Global custodians are becoming nervous. For the last six months they have been making representations to the UK Securities & Investments Board about its demands for tougher regulation following the Barings and Maxwell affairs. Now they must await the SIB's findings to discover the form of regulation likely to be demanded.
The industry accepts that some form of regulation is virtually inevitable. "The odds are better than even that we will become a regulated industry," says Mike Devine, director of securities services at Royal Bank of Scotland (RBS). "I am convinced it will happen," agrees James Economides, custody director at Citibank. "But we support it. We have decent internal controls and we are regulated by every authority round the world, so it is very unlikely someone is going to come to us and say that more controls are needed."
As part of its initial guidelines for regulation, the SIB indicated three categories where tougher rules might apply. First, it proposed to enhance regulatory standards for custody providers; second, it flew a kite for tighter segregation of customer investments from those of the firm; third, it expressed a "provisional view" that the law should be changed to require custodians to be authorized.
The SIB appears confident that it can push through the first two categories of regulation, but a spokeswoman was less confident about implementing the third. Authorization under the act is "probably the most contentious part", she says. "It is most likely to cause problems and difficulties because it might require changes in law. It is not as straightforward as it might appear." The doubts now surfacing may suggest that the custody industry will receive fairly lenient constraints when the SIB eventually reports.
This will be in line with the view taken by professor Roy Goode after the Maxwell debacle in which the late Robert Maxwell was found to have been raiding his employees' pension fund to support his business empire. In his report Goode advised that pension fund trustees only review their custody and investment arrangements to see if segregation was appropriate. Those demanding tougher controls were disappointed, says Citibank's Economides. "Some people were hoping that there would be more onerous restrictions to safeguard the interests of the beneficial owners." Terry McCaughey, the director of Midland Securities Services, puts it much more strongly: "From a custodian's perspective the Goode committee didn't go far enough."
McCaughey believes the regulators should now act to impose strict segregation. He argues that fund managers should be required to segregate investments owned by the firm from those they are managing for customers. "If you are dealing with a fund manager with pooled funds, how do you know what's yours? If a bank's nominee holds your shares together with the bank's own shares, you have to rely on their definitive record to identify ownership. And if trouble arises, who's to say that the liquidator will not take possession of the whole lot?"
Deposits of cash are particularly at risk when a pooling system is in operation, says McCaughey. "In most cases, you can segregate your securities from those of the beneficial owner. But cash is fungible, and that makes it difficult to protect yourself if the bank goes belly up and a liquidator comes in. I don't think everyone has quite understood the lessons of Barings."
The concern for protecting cash is also shared by Economides, who saw the Barings debacle at first hand - Citibank was a custodian for Baring unit trusts. "None of the underlying unit holders had a problem, as the securities were controlled by trustees. But those institutional investors with cash and assets with Barings found that their cash was not safe as it was on the books of Barings when the bank hit the rocks."
While the custodian cannot provide fullproof protection against fraud, McCaughey argues that the separation of fund manager and custodian will give comfort to the pension fund trustee anxious about the security of his investment. The three-way reconciliation between fund manager and custodian, custodian and customer, and fund manager and customer provides a check and balance on abuse in any of the three parties. "A pension fund trustee looking at two sets of records should have some comfort that there is a clear segregation of duties and responsibility," he says.
Super-league custodians
The expected arrival of tougher regulation will undoubtedly speed up the current consolidation in the custody industry, says Economides. The contraction, spurred by the cost of compliance and advances in technology, began in earnest in the middle of last year when such stalwarts of the industry as JP Morgan, Bank of America, Nations Trust, US Trust and National Westminster announced they were selling their operations. The first three portfolios were picked up by the fast-growing Bank of New York, while the latter two were bought by Chase Manhattan and Lloyds.
The contraction has probably not stopped. Observers believe that within five years most British custodian tasks will be controlled by a handful of highly rated American and British commercial banks.
The greatest force for consolidation and outsourcing is the cost of entry and the cost of technology needed to stay up with the leaders. "The investment hurdle in global custody is rising year-on-year," says Devine of RBS. Citibank's Economides expects the industry to segregate into five big global players, a tier of medium-sized regional players, and some specialist operators. As much as 80% of custody assets could now settle with one-fifth of the banks, claims one contender.
Two of the banks in the top tier are not in doubt. Citibank and Chase have wider global networks than any other banks and they have led the field in service and technology developments. Other contenders for the top slot are harder to guess. Deutsche Bank, for example, is making a play and ABN Amro is sometimes tipped as a bank with custody staying power. Midland Securities Services is also bidding for a place, although its move to prominence is recent. Midland made the leap to global status following its acquisition by Hongkong & Shanghai Bank.
With HSBC came one of custody's brightest sparks, New Zealander McCaughey. As he reorganized the custody operation on geographical rather than functional lines, costs and fail rates fell and productivity rose. The bank has pursued business aggressively and McCaughey now calculates it has £300 billion of assets against £40 billion three years ago. "This is a spectacular growth rate and we have to make sure we keep the wheels on the trolley," he says, admitting that there have been hiccups along the way.
