A lot of foreign money is flowing back into Latin American countries now that they are putting their economic houses in order and the ripples of fear from the 1994 peso crash have dissipated. Relatively poor performance from the Asian tigers and US interest rate jitters have added impetus to the revival of investment inflows. Western custodian banks on the ground in the region – and there aren’t that many – are competing for custody revenue in a business that has to cope with increasingly tight profit margins and costly investments in the technology needed to deliver an efficient service.
Which institution does a custody relations manager for an investment house turn to to look after his paper when it isn’t clear that Latin American custodians are able to offer distinctive, advantageous services? There is a belief, which the banks concerned don’t go out of their way to counter, that they have different styles. But in fact local market inefficiencies constrain emerging market custodians to offer packages of services that are broadly the same.
This is not the case in developed markets where custodian banks can take a smooth-running market for granted and can target clients with tailored packages. When and if emerging market infrastructure comes up to international standards, will the banks there be able to offer genuinely distinctive custody services? Or will the business be dominated worldwide by such goliaths as Chase, Citibank, Bank of New York, State Street – able to take on all-comers with broadly the same style. The shake-out in custodian banking in recent years points to the latter outcome.
After the 1994 crisis, the question was when, not whether funds would return. The increase in investment flows into Latin America is happening now. Fund managers are increasingly switching funds from underperforming Asian markets. The flow of money is expected to come from newly mandated funds and regional funds that are market-specific. Existing investments in Asia will largely remain in place as many Asian portfolio managers are legally prevented from moving capital overseas. But situations such as Thailand’s, where property and banking have caught the Japanese disease, and South Korea’s, where similar banking problems are afflicting the market, will force money out of the region.
Such large investment flows into Latin America would not have occurred without substantial economic reform in key Latin American countries. A four-figure inflation rate in Brazil has been slashed, partly because of the government’s adoption of a tight monetary policy based on the pegging of the newly created currency, the real, to the dollar. Peru and Argentina have liberalized their capital markets, enabling foreign investments to be made more easily. Moreover, Latin American stock is cheap compared with Asian stock. Price/earnings ratios in the region are lower than in Asia. In Venezuela they average around nine compared, for example, with around 40 in Japan.
Global shifts
On the ground in Latin America, the global shifts in money are being felt by the main banks that operate there as custodians for foreign companies. Global custody and sub-custody (where a custodian bank acts as a sub-agent for global custodians) in the region is dominated by three big US players, Citibank, Bank of Boston and Chase. All three banks have seen an upturn in client throughput in recent months relating to transactions that go back as far as November 1996. “We noticed an increase in the number of transactions coming through from November,” says Alejandro Berney, securities services product manager for Latin America at Citibank in Buenos Aires. Citibank’s experience is borne out by figures coming from the region’s stock exchanges.
Equity trading activity has increased most in Mexico where, because of the intensity of the 1994 crisis, recovery has had to take place from a lower level than elsewhere in the region. Citibank, which accounts for 60% of foreign custody provision in Mexico, has reported a doubling of transactions going through its systems there since November 1996. Its figures at the sharp end accurately show the level of foreign investor interest. “The impact is direct,” says Berney. “Since we have the larger share of foreign investors in each market, when they become more active we see increased transactions very quickly.” And so far these high transaction levels are being sustained. It seems that the so-called hot money – capital originating from outside that can be withdrawn quickly – which fled the country three years ago is pouring back in. But analysts are optimistic that it will stay put this time around.
The picture is similar elsewhere. Transaction volumes from Citibank Brazil are running 50% higher; in Argentina volumes are around 30% up. Bank of Boston and Chase have seen similar increases across the region.
But these figures must be treated with some caution. On their own they do not necessarily mean that foreign investment has increased by those amounts. Transaction figures can be influenced by the structure of the market. Brazil has a relatively well developed pension fund industry with a greater number of corporate pension schemes than elsewhere in the region. This means that liquidity is lower since securities are held by institutions geared to income generation. It is harder for foreign investors to buy equities in Brazil than in Mexico where domestic institutional money management is not so developed. Foreign investors wanting to buy large amounts of stock must spread their trading across a number of Brazilian brokers in order to fulfil their orders. Lack of liquidity in the market means that individual brokers may not be able to accommodate large orders, so headline transaction figures may give an exaggerated view of investment activity. The broad signs, however, are of increased foreign investment.
