Q148 – How Much Does A Custodian Cost?

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Also available as podcast (Episode #148)

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How much does a custodian cost?

TL;DR – Several solution providers are needed to run a modern RIA. One of those solutions is a custodian, which provides custody of client assets and clears trades. While the RIA pays directly for most solutions it utilizes, custodians are unique because a portion, and in some instances all, of their revenue is indirectly generated from the underlying client accounts rather than directly from a fee paid by the RIA. Understanding when and how that revenue is generated is an important component for deciding which custodian(s) to use with your RIA.

Host:

Brad Wales founded Transition To RIA in 2020 after nearly 20 years of prior industry experience, including direct RIA related roles in Compliance, Finance and Business Development. He has an MBA and has held the 4, 7, 24, 63 & 65 licenses. He has been quoted or featured in 100+ industry articles including in the Wall Street Journal, Barron’s, and most every other major industry publication. He is well known for his RIA video explanatory series, and Kitces named his podcast as a “Top Podcast for Financial Advisors.”

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Full Transcription Of Video:

How much does a custodian cost? That is today’s question on the Transition To RIA question and answer series. It is episode #148.

Hi, I’m Brad Wales with Transition To RIA where we help you understand everything there is to know about why and how to transition your practice to the RIA model.

If you’re not already there, head to TransitionToRIA.com where you’ll find this entire series in video format, podcast format. There are articles, there are whitepapers. A Vendor Profile Series. All kinds of things to help you better understand the model.

Again, TransitionToRIA.com.

On today’s episode we’re going to talk about what is the cost of using a custodian?

As a quick primer, reminder for some folks who it might be the first time you’re hearing this and understanding this….what is a custodian?

Whether you are starting your own RIA or you are joining an RIA, a custodian will be applicable in both cases, presuming that part of your service, your value prop, to your clients is to manage their assets. You will need a custodian if that is the case.

So, specifically what is that?

Let’s say you start your own RIA. You will have your own RIA. You will perhaps, if this is part of your value proposition, manage the client’s assets. There are several different ways to do that. Perhaps you create your own portfolios or your own models, or maybe you use third parties like separately managed accounts.

But either way, you are helping to manage that client’s assets. Well, those assets need to be held somewhere. And so those assets are held at what is referred to as a custodian.

And by design, in most all instances, the RIA is separate from the custodian. And that is in part because providing custodial services is a giant undertaking that requires enormous scale. There are all kinds of regulatory challenges to be able to provide custody to client assets.

And so the typical approach is when you go and start an RIA, and you’re putting together all the different pieces like technology, E&O, marketing, and all the things I talk about on these episodes, well, one of those things you need to put together is, who am I going to use as my custodian to hold my client assets? Which for some of you, over time, that might even involve more than one custodian.

But typically as part of a transition, you’re starting with at least one custodian. And again, by design, these are separate from the RIA itself. These custodians in the marketplace are highly capitalized, highly regulated entities. Some of them even hold trillions of dollars in client assets.

A big decision in this process is which custodian you should use with your RIA. That’s a big part of what I help advisors figure out is why they might choose one custodian over another.

As part of your analysis of those custodians, you will want to understand what the cost of using a custodian is.

I would start by pointing out a unique aspect to the custodial part of the pie. If you are starting your own RIA, at its most basic level, that’s an exercise in saying… “we’re going to start the RIA, we’re going to build out a set of necessary solution providers, vendors, whatever we want to call them, around it to provide certain services that are necessary to run a modern day RIA.”

Again, that’s things like technology, that’s things like E&O, that might be managed IT support. A custodian is one of those pieces.

Now, unique to the custodian is, unlike everything else that’s essentially on that list of vendors that you need to put together, the RIA pays for those services directly to that vendor. So for instance, if you have a CRM as part of your tech stack, you are going out in the marketplace looking at the available CRM solutions, deciding on one, signing up with them, and you pay them, generally an ongoing fee, for use of their CRM tool.

