Written by John Gubert

Editor’s Note: This article first appeared on The Global Custodian blog

Cost reduction was the clarion call at NeMa Vienna. This is particularly relevant for the besieged investment banking community with returns on equity far below the acceptable norms. But it resonates as well with the custody world, attuned to regular cost reductions, albeit more on the back of the endowment value of rising markets than alchemy across the securities transaction lifecycle.

The paradox is that post-trade costs are likely to rise. First, the regulators will undoubtedly take action to eliminate the risk of the ever growing intraday exposures that are offered by banks for minimal cost. This is mainly due to a flawed perception by those suppliers that they are really at bank option exposures. They are not, as is well understood by the regulators, for they are the very life blood of the brokerage industry, among others. As one who has lived through two major crises in markets, I can assure everyone that the incredibly difficult credit judgement at the crisis point is a systemic one across each bank’s portfolio of exposures rather than a counterparty specific one. What will regulators do? They are likely to look for committed offerings from banks for at least a component of the total exposure or ring-fenced liquidity pools from those capable of generating them.

And second, the market is becoming more complex in geographical, instrument and infrastructure terms. There are more moving parts and, even if the unit cost of each part reduces, the likelihood is the sum total of the costs will increase as the average portfolio becomes less OECD and more global, less cash instrument based and more derivative biased, and a mandatory user of more, rather than fewer, infrastructures.

So how do we reduce cost? Standing back and looking at the world of investment from a distance, some things become apparent. The main one is that cost reductions are an imperative and not a nice-to-have! Investment management is severely overpriced. Fees range from the odd basis points for dumb beta through to the outrageous 2+20% for some alpha seeking alternatives. Those fees will reduce, especially as investment managers become ever more aligned to the politically charged world of supporting post-work lifestyles of the greying population through pensions and other saving vehicles. Second, trading spreads are ridiculously high especially for liquid counters. Foreign exchange is moving to a computer based transaction matching process. The same will happen with investment counters, at least in marketable instruments, which account for over 70% of all transactions. Third, the post-trade market infrastructures will rationalize. The traditional exchanges will not be able to continue in their current form; they are people-intensive and costly, with the MTF world showing the way they will need to develop. In that world, cost allocation and logical business process is critical; the subsidy of the liquid for the illiquid counters does not work in a free market. CSDs will consolidate; T2S will start with transaction flows and, although it may take a decade or more, asset servicing will follow suit.

But this will not reduce costs dramatically. It will, though, reduce revenues for the two key custody drivers, the investment manager and the broker dealer. So, how is the industry going to help them?

The first issue will be to reduce demand for credit. There are multiple ways to do this including adapting the algorithms used in settlement, standardizing settlement timeframes globally and seeking legal changes to enable custodians to clear across clients as well as market side.

The second would be to reduce the number of infrastructures…Click Here to Continue Reading Article at the Global Custodian.

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