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Explosive” and “expansive” are words not often used to describe the market for providing securities-custody services to pension funds. Until now.
Pension scheme managers, increasingly struggling with underfunded plans as the world’s population ages, are adopting more-aggressive investment philosophies aimed at meeting future liabilities rather than beating indexes or other benchmarks. And custodian banks, which process completed transactions and safeguard plan sponsors’ assets, are responding in kind. These firms are offering a barrage of new products that allow for settlement of complex financial instruments such as credit default swaps and other derivatives.
“All traditional long-only managers are moving quickly into alternatives,” says Margaret Harwood-Jones, who heads the institutional investor group at BNP Paribas’s securities services unit in London, adding that clients are looking to do more around hedge funds and derivatives. “We now support a larger and more complex range of investment instruments.”
Pension managers are especially interested in playing the derivatives markets to boost returns. The volume of derivatives trades processed at the custody unit of Northern Trust Corp., for instance, has grown by 30 percent a year for the past three years, according to senior vice president Ray Carney, who is based in Chicago.
Accommodating the evolving needs of plan sponsors as they move into riskier assets is one way that custodian banks are increasing their assets under management. The industry’s biggest players have seen significant growth in the past year, according to this magazine’s annual ranking. Citigroup, for instance, increased its global custody assets by roughly 17 percent during the 12 months ended March 31, to $5.32 trillion. The financial-services behemoth retains its position as the world’s biggest custodian by far. Bank of New York Co., which vaults past JPMorgan Chase & Co. to take second place, grew its assets by 35 percent during the same period, but its total, $3.73 trillion, still pales in comparison with Citi’s. JPMorgan drops to third, with $3.44 trillion, an increase of approximately 14 percent. Rounding out the top five are BNP Paribas, with $3.23 trillion (up 34 percent); and HSBC Bank, with $2.79 trillion (up 25 percent).
The move by pension systems to juice up investment returns is not just a passing fad. According to the Pension Benefit Guaranty Corp., U.S. pensions are underfunded by more than $450 billion. Last month, President George W. Bush signed into law the Pension Protection Act of 2006, which gives employers with underfunded plans seven years to make up the shortfalls. “From a macroeconomic perspective the overarching factor is changing demographics — an aging population with underfunded pension plans,” says Paul Stillabower, head of business development for HSBC’s global investor services division in London.
Fund sponsors have two ways to make up their shortfalls: Contribute more from company coffers (or raise taxes, for public pension funds) or achieve higher rates of return. It’s no surprise, then, that managers are seeking to maximize returns and minimize costs by allocating assets to hedge funds and employing sophisticated analytics and risk-management systems to manage some alternative investments themselves. That makes the job of processing trades and safeguarding client funds more complicated.
“All of this exacerbates the demands on the custodians, especially on the fringes where there isn’t a lot of automation,” says Jin-Chul (Gene) Kim, a senior analyst at research firm Financial Insights in Framingham, Massachusetts. “If you have a fund that wants one tenth of 1 percent of its fund to have exposure to credit derivatives in Singapore, then you probably need a subcustodian in Singapore. But that subcustodian won’t have nearly the level of resources to invest in automation that a Mellon [Financial] would.”
Brown Brothers Harriman has responded to what Susan Livingston, partner and head of investor services for Asia, calls “exponential growth” in client derivatives use by building special accounting tools that can more easily accommodate the effect of derivatives on portfolio valuations.HSBC has expanded its technology, too, to meet the changing needs of pension fund managers. “We have an automation program and a technology strategy that incorporates automatic processing of alternative instruments,” says Stillabower, although he acknowledges that the system falls short of full straight-through processing. “You try to gravitate 80 percent of the instruments to automated processing and then chip away at the remaining 20 percent,” he says. But that 20 percent is a moving target, as new products are being developed faster than the bank can automate them.
Some banks have opted for a different approach, either withdrawing from the global custody business or establishing partnerships with bigger financial institutions that have the resources to keep up with changing client needs. Timothy Keaney, head of global investor services at Bank of New York, notes that several European banks have moved out of global custody rather than try to build the infrastructure required to support their clients around the world. BoNY has entered into partnerships with some of these players, including Natexis Banques Populaires in France, BHF-Bank in Germany and Nordea Bank in Scandinavia, he says. BoNY handles global custody, securities lending and foreign exchange for these institutions, leaving them to handle subcustody and fund administration for their local clients.
As their clients invest more globally, these European banks face a quandary, says Keaney: “Do they invest to build the global superstructure that the big custodian banks have, or do they want to draw a line around their local capabilities and use a global partner? Invest, exit or partner are the options.”
For those that choose to invest or partner, opportunities are growing. “Retirement groups from Europe will be significant drivers of profitable growth for banks, insurers and asset managers over the next five to 15 years,” notes Jay Hooley, head of global investment servicing at State Street Corp. in Boston. “With local barriers eroding and new member states entering the European Union, asset managers are finding more and more opportunities for cross-border business.” i
