EVANS:
There is enormous opportunity. The o u t s o u r c i n g concept around custody and securities lending has long been accepted, but its evolution continues. We are seeing great opportunities in hedge fund servicing and private equity servicing. And there is opportunity in the separate account market. Also, for the first time, we are seeing ‘bulge bracket’ mutual funds looking hard at whether they need to be in the fund servicing business. They have performance issues, and they are looking hard at their expense base. We are seeing the same phenomenon now in the 401K market.
APPELL:
While some of the larger opportunities are in full back-office outsourcing, we do not see outsourcing as a predetermined package, but as an entire value chain of back-office activities cust o m i z e d around individual client needs. Clients find this component approach very compelling.
DARMANIN:
The evolution of outsourcing is initially cost driven. The most popular outsourcing applications are those that would require additional investment. We’ve seen successful outsourcing projects of late in the hedge fund industries and in the separate account marketplace.
LATTIMER:
As markets continue to g e t stronger, people will now have the luxury to take a look at things like outsourcing and make some real decisions.And in a strong market, the real cost savings from an outsource relationship can be great enough to justify the upfront cost.
D’ANDREA:
Europe is leading the way: The appetite is much bigger there than in the States. But you have to be careful which deals you choose because they are all huge. Once you choose a deal, the market boxes you out of a lot of other opportunities.
CONNELLY:
With complete outsourcing there are concerns about the lack of diversification, so we take an open architecture, b e s t - o f - breed app r o a c h . One organization is not going to do everything well. In that context, we have been focusing on certain areas that can enhance connectivity.We have developed a router product that is designed to make it look in the back office like you can deal with one portal or one entity but, at the same time, plug in the best outsourcing solutions.
GF:
What issues are developing in the operational risk management area?
GREENE:
The principal regulators are becoming more involved. We are starting to see increasingly specific guidance on how these plans should be developed and operated.
D’ANDREA:
The most recent development on our side, directed for us by the regulators, is what we are calling extreme continuity of business—how we would cope if a building was just gone.We are working with the Fed, with the depository trust company, making sure that we have backup. It’s a huge effort, but unfortunately it’s something we really have to do.
CONNELLY:
One result of this is a spirit of cooperation between providers and customers. This is a shared operational risk that leads to a sharing of information, which enhances the relationship we have with our customers.
APPELL:
The geographic dispersion of data centers is an issue: You need them to be far apart but not too f a r . A n d there’s the i n e v i t a bl e expense issue. We’ve all signed up for additional data centers, and it’s a huge expense. The key is to leverage that expense via increased operational efficiencies.
DARMANIN:
It has also shown how important it is to have global platforms that operate using the same applications. That gives you a real ability to switch on other service and data centers in the event of a disaster.
EVANS:
There is a new focus on auditors to sign off on business continuation. A lot of firms are looking at that now.
LATTIMER:
There is a lot more precision today when it comes to continuity planning. Not only should you be able to continue your operation; you have to make sure there is no downside in compliance, regulatory observation or monitoring. It’s a much more complete environment that you need to be able to recover to.A lot of clients are really wrestling with that.
GF:
How are custodians servicing clients in the $500 billion alternative investment market?
GREENE:
This is basically a build or buy decision.We elected to buy because the asset class was growing so rapidly.This business is pretty complicated but has excellent growth potential. The regulatory reforms under way will make customers more comfortable with these products, which will be good for everybody in the business.
LATTIMER:
Our Eagle Investment Systems subsidiary developed in partnership with Morgan Stanley Prime Brokerage a system called PTS Plus that provides hedge funds with an integrated solution that will handle all aspects of their fund, partner and shareholder accounting and reporting.We are excited about the alternative investment arena. When you look at the returns that investors are seeking, alternative asset classes will continue to make more sense.
EVANS:
I think that you have to buy to be a meaningful player. If you don't, you’ll be on the periphery. This market is global, and it’s a huge growth story: These are sophisticated products, but at the end we are offering a lot of the very same services whether it be accounting or tax.
CONNELLY:
This is one of the great frontiers. Regulation will be moving our way in this asset class, with regard to arms length, separation—the need for a cus- todian in the process.You’ll have to be nimble and customized, because all these alternative investments have a different slant so it’s a little more difficult to leverage this business.
DARMANIN:
We also bought our capability in this market.We saw this very much as an additional service that our clients were looking to obtain from us as part of the range of services that they expect from a custodian bank.
GF:
Some observers are questioning the value and wisdom of clients keeping exclusive custody relationships. Do you agree that diversification of providers will reduce risk and, in the long run, lower costs?
DARMANIN:
Clients increasingly want to consolidate with one service provider. It gives them more leverage from a buying power point of view, and more uniform information.
D’ANDREA:
It’s only the largest of the large that choose multiple providers. A lot of it has to do with technology:You don't have to manage two different custodians, two different interfaces, so it is more cost effective. The large customers are going to get the fees they want.
LATTIMER:
The level of integration and the ability to support multiple product lines, the technology required to deliver information, the type of relationship that clients want with service providers, is very different than in the past.Today it doesn’t make sense to have multiple custody providers.
EVANS:
As custody itself becomes a commodity, people are diversifying around it. Customers may not use you for all their FX, or all their securities lending. The focus in today’s buy is less custody-centric.
APPELL:
While custody is at the core and it brings the assets into the shop, it’s the higher-value type products that help build the relationship for us and add the most value for the client.They make the relationship more meaningful so you do not pick it apart from a profitability standpoint.
CONNELLY:
I find it difficult to understand why an ind e p e n d e n t trustee would decide it was in their best interests to go to one provider. You might have a majority custodian, but you will have one or two other players to provide that pricing benchmark, so you don't have all your eggs in one basket.
GREENE:
Companies do look at each of those services individually to make decisions on each of those services. Once they have satisfied themselves that they are getting best-of-breed in each of those categories, then the deal has to make sense in the aggregate financially.
GF:
The custody industry continues to consolidate around fewer and fewer providers. Is this process of consolidation over? If not, where will it lead?
EVANS:
There are a lot of bit players in the custody game that have to be considering cashing out while their business is at a premium—before it continues to erode. The bigger players, too, have to think very hard about transforming their business model and finding alternative revenue streams and look creatively at partnerships and alliances.
GREENE:
Consolidation is definitely not over. Size matters in this business. Scale drives unit costs.We expect that there will be very few global full-service fully dedicated firms specializing in this business.Those that survive and succeed will have to be, we think, exclusively fo c u s e d on asset s e r v i c - ing.
D ’ A N - DREA:
It has to end at some point. There are going to be very few true global players, and we might be getting down close to that number now. There is always room out there for a regional player, though, a niche player.
APPELL:
Size and scale matter to a point. But clients are looking for two things: real value and focused capabilities. They are looking at how closely focused your business is in supporting the custody function, and if you can compete in terms of costs. If they like the answers, there’s a good chance you’ll remain in that business.
CONNELLY:
There is enough there for a couple different types of firms to prosper. The smaller players that have custody as their primary business still have a place at the table because, as the consolidation continues, it creates an interesting byproduct whereby your business partners become your competitors. ■