Having the right custody model in place entails being prepared to embrace change quickly. This year, it will be critical for banks to get tough on standardising in areas where they have strived to add value, says Frances Maguire.
Custody, and its related services, has now become synonymous with large lift-out deals in which the custodian banks take over the systems and staff of fund managers’ back offices and run them. However, new research into the securities services sector argues strongly that the lift-out model is flawed and unsustainable, and that unless the custodian banks react quickly, they are leaving themselves open to selective cherry-picking by prime brokers and other specialists.
The Mercer Securities/Mercer Oliver Wyman report, Securities Servicing: Profiting from Outsourcing and Operational Risk, says that although custody outperformed the rest of financial services in the past decade, this is slowing down. Custodian earnings are projected to grow 9% in the next year, significantly less than the 30% growth of the past 12 months. Despite increasing service functionality, gross margins are contracting, especially in the ancillary value-added services, such as securities lending, foreign exchange and cash management, which have helped custodians to grow. The report shows that these services have commoditised faster than the already low-margin, basic services, due to clients’ demands for increased transparency.
Imran Gulamhuseinwala, senior report analyst at Mercer Oliver Wyman in London and author of the report, says: “Competitive boundaries between custodians, prime brokers and clearers are blurring, which makes it even more important to understand who is capturing revenues and how. The sector trend is really about convergence. Traditional asset managers are beginning to move into derivatives products, partly to manage liquidity but also for more sophisticated risk management, and that requires far more than just the services that a global custodian could provide.”
The main reason why global custody outgrew the market was because the proportion of assets under custody doubled in the past 10 years. “There was not only asset appreciation but there were also net new inflows. There will be a lot less of these net new inflows because we are coming close to a saturation point of assets under custody,” says Mr Gulamhuseinwala.
This slowing of growth in core custody, coupled with the predicted rise in outsourcing as a direct result of the need to mitigate operational risk under Basel II, means that making sure that the outsourcing model is right is more important than ever before. Custodian banks are still well positioned to benefit from the trend to outsource, so long as they can act fast enough to get the model right.
Criticism of lift-out model
“The lift-outs traditionally introduced by the custodians do not seem to work,” says Mr Gulamhuseinwala. “Look at the small number of mandates granted. They are not hitting the growth rates that anyone expected them to hit when they set out their plans a couple of years ago.”
He argues that the economics of the transactions to date have been hugely favourable towards the clients because the custodians felt that they had to buy the platforms from the asset managers to start the business. It is this that is not sustainable, he says. Having bought the platform, the custodians need to sell it to others to gain economies of scale but that is precisely where many have stumbled. A lot of custodians have created their first outsourcing transaction, in a particular geography, for a particular client, and then failed to follow up with other deals.
According to Mr Gulamhuseinwala, the only way that custodians will profit from outsourcing is to abandon the
lift-out model in favour of a more component-based model. “The component-based model is not predicated by creating scale platforms but on integrating third-party technology and services with in-house platforms. There is not one back-office solution for all asset managers – and the component-based approach allows for this.”
Lift-out works for some
Daron Pearce, managing director of BNY SmartSource at The Bank of New York, says that BNY has made the lift-out model work. “We are the only asset management outsourcing solution that has deployed a strategic solution on which multiple asset managers are being serviced. We will only do lift-outs if there is an agreement to there being a migration to our platform because we do not think that any other model is sustainable. We have got to drive the economies of scale and you cannot do that if all you have is a series of lift-outs that are costing money to run,” he says.
There are four live clients on BNY’s platform; the number is expected to rise to seven by the end of this year, when all current implementations are complete. Mr Pearce says that lift-outs will continue as part of BNY’s plan to build scale. “We believe we are the only player that has been able to make this model profitable, because the object of all our lift-outs has been to migrate to the SmartSource platform.”
