In deciding not to monitor the fees charged by UK custodians for some value-added outsourced services, the UK’s securities watchdog may have just opened a floodgate of lucrative business for third-party consultants.
A new committee just established by the UK fund management trade group Investment Management Association (IMA) along with fund managers and custodians is proposing high-level guidelines for how outsourced services can be controlled by fund managers. The recommendations refer to establishing standard terminology to describe the scope and nature of contractual agreements. Such an effort will certainly go a long way toward improving the dialogue among fund managers and their service providers.
Yet without any regulatory requirements affecting the services outsourced directly by pension plans and other asset owners, those investors could end up relying a lot more on external help to understand whether or not they are being serviced correctly by their custodians, some UK pension plan specialists tell FinOps Report. “We don’t have any sense of just how extensive the information will be as the guidelines are still preliminary and don’t know how it will ultimately impact us,” says one operations manager at a UK pension plan who spoke on condition of anonymity. “At best they only address some services and not the ones most subject to fraud.”
While fund managers are increasingly outsourcing their middle and back-office operations to custodians, the asset owners rather than the fund managers are responsible for hiring custodians or negotiating the terms of contracts involving some services which exceed investment operations. Cases in point: transition management, execution of foreign exchange contracts and securities lending transactions.
The cottage industry of third-party consultants which help asset owners negotiate their custodian bank contracts and evaluate their performance won’t disclose how much they earn on any particular engagement but they admit business is booming. A handful of UK pension plans that spoke with FinOps Report also confirm they are asking those consultants to become more active in evaluating the fees charged or profits made by custodians compared to the quality of services offered. “We are going through a far more intensive process negotiating the specific services, benchmarks and fees charged in service level agreements,” says one operations executive at another UK pension plan.
Neither the IMA nor two custodian bank members of the outsourcing working group– HSBC and State Street — were willing to elaborate on their recommendations mentioned in a press statement issued by the trade association on December 9. Neither were other custodians, all citing their hesitancy to link the committee’s recommendations to any regulatory edict or lack of one. In its statement, the IMA and other participants of the committee say that the committee consists of over 30 individuals from 24 organizations, but did not name all of its members.
Holding Custodians Accountable
The high-level guidelines surfaced several weeks after the UK’s Financial Conduct Authority (FCA) publicly announced there was no cause for regulatory oversight of custodians. “The FCA has concluded that standards and transparency across the industry have improved over the past few years. Custody banks have improved their service levels,” said Clive Adamson, the FCA’s director of supervision at the regulatory body’s October 2013 asset management conference.
In putting the onus squarely on pension plans and other asset owners to fulfill their obligations to investors he added, “You need to continue to hold the custody banks to account to ensure you are getting the services expected.” The FCA followed that speech with a “Dear CEO” letter in December 2012 asking 125 asset managers to take a closer look at their outsourced services.
Overcharging for services rendered ultimately impacts asset owners, because it can hurt a fund manager’s return on investment by increasing an investment fund’s expenses. As fees for basic safekeeping services decline, custodians are earning far more of their keep through ancilliary work such as transition management services, executing foreign exchange orders and arranging securities lending deals. Banks won’t disclose what chunk of revenues generated by their securities services unit comes from those so-called value added services, but the FCA estimates it can amount to as much as forty percent.
It stands to reason that fund managers won’t take too kindly to being held responsible when the relationship between their underlying pension plan or asset-owning clients and custodian banks goes awry due to either intentional fraud or simple misunderstanding. Nor will fund managers necessarily want to get involved in the negotiations process between their asset owners and custodians, for which they really have little or no say.
“Historically reliant on their fund managers to do the work, asset owners will ultimately need to rise to the occassion to evaluate whether their custodians are charging the correct fees for the services offered,” says James Economides, president of Amaces, a London-based consultancy which helps pension plans select and monitor their custodians.
Understanding whether or not a custodian is living up to expectations is no easy operational task. Regardless of any industry guidelines set, pension plans and other asset owners will need to do some hefty number crunching on how their custody providers fare compared to their contractual obligations and how they match up to their peers. Difference in methodologies aside, the common goal is to understand whether the custodian bank is within an “accepted” range of fees.