Mixed message
More proof of increased foreign interest in Brazil – but with a mixed message – comes from the Brazilian stock index, which has risen more than any other in the region. But again, lack of liquidity has had an effect. In Mexico there is more liquidity than in some other Latin American countries since its relatively open capital markets allow foreign investors in and out quickly. It therefore takes a more broadly-based demand to push up the Mexican index.
But however mixed the evidence in particular countries, across the region more foreign money is entering. Recent estimates from Deutsche Morgan Grenfell in London put the expected increase in money going into Latin American stock at around 25% this year compared with 15% in 1996. High levels of liquidity internationally, following a rise in US interest rates in late March, will help fuel this. Additionally, privatization programmes in a number of countries in the region, as they continue programmes of economic reform, will be an added impetus to foreign investment. Brazil in particular is expected to privatize between $10 billion and $12 billion in the remainder of 1997. Additionally, domestic investments held in custody are increasing, but are still dwarfed by foreign inflows.
All this amounts to a lot of foreign business on the ground for the banks to compete for. Unfortunately, it is not always easy to differentiate between custody products in emerging markets, where market inefficiencies and client pressure are likely to force custodians to offer a similar service. Potential clients must decide whether there are different ways of doing emerging market custody, and whether they want the choice.
Two of the dominant custodian banks in the region, Citibank and Bank of Boston, are indeed perceived as having different approaches. The story goes that Citibank favours a large-scale, standardized approach. Its clients can, the bank argues, expect the same, high-quality service regardless of the country. The bank believes that foreign institutional fund management companies are increasingly geared up to a standardized approach themselves, so Citibank is simply fitting in with that change. There is a lot of truth in this. But can Bank of Boston, the smaller of the two, do things differently?
“Frankly, there isn’t that much difference in the styles of the banks down there,” says Bill Imhoff, a US custody consultant. “I would be surprised if Bank of Boston is closer to the market. Citibank operates through its own branches down there, so they are on the ground just as much as Bank of Boston.”
Chase’s head of western hemisphere network management, Gillian van Schaick, disagrees. She believes that Latin American custodian banks are able to offer differentiated services. “I think it’s based on the individual bank’s philosophy about servicing clients. Also, banks have expertise in other markets that they can bring to bear,” she says.
But perhaps the most important difference between custodian banks in the region is in their client base. Citibank has a relatively small pure custody business. Most of its business comes from US brokers. It is more oriented to a quick turnround brokerage service than the buy-and-hold service which Bank of Boston specializes in. Citibank, though, has a larger sub-custody business and a larger global business.
Global reach
Citibank’s genuinely global reach – the area in which it has an edge – is not shared by Bank of Boston or many other custodians and means that it can always overcome temporary problems. This can be frustrating for competitors. “We smoked them in a lot of markets in 1995, and that got their attention,” says a member of a rival custody team. “They put a lot of money and a lot of management focus on Brazil and Argentina, and they turned it around and beat us this year. They can do that because they are ‘Citibank: World-Wide Custodian’. They have pockets where we don’t even know that pockets could exist. They’ve got technology dollars, brains, deeper pockets and a broader base,” he observes.
Citibank certainly has a wide coverage. It is larger than Bank of Boston. It is present in 25 countries in Latin America and offers custody in 10. “Being the same bank we are selling the same system in all those countries,” says Citibank’s Berney. “It’s much more convenient from the client’s point of view because they have to deal with one bank only.”
Bank of Boston’s coverage is smaller than Citibank’s. It has custody operations in Argentina, Brazil, Chile, Panama and Uruguay and it opened for business in Peru in November 1996. The bank has plans for expansion and will open for custody in Colombia in the fourth quarter of this year. It also has offices in Mexico. “We are looking very hard at opportunities in these markets,” says Bank of Boston’s Neumann.
But all custodian banks operating in Latin America are constrained by the same pressures. A client buying stock in one market wants the same sort of protective service as in any other, regardless of market conditions.
It seems, then, that differences in the custody product offered by emerging market custodians may be as much perceived as real. This is partly because banks are keen to talk up differences for commercial reasons. But
it is also partly because emerging market custodians are forced to devote time and resources to overcoming market problems and providing smooth-running settlement for their clients. “There is a great need for more straight-through processing at our end and the customer’s end in order to achieve greater efficiency,” says Citibank’s Berney.
Paul Hedges, director of network management for Royal Trust Corporation of Canada, confirms this. “For the past few years, global custodians have been demanding a product that meets their own clients’ expectations,” he says. “Emerging market custody has been driven by global custodians’ systems and the need to smooth out market problems.”
