Why transfer agents should embrace an infrastructural future

16 Feb, 2016

Over the years, as my exasperation at the apparent death wish of the securities and funds services industry has mounted, I have called its leaders many unkind things.

Dinosaurs, obviously.

Cockroaches, less obviously.

Most recently, Neanderthals.

But this morning is I think the first time I have chosen to call them boiled frogs.

I am sure you are all familiar with the metaphor.

But since we are in Dublin, it is appropriate to record that the first man to introduce me to the metaphor of the boiled frog some 25 years ago was an Irish management theorist.

His name was Charles Handy, and he was at the time a visiting professor at the London Business School.

He put the metaphor on the cover of his book, The Age of Unreason, which was first published in 1989 – and is still in print today.

The metaphor runs like this.

If you put a frog in a pan of boiling water, it will try frantically to clamber out.

But if you place it gently in a pot of tepid water and turn the heat on low, it will sit there quite placidly.

As the water gradually heats up, the frog raises its own temperature.

In this way, it will, unresistingly, allow itself to be boiled to death.

This, argued Charles Handy, is what happens to businesses that refuse to adapt to the way the world is changing.

The frog died because it expected the future to be like the past.

It expected change to be continuous, not disruptive.

But before we mock, or pity the frog, consider this.

Our brains, whose chief strength is pattern-recognition, also tend to find in any development not what is new, but what we have seen before.

We expect things to change - of course we do.

But only to give us more of the same – just better than before.

Or, in my case, worse.

I remained convinced that the same person is still in there somewhere, just a lot less hairy.

In the same way, from the inside, the mutual fund industry feels much the same as it always did, only an awful lot bigger.

Anyone working in the industry when it started in the United States in 1924 would feel at home immediately.

It has fund managers, to buy and sell stocks, in exchange for management and performance fees.

There are data vendors, to collate closing prices on stock markets.

Fund accountants, trained to use those prices to calculate net asset values (NAVs).

And fund distributors with captive client bases to sell the funds to, in exchange for sales commissions.

There are correspondent banks to move cash from buyers to sellers, and back again.

And custodian banks to hold the shares in custody.

And of course there are transfer agents, to keep a tally of who subscribed and who redeemed.

That is seven layers of intermediation.

All taking a cut of the flow of funds into and out of the mutual fund industry.

A study by Deloitte estimated recently that the distribution costs of the Luxembourg fund industry alone amounted to €1.37 billion a year.{1}

It is a lot of money.

But still a modest slice of a $90 trillion worldwide asset management industry.

Transfer agents are looking after more than two fifths of that figure, or $40 trillion.

That translates into $1.7 billion a year in revenue, and it is growing at 10 per cent a year.

So what is not to like?

We have linear growth of assets under management, every year since 2011.

All the factors driving that growth – more people, more older people, ever-rising personal incomes, growing economies, mounting wealth – are unlikely to go into serious reverse.

According to PwC, asset managers will be looking after $100 trillion in five years’ time.{2}

That is enough to turn transfer agency into a $4¼ billion a year industry.

And if we extrapolate current growth trends out to the middle of this century, we are talking about a $400 trillion industry.{3}

That is, on unchanged revenue assumptions, a $17 billion industry.What could possibly go wrong?

What could disrupt this trend of ever-increasing assets under management (AuM) and transfer agency revenues?

What, to borrow a phrase, could turn us into boiled frogs?

The likeliest candidate, inevitably, is information technology.

Levels of automation in the transfer agency industry are embarrassingly low.

This, after all, is the industry which gave us the automated fax machine.

And low levels of automation matters for reasons far beyond the obvious.

If PwC is right, we will soon be working in a $100 trillion industry.

But if Ray Kurzweil is right, we will also be living in a world in which you can buy for $1,000 a computer capable of processing the same amount of information per second as billions of human brains.

Now I know that many incredibly intelligent people work in the mutual fund industry.

Some of them probably even work in distribution support.

But in a world in which computers think billions of times faster than individual people, I humbly submit that we may not necessarily need ….

Fund managers.

Fund accountants.

Fund distributors.

Correspondent bankers.

Custodian bankers.

Or, I regret to say, transfer agents.

Ultimately, any business – like any industry – in fact, like any economy – is an expression of its technologies.

And the open-ended mutual fund industry of today currently expresses the technologies of the 20th century.

Those technologies reward the skills of stock-picking.

Net Asset Value calculation.

