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The truth about custodian fees

It could be argued that custodians have had years of super profits due to unadjusted custody fee schedules, opaque charging for foreign exchange and unidentified revenues from spreads on interest paid and charged. However, the past few years have seen significant downward pressure on custodians' fees and improved transparency of charging, and now some custodians are hinting that further lowering of price points will only come as a result of reduced service. How are custodians reacting to this pressure and how does it affect their existing client base?

During the bull market years, the banks that were able to build a reliable client base and revenue stream have been very fortunate; the markets carried them along for many years on a wave that produced materially more revenues than anticipated. The banks that have remained in the industry have generally amassed huge portfolios and benefited enormously from the lift in asset values, and have generated additional super profits from several sources including:

❑ Unadjusted fees in a market which has seen significant reductions in fee levels, during the last three years especially

❑ Unidentified revenues from spreads on interest paid on long balances and charged on short balances

❑ Opaque pricing in terms of the margins applied to FX rates where the custodian is given discretion as to execution.

To varying extents, the remaining banks have reinvested in people, technology and service quality initiatives, so in some respects, the customers may have received what they have paid for. However, there exists a serious crisis of confidence from the client side in the custodian banks who have;

❑ Failed to benchmark client fees to the market

❑ Applied usurious rates of exchange to FX conducted by the bank

❑ Applied outrageous interest margins to debit and credit balances

❑ Deployed financial penalties for moving cash away from the custodian and,

❑ Established barriers to facilitating third party securities lending

The consequence of this parlous state of affairs is that the custodian banks are now on the ropes when it comes to custodian reviews. Many are between a rock and a hard place as clients become aware that their custodian has been enhancing its share of the "client's wallet" (a favoured custodian sales term usually meant to refer to cross selling other custodial related products) without their knowledge or assent. The problem is that the client usually only learns of the problem at the time a review is undertaken and competing bids are received from other banks.Seeing an incumbent custodian's headline fee fall say 25% may come as something of a shock, but that is quickly put into perspective when other bids are received that may be 40, 60 or 70% less than the current fees. It may be fine going forward, saying that the review produced fee savings by appointing a new custodian of say 60%, but what of last year and the year before that.

Increasingly, disaffected clients are demanding restitution from custodians.

Therein lies an enormous problem. For the custodians, there exists an admission of guilt conundrum. If we pay, (to preserve the relationship) then we will be admitting guilt. If we don't pay, we will certainly lose the client. If we pay, it ought to be applied against previous years' income, but we can't do that. A reduction in forward revenues is even less attractive when the new fees are very fine in terms of margin already.

Although overcharging has been going on for years, some custodians have taken the view that it is better to enjoy the margin while they can, and when the overcharging is brought to light, they can argue for a while and reduce the fees progressively, as part of a loyalty incentive. That is to say, the client stays, and pays. (A reduced rate that is progressively discounted).

Other custodian groups have seen that this approach is not very palatable to clients and have now, (somewhat cynically) launched their own unsolicited re-pricing initiatives where they are taking new, discounted rate cards to the clients they don't want to lose. While the discounts are usually much shallower than they would be in an open market tender, some clients are persuaded and sign an extended contract that prolongs the relationship, and the cost. The issue is, as identified above, that headline fees are only one component of the fund/custodian revenue equation. Reducing headline fees by 20-25% is a start but what about reviewing the FX rates, the interest margins, the securities lending split. And are the levels of service commensurate with best market practice? How does the custody agreement deal with asset safety and risk minimisation? Is the custodian treating my fund consistently with other groups in terms of their willingness to take responsibility for losses? Am I getting best market practice across service, contractual representations and commercial terms?

The custodians who treat their clients as long term partners, rather than simply saying so, are more likely to continue to build long term businesses than those who treat them with abject contempt.

The losers will be those who continue to complain that the consultants are the culprits who are driving custodian fees down to unsustainable levels. For the record, the custodians set the fee levels they charge their clients AND the fee levels they propose in the review process.

Now the good news is that for a variety of reasons we believe that the rates custodians can charge, will begin to rise again as can be seen from the attached chart.

However, the custodial services industry remains with its challenges as it continues to adjust to:

❑ Changing market and service requirements,

❑ Increased competition,

❑ Uncertainty over capital markets,

❑ Lower global interest rates,

❑ Reduced volatility in foreign exchange markets,

❑ Enhanced regulatory interest,

❑ Pressure to conform and source new revenue generation opportunities

❑ Increased transparency in respect of ancillary revenues

❑ Harmonising tax regimes in Europe

But perhaps the greatest immediate challenge for custodians against this background is, what to do about an increasingly overpriced client base and increasing RoE targets.

Joanne Parker is the director of investor services at Thomas Murray (www.ThomasMurray.com)

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