Also available as podcast (Episode #36)
How does an RIA custodian generate revenue?
The typical arrangement in the Registered Investment Advisor (RIA) model is for the RIA to receive a 100% “payout” on their advisory fees. This then begs the question though….if the RIA is receiving 100% of the client fees being generated, how does the custodian itself generate revenue? While there are in theory a variety of possible revenue drivers, the largest three sources of revenue are interest rate spreads on cash holdings and lending (margin, non-purpose loans, etc), transaction revenues, and mutual fund revenues. As to what level of revenue any particular RIA might derive for a custodian is highly dependent on the specifics of that particular RIA and their business profile.
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How does an RIA custodian generate revenue? That is today’s question on the Transition To RIA question and answer series. It is question #36.
Today’s question is, how does a custodian generate revenue? I get asked this all the time, and it’s usually the second part of…the first part of the question is, is the payout that I would receive as an advisor really 100%? I’ll end up doing a whole separate video on that, but the short answer is yes.
As an advisor in the RIA model, you keep 100% of your advisory fee. So in theory, the “payout” is 100% back to you as the RIA. That then leads to the next question…. “well if I’m the advisor, if I’m keeping 100% of the fee, how is the custodian generating revenue? There must be some catch here??”
That’s a common question, and I completely understand, and I explain this all the time. I’m more than happy to have a one-on-one conversation about it as well if you’d like, but I did want to do a video because it does come up so frequently. And I’d tell you, this is near and dear to my heart, I spent many years working at a custodian, literally running the budget for the custodian. So I’m well aware of exactly how a custodian generates revenue. And I’ve had this conversation for years to help advisors understand how it works.
I would tell you, one thing to think about, and we’re going to go through each of these revenue sources so you can kind of understand them – and it is not like 20, don’t worry. But the main thing to think about is, compared to a broker-dealer environment where as a broker-dealer they have to provide supervision, oversight over you as an advisor, they have to provide this massive compliance apparatus, all kinds of other factors that just aren’t relevant in the custodial model, where the custodian does not supervise you as an RIA. The custodian does not do your compliance.
So as we go through these, the thing I always point out to folks is, yes, a custodian…well, we’ll take an example. Say an advisor has $200 million in assets, and they’re sitting, maybe in a custodial model, or they’re sitting in a more traditional broker-dealer model with one of the large firms. For that same $200 million, the broker-dealer will bring in significantly more revenue, top line revenue, because they’re taking, among other things, a big payout on the fees and commissions you are generating.
So they bring in a lot more revenue than on that same $200 million that the custodian would bring in. However, the broker-dealer model also has significantly more embedded costs, again, things like supervision, things like compliance. These large firms have armies of people, hundreds of people that they have to pay to do all of these things. And so while that broker-dealer model brings in on that same $200 million in assets on their platform a lot more top line revenue, they also have a lot more expenses that a custodian simply doesn’t have.
Even though a custodian brings in a lot less top line revenue, again, they take away a big piece of that cost structure that is just not applicable to them, that is in the broker-dealer world. So it’s not to say that at the end of the day their net incomes are the same, but just to give you a framework of how it does work that a custodian, yes, understandably, brings in less revenue. But again, their cost structure to provide the service to RIAs is significantly less, because again, they don’t have a lot of these responsibilities that a broker-dealer has.
Related to that, as we get into this and I go through these, I would just remind you, as an RIA, you will be working with a number of different vendors. You might have a compliance consultant to help you, you might have an IT person, you might have a marketing consultant. And your custodian is no different. At the end of the day, your custodian is just another vendor necessary to run an RIA. In this case, they provide custody and clearing services for the RIA. So they are a vendor. You’re not affiliated with them. They don’t hold your licenses. I’ve done a whole number of videos on being a single custodian versus multi-custodial, and how all that process works.
But the main key is the custodian is just a vendor, but you’re still…there’s still a partnership there. Even though it’s not a legal partnership, it’s not a formal partnership, you still want to make sure you’re a good partner to the other one. What I mean by that is it’s because of these economics, a custodian still needs to generate revenue. They are a for-profit company. They need to cover their costs, cover their own risk that exists with any business, and of course make a profit margin as well.