Personal investment advice.

The registration and settlement of subscriptions and redemptions.

Transfers of value between bank accounts.

And the safekeeping of titles of ownership.

Between them, these rewards probably account for 80 to 100 of the 150 basis points collected by the mutual fund industry as a whole.

That revenue stream is going to go away when the marginal cost of instructing a computer to do any of these things is effectively zero.

Transfer agents face already the threat of new entrants, and of internalization - both based on more effective use of technology.

If you think the rewards for transfer agency are low now, imagine how much lower they are going to get when your competitor is a computer that can think 4 to 5 billion times faster than you.

If you believe in bundling and cross subsidy – if you think transfer agency is the price you have to pay to get assets into custody or fund accounting contracts - think again.

By as soon as 2025, it might well be robots, not human beings, that are competing for NAV calculation contracts in on-line auctions determined by price and capacity.

And if you think your KYC service has raised an impenetrable barrier to entry, consider this.

Digital memory and storage power are also increasing exponentially.

Services such as Arachnys and KYC3 are just the beginning.


Of course, this industry has a tremendously strong track record of smothering new technologies.

Fund platforms, for example, were an Internet-era technology rich in disintermediatory potential.

Fund distributors worried their clients would buy funds directly from fund managers, or from on-line supermarkets.

Transfer agents feared bulk orders would put them out of business.

So platforms were absorbed into the industry, and castrated.

They became, quite simply, another layer of cost.

The same is true today of the central securities depositories.

They too have become just another layer of cost.

So who is to say that the industry will not absorb and asphyxiate the latest technological threats?

The regulators, for one.

Regulatory costs are already squeezing margins, and distorting investment, in transfer agency.

But it is worse than that.

Regulation is doing more than reduce the profitability of transfer agents.

MiFID II does not just order fund managers to be transparent about their costs.

It does not just tighten the rules on inducements.

On the most extreme reading, it makes fund managers, not fund distributors, responsible for mis-selling.

Then there is the Anti Money Laundering Directive (AML IV).

This obliges managers to more than Know Your Distributor (KYD): managers now have to know who the underlying beneficial owner is too.

It is hard to see how the omnibus account can survive these measures.

In future, fund managers will need to know exactly who their investors are.

That prospect ought to bother fund distributors.

But not as much, perhaps, as the new version of the Payment Services Directive (PSD II).

This puts many fund distributors under the obligation to disclose full details of a client account to any third party a client chooses to use.

In this new regulatory environment.

Of ever-fuller disclosure of costs.

Of registers and accounts in the name of the beneficial owner.

Of open access to the account information of investors.

Of ever-deepening due diligence investigations into the identities, not just of clients, but of the clients of clients.

When the price of getting it wrong is not embarrassment – it is punitive fines and incalculable reputational damage.

In times such as these, fund managers need to stop being afraid of fund distributors.

And fund distributors need to be a lot less content about the multiple methods they choose or are forced to choose when they do business with fund managers.

In other words, the time is ripe to reinvent the infrastructure of the mutual fund industry.

Infrastructure is word which is rich is negative connotations for people in business.

Infrastructure is often provided by the government.

It is more difficult to prevent actual or potential customers from using an infrastructure for free.

Worst of all, the value created by infrastructures is hard for private companies to appropriate.

But we think like this only because we have approached the question of infrastructure from the point of view of what it provides.

And not from the point of view of what it makes possible.

So we fret about who owns it.

What services it provides.

Whether it is a monopoly.

Or a member of an oligopoly.

If so, whether it will put its prices up.

Whether we will have to use it.

Who can access its services.

And whether we should restrict its membership to people like us.

In short, we have seen infrastructure from the supply-side perspective only: our goal has been to prevent it exploiting us, or competing with us.

As a transfer agent put it to me in Luxembourg a couple of weeks ago: “For me, an infrastructure means you are not competing with the company that provides the value out of that infrastructure.”

But see what happens if you take that argument seriously.

Ask not what an infrastructure will do to your business.

Ask instead what an infrastructure might make it possible for your business to do.

What happens if we see infrastructure not as an end to competition.

But as the beginning of forms of competition that would be impossible without it?

On this view, infrastructure becomes a shared means to many (competitive) ends.

Think, for example, what resources a shared fund distribution utility might free up for more valuable purposes.

It could maintain a register of fund holders.

Open and operate beneficial owner, end-user accounts.

Centralize order flows.

