Understanding how custodians have changed over time requires first looking back to the late 1990s. Most of the consolidations in the custodial industry took place at this time, as Canadian banks found the technology investment too costly and, as a result, sold their businesses. “The acquiring firms had a lot of business to absorb, and there was a period where service levels dropped off,” says Robert Baillie, chief executive officer, The Northern Trust Company, Canada, in Toronto, “and there was a fairly high rate of discontent among pension sponsors.” Even though consolidations have happened more recently—RBC Global Services’ joint venture with Dexia Investor Services, the merger of the Bank of New York and Mellon Financial, and State Street’s acquisition of Investors Financial Services—the remaining providers believe that the bulk of it is over. And, the industry as a whole has actually benefited.
“The choice has been reduced, but it has provided plan sponsors with a certain peace of mind in that the providers that have exited have demonstrated their lack of commitment to the business and their unwillingness to continue to invest,” says Stephen Smit, president, State Street Trust Company Canada. MacMillan agrees: “The ones that have remained are committed to the business. They are actually giving a much better level of service because they have the scale and investment dollars.”
The second reason for the evolution of custody services is plan sponsors’ increasing interest in more complex investment strategies. “As the funds move into the alternative investment space, the notion of providing real-time information, which will allow them to see the movement of their funds on a daily basis, has become the key,” says José Placido, chief executive officer, RBC Dexia Investor Services, in Toronto. “We are moving into a much quicker world, where getting access to information to make decisions is critical.” Plan sponsors are also looking for access to securities lending, foreign exchange and support around new strategies such as 130/30. This requires real-time transactions, data reporting and performance management. “There are more and more demands from them to also support a wider variety of customized needs,” says Michel Prefontaine, vice-president, Desjardins Trust, in Montreal.
In addition, plan sponsors are increasingly concerned about transparency, risk management and governance. “We continue to work on non-conventional methods of evaluating investment risk and performance to create more relevant insights for our clients. Clients are telling us they need more of this, due to increased regulations and the need for transparency,” says Baillie.
It’s Evolution, Baby
The scale achieved by the consolidations has allowed the industry players to grow into areas beyond traditional custody services. Providers insist that the notion that custody is a commodity business is an outdated idea. “I would say that is an old paradigm view of the custody business,” says Placido. “It is a much more complex business than it was 10 or 15 years ago, because the services that the money managers and pension funds are outsourcing have changed.” MacMillan says he would be disappointed if people believed custody services are a commodity. “We constantly differentiate ourselves on our ability to deliver service and the quality of our products. If you can differentiate yourself, then I believe that we are not in a commodity-type industry.”
Industry players agree that traditional custodial services are non-negotiable things that plan sponsors expect. Such services do not set one provider apart from another in the marketplace. “I can see how it could become commoditized if you consider this business to be pure safekeeping and settlement. That’s the bare bones of what we provide,” says Baillie. It’s what custodians are providing in addition to these services that sets them apart. These additional services include advisory services, analytical tools, risk management, electronic trading, compliance monitoring, securities lending and transition management services, to name a few. Custodial providers are increasingly using the new moniker “asset servicing” because it more accurately reflects the services provided.
“What we are dedicated to doing is really providing the ability to manage enormous amounts of information quickly and reliably,” says Smit. “There is an increasing focus on information and tools to allow clients to make better investment decisions to enhance their investment performance and more effectively manage risk.” This is known as value-added service, and, according to providers, plan sponsors are willing to pay a premium for it.
Meeting Needs With Technology
For asset servicers, technology is the key to providing huge amounts of information and added value. Organizations are spending between 20% and 25% of their annual operating budgets on the latest cutting-edge technology to meet plan sponsors’ growing needs. “To be in this business, you need to invest at least 20% of your budget on technology,” says Placido. Clients are looking for partners with technology capabilities, a full array of value-added services, and the global scale that will allow asset owners and managers to continue to grow their business, says Smit.
But, the most pressing need for plan sponsors is getting up-to-date and accurate data. Technology products are meeting these needs while also allowing providers to give customized information to their clients. In the past few years, all of the major custodians have made significant investments in their technological capabilities to increase transaction capacity and provide accurate data. They are also dedicating more staff to technology services. For example, State Street has, globally, more than 3,000 employees dedicated to IT.
CIBC Mellon’s Workbench and Northern Trust’s Passport are examples of Internet-based systems that provide plan sponsors with real-time information at their desktops. New tools are easily added to such systems, so if a plan sponsor wants to start in foreign exchange or just wants more information about current trades, it is quickly accessible from the computer. “It’s an enabler for our people and our clients to do more,” says MacMillan. Baillie agrees. “This business is a blend of technology and human capital. How effectively you deploy both is going to have an impact on how successful you are in the business.”
Technology is only making the environment more competitive. “To provide a complete and integrated array of solutions to customers, you need to keep pace with market demands and the very substantial technology demands,” says Smit. “That necessitates continuous reinvestment in the business and, honestly, I don’t think that all of the current providers with multiple lines of business will be able to maintain their participation.”
When it comes to success, this was a good year for the custody industry. Canadian pension assets under custody increased 9.6% to $1.23 trillion in 2007 from $1.12 trillion in 2006. The mutual/pooled fund assets under administration grew 13.3% to $1.2 trillion in 2007 from $1.06 trillion a year earlier. Among the largest players, CIBC Mellon had the greatest growth in Canadian pension assets under custody with a 14.2% increase. MacMillan attributes the growth to three things: market appreciation, winning new business and retention of current clients. State Street was a close second, at 12.6% growth. Smit says State Street’s growth in 2007 was primarily due to winning new business from existing customers by providing some of the new value-added services.
