Over, Under, Sideways, Down (RIP Jeff Beck)

2022 laid bare a lot of the industry’s shortcomings. In 2023, leaders need to fix the model.

There is an inevitable, perhaps unbreakable, cycle in the investor services industry. We saw it at work in 2022, albeit with some different wrinkles. Here’s how it goes: custodians routinely underprice their core services – or, in some cases, give them away – in their enthusiasm to win mandates and, they hope, get their hands on the more lucrative work around asset servicing. In the old days that included FX, sec lending, transition management, inter alia. Nowadays, it’s more likely to be all about front-to-back, outsourced trading, data management and analytics, etc., etc.

In 2022, the bean-counters realised that they hadn’t accounted for inflation. Well, why would you? A lot of those number-crunchers have never experienced real inflation, or higher interest rates. Or, critically, staff asking for more money, just to stand still. And, whilst the Fed and other central banks gave the banks a lovely gift in the form of higher NIR, the bottom line for many providers was weakened by these other factors. Add in unfavourable valuations, and there are plenty of reasons why 2022 was a year to forget.

Except, this time, they should not forget the experience, but learn from it. And, by learning from it, I do not mean going back to the tried and tested toolkit of reactions to poor performance: Ask the clients for more money (in what has come to be known as a repricing exercise)? Cut costs? Move into new markets? Buy someone else and try and squeeze out some cost through synergies? Appoint a productivity czar?

They’ve all been tried. And, let’s be honest, they’ve all added up to very little in the form of long-term, sustainable gains. As soon as the NIR line ticks up – NIR having long been the mother’s milk of the inserv business – any long-term solutions get parked or, at best, handed over to a productivity officer who may or may not have the power to change things. In the era of low, zero or negative interest rates, senior management could be heard talking about the need to align non-interest income and non-interest expense more closely. A couple of rate hikes, and all that’s changed.

Custodians learnt practically nothing from the events of 2007/8, when the securities lending gravy train finally hit the buffers. It has taken many of them a good 15 years to realise that there are other, smarter ways to make money out of the securities finance business. It didn’t die: it simply followed a new path, and the custody banks were slow to find it.

With pure asset servicing fees having barely shifted since 2017, it’s clear that inserv providers have not yet settled on an approach that would deliver a better return on core asset servicing. Instead, they are working incredibly hard just to stand still. Without fintech solutions, an expanded product range and – yes! – a much closer focus on productivity, how much worse the situation would be.

For many, diversification appears to be the answer. For some, it is front-to-back, or whole office. For others, it is getting into the weeds of ESG and trying to make themselves a trusted partner. And, of course, there is a huge amount of investment in the digital space, which extends far beyond cryptocurrencies – another bet for which there is no guaranteed payback.

In some cases, that diversification is showing signs of working, however slow that process might be. State Street, for example, is finally reaping the benefits of its 2018 USD2.6bn acquisition of Charles River. Its software and processing fees for 2022 reached USD789m in 2022, representing >8pct of total fee revenue. Clearly, the CRD deal is having a significant impact on State Street’s earning power, a vindication of its decision which was almost universally vilified, especially by the Wall Street dullards.

Elsewhere, it’s a slow burn. No one knows how they will ever make money out of ESG. Digital and data are similarly slippery when it comes to a meaningful bottom-line contribution. But where else is there to go? Thirty years ago, the first SPDR ETF was launched. As administrator, State Street was paid 15bp. But the laws of economics soon kicked in, and competitors keen to buy market share did exactly that. 15bp is but a distant memory. So, for all the investment that’s required to stay in the game, margins are diminishing. Is that a sustainable business model?

Next year marks the fiftieth anniversary of the “invention” of global custody. It would be fitting if the current crop of custody executives could mark the occasion with a radical re-invention of what is clearly a broken model.

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