We have recently been assessing the potential for more unbundled pricing in our GSS Executive Committee. The demand from clients is for a fresh look at custodial charging, given a feeling that there is an imbalance between settlement and asset servicing pricing. This is a generic market issue rather than a UniCredit one, and the lack of open debate on the matter is, in part, driven by fears of competition law and, in part, due to the actual complexity of the issue.
At one level this appears to be a simple exercise, for we can gauge the direct costs of our business. We can also identify the costs of a CSD and other infrastructures we may use. Experience I have had from other exercises, in my lengthy past, shows that even a simple assessment based on the cost of operations, excluding risk premiums, rarely bears comparison across different companies. Different approaches to depreciation, varied bases of assigning head office or other central costs, non-market bases for attributing the cost of premises or the process for charging new development, if shared across a firm, can be varied and have material impact on the results of the exercise.
But the biggest challenge, even in our allegedly off balance sheet business, lies in agreeing the cost of liquidity and the cost of risk. I have suggested in the past that the basic custody business should be backed by around USD 400 million of equity per trillion dollars of assets. With around fifty trillion of assets under custody worldwide, this implies a global capital need of around USD 20 billion. It has been suggested that this is on the low side but it needs to be seen in context. This relates to basic custody, with all the related activities of the full service custodian needing incremental notional capital allocations, or in the case of the specialised custody banks, their own dedicated real capital base.
Liquidity is easier to cost and I usually suggest looking at the yield curve between overnight and three month money to identify the base rating, currently around 10 basis points in several major currencies. However, a risk premium needs to be added to this base figure and that will fluctuate according to the credit rating of a firm, from time to time. Credit Default Swaps are a useful surrogate for the cost of that element.
Unbundling of settlement is perhaps the easiest component to consider. To some extent, settlement has already been unbundled. We have, by definition, three types of settlement. There is client side STP, client and market side STP, and non STP transactions. Together with a charge for liquidity, that fulfils most requirements, segregating the automated from the manually supported transaction.
If we can allocate the bulk of notional (or in some cases real) capital to the asset maintenance side of the cost structure, having covered settlement risk in the cost of liquidity, then that cost becomes simpler to allocate. On a billion dollar portfolio, the cost of risk, under my assumptions noted above, would be around USD 40–60,000 per annum based on a 10–15% ROE on the required associated allocated notional capital. That equates to around half a basis point. Paradoxically, although this appears high when set against average global ad valorem charges, it appears low when measuring against capital allocated in the stand alone firms
Then we get to the real challenge. How do we allocate the operating costs of a custodian? If only, it were as simple as taking the headcount associated with asset servicing or settlement and assigning them proportionately according to some time based computation. The bulk of people, and often the most costly, are focused on asset servicing. But on top of their costs, and that of the settlement teams, we need to allocate the cost of business management, relationship and sales management, and risk management in all its guises from audit to operational risk and on to compliance. We need to identify the costs associated with technology, not only running the big boxes and diverse applications or communication hubs, but also the developers in our fast changing environment. And where do we assign the legal teams, whose services we need more and more? HR has to be allowed for. And central management overhead is also no minor cost.
A further trouble with unbundling is this allocation of overhead. The global custodian is a regular user of asset services. This is where the bulk of their cost lies. They are also a much lesser user of settlement. In principle, at a sub custody business level, we could identify total overhead and allocate it pro rata by headcount between asset servicing and settlement. But how do we handle the different components of asset servicing? Costs are constant but account opening is a volatile function. Income collection has its seasonal peaks but is a stable flow. Proxy voting is likewise seasonal but stable. Corporate actions are another volatile function for no one can forecast the number of mergers and acquisitions, corporate restructurings, capital raising exercises, and so on in any period of time.
But then the broker dealer is a much smaller user of corporate action services. However, they do use account opening and, more and more, many of the universal firms are hybrid custodians, prime brokers and broker dealer operations. But I struggle to find an equitable way of assigning cost across those three functions. The trouble with broker dealer activity lies in the nature of their business. The risk profile of handling a corporate action in an active counter, with market claims to and from the broker, means their occasional use of this service is much greater in labour and risk terms than managing a corporate action for a stable long only fund.
The industry talks of unbundling and also calls for transparency. The latter is a definite good idea. For it will allow us to tackle the former. The truth is that we are not able to apply a component based charge easily across the multiplicity of moving parts, especially in the non-settlement area. And, if we progress the idea to the fund administration space, the challenge becomes ever greater. Perhaps the risk premiums for funds operated under some of the more stringent regulatory regimes will, in this environment, soar towards those halcyon levels forecast by some commentators in the early days of the gestation of AIFMD.
John Gubert
Chairman
Global Securities Services
Executive Committee