An explosion in foreign investing has sent the largest U.S. banks on a global mission to provide securities-related support services. As these big providers work out the kinks, they are likely to lead other banks into charted territory.
It has been almost 20 years since a handful of big pension fund managers first began investing in overseas markets. Today, in a continuing search for higher returns and risk diversification, insurance companies, mutual fund companies, banks and even individuals have joined the pension funds in trading outside the borders of the United States.
A number of factors have contributed to the rapid, almost overnight expansion in foreign investing, including financial market reforms in many countries. But a crucial factor has been the application of technology that makes it easier--and less risky--to accomplish cross-border trades.
And it is here that a handful of leading U.S. banks have influenced the dramatic increase in foreign trading, where turnover of foreign securities topped $2 trillion last year.
Banks have always provided a number of what Wall Street somewhat condescendingly refers to as "clerical functions," including settling trades and keeping track of the assets involved. Indeed, the custody business is a natural act for banks. In its most elemental form, which is the safekeeping of assets, custody has always been the most fundamental business of banking. Today, though, custodians are evolving from pure transaction processors to pioneers in the world's capital markets by providing services and information that make foreign investment easier. "Global custodians are the intermediaries between the investors and the actual international markets," says Frederick R. Walsh Jr., a managing director for Morgan Stanley & Co., one of the few Wall Street finns to establish a significant global custody business.
The money center banks and a handful of others have invested hundreds of millions of dollars in both systems and human resources to build the back-office capabilities that facilitate foreign trading activity. They became global custodians out of necessity, establishing a presence in markets where their largest trust customers wanted to do business.
From this beginning, they have built lucrative securities processing businesses, in which they have established beachheads in scores of foreign markets with the ability to handle almost any type of financial instrument. They process an estimated five million transactions each year, and have some $1 trillion in assets under custody at any given time. And the payoff is rich: The global custody business provides substantial fee income for the largest providers, and is an area with enormous growth potential.
In addition to the institutional investors, global custodians are paving the way for other banks, particularly those with significant trust departments, to capitalize on the globalization of the world's capital markets. Though many of the largest players still view institutional investors as their primary market, they are also targeting other banks for their services.
Joining the Fray
To remain competitive in the trust business, large regionals and even mid-sized banks must provide the full array of trust services offered by larger competitors. That includes money managers with the knowledge to invest in foreign markets. There is no reason to believe that the pressures driving institutional investors into foreign markets are not also coming to bear on smaller funds.
"Any bank with an investment department, or trust or private banking department, is eventually going to face someone saying they want to invest outside the borders of the United States," says Mark C. Aprahamian, director of the global broker/dealer business of Barclays Bank PLC, and until last month the head of Barclays' securities services sales unit in New York.
Outside the trust department, banks with their own mutual funds will also soon be faced with the need to offer foreign funds, following the lead of the giant mutual fund companies. A handful of adventurous banks have already established a few emerging market funds.
As regional banks' portfolio managers and trust clients get caught up in the internationalizing of the capital markets, the need for the regional banks to provide support services will mount. "Institutions that have ducked the issue so far will eventually have to provide the service or be faced with losing business," says Jennifer Kamp Tretheway, senior vice president for trust and financial services at Northern Trust Co.
The pressure to invest in foreign markets is enormous. Anyone who doubts the intense interest today in cross-border investing need only review a U.S. Treasury Department study of international trading during the 1980s, which found that the total value of purchases and sales between U.S. citizens and foreigners increased by some 2,000% during that decade, from $251 billion to a whopping $5.1 trillion. This includes the purchase and sale of U.S. securities by non-U.S. investors, as well as U.S. investments overseas.
Most of this capital flowed into the U.S. securities market, with U.S. investment by foreigners rising to $4.2 trillion in 1990 from only $198 billion in 1980. But foreign investors have long looked to the U.S. capital markets for safety as well as high returns. The more significant trend was the growing interest on the part of U.S. investors in foreign markets. By the end of the 1980s, U.S. investment in foreign securities had risen to $906 billion from only $53.1 billion in 1980, an increase of 1,600%.
And that was only the beginning. The real explosion has come in the past three years, as U.S. investors have more than doubled their purchases and sales of non-U.S. securities, trades that had totalled $2.1 trillion at this time last year, the latest date for which figures are available. This was an increase of 127%.
"Modern portfolio management is driving the need for global custody," says Francisco D. Valeriano, senior vice president of Global Securities Services for Chase Manhattan Bank. "The savviest investment managers believe that to achieve good returns and diversify risk, 20% to 25% of a portfolio should be invested outside the home market. Today, institutional investors have about 7% to 9% invested outside the United States. There's a lot of room for growth still."
Global vs. Domestic Services
Smaller banks, for the most part, will not be able to establish their own custody networks, as the barriers to entry are overwhelming. Most of the top-tier providers are spending upwards of $50 million a year on technology alone to build the infrastructure for global investing.
