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Low yields. Low fees. How’s a custody bank to make money?

“The industry’s pain becomes our gain,” said Ron O’Hanley, chief executive of State Street, providing a neat summary of his strategy for the Boston-based custody bank.

The industry in question is not banking, but asset management, where State Street’s key customers operate.

In recent years asset managers have passed plenty of their pain on to custody banks such as State Street, BNY Mellon and Northern Trust. With revenues under pressure from the rise of low-cost passive investing, money managers are less willing to pay up for custodians’ back office services: settling trades, holding securities, keeping records and exchanging currencies. This comes on top of other pressures on custody banks, notably falling interest rates and correspondingly lower interest income.

State Street is expected to report revenues of about $11.6bn for 2019, down 3 per cent from the year before. The decline in profitability has been more dramatic: in the first three quarters of 2019, return on equity, at 9.5 per cent, was 4 percentage points lower than the year before.

Mr O’Hanley thinks the shake-out in asset management will continue, and with it the pressure on custodial fees. His solution? Sell a wider range of services, becoming a full-service administrative outsourcer and helping money managers take costs out of their businesses.

The centrepiece of the strategy was the $2.6bn acquisition of Charles River Development in July of 2018. Charles River provides order management and analytics tools for traders, what is known in the asset management industry as “front office” software. The vision is that combining trading software with State Street’s “middle office” tax and accounting software and “back office” custody services would allow State Street to lower clients’ total operating costs significantly.

Yet investors panned the deal when it was first announced. State Street’s shares fell 8 per cent on the day, and fell another 40 per cent before they bottomed over a year later, underperforming even those of slumping peer custody banks.

That the shares have rallied since, State Street is the best-performing large bank stock over the past six months, contributes to Mr O’Hanley’s confidence in the deal.

The idea of acquiring Charles River originated in partnership offers State Street received from competitors to Charles River in front-office software. (The other big players in the front-end space are Bloomberg and BlackRock’s Aladdin platform.)

Mr O’Hanley recalls with a quiet laugh what the offers amounted to: they wanted to sell State Street’s custody offering to their own clients, have access to the data the custody business generates and control the client relationships.

“Well, that sounds good; how many of those can I have?” he says wryly. State Street was at risk of ending up “in a position where we would be doing all the hard work yet being paid commodity rates”, he said.

It made more sense to own all the value to be gained from combining trading and custody tools, he said. “We went from viewing the situation as purely defensive to, ‘let’s go on the offence’.”

Mr O’Hanley, who became State Street chief executive a year ago, knows a thing or two about the pressure on asset managers. He founded the investment management practice at McKinsey and then served as an executive at BNY Mellon’s asset management arm and Fidelity before joining State Street in 2015 to run its own asset management business — which pioneered the index-tracking exchange-traded fund that has undercut traditional active managers.

Investors and their advisers have always looked to drive down fund fees, he said, but after the financial crisis “it became seared in people’s brains: the sure way to increase your investment returns — the only sure way — is to lower your costs”. To top it off, the relative performance of active managers has been poor since the crisis.

Most asset managers use trading tools developed in-house, Mr O’Hanley said, meaning there are enough potential new clients for the Charles River business without having to wrestle away those who have already picked Bloomberg or BlackRock.

Investors will have to trust State Street on the strength of the deal pipeline for now, he said, but “front-to-back” deals combining its traditional and newly-acquired offerings are coming in faster than anticipated. “There has only been one deal announced publicly [with Lazard Asset Management], there is a second one not public, then there are five or six that are working their way through [negotiations].”

Even asset managers with trillions of dollars under management are interested in outsourcing, he said. The ongoing pain means it is an industry that will continue to consolidate, with passive investment strategies driving out sub-par active managers, and the most efficient passive managers driving out the less efficient.

And the winners will be decided, in large part, by the ability to control costs.

“Twenty years ago, I don’t think you could find a CEO in [asset management] who could tell you, hey, what percentage of your costs are operations,” he said. “Now its very much on the CEOs’ agenda.”

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