Shrinking wallets fuel strategic partnerships

Case study

Banks and broker-dealers have been under relentless pressure to reduce overheads ever since the 2008 financial crisis, fuelled by the added costs of new regulations, persistent revenue challenges and increased operational requirements. In response, a growing number of regional financial institutions have looked to obtain cost synergies by leveraging global custodians to support them with additional pretrade and post-trade processing.

Elsewhere, other firms simply consolidated their existing custody relationships to maximise efficiencies. The Covid-19 crisis has accelerated some of these dynamics even further, as organisations attempt to better manage their costs and operational risks (e.g. business continuity planning [BCPs] redundancy arrangements), while simultaneously trying to achieve scalability. A recent report by Oliver Wyman and Morgan Stanley suggested that optimisation of third-party relationships might even generate cost savings of between 5%-10%.

This realignment towards consolidation is also being driven by ongoing client concerns around redundancy set-ups at some of their external providers. Counterparty risk may also be another factor in prompting some risk-averse firms to consolidate their custody relationships. The same Oliver Wyman paper highlighted that European banks are more vulnerable to a prolonged recession than their peers in the US. The paper said the top seven European banks on average currently have $3.8 billion of capital for every $1 billion of fixed cost base, in comparison to $5.1 billion at the top five US banks.

Identifying cost optimisations

Even though the long-term economic impact of Covid-19 is unknown, it is widely expected that banks and brokers will see a substantial contraction in overall revenues [Table 1]. Moreover, financial institutions are also still struggling under the weight of regulations such as Basel III, which subjects banks to much tougher minimum balance sheet capital requirements. Other regulations including the Markets in Financial Instruments Directive II (MiFID II) have also had a detrimental effect, especially on small to mid-tier brokerage firms.

The rising costs of compliance more generally – coupled with the diminished revenues from their trading functions – will result in more firms outsourcing post-trade activities, especially if such a transition helps them pivot from a fixed cost to a more variable pricing structure.

The consolidation trade-off

Consolidation

A European bank client had an operating and technology infrastructure that supported its own customer service and change management requirements, but its systems were impeding the organisation from entering new markets in Europe. They needed a scalable platform to facilitate higher levels of trading and easier entry into new markets; and were looking for a global provider in order to consolidate services and maximise economies of scale, thereby reducing their servicing costs.

Citi built an end-to-end solution covering trade execution through Citi Global Markets, along with integrated domestic and global custody services through Citi direct and global custody businesses, providing the client with direct access in home markets and full global coverage. An integrated service approach supports the client across multiple locations with a global service model, providing local senior level governance and access. A single, global contractual structure simplified a previously complex legal framework. Fees were structured to be competitive and long term in nature so as to reward growth.

Introduced in January 2018, MiFID II barred banks from selling bundled research and trading services to clients, leading to a sharp drop in commissions. One study - for example - found European commission rates paid by asset managers to brokers fell by 28% in the first three months of 2018 when benchmarked against the same time horizon back in 2017.

However, financial institutions also need to be diligent when streamlining relationships, as it can potentially increase counterparty risk. While consolidation can help expedite operational efficiencies, firms should ensure that they engage with credit-worthy, well-capitalised and regulated custodians. As part of their due diligence, they should also regularly review the applicability of mitigating constructs, such as account operator services, which help reduce counterparty exposure.

Facilitating operational stability during Covid-1

The Covid-19 crisis has forced financial institutions into stretching their operating models so that business can continue as normal despite the overwhelming majority of staff working remotely. While most financial institutions implemented their BCPs and remote working structures relatively seamlessly and without major issue, a handful of organisations did struggle initially when Covid-19 lockdowns were first announced. Although this disruption was temporary in nature and was resolved quickly, the experience is likely to prompt more organisations to move parts of their outsourced operations to service providers whose BCPs proved resilient and stable from the get-go. Some of these operational shortcomings could also result in regulatory intervention at a later stage.

Certain institutions who had previously outsourced their operational activities to third party providers located in lower cost, offshore jurisdictions, did in fact encounter difficulties. A handful of markets - where some of these third party providers reside - simply did not have the physical infrastructure and technology (e.g. household Wi-Fi, laptops) to facilitate remote working to begin with, resulting in settlement delays and errors. As a result, these institutions have begun to reassess their dependencies on outsourced providers in low cost markets.

It is evident that outsourcing is not a risk-free process, but those risks can be mitigated by working with experienced global providers. The custodians who navigated the initial Covid-19 disruption effectively and who have since adapted to this new “normal” operating model will be the ones who attract market share moving forward.

Migrating away from legacy technology

Legacy technology and infrastructure at banks and brokers are likely to come under review as financial institutions look to offset their costs. A lot of the technology in the financial services industry is ageing, inefficient, expensive and requires manual intervention. Not only does this ongoing reliance on legacy technology make it harder for organisations to realise meaningful cost efficiencies, but it dramatically increases the likelihood of risks and errors during the operational process itself. It also makes it harder to roll out new product suites, and take advantage of nascent technologies. Replacing antiquated systems with new or disruptive technology is an exhaustive undertaking, with often staggering investment requirements in terms of the levels of financial and resource commitments. Few firms are in a position to or will want to commit to making these changes.

Simultaneously, these banks are also increasingly partnering with industry-leading fin-techs to deliver augmented and enhanced services to clients. Among some of the technologies being beta-tested across major banks and their fin-tech partners include big data; artificial intelligence, DLT (distributed ledger technology); cloud and application programming interfaces (APIs). However, incorporating these new technologies requires a lot of internal infrastructure and focus. Citi, for example, has invested heavily in a number of technology initiatives, including its Citi Ventures vehicle, which is at the forefront of the bank’s innovation strategy.

By forming strategic partnerships with global providers, banks and broker-dealers can work together to identify and develop tangible solutions that support their business growth.

Identifying the right balance

Outsourcing and consolidation should not be seen solely as an exercise in cost reduction. Simply externalising operational processes to third party providers based on cost alone could have unintended consequences. Instead, firms should be assessing whether their custodians can provide them with the latest technology and access to dynamic fin-techs. Moreover, they need to have confidence that their providers can withstand crisis situations, such as the continuing Covid-19 pandemic.

Similarly, consolidation if executed badly, can be potentially destabilising and risky. Relying on a single custodian is not typically best practice for institutions, but equally inefficiencies could emerge if various operational activities are outsourced to a disparate number of custodian partners. Clients should therefore look to form strategic partnerships and avoid spreading their wallet share too thinly across multiple counterparties. This will enable them to not only obtain more bespoke solutions but optimise their book of business with their custodians in a long-term and meaningful way.

Reto Faber EMEA Head of Direct Custody & Clearing

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