So emerging market custodians deliver what they must to work within their markets. And much of that is focused around the settlement function. This is because the typical emerging market investor is investing outside mature markets in order to achieve relatively high returns. Efficient settlement is therefore more critical since paper is less likely to be held for long periods. “You can’t really differentiate between emerging market custodian banks because they are putting all their efforts into meeting the settlement demands of global custodians,” says Hedges.
The added extras that allow differentiation among developed market custodians – corporate reporting, stock lending and so on – are beside the point in a country where the depository may be inefficient, and the client may not want to make use of it in the first place.
Whichever bank he uses, a client’s trades will be processed in roughly the same way. Banks use the same messaging system, Swift, to communicate with their customers.
“I think that custodian banks are constrained by the markets,” says Royal Trust’s Hedges. “Historically, emerging market custodians have had to respond to the global custodians’ need for smooth settlement above all,” he says.
Nevertheless, Citibank and Bank of Boston are perceived as having different styles – particularly in their approach to technology. Bank of Boston calls its system a common platform, as opposed to Citibank’s centralized system. It is a system common to all markets in which the bank operates, but is not centralized in one place, as is Citibank’s.
Delicate balance
Bank of Boston’s Neumann believes that the bank’s less centralized system offers advantages. “I believe that there is a delicate balance between investing in technology and substituting technology for the human element,” says Neumann. But what would a client notice that is different with Bank of Boston? “Flexibility,” he says. “More market-based expertise.”
Custody is fast becoming a process-oriented business with small profit margins. In the past, the benefits of computer technology have been hard to implement in most emerging markets because of the relative lack of a good trading infrastructure. It is no good having the best straight-through processing systems if the local bourse loses share certificates. All custodian banks have as their first priority the task of smoothing out market inefficiencies in order to protect and retain nervous, risk-conscious foreign clients.
If this is hardly the stuff to make a banker’s pulse quicken, it is nonetheless important in a world of small profit margins on high trade volumes. In developing countries where the trading infrastructure may be weak, a failure to put in place a system that mitigates the worst effects of market inefficiency will cause the bank problems. Customers will go elsewhere. There are only so many things that a fund manager wants his custodian to do with his securities. Those things are quite mechanical, like share registration, notification of trades and so on. “To continue the automation of Swift straight-through processing in those markets where we don’t currently enjoy that,” says Neumann. “That is something worth spending money on.”
Certainly, Bank of Boston’s clients, along with every other emerging market custodian, would constantly look for smoother technology and safer trades above all else. And this is what puts pressure on emerging market custodians to conform to a standard model. “In some of the markets, the lack of infrastructure does not allow custodian banks to differentiate their product at all. They are very reactive to local market pressure and global custodian pressure,” says a network manager for a global custodian bank that invests in Latin America.
But what of the local banks that have been offering custody for some time? Are they able to offer a different service? As yet, local banks have not begun to challenge the dominance of foreign banks. Of the potential challengers, Banamex and Bancomer in Mexico, Banco Roberts in Argentina and Banco Itau in Brazil are the best placed to take business away from their northern competitors. “We view some of the local providers as serious competitors,” says Neumann. “Also, there are foreign banks that are new to the market who we are keeping our eyes on.”
Serious competitor
Banco Santander has taken a stake in Banco Geral do Comercio in Brazil and is considered likely to become a serious competitor by the more established players. Chase’s van Schaick does not discount local banks’ capabilities lightly: “In terms of leverage in the local markets,” she says, “many of the local providers may have better contacts with the regulators and can bring that to bear. That’s something we look for.”
As yet the domestic banks largely service local clients, leaving the rich foreign pickings to the major players. The locals face competition coming from the other way, though. Citibank is making inroads into local business. In Argentina it accounts for 45% to 50% of local pension fund business. Local banks are generally cheaper than their foreign counterparts, but their processing services are less efficient. This may be a bar to their picking up much more foreign business.
But there are signs that the increase in local institutional money in the region’s capital markets will have an impact on market stability – an important step in improving trading from start to finish and allowing foreign custodians the option of tailoring their business.
The Chilean pension fund business, for instance, now has holdings worth over 100% of Chilean GDP. Argentine law was changed to require individuals to contribute to private pension schemes three years ago. Already Argentine pension funds hold $6 billion of a market capitalization of $54 billion.
Argentine pension funds, which amount to about 1.5% of GDP, are expected to account for 5% by the end of the century. Peru and Colombia have followed in reforming their pension fund sectors and increases in institutional holdings are already noticeable.
