Custody growth and diversity

As superannuation funds report another year of positive returns, the major custodians are generating similarly satisfactory outcomes for their shareholders but, as Damon Taylor reports the custody market is also becoming increasingly competitive and diverse.

In a financial services landscape in which performance continues to be key, it seems Australia’s superannuation and custody industries have plenty to be pleased about.  

Indeed where Australian super funds are headed for their fifth consecutive year of positive returns, assets under custody figures released by the Australian Custodial Services Association (ACSA) show similar growth and for David Braga, Chair of ACSA, this is simply proof of the vital industry role that custodians continue to play. 

“If you look at those numbers, we’ve got more than $2.2 trillion in aggregate assets under custody,” he said. “And what I think it demonstrates is just how critical our services are with respect to Australia’s financial services infrastructure.” 

“The role that we play in asset segregation and asset safe keeping is fundamental to the whole foundation of the financial services market, both for super funds as well as managed investment schemes,” Braga continued. “And when you consider how much the Australian superannuation industry is expected to grow in coming years, it’s clear that that foundational piece is set to become even more critical.” 

Alternatively, Justin Burman, Head of Product - Asset and Fund Services for BNP Paribas, said that what ACSA’s figures showed wasn’t nearly so interesting as what they didn’t show. 

“On the surface, what they demonstrate is the growth of both the superannuation and custody industries,” he said. “As people put more money into super, the size of Australia’s superannuation pool increases and so too does the custody business.” 

“But what it doesn’t show is that the nature of that increase is changing,” Burman added. “As the Superannuation Guarantee (SG) grows from nine to 12 per cent, you’re obviously going to see more assets under custody management but the real issue is how super funds’ requirements and expectations are changing as a result of that growth.” 

“Custody isn’t just about holding shares anymore, its about data, analytics, risk profiles, performance statistics - its that next level of data that’s become key.” 

Of course, while custody may provide the superannuation industry with its foundation when it comes to the safe keeping of assets, Burman’s comments with regard to super funds’ requirements and expectations are important to note. 

The role of custodians has changed and developed significantly in recent years and for Ian Martin, Executive Vice President of State Street Global Markets, it is largely due to the increasing size and scale of the funds they are supporting. 

“There’s absolutely no doubt that the role has expanded,” he said. “It started off being very focused on the core competencies of custody and safe keeping and expanded into accounting functions and now it’s very much about tax, regulation reporting, compliance.” 

“But that sort of expansion has come and will continue to come as the core customer base itself looks to really understand what its own core competencies are,” Martin continued. “So for a big investment management house, the areas of middle office have become prime targets for outsourcing and I think as super funds continue to grow, the same logic will apply.” 

Martin pointed to AustralianSuper and QSuper as the examples. 

“If you look at the big super funds in this country, they’re doubling in size every five years,” he said. “AustralianSuper, for instance, has recently come out and said that they’re going to be a $200 billion fund by 2020 or even 2018 and QSuper are pushing up towards that $100 billion mark as well.”  

“Now as a consequence of that sort of growth, those funds will quite clearly be doing a couple of things,” Martin explained. “One, they will be expanding the range of assets they have in the fund and that has very significant implications for custodians in terms of supporting investment into alternatives, private equity, hedge funds, property and so on.” 

“And two, in an effort to develop scale, they’ll be firmly establishing their core investment capabilities and then developing strategies for front and middle office support.” 

Similarly, Tim Helyar, Head of Product Development for Investors Services, Australia and New Zealand for JP Morgan, said that super funds’ increasing interest in outsourcing certain data-related activities had meant that the value-adding services being offered by custodians had come to the fore. 

“Yes, I suspect that if you talk to any custodian and ask what they’d prefer to be doing, each and every one of them would prefer to be focusing on master custody because that’s their strength,” he said. “But that core service that custodians offer is so much more commoditised now.” 

“So as super funds have grown, we’ve ended up doing more, moving further up the value chain into middle office, offering services related to administration, to compliance, to performance and so on,” Helyar continued. “And that’s largely because of one key question that many of the larger funds have had to answer.” 

“Do we buy a vendor application and put the staff in place to support that or do we outsource?” 

And according to Helyar, the answer is more often that not the latter. 

“For performance, for compliance, for all of these things that have become critically important for super funds, they outsource because at the end of the day, we’ve got all their data already,” he said. “And why wouldn’t you rely on your custodian for such things?” 

Offering a slightly different perspective, Christine Bartlett, Executive General Manager, Asset Servicing for the National Australian Bank (NAB), said that super funds still wanted quality service and reporting from their custodians before they would consider anything else. 

“So the services that we provided 20 years ago, we’re still providing today,” she said. “And unless you can get that base service right, most customers aren’t interested in talking to you about anything else.” 

“But you’re right, custody definitely has grown out into tax, compliance and risk management,” Bartlett continued. “Its almost as though the custodian has gone from being in the backoffice to now supporting the middle office and, because we have that data and information about investments, providing the insights the front office needs in order to make timely and effective trading decisions.” 

