Robert Scott of Commerzbank considers how the security services, custodial and asset servicing businesses are pricing their offerings, and whether change is needed for the good of clients
Pressure on pricing has been the overriding dynamic of the securities industry for the past decade. When lobbying of the stock exchanges failed to bring down execution costs, the big banks worked together to create alternative trading venues and multilateral trading facilities. The resulting drop in executional pricing and the introduction of true competition and innovation was something to be celebrated.
But in security services, custodial and asset servicing, has the pressure on pricing become too great? In the race to push costs to the floor, are we in real danger of jeopardising the long-term sustainability and stability of an essential and necessary part of the transaction lifecycle?
The services performed by custodians and sub-custodians are critical. If they are not performed correctly, it can cause enormous problems with clients and lead to significant cumulative losses. Moreover, in the new regulatory environment, poorly managed post-trade activity can also create huge drains on capital and collateral efficiency.
So, is it time for a fundamental change in how service providers do business, and how clients are educated as to the real value of the tasks executed daily around the world on their behalf? To use an analogy, is it time clients understood the implications of taking their highly-prized Rolex or Cartier watch for servicing in a local budget jeweller?
Fee compression
The squeeze on margins for service providers has been relentless at a time when providers have had to invest in regulatory compliance, increased transparency and market innovation. Ten years ago, custodians could have expected to levy fees of multiple basis points or more for core custody and safekeeping. Now, pricing rarely begins at more than a basis point (in fact, it’s often lower), while transaction fees that used to be in the 10s of euro/US dollars have fallen by 80 percent or more.
Fees used to be negotiated once every two to three years. Clients now routinely want to review them annually or semi-annually. Negotiations are often expected to begin at the very bottom-end of pricing scale regardless of volume, with clients still demanding the highest level of servicing.
Attempting to maintain a profitable business against this backdrop of continuous fee compression and growing costs is, of course, unsustainable. For many custody providers, operating in mature European markets often means having to accept a negative cost-income ratio. So what’s the solution?
Profitability tactics
Banks have used a number of tactics to address the profitability challenge. The first, and most popular, is simply to go for scale and process as much volume as possible, typically going offshore to keep costs ultra-low. The second is to hope that offering custody as a loss leader will bring in other reciprocal business. The third is to accept the status quo and look to other markets such as Asia and Central and Eastern Europe, where pricing hasn’t been so sensitive, to help cross-subsidise custody activities closer to home.
But all three tactics have their issues. Processing huge volumes for little return on equity isn’t a business model that even the biggest banks want to be seen to rely on now, and clients are often vocal in their dislike of being serviced offshore; client business reciprocity has stubbornly failed to materialise.
Finally, as regulation now demands banks carry a capital charge for non-profitable business, simply cross subsidising loss-incurring European business with profitable business in, say, Asia and Central and Eastern Europe is far more challenging. Plus, it’s only a matter of time before the same pressure on fees hits these markets in the same manner.
Put bluntly, allowing custody services to muddle along unprofitably and inefficiently can’t last much longer, as many banks have started to realise. We’ve already seen some major names exit certain business lines, such as clearing, as they look to redefine their business models. Banks are also exiting unprofitable or imbalanced client relationships, forcing smaller and less well-capitalised institutions and intermediaries to look elsewhere for the services they need.
But while banks begin to address unprofitability, they aren’t necessarily tackling the underlying problems that are making custody and asset servicing so unviable. In our view, a real sea-change is required over the next three-to-five years in how banks provide post-trade services if the industry is to remain stable, sustainable and deliver the reliability and efficiency that clients require. Here are the key areas that need to be addressed:
Legacy systems: most banks are still working with aged systems and platforms that are complex, inefficient and light years from the level of functionality being used in other sectors. A 2014 study showed that the average age of a securities platform in Europe is 18 years or more. That’s equivalent to using a Nokia 3310 when the rest of the world is using the iPhone 6.
Overhauling a proprietary global mainframe platform can easily cost €100 million or more. Given that banks have been diverting all of their resources to keep up with regulatory change over the past eight years, that’s capital most simply don’t have available.
This is largely why we are starting to see some major high profile IT outsourcing announcements. By transferring to third-party platforms rather than changing their own technology, banks are citing cost savings of up to 40 percent, and this outsourcing will be a continuing trend among the big players.
Lack of fee transparency: post-trade billing has become overly complex, with hundreds of charge points and lack of clarity on new billing items that were previously bundled, such as corporate actions. The challenge of reconciling bills and invoices is such that most clients now simply look at, and make a comparison between, the headline amounts each month. Effective reconciliation in most cases is pretty much impossible.
Industry standards on certain price components are now sorely needed to ensure transparency, to reduce the administrative burden on clients, and to align with the post-credit crisis ethos of openness and honesty.
Realistic pricing: open and honest conversations need to be held with clients as to what is fair but sustainable pricing, taking into account balance sheet and regulatory demands. This is an educational process. If clients want a partner that will be there for the long term, and which isn’t going to abruptly pull out of the market under pressure from shareholders, then realism about the risks and costs of doing business is required.
No one has bitten the bullet yet, but we anticipate at some point, banks will look to charge explicitly for services such as intra-day credit, which clients currently expect to be provided for free. There are also some compelling opportunities for banks to charge for other products and services where they can add substantial value—for example, helping clients to navigate regulatory change by providing trade depository reporting services.
The key will be to sit down with clients and ask them what they want and what they are willing to pay for, which is not exactly a revolutionary step, but one that is not being taken right now.
A new business model
For too long, banks have tried to be all things, in all markets, to all people. The need to manage risk-weighted assets and balance sheet consumption are forcing service providers to abandon that volume approach.
Now, banks need to define their strengths, show where they can add value for particular groups and work out a focused, long-term sustainable business model. This is particularly urgent now that so many other participants, including exchanges, CSDs and CPP, are seeking to encroach on service providers’ business to recoup revenues lost on their traditional service offerings. Most of all, banks need to work out how to tackle the burden of sometimes enormous internal overheads and cost allocations, which so often affect the bottom line performance of a service unit.
As regulation starts to settle down and banks have more time and space to think about their future business strategy, I’m hopeful that change will occur. We are already seeing the glimmerings of some exciting disruptive technology that could transform how our business operates, and that needs to be accompanied by some bold innovation in fees and pricing transparency.
In five years, I would hope that the world of post-trade will be very different. If it isn’t, the ability of the industry to service the long-term needs of its clients will be severely compromised.
