Over the course of 2019, we went from expecting an endless runway of rising rates to three interest rate cuts that year by the Federal Reserve, to continued rate reduction this year, putting yet more pressure on the custody industry. Custodians, some of the largest of which could lose hundreds of millions of dollars due to reduced spreads, were already contending with shrinking margins in this era of free trading and fee compression. These pressures are likely to drive further consolidation in the industry, which has seen a number of high-profile mergers and acquisitions recently. Chief among them:
- In November 2019, Charles Schwab announced the acquisition of TD Ameritrade. This merger, which by conservative estimates could take 18 to 36 months to fully digest once the deal is finalized, has the potential to cause significant friction for firms currently utilizing one or both platforms.
- In February 2020, Morgan Stanley announced it was acquiring E*Trade, less than two years after E*Trade purchased Trust Company of America in April 2018.
Much of the focus of these consolidations will be cost reduction to maintain or improve margins. What is often missing in this process is a focus on the clients’ needs. Most private wealth managers and family offices provide hands-on, high-touch, bespoke services, and they need quality custodians who can match the service levels that the advisors and their clients expect.
Today, even advisors with more than $1 billion in assets under management often find themselves outside the top servicing tier of the largest custody banks. This trend will only continue as further consolidation takes place.
Expect Post-Consolidation Changes
The Schwab-TD Ameritrade merger offers a good example of the changes that are in store for the custody industry and its clients.1 For starters, there is likely to be a change in the service model for many TD clients, who, regardless of size, had a dedicated relationship person overseeing their business. Historically at Schwab, for instance, a client would need to have at least $200 million of custody assets to graduate from a self-service, 1-800-number-based support model.2
Also, much has been highlighted about the current “crossover” between the two firms. By some estimates nearly 6,000 of the clients serviced by at least one of the two firms currently have accounts serviced by both Schwab and TD. It is classic “Merger 101” that staff positions — both front office and back office — supporting a firm on both sides could be consolidated. The question becomes: To what extent will people be replaced by a computer asking you to press “zero” for more options?
Another area of change — and expense reduction — will no doubt come in the form of technology. It is unlikely that the new combined firm will support two front-facing technology platforms any longer than absolutely necessary. This means a large share of clients could experience a platform conversion in the next few years. For many clients of either Schwab or TD, this will represent a big change. There’s also another concerning question: Will the new entity decide to charge advisors for what historically has been provided for free?
Cash is Still King
Beyond the recent merger activities, cash is also an important consideration. What custodians do with a client’s liquid cash is an increasingly important source of profitability for brokerage and bank custodians alike. Custodians typically earn a spread on cash balances through sweeping cash onto their balance sheets, or through receiving fees from money market mutual funds. Lending and other banking activities in the background can enhance their margins.
Last year, many firms were making in the neighborhood of 170 basis points (1.70%) off of their clients’ sweep deposits. On a $1 million account, with a 5% allocation to cash, that’s $850 a year that the client would not see in their pocket. Translating that back to an “all-in” analysis on the lost yield alone, the account is paying an effective 8.5 basis points for the “convenience” of cash sweep.
Oftentimes money markets are available for purchase at the custodian but are only available on a T+1 settlement basis, and therefore do not have daily liquidity. Generally, the classes of funds offered also have a shareholder servicing fee, which is payable by the fund back to the custodian in the average range of 25 to 75 basis points. This can result in the family office or RIA being forced to manage cash, an asset class that often times is excluded from their own fees. Cash balances that wander higher than the average 5% can also have a noticeable negative impact on performance.
Some custodians have seemingly become more creative, but the ultimate benefit to the end client is limited. For example, JP Morgan, whose balance sheet cash sweep option pays around three basis points (0.03%), recently rolled out a product called “Notice Deposits” that provides a higher yield but requires a balance to be locked in for a term of either 35 or 95 days.3 If cash is withdrawn prior to the lock-up period, a prepayment penalty is assessed. Also, an individual investor would need to lock up at least $5 million for the 95-day option to realize a yield that is equal to what an institutional class government money market fund would pay.
Finally, if yield spreads continue to compress, and this last main source of revenue to subsidize custody costs shrinks, will the brokerage custodians adopt an explicit AUM-based custody fee model? We’ve already seen some precedent for this, with firms like Fidelity charging a basis point fee for the use of their trust accounting platform.
Back Office Support
Offshoring is not a new theme in the custody industry, with all the major players employing lower cost locations for call centers, back-office support and reconciliation, and tasks that have been deemed repetitive. What’s interesting is that although the federal tax law passed at the end of 2017 was, in part, designed to encourage the repatriation of funds and a movement of manufacturing jobs back to the United States, that has not been the trend in these softer-skill positions. It is often difficult to obtain hard data on the number of staff used by one of the large custodians in an offshore location, as many times the people are employed by a separate company or joint-venture. However, anyone who has interacted in person with their custodian may have experienced the delays and operational miscues that are hallmarks of service organizations that have been turned into nothing more than massive global assembly lines.
While the number of family offices and RIAs continues to rise, the overall quality of custody options continues to decline. When reviewing options, RIAs and family offices should partner with a custodial provider that can offer permanence, and this can only be achieved through independence and demonstrated long-term profitability.
At Fiduciary Trust Company, we’ve been a bank custodian for over 90 years, spanning events such as the Great Depression, the Great Recession, and countless other geopolitical upheavals. Through it all we have demonstrated soundness and permanence in a tumultuous world. We employ world-class trade-date trust accounting software that provides full tax-lot accounting and reporting as well as a true segregation of principal and income cash. We have experience with accounts of all shapes and sizes (including handling complex and illiquid assets), and the technology and expertise to account for client situations today and as their needs evolve. In addition, we provide FDIC-insured sweep deposits with attractive yields.
Although we view robust systems as essential, we never attempt to replace human interactions with technology simply to enhance our margins. We provide a highly engaged and personally tailored model that will get things done right for your clients the first time. With Fiduciary Trust, you benefit from our precision, timeliness, and decisions rooted in our clients’ best interests. We have been a trust company for over a century and our record demonstrates a legacy of excellence in fiscal management.
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1Lisa Beilfuss and Daren Fonda, “The Charles Schwab-TD Ameritrade Merger Shocked Wall Street. Why It Had to Happen,” Barron’s. Dec. 16, 2019
1Oisin Breen and Brooke Southhall, “Schwab Sends Most RIAs to 1-800 Custody Service…,” RIAbiz. Dec. 2, 2019
1JP Morgan client notice Feb. 1, 2020. Chase.com/personal/investments/sweep-options-yields
The opinions expressed in this article are as of the date issued and subject to change at any time. Nothing contained herein is intended to constitute investment, legal, tax or accounting advice, and clients should discuss any proposed arrangement or transaction with their investment, legal or tax advisers.