As they expand their own businesses, clients are demanding increasingly sophisticated services from their global custodians.
GLOBAL FINANCE: How has the recent market volatility affected global custodians?
, senior vice president, global custody regional product executive, Western hemisphere, JPMorgan Worldwide Securities Services: The need for information has certainly been highlighted recently. Clients are looking to the custodians for the most accurate and timely information on the value of their portfolios, including fair market value adjustments.
They want more than just the traditional services; they want consulting-type services where we tell them what’s going on in the market, drawing on our experience from an investment management and investment banking point of view. Also, during any type of market volatility, clients look for their service providers to be a potential liquidity source.
JOE KEENAN , head of sales and relationship management, asset services, The Bank of New York Mellon: All of our institutions are about high-volume processing; to see trading volume go up is very positive, and it has recently. On the fixed-income side there is a need for transparency, strong and robust valuation capabilities. Our clients and their underlying investors want to know what their portfolios are worth. And when you’re in a period where there is market concern and there is volatility in the valuation of the underlying assets, your clients want to know you’re there in terms of providing liquidity. Portfolio managers want to be certain they don’t necessarily have to sell assets to meet market demands for redemptions. They want to ensure that they get maximum value for their portfolios, and that may very well mean relying upon credit facilities. In that way, we are a stabilizing force.
GF : How are global custodians providing liquidity?
Martin: We have to become even more efficient in how we process our traditional services
, head of global institutional strategy and product development, Northern Trust: The simplest form is a line of credit for intra-day and overnight overdrafts. There’s a possibility that redemptions need to be funded before the money has come in. Our role as a custodian is a combination of providing liquidity as well as helping to prevent the need for it. We’re all finding we have to sit down with our clients and work with them through this process so that they can manage their own portfolios and investments effectively. Regarding the volatility issue, valuation has also become important. It is much more complex than it used to be. Now clients are saying, “We don’t want the price from the brokers. Get a third-party, independent evaluation. We don’t want to go to the source anymore to get that quote; we want independent valuation.”
MARTIN : We’ve seen also the need for information on other markets outside of the US. During the recent volatility, some emerging markets actually halted trading on their stock exchanges briefly, due to price fluctuations. Our clients expect us to know that so that they can make appropriate investment decisions and know what type of risks they face in those markets. So it’s really jumped from being a local provider to being a global provider of information on a real-time basis.
GF : What can we expect to see in terms of consolidation in the next two to five years?
KEENAN : It has truly become a global business. For many years regional players were able to succeed within their regions, but as clients have become not only global asset managers themselves but more sophisticated, they expect their provider to be able to get them into each and every capital market, whether it be developed or emerging. Those pressures will lead to more consolidation. European banks are still in the custody business, and yet it’s not a core business for them. In order to be successful in global custody, it really needs to be your core business. We’ve doubled down our bet on the custody business and continue to do so because it’s really our primary focus.
MARTIN : In the next two to five years we’ll see more consolidation. We’ll also see creation of two tiers. You’ll have the mega-players that have the scale to handle all the buy-side servicing requirements, from structured products all the way through to middle- and back-office servicing, on a global basis. There will also be niche players, those that specialize in either a particular geography or a particular product and service that they’ll become best-in-breed in. They’ll still have a market because some clients want a best-of-breed approach and some want to use the scale of going with one provider to get buying power and efficiency.
CHERECWICH : Given the amount of activity that’s happened recently, the next few years will be a time of bedding down not only the acquisitions that have been made but also the middle-office work that’s been taken on by many custodians. To achieve scale on a global basis, like Northern Trust, you’ve got to have an operating model that is truly global. You need one standard operating platform; it can’t be multiple platforms with multiple ways of doing things. We are focusing on how to maintain consistency globally on all of our operations so a multinational pension fund, say, can come in and get the same product in the UK as they get in the US or in Hong Kong. That’s why the regional players will only be niche players because unless you have offices around the globe and have one global platform, you won’t be able to be successful in this business.
GF : Is consolidation in this market good for the clients? PETER CHERECWICH
Cherecwich: Our role … is a combination of providing liquidity as well as helping to prevent the need for it
: It can be both good and bad. Some clients have very deep and strong relationships with some of the smaller players, and they can be impacted. It would certainly force them to make sure they are aware of the alternatives in the marketplace. But in terms of consistency, efficiency and seeking the best value for the price, it’s a good thing. This is still a buyer’s market: Our clients and prospects continue to be very aggressive in terms of their demands for the highest level of customer service but also the lowest possible price. It forces organizations like our own to make sure we have the same systems on a global basis and very stringent controls.