Local investment management money has had a sobering effect on stock markets. More local money on Latin bourses means proportionally less that is liable to disappear at the first sign of trouble. Mexico and Argentina in particular have suffered from this hot money because of their very open capital markets.
All is not yet stable, though. The mechanisms by which the pension funds are marketed and distributed is very fluid. There are innumerable incentive schemes encouraging customers to move around between the schemes. The offer of free gifts, such as electrical goods, to switch between schemes is not uncommon in some countries. As yet fund managers are in the early stages of learning to appreciate the advantage of a third-party custodian. When they do, and more money is there for a custodian bank, the foreign custodians will hope that they are well placed to mop it up.
Partly because of this, but mainly because of the inevitability of the return of foreign money, Citibank and Bank of Boston clearly made the same decision at about the same time, three years ago, to start spending on systems technology appropriate to emerging markets. Although, predictably, neither bank will disclose how much and exactly when, Citibank invested “tens of millions of dollars” in expectation of a massive rise in business. And Bank of Boston “continues to invest significantly in technology in all these markets”, says Neumann.
Settling on time
Emerging market custody is still at the hand-holding phase. Clients care more about settling on time than they do about the value-added services that developed market custodians can offer. Specialization, in terms of custodian banks targeting their client base and tailoring their custody product accordingly, appears some way off.
But the combination of increasing amounts of domestic money, better infrastructure and more foreign financial institutions entering the market may well end up creating the conditions that will enable banks to offer specialized services. “With the influx of foreign banks, there will be more choice. The new foreign entrants will be able to target clients and custody will diversify. Citibank is beginning to try to differentiate itself. They have been in the market for such a long time,” says Royal Trust’s Hedges.
But it is wise to be cautious. More banks in a country do not necessarily make the market easier to deal in. India, for instance, has a well-developed market serviced by a number of western banks. And some of them are experienced players in the region, such as Standard Chartered Equitor and HSBC. But a bad back-office processing environment makes India a byword for custody problems. The size of the Indian market, plus the large number of experienced banks operating there, does not alleviate the central problems of settlement in the market. Indian custodians are not in a position to begin to differentiate their product when market conditions are against them.
At present Latin American custodians are constrained by an overriding consideration: attracting clients. “You’re going to go for whoever you can get. You’ve got to get volume into those shops,” says one US specialist in custody. Only when Latin American markets are smooth and stable enough will they be able to tempt clients with value-added services or target clients in the first place.
The more developed the market, the greater the real difference in style will be. The logic of developed markets means that custodian banks are more able to tailor their custody product to specific types of client. For instance, Bank of New York has a technology-intensive approach that chimes well with its mutual fund clients’ needs. Bank of Tokyo-Mitsubishi fills another niche. Its custody product is tailored to its wholesale clients: other, medium-sized banks and financial institutions which need custody systems but which don’t have their own.
Similarly, Northern Trust Company is geared to pension fund clients. “That’s their bread and butter. Their whole product line is geared to that,” says the US custody consultant. State Street is much more diversified, but is also looking to offer a value-added product; that’s where it sees there is money to be made. It has been expanding through acquisition in order to add to the service range and migrate to the front office, meaning more value-added services. State Street’s recent acquisition of Princeton Financial – a software house for insurance company trading – was an indication of this.
Similarly, both Bank of Tokyo-Mitsubishi and the former Barclays custody business, now taken over by Morgan Stanley, were geared to offering wholesale back-office products to third-party, medium-sized banks. They did not compete directly for large pension accounts.
But there is another way custodian banking could go – both in developed and emerging markets. Banks such as Chase, State Street, Mellon Bank and Bank of New York have a broad client base and look unshakeable in their market position. Although it may make sense for custodian banks to focus on one or more client types, there is a world stage to play on. The consolidation of custodian banking in recent years can equally point away from specialization and differentiation of client base towards a smaller number of custodians offering supermarket custody, where all client types are catered for.
The march of the universal custodian looks unstoppable. A technology-intensive business with small profit margins favours bigger operations with larger throughput – something that will not have been lost on Citibank. “A lot of the profitability has been bid out,” says Imhoff. “It is the add-on services where they make their money now. Only the big players with deep pockets will stay in.”
But not all of the big players agree on this. Chase’s van Schaick believes emerging market custodians will in fact go down the route of tailoring to meet the client’s needs. “The market infrastructure tends to get easier over time. Then the agent banks can differentiate themselves to global custodians by their level of contact with the market and detailed information,” she says. “In a market which requires a certain type of transaction processing, a certain type of paper flow, that may not fit easily into a predetermined system or servicing model,” she concludes.