Gaining Information Leverage
That “accepted” range is largely dependent on benchmarks, which are only as reliable as the data received from the pension plans, fund managers and even the custodians themselves. While any analysis presented by consultants is subject to interpretation, it still gives pension plans and other asset owners plenty of leverage over service providers to either renegotiate their fee schedule or lose business.
“We are advising clients to look at their fees holistically — in their entirety rather simply on a service by service basis,” says Nick Bradley, joint managing director of Thomas Murray IDS, a London-headquatered consultancy which counsels pension plans and underlying asset owners on monitoring their custodian relationships. “The more enlightened the client the more likely it is to speak up and address any issues early on.”
Armed with more information on just how much services will cost, pension plans will also be a lot savvier about their provider. “In the case of transition management services, they may have once automatically relied on their existing custodian, but that’s no longer the case,” notes Economides. “When we clarify the differences, they are more willing to negotiate on rates and turn to another bank.”
The FCA’s review of fees charged by custodians for value-added services requested by underlying asset owners came after State Street publicly revealed in 2011 that employees of its London-based transition management unit overcharged and misled a UK pension plan. The bank, which subsequently laid off top-ranked executives for violating internal policies, say they have reimbursed that UK pension plan and others — including an Irish pension plan — for any overcharges. The FCA’s predecessor, Financial Services Authority, reportedly conducted a more formal investigation into State Street’s activities which cast a broader spotlight on how banks charge for transition management services and other non-core operational functions.
Transition management — a practice which involves helping asset holders switch fund managers or change their portfolio allocation– is ripe for fraud, if not at least misunderstanding. Fees charged by service providers largely depend on the types of assets involved and the roles they play. Critical to understanding whether or not fees are fair is knowing whether a bank is taking an agency or principal role in executing orders. In the case of fixed-income securities, taking on a principal role typically means that any fees earned are based on a spread rather than a flat commission fee.
Banks justify the difference as the cost of doing business and even necessary to executing a fixed-income deal quickly. However it is uncertain whether pension plans actually understand how much they are paying, unless the bank breaks out the specific amount. So they are often relying heavily on trust. State Street’s overcharges were uncovered when the pension plan in question called on a third-party consultancy — reportedly Inalytics — to verify whether it paid the correct fees.
“We have also seen major differences in basis points between custodians when it comes for forex execution and the revenue split for securities lending,” says Bradley. Those discrepancies can come to as much as forty basis points in foreign exchange trades and twenty percent on the split of revenues for securities lending deals between custodians and fund managers.
Custodians often execute dozens if not hundreds of foreign exchange transactions each day to convert income and dividend payments along with trades settled in a non-local currency into the home market’s currency. Such deals are based on “standing instructions” which give custodians plenty of leeway on just how much they can earn. As few, if any, custodians provide details on when the transactions were actually executed or even how they differ from the interbank prices, it is hard for pension plans to understand whether the prices are fair.
In the case of securities lending transactions, custodians typically divide any fees earned from borrowers with their customers’ fund managers, which pass the earnings along to the underlying fund. It might sound easy to understand, but without specific benchmarks it is difficult to fathom whether the fund is earning fair revenues. Technology giant SunGard and data specialist Markit do offer some glimpse into the validity of securities lending revenues and fees for a price, while EquiLend provides such an analysis for free to contributors only — those who use its electronic lending and borrowing platform and provide the relevant data.
UK consultancies predict that custodians will likely have far less to worry about when it comes to reputational risk from UK clients than their US peers — notably BNY Mellon, State Street, JP Morgan and Northern Trust– which have found themselves the target of litigation. Media coverage of State Street’s wrongdoing or errors in charging UK and Irish pension funds was a notable exception to what is typically a behind-the-scenes negotiated settlement for any overcharges, notes Economides.
Still custodians servicing UK customers should think twice about being less than forthcoming. “We don’t want our pension plan customers to nickel and dime their custodians, because that could decline their level of service, but we do want them to be aware of whether they are getting good service for what they are paying,” says Bradley. “Custodians may not like the higher level of transparency, but if they are doing their jobs correctly they should have nothing to worry about.”
[whohit]-FCA Leaves Asset Owners to Self-Police Custodian Fees-[/whohit]