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A buyers market

Iain Morse assesses trends in the German custody market

"The German custody market is already very competitive and likely to become more so," warns Uwe Dreger, head of domestic custody services, Western Europe, at Deutsche Bank. Deutsche withdrew from global custody a couple of years ago, selling its business to State Street, but has since built a position as Germany's biggest sub-custodian. 23 November saw the launch of its real-time CASCADE connection to Clearstream banking Frankfurt (CBK), the German central security depositary. "We are the first German sub-custodian to offer this facility, a step change in this market designed to meet needs of global custodians," adds Dieter Bernhard, head of domestic custody services, Germany, at Deutsche Bank.

It is also one likely to leave many of Deutsche's competitors facing some thorny decisions. Do they invest in the same, expensive, technology, sell their business, or muddle along as best possible? There's nothing new about this quandary.
Rationalisation is taking place throughout the European custody industry. UCITS IV is one of a number of current and imminent regulatory changes that are restructuring the competitive environment for depot banks. "Basically this will lead to a situation where pan-European depot banks will be advantaged over one country providers," cautions Dietmar Roessler, managing director at BNP Paribas Security Services Europe. The days of local, independent depot banks operating in the custody market appear to be numbered.

Rationalisation may be inevitable, but in Germany this process has been far slower than expected, inhibited by the regulatory structure of the domestic banking system. The architecture of this system is famously complex, regarded by some as archaic; there remain some fifty-five depot banks, still involved in the custody of domestic equities and bonds. A handful of these, including West LB, UBS and LBBW banks, own a majority of the business but reliable data on the bank's market shares is scant.

To complicate matters, there are several different types of pension entity which may require custody services - Pensionskassen, Unterstützungskassen, Pensionsfonds and Contractual trust arrangements (CTAs). Domestic insurance companies are also starting to review their arrangements, outsourcing both administration and custody. This is still a market where local relationships can be vital, not so much in winning as retaining business. It also cuts up a little differently from the Anglo-Saxon market where global custodians expect to supply clients with a comprehensive service range.

For instance, insourcer Universal Investment is by far the largest provider of administrative services to Spezialfonds but does not provide any custody services. Many of the smaller depot banks provide no administrative services and ‘plain-vanilla' custody services. Investors holding only domestic bonds, some hold-to-maturity Schuldscheindarlehen, and narrow portfolios of German equities, may regard this level of service as quite adequate.

Then there are complex corporate relationships that have depot banks and master KAGs belonging to the same group. Even where custody services are provided without real profit, providers will treat custody as part of a far wider relationship. "Cross selling is a feature of this market," judges Reinhard Liebing, senior consultant at Mercer Deutschland. "It may keep some depot banks in the custody market."

The master KAG market is now very competitive. "Players are trying to survive by aggressive pricing and improving their service quality," adds Liebing, "Capital has been invested in the systems required to support ‘next generation' master KAGs and the relevant custody services by existing players." The cost of this competitive upgrading may leave some master KAGs running at a loss, just as it becomes harder and harder to squeeze economies of scale from this market.

Fallout from the credit crunch has made investors more conscious then ever of counterparty risk. "The fact that we have a strong double-A credit rating is now seen as important by existing and prospective clients," argues Gerald Noltsch, managing director at BNP Security Services. "Post-Lehman, default risk has become very important and by moving to us or a similarly rated bank this risk can be minimised."

Needless to say, the issue of counterparty risk and the credit ratings is being used by the global custodians as an argument for prospective clients to review their custody arrangements. Counterparty risk extends to any sub-custodian relationships entered into by a custodian; once again, using a global custodian minimises or eliminates this risk. This is a key issue for clients diversifying into relatively exotic asset classes such as emerging markets. The global custodians also report a sea-change in the attitude of clients such as to the frequency of reporting and analysis of risk in client portfolios. This says nothing about issues such as the portfolio valuation of derivatives or the use of hedging strategies. Local custodians struggle to meet these rapidly changing requirements.

The recession has seen a collapse in the price put on local custodians. Multiples of ten to twelve times custodian's trading income were being paid a couple of years ago. These have fallen to low single digits: "That was a sellers market, but this is a buyers market." cautions Noltsch. Some custodians would still like to sell, but can't find the right price. Other will have re-valued their custody derived income steams deciding they are worth more than much reduced price multiples on sale. Nevertheless, everyone agrees that over the next five to ten years the positions of all but a handful of the largest depot banks will become less and less viable.

Meanwhile three global custodians, JP Morgan, State Street and BNP Paribas, now dominate the upper strata of this market each with assets under custody in the €80-234bn range. Behind them come newer market entrants like SocGen and Kas Bank."Not surprisingly, the global custodians are playing to their strength, emphasising their expertise in serving global investors, trying to play the card of broad service areas," notes Liebing. These strengths don't always play as well as expected, however. For instance, in markets like the US and the Netherlands, price data on best execution is likely to be sought by investors, not to mention issues such as market impact. "Some investors will want to know about this, but there is a tendency to focus on net returns rather than to analyse the investment process in any granular detail," says Liebing.

Success in the German market requires more of global custodians than in other more mature markets. Take the example of JP Morgan, longer established than its rivals and now with assets under custody of some €234bn. Fully licensed as a German domestic depot bank, JP Morgan also manages a master KAG. "A key part of our relationship with clients is that we are very close to the German and indeed, the Swiss markets," says Oliver Berger, managing director of JP Morgan, Germany. JP Morgan's online client portal is available in German. It has 185 Spezialfonds clients, as well as thirteen of Germany's largest pension funds. All of this has been achieved through organic growth. "Going forward growth will be both organic and inorganic. If we want to gain significant new market share this may have to be through acquisitions," adds Berger.
 

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