Automate and standardize reference data, transfers, and commission payments.

Provide asset-servicing, such as income collection and distribution.

Above all, such a utility could settle subscriptions and redemptions on a gross basis, in real-time, in central bank money.{4}

That would free up tens of millions of euros in liquidity savings alone.

The utility could provide KDD, KYC and KYCC services.

If it used blockchain technology, the utility might even obviate the need for such crude measures as maintaining long lists and blacklists of people and companies to check.


Frankly, I would be surprised if an audience of transfer agents thought it was a good idea to build what many of you will recognize as a fund CSD.

And there is an easy way to dispose of it.

This is to refer it to an industry committee or working group.

On a recent visit to the ALFI web site, I came across a list of 4 forums, 9 technical committees, 47 steering committees, and 63 working groups.

I see the Irish Funds Association has a mere 7 steering committees directing the efforts of 37 working groups.

The industry itself grows committees.

In London the Investment Association runs 34 standing committees, most of which appoint task and working groups under them.

The industry itself spawns more of its own.

We have the Findel Group.

And now the Gaia Group.

But committees do not just proliferate.

They seek consensus.

Committees seek compromise.

In this case, they are more likely to spend their time working out how keep the present incumbents in business than they are to embrace a future whose inhabitants are unknown.

It is not difficult to predict that an industry committee will predict that some fund managers will stick with the present system, while others will opt for a funds CSD.

Because that is what is happening already.

In other words, a committee will never fail to fulfil its own expectation that things will remain the same.

In my view, that is serious mistake.

But you do not have to take my word for it.

Listen to a payments banker.

He works in an industry where the adoption of a shared infrastructure is proceeding much further and much faster in its impact on the industry.


Start, as Mark Buitenhek says, thinking like customers, not suppliers.

Steve Jobs famously said the same thing about technology: the customers drive the technology, not the technology the customers.

Charles Handy thought much the same, 25 years ago.

And he was a fan of another great management thinker, who said exactly the same thing, 60 years ago.

What Mark Buitenhek, Steve Jobs, Charles Handy and Peter Drucker are telling us is this.

Do not think of infrastructure as a supplier.

Think of it as a customer would think of it.

Do not use infrastructure the wrong way: to preserve the status quo, exclude competitors, or cut prices or costs.

Use it the right way.

And the right way to use infrastructure is to increase the possibilities and the options for your customers.

It is easy to think that indexed funds and ETFs are not a mortal threat to the mutual fund industry.

But an ageing population needs cost-efficient investment products.

The Millenials paying their parents’ pensions need them even more - and they are not going to buy them the old-fashioned way or at old-fashioned prices.

And indexed products –m including ETFs – are the default option for on-line platforms and robo advisers to sell to their clients.

This industry needs products that have lower expense ratios - whether they are indexed or not.

The American experience shows that investors are gravitating towards them already.

The Lipper data indicates that something similar is starting to happen in Europe too.

In Europe, institutional investors are starting to attack closet index managers directly.

Robo-advice can only accelerate this trend.

So if you are going to continue to make money, you need to change.

And an infrastructure can help you do that.

Deloitte reckoned the Luxembourg funds industry would save €900 million a year by mutualizing distribution services alone.


In the end, we have a choice.

We can waste a lot of time, effort and money resisting change.

Or we can welcome it, and steer it in directions that create value for us, our shareholders and our customers.

We can be corporate bureaucrats.

Or we can be risk-takers.

They say that science proceeds by conjecture.

So business makes its breakthroughs by the taking of risks.

And risk is the right word: doing something different inevitably entails the risk of making a mistake.

There is no other way.

An industry is robust and successful precisely to the extent that the individual businesses that make it up are fragile.

So be bold.

Whatever the physicists tell us, relative to us in this time and this place, the past is fixed but the future is open.

And the future is not like the past.

But it is not inevitable either.

We have choices – and the ends of those choices are open.

All the leaders of this industry need is the imagination to seize them.

Dominic Hobson

{1}.Deloitte and FundSquare, Europe’s fund expenses at a crossroads: The benefits of mutualizing the cost of distribution, July 2015. This covers order routing, transfers, asset servicing, cash processing, KYC, KYD, data and document distribution, and errors and reconciliations.

{2}.PWC (2014), “Asset Management 2020: A Brave New World”.

{3}.$6 trillion.

{4}.The Deloitte FundSquare paper envisages netting via a centralized cash compensation account.