Same thing with all the other pieces that you put together, with one exception. The main exception to that is the custodial piece.

Historically, and I’m going to get into all the variables that go into this, custodial services have not had a direct cost to the RIA. The custodian instead, they are compensated for the services they are providing, for providing custody of the client assets, clearing trades, creating statements, all the things that they must do as a custodian, they are paid indirectly by the client.

I’m going to get into what I mean by that. And so it is a unique element to this that everything else you pay directly by the RIA, but in most cases nowadays, there’s some nuances to it, which I’ll get into as well, the RIA is not paying directly the custodian for the services that are being provided.

That’s in part because decades ago, where this kind of new model was established, well, the RIA model has been around since 1940, but more in its modern day version, modern meaning at least last several decades. That’s just how the relationship started decades ago between an RIA and custodian in this indirect way of how the custodian is compensated, and that has just stuck, and it is still primarily done that way today.

There’s no other explanation for why everything else needs to be paid directly by the RIA and not the custodian except for the old cliche saying because “that’s how it’s always been done,” and that is just factually correct.

A couple elements related to this.

First, well then what’s the catch if I as the RIA am not paying for the custodian directly and supposedly the client’s indirectly paying for it? How exactly does that work? Is the client having to pay a fee or what does that look like?

In most cases, at least in the client’s impression, it doesn’t even look like a direct fee, although there are some cases where that might come into place.

But to give you a couple examples of how a custodian generates revenue, and I did a whole different episode on this if you want to dive into it even further, and again, this is how the custodian is compensated.

So, I want to go through a couple of those.

First, which is by far the biggest revenue driver for a custodian in this relationship is where they make a spread on the cash sweep.

You have your clients in accounts, and while you might keep them relatively fully invested or even if you think…. when we hold cash in the account, we buy into money market funds perhaps, but the reality is there’s always some amount of cash sitting in an account. For if nothing else because some of the positions in the account are paying dividends perhaps, or there are fixed income bonds that are maturing and that’s going into cash and hasn’t been reinvested yet. Among other things, you need to have cash in the account for your fee, each perhaps quarter, whatever frequency you do it on.

So there always is some amount of cash in an account that most custodians will, as they say, “sweep” that money into an interest bearing vehicle for the client’s benefit. So…. “hey client, as opposed to that cash just sitting there not generating any return, we will sweep it here into an interest bearing vehicle that will pay you some interest.”

Now, to be clear, this is what all the major broker-dealers do as well. This is very common to have swept cash. But in the case of the custodian, they sweep that cash, they pay the client a certain amount of basis points on it, they then take those assets and put that back to work, lending those assets back out in different ways at a higher interest rate than they’re paying the client and they make the spread on that swept cash.

Now you might think, is that really that big of a revenue driver? Because hey, maybe you personally keep very little cash in the account. And again, there’s always some cash. But the reality is consider how particularly the larger custodians in the marketplace have trillions, with a T, trillions in aggregate client assets on their platform. So if you just take even a small single digit percent of trillions of dollars, multiple trillions, and then you can make a spread on that, that does generate meaningful revenue.

That is by far the number one way is with cash sweep spreads that they generate.

And then just some of the other ways, I won’t go into these as extensively because like I said I did a whole different episode, but a custodian also makes money off of if you utilize margin in the account. That’s a good revenue source for a custodian.

There’s also at times payment for order flow, whereby directing trades to a market maker, they get essentially a small, very tiny per share revenue back to the firm. That’s very common across the entire industry as well. Broker-dealers, RIAs, or custodians, all the different models. But that generates some revenue.

Next, there is also some instances of transaction revenue that a custodian makes.

For those that have been in the space for long enough would know this, but if you go back and we’re now coming up on five, six, seven year time period, there was a time, let’s go back then, that part of the way a custodian, one of the main revenue drivers, was every time a transaction was done in a client’s account by the RIA, the RIA managing those assets, there was a transaction charge to facilitate that.

