Custodians face greater expectations from superannuation trustees

With markets again exhibiting volatility reminiscent of the global financial crisis, Damon Taylor writes that superannuation trustees are expecting more from their custodians.

In superannuation, there are a few key service areas where getting the basics right is paramount. In the wake of experiences through the global financial crisis (GFC), custody is at the forefront, and yet for Paul Cutts, Chair of the Australian Custodial Services Association (ACSA), core custody is simply a foundation for the broader array of services that a custodian can provide.

“As custodians have moved up the value chain — and given their expanded capability I think there’s a general recognition that they have — there tends to be more focus these days on the value-added services,” he said.

“Obviously, core custody processes can’t be overlooked because in terms of driving efficiencies and risk management, having very tight core custody processes in place is critical. They’re absolutely fundamental to the smooth running of a relationship but they’re only the starting point.”

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Cutts said what super funds were looking for in their custodians was an organisation that would be there for the long haul in terms of its commitment to the custody business.

“They’re looking for very solid core custody processes and risk management frameworks, but most importantly, the ability above that to deliver value-added services,” he said.

“For this market, in particular, when we talk about value-added services, we’re talking about the way that the service provider — a custodian — can bring greater transparency of the investment process to superannuation trustees.

“That will be through the provision of performance reporting, for example, attribution analysis, the ability to help trustees monitor risk within the portfolios, and it will be shown in trustees being able to demonstrate compliance across their various investment managers and at a total fund level,” Cutts said.

Managing director and head of sales and client management for JP Morgan, Bryan Gray, believes that despite the super industry’s growing interest in how custodians could help them , the challenges of the past few years meant that trustees were looking for reassurance that those custody basics were in place.

“There has definitely been a back to basics focus on security and the safety of assets,” Gray said. “It really came out of the financial crisis at a time when a number of banks around the world got themselves into a little bit of strife.

“Pre-financial crisis, people were confident that their assets were safe and weren’t worried about how they were held. They were focused on what reporting and information their custodian could provide.

“But post-financial crisis, people are suddenly a lot more concerned about the credit rating of the counter-party that we’re dealing with, and they want to be comfortable that their assets are actually being kept safe in various markets around the world.”

According to Gray, the most important questions for trustees revolved around what would happen if certain banks around the world collapsed, how secure their assets were and how they would access them, and what would happens to their cash.

“There’s been a lot of interest again just in terms of super funds’ understanding of what it means to have your assets custodially held, how they’re controlled, what risks might there be and those sorts of things,” he said.

“We’ve had a lot of discussions just reassuring clients about how we operate, again reiterating strength of balance sheet, strength of credit rating and so on.

“The reporting side, and the additional services that a custodian can bring to its clients, are still critically important, but I think there’s been a little bit of a focus on making sure that the assets are safe,” Gray said.

New products

Yet the reality is that services beyond what is traditionally thought of as core custody are often brought to the table as a direct result of that need for reassurance. Giving an insight into exactly that, Greg O’Sullivan, head of sales for State Street Global Services Australia, said that the majority of new services related to investment analytics.

“What we’ve spent a lot of time doing is providing that look-through from an attribution standpoint down to the security level, whether that be equities or fixed income,” he said.

“That’s a differentiator for us — there’s not too many providers out there who can provide that detailed look-through and attribution down to the security level of a portfolio, whether it be at the manager sector or asset class option, or even the fund as a whole.

“Another product that we’ve been in the process of rolling out recently is around a solution we’re calling entity exposure,” O’Sullivan said.

“That really came on the back of the GFC where what funds wanted was to be able to assess what their exposure was to an entity at any given time.”

However, O’Sullivan points out that he was not only talking about exposure from a direct holding standpoint, but from a collateral standpoint as well.

“What we’ve developed is a product which enables a super fund to say ‘what was my exposure to Lehmann’s when it went under?’” he said.

“They can ask ‘do I hold Lehmann bonds, do I have collateral with Lehmann, do I have stocks on loan to Lehmann?’

“To answer those questions, we’re able to provide that complete look-through at any instant to assess what the fund’s risks were, are, or could be,” O’Sullivan said.

