© Copyright 2002 Rogers Media. The following article first appeared in the February 2002 edition of BENEFITS CANADA magazine.

The Next 25 Years: Custody

Thomas MacMillan examines an evolving sector. More consolidation and an expanding new role for custodians is in store.

Canada's custody industry has undergone more change in the last 25 years than just about any other in the pension and benefits sector. Over the years, demand for faster and more detailed information has required custodians to make a significant investment in technology. The need to minimize the risk of failed settlements resulted in the creation of the Canadian Depository for Securities, while the emergence of independent investment management firms has led to much more complicated investments. In addition, security settlements beyond Canadian and U.S. borders created a need for a global custody network, supported by real time, multi-currency, trade date, custody and accounting systems.

These developments occurred quickly, and custodians often had trouble keeping up with the pace of change. Substantial investments in technology were beyond the budgets of most firms, leading to a massive restructuring of the industry over the past decade. The industry and the players today look nothing like they did 25 years ago.

Consolidation created conversion headaches. Plan sponsors were forced to change suppliers--many more than once. As a result, service levels have not always been optimal. Custodians have tried different approaches to meeting clients' needs while keeping in mind the cost of operational changes and developing new products. This challenge will continue in the future. Custodians need to stay focused on service in spite of the changing business environment.

As custodians adapted to change, their role in the industry evolved. Core services such as settlement, safekeeping, income collection, accounting and benefits payments are as important as ever, but custodians are now entering new territory. Data warehousing, trade date plus one day (T+1) settlements, straight through processing (STP) and outsourcing are the latest additions to the custody lexicon.

CHANGING ROLE
Technology and the huge amounts of data collected are transforming custody firms into data warehouses. The type of information available is virtually unlimited.

For example, beyond analysis at the portfolio level, custodians are starting to identify trends that investment managers will find useful. Global custodians can report on the flow of funds into different capital markets around the world. This provides investment managers with information on changing market weights so that they don't have to wait for several months until an official report is issued from a particular country.

This information can shape a manager's view of the markets and help the individual identify an area that needs further investigation. The key here will be not to get carried away with the possibilities.

Custodians have a vested interest in influencing the future of their industry. The need to improve efficiencies positions custodians as leaders in raising the rate of STP settlements, which will be important as the industry moves to T+1 in 2005, and perhaps to T+0 in the future. An STP rate of 100% is the ultimate goal. This will allow custodians to focus more attention and resources on clients and investment managers.

The industry's infrastructure and operations experience is enabling it to become an outsourcing supplier. For example, in order to be ready for T+1 in the next three years, investment managers will have to re-examine how they are positioned. Custodians will be able to take over the entire back office of an investment management firm and allow the manager to focus on its core business and clients. The custodian, in turn, can build on economies of scale and strengthen its client relationships. This type of back office outsourcing is already taking place in the U.S., and it will be here before we move to T+1.

LONG-TERM GROWTH
Further down the road, the future of the custody industry is clearer when we look offshore, where the big players have grown bigger and the landscape is dominated by global powerhouses. The top 10 global custody providers have almost US$35 trillion in their care (see "The top guns," above). Growing through acquisition and maximizing economies of scale with huge transaction volumes, global custody companies are entering more markets and supplanting local custody suppliers along the way.

Canadian custodians are well represented among the top powerhouses through their parent companies or alliance partners, illustrating just how far ahead we are when it comes to consolidation.

Continuing offshore expansion will be a primary goal in the future. It will provide Canadian firms and plan sponsors with more products and greater efficiencies. Meanwhile, the small players will remain small in the years ahead as big and small players work together.

Niche providers will focus on select market segments, emphasizing service rather than low cost. Smaller custodians can preserve their independence by forming an alliance to outsource their back offices to larger suppliers that offer white label products. This will allow larger custodians to further increase their scale.

THE NEW CONSULTANTS
The complexity inherent in many areas of the pension business means that custodians will play a consulting role with parties that want the big picture when they are contemplating portfolio changes.

Custodians have already paved the way for investment managers to look to diversify internationally, opening local offices, seeking subcustodians as well as sorting out settlement, income collection and tax obligations in overseas markets. Armed with insight into local best practices and the due diligence required to minimize risk, custodians are a logical resource for investment managers and plan sponsors seeking to understand the day-to-day operational complexities of international pension and monetary markets.

Standardized file layouts and real-time messaging formats, along with the operational efficiencies that will be gained in the move to T+1, will allow custodians to provide accounting services, even if they do not have custody of the underlying assets. Third-party suppliers have often come along to poach the value-added services that custodians have regarded as their turf. There is nothing to stop the custodian from reversing this trend and taking this business back. In this environment, custodians can go after their competitors, and investment firms and plan sponsors can choose the specialty services they want from any custodian.

Regulatory change is another factor that will transform the industry. Governments can protect or encourage financial services in their jurisdiction. Their actions can draw in new providers looking for opportunities beyond those offered by the existing marketplace.

This type of transformation occurred in Ireland. In the 1990s the Irish government provided favourable local tax treatment and the necessary high-tech infrastructure to grow its financial services sector. Today, Dublin is home to more than 300 financial services providers, including custodians. If a similar initiative were put into place in Canada the balance of the market would certainly be unsettled by new providers. Attracted by the opportunities, these players would compete against existing local firms.

There is a move towards consolidating central securities depositories throughout Europe. It is not difficult to imagine a future with one worldwide securities depository. If that occurs, the role of the traditional custodian will certainly change. As companies look at the most efficient solution for all of their needs, the custody industry may actually outsource custody and focus on its developing forte--accounting, recordkeeping and data management.

For this type of change to take place, local regulators would have to hand over most of their control to an international body. While the thought of a regulator giving up power voluntarily seems unlikely, such a change would go a long way to improving the cost structure and efficiency of capital markets. Custodians would then be free to focus on the service and product development side of the business, knowing the fundamental infrastructure was secure. BC

Thomas MacMillan is the president and chief executive officer with CIBC Mellon Global Securities Services Co. in Toronto. thomas_macmillan@cibcmellon.com.This article is the first in a series commemorating Benefits Canada's 25th anniversary.

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