Author: Gordon Platt

Ehrenstrom: Custodians mitigate risk and respond to regulatory and cost pressures
Total assets under custody worldwide have surpassed $80 trillion, according to, an online database of 48 securities services providers. Not only is the industry getting very big, but the costs of providing services also is increasing, along with the complexity and risks in global trading.

Griff Ehrenstrom, senior vice president and head of US institutional sales at Chicago-based Northern Trust, says the growth of the industry reflects the fact that the services global custodians offer are very attractive. “These services mitigate risk, respond to regulatory and cost pressures and allow institutional investors to focus on their main business of investing,” he says. The growth of the global custody business also reflects the growing assets accumulated by retirement programs, he adds.

While the majority of assets under custody are concentrated in a handful of custodians, there haven’t been any recent major mergers in the business, Ehrenstrom says. That is symptomatic of a change that is taking place: Rather than outright acquisitions, creative partnerships will be important in the future, such as the agreement between Svenska Handelsbanken, based in Sweden, and Northern Trust. The partnership allows Swedish mutual funds to select a global custodian that can also offer trustee services through a local provider. “We use Svenska Handelsbanken for local custody in Sweden, and they rely on us for global custody,” he says.

In developing new services, Northern Trust considers the pressures that institutional investors face, ranging from the under-funding of pension plans to the need to control costs, Ehrenstrom says. “Outsourcing is one way to enable fund managers to manage costs and to focus on their objective of obtaining higher returns,” he explains.

Northern Trust in April 2006 added socially responsible investing guidelines to its Compliance Analyst product that monitors investment portfolios. Under an agreement with Rockville, Maryland-based Institutional Shareholder Services, it provides research on whether institutional and wealth management clients are investing in companies that derive revenue from areas such as adult entertainment, alcohol or weapons production.

Alan Greene, executive vice president and head of investment servicing in the United States for Boston-based State Street, says the growth in assets under custody reflects growing economies and increased interest in saving for retirement and education. The industry likely will continue to grow at a rate of between 5% and 7% over a long period, he says. Consolidation is likely to continue, he adds. “This business requires a lot of capital and a lot of focus, which will limit the number of participants,” he explains. The likely survivors will be the biggest providers and the niche players.

State Street operates in 26 countries and uses sub-custodians in more than 100 markets worldwide. While some progress has been made in streamlining the global trade-processing infrastructure, there is more coming, Greene says. “This requires industry collaboration, which is starting to happen,” he says.

Meanwhile, there is growing interest in outsourcing in the US, which has lagged Europe in the scope of functions that institutional investors outsource, according to Greene. “These functions now are moving well into the middle office,” he says.

Richard Ernesti, managing director and head of international sales for alternative investments, fund services and securities services at Citigroup, says the main reason for the industry’s growth is that the economies of the big industrialized countries are still expanding. “There is also growing demand from individual investors to go cross border to diversify their portfolios,” he says.

On a regional basis, the growth in assets under custody at Citigroup has been particularly strong in Latin America, which had a year-on-year increase of 70% in the first half of 2006, Ernesti says. The bank’s custody assets for Europe, the Middle East and Africa rose 30% in the same period, while assets for Asia were up 28%. Citigroup’s US custody assets rose 10% in the first half.

“The domestic markets in many developing countries are continuing to grow, while pension funds are expanding and new types of investment instruments are being introduced,” Ernesti says. Brazilian pension funds are seeking more exposure outside of their home country, while intra-regional investments are increasing in Latin America, along with a growing outflow from the region, he says. “The recent flow from the emerging markets to the Group of Seven [industrialized nations] is unfortunate, because in this flight to quality, investors are overlooking good assets,” he says.

global_custody2_big global_custody3_big
Ehrenstrom: Custodians mitigate risk and respond to regulatory and cost pressures

Compression of margins in the global custody business is likely to continue, according to Ernesti, and there could be further consolidation in the industry. “While none of the top-five providers is likely to merge, there could be consolidation at the next tier of providers,” he says. There could be consolidation within Asia, for example, with providers exiting sub-custody to focus on global custody for local banks in the region.

Meanwhile, more and more of Citigroup’s custody clients are asking the bank to provide additional outsourcing services. “They are redrawing the line where the back office ends and the middle office begins,” Ernesti says. “This enables them to move from a fixed cost to a variable cost for these processes.”

Lazard Asset Management, Janus Capital and Federated Investment Counseling are among the asset managers that appointed Citigroup in the past 12 months as the operations service provider for their separately managed accounts businesses.

Slimming Down the Process
There has been a great deal of progress made in streamlining the global trade-processing infrastructure, Ernesti says. “Straight-through processing accounts for 98% of such transactions at Citigroup, and we will see more and more,” he says.

Kevin Smith, senior vice president, global custody operations, at The Bank of New York, says the growth in global assets under custody reflects increases in the overall valuations in client portfolios over the past two years. It also reflects the fact that clients are allocating additional funds to global fixed-income and equity markets, as well as the trend toward outsourcing, whereby assets that formerly were held directly in the market are now being held in custody, he says.
Concentration of assets in the hands of a relatively few major providers is the result of corporate-level mergers, as well as the fact that some firms are divesting from the business, Smith says. “Meanwhile, the barriers to entry are very high in terms of expenditures, size and commitment,” he says.

Different types of industry structures are emerging, according to Smith, and many custody banks are entering into alliances and other forms of cooperation to gain economies of scale and improve their ability to meet customer demands. The Bank of New York made a strategic investment in the data-hub and warehouse business of Netik in 2004, acquiring a majority stake in the transaction-processing software firm and entering into a partnership to provide integrated products and services to financial institutions.

“Our commitment to information technology is not and never has been a one- or two-year proposition,” says Smith. “It is ongoing and increasing in a continuous manner, year after year.”

With the addition of Serbia in July, The Bank of New York provides securities services in 102 markets worldwide. In June the bank announced the creation of an Office of Innovation to accelerate product innovation across its securities-servicing business. The initial focus of the office, headed by chief information officer Kurt Woetzel, will include areas such as hedge funds and derivatives.

Gordon Platt