MARTIN : To be a large global custodian, it takes a huge amount of capital investment. You have to maintain a balance to be able to support that investment. We’ve spent roughly $2.2 billion dollars on technology over the past three years. You also have to look, from a client’s point of view, at concentration risk. If I have all of my assets with one provider and something happens to that provider, what happens to my assets? There’s a lot of risk to servicing this business still today. Being with one player, you really have to assess the concentration of risk and become comfortable with the balance sheet of your provider.
GF : The range of investment vehicles used by custodians’ clients continues to increase. What special problems does this multiplicity of vehicles present to custodians?
KEENAN : It creates opportunity for us. If everything flew through STP and came out perfectly every day, our clients wouldn’t need us. As new and complex instruments emerge, we have to find a way to service them. Much of this is driven by sophistication, in particular the emergence of structured products and very complex derivatives. There is a continuing chase for enhanced yield and structures that minimize risk, but, as a result, these are not simple products to support. When we have clients who have significant books of derivative holdings that have issues with transparency from a valuation standpoint, I think it creates opportunity for vendors. As the business grows and the complexity grows, there’s more need for institutions like us to be there to do the dirty work on behalf of the client—and do it in a way that minimizes risk.
CHERECWICH : Twenty years ago custodians had a separate international group because international settlements were so complex and international accounting was even more complex. Today it’s all in one operations group. We don’t know what tomorrow’s complexity will be, which is why we continue to invest in technology. If you don’t streamline today what is complex, you will be behind tomorrow.
MARTIN : In this industry, new products can be manufactured very quickly. This puts an immediate strain on service providers, as they do not have the systems, processes and knowledge to handle them efficiently. So we all end up working in a manual environment for a while until all the organizations involved can agree on some type of standardization. Once that happens, we can reduce risk and become more efficient, providing the information seamlessly to our processing systems and back to our clients in a useful manner.
GF : Will the recent market volatility result in a pullback in the use of some of these more complex instruments?
KEENAN : Investors haven’t necessarily responded by unloading their more esoteric instruments, but in general we’ve seen some institutional clients raise a level of concern. But it’s really been a short time window, if you look at how successful the markets have been over the last several years.
MARTIN : The pension investors in the US who have traditionally been slower to invest in the derivatives marketplace—and in the past year allocated a higher percentage of their portfolios to it—will probably take a step back. I don’t think they’re willing to take the risks involved—at least not until things settle down.
CHERECWICH : I haven’t seen a pullback from these vehicles—just many more questions about what the risks really mean and demands for the tools to provide more information about those risks. For example, we now provide fixed-income attribution to our investment operations outsourcing clients. I agree that a lot of decisions that haven’t been made will probably be postponed and studied more carefully.
GF : From what sectors and regions will custodians’ future growth come?
MARTIN : I think from all sectors and all regions. In the US some of our traditional long-only clients are going into short strategies, and they’re looking for us to extend our services. The Pension Protection Act from last year has also stimulated growth in the defined contribution market. In Latin America we’re seeing a lot of the restrictions in cross-border investments being lifted and more investment from Mexico and Brazil into the US. In Europe we’re seeing a big push with funds being allowed to invest in more types of securities, attracting more investors. There is huge growth in Asia—India and China are very bullish, and there’s still a lot of opportunities there—also in Australia with huge expected growth in its superannuation asset pool.
CHERECWICH : A massive amount of our growth as custodians comes from our existing clients, primarily because of the service they receive. When they want to go into markets, we’re there—normally with one client, and then a lot of others follow. We also look beyond the question of sectors and regions and focus on what products are appropriate for Northern to distribute. Depending on the market, we might lead with custody or alternatives administration or asset management. In any new market it is especially critical to have the highest level of service, as this will set the foundation for future growth. KEENAN
Keenan: You have to be creative and innovative on behalf of your clients to get them the access that they need
: We think there’s tremendous potential in Asia, Eastern Europe and the emerging markets from a regional perspective. We characterize North America as relatively mature: The traditional funds business has been relatively flat, and a significant majority of households are mutual fund investors, many through 401(k) programs. So we are trying to look to segments of the industry that offer high-growth potential. From a pure beta perspective, the emergence of passive products, and in particular exchange-traded funds, is huge. We’ve enjoyed a lot of success as an institution in terms of capturing mandates and helping our clients gather assets in that space, the vast majority of which are either index-based products or offer exposure to certain asset classes like commodities. On the other side has been the growth of the alternative funds business—the alpha side of the continuum. As publicly held companies, we have an obligation to make sure that we provide the infrastructure and we expend the capital to support our existing, albeit mature, clients and then to devote our energies to other parts of the globe or specific types of products that will grow faster than the market.
GF : What special conditions do custodians and their clients face in China, India and Russia?
