As the US market’s biggest neighbour, and with relatively similar economies and financial markets, Canada was bound to catch a cold when the financial crisis hit Wall Street. And it could not have come at a worse time.
As the US market’s biggest neighbour, and with relatively similar economies and financial markets, Canada was bound to catch a cold when the financial crisis hit Wall Street. And it could not have come at a worse time.
Canadian funds, particularly hedge funds, had been outperforming their counterparts across the line for some time, and investors who were looking for safe steady returns had started to flock to this market. It was never considered particularly exciting or dynamic, but growth was steady and a highly-regarded regulatory structure meant that investors felt safe investing in the market.
But in 2008, it all turned. The S&P composite index lost more than 37 per cent of its value over the course of the year, and other markets also fell. Funds available dried up, as international investors tried to shore up their balance sheets and withdrew - or at least reduced - investment from many markets. 2008 was certainly the toughest year, but the situation didn’t look much better at the start of 2009 either. But then the market did start to rise again.
But while the funds were struggling, Canadian banks were managing the crisis exceptionally well. Canada is one of the very few Western economies that hasn’t had to bail out any of its domestic financial institutions, leaving them free to consolidate their positions domestically while - in many cases - expanding internationally. RBC’s acquisition of Blue Bay earlier this year is testament to their newfound confidence.
The economy
The Canadian economy continued to slow through the third quarter of this year with annualised GDP growth dropping to one per cent following a revised gain of 2.3 per cent in Q2 (initially reported as 2.0 per cent) and a revised 5.6 per cent in Q1 (previously 5.8 per cent). Net exports subtracted a sizeable 3.5 percentage points (pp) following a revised 4.0 pp subtraction in Q2 (originally reported as 3.0 pp). The deterioration in trade resulted from both imports rising 6.4 per cent and exports falling 5.0 per cent.
The September GDP report showed a 0.1 per cent drop following a 0.3 per cent rise in August. Given the underlying strength in consumer spending and investment and with the weakness in Q3 emanating from the volatile trade sector, we continue to assume that GDP growth will rebound in Q4 to around 2 1/2 per cent to 3 per cent. RBC has said it expects the sizeable drag from net exports in the third quarter of 3.5 pp (and 4.0 pp in the second quarter) will not continue. Improvement in external trade will be hampered by imports likely continuing to grow by six per cent in Q4 reflecting the strong Canadian dollar and investment spending in Canada. The improvement in trade is expected be paired with continued solid gains in final domestic demand in Q4.
The players
Domestically, the top rated banks in Canada are RBC Dexia and CIBC Mellon, but all the major players have a significant presence. Citigroup, Northern Trust and State Street are all active participants.
“If you’re not already in Canada in a big way, then you’re going to find it very difficult to gain a foothold,” says one fund manager. “Custodians here have a very good reputation, both for the quality of their service and their ability to keep costs down. I don’t really think there’s anything we could expect from a new entrant that isn’t already done well by the big players and because we’re now increasingly looking at long-term stability we don’t want to work with a firm that doesn’t have a large footprint here, even if they are a major custodian elsewhere.”
When it comes to pension assets under custody, State Street is Canada’s largest player, with CAD354.6 billion in assets at the end of last year. RBC Dexia is just behind, with CAD349 billion. CIBC Mellon, Desjardins Trust and Northern Trust round out the top five.
Safety
Transparency and risk management remains key, and has filtered down into the ‘non risky’ areas of the market, such as custody and other asset servicing products. While Canada’s banks remain amongst the safest in the world, institutions are now expected to delve into the financial strength of an outsourcing provider during the RFP process.
“It can feel a little silly,” says a spokesperson for one of the country’s largest pension funds, “we’ve been dealing with these guys for years and know they’re on the straight and narrow. We can see their credit ratings and we generally know about the values of their assets under custody and their performance with both us and our counterparts in Canada. So we feel safe with them. But our new corporate governance rules expect us to investigate every time we are looking at awarding a new mandate - it’s almost just form filling, we only look at the safest banks anyway. But I suppose that three or four years ago, no-one thought Lehman would go under.”
These new rules have benefited the larger players, those with trillions in assets under custody worldwide. They are able to play to their strengths and show that they have the ability to withstand anything that the market can throw at them. But it has hurt some of the more bespoke providers.
“We’ve been in the market a long time and have always done well for our clients,” says a spokesperson for a smaller global custodian. “Because our client profile tends to lean towards the more specialist fund managers who require a bespoke service and tend not to worry so much about the costs, we’ve always attracted smaller funds. This means that our footprint in the market is not as large in terms of assets under custody as some of our competitors.
Until recently, this has not been a problem for us - we don’t offer the one-size-fits all approach that some of the major players do, so we have always won business by tailoring our approach. But as funds now look at the value of assets under custody at the beginning of the process and often have a level they won’t go under, we find we are not only losing business, but we are in some cases not encouraged to bid for it at all. To be honest, we find this absolutely ridiculous, we have one of the highest ratings any bank has in the world, we have risk management systems in place that can’t be beaten by anyone and we have a team that knows our clients inside out. But because we think of ourselves as one of the last boutique asset servicers, we are being frozen out.”
“Clients are broadening their focus on transparency in their portfolio holdings and what they’re looking for in the analysis of their exposure,” said Northern Trust’s John Folk earlier this year. “Asset liquidity, counterparty exposure and interest rate sensitivity are being viewed at an overall portfolio/plan level, and the requirement for flexibility and timely access to data is increasing accordingly. Custodians are responding with more automation to minimise operational risk, while at the same time helping clients to better understand and minimise their counterparty risk. Until recently, a 30-, 60- or 90-day cash forecast was the norm. But in today’s markets, and with more alternative investments in their portfolios, clients are looking for a view on liquidity that includes hedge fund investments and potential capital calls on private equity.”
Cost
As with all middle and back office services, cost remains key. Canada is not considered an expensive jurisdiction in which to do business, and fees for custody tend to reflect that. “We don’t just compete on cost, we like to show that the quality of our service is just as important,” says a spokesperson for RBC. “But it’s certainly true that we put a lot of effort into automating our systems and streamlining our infrastructure as much as possible to keep the prices down for our clients.”
Investment managers who believe their core strength is picking assets will discuss everything else for outsourcing. “We don’t want to be fund administrators...we knew our custodian had the capability to do it, and do it quickly,” says one. “We ask ourselves, ‘Is the risk transferable?’”
Growth
The key growth in assets under management is expected to come from pension funds. The Canadian pension system is not facing the enormous shortfalls seen in other parts of the world, but it is going to have to grow significantly if it is able to keep up with an ageing population, especially as contributions to private plans have dropped during the downturn. With over CAD100 billion in assets, the Canadian Pension Plan (CPP) is a major player in the equity and bond markets, while private pension schemes are also having an impact. AST
