In the last of a three-part series, Roger Harrold shares his take on the models of sub-custody that works for the future. He believes that if a sub-custodian exists as part of correspondent banking, the future looks bleak
Some sub-custodians believe that waiting for how the competitive landscape eventually gets reconfigured will provide better opportunities. I cannot imagine anything worse than sitting on a dying business with no more investment to follow. Yet, I still think that sub-custody in the right model makes sense and is necessary. Let’s look at various business models.
International central securities depositories
Here we have huge efficiencies in one model alone — starting with one core application/system servicing all markets and customers. That ability to internalize nearly every trade and settlement in a fully automated way sets the international central securities depositories (ICSD) years apart from many other providers. Sub-custody is a core element but with significant benefits attached to the service.
ICSDs have many financial institutions as clients and can segregate millions of accounts if necessary. They also have many non-bank financial institutions and this portion will increase. Then those that have the exchange as part of the group extract additional value and synergies for the client as the global service provider.
Global custodians service an array of complex clients such as global fund managers, pension funds, sovereign wealth funds, public pensions, corporate funds, special purpose funds, private equity and hedge funds. Financial institutions (banks) are the smallest part of their client base.
Offering a big range of products, global custodians have a highly diversified client base and revenue stream. They can capture the entire investment cycle and benefit from client growth. It is more likely that a new fund manager, hedge fund or private equity company will be established than a new bank. The number of clients is increasing sharply and each successful client gives you new funds and revenue streams. You just have to select the right clients. Sub-custody makes sense for the global custodian when it cannot go directly to the CSD or does not want to or where the market has too few providers (because they relied on sub-custody as a core product).
If a global custodian dominates any market, here it makes sense to take that business in house until such time as the CSD takes it on directly or a fintech helps the CSD find the best direct service model. The largest global custodians typically now also do sub-custody in the largest markets that they dominate. As their asset base increases away from home, this trend will continue. When double-digit market share is reached, does it make sense to outsource especially when risk is passed back to the global custodian by the sub-custodian?
Some thought that global custodians will not do it themselves due to the fact that they do not want to have the increased operational risk and build IT capability to connect to local infrastructure. This view has gone or is disappearing. Many viable low-cost options now exist to connect infrastructure and many IT applications support the service provision. Here sub-custody makes sense.
Global banks and sub-custody
Where a global bank has a big transaction banking unit with multiple banking licenses in markets around the world, it may make sense to provide sub-custody as a part of a broader, bigger product portfolio. Where sub-custody today is already a significant (>40%) proportion of investor services revenues, it is probably too late to change especially if sub-custody is offered primarily to financial institutions as part of correspondent banking. Given margin pressure, unless it is highly commodity based, sub-custody is unlikely to provide enough revenue to grow the business going forward.
The issue for many global banks is the shrinking size of the global network due to regulatory change, the taking of capital onshore and a lack of profitability. This, with competing global businesses within the bank (asset management, corporate finance, trading and sales, retail bank), makes it hard for sub-custody to be heard and even harder for it to attract investment in technology and compliance.
In good years such as 12 years ago investment tended to go to areas with the fastest increases in return on equity (ROE). In bad times like now, with investment hard to come by, most wish they had invested properly when they could. Now they cannot.
Those that can manage this situation and offer many domestic products, where sub-custody is an important but not dominating revenue stream, may still want to provide sub-custody. This is especially the case when the bank has a large asset management business or a global custody product servicing institutional clients in house since it leverages sub-custody capabilities.
Asset gatherers: growing opportunity
As wealth creation in emerging markets continues, so does growth for those managing and gathering assets. As these managers get big, the same concept applies as to a global custodian where the asset owner may want these assets to move into a segregated account in their own name. This trend looks set to continue given tighter regulation, investor protection and the use of omnibus accounts. Once these assets are segregated the sub-custodian becomes an account operator. This is very different from having those in-house in the name of the sub-custodian.
In 2017 the International Securities Services Association (ISSA) published a paper on “Inherent risks within the custody value chain”. Compiled by prominent institutions, it highlights the complexity and huge risks of the custodian business. The report provides reasons for the time being for the existence of sub-custodians. But they are coming up against intense competition from fintechs and start-ups. Other entities are changing the process using application programming interface, artificial intelligence, blockchain and data mining to overcome the challenges.
Still not for the faint of heart
Sub-custody still has large revenue clients but they are part of the previous model. When these clients start to move they will create big waves. Substantial revenue streams may be at stake (irrespective of profitability). Reciprocal arrangements resulting from desperate measures of engagement create further blurred lines and bottom-line value. This situation should clear up in the next three years as business practice shifts challenged by fintech, big data and client realization that indemnities given to sub-custodians mean that the difference between self-custody and outsourcing has become negligible. It was said that sub-custody is not for the faint of heart. That is one of the few things that remain the case today.
This article was published in the June print edition of The Asset magazine. Please contact us for details on how to subscribe.