That infrastructure is very complicated. Banks in the global custody business must develop a network of subcustodians around the world to service trading activities. Banks with international branch networks, such as Citibank, may provide service through their own branches, as well as contract with local agent banks in markets where they do not have a presence. Some providers establish offices in trading markets where there is no satisfactory local provider and trading interest is sufficient to warrant such a move.
Global custodians may also tap into the services of two transnational securities depositories--Brussels-based Euroclear and Luxembourg-based CEDEL. Both Euroclear, owned by J.P. Morgan & Co., and CEDEL were established a couple of decades ago as Eurobond clearing operations, but now offer clearance, settlement and other custody services in the foreign securities of a number of countries. Their systems are highly automated to interface with custodians and investors.
The custodian bank manages the subcustodians that perform the actual "clerical" functions, and gathers and relates information to their investor clients. Except for very mature markets like the United Kingdom and Japan, the business is paper-intensive, with fax machines considered the ultimate in technology in many places. For the most part, automation occurs on the user end, where providers are competing frantically to offer the best information possible in the fastest, most easy to use way.
Increasingly, those users will be bankers, whether they are trust bankers, proprietary fund managers or managers of the banks' own portfolios. Some of the custodians feel that many more regional banks would already be involved in global investing if they had a better grasp of the process involved. "The lack of information about how all this works can be intimidating," says Lee Harvard, senior vice president of BankAmerica Global Securities Services. "As banks get more information, their confidence level will build and that will help foster demand."
In truth, banks already acquainted with the domestic custody business don't have too far to go in grasping how global custody works. All but a handful of the largest banks have always looked to their bigger brethren to provide the processing involved in the maintenance of trust accounts. Master trust banks, like Boston's State Street Bank & Trust Co. and Bankers Trust New York Corp., have long provided the technical support services for large institutional investors, as well as trust processing services to other banks.
The custody business for U.S. investors putting their money to work here at home--called domestic custody--is a mature, technology-driven business where the services have become commodities. Where value can be added, it tends to be provided to the end user (the trust client) by the bank having the direct relationship with that customer.
The same processing demands apply to global custody, with the added layer of doing business in a foreign location with foreign currency implications. Most of these locales have nowhere near the sophisticated telecommunications networks and systems that have made domestic custody a commodities business. Yet investors in foreign securities demand the same processing and information services as that available in the home market. "When you get to global custody, the back room becomes the front room," contends Walsh at Morgan Stanley.
Until recently, global custody was treated mostly as a separate business from domestic custody, although both businesses fall under the umbrella of securities services. But the major players today are making less and less distinction between the two. "The two terms are not so relevant anymore; everything is global," says Jeremiah F. O'Leary, senior vice president of Chemical Bank's Global Securities Services.
It is in foreign markets where big bank providers have the potential to grow their securities processing activities, eventually piggybacking the foreign operations onto their already-formidable businesses of scale in the home market. With margins razor thin in a relatively mature home market, the search is on for fatter margins in the growth business of foreign markets.
The less mature the market, the higher the charges to investors, which come as a percentage of assets invested and in the form of transaction processing fees. But as those markets mature, global custody begins to resemble domestic custody in that it also becomes a commodity. The big bank providers hope to keep margins healthy in global custody by "lowering internal unit costs and developing incremental services," says Citibank's William A. Urban, director of technology services for the Global Finance Operations and Technology unit of Citibank Worldwide Securities Services.
Becoming Information Providers
Global custodians have already made great strides in offering incremental services---services that have become so integral to the global custody business that they are no longer considered value-added. In fact, many consider global custody to be the value-added service to other activities, such as master trust and foreign exchange. There are five basic elements to the global custody business, all of which are involved in affecting a foreign trade: settlement, safekeeping, cash management, custody reporting and foreign exchange.
Proficiency in these areas separate the players from the wannabes in emerging markets, but they are more commodity-like in established markets such as the United Kingdom and Japan. In more mature locales, custodians may distinguish themselves in a number of areas, including their technical expertise, how skillfully they manage their subcustodian networks, and by offering ancillary services like securities lending, which involves the loan of securities from an investor's portfolio to a broker/dealer to support the dealer's trading activities. The lender receives collateral and retains all fights of ownership, such as dividend payments. The custodian bank receives a fee for arranging the loan.
But the crux of the custody business today is providing information. "Our business today is changing significantly and quite rapidly," says Paul Maregni, senior vice president of Mellon Trust, formed by the merger of Mellon Bank's trust operations with that of Boston Safe & Trust Co.