That was not a commission that went to the advisor or the RIA, that’s a transaction charge that the custodian generated to facilitate that trade. None of that is shared with the RIA. That is solely for, again, for the custodian for providing that service.

Well, about six, seven, eight years ago, in almost every instance, there was a transaction charge. You want to do an equity trade, there’s a transaction charge. You want to do a fixed income trade, there’s a transaction charge.

That changed about six, seven years ago now, where now in most instances, a lot of those transaction charges have gone away. In most instances on equity trades, there is no transaction charge. On ETF trades, which ETF by nature are an equity, there is no transaction charges. A lot of mutual funds are now transacted, and they were previous as well to a degree, but without a transaction charge.

A lot of that has now gone away, but not all of it. There are generally still some scenarios where transaction charges occur. That could be option trades, fixed income trades, again some mutual funds depending on the share class of the fund family.

So there are still transaction charges applicable that at times generate a custodian revenue. But again, it’s far less than what it once was.

And then the last two examples of the indirect way clients are generating revenue for custodian, if you use mutual funds in your client’s account, the custodian in most instances receives from those mutual fund companies what’s often referred to as “revenue share.” The fund family pays the custodian essentially for shelf space, if you will, for being on the platform.

That is common in every broker-dealer scenario pretty much as well, so that’s not unique to just custodians. That’s across the industry, but that is another revenue generator as well, to the degree mutual funds are used and there’s all kinds of nuances when or where that might not apply because of share classes or fund families, but there is some revenue.

This has not been an exhaustive list of ways custodians generate revenue, as there are a couple other more auxiliary ways that custodians could generate revenue as well.

But my point for saying all that is that’s why essentially in most cases the RIA is not paying for custodial services directly as the RIA paying some sort of fee to the custodian. Because the custodians generate revenue via these indirect sources that essentially the client is paying for because whether they’re holding cash in the account or there’s a transaction that does generate a transaction charge. So the client is effectively paying those fees although it doesn’t necessarily show up on any statement as a client fee or custodial fee that that client is paying.

So I did want to start by giving you that little background of historically how this has worked, why as an RIA you’re oftentimes not paying for it. But custodians are not a charity, they are for-profit. They do generate revenue from primarily the sources I just listed.

I talked about as an example, six, seven years ago it was different with respect to transaction charges and it’s now a different arrangement with that. That is an example that no matter what the arrangement is today, just as that changed, transaction charges, we don’t know what the future could hold as well. So I want to give you an idea of some of the trends I’m seeing now and what might come about in the future as well.

There are some custodians now that even with all of those indirect sources I just described, will look at a potential RIA that wants to do business with them – which as a reminder, that’s a two-way street. As an RIA, you might be going out in the marketplace trying to decide what custodian, or again, one day it might be plural, custodians that you want to utilize. While at the same time, they want to make sure that you would be a good partner for them in that relationship.

I’ve done a recent episode on how to choose a custodian. I talked about there’s all kinds of variables that go into that. Some custodians might not even be available to you based on the size of your practice and some other variables.

But my point being it’s a two-way street. You are evaluating the custodian. The custodian is evaluating your practice and there are some custodians that have started to trend more into, they’ll profile your practice and they’ll try to project out these indirect revenue sources based on your practice.

How you invest client assets, are you using mutual funds, how much cash do you typically keep, are you doing transactions that might result in a transaction charge.

That sort of analysis is typical. Any custodian, when you might come to them, will try to build out a revenue projection for themselves to say, is this going to be a good relationship for us as custodian?

There’s some that are looking at that and they’ll say, okay, yes, there are those indirect ways that we generate revenue, but that’s not exceeding perhaps whatever internal bar they have set for how profitable any particular relationship needs to be.

So there are some custodians, in some instances, will assess what’s often referred to as a “custody fee.” It’s generally expressed in basis points.