It’s always important, you have to respect that, that they do need to make money. They do need to generate revenue to reinvest back into the platforms, so the technology continues to improve, the service offering continues to improve. And, quite frankly, unless they have that revenue, they can’t reinvest that money back into it. So I think it’s just always good as an RIA to appreciate that.
That’s why nowhere on my website will you see that part of my offering is to tell you….”Oh, here is how to squeeze your custodian to death on every little fee, in every little possible way they can maybe make revenue off of you.” While I understand all the levers at play, because again, I ran a budget for many years, the reality is that’s not a good partnership, and that ultimately will not be good for you if that is how you approach your partnership with the custodians. Because quite frankly, again, they need good partners on the other side as well.
Part of it just comes back to what’s best for you. Think of two clients you have. Maybe the same size clients, each of them have a million dollars. And one client really values what you’re providing for them. Understands that you have members of your team you have to pay for. You have your office and you want to reinvest in the business, and you do need to generate a reasonable return as a professional to provide that service. They value what you’re providing them and the fee you charge.
Then you might have a similar size client that doesn’t appreciate all that and just wants to squeeze you, and squeeze you, and squeeze you on your fee. And two things could happen. One, it might get to the point where you no longer want do business with that client. You just say….”Okay, if you don’t see the value of what I’m providing, I’m not going to keep discounting your fee every time you ask.”
Or the second thing is, even if you discounted some or maybe a lot, think about the next time if both of those clients were to call in and maybe leave a message, and you get those messages simultaneously. Who are you going to get back to first? The client that really appreciates your value and is not trying to nickel and dime you, or the client that is just constantly trying to essentially shake you down on your fees?
Now, I’m not suggesting you shouldn’t be conscientious of the fees and everything that you pay and make sure that you’re getting a competitive arrangement. That’s part of what I help advisors with is let’s make sure this is competitive. But I would encourage you, think of it as a partnership.
Yes, a custodian needs to meet you in the middle. You’re not having to swing one way or all the other way. You both have to be in the middle, and make sure it’s mutually workable for both of you. And as we go through these, and at the end, I’ll talk about kind of what I think the future brings. You’ll see how that dynamic is kind of changing.
With that I want to talk about the revenue sources. There’s primarily three main ways a custodian makes money or generates revenue. And then there’s some other smaller auxiliary stuff that are quite frankly, in aggregate, are not big enough to necessarily line item in this conversation. Because again, these big three cover so much of it. And so I did want to go through each of these.
The first one, and I kind of lumped these together, is cash and lending. We’ll kind of split those out. No doubt, a significant way a custodian generates revenue is on the spread of free cash that’s sitting in an account. When your client has cash and it sweeps somewhere, typically the model nowadays, most custodians enable or have it where it sweeps to perhaps a bank that is owned by the custodian. And for that, the client gets an interest rate. The bank then takes that cash that they’re now paying the client an interest rate to have access to it, and then goes and lends it out for a higher interest rate. That of course is the spread.
This is a significant way that custodians make money is on the spread on free cash. And you can think….”Well, how much cash do I really have in accounts?” But the reality is, when…and it’s usually a single digit percentage amount in any given cash, any given account, but sometimes if you’re maybe being defensive or tactical with the market, sometimes I’ve seen it go 20%, 30% in an account.
And even the advisor that I have tell me….”I don’t keep any cash in accounts.” Well, there’s always some cash. There’s always something that’s paying off a dividend. Or maybe it’s a bond that has matured and it’s paid off, and it hasn’t been reinvested just yet. So there is always some cash, not to mention you need cash in the account to cover your advisory fee as it comes through. So there’s always some cash. And in aggregate, when you take millions of accounts in all these little cash balances – sometimes little, sometimes large – and add it up, that is billions of dollars….tens of billions of dollars that the custodians make the spread on.
That’s a primary way a custodian generates revenue. I don’t want to talk just yet about what the future brings, but that has really gotten squeezed because those interest rates have come down here recently, and so the spread they can make on that has come down as well. That is a meaningful challenge that custodians are having as a result of that. I’ll touch on at the end of this kind of what I think the future brings as a result of that.
