A matter of survival

In part one of a three-part analysis, Roger Harrold explains why sub-custodians are facing strong headwinds

Viewpoint

In part one of a three-part series, Roger Harrold of AlfaSec Advisors discusses why sub-custodians are facing strong headwinds. 

What does the future hold for sub-custody? This hinges on where you are in the value chain. A sub-custodian provides custody services for securities traded in a particular market or jurisdiction, on behalf of another custodian (such as a global custodian) who may not be in that jurisdiction.

The holding of assets, managing transactions and handling corporate actions is a critical function in cross-border investment that cannot easily go away. If you were to build the world of cross-border investment from scratch, you would not create what we have today. Instead you would build several central securities depositories (CSDs) providing all these services to everyone. Alas, that is not the case.

Many CSDs could do more but do not in fear of upsetting clients or protecting other interests. Over time more CSDs will appear. The sub-custody service provider would then offer an account service to an investor to hold, settle, receive entitlements and provide asset reporting. Target 2S (T2S), European Union directive shows the power of direct connectivity. Until each CSD can provide this worldwide, we need the sub-custodian service provider.

A decade ago providing sub-custody was lucrative. The bigger the in-house network the better. IT companies provided big bulky solutions to global/regional providers, while cost of entry was huge and fintech was a distant theme.

Most markets allowed sub-custodians to charge a few basis points on holdings and fixed fees for transactions and processing corporate actions. Voting the rights and collecting withholding taxes were also chargeable services. When rights issues happened, custodians were asked to buy and sell, generating trading revenue. If the client wanted to repatriate proceeds, FX also earned the sub-custodian significant revenues. The more emerging the market, the higher the fees.

Cash float was most sought after. These are balances that clients left with the custodian. The custodian used this liquidity for itself and what was left over was deposited in the interbank market. Banks seldom shared the accrued interest but the big clients or those with more weight forced custodians to share. In those cases the custodian had no choice.

This single revenue stream was the most valuable since most of it impacted the bottom line. This stream comprised 40% or more of the sub-custodian's total revenues. Plus if the sub-custodian had a retail client base as part of the global bank then the multiplier effect on fees was huge. The average retail client pays 3% (300 basis points) for custody, while an institutional client pays less than 5 basis points.

Now we are in a different world. Capital controls and increasingly inward focused markets mean more local banking licenses requiring onshore capital. Regulatory pressures have forced most big sub-custodian providers to also reduce their networks.

Investor protection, anti-money laundering, regulation and compliance requirements have ballooned. Risks in investor services have multiplied with reputational risks a key concern. On top of that all parts of the custody value chain have fintech on their heels providing solutions via application programming interfaces (APIs) to institutional clients — gradually removing custodial product service.

The worst factor was the loss of that rich source of bottom line profit — interest float. With interest rates at record lows, the loss drove most sub-custodians to think hard about the business. If you need to generate 40% of your bottom line you need at least 100% in new fees (if you are doing better than most and working at a 60% cost-to-income ratio) to replace it. A tough task. I doubt that line will return.

When rates start to come back (as they are now) clients will ask for interest on their balances. Clients were forced by some sub-custodians to pay for leaving balances with banks when we went into a negative interest territory. Some custodians even stupidly used low rates of interest as a reason for increasing transaction fees.

Clients have long memories — do not expect them to allow banks to take the benefit when interest returns. Clients also have learnt how important cash balances are to custodians.

The fees of a sub-custodian are severely under pressure. Investment dollars are hard to come by and regulation increasingly makes this a harder business in which to make money and a risky business for those not properly invested in expertise and IT.

Roger Harrold is the managing director at AlfaSec Advisors