The smaller player, Canadian Western Trust (CWT) in Vancouver, experienced growth in assets under administration of 45% this past year. Vice-president and chief operating officer Adrian Baker attributes this, in part, to picking up business from other custodians and from insurers. “Some plan sponsors are looking to unbundle previously bundled services, like recordkeeping, investment management and custody,” he says. “That’s where we’re seeing growth.” Baker has also noticed, in the last few years, that larger custodians are now retaining more of their smaller clients, which is forcing smaller custodians like CWT to branch out into new services, such as employee stock plans.
Despite consolidation in recent years, the custody landscape remains competitive as players vie for a limited amount of pension business. “As custodians in Canada, we have to be open, we have to listen well and look at ways we can provide a broader array of custodial services,” says Baker. Some intend to focus on clients individually to develop customized strategies. “We are going to further segment our client base to see which ones are moving into different investment strategies,” says Placido. “Then, we will facilitate an intimate business-to-business discussion to make sure we can respond to their needs.”
While most asset servicers believe major consolidations are over, none of them ruled out the possibility of future activity. It seems that the custody environment will only get more competitive in the future—and this could be a great thing for plan sponsors.
Coaching on Custody
The Halifax Regional Municipality Pension Plan recently undertook a search for a global custodian. To help plan sponsors make more informed decisions when selecting a custody provider, here are some lessons learned.
Obtain a guarantee from the parent company – Many custodians have non-Canadian parent companies. However, it’s important to assess the financial strength of the Canadian subsidiary as well, since the subsidiary may be the contracting entity. Obtain a guarantee from the parent company to help minimize the risk of being unable to collect from the Canadian subsidiary in the event of a future lawsuit.
Negotiate competitive cash rates – Excess cash usually causes a negative drag on a pension fund’s performance over the long term. While it’s necessary to maintain a certain amount of cash to pay pensions and expenses, make sure that you negotiate a competitive rate on USD and CAD cash balances.
The CAD cash rate is normally quoted at the Canadian Banker Acceptance (BA) rate minus x basis points (bps) and the USD cash rate at the Federal Funds rate minus y bps. You will want to minimize the x and y amounts. For example, if the CAD cash rate is BA – 30 bp, you are essentially paying the custodian 30 bps to have the cash sit idle. Some plan sponsors set up a bank account outside of the custody account to maximize the interest rate earned on the cash and to minimize the transaction costs associated with issuing cheques and wire transfers.
Negotiate a transition allowance – If you change custodians, you will incur costs such as legal fees for reviewing contracts and transaction costs for moving securities. A transition allowance will help offset these one-time costs.
Benchmark the proposed fees – Compare the fees from the custodians under your consideration with the fees you’re currently paying to ensure that the proposed fees are competitive.
Negotiate a cap on transaction fees when moving securities from one account to another – With a cap in place, it’s surprising how much money you can save when moving securities between investment manager accounts due to changing mandates or investment managers.
Review the custodian’s tolerance for reconciling accounts with investment managers – Some custodians will reconcile only up to a 20 bp difference—but on a $1 billion plan, this means that $2 million may not be reconciled. It’s in the client’s best interest to reconcile the accounts as close to 0 bp as possible, to account for the total market value. To help protect the plan’s assets, ensure that both the custodian and the investment managers follow tight reconciliation procedures.
Don’t forget about foreign exchange (FX) costs – Best practices indicate that clients should monitor what FX rate was executed, and at what time. Benchmarking reports are available from some custodians.
Use technology to increase operational efficiencies – A robust front-end technology platform, combined with a flexible and dedicated IT team, can reduce the time spent on compliance monitoring, cash management, asset mix balancing and other activities.
Consider securities lending – In addition to negotiating a competitive revenuesharing arrangement, negotiate a revenue floor. Failing to achieve the floor means that the client gets 100% of the revenue, which serves as protection from exaggerated securities-lending proposals.
A global securities-lending desk will likely maximize revenues; however, ensure that the collateral guidelines are consistent with your fund’s Statement of Investment Policies & Procedures, and decide whether or not you will trade off additional revenue for an enhanced indemnification from the securities-lending provider. Consider whether or not you’re willing to entertain cash as a collateral option, and if you’re comfortable assuming the associated risk.
Maintain a robust benefit payment service and an experienced team – Negotiate additional compensation in advance for potential problems associated with the transition that may negatively affect the payment of pensions.
Know the applicable privacy legislation – Each province has different privacy rules relating to plan member data housed on foreign computer databases. Understanding these rules is extremely important when outsourcing pension payments.
Be aware of consolidation in the industry – Negotiate a commitment to no system conversions for three to five years unless you are compensated for the inconvenience. Be mindful that your current custodian may not exist in a few years’ time. Negotiate compensation to help offset any new transition costs that aren’t within your control, in case your custodian decides to exit the business in the future.
Meet the team – A fully dedicated day-to-day contact and an experienced team are essential. Make sure that you meet the whole service team, including your future day-to-day contact person. It’s also a good idea to do on-site due diligence and ask for references.
Grace Yu is an investment associate with the Halifax Regional Municipality Pension Plan. firstname.lastname@example.org
Don Bisch is editor of Benefits Canada, and Leigh Doyle is a freelance writer based in Toronto. email@example.com
For a PDF version of this article, which contains charts of the largest custodians in Canada, click here.