The financial services industry will go through a consolidation as firms try to capture economies of scale and to insure coverage of major costs such as salaries and technology investment.
This trend is best seen through the business model shown in the figure. Each factor within this model is driven by factors within the levels beneath it. For example, assets under custody are driven by the combination of existing and new client assets. Existing client assets are driven by service quality and processing performance; these are in turn driven by technology and personnel.
Given this model it is easy to understand what is happening within the industry. Revenues increase with fee percentages and assets, yet costs remain relatively fixed. However, fee percentages are difficult to increase given the competitive nature and number of players in the industry. Furthermore, the trend will be lower fees, and with extra services and products it squeezes the net results to the custodian firms. Therefore possible alternatives to enhance the revenues are to increase assets and/or to provide high margin added-value products and services.
A reason for the drive for asset growth is that inefficient organisations, as measured by the ‘total expense ratio’, will become comparatively expensive, ultimately making them less competitive.
Capturing new clients requires good reputation awareness, solid processing performance and quality of service. The importance of these factors is evident from the brochures and advertisements of custodians. These can be further distilled to a tremendous capital investment in technology, advertising and quality personnel.
In the old days, the key to the business was simply the delivery of an acceptable processing performance. The marketing people were left to gather the assets. The custody business of today requires something more than acceptable processing performance, and this provides tremendous opportunities for new services.
Trends driving the client relationship include:
q Increased emphasis on the client relationship and dedicated client servicing.
q Increased market segmentation by client type, geography, risk profile and product type.
q Increased demand for integrated client reporting, monitoring and/or control.
q Increased focus on marketing, that is “product packaging”.
q Increased demand for straight-through processing.
q New players from other industries both financial, like Reuters and Bloomberg, and non-financial, like Microsoft, ADP or KPMG.
The role of the global custodian, servicing institutional investors either operating individually or in a very complex environment with external asset managers, should change. The traditional role of the global custodian is concerned with safekeeping in a large number of markets and a number of related services such as the post-trade settlement process, the processing of income and corporate actions, tax reclamation, proxy voting, integrated reporting related to these services and so on. This role mainly deals with operational processing services, related to a relatively small part of the investment value chain.
The custodial service approach does not include the whole pre-trade, trade execution, trade matching and confirmation process. Nor does it cover the after-sales services at the end of the value chain. Only the middle part of the process is included.
As many institutional investors face an environment of growing complexity –more markets, external asset managers, more complex investment instruments. Their biggest problem is not the correct, timely and cost-effective processing of separate parts of the value chain, but the integrated control of all these parts and the way these parts are interconnected. An example is all the consequences of risks, exposure etc, related to investments in emerging markets.
In other words, institutional investors are requesting a dedicated “investment value chain manager”, in control of the processing of all separate parts of the value chain, supervising the interaction between the separate parts, being aware of all the risks involved, taking action as soon as necessary and thus taking away all the operational and supervisory burdens from the institutional investor.
Moreover, this integration of management of risks and processing/accounting, must be very client-oriented. A condition of this service is extensive knowledge of the business environment of each client and its particular requirements.
The custodian becomes an ‘ information manager’.
Lex Elfers is director of business strategy at MeesPierson Information Bank in Amsterdam