Changing role of Custodians

The role of the custodian has expanded rapidly over the last decade, providing a wider variety of services in addition to global custody.  In this article we look at this expansion and ask what the future may hold.

As investor demands have grown for support in implementing ever more sophisticated investment strategies, risk mitigation, improved efficiency, and to keep pace with continuous regulatory change, so too has the demand for custodial services.  This is because there is an increased need for institutional investors to have access to more data, market information, and information on Environmental and Social Governance (ESG) as well as continued support for regulatory change.

Years ago, the role of the custodian was limited to just that, providing custody of the assets (including collecting income, settling transactions and other administrative tasks on behalf of either the investment or superannuation fund).  Nowadays the role of the custodian is much broader, encompassing playing a significant role on fund boards and being more involved with the overall operation of the fund.  As a result of this shift, the role of the custodian has become less defined.  The increasing growth in synthetic assets such as Over-the-Counter (OTC) derivatives has increased the role of a custodian merely safekeeping assets.

Providing oversight of the funds the custodian has been contracted to look after is a significant extension of its previous duties.  This not only involves making sure the custodian has adequate controls in place to prevent losses or misconduct but also means that the custodian is an integral part of fund governance.  Data flows must be set up to enable the custodian to conduct ex-post controls on aspects such as valuation of shares, transfer agency functions, settlement of transactions, income calculation and investment compliance.

Cashflow monitoring is another function that custodians have frequently seen themselves take on.  This is because there is a need to immediately investigate all major cashflows and identify their purpose.  Where any discrepancies arise, it is the role of the custodian to remediate the issue.  This provides a level of protection for the investor as it helps prevent fraud and other criminal activity.

One of the disadvantages of this expansion of services is that medium-sized custodians are being squeezed out of the market.  The trend in the market in recent years has seen that company size is an important factor when choosing a custodian.  In Luxembourg for example, which is the largest fund domicile within the EU, 75 percent of assets under management are held by the ten largest custodians.  This trend looks set to continue as tightening regulation will likely increase custodians operating costs.  However, for smaller custodians there is still a market as they can offer a cost-effective alternative for smaller investment managers and hedge funds who do not require a custodian with a global operating model.

In Australia, there has been a trend in recent years to switch custodian.  This decision is driven by more competitive prices, better service and a fund’s greater allocation to overseas investments.  As funds look outside of Australia for investment opportunities, the need for a more global custodian becomes greater.  Superannuation funds are also more stringent in what they look for in a custodian, with many revisiting what the offering is with their current provider.

The role of a custodian has changed significantly over the years and financial companies are expecting more from a service.  With the ever-changing landscape brought by regulatory changes, firms are more closely examining the service their custodian is offering and whether they are getting the best deal.  However, with custodians offering more services than ever before, the trend is for the larger players to dominate the market, creating a barrier to entry for medium sized firms.  On the one hand medium sized custodians are unable to compete with the global operating models and high volumes of larger firms, while at the same time being too expensive for niche investment companies.  Despite this trend towards increasing market share for larger custodians, a market still exists for smaller custodians who can be cost effective and provide targeted services to boutique investment firms and hedge funds.

James Girling
Managing Consultant

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