Of course, one of the interesting sidenotes related to custody services is a recent trend within the super industry for funds to employ their own in-house investment teams.

Naturally, those funds embarking on direct investment could not do so without the information provided by custodians, but according to Gray, the key point is that custodians are enabling the trend rather than driving it.

“Custodians are certainly enabling it, but I think what’s driving it is the merger and consolidation activity that’s been occurring in the marketplace,” he said.

“Funds, as they’ve become larger, have started to see that it makes sense for them to build up their own in-house investment expertise, to hire investment professionals out of the market.

“It is particularly apparent at the larger end of town where they have been building up those in-house investment teams. The obvious requirement they have is the delivery of data and delivery of information. So they look to the custodian to say ‘how can you make this information available to us?’

“They really view the custodians as the data repository and a means of feeding data to them so that they can then enrich with other things they might do internally,” Gray said.

Sharing Gray’s sentiment, O’Sullivan says it is the custodian’s job to evolve with the demands of the client.

“When clients want to be able to run investment decisions in-house, we want to be able to support them in achieving that objective,” he said.

“That support extends even to functions like middle-office, where we want to be able to support their investment decision processes by helping them with things like trade matching, in addition to the back-office custody and administration functions that are standard.

“The idea is that we’re sitting down with our clients, working out where they want to go, what strategies they’re looking to employ, and then looking at our

toolkit to see how we can support and enable them,” O’Sullivan said.

“I firmly believe that your custodian shouldn’t be an inhibitor to anything a fund wants to do, and that’s fundamentally why we need to be developing more products and talking to our clients about the services they need,” he said.

Internal investment

The trend developing towards internal investment teams is just one part of broader change occurring within the super industry. Gray believes it is likely to be a result of consolidation, because as funds grow larger, direct investment and in-house expertise makes more sense.

Yet consolidation has also occurred within Australia’s custody market, and the question is whether or not Australian super funds are best served by a local custodian, or by one with a broader global base.

Commenting on how individual players’ entries and exits had shaped the Australian custody market, Cutts said that firstly there had been a real shift in terms of investment trends in recent years.

“That’s been in terms of more overseas investments on account of the Australian market being limited or finite,” he said.

“The Australian superannuation market is growing, so there’s been a need to diversify globally, and I guess that, to an extent, plays towards the capabilities of the global provider,” Cutts said.

“At the same time, there’s been diversification in terms of asset classes as well,” Cutts continued.

“There’s been an increased use of alternative asset classes such as private equity, the more frequent use of derivative instruments to gain certain exposures, and these are all requiring a broader capability from a custodian or fund administration point of view.

“But those two investment trends are the key drivers here,” he said.

In terms of business models, Cutts said both locally-based players and global players were sustainable in the Australian market, as long as they had good overseas networks and their core businesses remained integral to the strategy of the parent organisation.

“Whether it’s a global bank or a local bank, a client or a prospective client needs to be convinced that custody is a core business,” he said.

“They need to know that it's going to be there for the long-term. That’s because this is a scalable business which requires constant investment in terms of technology, and any client is going to want to be reassured that that’s going to continue,” Cutts said.

Australian owned

O’Sullivan said global players in the custody market had grown dominant, because they had been able to push the benefits of a ‘follow the sun’ model when it came to working with on-shore and offshore managers and supporting onshore and offshore investment strategies.

“We really only have one Australian-owned custodian these days, and I think there are good reasons for why we’ve seen that diminish,” he said.

“If you think about the fact that custodians were typically born out of the local banks and then look at a company like State Street, 80 per cent of our revenues are derived from the investment servicing business, that sort of core custody business.

“Now if you look at some of the other players — they are retail banks and their focus is not the institutional market. While they’ve certainly got resources dedicated towards it, it’s not a big piece of their overall business,” O’Sullivan said.

“So I think we’ve just seen organisations make the same decisions that State Street, and others have, where we want to focus on what we do best — we want to focus on our core capability and our core business.”

“And frankly, for a lot of the Australian banks that are no longer custodians, I think that’s because they’ve decided to focus on their core business, which is retail banking and wealth management, and not custody.”

