Summary and Highlights: The Securities Services Industry in the ‘New’ World
The margin pressure exerted by asset management clients is forcing global custodian banks on to an unsustainable path of rising asset values and shrinking revenues. Tokenization, while rich in opportunity, could exacerbate the problem by increasing asset safety and compliance risks without reducing the need to invest in new technology. Financial market infrastructures reeling under the same pressures offer no immediate release in the form of cost-sharing. To contain the effects, custodians are consolidating, forming partnerships and investing in front-to-back-office outsourcing services built on managing the flows of data consumed by asset managers.
The securities services industry confronts an increasingly uncomfortable paradox. For the last five years, assets in custody (AuC) and assets under administration (AuA) have grown healthily but revenues have not kept pace. While AuC is climbing at 9.8 per cent a year, total revenue is lagging behind at 3.1 per cent a year.
Clients, not shareholders are enjoying the benefits of cost-cutting
It amounts to an annual discount to clients of around 6 per cent a year, or 29 per cent of total income since 2016 on a cumulative basis – and the trend line since 2016 shows that the discount is getting steeper. In effect, custodian banks are giving the whole of the benefit of cost-cutting measures not to shareholders, but to clients.
There is no sign of any durable change in this trajectory. Revenue did surge in 2020 as volatility increased and transaction volumes rose in response to the impact of the Covid 19 pandemic. But in the first half of 2021 revenues reverted to the flattish path which characterised the period of stasis between 2016 and 2019.
Growth in fee income, which has been especially strong in the fund servicing business, is still offset by lower net interest income and shrinking foreign exchange (FX) revenue. Although income from collateral management has remained relatively buoyant, tighter spreads have squeezed revenue from agency securities lending.
Custodians are investing in data management for buy-side clients
Doing nothing in response to the challenges is not an option for the industry since the margin pressure is unlikely to abate. Competition – not just between custodian banks but between custodian banks and non-bank fund administrators – will continue for the foreseeable future. Worse, asset managers are passing on their own margin pressure to the custodian banks. So the industry must respond.
Its first response is to invest in higher growth areas such as Exchange Traded Fund (ETF) servicing and front-to-back-office outsourcing services. The open architecture data management platform (Alpha) being built by State Street for its buy-side clients, following its acquisition of Charles River, is the highest profile example of the outsourced custodial service of the future.
Indeed, data management is the most promising new revenue source for custodian banks altogether. Although data flows are presently obstructed by lack of common data standards, managing data flows for buy-side clients helps to explain why investments by custodians in front-to-back-office outsourcing services and fund servicing have grown 37 per cent since 2016. They now account for 27 per cent of the revenue of the securities services industry as a whole.
Margin pressure will accelerate industry consolidation
The second response by custodians to their strategic dilemma is both familiar and predictable: consolidation. In September 2021, Brown Brothers Harriman (BBH) became the latest custodian to give up the struggle. It sold its investor services business to State Street for US$3.5 billion. This reduced the number of independent global custodians to less than ten and strengthened the grip of the four largest providers.
Although it amounts to a tightening of the existing oligopoly, it is an industry structure which is more likely, at least in the short term, to eliminate the smaller providers than fatten margins. Consolidation in the asset management industry – which has progressed much less than in the custody industry – will accelerate this trend as smaller custodians will struggle to support truly massive, global asset managers.
Consolidation also becomes self-fulfilling, as the larger custodial service providers find it easier to cross-sell. A universal bank can offer not only custody and fund administration but corporate advisory, capital markets, treasury, prime brokerage and other services to asset managers. The medium-term prospect is one of larger custodian banks servicing larger asset managers.
Strategic partnerships offer an alternative to acquisition and investment
Partnerships are a third alternative. BNP Paribas Securities Services, for example, has bolstered its fund business by forming a fund distribution partnership with Allfunds, sealed with an equity stake of 22.5 per cent in the fund platform. The French bank has also acquired a stake in AssetMetrix, to offer its clients access to data and data analytics in the private equity and debt markets.
Partnerships are also a low-cost alternative to investing to compete with FinTech challengers. Banks offer FinTechs access to clients, reputation and global reach, while FinTechs offer banks a faster and cheaper path to market for innovative services. Partnerships with FinTechs can also close points of vulnerability to technology-based challengers, without heavy investment.
Although technology is often touted as the obvious way for incumbents to widen margins by controlling costs, any spending on new technology must compete with investment to meet regulatory compliance obligations and maintain legacy systems, let alone link them to new systems. As a result, investment in change-the-bank technology is a fraction of investment in run-the-bank technology.
Securities industry infrastructures need to transform themselves before they can help custodian banks
Sharing costs through industry utilities – such as central securities depositories (CSDs) and SWIFT – is also becoming a less viable option. Most utilities are themselves struggling to respond strategically to margin pressures and the challenges posed by new technologies. This reduces their ability to help custodian banks transform their cost structures.
One challenge custodian banks and industry utilities face in common is the potential tokenization of the securities industry, through the issuance, placement, trading, safekeeping and servicing of equities, bonds, real estate and other asset classes on to blockchain-based networks. Both need to decide whether to own the technology or leave it to others and own the client relationships only.
The main challenge of tokenization is delivering inter-operability between new and traditional markets
Since tokenization will not overwhelm the traditional securities industry immediately, custodian banks and CSDs will also have to operate through a potentially prolonged period of coexistence between tokenized and non-tokenized securities markets. Buy-side firms active in both will expect service providers and market infrastructures to ensure there is seamless inter-operability between markets.
This is a task which may not be eased by the availability of commonly agreed standards between the operators of traditional networks and blockchain-based networks. The absence of settled regulatory regimes for security tokens in the major markets adds a further complicating factor for custodians (and CSDs) obliged to help clients navigate the transition, let alone the period of coexistence.
Trust and capital still trump technology in securities services
However, custodian banks do have valuable advantages which their technology-driven competitors do not: the trust built of decades of servicing clients and the material resources to make clients whole if assets are lost or stolen. This gives custodian banks a considerable degree of power to dictate the pace at which the securities services industry adapts to the tokenization challenge.