They might say… “yes, there are these indirect sources, but based on the size of your practice advisor, or based on the profile of what you’re doing with those assets, we need to charge a custody fee to make sure we’re hitting our necessary revenue projections for this relationship.”

Again, that’s typically expressed in basis points. In most cases that’s single-digit basis points.

But that is something I’m currently seeing coming to play and we’ll see going forward if that is going to become more prevalent.

If a basis point charge is assessed or a custody fee is assessed the RIA generally has some flexibility on how to handle that fee. Some RIAs choose to essentially absorb that out of their top line revenue and the client basically is generally not even aware that that fee occurs.

Now, it’s disclosed in the ADV for different reasons. But the RIA has made what’s often referred to as a “wrap” account where they say to their client… “Here’s all the services we’re going to provide. We’re going to charge you 1%.”

Out of that 1%, among all the other costs that it involves to run a modern-day advisory practice, the RIA has chosen to pay that custody fee out of that, in this example, 1%.

Other times, RIAs choose to break it out and they’ll say to the client… “We charge 1% for our services, here’s all the things we will do for you in return for that 1%. We are going to hold your assets safely at a custodian. That custodian has a fee to it.”

Again, in this example, assuming there’s basis points… “that custody fee client, you will see that show up as a separate fee on your statement every quarter. You will see our fee and separately you will see a custody fee.”

I’ve seen some RIAs do it that way as well. Is it to say one is better than the other? Not necessarily. It’s just more what you feel is going to resonate best with your clients and your practice and your P&L.

Related, you might ask… why would that trend (of custodians assessing custody fees) perhaps pick up going forward?

I would point out that none of us know what the future holds in the industry. Five years from now, 10 years from now, 20 years from now. What changes will continue to occur? Change will occur. It’s just a matter of what will that change be. And might that necessitate a change to how custodians generate revenue, or are they going to charge more directly?

An example from the past are transaction charges. There was a time that generated meaningful revenue for some custodians. Well, guess what… in about 90-ish percent of the situations, that went away. And so custodians had to adapt accordingly as a result of that.

Change does happen. What change could happen five years from now, 10 years from now, it’s hard to say.

Just to give an absolute extreme example, where you say, why might what has worked for decades, this indirect way, that should just continue to work, what can possibly cause such a shift?

An extreme example would be for some reason, and I’m not anticipating this, but for some reason, if maybe regulations came out or legislation came out that said custodians, and again, broker-dealers do the exact same thing, but said… you can no longer make a spread on cash sweeps.

Now, again, I have no reason to believe that will ever happen. But just an extreme example, if that ever happened and considering how big of a revenue source that is for the custodian, something would have to adjust. They would need to make that revenue up some other way, whether it’s in basis points or other fees or whatever the case is.

Now, if that were to ever happen, and if I’m a betting man it won’t happen, but if it ever did, that won’t just disadvantage custodians. The same thing would presumably apply to broker-dealers as well. They would be in the same boat of… if we cannot generate revenue that way, we’re going to have to make it up some other way. If you’re at a broker-dealer, that will probably be lower payouts as a result.

Main point being, we don’t know what the future could hold. The idea is you want to say… “what’s going to be the best partner for me now as a custodian who has demonstrated the best track record of navigating the inevitable changes that will come along and hopefully navigating those in a way that needs to be fair to the custodian. They need to generate revenue. But is also fair to the RIAs that use the custodian.”

Last, two final thoughts.

There’s also a trend now, and I think we’ll see more of this, where custodians are providing more and more services as part of their value prop.

Historically, and even to this day, the overwhelming bulk of what a custodian provides is literally the custody and clearing of client assets. But custodians are starting to layer on more technology that the RIAs can utilize as part of that.

Traditionally, you might have had to go out to third party technology. Now they are building that into their offering. And so as a result, they’re saying… “here’s everything we’re doing for you. We are going to have basis points on here because of all this value we’re providing you.”

