Global Markets, explains the potential for the business.

GC: How has the offering developed over the years?

PF: State Street has two types of Securities Finance clients. In the traditional agency lending program, customers have fully-paid for, long assets in custodial accounts and lend those assets to generate alpha for their investment strategy. The other class exists within our servicing business and has short portfolios. Historically, we had outsourced the financing of those short portfolios to third-party providers, the major prime brokers. We reviewed our servicing model and realized that if we were helping clients generate alpha on the long side, we should be thinking about helping clients generate alpha on the short side.

As our Alternatives Investment Servicing (AIS) business continues to grow in tandem with our traditional asset management servicing business offering more alternative products, it’s become more and more relevant for us to play a role in this financing space. We took some of the expertise in technology that we had in the agency securities lending business and re-engineered that to support our clients’ short portfolios and their financing needs. We put a team together of internal folks with a strong institutional knowledge of State Street and combined them with new employees with experience in prime brokerage, and it has been a recipe for the right mix of talent that our clients really appreciate.

The business has been around for nearly five years, but we’ve seen a lot of momentum and have come in to our own recently. I would attribute that to giving the platform the opportunity to mature and our pursuit of enhancements in technology, talent, the sales pipeline and support functions.

Our clients see us as a good alternative to conventional prime brokerage and use us a complement to their suite of prime brokers, particularly in the hedge fund space. The majority of our business is in the hedge fund space, although one particularly exciting customer segment for us has been in the institutional manager space—or what can be more commonly referred to as liquid alternatives.

GC: What are some of the challenges in getting clients to use the platform? Are they reluctant to leave the prime brokerage model and work directly with a custodian?

PF: Most of our clients use us as a complement to conventional prime brokerage as opposed to a replacement. We’re not a replacement for the prime brokerage model; we offer a different way of financing assets. After Lehman, a lot of funds multi-primed. Those funds in that instance were essentially distributing their risk across providers with a similar financing model. Our model is differentiated by our balance sheet funding. Also, we have unique features that offer true differentiation over what is more traditional financing out of the margin account within a broker-dealer. For example, all the financing done at State Street is done within the context of our clients’ custodial account here.

GC: Are you going after the same clients as prime brokers, or do they not want to finance certain clients that you’re interested in?

PF: In the hedge fund space, we are all competing for similar customers, but beyond that, the territory is different. Mutual funds are harder to finance for the investment banks because each fund has to hold their assets at a qualified custodian. When prime brokers hold those assets in a tri-party account, they are unable to re-hypothecate assets, making financing expensive. State Street’s ability to pull that capability in-house and do the financing within the custodial account can create efficiencies and potential cost savings for our clients, which is why we’re excited about the growth we’re seeing in the mutual fund space.

GC: Do you see any difference regionally in clients’ acceptance of this model?

PF: So far the vast majority of our clients are headquartered in North America. Our expansion plans that are underway now include building up our presence in EMEA and APAC—so we’re putting boots on the ground in those local markets to replicate the service model that we have here in the U.S. Those teams include trading staff, sales staff, client service staff, support functions like legal, credit, risk—everything you need to make the business self-sufficient locally. Our ongoing strategy includes developing that global footprint and adding complements to the technology and financing platform that we have in place today. One example of that would be the addition of equity portfolio swaps, which is the synthetic version of what we do today in the physical lending space.

GC: Other than having a possible first-mover advantage, how would you differentiate from other custodians replicating this model?

PF: Our team is what will continue to set us apart from competitors. As mentioned, we’ve taken a lot of care in getting the right mix of people with institutional and prime brokerage knowledge. But given the traction we’ve experienced, I would expect to see other custodians with similar balance sheet, capital and liquidity potential, as well as the right credit and risk management expertise to finance their customers building a similar product. That being said, having enough runway between us and our competitors can go a long way in terms of product development, and we hope that we can continue our current pace of growth for the foreseeable future.

GC: How much are you seeing your competitors actually work on building out this product?

PF: It’s a little bit of a mixed bag. We’re seeing a few other custodians trying to build something out that would compete head-on with this. But some of our competitors in the servicing business also have investment banks with established prime brokerage business, making it less likely that they would create something that may cannibalize their prime brokerage franchise.

GC: How much bigger can the market get for this type of model? As other custodians build out their products, will funds want one custodian and multiple prime brokers, or possibly multiple custodians and prime brokers?

PF: I think it will continue to be an a-la-carte model; a lot of the bigger funds will want a little bit of everything. In the ’40 Act space, it’s likely that if a fund is a client of our servicing business, partnering with us for Enhanced Custody is a natural extension of their existing relationship with us. In the hedge fund space, there’s still a lot of room to grow. If anything is going to be a constraint, it would be balance sheet and capital. I’m optimistic about the future of this market.