On the horizon
17 September 2013
David Lewis of SunGard takes on the mammoth task of predicting the future of custodian banks—from a securities lending perspective
Image: Shutterstock
Like it or not, the role of a custodian bank has never sounded like an exciting one. Safekeeping of assets does not invoke images of the cutting edge of financial markets, the cut and thrust of the next big deal. Instead, they have always appeared to be the steadfast, stable service providers and cash cow segments of the world’s dominant financial institutions delivering services to a large homogenous group of loyal clients.
The turmoil of the last few years has not left this group untouched; they have had to change to align themselves with the rapidly changing environment in which they live, and that state of flux shows no signs of slowing down. In previous years a custody client would dutifully sign up to a veritable menu of services, a truly one stop shop; now it is a very different story. Increasing regulations and an ever greater aversion to risk are just two of the pressures that have led clients to be much more demanding across all the services they pay for. Custodians have had to respond and change their service models accordingly.
Today’s clients demand the best in class for each and every service; securities lending makes a good example of how this has affected the business. In some cases, participation in securities lending and other relatively ‘high margin’ businesses such as FX or transition management, meant that custody fees themselves could be low or even free—services all tied together into a package. Now the competition is fiercer, revenues are lower some clients have broken their service buying into individually priced and delivered services, bringing price transparency and arguably more level playing fields upon which to compare the competition.
Clients are also more demanding in other ways. Gone are the homogenous pools of lending clients, all accepting the custodian’s standard collateral and approved counterpart schedules, to be replaced by clients dictating their own custom collateral requirements and lending only to those they deem worthy. Gone are the automatic inclusions of all your assets—beneficial owners are now acutely aware of exactly where their incomes come from and, just as importantly, where their risks lie. As a result, general collateral (where volumes and values on loan are large and fees low) has fallen from favour and is longer providing the steady fee split incomes custodial lenders enjoyed. In are the intrinsic value programs, actively managed by their beneficial owners adhering to the old 80:20 rule. They have correctly identified that 80 percent of their income comes from 20 percent of their loan balances (generalised levels of course, but you get the picture) and 20 percent of their revenues come from 80 percent of their balances, those balances also accounting for the majority of their risk.
The result? Clients taking an active management role in their lending programs, dictating specific collateral requirements, who their custodian can lend to and in some cases, only above a minimum fee level. What does this mean for the custodian bank?
Their high margin businesses have been eroded to some extent whilst their costs have risen—indemnity policies for example, where they insure the beneficial owner against a Lehman Brothers-like counterpart default, will attract greater capital costs under Basel III regulations. Competition is fierce and clients are likely to be resistant to a change in fee splits to pay for such insurance. According to Finadium, 69 percent of lenders feel that indemnification is a very important factor in running their program and almost half of lenders would either not accept a change in their fee splits to pay for it or launch an RFP with a view to moving providers in response.
Squeezed from all sides, the custodian banks have had to adapt their existing models to suit their client’s increasingly sophisticated and individual demands. Falling revenues have driven several of them into new markets; prime custody is, well, a prime example. The combination of their steadfast safekeeping services tied into the lucrative hedge fund space is a sign of the providers morphing their profiles to make best use of what they do well. This is only one step on a long journey for these organisations; much remains in flux and the need to focus on more lucrative markets and services gets ever more pressing.
Emerging markets will feature strongly in their search for new revenues, providing services to markets that are not only developing but have great ambitions for the future. Combining such markets, such as the United Arab Emirates, marries the demand for services with the solid, secure and experienced providers looking for new assets to keep safe.
The turmoil of the last few years has not left this group untouched; they have had to change to align themselves with the rapidly changing environment in which they live, and that state of flux shows no signs of slowing down. In previous years a custody client would dutifully sign up to a veritable menu of services, a truly one stop shop; now it is a very different story. Increasing regulations and an ever greater aversion to risk are just two of the pressures that have led clients to be much more demanding across all the services they pay for. Custodians have had to respond and change their service models accordingly.
Today’s clients demand the best in class for each and every service; securities lending makes a good example of how this has affected the business. In some cases, participation in securities lending and other relatively ‘high margin’ businesses such as FX or transition management, meant that custody fees themselves could be low or even free—services all tied together into a package. Now the competition is fiercer, revenues are lower some clients have broken their service buying into individually priced and delivered services, bringing price transparency and arguably more level playing fields upon which to compare the competition.
Clients are also more demanding in other ways. Gone are the homogenous pools of lending clients, all accepting the custodian’s standard collateral and approved counterpart schedules, to be replaced by clients dictating their own custom collateral requirements and lending only to those they deem worthy. Gone are the automatic inclusions of all your assets—beneficial owners are now acutely aware of exactly where their incomes come from and, just as importantly, where their risks lie. As a result, general collateral (where volumes and values on loan are large and fees low) has fallen from favour and is longer providing the steady fee split incomes custodial lenders enjoyed. In are the intrinsic value programs, actively managed by their beneficial owners adhering to the old 80:20 rule. They have correctly identified that 80 percent of their income comes from 20 percent of their loan balances (generalised levels of course, but you get the picture) and 20 percent of their revenues come from 80 percent of their balances, those balances also accounting for the majority of their risk.
The result? Clients taking an active management role in their lending programs, dictating specific collateral requirements, who their custodian can lend to and in some cases, only above a minimum fee level. What does this mean for the custodian bank?
Their high margin businesses have been eroded to some extent whilst their costs have risen—indemnity policies for example, where they insure the beneficial owner against a Lehman Brothers-like counterpart default, will attract greater capital costs under Basel III regulations. Competition is fierce and clients are likely to be resistant to a change in fee splits to pay for such insurance. According to Finadium, 69 percent of lenders feel that indemnification is a very important factor in running their program and almost half of lenders would either not accept a change in their fee splits to pay for it or launch an RFP with a view to moving providers in response.
Squeezed from all sides, the custodian banks have had to adapt their existing models to suit their client’s increasingly sophisticated and individual demands. Falling revenues have driven several of them into new markets; prime custody is, well, a prime example. The combination of their steadfast safekeeping services tied into the lucrative hedge fund space is a sign of the providers morphing their profiles to make best use of what they do well. This is only one step on a long journey for these organisations; much remains in flux and the need to focus on more lucrative markets and services gets ever more pressing.
Emerging markets will feature strongly in their search for new revenues, providing services to markets that are not only developing but have great ambitions for the future. Combining such markets, such as the United Arab Emirates, marries the demand for services with the solid, secure and experienced providers looking for new assets to keep safe.
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