I think we’ll start to see more of that. Some custodians are doing that now. And you shouldn’t immediately discount that because some custodians are using that basis point approach that I talked about, that custody fee approach, but there could be reasons that that is arguably better for you and your clients than paying perhaps for technology separately.

And oftentimes when basis points are being assessed, the transaction charges I talked about, which in most instances are gone, but there’s still some, generally if you’re paying basis points, there’s no transaction charges, even with options or fixed income or whatnot.

Just like you with your own fee might over time continue to charge your client, say 1%, you might be adding more value to that over time because the competitive marketplace requires it. I think we’ll see that in the custodial space, whether those currently using basis points or they’re going to add basis points and maybe it’s an optional way to do business with them, but they’re going to provide value for that.

You want to assess… “if I need these services one way or the other, and I have to pay for these services one way the other, maybe it is best to pay it via a basis point approach.” Don’t automatically discount it if it’s priced that way.

But of course, the devil’s in the details. You want to understand what you’re getting, how that compares to the alternatives. That’s a big part of what I help folks do is understand how these different custodians compare and why you might choose one over the other, knowing there’s all these different variables out there.

And then the second point, there are voices in the marketplace that for quite a long time have looked at everything I’ve just said in this whole episode and said… “Why can’t we just make this simple? Why can’t there be a basis point fee? That’s how the custodian will get paid. And in return for that, the clients will get the highest paying sweep option available, perhaps it’s a money market. There won’t be transaction charges. There won’t be mutual fund revenue share because then we eliminate any potential bias of which mutual funds are available on the platform or not.”

There’s the voices that say… “Won’t that be simpler and cleaner for everyone involved?

Arguably, that is correct. That would be simpler and cleaner for everyone involved. The problem is we have decades of history where that’s not how it was done.

What I just described might be appealing for a new RIA launching perhaps from a wirehouse. Where everything about this is new for you and you’re understanding all the different costs and vendors that you’re going to use. That might be appealing.

But for the RIA that for years, if not decades, have not had to pay a fee directly, and for better or worse, it’s been indirectly paid by clients, it’s hard to change course when it is so embedded in the industry the way this has been done.

And again, we are talking trillions of dollars in assets that are held in these custodians. It’s just not realistic, short of something forcing a change like a regulatory change, I just don’t see a wholesale shift occurring.

What I do see though is more custodians coming out with alternate ways to price this out and giving choice to the RIAs. But I don’t foresee it solely going into that nice clean simple approach. I get it why some people would like to see that, but it’s just realistically unlikely to happen.

Hopefully this has helped you understand why there’s so many variables that go into choosing a custodian. Again, I did a different episode, deeper dive on that. But a lot goes into this, and you want to understand how your potential custodial partner generates revenue and how that compares to the other options out there in the marketplace.

While some custodians are more well-known than others, the reality is there’s about a dozen or so custodians out there serving the RIA space. This is a big decision. You will want to take your time, understand who your option are, understand why you might choose one over the other. Understand who’s even available to you.

Again, depending on the size of your practice, the profile of practice, some custodians might not even be available to you. That’s a big part of what I help you do is understand the landscape. Understand what’s available to you. And then help you figure out which one will ultimately be the best for you and your RIA.

I’m happy to have that conversation with you.

Like I said at the top, my name is Brad Wales with Transition To RIA. This is the type of conversation I have all day long, whether it’s talking about how to pick a custodian, or how custodians operate, or anything else related to potentially transitioning your practice into the RIA model.

First things first, head to TransitionToRIA.com where you’ll find this entire series in video format, podcast format. There are articles, there are whitepapers. There is a Vendor Profile Series.

At the top of every page is a Contact link. Click on that and you can instantly and easily schedule time to have a one-on-one conversation with me, whether you want to talk about today’s topic or anything else RIA related. I’m happy to have that conversation with you.

Again, TransitionToRIA.com.

With that, I hope you found value on today’s episode and I’ll see you on the next one.

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