Before subprime woes surfaced in 2007, strong equities markets and an ever-expanding breadth of fixed income products have allowed the securities servicing industry to enjoy solid top-line growth.
This benign market environment, however, has fostered unsustainable fee structures and business models.
High fixed costs, resulting from an era of ‘custody industrialisation’ in the 1990s when custodians spent an estimated 7 billion upgrading legacy systems, increased further in the early 2000s when similar amounts were spent on developing insourcing businesses targeted at asset managers’ back office services.
Up to 5 billion in value has been destroyed in the outsourcing business through lost opportunities, unrealised efficiencies and remediation when things go wrong.
Combined with poor pricing discipline and volume driven sales models, rising fixed costs have left custodians with inflexible business models at a time when key client segments, particularly hedge funds, are demanding the opposite.
While it is commonly known that if it were not for strong growth in ancillary services, custody and administration businesses would be running at a loss, if asset values were to fall by 20%, custody profits would be reduced by as much as 50%.
Prime brokers, who leverage their investment bank’s back office, have been the primary beneficiaries of the strong growth in the alternative assets industry. However, not all prime brokers have fared equally well and a number of players have exited the business mainly due to high capital and risk management requirements.
As margins have diminished, the aggregate industry cost/income ratio has increased by as much as 10% over the last five years. Prime brokers will now need to sufficiently industrialise their operating model while retaining their flexibility and culture of innovation.
In the future, we anticipate particularly strong growth in the fixed income segment, as alternative asset managers are beginning to intermediate in the credit markets for investors, who are increasingly shunning credit investments through structured credit assets.
With the hedge fund industry maturing and consolidating, the full service prime brokerage model will be at risk. In fact, prime brokers will be pulled in two directions: towards servicing smaller, newer funds and the demands of larger established funds.
Regulators are striving to reduce costs to industry participants by increasing transparency, fostering competition and pushing for greater operational and risk efficiency.
Much confusion surrounds the Code of Conduct. At the time of writing, there are over 70 requests for interoperability outstanding, and the industry remains unclear about how they should be prioritised and evaluated. If the industry wants to avoid having regulators step in, they would be well advised to formulate a more effective solution
Meanwhile, innovation across products and client delivery/customisation continues to gain in importance, driving value towards the most agile providers. Oliver Wyman project that the ability to clear across all asset classes, middle office operations and over-the-counter (OTC) derivatives processing will be the principal battlefields over the next five years. Oliver Wyman therefore reiterate their previous view that a flexible business model that is structured around the core business with a clear line of sight of marginal sales is likely to succeed.
As industry boundaries continue to blur, many of the business opportunities outlined also apply to prime brokers. However, in contrast to the custodians, the challenge facing prime brokers will be to sufficiently industrialise their operating model while retaining their flexibility and culture of innovation. In particular, end-to-end trading and administrative capabilities for alternative asset classes such as physical commodities, energy or real estate will allow prime brokers to move ahead of the competition.
As custodians and prime brokers extend their product sets into areas such as OTC valuation, they must carefully consider the operational risks associated with such services and how they may impact their regulatory capital requirements.
Amongst the players in market infrastructure, the most visible group is the exchanges, which have outperformed spectacularly, largely due to high barriers to entry, monopolistic positioning and tremendous economies of scale.
However, Oliver Wyman’s unfavourable outlook for this segment is largely a result of the threats to growth and historically low, but increasingly unsustainable, cost-income ratios.
We see an increasing cost awareness of asset managers in Europe, where exchange costs have largely remained invisible as they have typically come out of the fund’s performance. Oliver Wyman believe that stock exchanges still underestimate the risk from MiFID. Finally, new initiatives such as Markit BOAT could undermine the data revenue stream for exchanges
Over the next few years, we expect CCPs to move further into the limelight. Though they have always played a primary role in clearing/netting trades and mitigating counterparty risk, CCPs are increasingly becoming the controlling link between the trading and the settlement layers. Particularly for derivatives, integrating with the trading layer capitalises on risk management and reporting efficiency gains; integrating with the settlement layer can yield collateral efficiencies, especially in the fixed income and OTC asset classes.
Niche providers sprang up in response to various market needs that were not being met by incumbents. For example, by positioning themselves in the right niche segments, hedge fund administrators, private equity administrators, credit derivatives processing and analytics technology providers have all enjoyed success over the last five years.
Historical precedent suggests that the majority of start-ups in this area will fail. Such failure often occurs in the transitory stage, when start-ups attempt to scale up from a tiny operation into a midsized firm. The two main reasons for failure are: Operational issues: inability to institute sufficient controls around (largely manual) processes, leading to operational failure.
Lack of sales momentum: inability to capture enough business to stay afloat. Specialists can place themselves in a strong position by focusing on the ‘pain points’ of the middle/back office. Oliver Wyman expect the hot spots of the next three years to include: integrated front to back cash/derivatives platforms, workflow management, middleware, and independent valuation, especially for OTC derivatives.
Deal activity amongst private equity firms boomed in 2006 and 2007 and, given the relatively stable cash flows and solid growth prospects, we expect the trend to continue.
While historically private equity activity has focused on technology providers and infrastructure, Oliver Wyman expect this to change, as incumbents, battered by the credit crunch, will attempt to focus their business models and dispose of non-core assets.
Finally, Oliver Wyman believe that agile infrastructure plays and carve-outs for example, the monetisation of core infrastructure through spin-off as a utility or the disposal of non-core assets at over-stretched institutions will be the major themes in the private equity sector going forward.