Pooling is hot. That, at least, is what the big global custodians would like you to believe. They maintain that an increasing number of pension funds are pooling their assets with fund managers, rather than holding them on a segregated basis. In turn, these managers are dealing with their custodians through wholesale, rather than individual client, accounts.
If this is true, it represents a complete volte-face for the industry. Ever since the US custodians arrived in Europe, more than 10 years ago, they have been highly vocal in their promotion of the segregation of fund management and custody. After the Maxwell affair, some even went as far as to recommend that, in the UK, pension funds should be legally obliged to contract separately for the two services, an idea ultimately rejected by the government. But, through assiduous marketing and sheer persistence, the custodians have successfully challenged the hegemony of fund managers and universal banks, wresting key pension fund mandates away from the established, in-house providers.
As a result, very few investment managers now offer custody as part of their package of services, whilst universal banks that previously bundled together all management and administration have found themselves under pressure to become more competitive or cede control of the custody component. To their credit, the global custodians swept away much of the indifferent service to which buyers had grown accustomed and created a more competitive and efficient marketplace.
So, European pension fund sponsors should have little to complain about. There is still a healthy amount of competition, keeping fees under control, and there has never been such a breadth of product and service on offer, from securities lending through to performance analysis. Why, then, should anybody be concerned about the custodians' new focus on asset pooling?
If you’re a big fund – and big nowadays means over e1bn in assets – then you are one of the lucky ones. Custodians will happily do business with you on a direct basis, offering you all the bells and whistles at their disposal. But if you are unfortunate enough to be smaller than this, you may run into some difficulties. What the major global custodians appear to be saying is that they simply don't want to deal with you directly if they can possibly avoid it. Instead, they would much prefer to have a wholesale relationship with your fund managers, servicing the much bigger pool of assets that these managers can offer them.
The big custodians have become victims of their own success. Their systems and operations have grown so large that they must consistently pump huge volumes through them to make any sort of economic return. Smaller funds, with lower transaction volumes, cannot generate enough revenue to make a difference to the largest custodians.
But it is not just a volume business: more than ever, custody is now about the added-value services on offer. Custodians can make big money from liquidity management, securities lending, performance measurement, fund accounting and a host of other investment administration products. The biggest pension funds tend to be the ones most likely to understand, need and buy these services, so it is only logical that the custodians focus their attention on them. It is the old 80/20 rule: 20% of the clients generate 80% of the revenue. For many custodians, the other 80% of clients are going to have to fend for themselves from now on.
Is this short-sighted? Does it represent good business practice? The answers to these questions will come primarily from some of the smaller players now preparing to fill this gap in the market. Banks like MeesPierson (featured last month in IPE) and Société Générale have already signalled their intention to move into the British market, whilst specialist providers like the UK’s Lawshare are gearing up to take on more business. If enough credible suppliers move into this niche, the smaller funds should be able to find a direct custody service that fits their needs at a reasonable price. If not, the market will experience its unique form of apartheid.
Small pension funds often grow into large pension funds. Almost all the global custodians will publicly deny that they have a selection policy based on asset size, yet many either refuse to bid for small mandates or do so with deterrent pricing. We are repeatedly told of the great strides being made by the custodians to reduce risk, cost and error through the implementation of automated transaction processing, but those benefits appear to accrue mainly to the custodians themselves or their biggest clients. When will the smaller pension funds be allowed to share in all this success?
The fundamental tenet behind the custodians’ new enthusiasm for asset pooling is this: custody is not a profitable business. All the services wrapped around it are the real money-spinners, whilst pure transaction processing remains distinctly marginal. Rightly or wrongly, profitability has become the primary criterion on which the value of a client is now judged. Relationships count for little in this hard-nosed world. What will be fascinating to see is whether the universal banks of Europe, famous for their relationship management skills, can reverse the trend.