Custodians juggle challenges of risk and reward

Custodians have a love/hate relationship with risk. On the one hand, they are wary of using their balance sheets for client financing, a reluctance that has helped investment banks make headway in the administration business.

At the same time, custodians are interested in administering highly complex investment portfolios and products, many of which carry a significant operational risk. Custodians also want to play a part in risk measurement and analytics, although few have developed a compelling service proposition. Even the largest custodians are feeling their way when it comes to risk services.

According to Gunjan Kedia, global head of product management at Bank of New York Mellon, part of the problem is that each client has a unique perspective on risk. She said: “There is no hard and fast definition of risk services. Clients talk about risk in different ways, and we take a consultative approach to providing management and analytics products. Risk is a very broad spectrum and we need to ensure that we have sufficient intellectual capital to cover it.”

Some firms, such as JP Morgan, leverage their investment banking expertise to develop their risk capabilities, while others provide turnkey solutions to smaller clients. Jay Hooley, a vice-chairman of State Street, said the bank was concentrating its efforts on this sector. He said: “We are working on our risk analytics and modelling capabilities. We are focusing on those boutique managers that do not have the infrastructure to handle risk analytics in-house.”

While risk measurement and analytics represents a further expansion of value-added services, the real challenge for administrators lies in quantifying and managing the risks associated with processing complex structured products and dealing with a very different client base. Alternative investment managers do not behave in the same way as institutional pension plans and mutual fund managers, presenting administrators with client servicing, operational and technological issues.

Hans Hufschmid, chief executive of GlobeOp, one of largest independent administrators, said the “know your customer” principle has never been more important. He said: “You definitely have to be more careful about the firms with which you do business.” Hufschmid said despite the fact that the alternatives industry is relatively tight-knit, a lot of due diligence is still required.

“This is an industry in which everyone knows everyone. We get referrals from prime brokers, law firms and accountants, and then we work hard to get to know our prospective clients.”

Custodian banks are fully aware of the challenge. Tim Keaney, head of international asset servicing at Bank of New York Mellon, admitted that the industry has not yet got everything right. He said: “All of us could do a better job of understanding clients, but we are all starting to ask the right questions.”

Some of those questions will undoubtedly revolve around the risk/reward ratio. Custodians have long argued that they need to be better compensated for the work they do and the risks they assume, and they are quick to make the point that the price of staying in the race is increasing all the time.

Hooley said complexity has its costs. “To meet the demands of clients in servicing more complex instruments, we have to spend at higher levels, and others will have to as well.”

Specialist services
For some custodians, one way to deal with the pressures of complexity is to outsource specialist services. GlobeOp, for example, said “three or four” of the world’s largest custodians use it for over-the-counter derivatives processing, while SuperDerivatives, the asset pricing and revaluation specialist, claims the majority of global custodians use its revaluation services.

David Gershon, chief executive officer of SuperDerivatives, said custodians need the help of specialists in such a complex area. He said: “Custodians realise that they cannot afford to deliver a poor service. That’s why they use us.”

Gershon feels the widespread adoption of derivatives as an asset class is putting pressure on administrators and their systems. “Planning capacity for future volumes is not a trivial issue. The growth of the OTC derivatives market requires a serious review of the operational infrastructure needed to support client activity. There is also the significant challenge of managing multiple data sources,” he said.

Even as custodians look to specialists such as GlobeOp and SuperDerivatives for support, they are discussing new outsourcing opportunities with clients. Most of the banks report a renewal of interest in investment operations outsourcing, largely driven by the buyside’s need to find processing solutions for alternative investments.

Many custody firms are also looking at increasing their business with hedge funds, having recognised that they need to get closer to execution and financing if they are to generate better returns.

BNY Mellon is evaluating the opportunities with hedge funds from a number of angles. Art Certosimo, head of broker-dealer and hedge fund services for the bank, said it is interested in collaboration, rather than straight competition, with the investment banks. He said: “We want to build partnerships with the top-tier prime brokers. We can help them to manage their administration more effectively. We are looking at establishing tripartite relationships with prime brokers and hedge funds.”

At JP Morgan, the focus is on better integration of what the firm does for hedge funds, according to Conrad Kozak, global head of investor services. He said: “We are improving the packaging of our services for hedge funds. The firm has a lot of different relationships with hedge funds, and we are working on a more integrated marketing approach.

Brokerage model
There is also an increasing amount of noise among trust banks about the need to change the securities financing and prime brokerage model. Although Citigroup has launched a comprehensive hedge fund servicing capability that combines execution, financing and administration, no other custodian has publicly indicated that it is ready to take on the prime brokers.

However, the mood is certainly moving in that direction. Trust banks believe they can offer a different type of service that would enable hedge funds to break their dependency on prime brokers.

Hufschmid is sceptical about their ability to compete. He said: “Trust banks do not have a Wall Street mentality. Prime brokerage is alien to their culture, and that will be a hurdle.” Yet the big interest in 130/30 funds, a market Merrill Lynch predicts could rise in value to $1trn within five years, may force custodians to take a more aggressive approach to protect their client base. They will not want to see their clients launching 130/30 funds, only to miss out as the valuable administration mandates go to independent administrators or investment banks.

As this year’s R&M Global Custody Survey results show, the big custodians are in no position to relax when it comes to client service, a lesson that JP Morgan has taken to heart. Kozak said: “We are focusing on the delivery of our services on an end-to-end basis, from implementation onwards. We need to ensure that the quality is consistently high across all areas. We have to do a better job of understanding what the client wants and how we deliver it. That’s the challenge facing the industry.”


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