Plan administrators long ago became accustomed to on-line, real-time delivery of information in the domestic market; now they want the same services for their international investments. "Today, the role of the global custodian is that of an information provider," says Barclays' Aprahamian. Adds Clarisse M. Persanyi, the bank's sales and marketing manager: "We are following the same path in global custody that we did in domestic custody, that of switching to the information management business."
The game today is to provide detailed information to the user in addition to safekeeping and settlement services. "We have moved from schlepping bonds up and down Wall Street to being information providers," says Bank of America's Harvard.
This information includes not only record keeping-related details, but increasingly performance measurement and analytics as well. Banks that can deliver this capability electronically--and quickly--are those that will prevail in the global custody business. Banks "will begin to fall out (of the business) over this area," predicts Chase vice president Naomi Solomon.
A Long Way to Go
For all its sophisticated reporting techniques and huge technology investments, the global custody business is still in its infancy. The international markets lack the standardization that has made domestic custody a commodities business. "Global custody is still in the early growth stage," says Janet E. Potter, vice president and manager for Mitsubishi Global Custody, a division of San Francisco-based Bank of California, which is owned by Mitsubishi Bank in Japan.
For instance, the industry lacks common numbering for securities identification, so that securities identified by one number in the United States may carry a different number in London. Thus, even the basic settlement procedure is complicated in that it entails the risk of settling the wrong security. Each market carries different processing standards, such as requirements for when trades must be settled, as well as different message standards concerning those trades.
Rapid growth in cross-border investing has raised risk management concerns worldwide, prompting the Group of 30--an international planning body that tackles fundamental issues in banking--to recommend certain standards for conformity of global securities trading. Most of these recommendations were already in effect in the U.S. market, arguably the most sophisticated in the world, but not in many overseas markets. Progress has been slow, but sure.
As a result of the Group of 30's recommendations in May 1989, a growing number of countries are adopting a standard message format sponsored by the Society for Worldwide Interbank Financial Telecommunications (SWIFT). And many countries are moving toward T+3 settlement, meaning that trades should be settled within three days of their initiation.
Though the group urged that T+3 settlement be implemented in all markets two years ago, only a handful of countries have accomplished this. Some U.S. observers doubt that it will ever happen. "T+3 won't work," Barclays' Aprahamian flatly states. "It's like trying to turn the Queen Mary around in a brook."
Any progress helps, to be sure. But "until standardization occurs in every market, global custody won't become a commodity business," says John H. Deutsch, senior vice president of ABN Amro Bank, which offers global custody services in the U.S. through its Chicago-based LaSalle National Bank subsidiary.
That means cross-border investors will continue to depend heavily on their custodians to create order from disorderly capital markets. "There are a lot of bumps and grinds on this road," says Aprahamian. "We are accustomed to a very sophisticated, steady market here, but it's a different story elsewhere in the world."
Coming to Terms with the Terms
Custody: In its most basic form, custody is the safeguarding of assets. Global custody generally refers to the safekeeping of assets invested outside the investor's home market, while domestic custody refers to the safekeeping of assets within the investor's home market. The term global custody is increasingly being applied to both kinds of custody, and encompasses many services ancillary to the basic safeguarding function.
Subcustodian: Global custodians contract with local subcustodians in foreign markets to perform securities-related services. The subcustodians may be branches of the global custody bank, foreign banks that provide such services or branches of another bank that has a presence in that market, including other global custodians.
Direct custody: Direct custody occurs when the investor goes directly to subcustodians in foreign markets for the most basic securities services. The users are usually large sophisticated investors, such as public pension funds.
Securities services: The term refers to a set of functions that are required in executing cross-border trading. They include: settlement, safekeeping, custody reporting, cash management and foreign exchange. A number of other capabilities may also be provided by the global custodian, including in-depth investment performance reports and securities lending.
Settlement: This is the actual exchange of funds or securities in response to a trade directed by an investment manager.
Safekeeping: In global custody, this term refers to the actual handling of assets, whether securities or funds, for investors. The custodian keeps track of the assets involved and makes collection or disbursement as necessary.
Custody reporting: These are reports from the custodian to the investor that provide details resulting from trading activity, such as when trades were settled.
Cash management: This service is designed to help investors maintain a flow of funds to their best advantage.
Foreign exchange: Foreign trades are settled in the currency of the market where the securities are bought or sold. A U.S. investor, for example, would have to convert payment for the sale of foreign securities into U.S. dollars, and banks that offer forex services help the investor do this. Foreign exchange may be offered as part of a package of global custody services, or from the foreign exchange operation located in another part of the bank. The investor also may elect to rely on a bank other than the global custodian for forex trading.
Securities lending: Like foreign exchange, securities lending may or may not be offered under the auspices of custody operations, though they are related. This is the loan of securities in a portfolio to a broker/dealer, who in turn provides collateral for the loan. The portfolio owner retains all rights to ownership of the securities, including dividend payments. Securities lending provides liquidity in foreign markets.