Wade McDonald, head of BancAssurance/Asset Management for Northern Europe at State Street Investor Services, says that the firm is due to go live with new enterprise architecture in 2005 on to which its outsourcing customers, including Scottish Widows, following a lift-out in 2001, and AXA Investment Managers, will be migrated. “We’re in the middle of a number of implementation plans that started as lift-outs and which we’re migrating onto our strategic platform,” he says. “We would still consider lifting out certain aspects of an operation to deliver immediate business benefits for that client. Lift-out is not something that will come and go – it is still a valid approach – what will go are the acquisition premiums for buying a fund manager’s platform. There is no value in paying someone for their processes, systems and operations.”
Although Mr Gulamhuseinwala thinks that prime brokers may not be ready for this yet, he believes they may approach second-tier traditional asset managers in the future and offer to take on functions such as trade reconciliation, accounts monitoring, portfolio and trade risk analytics – without the derivatives, leverage or financing services that they traditionally offer hedge funds.
Mark Harrison, head of international prime brokerage at Deutsche Bank, also believes that this is feasible. He says, though, that it remains an unlikely direction because it is away from the prime broker’s core business. “That’s not to say that banks like Deutsche Bank, which are in the prime brokerage business, might decide that there is another opportunity for using their platforms by providing securities services. But if you look at the revenue streams of prime brokerage, they don’t make their money from clearing securities, they make their money from financing activities – lending money and lending stock,” he says. “It is a different type of business model from financing. However, there’s no question that we have a big plant and there is an opportunity for us there to offer a wider selection of securities services and provide outsourcing for long-only fund managers.”
Smaller deals predicted
Whatever happens, Mr Gulamhuseinwala believes that the run of lift-outs will come to an end because the buy-side firms will also shy away from them in favour of smaller deals due to the introduction of Basel II. It is thought that outsourcing on a large scale inherently increases operational risk. “The lift-out model does not provide enough flexibility to the asset manager, it does not allow them enough control and it does not mitigate operational risk. The very nature of the lift-out is that it tends to bear-hug the entire middle and back office function; but embedded within there are a lot of mission critical activities and the asset manager cannot feasibly get rid of these.”
Jonathan Clark, executive director of Citisoft, a specialist consulting firm to the investment management industry, disagrees. Although he recognises the same continued trend of outsourcing buy-side firms, albeit at a more stable rate, he believes that the current outsourcing model will continue for a number of years. “More firms will go down the outsourcing route but at a steadier pace,” he says. “There has been a lot of talk of unbundling and outsourcing components but we have not seen it happen very much. Fund managers have been more interested in the full service. Custodians, if anything, are working to build up their services.”
Jonathan Clark, executive director, Citisoft
Mr Clark says that, increasingly, fund managers are considering outsourcing more to the custodians. “Many fund managers are looking at whether their foreign exchange is adding value to the investment process. A lot of firms are reviewing whether they want to retain these operations.”
Deeper involvement
Both custody and payments, which are intrinsically low-margin services, are wholly embedded in a wider scope of securities services and cash management. Lift-outs are just one way of bundling services and bulking the services provided around these core products. Even if lift-out deals do diminish, it seems that banks will continue to move deeper into their customers’ business models in offering infrastructure, data and even compliance support.
JPMorgan Investor Services (JPMIS), which already enables fund managers to communicate instructions to custodian and sub-custodians over its Swift interface and IP network through its Message Express product, has launched compliance solutions for asset managers. Neil Henderson, senior vice-president for JPMIS, based in New York, says that the impact of regulation on fund managers has been huge. “We are seeing a big demand for our compliance services where fund managers want independent verification of compliance with investment guidelines. We are also experiencing a big take-up of our performance measurement and analytics products to give end investors assurance about how returns are being generated and the risks being taken.”
Value added is finite
There is always going to be a finite amount of value that can be added to services that are becoming commoditised and, to some extent, banks are creating a rod for their own backs in creating services for which they are adopting more proprietary standards and supporting an increasing number of infrastructures.
On either side of the Atlantic, the banking industry is struggling to replace legacy payment systems. In Europe, the number of payment systems since the introduction of the single currency has increased and in the US, where 80% of the world’s cheques are cleared, a new payment instrument is being created in support of cheque clearing.
