Is big becoming a problem in the custodian world? This article explores the issues that big custodians are having to contend with in an environment of more rapid change and fierce competition.
The catchword of the large custodian banks has traditionally been that size matters. To make money, develop technology and service customers, they argue, the larger you are the more scale you have, and the better placed you are to develop, grow and flourish as a custodian. This thinking has driven a plethora of takeover and merger activity over the past 30 years and has produced an environment where the constant prediction is of further consolidation.
Much of the thinking that has driven this approach has been predicated on an established technology environment that has its origins in the 1970s. The large custodians, which got that way primarily on the back of mergers and acquisitions, run this business on legacy systems that have their genesis in the 1970s and 1980s. In many cases they are running multiple systems for the same function and have found it extremely difficult to migrate customers on to a common platform. In fact, it is this type of process and the difficulties of these types of systems that have forced the custodians to spend hundreds of millions of dollars on technology. Based on the above we should be asking if this is in fact a good application of resources from a customer’s perspective or is it being dressed up in marketing speak to put a good spin on an inefficient system?
The whole discussion around scale and technology budgets has created significant barriers to entry for new players or an incentive for smaller players to leave the marketplace on the basis they cannot compete on the playing field. But is this line of thinking still valid? New technologies offer new opportunities and are changing the industry dynamic. Large custodians with billions invested in legacy systems are finding the going increasingly tough. Let’s build on this theme.
The changing pace of this investment industry and regulations has hampered the large providers of custody in the world markets. Rapid change in the industry has become the norm and it likely that change will become quicker and more regular. In this environment we all know the difficulty of responding continually to change with legacy systems that are difficult to code and test.
In addition, the customer is also becoming far more demanding in terms of service levels and service requirements. They are looking for customer-specific reports or customer-specific practice, which does not fit the traditional assembly line approach that is the required modus operandi for inflexible legacy systems. Customers are demanding and want their specific requirements fast and as part of the standard service. They don’t want to have to wait while the software is cut, testing completed and an appropriate window can be found to complete their ‘system upgrade’. In fact, unless you are a very large customer you probably won’t get this anyway.
Modern technology solutions are available that counteract these problems. They are available to all players in the market. But here is the rub for the large players. The sheer size that made them successful is now inhibiting their ability to adopt and benefit from this new technology now. To move trillions to a new system is an enormous project and one that is high is risk in terms of cost, failure and service impact to clients. The large players have instead taken the approach of putting a nice wrapper around their legacy systems to make them appear up-to-date. What this does is make the overall architecture more complex and difficult to change over time.
The new technology solutions are relatively inexpensive. The whole system costs substantially less than what it costs the large players to keep their legacy systems functioning. This provides new players in the market and existing small players with opportunities that previously did not exist. They have the opportunity to offer new services, to move up the value chain and provide customers with solutions, that are cheaper, more flexible, more accurate and faster to market than their larger competitors. These new solutions are acting to significantly reduce the barriers to entry. As the price of technology falls there is incentive for new players to enter the market. As the price drops further large outsourcers will be provided with the incentive to insource again . The market dynamics are changing and it is the smaller players who will be best placed to take advantage of these changes.
The trillion-dollar custodians are constantly marketing the fact that they have huge economics of scale and that this is a significant advantage. But does increased size necessarily mean increased efficiency? Research tends to point to the opposite effect. In manufacturing optimal economics of scale in a competitive marketplace and that efficiency loss is small where operations are below optimal scale. Today’s technology, with higher levels of straight-through processing, electronic data feeds, new SWIFT standards etc, is ensuring that smaller custodians are achieving the necessary efficiencies on far smaller operations than was previously the case. In fact size and complexity are creating major management headaches for the large custodians.
Hungry new entrants to the market are using all avenues possible to break in and become successful. Put bluntly they are innovating to differentiate themselves from the existing dominant players. The technology adopted and used by the smaller players is giving them the ability to challenge the boundaries of what has been the accepted norm in the past. The larger players, constrained by their old technology, size and enviable track record, are finding it difficult to adopt or rediscover a culture of innovation. New ideas, services and opportunities for customers are starting to emerge from smaller players taking a leadership role within the industry. To keep up, the larger players are adopting the tactics that they have always adopted – simply to acquire, not realising that this is just adding to the issues they are continually faced with.
All businesses to remain viable must show ever-increasing growth. The larger the business is the harder it is to do this. Custody is no exception. The larger custodians are interested in the larger deals to be able to make an impression whereas the smaller custodians are in a position that they are willing to look at any deal and that these will have an impact on their bottom line. In short, smaller custodians are hungry for any business and are therefore more likely to service a wider spectrum of the market.
The smaller and more nimble custodians are hungry and ready to please. Their technology is now in many ways superior to that of the large custodians. The industry dynamics are profoundly changing. The large custodians will say they have the resources to do whatever a customer wants but do they really have the desire? The smaller custodians are focusing on delivering client-focused solutions faster, cheaper, accurately and flexibly. New technology is giving them the opportunity to do this in a very efficient manner. It would be no surprise if, rather than see further consolidationt, we see some old players returning to the market. For service is not a question of big beating small but fast beating slow and this is the new catchword in custody. Pension fund trustees and fund managers should keep this in mind when considering which custodian best suits them as a future service provider.
Chula na Ranong is global head of productivity and quality assurance and director of IT, CIS, Clydesdale Bank in Glasgow