Expansion of Services in the Custodial Market

This blog was originally published as part of Citisoft’s Outlook 2023

As the services market has evolved to embrace a tech-driven market strategy, it has also expanded. Driven by client demand, several custodians known more for back office services have been making a play to move up market into non-commoditized services. The driving force behind this shift seems to be a major uptick in outsourcing interest within asset management—the pie is expanding, and more service providers are angling for a slice. The question of what’s driving this increased appetite can be traced back to the events of the last two and a half years—in particular, changes to operating models and talent driven by the pandemic.

Legacy, on-premises investment technology isn’t efficient in an operating environment where IT and operations teams are working entirely remote. The pandemic-driven rise of remote workplace norms has been difficult to reconcile with operating models that rely on in-person oversight. Striking the right cultural balance has not been easy and this challenge has been magnified by the tight talent market. Asset managers are faced with a self-feeding issue: firms want to upgrade to a modern technology stack, but they need manpower to do so—and lack of manpower is a difficult issue to surmount.

These factors are driving asset managers to increasingly examine their entire operations ecosystem and to identify those functions that add value for their clients vs those functions that don’t. Outsourcing contracts are now several generations deep, but increasingly, asset managers are looking to outsource more of their operating model in order to shortcut staffing issues and minimize conversion risk. Service providers are not only helping asset managers meet these existing challenges—they’re also promising to enable them to leverage modern technology to accommodate new investment strategies and perform sophisticated analytics.

Custodial banks reassess their offerings

This shift in sentiment towards outsourcing has prompted many custodial banks to reassess their strategy and increasingly view holistic, front-to-back outsourcing as a necessary part of their offering. This evolution is helping come custodians gain market share and move up the value chain to a more lucrative margin business, especially as they foresee headwinds from legacy profit centers such as foreign exchange processing, securities lending, and core custody services.

Front-to-back outsourcing is now the new battleground for service providers; however, how each provider is playing the game is different. Essentially, three models have come into play: proprietary, partnership, and open architecture. Each model has its strengths and weaknesses, and service providers are quick to point out the benefits of their approach. Asset managers need to fully understand these offerings to assess which model best supports their business needs based on their investment strategies, data requirements, integration, and existing technology stack.

Service providers that are back office focused tend to have partnership and open architecture models which allows asset managers more customization. Conversely, several services providers known better for front-to-back services are leaning into proprietary models. Proprietary models provide simplification while partnership or open architecture models require more inputs but offer greater flexibility.

Challenging the incumbents

The flexibility of service models is not the only way that service providers known for the back office stand to gain ground in the outsourcing market. With some exceptions, asset managers tend to prefer to work with a single service provider for middle and back office. This is due to a number of factors—cost efficiency, better integration, and ease of maintaining fewer relationships, among others. Outsourcing providers that have historically serviced a significant share of the global back office have not always provided a compelling option for middle and front office needs. However, this is changing as back office custodians are maturing their font and middle office services through new partnerships, licenses, and overall technology investment.   For their existing back office clients, this provides a viable option to extend services upstream and also poises them to go head-to-head with middle office incumbents.

Despite competitive pressures, the question may not be whether back office custodians will be taking a slice of the incumbents’ pie but how big the pie will grow in coming years. Regardless of the scale of market expansion, recent investment across outsourcing providers will likely reinforce a competitive market and provide more options for asset managers over the long term.