Recent US financial legislation, the Check Clearing for the 21st Century Act, means that US banks are investing hundreds of million of dollars to create a new payments infrastructure to capture images of paper cheques, destroy the paper and exchange the digital images. However, because the Act is optional, a new payments instrument, the Image Replacement Document (IRD) or substitute cheque, has been created. So, instead of getting rid of the paper cheques, in effect the US has created two additional infrastructures: one to process images and one to print IRDs.
Targets to meet
At the Sibos conference in Atlanta last October, keynote speaker Heidi Miller, JPMorgan Chase’s head of treasury and securities, threw down a gauntlet to the banking sector: by the next Sibos, banks should have:
- taken at least one step towards making cross-border transactions dramatically easier and cheaper;
- developed a strategy to reduce IT and operations costs of securities and payments transactions by more than 5% within five years;
- and worked towards convergence on Swift formats for payments and securities-related transactions.
Heidi Miller, head of treasury and securities, JPMorgan Chase That is no small task. Ms Miller’s point was that if the banks did not do these things, then others would. Disintermediation by non-banks, along the lines of the eBay/PayPal model, is already a real threat. The support of too many redundant infrastructures and legacy back office systems, and the unwillingness to enforce standardisation on customers add up to an industry that needs to be faster at embracing new for old models. “In some ways, our problem may be that we are sometimes too customer-centric – not willing to enforce more standardisation on business rules, formats and processes,” said Ms Miller.
Standardisation is needed
On that point, Mr Henderson says: “Swift needs to take more of a leadership role in further standardising things in the industry so that overall costs to participants can come down. Not just Swift messaging costs – that is a minor part of our overall costs – rather, the entire cost of communication processing, including all the internal costs borne by the participants in the chain.
“The challenge coming out of Sibos is to be a little bit more visionary and to push standards forward much more aggressively so the overall costs come down and the efficiency rates go up, as opposed to just bringing out new messages to automate practices as they now exist.”
Swift is due to issue a paper in March, which will be a first response on how to remove the barriers in Europe. It will highlight the fact that, although there has been significant progress in reaching standards on cross-border activity, proprietary standards are still being used at a national level.
Automated clearing house
Frank Abraham, head of Bank of America’s Global Treasury Management business in Europe, says that the single most significant issue development affecting the cash management and payments industry is the long awaited development of a pan-European automated clearing house (ACH). “The vision is that at some point there will be a single clearing system within Europe. This is one of the most significant things impeding an efficient exchange of payments and receipts in Europe today, and what was envisioned as a result of the EU impact on the financial markets,” he says.
However, it is still far from a reality. While the larger banks enable their clients to access clearing systems throughout Europe, there is a strong suspicion that further regulation will emerge to accelerate the creation of a pan-European ACH. Banks are unlikely to tolerate the sizeable costs that this could demand and are awaiting further clarification early this year on what shape the ACH will take.
Mark Davies, director of international product management at Royal Bank of Scotland, says that this is a key focus for cash management in 2005. “There are three possible scenarios,” he says. “The most likely is that we will end up with three or four dominant ACHs in Europe that provide both a cross-border and a domestic ACH service for a number of countries. Essentially, these ACHs would compete, unlike the US model in which there is no overlap. To meet the demands of the European environment, they would all have to provide a basic trade transfer service and a direct debiting service to a set of harmonised rules, and based on a harmonised set of standards, and compete on value-added services.”
Andrew England, head of product management, cash management at Deutsche Bank, says: “These developments always take longer than you would like them to do. There is one other entity that is looking seriously at leveraging the domestic platforms in Europe, so there will be a few strong contenders for providing an ACH for Europe. But it is not a compelling business case, because it is a high volume/low margin business, and it is doubtful whether the banks would be prepared to fund a pan-European initiative. It can be margin [that is] attractive domestically just by the sheer volume but cross-border bulk payment clearing is not a high revenue-earning activity for banks.”