KEENAN : Russia is particularly problematic. The underlying infrastructure there isn’t really up to snuff yet. We’ve had to work very closely with our clients, and unfortunately, because of the nature of the market, they’re sometimes limited in terms of the breadth of investing they can do there. There is a desire in Russia to be as open as possible for the influx of capital, and one of the things that needs to happen is for there to be more stringent controls among regional transfer agents. We’re working with local industry bodies to bring that market up to snuff. The way to do that is to establish the infrastructure to ensure that our clients’ investments are protected. Russia’s not there yet, but there’s still tremendous opportunity.
CHERECWICH : For the first time in a long time, clients are looking for assurances that custodians have the ability to settle transactions, help them open accounts and get payments through in these emerging markets. They want details of how to get invested in China, what it involves, who fills out forms and so on. As custodians, we need to be prepared to hold their hands through that process.
MARTIN : We just bought an equities business in Russia. We’re growing our ADR business and our trade finance business there, and we’ve found that not having a central depository for equities has created a manual, expensive and time-consuming process. We all need to work together as an industry to correct that. There’s a lot of interest from our clients in investing there, and we need to continue to find ways to help them do it.
KEENAN : You have to be creative and innovative on behalf of your clients to get them the access that they need. It’s very difficult—for instance in China—to secure the status that asset managers want secured in order to get the investment exposure that they’d like. ADRs continue to be an excellent way to afford our underlying clients access to the potential for performance in those markets without having to bear those burdens. But eventually and inevitably we’re going to have clients who want to hold local shares too.
MARTIN : India is closer to being able to accommodate the types of global custody services that we provide around the table here. Currently we offer local administrative services within India, and as the market deregulates, we will be ready to provide global custody, securities lending and other investment products.
GF : What regulatory considerations around the world are of most concern for custodians and their clients?
MARTIN : They’re not really concerns because a lot of the regulatory initiatives are promoting efficiency and transparency. Those are good things. But there are so many things happening at the same time—in Europe and Canada and so on—which are a real cost burden on all of us and our clients. We have to become even more efficient in how we process our traditional services to cope with the rising cost of regulatory compliance.
CHERECWICH : One of the concerns I have is the vagueness around some of the different regulations. The specific role of the custodian can be unclear. Exactly what is expected of the custodian in each country? Many times there are different interpretations of the regulations—at the country level and at the client level. As an industry we should try to come together to help our clients by proposing standard solutions to the regulatory bodies. This is a global business, and we should be lobbying for global standards.
MARTIN : Sometimes the regulations have unintended consequences, too. The Markets in Financial Instruments Directive [MiFID], for example, states that you don’t have to trade on exchanges, so now we’re finding several investment banks working together and doing their own trading and not using an exchange. As custodians, we have to deal with our clients using these types of setups. Also, with MiFID, the reporting requirements are different in each country. That makes it extremely difficult for service providers and for clients who deal with each one of those markets.
CHERECWICH : The goal of MiFID was to make transactions more transparent. It sounds simple, but by the time we’re done with the regulations and the interpretations, it can be very, very complex.
KEENAN : We’re in a period of greater regulatory scrutiny, and it will take a while for true best practices to emerge. We like standardization, we like to know what the rules are, and we will play by them. We have a problem when the rules keep changing and they’re different for everyone. The general trend is toward greater transparency, which is a good thing, but in the process we’ve added a great regulatory burden, and I still don’t know that we’re actually achieving the goal. Another point is that this has caused our clients and prospects to really look at their service-provider arrangements and make sure that they’re being well served, that they’re getting greatest value. That’s created an extraordinary opportunity in the marketplace.
GF : There’s been a blurring in the distinctions between traditional investors and hedge funds. How has this affected custodians and the relationship to prime brokers?
MARTIN : We have devoted capital and resources to delivering new capabilities, integrating the financing, collateral management, accounting and asset servicing needs to support this type of business.
KEENAN : Most recently we have seen a tremendous interest among our traditional long-only clients in the potential of 130/30 and similar “hedge fund light” strategies. In fact, we recently announced a turnkey capability—from prime brokerage services, to custody and accounting for long and short positions, coupled with innovative collateral management services all designed to support the needs of these traditional asset managers as they expand their products to include these products. We really believe that this approach will offer significant potential from a cost-savings and risk-reduction perspective and have already enjoyed significant interest from our clients in our holistic approach to this high-growth segment of the funds business.
CHERECWICH : Our product-development group combines innovation with reacting to customer needs. The trick is not just building for one client—rather, creating solutions that can be commercialized to meet multiple client needs. Pooling is a great example. We needed a way for multinational organizations to be able to combine their assets across multiple jurisdictions but still get the same tax benefits they enjoyed by running the plans separately. This idea came out of a combination of client demands and forward thinking. Our Passport product is another example. Our clients expect information to be on their desktop right away. They expect it to be easy to obtain and be presented in ways that make their job easier. In order to do that, we must not only show them the information that they are looking for but also answer questions they haven’t yet asked. KEENAN