The poor performance of markets has hit ad valorem returns and, at least in markets where custodians self-custodise, these revenues have close to a zero variable cost attached. The source of endowment profits when markets rise, they are the source of P&L attrition on the downside. In the short term, most custodians have seen sharp rises in transaction income as investors have shifted out of high risk (including cross-border) assets. Currently, though, many players are seeing revenue running at well below the year to date monthly average and far below over optimistic 2011 budgets.
 

The problem for custodians is that they are being hit on several fronts. On the ad valorem side, lower markets and the shift of many pension portfolios to lower equity exposures has adversely hit revenues. The short-term benefit of higher transaction volumes is a one off although custodians with high exposure to hedge funds could continue to gain traction from this source if markets are volatile. And two other core sources of revenue – net interest income (and even spread income) as well as foreign exchange revenues are under pressure.
 

The likely low level of interest rates has hit free balance-related revenues while interest bearing accounts have also had to have their spreads pared in the face of low absolute returns to their beneficiaries. Recent US court cases on undue enrichment through “soft” exchange rates has led to demands for greater transparency in this field, and, more difficulty in using higher spreads on exchange rates as a counter to other income shortfalls. Past challenges on stock lending programmes using yield curve to create value has also meant that the different parties to these programmes have adopted a more prudent approach to collateral re-investment.
 

All this implies that the second half results of custodians are going to be below expectation and the final quarter, without a major change in market direction, could be quite challenging. More importantly, as custodians move into the budget period, they will be under pressure to compensate for 2012 target revenue shortfalls. Cost reductions are the only option.
 

That does not augur well for headcount plans, as people account for 60% of the average custodial cost base.  But it also will hit discretionary spend – IT development will be in the firing line again. With infrastructures and regulators unlikely to slow down their change programmes, calls for absolute cost reductions will be hard to meet. Some custodians, unless there is a sharp and unexpected move to optimism and bull markets, will be searching for that elusive partner willing to pay the premiums seen over the last two years for their business. Unfortunately, the value of the average custody business has now most likely reduced by more than 25% from its peak two years ago and so the sellers will need to taper their ambitions unless they can provide a really unique opportunity in terms of client or market coverage.