Yet what may fly in the face of suggestions that the Australian custody market is rapidly progressing towards having only global players is the fact that the one remaining local custodian continues to win tenders, and continues to service a number of the industry’s more significant funds.

In the past, the reasons cited for that relative success have been an intimacy with the local market and a unique knowledge of the Australian taxation environment, but for Gray it is simply marketing.

“Clearly, to be able to support an Australian client base, you do need to understand the nuances and intricacies of the Australian environment,” he said.

“It would always be difficult, after all, to support an Australian client base if you were only doing it from a location outside of Australia.

“You need to have people on the ground, you need to have a connection to what’s going on in the marketplace to be able to support that, but if that’s all you’ve got, if you’re restricted in accessing scale benefits, then it becomes a little difficult to generate the return that you might need in the business,” Gray said.

“Furthermore, I think the one provider in the marketplace that is doing that would say it would be very difficult for them to do if they weren’t teamed up with a global partner who could bring those capabilities.

“I don’t doubt that you need to have people on the ground and you need to understand the local marketplace, but I also don’t think there’s any doubt that the global players who have been here for any length of time have demonstrated that they can do both,” he said.

But regardless of whether a custodian is locally or globally based, it is clear that the Australian superannuation marketplace in which they operate is set to change significantly.

With SuperStream and MySuper, the change for super funds themselves is obvious and yet, in custody, it seems that impact is less apparent. Cutts says he expects the impact would be both direct and indirect.

“The indirect impacts are going to relate to the increased regulatory oversight of superannuation funds whose trustees and executives will require a different approach from their service providers,” he said.

“And that will be in terms of support and information, data frequency and so on.

“Overall, we’ll see a higher standard of governance across the industry and custodians will need to support that.”

Performance

Cutts said the direct impacts were likely to relate to the implications of MySuper.

“So if, for example, let’s take a well known industry fund in the market. Whether through choice or default, it’s likely that there will be an asset pool assigned to MySuper that, from an accounting perspective, will need to be supported by a separate book and record,” Cutts said.

“That’s a change that the custodian will undertake. But then when trustees are overseeing MySuper within that fund, they’re going to be looking for transparency as well,” Cutts continued.

“They’ll want the ability to look at the performance of that relative to other investment choices, the differences in fee structures, or maybe the trustee is going to want to look at performance post- and pre-expenses.

“So to me, these are practical things that the custodian can, or will need to be able to, help with.”

Alternatively, Gray said the impact on custodians would largely be driven by industry consolidation.

“We’ve already had three of our clients undergo pretty significant merger and tender activity and that has a direct impact on us as a provider,” he said.

“As a custodian, we need to make sure that we support them through that transition, because they’re pretty complex mergers where you’re bringing together two sizable funds with an even broader array of investments.”

“You could, perhaps, call that a secondary or indirect impact, in so much as we’re not directly impacted by SuperStream, for instance,” Gray said.

“We are, however, somewhat impacted by MySuper in the sense that what our clients are going to be looking for is cost efficiency.

“But that’s really going to come through economies of scale, and we are under no illusion that as our clients merge and grow they will be looking for services to be provided to them cheaper than they were before.”

According to Gray, such a reaction on the part of super funds just plays back to the scale argument.

“If that’s the way your clients are driving their business, then they’re going to be looking to you to just continue to deliver more services to them at a cheaper price,” he said.

“The only way you’re going to be able to do that is if you can build and leverage your scale globally.”

So with an eye to the future, and to how custodians could best support their super fund clients in what continued to be a rapidly changing superannuation environment, Cutts says the key themes remained unchanged.

“The main themes continue to be risk management and driving efficiency,” he said.

“The end-to-end custodian process from core to value-adding services, fund accounting, fund administration is a highly complex process in any market, but especially in the Australian market, given its taxation and regulatory reporting requirements.

“Custodians need to be prepared to continually redefine those processes, to make sure that they’re at good levels of automation and control,” Cutts added.

“No matter where you go, there’s always an opportunity to strive to get to a better position, and that will continue to be the challenge for custodians. If you’re making your shop more efficient, it helps the client, but it also helps with the scalability of your own business by making it more resilient into the future.”