The contemporary custodian: Challenges and opportunities
Custodians have faced existential headwinds for decades, a situation that has escalated in the aftermath of the Global Financial Crisis. Encroachment from new competitors has compressed margins, while additional regulations and paper-intensive processes have increased operational and compliance burdens. Compounding matters, lawsuits, volatility, and persistently low interest rates have reduced or eliminated ancillary revenue streams from FX trading and lending. This new world of depressed fees and ballooning expenses has forced custodians to take a hard look at the services they will and will not provide the marketplace.
To optimise operations, custodians have investigated a range of options: automating through technology upgrades, exploiting economies of scale through expansion, and/or cutting costs via downsizing, outsourcing, or relocating. While popular, these latter options can lead to unanticipated problems stemming from loss of control, regulatory uncertainty, and communication challenges. Selectively externalizing certain operational components, by contrast, has proven more effective. By taking a ‘mix and match’ approach and selecting outside offerings to complement core competencies, custodians can offer a range of best-in-breed services at competitive prices.
Historically, many vendors have taken a ‘black box’ approach to service provision, limiting oversight of internal processes to protect intellectual property. Given the risks around data protection and cyber-security, this method no longer satisfies clients, custodians, or regulators. Thus, to enjoy the benefits of third-party specialists while minimizing the risks, custodians need an efficient structure for integrating, managing, and deepening relationships, in essence, turning vendors into partners.
Application Program Interfaces (APIs) can bridge that gap. These technological translators allow custodians to integrate their systems with vendors’, facilitating seamless and governable service provision. By strategically combining different APIs, custodians can develop asset servicing platforms undergirded by best-in-class providers. An administratively burdensome task that customers want but custodians find challenging, foreign withholding tax reclamation offers a case study in the power of using APIs to externalize product offerings in a governable manner.
The rise of component externalization
As an industry, custody lends itself well to externalization. Highly commoditised, it entails a series of intensive tasks. Highly competitive, it mandates operational efficiency. This combination of characteristics requires custodians to be strategic about the services they provide internally versus those that they delegate to outside providers.
Recognising a market opportunity, fintech upstarts began specialising in the niche asset servicing components cast off by custodians - 40 Act fund accounting, class actions, Blue Sky regulatory reporting, and withholding tax processing. By specialising narrowly in sought-after services, vendors exploited economies of scale, provisioning many firms while developing expertise and deepening institutional memory. Likewise, custodians reaped the benefits without expending the time, resources, and training to develop teams in-house.
The risks of component externalization
Any vendor relationship requires an active risk management program to oversee operations. Without established transparency regimes, legal frameworks, and security protocols, custodians can fall victim to a host of negative consequences.
On the firm-level, custodians face financial and reputational risk should vendor operations falter - an existential threat in an industry dependent on trust. System-wide consequences also exist. Custodians play an integral role in financial markets, ensuring the seamless flow of securities and payments globally. Provider errors can spillover into the wider marketplace, motivating the increase in recent regulations governing vendor management.
APIs: Risk-managed component externalization
APIs can balance the risks and benefits of component externalization. With only a few snippets of code, APIs allow firms to seamlessly access real-time data from the servers and databases of cooperating enterprises. The interfaces essentially work as a translator, serving as a common language (XML or JSON) to facilitate querying of information across systems. Everyday examples include retail websites that accept PayPal or offer automatic FX conversion for international buyers.
Because APIs fundamentally involve allowing outsiders into proprietary data warehouses, security is a natural concern. APIs thus take steps to authenticate users via unique tokens, ensuring that only those who provide particular codes can gain entry. In addition to validating identity, tokens also control eligibility levels, setting parameters for the types of information a user can access.
Balancing security and accessibility, APIs let custodians do more with less. Through the technology, custodians can add vendor-managed services to their own ecosystems, providing clients with a seamless and consistent user experience. APIs can also be integrated with custodial back office processing systems, offering centralised oversight to efficiently manage KPIs and vendor performance. By combining APIs like building blocks, custodians can develop asset servicing platforms supported by the best vendors in the world. Because of these characteristics, APIs promote innovation, facilitate transparency, and support regulatory reporting—all while minimising costs and operational risks and increasing organisational efficiency.
Foreign withholding tax relief and recovery: A case study of API integration
While not every custodial function can be externalized, tax relief and reclamation represent a prime use case. A boon to portfolio performance - often offering upwards of 25 bps of added return - it is a service that investors seek. However, complex and logistically intensive, it is a service that financial intermediaries find time-consuming to provide. To offer it, custodians must keep track of global tax rates and process changes, collect beneficial owner information for segregated and omnibus account holders, and generate hundreds of customised documents per client. Upon onboarding clients, they must identify opportunities for reclaim and recovery, submit claims through various custody chains, liaise with foreign tax authorities to ensure proper submission, track income payments, and report information to clients, regulators, and internal auditors - to name but a few of the many elements.
Easing the process, custodians can leverage the flexibility of APIs to provide either a comprehensive withholding tax offering or tailored services to fit the varying needs of different client segments - whether buy-side or sell-side market participants. By integrating reporting-centric APIs, custodians can delegate the entire process to a proactive provider while continuing to oversee the process in real-time. Alternatively, by embedding a combination of query, validation, submission, or tracking functionalities into their proprietary portals, custodians can provide components of the service in the customizable format of their choosing. As an added benefit, embedding functions via APIs keeps clients on one centralized platform, eliminating the need for multiple redirects to the pages of different vendors.
The custodian of tomorrow
By designing APIs into existing system architecture, custodians can enjoy the benefits of third-party asset servicing specialists while minimising operational, financial, and reputational risks. The interfaces transform the way that enterprises work together, enabling custodians to integrate the best-available external technology and administrative practices into their own systems. By adopting this nimble and modular style of development, custodians can broaden the range of service offerings while transforming into digitally-forward firms, allowing them to compete more effectively in the high-pressure world of asset servicing.