As the custody market continues to mature, pension funds are beginning to seek additional services from their custody groups, over and above the core settlement and custody of assets services. But, although the evolution has begun, change is occurring slowly.
In the US, offering value-added services has been ‘a way of life’ for 20-25 years, according to Mike McShee of Buck Heissman in Switzerland: “We are now moving towards that in Europe.”
Before the provision of supplemental services to pension funds can take off, however, the custody relationship has to be broken away from the investment management one. Especially as the trend towards multi-manager funds continues to gain pace, pension funds are beginning to appoint global custodians, independent of investment managers. And global custodians are beginning to view the pension funds themselves as clients, not just looking to the investment managers. But the fact that this fundamental revision is required, is one of the reasons that the market is changing as slowly as it is.
“Once the relationship between pension fund and custodian has been redefined, phase one is expanding the trustees’ knowledge of custodians regarding what they do and the range of value-added products they can offer,” says Sean Henaghan, senior investment consultant at Watson Wyatt.
The key areas for additional services are: “those services that it is more efficient to buy from the custodian than somebody else,” according to John Conroy, principal at Towers Perrin.
Carl Hitchman, head of European custody consulting at William Mercer, distinguishes three categories of added-value services:
o anything that makes the client’s life easier, eg, back-office administration;
o or that helps to manage or assess investment, such as compliance monitoring or performance measurement; o or that offers monetary added-value, such as securities lending.
The back-office services are the most basic on offer. Koen de Ryck, at Pragma in Belgium, notes that among pension funds that have separate custodial relationships not tied to their investment managers, a number are availing themselves of accounting services as well as proxy management.
Conroy cites performance measurement as a classic add-on: “There should be a vast increase in that sort of business for custodians. After all, they own the data. And the power is that it is incredibly added-value. The client already buys it and has to have it.”
But, although it is a logical market for custodians to enter, the scene is surprisingly quiet. The UK is a particular case, since traditionally Caps and WM have controlled the performance measurement market, providing peer group benchmarks. WM’s move into the Deutsche Bank camp is designed to be on the same arm’s length basis as when it was owned by Bankers Trust.
But even in the UK, there is a steady move away from samples and towards fund-specific benchmarks, which should open up the market to competition from custodians. “And in Europe, there is no historical hangover, so there is potential for custodians to get in at the ground floor,” says Conroy.
In the area of performance measurement, however, custodians are hindered by their reputation of offering a sub-standard service: “There is a history there of custodians not doing it too well,” says Henaghan. But the service quality is improving, and soon this area should represent a core added-value service.
Another key area will be compliance monitoring, especially as pension funds continue to move to multi-manager structures. “By putting single custodians in place, funds can use them to provide an overall view,” saysHitchman. Although using the custodian to provide compliance monitoring seems a logical extension to the relationship, relatively few firms are taking advantage of the service, according to most consultants.
The provision of compliance monitoring and other reporting services is likely to grow as the move to prudential, or fiduciary, monitoring and regulation gathers pace in Europe. Pension funds are becoming keener to look for external reporting services in order to offer a more impartial account of the status of the fund, and custodians should be able to benefit from this trend.
One area that generates more excitement throughout Europe is securities lending. Pragma’s De Ryck notes that the larger, more sophisticated pension funds are turning towards their custodians to provide this service. The attraction, according to Henaghan, is the potential revenue: “It can partly pay for the custodian,” he says.
Bu, although trustees are starting to talk about securities lending again, there is a long education process involved, since it is still perceived of as a high-risk area.
Although the market for additional services is evolving slowly, it is set to play an important role in the relationship between pension fund and custodian. As pension funds increasingly select their own global custodians, the range of added-value services on offer could become a determining factor. “Any fool knows how to hold the stuff without loosing it,” says McShee. “You wouldn’t talk to someone not able to perform the basic service. The decision comes down to range of services, quality, and price.”
What will custodians have to do in order for this market to take off? According to Conroy, many custodians are focused internally at the moment: “They are so big and have so much rationalisation and integration to do, that their focus is on that.” Also many custodians still see their clients as the fund managers, and not the pension funds. Thus they need to recognise the value of the relationship with the pension funds on their books and conduct an effective education programme among the trustees. They may also have to “buy their way in,” says Henaghan, perhaps by providing a bundled service at a competitive rate.
McShee notes that across the board, more and more pension funds are using consultants to assist in the selection process, although his own firm is not active in that area (its parent, Mellon, is a major provider of global custody).
The firms that are active in custody consulting are seeing an increase in business. For example, Watson Wyatt is involved in this area because of demand from existing clients, and there is a team of nine people globally consulting on custodians. Mercer also sees this as a growing market, with a large team providing global assessments of custodians: the firm holds a database ranking custodians on more than 300 criteria.

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