The good old days are over for custodians. If they do not address swiftly their operational inefficiencies, they will eventually become obsolete. In this report, Opimas will show that custodians must change their culture and abandon their historical focus on economies of scale to adopt a leaner structure. They must accept that being transactional hubs is not enough and that data is the cornerstone of their future operating model. To exploit their data profitably, custodians will have to embrace innovation and leverage artificial intelligence capabilities to reduce their costly reliance on human resources.
The banks’ custody businesses have struggled since the financial crisis. Economically, low interest rates combined with reduced foreign exchange volatility and cost pressures have substantially reduced the traditional sources of revenue of custodian services. On average, these institutions have lost 26% to 39% of their revenues generated by FX trading and securities lending activities respectively. In the meantime, they have had to cope with a patchwork of new regulations that have sprung up in capital markets in the aftermath of 2008.
The result is that custodians’ costs have soared. While the cost-to-income ratio was around 67% industry-wide eight years ago, it has now stuck for the past seven years at around 77% (see Figure 1). This demonstrates that the numerous cost reduction schemes they have implemented have not compensated for declining revenues and increased compliance costs.
FIGURE 1. THE COST/INCOME RATIO OF THE SECURITIES SERVICES INDUSTRY HAS INCREASED BY 10% SINCE 2008
Source: Company annual reports, Opimas estimates
It is illusory to think that the industry will find the necessary US$10 billion of new business – equivalent to more than 10 Norwegian sovereign wealth funds -- that would be required to regain its pre-crisis profitability level; therefore it is time to consider more radical strategies.
To improve their operational efficiency, custodians must first reduce their heavy reliance on human resources that currently accounts for 53% of their overall expenditure.
While the business has traditionally relied on human intelligence for processes and market expertise to cater to diverse clients, help is at hand from technology. Artificial intelligence, through its ability to analyse to vast amounts of data and identify patterns and potential resolutions, has the potential to profoundly improve custodians’ operations. By allowing staff to achieve more with less, AI by our estimates can potentially generate over US$5 billion of cost savings to the custodian industry.
At the same time, other aspects of internal culture have to change. Custodians have to abandon their traditional school of thought that “bigger is better.” The focus on adding assets has increasingly complicated the firms’ operations, reducing the benefits that were expected from economies of scale. Custodians need to conduct a granular analysis of their operations and potentially exit certain activities and businesses to refocus their resources where they can make a difference.
It is also crucial that industry collaboration, debated for too long, should finally bear fruit. Considering the regulatory burden that has been imposed on custodians, we believe they could cooperate on several related fronts to the benefit of all. Creating a European body that would handle all the due diligence on third-party delegates used by custodians would be a good place to start.
Succeeding in the new era will require custodians to accept that their future probably requires them to transform themselves into specialist data-and-information companies with financial-market expertise. If they fail to evolve this way they will remain processing hubs, eventually utilities, until their services become obsolete.
By repositioning their business model and leveraging their data sources, custodians would ensure their survival by decreasing their reliance on current market infrastructure. With the right model, even in a Blockchain world, custodians’ services would remain relevant.