Over the last three years the global content of Midland's portfolio has climbed from a quarter to over a third, but McCaughey is adamant it has achieved this expansion without tapping the strong east Asian franchise controlled by HSBC. As sub-custodian to a number of major global custodians, HSBC cannot offer preferential terms to Midland without jeopardizing its existing businesses, he says. "Midland Security Services gets no preferential treatment from HSBC group's Asian securities operations by being a member of the group. As soon as they start offering me concessions, it would be goodbye to a number of their clients. We run completely separate operations." It is possible that once the industry has consolidated still further, the two operations may combine their strengths and trade under a single global operation. Midland received a considerable fillip earlier in the year when it took over Prudential's massive investment portfolio.
The consolidation at the top has opened up larger niches for specialist providers in geographical or product areas which do not offer the returns demanded by the majors. Northern Trust, for example, has built up a loyal pension fund clientele on both sides of the Atlantic, and Brown Brothers Harriman has created a niche in the custody of private banking assets.
Royal Bank of Scotland has built up a leading regional position in Europe by spending heavily on technology. Devine says a four-year investment programme, investing £30 million in communications technology, has just been completed. The bank went on the acquisition trail recently with its purchase of NatWest's registration arm.
Another set of custody players snapping at the heels of the majors are the central securities depositories (CSDs). They have sharpened up their act in line with the suggestions of a paper JP Morgan produced two years ago which recommended that CSDs improve their efficiency and provide custody services. Now those institutions are taking on the individual banks by offering a plain, core service.
McCaughey emphasizes the limitations of the CSDs. "If everybody had the same disciplines and accounting systems then you could offer a stock product. But if you are running a very complex derivatives book, with multi-currency exposure and stock lending, then this will not be helpful." According to one custodian, the impact on the industry of leading CSD Cedel was likely to be muted because of its ownership structure. Cedel is owned by the banks themselves. "The banks are not going to let them get into industries that will hurt them," the custodian said. The European banks in particular have a very strong say in the running of Cedel.
Fees bottom out
As the industry settles down to consolidation and restructuring, fees and commissions have started to bottom out. Prices of standard custody services dropped by 15% a year over the last five years as competition intensified. Now the decline is a more manageable 7% to 8% a year, says Economides. McCaughey is even more bullish, arguing that prices are no longer falling and in certain markets may "ever so slightly be ticking back again".
McCaughey says custody providers have stopped giving away the service as a loss leader for other banking products. This is confirmed by Paul Molloy, a vice-president at Chase, who argues that "with the industry's consolidation, the need to take on loss leaders is not quite so pressing. Although there are plenty of competitors, no-one offers custody for free any more. Customers are beginning to realize there is an irreducible minimum."
Yet bankers complain some custody prices are still remarkably low. For example, custody of UK assets for a UK institution may be no more than 0.2 basis points, making the price of a trade £8 to £10. "It's sometimes not worth producing the invoice," says a custodian.
However, the economics are complicated by fees for services that go with custody, such as stock lending and portfolio valuation. "If you rely on custody, you cannot survive," says Devine. "You make money on cash balances. That's why you have to get into value-added products." He says RBS is seeking to differentiate the product mix. "We tell clients: 'If you want more, you have to pay more'."
In fact, guaranteed lending income often offsets a superficially low price for basic custody services, and complex custody accounts still yield 30 basis points or more even today. Paper-based clients - and there are still plenty of them in London - will always have to pay more than that. Most UK custodians are seeking between 60 bp and 80bp for a middle-sized UK portfolio. In emerging markets, between 30bp and 40bp is routine, and some markets, such as India, yield exceptionally high returns. Only a handful of custodians are serious contenders in these markets, and although competition is increasing, especially in Latin America, margins as yet are not seriously being eroded.
As the number of providers of full-service custody diminishes, the amount of business is growing. The mushrooming of mutual funds and pension funds on both sides of the Atlantic - said to have grown by $50 billion over the last six years alone - has provided an unprecedented wall of money for the custodians and the fund management industry.
Even some of the largest mutual fund managers and pension funds now want to rid themselves of the problems and difficulties of custody. Hence the decision of the Prudential, the UK's largest industrial life assurance company, to send its custody businesses outside to its house bank, Midland, whose securities services teamed up for the deal with Mellon Bank and Trust.
Other notable instances of outsourcing in the last year have included leading London fund manager Henderson Administration, which awarded a £7 billion custody account to Royal Bank of Scotland Securities Services. Pharmaceuticals company Zeneca and chemicals group ICI handed control of their pension administration to Chase Manhattan and Midland Securities Services, respectively.
The rising infrastructural costs associated with the failed London Stock Exchange Taurus electronic clearing system and with its successor, Crest, have pushed funds to outsource investment services, says Devine. The cost of installing an interface with Crest is between £250,000 and £500,000, and efficient use of the new technology requires retraining of staff. "Crest has been a catalyst for outsourcing," says Devine.
Changes in the industry now force the question: Where is the limit to growth? "Are there limits to the economies of scale?" asks one custodian. "How big is big?" He concludes that investment in technology will proceed so long as margins sustain it. That should mean that the survivors will find the rewards huge; those that fail will lose their shirts and regret they ever started.
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