“So its been an evolution but again, unless you get the basics right and you’re providing that quality, everyday service, people aren’t going to trust you with the additional capability that they’re looking for.” 

But whether their focus is core custody or the value-add, the net result, according to Martin, is that super funds are expecting more from their custodians. 

“To put it broadly, custodians are going to need to continue to be able to support expanding asset classes and ranges and also to support further up in the investment chain - in front office, in middle office, anywhere data and analytics are required,” he said. “And in my opinion, it really comes downs to one critical ability on the part of custodians and that is to be able to understand, package up and deliver data in a meaningful way back to a client.” 

“Whether it’s tax, compliance, performance or risk management, we have to be able to provide data in a way that it supports all of those activities,” Martin explained. “It has to support investment activity and sit firmly alongside our very important core competencies of settling trades, doing unit pricing - all those things we’re all very good at.” 

Yet it isn’t just the quantum of custody services that has expanded in recent years, it is also level of service. Indeed while the relationship between a super fund and their custodian is normally long-term, mandates continue to change hands with relative regularity and for Helyar, it is again because expectations have changed. 

“As custodians, I think it’s fair to say that we’ve set a very high benchmark,” he said. “So everything we’ve just talked about in terms of client facing technology and product development, whether it’s tax, performance, compliance, collateral trading services, whatever it might be, the reality is that super funds are placing a higher value on those sorts of value-add or niche services and expecting so much more.” 

“But to be honest, I think it comes down to getting better deals as well,” Helyar continued. “So the custody industry has always been competitive but the downward price pressure that we see today simply wasn’t there three, four or five years ago and for me, that’s what’s changed.” 

“Coming out of the global financial crisis (GFC), funds are assessing their operational cost, they’re looking at the deals they have in place with all service providers and saying ‘how do I get this down?’” 

However for Bartlett, changing a custodian was sufficiently complex to mean that mandate changes would not normally be common. 

“So if you’re a larger fund, it could take anywhere from six to 12 months just to do the transition from one custodian to another,” she said. “And what that means is putting all of your strategic objectives on hold while you’re doing that transition, something that’s just not advisable given the pace of change at the moment.”

“But I think what’s encouraged many funds and their trustees to go out to tender recently is the greater supervisory role being placed on them by APRA (the Australian Prudential Regulation Authority),” Bartlett added. “They’re wanting to make sure that all of their service contracts are current and have been reviewed recently.” 

“I think that’s clearly a key driver here.” 

Echoing Bartlett, Braga said that while no super fund ever undertook a custody change lightly, trustees had shown themselves to be all too willing to change providers if it meant additional service or savings for their members. 

“What’s been made abundantly clear in recent years is that super funds are willing to shop around to make sure they’ve got the best possible arrangements in place,” he said. “People are looking at their custodian and at what they provide carefully and saying ‘I’ve got to make sure that I have the right custodian now and into the 3-, 5-, 7-year future.’”  

“Essentially, I think the competitive environment has moved,” continued Braga. “It’s no longer about simply getting the basics of core custody right, it’s about strategic alignment and making sure you’ve got the right custodian to deliver that alignment.” 

The reality, according to Angelo Calvitto, Head of Sales and Relationship Management for Northern Trust, was that custody was one of the more competitive businesses within financial services and one in which players needed to constantly evolve. 

“Its undoubtedly one of the most competitive environments that I’ve seen in my 20+ years in financial services both here and abroad,” he said. “Even in the last six or seven years, the addition of players like ourselves has expanded the choice for clients, regardless of whether they’re superannuation funds or investment managers.” 

“So whilst in some case custody relationships have been in place for a long time, funds or institutional investors are taking the opportunity to look in the marketplace simply because there are more options or because, on the back of client demands and regulation, their business models have changed,” Calvitto continued. “And then the changes we’ve seen in investment landscape in terms of funds looking to invest either more outside their domestic markets and into unlisted assets comes into it as well.” 

“All of these factors are driving our clients to canvass at the marketplace more carefully and seek out a provider that is aligned with their business objectives and their longer term needs.” 

Yet if an alignment of needs is truly what Australian super funds are seeking from their custodians, recent industry discussion around employing multiple custodians in order to achieve a best of breed approach may achieve the required result. 

There is, after all, precedent in other global markets but for Braga, there are significant advantages in super funds dealing with one custodian and one custodian only. 

“I think there are multiple ways to look at this,” he said. “The first question is at what level could you run multiple custodians? And if you start at the base level of the actual custody of your assets and that safe-keeping role, I think the dynamic there is that Australia is a very different environment to other markets.” 

“In other markets where having multiple custodians is commonplace, you will have funds who say ‘I want to give either particular assets classes or particular geographies’ and they split that between custodians,” explained Braga. “But when you look at our system, I think APRA has very sensibly considered the systemic risk for the Australian environment and said that with a full defined contributions system, it is critical for there to be confidence and surety.” 

“And for me, the best way to deliver that in terms of asset safe keeping is to ensure that each fund has one and only one custodian and that all of the assets of the fund are with that custodian.” 