Then the other part is lending. That would be things like margin loans, non-purpose loans, some firms call them securities-based lending. Where your client wants that typical margin loan, that is good business for a custodian to loan them at whatever that market rate amount is, and obviously they’re making a spread there on their cost of capital for the cash that now they’re extending to the client and the interest rates they’re charging. And so, again, those are two big primary drivers of revenue for a custodian.
Now there’s nothing at all wrong with that. I’m not implying that there’s anything, any reason a custodian shouldn’t make revenue that way, but just know that is a typical way. In most instances, that is the primary way that custodians generate revenue is that cash holding and then the lending piece.
The second of the big three revenue sources that I want to go over is transaction pricing. I’ve done a whole number of videos on this about who pays the transaction prices. Is it the RIA? And this is…I’m referring to every time a trade is made, and there could be a transaction charge attached to that, does the RIA pay for it? Does the client pay for it? I’ve talked about no transaction fee programs. I’ve made all kinds of videos on that if you want to dive into those more to understand them better.
This part of the revenue source is certainly evolving right now for custodians. If you go back 12 and certainly 24 months, a typical arrangement at almost every custodian was every time, for the most part, except for maybe with mutual funds – like I said, I did a whole video on no transaction fee platforms, which are primarily mutual fund platforms – but back call it 24 months ago, every time a trade was done, like on an equity or an ETF, there was a transaction charge.
Depending on your size and your relationship with the custodian, it could have been maybe $5, $6, $7, $8, $9, $10, something like that. Every time there’s a buy, every time there’s a sell, it would do a transaction charge. Fast forward though, the world has changed quite a bit and a lot of custodians, not all, but a lot of custodians have now gone down to zero on those transaction charges.
To the degree they still exist – and I’ll touch on this here in a little bit why some custodians do still have transaction charges – whether they still exist or they exist generally on mutual funds still to this day, there’s certain scenarios where mutual funds you will pay a transaction charge on, that is a revenue source for custodians. And again, you think….”Well, that’s $6 a trade” (for an equity trade). But you multiply that by tens of thousands of trades, perhaps a day, and then it obviously adds up and generates revenue.
Then alongside that, there’s kind of a movement – and this is part of what I’ll touch on about what I think the future might hold, is this idea that I did a whole video on transaction-based pricing versus asset-based pricing. But this concept of asset-based pricing, ABP some people refer to it as, is the idea that as opposed to paying a per transaction charge of $7 here, or $7 there, or $20 for a mutual fund, whatever, that it’s just charged as a basis points fee. It could vary, but easy numbers, let’s say it was three basis points. And for that, that is the charge to the account, but then there’s no transaction charges at all. So the degree that any RIAs are working with a custodian in that capacity, that again is a revenue source kind of tied in with transaction charges.
I’d remind you here right in the middle of this, that this is a large part of what I help advisors with. Because there’s so many nuances here, I’m giving a very broad overview of how this works. But as for whether you specifically might enter into an arrangement and use transaction pricing, or asset-based pricing, or whatever the case may be, that’s why having a one-on-one consultation with me is so helpful because every advisor’s situation is different. I can only speak high level on this kind of video here to say….”this is generally how it works.” But ultimately, all you care about is how would it work for you. And so I do encourage you to reach out to contact me. I’ll mention at the end how to do that. And we can talk about your specific scenario and exactly which of these levers would or would not be applicable to you.
Then the third revenue source, and this is getting squeezed as well, is revenues that are generated from mutual fund holdings. If you don’t use any mutual funds at all, this is not even applicable to you. If you do use mutual funds, there’s two kind of main ways that a custodian generates revenue from that.
First, and this is really phasing out, but if you hold mutual funds that pay a 12b-1 fee in a custodial relationship, that 12b-1 fee is technically a commission. And as an RIA, at least with respect to your relationship with a custodian, you cannot receive commissions as an RIA. Now, I did do a whole separate video on how you can still do commission business on the side separate from the RIA. If you want to dig into that, go watch that whole question and answer. But with respect to a mutual fund in the advisory account, if it pays a 12b-1, the custodian retains that. That does not get remitted onto you…whether partially, or in full, or anything. You do not get it, the custodian retains it.
