Written by Christine Senior
Times have been tough for custodians and uncertainty is set to remain for a while yet. Christine Senior explores how they are dealing with lower revenues and new regulations
Custodians are being assailed on all sides by a battery of contrary forces. New developments and more difficult trading conditions that threaten their profitability are forcing changes on their business. There has been litigation over claims of overcharging for foreign exchange services in the US, while closer to home custodians are feeling the impact both of lower revenue from some of their services and a raft of new regulation they need to comply with.
High profile legal cases in the US have raised awareness of the potential for overcharging on standing instructions for custodians to handle forex. Both State Street and BNY Mellon have faced accusations of fraud in their dealings with some of their US pension fund clients. Happily pension funds in the UK and Europe seem to have escaped these kinds of scandals, perhaps because of a greater awareness of currency issues this side of the Atlantic.
James McGeehan, co-founder and CEO of FX Transparency in the US and UK, which specialises in transaction cost analysis, says: “In European-style management there has historically been more focus on currency concerns. Europe’s long history of strong intra-European trade in legacy currencies, coupled with a greater propensity to utilise currency hedging mandates, has left currency execution quality on people’s radar screens more than in the States.”
It seems likely pension funds in Europe have had more of a handle on costs of currency transactions and a willingness to track costs. Mercer Sentinel Group senior associate Stuart Catt recalls that as far back as 2000-2 pension funds were specifying in their contracts with custodians agreed spreads for forex transactions and were using independent parties to monitor costs. Several firms including Mercer itself have long been offering cost tracking products for currency deals.
In the US, by contrast, it seems there may have been an element of custodians misleading clients into believing that forex execution was a free service.
McGeehan comments: “In discussions on FX custody services, our global pension clients have highlighted that custodians point out ‘we don’t charge anything for these trades, there’s a higher risk of settlement issues if you execute through a third party dealer and there is an explicit charge if you trade away from us’.”
But custodians are also under the cosh from reduced revenue sources. It’s evident that some of the services they have traditionally offered are no longer the profit centres they once were. Revenues from securities lending and forex transactions have been squeezed through reduced activity, and low interest rates have driven down cash management income.
In the case of forex revenue, FX Transparency did some research on trades on behalf of its clients over a period of 10 years, looking at both forex trades based on standing instructions to custodians and negotiated transactions between investment managers and third party banks.
McGeehan says: “If you demark a point in time when the California v State Street litigation came out in the news, over the next 12 months, without a commensurate change in the volatility, the key determinant of bid ask spreads, there was a 63 per cent decrease in transaction costs on standing instruction/custodian transactions. That can’t be good for the overall earnings and profitability of custodians.”
For many it has been the norm to cross subsidise core custody fees with revenue from the historically more profitable non-core services. All has changed now. Core custody charges have become a more central source of income, but options to increase those are limited.
Some relationships with clients may actually be a drain on custodians’ profitability.
Catt says: “We are seeing more frank discussions in the market with custodians going to smaller clients and saying ‘we are not making any money having you as a client, we actually lost money, therefore we need to put up your fees’, and they’re having a fairly adult conversation.”
Custodian benchmarking consultancy Amaces director Tom Robertson says custodians are looking carefully at costs and fees, with some implementing minimum fee scales to ensure they don’t service clients’ portfolios at a loss. The impact this may have on clients can vary enormously, with smaller clients likely to be under more pressure. In some cases clients have even been told they are no longer wanted because they aren’t profitable.
At BNP Paribas Securities Services it has never been the practice to cross subsidise core custody fees with revenue from add-on services, says head of the asset owner client segment Dietmar Roessler.
“Our rules of engagement are such that we believe a custodian relationship needs to be profitable on a standalone basis based on its core services. That prevented us from relying on treasury services. But we have been keen to add treasury services to the relationship. That creates margin on top of the very hard fought custodian relation-ship component.”
Another source of increased costs comes from the plethora of new regulations and directives that will impact on custodians’ business. That ranges from Foreign Account Tax Compliance Act (FATCA) and Dodd Frank in the US to European directives such as EMIR, the Alternative Investment Fund Managers Directive (AIFMD), and UCITS V. These will require new procedures and processes, perhaps the appointment of new specialist staff and probably technological upgrades.
Compliance rules will become more burdensome. Take for example the forthcoming changes to the AIFMD, which will take effect on 1 July this year. Currently when custodians delegate responsibilities to sub-custodians, if they can demonstrate they have a proper standard of care and supervision of delegates, their liability is discharged. Under the new rules custodians will remain liable for responsibilities delegated to sub-custodians.
As for increased costs, it’s inevitable that custodians will be forced to pass them on to their clients. It’s not yet totally clear what that will mean in actual figures. But Roessler is aware of some figures being talked about in relation to AIFMD and UCITS V, and if these turn out to be correct they will add considerably to the cost of doing business.
Roessler says figures of 5-10 bps on assets, depending on the market and vehicles used, is being discussed, though BNP Paribas itself has not done any simulations to confirm these figures. “If at the moment you are paying a basis point for your global custody fee, and the market discussion is ongoing this might increase three-, four- or fivefold, or more.”
These are only estimates, but whatever level fees may take, they are likely to have a major impact on providers and their clients.
Roessler says: “These are early days. I don’t know any provider who has come out with a clear pricing strategy in response to AIFMD and UCITS V. But it’s going to have a heavy impact on the asset owners who invest in AIFM and UCITS structures and will completely change the competitive landscape among custodians.”
Custodians may be forced to adapt their business model to the new landscape. BNY Mellon has recently announced the launch of a new venture – its Central Securities Depositary in Brussels, a response to a number of regulatory developments. BNY Mellon CSD CEO Chris Prior-Willeard says: “The current raft of new legislation – notably EMIR, AIFMD and T2S – requires us both to expand our service in the post-trade space and to more closely integrate key processes within the securities value chain to provide our clients with greater efficiencies and decreased risk.”
Whether other custodian banks will follow this route remains to be seen, but it’s an option only open to the very biggest players.
Written by Christine Senior, a freelance journalist