According to Braga, having a sole custodian avoided any possible confusion that could arise from a super fund ‘splitting its book.’ 

“It avoids the situation where a fund has split its book in some way and the two custodians say ‘I thought you had that asset’ and ‘I thought you did’ and it turns out there’s been some fraudulent activity and the assets have gone missing,” he said. “I think if you look at custody within Australia at that systemic level, the outcome is well aligned to the type of overall system we have and actually makes a great deal of sense.” 

Looking at the question more broadly, Martin pointed out that while APRA regulations required Australian super funds to have a single custodian, an exemption was also possible. 

“But while there are some examples of super funds who have registered assets internally, in a meaningful sense it hasn’t happened,” he said. “And that’s interesting because if you look at the off-shore environment, particularly at the bigger institutions, there are numerous instances where multiple custodians are being employed by a single institution.” 

“Often that can be a decision to operate around geographic specialisation or it can be around asset class,” Martin continued. “For instance, we have custody of the fixed incomes assets for a big sovereign wealth fund in Asia, whereas one of our competitors has custody of all of their global equities.” 

“And that really isn’t all that uncommon.” 

In fact, for Martin the protection referred to by Braga with respect to funds having a single custodian can just as easily become a weakness. 

“So if we looked at trends in investment management back in 2008, there were a number of managers with single custodians who woke up one morning and thought ‘Oh my God, how exposed am I? What happens if my one and only custodian falters?’” he explained. “So those people probably came out of that crisis with a view that some sort of diversification was healthy.” 

“The flip side, of course, is that there were entities that had multiple custodians and, coming out of the crash, as everyone looked to manage their expense lines, they simply weren’t getting the real benefit of having consolidated service,” Martin continued. “But in due course, I think it’s certainly possible that the really big funds may look for some sort of diversification.” 

“And they’ll need to either challenge APRA on the single custodian structure or look to see what else can be done to achieve that.” 

However for Burman, the far more likely outcome was that traditional custody would remain the domain of a single custodian while those increasingly common middle office services were prime candidates for outsourcing to specialists. 

“So traditional custody, I think, will continue to be covered by global custodians,” he said. “But what you may seen is an emergence of specialist administrators where those primary custodians can’t keep up with requirements from an asset sector perspective.” 

“So whether it’s private equity or infrastructure or even things like performance reporting and analytics, those are the sorts of areas where local players could find a niche,” Burman continued. “But it’s only the bigger global custodians who will be able to leverage their global investment budgets and offer services across multiple jurisdictions.” 

“They’re the ones generally able to keep pace with moves around asset sectors, administration and compliance on the back of their presence in any number of global markets.” 

So in a superannuation industry that seems set to continue a quite rapid pace of evolution, it seems custodians are destined to play a supporting role. On the one hand, they must support funds through reform but on the other, they must be cognisant of emerging industry trends. 

Indeed for Helyar, a strong partnership between a super fund and its custodian is mandatory. 

“So with some of our bigger funds, we’re constantly in their shops and when I say that, I mean we’re there every week, simply to understand their product development road map and match it back to ours,” he said. “And we’re actually in quite a luxurious position where we have a number of the bigger super funds as clients and they do talk amongst themselves.” 

“So we benefit from having a number of them on our books because we can work across the board and identify trends with them,” Helyar continued. “That then helps us guide our investments into the right things, whether it is tax, whether it is client facing technology, whether it is regulatory change.” 

“And it’s no coincidence that I mention those because they’re the three big things that have been trends over the last two to three years.” 

Reiterating Helyar’s sentiments, Calvitto said that it was incumbent on custodians to support their superannuation clients in achieving their business objectives. 

“So that could include risk management and oversight governance but it’s also providing any and all information they need in order to support their member requirements,” he said. “What we’re finding in talking to our clients and prospective clients is that the custodian should never get in the way, or inhibit an investment decision or a change in investment strategy or a risk management process that the investment professionals within the funds and also their appointed investment managers need to make.” 

“So yes, we have to be focused on the custody service because that will always be a key component to the holding of an asset but then we also have to truly aligned with our clients’ business objectives across those key areas of members regulation, investment decision, risk and governance.”  

For Martin, there was simply no room for anything but absolute excellence when it came to providing custody. 

“And when I say that, I’m primarily thinking of unit pricing, trade settlement, the core custody activities that all of us are going to be very focused on delivering,” he said. “So from a competitive angle, its very difficult to differentiate your capabilities there.” 

“Its more about having an understanding with your clients that you get it right and when things don’t go well, and inevitably everyone experience problems, its about how you handle them and how you resolve those issues and how you extract learnings to ensure you do it better next time,” Martin explained. “In a more expansive way, the way you differentiate your capabilities is very much around having control and flexibility within your technology, your data sets and being able to modify, manipulate, and do whatever needs to be done with that data.” 

“At the end of the day, it’s our customers’ data so we have to deliver it back to them in the most meaningful way, allowing them to get on with looking after their members’ interests and retirement outcomes.” SR

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