Now, the reality is we’re moving to a world where in the RIA-custodian relationship, less and less holdings are still in a mutual fund share class that does pay a 12b-1. But to the degree it does exist, the custodian retains that.
Then the other thing is when there’s a mutual fund, many mutual funds pay back to the custodian – there’s different terminology for it, “revenue share” is kind of the generic reference to it. And basically, that’s (usually) basis points of the holdings that the custodian has of…if mutual fund company X, collectively all the RIAs using that custodian have $5 billion in that, the mutual fund company pays back X basis points to the custodian on that holding amount.
For that, there’s a whole host of things that are provided for the mutual fund company in return as to why they would do that. One is just, quite frankly, it enables their mutual fund to be available on the platform. Two, it could put them on the no transaction fee program. Again, I did a whole separate video on that. Often, custodians will also do record-keeping, omnibus type record-keeping things for a mutual fund. And there is a cost to the custodian to provide that service, so they need to be compensated for doing that. So, to the degree an RIA holds mutual funds, again there’s some revenue sources there for the custodian as well that comes in.
So those are the big three. Again, cash/lending, I kind of lumped them together, transaction-type revenues, and then revenues generated from mutual fund holdings. And like I said, there are some other smaller auxiliary sources that could come up, that could generate revenue.
I would repeat though, a lot has changed. A lot has changed for the custodians with each of these three sources. If you think about it, the cash and lending, interest rates have plummeted. That spreads on both of these have come way down. Transaction pricing, a lot of situations now have zero transaction pricing where there used to be something. And then the last, even mutual funds, again, there used to be a time where almost every share class paid a 12b-1, and the custodian was able to retain that. Now, fewer and fewer pay that 12b-1 that the custodians can retain.
So just know that a lot has changed. It’s an evolving industry. Again, that’s something I help advisors with, to know what they can expect now, what they could perhaps expect in the future. I think it will continue to change, and certain things will reverse. Hopefully, interest rates, at some point, are kind of more normalized, and that provides more of a cushion.
Again, keep in mind the custodians need to generate revenue to cover their cost, to reinvest in their platform, to make it better for you, to increase and improve their service offer. So sympathize with them. They do need to generate revenue to provide you a good platform. And that’s why the custodian game is such a game of scale. These revenue sources need to add up to a fair amount of money to reinvest in that platform.
Something I would point out, and then I’m going to end on kind of what I think the future will bring, I have heard some criticism from people who are perhaps in a wirehouse firm or something like that – and certainly if they are management at the wirehouse firm – they love pointing this out, or attempting to point out, and they’ll say….”Wow, those custodians are getting squeezed over there. They’re getting squeezed on that cash, that’s such a big revenue driver for them. And now they’ve shot themselves in the foot, as they’ve gone to zero on transaction charges. So, hey advisors, if you go over to that RIA space, it’s going to change. They’re going to find some way to increase fees on you and things like that.”
I find it comical that anyone in a more, kind of a large brokerage firm would point that out, because the reality is that they need to look in the mirror. All of these same revenue sources are also applicable in the large wirehouse brokerage firm model as well. They make money on cash spreads. They make money on lending. They used to make money on transaction charges. Now most of that is…there’s no transaction charges in a fee-based account, or ticket charges, or whatever you want to call them. They’re getting squeezed on the mutual fund revenues as well.
So to the degree they want to say….”Oh these guys over here (the custodians), they’re going to have to change.” No, trust me, as long as interest rates stay low, at some point, the large firms themselves are going to have to find a way to generate new revenue. Their shareholders are not just going to accept smaller margins.
So, at some point, they’re either going to have to find a way to increase revenues or decrease cost. And I’ll let you do the math on one way to decrease cost is to squeeze the payout. That’s why you see comp plans perhaps always being changed. That revenue has to be made up somehow, or that income has to be made up somehow. If revenue is going to come down, expenses have to come down.
No one is immune in this industry, no matter what model you’re in, to these factors at play. So if anyone ever says….”Oh, this model is going to get hurt more than this model,” that’s not at all the case. The question is…and what I would challenge you to think is, if lower interest rates are going to cause changes to happen, where will you have the most control to adapt to it? If interest rates are going to ultimately make it harder to generate certain levels of revenue in this model or this model, well, if this model’s more flexible on what you can do to try to overcome that or build out or grow faster than this one, I would say you have to consider whether that’s a reason to be looking at maybe a different path.
