The new 'value added'
Back in the old days, custody was a reassuringly straightforward business, encompassing safekeeping, clearing and settlement, with a few ancillary services such as proxy voting and tax reclamation thrown in. However, by the early 1990s, the custody marketplace was becoming increasingly crowded, leading to downward pressure on pricing and the inexorable commoditisation of those ‘core’ products.
Faced with eroding margins, and aware of the importance of keeping pace with the evolving needs of a rapidly globalising client base, custodian banks adopted their own diversification strategy to maintain their edge. Accordingly, by the mid-90s the marketplace was awash with so-called ‘value added’ products – investment accounting, master trust, performance measurement and attribution, risk analysis and global securities lending being the most notable.
Fast forward, however, and it will come as no surprise that the global securities services product set has moved on once again in line with client expectations, and what were once useful add-ons have now themselves come to be viewed as core components. For instance, monitoring services – be they around compliance, performance, risk or accounting – are now viewed as indispensable by pension funds in light of the shift across Europe towards a more transparent operating environment.
With depressed capital markets forcing more and more corporates and plan sponsors to reassess both their investment strategies and concomitant choice of asset manager, custodians have begun to offer venture into the transition management space. A poorly managed portfolio restructuring will invariably result in higher trading costs as well as compromised performance and asset allocations along with other significant risks, all of which can be mitigated through the use of a third-party provider.
Where once the process essentially involved the liquidation and reinvestment of holdings, today it is not fanciful to compare the role of a modern transition manager to that of a short-term investment manager during the period that a fund is in transition. In addition to handling execution, the transition manager must act as a conduit between the legacy fund managers, the new managers, the auditors, the accountants and the custodians involved. However, providers are under pressure from clients to provide maximum transparency as regards costs; furthermore, clients often require ‘due diligence’ to be carried out so they can ascertain in advance the costs involved in a transition, and thus determine whether terminating a manager does indeed make good economic sense.
Perhaps more significantly, another niche now being targeted by custodians is hedge fund administration. However, buying capability in this area – rather than building it from scratch – seems to be the favoured route, as evinced by State Street’s acquisition of US-based fund administration and middle office services provider International Fund Services, and The Bank of New York’s decision to snaffle up International Fund Administration, a Bermuda-based alternative investment fund administrator.
Outsourcing service provider BISYS has also been on the acquisition trail, buying Hemisphere, the largest hedge fund administrator in Europe, and latterly the DML Fund Services Group. Other custodians are expected to join the party in the not-too-distant future, although some are understood to prefer alliances with established administrators as opposed to full-blown acquisitions.
This trend reflects the growing interest in alternative investment strategies amongst institutions and pension plans – indeed, a report on the investment habits of nearly 500 pension fund clients published a few months back by Mercer Investment Consulting found that no less than 32% of respondents were considering using hedge funds.
However, hedge fund administration has always been a demanding activity, and it is only getting more complex as traders seek to address eroding margins by utilising ever more exotic instruments and derivative structures become ever more inventive as they pursue higher returns. The need to reconcile positions with both the manager and the prime broker on a daily basis is a particular challenge for custodians, who lack both the sophisticated technology and the necessary skill sets required to service non-tangible assets – hence custodians new-found love affair with existing service providers.
Like so many aspects of mutual fund processing within Europe, transfer agency (TA) – which includes the registration/transfer of ownership of mutual fund shares, the maintenance of shareholder records, issuance of new certificates and the distribution of proxies, annual reports, dividends and company materials – is an extremely manual and costly undertaking, one whose complexity only increases as cross-border volumes rise.
As distributors seek to improve efficiency and provide a better service to their end-clients, so fund managers are coming under increased pressure to offer them a more sophisticated and customised service – and that includes providing a top-class TA capability. However, the cost of building and maintaining a truly multi-lingual and multi-currency platform capable of dealing with Europe’s diverse regulatory environments is simply too high for many managers, and hence are increasingly looking to outsource TA to custodians.