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

The spotlight in the custody industry over the past several years has been on next-day transaction processing (T+1). Custodians are still gearing up for this major event. But the buzz in the industry today surrounds outsourcing--a trend that will transform the role of custodians in the pension and investment business. "The capital requirements of T+1 are making investment managers and insurance companies pay more attention to their back office," says Thomas MacMillan, president and chief executive officer with CIBC Mellon Global Securities Services Co. in Toronto. "These companies are feeling the need to focus on what they do best, not back office securities administration and settlement." This means clients could hand over more non-core business operations to custodians.

"Everyone is looking at business redefinition--large plan sponsors, insurers, money managers--and asking 'where do I spend my money and can I partner with a global custodian to do this activity?' " says José Placido, senior vice-president, RBC Global Services in Toronto. He points out that outsourcing is a natural evolution for custodians as it capitalizes on the industry's forte of information technology and management with respect to investment trading.

Outsourcing has been on the radar screen of Canadian custodians for the past several years. While some outsourcing of fund accounting has occurred, no major deals have materialized here yet. The concept has gained ground among money managers since several major outsourcing partnerships were forged in the U.S. and U.K over the past year. "Twelve months ago there was some resistance in Canada, although there was no doubt it [outsourcing] was happening elsewhere. Now there is much more interest in Canada to understand back office outsourcing and its benefits," says Tim Houlahan, vice-president, marketing and strategic planning with State Street Trust Co. Canada in Toronto. "We have not seen a wholesale move towards it in Canada yet, but we are definitely talking about it with a lot more with clients."

The top three custodians readily admit that they are eager to take advantage of this new opportunity. They are confident at least one major outsourcing announcement will be made in 2002. More are expected to follow as money managers, plan sponsors, brokers and custodians move closer to the revised T+1 deadline of June 2005. "T+1 will require lots of time, attention and money. Chief executives need to think about that today," says David Toyne, managing director with State Street in Toronto.

THE RIGHT FIT
Outsourcing arrangements are expected to run the gamut from simple fund accounting to a custodian taking over the entire back office of an investment management firm. The latter would see a custodian directing all of a money manager's or plan sponsor's other custodians, preparing client reports and hiring on staff that work in the back office.

While the move is inevitable, Placido says large firms will think carefully before handing over a substantial chunk of their business--and in some cases staff--to custodians. "They are looking for stability in terms of continued investments in technology by the custodian, scale and the ability to take on their staff and manage with a similar philosophy. A true win-win partnership is about integrating custodial products with client needs."

Stuart Plummer, senior products manager with CIBC Mellon, adds that a good fit between a custodian and money manager or plan sponsor is crucial to the success of an outsourcing partnership. "Money management firms are not operating in a cookie-cutter fashion. They all have their own legacy systems and you have to see if your product meets their needs."

As the competition heats up for outsourcing business, custodians will differentiate themselves through their products, philosophy and ability to add value, says MacMillan. He adds the outsourcing trend will also see the big firms grow larger as these players will have the resources to develop more outsourcing products and capabilities.

THE NUMBERS
Talk of expanding business this year is a welcome change from the less upbeat picture painted by Benefits Canada's 8th Annual Report on Custodial Services, which shows the industry recording a year-over-year decrease of 11.4% or $83 billion in pension assets as of Sept. 30, 2001. Total pension assets under custody ring in at $646.7 billion. The decline is not as steep on the mutual/pooled fund side of the custody business, where assets stand at $520 billion, representing a 3.2% or $17.2 billion drop over the previous year.

All of the top five custodians experienced a decrease in pension assets, with the largest per cent (26.8% or $4.5 billion) coming from Northern Trust Co. Canada (No. 5) and the smallest (3.6% or $3.4 billion) from Desjardins Trust (No. 4). Among the top three players, RBC (No. 1) holds pension assets of $267 billion as of Sept. 30, 2001, a $33 billion or 11% decline over last year. CIBC Mellon (No. 2) has $138.2, a decrease of $28.1 billion (16.9%), while State Street Canada (No. 3) rings in at $132 billion, down 10.2% or $15 billion.

The decline in pension assets in the custody industry as of Sept. 30, 2001 is a result of the downward spiral in the markets felt by all major players in the pension business last year. The top three custodians point out that market valuations don't reflect the fact they actually grew their pension business last year. "In spite of a volatile economy we met our new business objectives," says MacMillan.

The industry's outlook for this year is optimistic. "In the last couple of months, we have already seen asset levels increasing," says Placido of the pension business. "We have already won new mandates and are seeing a lot of new funds being introduced."

Once again, the picture was more upbeat on the mutual/pooled fund side of the custody business in 2001. While RBC saw its assets shrink by $46 billion or 15.9% to $243 billion, all of the other firms in the top five grew their business. CIBC Mellon posted mutual/pooled fund assets of $135.7 billion, up 12.2% year-over-year. State Street had $123 billion in assets, representing a 10.8% increase over Sept. 30, 2000. North Trust and Desjardins experienced increases of 1.3% and 9.1%, respectively. "We saw an inflow of [mutual/pooled fund] assets, even though they were going into money market funds. The growth there was quite extraordinary," says Toyne.

POST SEPT. 11
On top of market volatility--already in full swing before Sept. 11--custodians had to manage the fall-out of market closures as a result of the World Trade Center tragedy. It was a test the industry passed with flying colours as money managers and plan sponsors were assured that trades would be processed and all assets were indeed secure. "We are in a business which everybody takes for granted. But in a situation like Sept. 11 one of the first calls is in fact to the custodian," says MacMillan. "It reinforced the relationship with clients and the importance of it."

The event has resonated in the industry in several ways. Most notably, contingency or business recovery plans are top-of-mind for all players and their clients. "What we have learned is that business contingency plans have to be an integral part of doing business--not regarded as a necessary evil--and reviewed regularly," says Placido. "Clients are now asking how often we review our plan as part of a proposal for new business. It makes a lot of sense." There is also an increased focus on risk management, says Toyne.

Custodians add market returns and the general business climate following Sept. 11 have led many plan sponsors to review their investment managers and restructure their plans--developments that are also keeping custodians busy. "We have worked with several large clients who are undergoing a major restructuring of their accounts, whether necessitated by the sell-off of a division or the takeover of a competitor. These projects require dedicated teams and months of planning. Clients are seeking us out in more of a consulting capacity. They are bringing us into their planning earlier in the process, giving us more of a chance to add value and ensure the success of the project," says MacMillan.

Meanwhile, efforts to prepare the investment industry for T+1 in mid-2005 (delayed as a result of Sept. 11) are ongoing. "Working with investment managers and educating plan sponsors is key. No one participant in the settlement equation can improve without cooperation from each of the other parties," says Plummer. This was a lesson the industry learned while managing the aftermath of Sept. 11. It will serve as excellent preparation for outsourcing ventures in the future. BC

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