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Changing the Custodial Dynamic

Please tell me what you think about paying your custodian directly for the services it provides, rather than having the money come out of client accounts through various vectors.

Last week, in my Media Reviews service, I reviewed a provocative column by Michael Kitces in this month’s issue of Financial Planning magazine.  Kitces pointed out something that I’ve noted at various times over the years: the custodians and the financial planners they serve are not very well-aligned in their interests.  Custodians make their money, Kitces noted, from the (often high) expense ratio in client cash and sweep accounts, and via ticket charges.  Custodians collect sub-TA fees from most mutual funds, ranging from 5-15 basis points on client assets, and NTF funds pay more.

Fiduciary advisors, of course, try to minimize their clients’ exposure to the 50 basis point charges by keeping as little as possible in the cash accounts.  They try to trade as little as possible, and are avoiding the sub-transfer account fees by building client portfolios using ETFs and the funds of companies like Vanguard and DFA.  They basically do everything they can to make their custodial relationship as unprofitable as possible.

Another source of custodial revenue, which Kitces did not talk about, is commissions and interest from (short-term) lending client share positions to short sellers.  I had originally thought that custodians could only lend shares held in margin accounts, but after doing some online research, I’m beginning to think that client custodial agreements often contain provisions saying those investment holdings could be lent at the custodian’s discretion.  This is not well-understood and well-disclosed, and nobody seems to know how much revenues it provides to the custodians.

I looked up the public filings of Charles Schwab & Co. and TD Ameritrade to see if I could find out how lucrative this activity is for them, but these revenues seem to be lumped under “net interest revenue” on both balance sheets—and there seems to be a lot of different items that contribute to that number, including margin loans and interest on cash and sweep accounts.  (At the bottom, I’ve included what appears to be the description of these activities in the custodial quarterly filings.)

The custodial platforms are providing valuable technology and services to advisors.  It is in the best interests of advisors that they maintain and improve their tech platforms—right?  By following their fiduciary obligation to minimize client costs, advisors are also reducing custodial revenues—and, theoretically, at least, the resources that would be used to build and maintain those tech platforms.  As I said, as Kitces pointed out, this represents a growing misalignment of interests.

The solution Kitces proposes is simple: instead of charging those various fees, custodians could simply charge the advisor an asset-based fee.  This fee could be roughly equivalent to what the advisor’s clients are paying now.  He proposes 10 basis points for smaller advisory firms, with tiers that would take this down to 7%, 5% or 3% for firms with more client assets.  These are admittedly arbitrary numbers, and any actual shift of this magnitude would require a closer analysis of how much money custodians are actually making on advisory firms of different sizes.

Here’s the point:  Several advisors sent me messages about my writeup of this column, some supporting the idea, some opposing.  It seems to me that if the new costs were closely aligned with the old ones, then the biggest difference would be: advisory firms would be paying these fees out of their own pockets, rather than having your clients (largely unknowingly) pay for the custodial conveniences that your firm now enjoys.  This would squeeze advisor margins by whatever that amount turns out to be—10 basis points, 7, 5 or 3.

Given the polar opposites of the reactions I’ve gotten so far, I’m curious what you think about this proposal.  Consider this a straw poll for the custodians who are considering a direct fee for their custodial and technology services.

First, do you support Kitces’ proposal to pay direct custodial fees on behalf of your firm and your clients, and eliminate the various other charges that are currently being assessed?

Second, how well do you actually understand the fees that are currently being charged?  Do you know what custodians are making on the fees your clients are paying, all-in, each year?  (Adding, of course, any securities lending revenues.)

Simple yes, no, not much, pretty well would be fine—and, of course, anything you have to add to the conversation is welcomed.

Note:  I promised earlier that I’d share what appear to be the custodial descriptions of client share lending activities.

This is what it says in TDA’s most recent disclosure:

Net interest revenue increased 90% to $332 million due to a 64% increase in average client margin balances, primarily due to the Scottrade acquisition, increases in the average yields earned on client margin balances, segregated cash and other cash and interest-earning investments as a result of the federal funds rate increases during fiscal 2017 and 2018, as described above, and a $21 million increase in net interest revenue from our securities borrowing/lending program.

And later:

We manage risks associated with our securities lending and borrowing activities by requiring credit approvals for counterparties, by monitoring the market value of securities loaned and collateral values for securities borrowed on a

daily basis and requiring additional cash as collateral for securities loaned or return of collateral for securities borrowed when necessary, and by participating in a risk-sharing program offered through the Options Clearing Corporation.

And in Schwab’s:

Interest revenue is recognized as earned on interest-earning assets such as cash and cash equivalents, cash and investments segregated, receivables from brokerage clients, investment securities, and bank loans. Interest revenue from these assets is based upon average or daily balances and the applicable interest rates. Interest revenue is also recognized from securities lending activities when earned based upon the securities and amounts lent and the applicable rates.

And later:

Securities lending: Schwab loans brokerage client securities temporarily to other brokers and clearing houses in connection with its securities lending activities and receives cash as collateral for the securities loaned. Increases in security prices may cause the fair value of the securities loaned to exceed the amount of cash received as collateral. In the event the counterparty to these transactions does not return the loaned securities or provide additional cash collateral, we may be exposed to the risk of acquiring the securities at prevailing market prices in order to satisfy our client obligations. Schwab mitigates this risk by requiring credit approvals for counterparties, monitoring the fair value of securities loaned, and requiring additional cash as collateral when necessary. We also borrow securities from other broker-dealers to fulfill short sales by brokerage clients and deliver cash to the lender in exchange for the securities. The fair value of these borrowed securities was $215 million and $213 million at December 31, 2017 and 2016, respectively. All of our securities lending transactions are through a program with a clearing organization, which guarantees the return of cash to us and is subject to enforceable master netting arrangements with other broker-dealers; however, we do not net securities lending transactions. Therefore, the securities loaned and securities borrowed are presented gross in the consolidated balance sheets.

Thanks—sincerely—for participating in this little survey.  I think it may be significant.


Bob Veres
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