CONCORD, Mass. — A struggle between custodians and prime brokers over 130/30 financing revenue that’s projected to grow to $1.26 billion by 2012 from an estimated $85 million in 2007 will force both sides to find new ways to compete, according to a new study by research and consulting firm Vodia Group.
“The challenge is in custody and is well known,” Josh Galper, Vodia managing principal and author of the report, said in an interview. It’s custodians’ game to lose: with custody of nearly all long-only assets today, and with 130/30 allocations typically funded by reducing equities, “anything less than 100% custody of 130/30 are a loss,” according to the report.
Custodians now control 79% of 130/30 assets, but 44% of institutional investors surveyed by Vodia said they would prefer to use a prime broker for their 130/30 assets, while just 11% said they’d pick their custodian.
The report “highlights how 130/30 contributes to eroding boundaries between brokers and custodians,” Mr. Galper said. “This, to me, is the straw that breaks the camel’s back. This is what will force brokers into general custody and make custodians take a long and hard look at their business models.”
To some extent, that’s already happening.
In September, Bank of New York Mellon Corp., New York, which has more than $20 trillion in assets under custody and administration, rolled out a “comprehensive 130/30 platform,” using subsidiary Pershing LLC’s prime brokerage capabilities. Northern Trust Corp., Chicago, with $4.1 trillion in assets under custody, also is offering bundled prime services through its Northern Trust Securities Inc. subsidiary.
But representatives from both firms downplay the importance 130/30 will have in turning risk-averse custodians and profit-focused brokers into competitors, even as they see assets in 130/30 growing exponentially.
“It’s hard to say” if it will become more competitive, said Terry Ransford, vice president and director of trading and technology for NTSI. “We’re all competing but the revenue source isn’t all the same. … Right now everybody’s dependent on each other.”
Both brokers and custodians would “like to have all the chips,” Mr. Ransford said, but each also has core competencies. Larger institutional investors, especially, will continue to keep long-only assets with custodians because of security, and brokers can’t match custodians’ level of information reporting. “Brokerages don’t slice the data 85 ways because they’ve never had to do that,” he said.
Joseph Keenan, managing director of BNY Mellon Asset Servicing, said brokers, who are used to earning 20 to 40 basis points on assets under management, aren’t drawn to custody’s revenue, at one to two basis points. “Those are slim pickin’s,” he said.Instead, there will be a segmentation of services fitting the strengths of each type of company, Mr. Keenan said. Hedge funds that use more leverage and need more complex financing will stick with brokerages; that business Pershing won’t compete for. But BNY Mellon would compete for custodianship, and leverage its client relationships to build its brokerage services that need to “walk, then jog, before (it) runs.”
Mr. Galper agreed that both custodians and brokers have advantages, especially with existing clients. “What we are seeing, however, is an increasing momentum, primarily from brokers, to reach out to different kinds of clients that have traditionally been the domain of custodians.”
And Mr. Galper argued that custody is needed to make 130/30 servicing profitable, in the form of relending securities held.
Notable exceptions are funds that must comply with the Investment Company Act of 1940, which include mutual funds. Custodians of these funds can’t provide financing to those clients. But when the custodian and brokerage are separate legal entities — such as BNY Mellon and Pershing — they can, Mr. Galper said.