So, just know if…again, if you hear criticism from one model to the other, no one is immune to some of these challenges here at the marketplace.
Then to wrap up, what do I think the future brings? Now, I would tell you that’s a hard one. If you had asked me that 24 months ago, would I thought that today we’d have, in many instances, zero transaction charges, or interest rates have now plummeted back to historical lows? So, certainly it’s hard to predict the future. I do think interest rates, hopefully at some point, will come back to a more normalized level. That releases some of the pressure, the revenue generating pressure on all firms, and certainly custodians are part of that.
I think custodians will also start to get innovative. We are seeing that now. Some firms do still charge transaction charges, and the reason for that is there are some firms that are saying….”We get there’s a movement to zero (transaction charges), but we want to maybe give you a choice.” As everything has a trade off.
I’ll give you an example. Typically, when you’re working with a custodian, if you’re going to have zero transaction charges, you’re not going to have much control for where that cash sweep goes. That will usually go to an in-house bank sweep arrangement. Which to be certain, can be good for the client. Make no doubt, they get FDIC insurance. Usually it’s even kind of a balloon FDIC insurance and things like that. So it’s certainly good for the client, but obviously it helps the custodian as well.
It’s like….“Hey, RIA, if you don’t want transaction charges, well, we’re going to make it so the only option of where the sweep goes is over here to this option.” Or maybe sweep options right now – it’s kind of a moot point because interest rates are so low – but maybe sweep options are important, and you actually want to have a number of choices of where your client’s cash could sweep to. “Okay, well RIA, if that’s what you want, we can do that, but because we as the custodian will now generate perhaps less revenue on some of that, in turn we have to now charge you, or retain the transaction charges on that.”
Everything has a trade off. If you want one thing to go to zero, the other thing can’t go to zero. I think you will see custodians continue to evolve here, going forward, of how they price things. Will they charge… Michael Kitces is a fan of – I don’t want to put words in his mouth, but as I understand his vision for it – custodians should just charge an asset-based fee, and that gives you zero transaction charges, there’s no mutual fund revenue share, you can sweep to (for example) 20 different places, all in return for just this one fee.
Who knows, maybe that’s where the future leads us to. There are challenges to that as well though because that’s not historically how it’s been done. To adapt into a model like that is quite challenging for everyone involved.
I think the reality is it will continue to evolve, but do not fear that because again, in the RIA model, you ultimately – and I’m biased, I’m a strong believer in this model – but in this model is where you are going to have the most control of how you manage your business, how you manage your P&L and all of that.
The entire industry will absolutely change over time. The question is, where will you have most control to adapt to what is most favorable to you? I would argue, or challenge you to consider where you are now, wherever that might be, and what the other options are, might there be a difference, and at least to the degree you don’t know the difference? As I say, look over the fence and see if the grass is greener on the other side or not. Maybe it’s not, but I think it’s important to at least understand how that works.
With that, like I said, I’m Brad Wales with Transition To RIA, and this is the exact sort of thing I help advisors understand. For advisors that want to transition into the model, whether to start their own RIA, maybe join an existing RIA, that custodial relationship is a big part of that.
It’s important to understand how it works, and again, what that partnership is. Because again, I can’t stress enough, you do want it to be a partnership. You can’t go and just squeeze a custodian and expect them to be able to provide you the service and support that you need to be successful. It’s a matter of meeting in the middle. Part of what I do is help advisors understand….”What’s a reasonable middle ground with that?”
If you’re not already there, head on over to TransitionToRIA.com. I have plenty more videos, podcasts, whitepapers, all kinds of things to help you explore this model further. And then the easiest way to start digging into it is at the top is a contact link. Click on that, you can instantly and easily schedule a one-on-one conversation with me and we can dive into whether it’s today’s topic, or any of the other topics related to the RIA model. I’m more than happy to have that conversation with you.
With that, I hope you found value in today’s question, and I’ll see you on the next one.
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