The custodian business model has changed vastly in the last year ahead of upcoming regulations such as Dodd-Frank, EMIR and Basel III. Amidst unprecedented regulatory change, risks have increased while margins have decreased, begging the question: Will custodians get pricing power going forward?
Service providers last month welcomed the release of the International Swaps and Derivatives Associations (ISDA) Dodd-Frank Protocol, and the Commodity Futures Trading Commission reached agreement on the swaps definition and clearing exemptions a month before that. However, the industry has only seen a third of the rules so far, and it is still uncertain on the cost implications of the new regulations in terms of systems.
Despite the uncertainty, one thing for certain is that custodians have had to invest heavily in order to prepare. J.P. Morgan in July combined its agency business for securities and derivatives. The new business, ACCE, resides in J.P. Morgans Corporate Investment Bank (CIB) and spans teams from Worldwide Securities Services (WSS) and the Investment Bank. ACCE provides agency clearing, collateral management and execution for CIB clients. The business brings existing capabilities under one roof in order to provide a holistic, end-to-end solution to J.P. Morgan clients across both the buy side and sell side. There will be an additional cost for using the services in this new model.
Following the formation of ACCE, J.P. Morgan launched a collateral management product allowing clients to maintain excess collateral in a depository institution, separate from their clearing broker, and have instant reporting and access to their account. The additional service, which aims to enhance the security and control over excess collateral, will be available for listed derivative and OTC cleared activity.
BNY Mellon has also integrated its services across the pre- and post-trade arena with the creation of Derivatives360 (D360), an integrated risk-management framework designed to support BNY Mellons client’s derivative strategy. D360 includes execution, clearing and collateral management as well as middle- and back-office services.
According to Nadine Chakar, who was named head of D360 in January this year, the business was developed partly in response to regulations such as Dodd-Frank and EMIR. We tried to simplify things for our clients, who were being hit from all directions, by creating a fully integrated process from trade, clearing, collateral management and all of the administrative services from middle to back office. Then in June we physically brought some of our additional businesses, namely securities lending, securities services and finance teams, together.
Chakar believes that even despite the uncertainty on the Dodd-Frank rules, the bank has a good idea of what to expect. The clients have been pushing us in this direction, mainly the hedge fund industry, as they have been at the forefront of this for quite a while; this is not something new thats been coming to them. We have gotten smarter at working as a bank in dealing with our clients. The industry is relying on us to be able to work through these issues, break down the complexity and break down these solutions, and we will work with the regulators and whoever else is out there to try and pull it all together.
Fees have gotten higher as the service becomes more integrated, says Chakar. If you go back [to] what we as global custodians did up to 2008, it was pretty much a race towards gathering more assets. As regulations began to add to this additional burden, the custodian began to assume the additional burden, and the pricing structure didnt work anymore. So we went back to basics to make sure, even on the custody side, that we were getting a fair price for the liability and the services we were providing. With D360, take all these issues and they get turbo charged now on a lot of different sectors, whether youre clearing, tradingtheres balance-sheet implications and risk implications, and were being very cautious in making sure these products stand alone, because theres limited bandwidth for all the industry providers. This is no longer a game of scale, but a game of value, and all were looking to do here is making sure were getting priced correctly because were leveraging balance sheet. Just if you look at the Basel III regulations, its going to be costly for banks to provide these services, its going to be riskier to provide these services, and we want make sure that we are adequately compensated. Pricing is going to be a total break with the past. It will be done a lot more to reflect the risk and the resources were investing, if you will, to provide that service.
I dont know if fees will go up, but they will be a lot more commensurate to the services we provide to recoup the expanded services and systems, she continues. But they will be priced separately. They will be higher than a normal custody service, and I would say thats at least where we see the markets trending right now.
I think weve gotten a lot smarter about what are the cost of services in terms of quantifying investments weve made in people, technology and infrastructure. I would call it smart pricing, and I think thats smart towards our clients and our shareholders, looking at a differing circumstances and adapting to the new world.”
State Street, too, rolled out an integrated offering for derivatives in March this year. The service, called DerivOne, includes services such as electronic execution, clearing, middle- and back-office servicing, valuation, collateral management and analytics. A lot of the underlying pieces weve had for some time, and the new pieces for us are really the expansion of our electronic execution platform capabilities into the swaps market in anticipation of the SEF [swap execution facility] and OTF [organized trading facility] rules in Europe and the expansion of our clearing offering into the swaps market as well, says J.R. Lowry, senior vice president of State Street Global Services, who is responsible for State Street’s DerivOne offerings. Weve designed our offerings to be able to be provided modularly or in an integrated fashion.
He continues: The biggest area where we expect fairly substantive pricing changes is in execution and clearing, because those are the two areas that are more substantively changing. Those two activities today are inherently bundled and provided by a dealer. Essentially the way that pricing occurs is that its all built into the spread when you make a trade. In the new world, much more of that pricing is going to be unbundled or disaggregated. Youll have an electronic execution fee that you will pay to a SEF or an OTF. Youre going to have a clearing broker fee, a clearinghouse fee and other fees that are all broken out piecemeal, whereas today all of that is wrapped into the spread. For the buy side, todays pricing is fairly opaque in that it is built into the spread that you dont always know. That will be replaced by all these explicit fees, and the buy side will feel the pain of all of those explicit fees. Hopefully theyll get back to some degree in reduced spreads driven by the shift to electronic trading platforms. Time will tell whether that really proves out. Beyond that, in the collateral management, the middle- and back-office servicing, the valuation pieces, we dont really expect to see meaningful price changes in the way they are provided to the market.
In conclusion, Lowry expects to see significant change in the way that the fee models work in the coming 12-18 months. Structurally, over the next 12-18 months, the range of fees paid to SEFs, clearers, CCPs and others will undoubtedly be in place. As to whether people waive fees in certain instances or cut fees as part of a bundled offering, all of that is very much up in the air. There is going to be a level of uncertainty in terms of how the revenue models and the fee structures for execution and clearing settle in. There are some things we do knowfor example, clearing houses will charge a fee for their servicesand there are things we dont know, such as what will those fees will look like numerically. There is just not enough volume in the new model to really feel like pricing is completely settled.
Whether custodians get pricing power going forward remains to be seen. What is certain, however, is that the battle lines are drawn, and, with their new service models in place, time will tell which one of them will get the most traction with investors.
(JDC)