Credit crisis pressures are forcing trustees and boards to seek more from their custodians both in terms of better risk management and lower costs, finds Iain Morse
Economic crisis always precipitates change. "Trustees and boards are focused on cost but also more and more on risk when it comes to choosing a custodian," notes Chris Angell, senior consultant at Mercer Investment Consulting. The terms of contract and fee structures for this relationship have never been standardised. Much depends on client specific requirements, but after years of cost pressure and consolidation the custodians are also unwilling to give away any negotiating advantage.
A little window cleaning suggests that for some years, most client-custodian relationships have been governed by an enforceable, penalty-laden contract covering the core relationship, but also a second tier service-level agreement (SLA). "The relative importance and content of these are not set in stone," says Wade McDonald, head of customer management and sales in the UK and Middle East for State Street. "Expect the contract to be standardised per custodian, at least as far as anything is in this industry, while the SLA is frangible and subject to change without formal renegotiation of the contract. It is likely to capture client specific requirements. For example, some may require derivative pricing or daily pricing."
"This flexibility is needed to reflect the constantly changing environment in which the client-custodian relationship takes place," he adds.
Full renegotiation over matters of lesser importance would be overly cumbersome even where the client-custodian relationship takes place in a single jurisdiction. Change to the SLA leaves the main contract intact. Under the impact of global recession, more and more international companies are looking to consolidate all their services with single providers. In cases such as this, expect an international agreement formed in the parent company's country of domicile, subsidiary national contracts and a corresponding set of SLAs. "Negotiating the client custodian relationship used to be pretty straightforward," adds McDonald. "But not any more."
The promise held out to pension funds for this effort is not just one of simple cost saving. If you are sitting in a head office, looking at a dozen rate cards for different countries from different custodians, making a like-for-like cost and quality comparison is near impossible. It is also time-consuming. Post Lehman, a relationship once seen as virtually risk free is now seen as potentially very risky. The fear is that counterparty risks, and the risk of sudden failure of a sub-custodian, may be hidden in a complex, ramshackle structure. Then there is an ever stronger demand for consolidated, group-wide and frequent risk metrication - this month, are the group's pension funds in aggregate surplus or deficit?
This relentless search for previously un-quantified, uncompensated risk during a sharp recession is driving change. This plays two ways - pension funds are under pressure to find cost savings, but will pay for risk reduction.
Traditionally, the duration of client-custodian relationships have varied from three to seven-year terms. Reviews tended to be infrequent; once a year, or less, often tri-annual. At the contract term, renewal clauses permitted the relationship to be continued without formal negotiation. This is changing, although there are strong reasons why both sides to the relationship still want durable, long-term partnerships.
Within conventional term contracts, expect reviews to be much more frequent - three or six monthly, with at least a full annual review. A growing number of new contracts are now continuous, or one-year rolling, and frequently reviewed. Failure to meet contract conditions and ongoing violation of the SLA will permit the client to break the relationship without penalty. How much substantive difference this makes remains to be seen but it chimes with mood of the times.
Assuming that both contract terms and SLA are satisfied by the custodian, the key issue at a review will be the cost of the custody service. Over the past decade, commonly accepted estimates are that core custody costs have fallen by around 50%, a massive decline made possible by the application of new technology and straight-through processing. "At review we can benchmark custodian fee levels," says Helen Smith, head of UK pensions governance at PSolve Asset Solutions. This can done by asking a consultant to look over fee levels and offer their opinion. A more testing review may ask rival custodians to compare fees on a no-name basis, without the identity of the pension fund being revealed.
Last and most complex is a full tender process. "Our role is partly to make informed judgements about whether custodians with very similar fees are actually offering the same level of service," adds Smith.
Charging structures are varied. A custodian may propose a minimum annual cash fee. This can range from as little as a few thousand euros to €50,000 or more. This is a fixed fee regardless of activity and transaction levels. Custodians will also want cash charges per transaction. A recent tariff proposal by a global custodian detailed per-transaction charges of approximately €117 for Russia, €35 for France, €10 for the UK and €11 for the USA. Respective safekeeping charges were set at approximately €64, €5, €0.80, and €1.20.
In addition, custodians may also want an annual basis point charge on the aggregate value of assets under management. This is negotiable but typically it will be in the 2-3bps range, although it may be higher. As always, there is devil in the detail. A fixed annual fee might pay for a number of annual transactions and other activity up to a given limit, beyond which charges will be triggered. Charges based on the value of assets under management may or may not be part of a particular contract. All is negotiable.
The custodian's side of this relationship is not often explored. "There has to be a limit to how far fees can fall, and we may be there," warns Ross Whitehill head of offshore management, EMEA, at BNY Mellon Asset Servicing.
Before the credit crunch, increasing asset values allowed custodians to concede reductions in ad valorem fee levels while still receiving healthy cash revenues. Collapsing asset values and a new round of client-led cost saving have put these revenues under pressure. At the same time, client portfolios are becoming ever more complex: "There has been huge growth in the use of alternative assets, and we are more and more being asked to put independently determined and robust valuations on these rather than merely accepting the price given by the manager," notes Whitehill. One way or another, this complexity has to be paid for.
Other cost pressures on the custodians are the result of far deeper, structural changes in the pensions industry. Many small to medium-sized defined benefit schemes are closed to new members. Many, including mid and large-sized schemes also now use pooled funds for their core holdings. "In some cases this may not leave much business for the custodian," notes Whitehill. Just as pension funds have become used to reviewing their custodians, so custodians are likely to be doing the same. This will lead to some difficult negotiations.
Trustee and board risk aversion has also led to a reduction in the volumes of securities lending. Although the revenue from lending is accounted separately they are a de facto compensation for custodian fee levels as well as a source of revenue to custodians. If aversion to lending continues, this will put yet more cost pressure on existing relationships. Custodians may decide that a client here or there is not worth the bother.