Custody in a post-Lehman world
While safe-keeping is now in the spotlight, it is in investment managers' search for a business model to withstand a bull or bear market that a custodian can add true value, says Andrew Gelb
The collapse of Lehman Brothers last year promises to have a long-lasting impact on the asset-servicing industry. With some investors still awaiting the restitution of their assets, the affair has fundamentally changed attitudes to counterparty risk and asset safe-keeping. Helped along by the Madoff scandal, safety and transparency are now top-of-mind for asset owners everywhere. A safe pair of hands has never been more important.
The investment management industry has suffered a sharp contraction in assets under management. In a June 2009 study of the investment management industry, co-sponsored by Citi and Principal Global Investors, CREATE-Research notes that gross revenues fell by 35% last year and a further fall is in prospect for 2009. Firms are responding by cutting headcount and pruning their product ranges. End-investors are putting pressure on managers' fee structures. It would be remarkable if none of this pressure found its way back to service providers. The research notes that there is evidence that, in the post-Lehman world, investors are turning their backs on complex products. It has been suggested that this might reduce investment managers' demand for the more complex, and higher margin, services custodians provide, such as full outsourcing solutions.
What does this all add up to? It is important to understand that the role of the custodian has shifted markedly in recent years. Today, good custodians are providers not just of securities processing services but also of investor services solutions. Tough times for investment managers make this role more, not less, relevant.
In Thriving Amid Change: A Playbook For the Securities Processing Industry (February 2009), management consultancy Booz & Company highlights how investment managers can reduce costs by moving from a fixed to variable cost base by transferring their non-core functions to custodians. The report says custodians should not be looking to retrench during the current crisis but should be "re-engineering processes, automating services and optimising the use of global facilities". In turn, this will enhance their offerings for investment managers, most importantly in the middle-office area.
The role of the custodian is now as much about cost containment and risk management as it is about safe keeping and settlement. It is about reducing the cost of asset ownership throughout the investment lifecycle - by using scale and a global technology set to deliver cost efficiencies no investment management firm can hope to achieve on its own. And it is about leveraging the data flows to deliver the risk management and analytics services that help clients monitor and manage their exposures.
The CREATE-Research study continues with a warning that, as investors increasingly turn their backs on complex products, so the dangers of commoditisation increase - placing further pressure on investment managers' margins. In conclusion, the report highlights how a variable cost model is now essential to cushion firms from exceptional revenue falls.
However, only 13% of respondents said their costs varied ‘to a large extent' with levels of activity. The report notes that more firms were now introducing variable pay structures and considering outsourcing elements of their front, middle and back office activities. In fact, the number of firms outsourcing either their middle or back office was expected to double. "The effect of this process," says the report, "is to create a distinct craft focus at the investment end, customisation at the distribution end and standardisation at the administration end".
In their quest for the right blend of best-of-breed products, investment managers seek to partner with providers other than their custodian. At Citi we have long supported this approach, providing non-custody clients with the benefit of scale economies and an enhanced custody service which is delivered flexibly through a modular product set that can draw on different capabilities at different points in the trade cycle - and with either bundled or unbundled pricing.
One example is foreign exchange. A firm managing segregated accounts will have many different custodians to deal with. Whether we are one of them or not, we can still capture all the trade data from that firm's middle office and give that client the benefit of aggregated FX dealing.
End-to-end integration is a prerequisite for being able to add value in this manner. But it is also increasingly important in delivering the safety and transparency investment managers and their clients, especially pension funds, now demand in the post-Lehman world.
Many believe a hybrid service for hedge funds presents the best solution. Citi's Prime Custody solution leverages both the skills of our Prime Finance and the security and transparency of our custody capabilities. While allowing a fund's unencumbered assets to be held by the custody arm, the service still provides combined reporting for all the client's assets, including those held by the prime brokerage division.
The same demand for safety and transparency is driving the development of integrated trading and settlement solutions delivering best-price execution across multiple markets. Our Execution-to-Custody service, launched with the best execution requirements of MiFID in mind, draws on both our capital markets and securities processing operations to deliver an end-to-end service that not only spans all major execution venues but is supported by a comprehensive custody service. Investment managers have the freedom to pick and choose the broker they wish to use to achieve the best deal for their client.
Scale is also a key element to asset safe-keeping. In today's environment investment managers require a comprehensive sub-custody network and the ability to operate on a single global platform. This means the investment manager has a greater sense of control, transparency and support in the form of local service centres around the globe with multiple disaster recovery options.
Lehman's collapse proved to be not only a major credit event but a reminder of the importance of the custodial function. It is too early to say whether the fallout from this and the subsequent Madoff affair will result in a tougher regulatory environment or even a re-evaluation of the security offered by different custodians. But the same market conditions that scuppered Lehman are now obliging many investment managers to rethink their cost base and business model. Clearly, a partnership with a custodian that is capable of supporting all or any operational area - front, middle or back - in an integrated manner is very likely to contribute to the future success of an investment manager.
Andrew Gelb is head of EMEA securities and fund services at Citi