Custody in the era of high technology
A major debate in the global custody industry centers on whether an asset service provider should focus on data delivery or on providing value-added services to more effectively meet the requirements of asset owners, asset managers, and their clients.
Essentially, the debate centers on where the bulk of revenue will come from in the future. Is it through the traditional sources of revenue, particularly by providing value-added services through custody? Or by becoming a data manager for clients, a new and untested but promising opportunity in this age of “big data”, which involves analyzing, systematically extracting information from, or dealing with data sets that are too large or complex to be dealt with by traditional data-processing application software?
In the case of the BNY Mellon-BlackRock strategic alliance, the deal is intended to deliver integrated data, technology, and asset management servicing capabilities to their common clients. These new capabilities integrate BNY Mellon’s data insights, accounting, and servicing tools into Aladdin®, BlackRock’s investment and operating platform for investment managers.
Essentially the deal makes BNY Mellon a “data aggregator”, which means they would gather, collate, and deliver the data requirements of BlackRock and their common clients. This shows that as an asset service provider, BNY Mellon is taking the “big data” route in this debate.
Based on its deal with BlackRock and Aladdin, BNY Mellon is working on the premise that asset servicing is all about harvesting data, packaging it, and delivering it to their clients in a user-friendly format.
This is because as asset owners, asset managers, and institutional clients shift to illiquid alternative investments, their appetite for data is growing beyond what comes from traditional portfolio valuation.
While this is a bold and transformational strategy, it remains to be seen how this business strategy will work out in the long term. Other asset service providers seem to be taking the position that data aggregation may be the weakest link in the asset servicing business model when it comes to generating revenue.
Some providers, particularly Citi and HSBC, are sticking to the value-added route by continuing to strengthen the service delivery capabilities of their respective custody networks.
Citi has recently completed upgrading its technology systems in Asia, a multi-year effort that now allows it to provide integrated services to its global clients in 105 different markets covering 24 time zones.
In the next five to 10 years, asset servicing is expected to evolve substantially with new technology as the driving force for all the changes. The pace at which technology is being applied to asset servicing and the financial industry in general has been very rapid.
Industry veterans like Lawrence Au, co-founder of ZiAsset Consulting and former Asia Pacific CEO of BNP Paribas Securities Services, predicts that new technology like blockchain, artificial intelligence, the “internet of things”, and edge computing will revolutionize and drive further consolidation of the financial industry in the next decade.
For the asset services providers, this means the industry will flatten out as various players consolidate. Since there are only a few major players that dominate the industry, each one of them are scrambling to find a business model that will allow their institutions to remain relevant in the midst of the consolidation.
In Asia, arguably the strongest players in the industry today are the “big four” custodian banks: BNY Mellon, Citi, HSBC, and State Street. Except for HSBC, all the others are major US custodians with huge state-side franchises.
BNY Mellon and State Street are pure-play global custodians so they do not maintain a physical network in the Asian markets. Instead they use sub-custodians to service their global clients in Asia.
Citi is better known in Asia as a sub-custodian although it also has a strong global custody franchise. HSBC began as a sub-custodian and today is one of the more dominant sub-custodians in the region. But more recently it has established a budding global custody franchise.
The debate between data aggregation and value-added services as a revenue source becomes more relevant as the trend towards outsourcing in the fund management industry intensifies.
There are generally three units in an institutional investor or asset management company: the front office, the middle office, and the back office.
The “front office” is the client-facing function, which includes customer service, sales, and advisory services. The front office generate most of the revenue for the firm and is where the deals are made.
The “middle office” is in charge of corporate strategy, risk management, calculation of profits and losses, and IT.
The “back office” provides analysis, technical, and administrative support services. This generally includes operational risk control, settlements, making payments based on term sheets, collection and transfer trade certificates, registration with clearing houses, and custodial services.
As cost-saving and increasing efficiency became more important across financial services, outsourcing became a major trend, particularly for asset owners, fund managers and institutional investors which have increasingly relied on their asset service providers for non-core businesses.
As a result, “middle office” and “back office” outsourcing have become big businesses and areas of endeavor for the asset service providers.
With the advent of “big data” capabilities, the opportunity for outsourcing all across the front office, middle office, and back office has opened up.
The principal feature of the BNY Mellon-BlackRock alliance is that it provides the capability for “front office”, “middle office” as well as “back office” outsourcing through data aggregation. BNY Mellon and BlackRock will now offer these joint capabilities to common clients, bringing significant and immediate benefits to front office, technology, and operations teams, including near real-time trade lifecycle information and more precise intra-day projections of net cash positions to enhance front office decision-making; enhanced real-time insights and transparency, exception-based monitoring, and drill-down capabilities into core accounting and custody oversight functions; and closer data integration and shared workflows in Aladdin, substantially improving operational efficiency and processing rates.
The issue with this model is that the ownership of the data generated by the asset service provider logically belongs to the client/asset owner, not the asset service provider.
This means that it is possible for the client/asset owner to disintermediate the asset service provider and take over the data aggregation themselves if it becomes more cost-efficient to do that in the future.
Also, the barrier to entry into the data aggregation business may not be that prohibitive for an asset owner which can generates billions of dollars in revenue.
On the other hand, other asset service providers are using technology to provide value-added services such as supporting clients in building financial market infrastructure (FMIs) as they comply with new market regulations and requirements.
FMIs are designed to fix inefficiencies in the market and enhance the quality of processes and operations of regulators, asset owners, and asset managers. FMIs also increase overall productivity, create cost-savings, and maximize the use of resources.
For example, as the Australia Stock Exchange (ASX) moves to replace the Clearing House Electronic Subregister System (CHESS), the computer system it uses to record shareholdings and manage the settlement of share transactions, the ASX is relying on asset service providers for usable solutions.
The same is true in the case of the Hong Kong Stock Exchange as it moves to enhance the capabilities of the Northbound Stock Connect, the cross-border access channel that connects the Shanghai and Hong Kong exchanges.
In Singapore, the Monetary Authority of Singapore (MAS) is also relying on asset service providers as it pushes the industry towards the adoption of distributed ledger technology (DLT) for clearing and settlements under “Project Ubin”, a collaborative project between the regulator and the industry.
Asset service providers are also playing a big role in the development of DLT in Thailand and Indonesia.
But while building FMIs is beneficial in the long term, it will take a while before they can generate sufficient revenue for asset service providers.
In order to strengthen their revenue streams in the short to medium term, asset service providers are focusing on servicing physical assets such as securities, real estate, and alternative assets.
Examples of these are the digitization of physical assets such as gold or real estate. This means converting them to digital assets that allow for a greater degree of liquidity and make them more accessible to a wider universe of investors. This often involves the use of blockchain technology.
Another example is enhancing the clearing process by shortening the execution period and accelerating the completion of transactions as well as reducing exposure to counter-party risk.
An asset service provider recently built a solution that allowed its client, a big Asian asset manager, to improve their returns on equity transactions by 11 to 13 bps.
The issue of whether an asset service provider, particularly a global custodian, should move in the direction of becoming a “data aggregator” versus sticking to providing value-added services to their asset owner/clients is still playing out.
As technology continues to advance, it’s possible that another model that can combine features of data aggregation and value-added services could evolve. Such a model would make this debate academic. Or it’s even possible that a completely new model beyond data aggregation and value-added services can come out. The deciding factor would of course be the bottom line.
The upcoming years should prove interesting for the asset servicing industry.