Why custody is no commodity
What is the real cost or benefit of custody activities and how can you work with your custodian, or perhaps fund managers, to improve the bottom line? Custody activities have been often criticised as opaque. Perhaps the arrangements were only reviewed once every three years or more. Not only was this costly and inefficient, it was hardly good practice to hire a major supplier and not monitor it to any degree.
Specialist services relating to foreign exchange and securities lending have been available for a few years. We developed a specialist custody service just over two years ago and the service already has over 50 clients, half of which are pension funds. The service measures all the services relevant to a pension fund. These include failed transactions, interest rates, securities lending, income and tax processing, proxy voting and foreign exchange.
It would have been simple if there was one ‘best custodian’. But not surprisingly, this has now been proved not to be the case. Variations exist because of:
q Policy – the number of markets where income is offered on pay date;
q Capability – obtaining tax relief at source or the speed with which tax reclaims are initiated;
q Efficiency – adherence to agreed time frames for accounting or performance reports.
What is more surprising, and perhaps somewhat alarming, is the variance of results achieved by schemes using the same custodian.
Over a three-month period two similar clients using the same custodian experienced a difference of over 180 basis points on credit interest rates. To make matters worse, the client with the lower rate was actually on a higher custody tariff.
Some results seem even more counter-intuitive. Because of complex administration procedures, one client utilised two different treasury units of the same bank for foreign exchange transactions. This client managed to suffer both the narrowest and widest spread in the same quarter.
Obviously these issues have now been amicably resolved, but they do serve to emphasise the need for continual review. A custodian highly rated for its ability to, say, lend securities, might not be able to replicate that service for all clients.
In another case a client discovered that the interest rates on its currency accounts were far from competitive. At the quarterly meeting with the custodian it transpired that operational changes in the way the client managed cash would result in better rates. This encouraged the pension fund to leave larger balances with the custodian while using our report to quantify the improvement.
Custody fees are the most transparent of all costs. They are paid on a regular monthly or quarterly basis. The invoice is often supported by a substantial, sometimes impenetrable, amount of computer printout. We have seen variations of 300% in fee levels for apparently similar institutions. However, it is far too simplistic to assume that requesting, and perhaps obtaining, a reduction in fees is an automatic benefit to the client’s bottom line.
In spite of claims to the contrary, custody is not a commodity. The price of petrol is clearly understood, as is what you will get for your money. This is certainly not the case with custody. Despite a decrease in service providers, custody fees have continued to fall to levels where most people realise that they have to be subsidised through other means. Traditionally this has largely meant foreign exchange spreads and cash account rates.
We also analyse and benchmark activities that the custodian merely facilitates, such as corporate governance. What is actually measured is the performance of fund managers voting in companies where they have a holding. We track not only if they voted, but how they voted – such as for or against management. There have been more than a few embarrassed clients who hold voting to be important and state so publicly, who have discovered that their actual voting records are poor and below industry norms.
Benchmarking has brought transparency to these areas. It is now possible to not only estimate the financial impact of these spreads, but also to compare the results with peer groups. Similarly the cash flow benefits of efficient income and taxation services can also be highlighted.
The full picture becomes clear and enables a far better understanding by all parties. It is unlikely that a client will receive the best quality service for the lowest cost. However, at least it is now possible to understand the costs incurred together with the quality and benefits of services received and be able to compare with a chosen peer group.
This understanding enables decisions to be made on an objective basis.
It is important to understand that custodians do not have full control over a number of the services which come under the heading of custody. Some of these are:
q Fundamentals such as trade settlement rely on receiving timely automated instructions;
q Proxy voting is in the hands of fund managers acting, hopefully, in accordance with client’s instructions;
q The style of foreign exchange trading, such as timing and netting, influences the bottom line;
q The client’s approach to cash management can make huge differences to the end result.
By increasing transparency, our reports make it far easier for the custodian to suggest alternative practices for consideration. Clearly some of these may impact their balance sheet. But, at the end of the day, this process is far more likely to enable the retention of a client and that should be a win-win situation.
We believe that benchmarking encourages a continual process of establishing the ‘best-fit’, rather than a subjective and expensive review every three or five years.
David Batten is a director at Amaces
How it works
Clients have to give permission to their custodian to provide data to Amaces, which runs CMS. Amaces has established automated extract routines with 11 custodians, which includes all the major service providers. CMS involves clients in no work at all. Data then goes through a quality assurance process at Amaces and it then provides the monthly reports to both the client and the service provider. They are available on the Amaces website.