The credit crisis shredded the earnings of almost every financial services firm in 2008, including the custodial banks that provide the infrastructure and back-office support for hedge funds, insurance companies, mutual funds, pension funds and other institutional investors, and which get paid on the size of the assets they oversee. But the events of last year — especially the bankruptcy of Lehman Brothers Holdings, which tied up about $30 billion in hedge fund assets, and the Bernard Madoff debacle — may ultimately give a boost to global custodians, as the previously unsexy business of settling trades and holding stocks and bonds has taken on a newfound importance.
“What happened in 2008, including Madoff’s giant Ponzi scheme, has everybody focused on transparency, simplicity and third-party oversight,” says C. Steven Crosby, the New York–based head of the U.S. private banking and wealth management practice at PricewaterhouseCoopers.
Stability and financial heft have become as important to clients choosing a custodian as the range of services offered, as evidenced in Institutional Investor’s annual custody ranking. Despite the market meltdown, the total custody assets of top-ranked Bank of New York Mellon Corp. fell just 10 percent from March 31, 2008, to June 30, 2009, to $20.7 trillion. J.P. Morgan, No. 2 with $13.7 trillion in custody assets, saw a 13 percent drop, while third-ranked State Street Corp., with $12.3 trillion, experienced a 17 percent decline.
The smallest players suffered the most damage. SEB Securities Services, No. 13 with $380 billion in assets, endured a 47 percent drop in custody assets, while KBL European Private Bankers, No. 15 with $163 billion, lost 34 percent.
Lehman Brothers’ bankruptcy has heightened clients’ awareness of the financial viability of every firm with which they do business. The firm’s demise in September 2008 left hedge funds’ assets tied up in its London-based prime brokerage unit and thousands of counterparties with failed trades. In fact, custodians like BNY Mellon with prime brokerage operations have been winning assets, because hedge funds are socking away their long-only positions with the custody operation and other positions that need financing with the prime broker.
“There really was for the first time in many years a real flight to strength,” says James Palermo, co–chief executive officer of BNY Mellon Asset Servicing in Boston.
Clients are now asking about credit ratings and the strength of balance sheets, says Mark Kelley, global head of the money management, pension and insurance business of J.P. Morgan Worldwide Securities Services in New York: “We’re getting the questions, ‘How big is your balance sheet?’ ‘What protections can you give?’”
Custodians that can provide services to hedge funds are likely to emerge from the crisis as winners, as pension funds and other institutions seek greater transparency from their managers. Investors are pressuring hedge funds to hire independent administrators, in part because of potential sweeping regulatory changes such as a proposed amendment to the custody rules under the Investment Advisers Act of 1940 that would require advisers to undergo an annual surprise examination by an independent public accountant to verify client funds and securities. In June, State Street signed on hedge fund Caxton Associates to administer $6 billion in assets for the New York–based multistrategy firm.
“When Lehman Brothers failed, we saw a flood of hedge funds move their securities and cash to us because the nature of custodians is that assets are segregated from the parent,” says Jay Hooley, president and COO at State Street in Boston. “It went back to basics.”
Third-party administrators are potential safeguards to fraud, a lesson that many investors learned all too painfully from Madoff’s epic deception, which exposed the troubles that can come when there isn’t an independent custodian to watch over assets and provide investment statements and other reporting.
The events of 2008 are leading more investment managers to outsource their operations. “Investment managers are constrained by their revenues because of a severe reduction in market values,” says Timothy Theriault, president of corporate and institutional services at Northern Trust Corp. in Chicago, No. 8 among custodians, with $3.3 trillion in assets. “They’re looking to reduce costs.”
Managers are also looking to outsource tasks such as private equity administration, collateral management, derivatives processing and fund accounting so they can get a product more quickly to market or expand geographically without building infrastructure.
Says Neeraj Sahai, New York–based global head of securities and funds services at Citi, which is No. 4 in the ranking, with $11.1 trillion under custody: “Asset managers need to deploy a different operating model, one that deals with the world of tomorrow that’s defined by uncertainty, extensive regulations, a need for transparency and a time of dropping margins.”
Click here to see the Global Custody rankings.
