GREG BAER, BANK POLICY INSTITUTE: I would like to start with an overview of Northern Trust. Your main lines of business are corporate and institutional services and wealth management. Should we think of you predominantly as a wealth manager, as a technology company, or a bank?
MICHAEL O’GRADY, Northern Trust: All of the above. We’re definitely a bank, and the banking capability is important to what we do. But like most other banks, we look to differentiate our services and compete in different ways.
I think of Northern Trust as three primary businesses: wealth management; the institutional asset servicing business, which includes custody and fund administration; and asset management, a business that has been built up over time serving the other two businesses, with approximately $1 trillion in assets under management.
These businesses are integrated, and part of that integration is technology. We think one of the advantages we have is our ability to leverage our technology investments across the three businesses.
BAER: I’ve seen a lot about Northern Trust’s drive to digitization and use of enhanced technologies. Can you provide an overview of how you’re using technology to enhance the business?
O’GRADY: We’ve been making and we’ll continue to make significant investments in technology. Integrating technology into our client experience and high-touch service model in each of those businesses is a top strategic priority.
The key to deploying new technology is whether it will make what is already an attractive business model even more scalable and flexible for us and our clients.
Let’s take something such as robotics. If you think about the nature of the asset servicing business – custody, fund administration, middle-office services – it involves processing high volumes of transactions. It’s the type of activity that has been deployed effectively for many years, yet it’s still ripe for the application of robotics and other automation opportunities.
Also, and this is important, it leads to a lower-risk business model. Because we’re able to automate activities and minimize the opportunity for manual error, operational risk is reduced and we can focus more on our clients.
Secondly, consider the use of algorithms. Much of what we do involves financial expertise. With algorithms, you have a very disciplined process and in return achieve a very precise outcome. One example is foreign exchange (FX), which we generally do for asset-servicing clients such as investment managers, pension funds, and sovereign wealth funds. Historically, FX has been executed off of a trading desk, and it still is. However, in some instances, we are providing execution using algorithms to get the best price. Trading in this way enables us to access the best pools of liquidity and execute customized client strategies.
Another aspect is how we think about developing new technologies. For many years, we’ve had a team that works on FX algorithms. However, early on, we partnered with a sophisticated FX tech company called BEx, and it has been a very fruitful relationship. It was working well enough that we decided to make an investment in the company. Then, in 2018, it was working so well that we decided to acquire the whole company. That’s just one area, but it shows how we think about innovation and development. We look to develop technology that fits what we’re doing and enables us to move quickly enough to keep up with the market.
BAER: A related question is about machine learning (ML). Part of the concern about ML is that developers don’t write some of the code in advance. Instead, the machine thinks for itself. Do you see a future for ML in your business?
O’GRADY: Yes, but to your point, you really need to understand the risk you’re potentially taking on by using ML. This differs from our FX algorithm today where we program the algorithm, and there is no machine learning.
But if you think about using machine learning to follow trading patterns and if you’ve set up the parameters to get greater efficiency in trade execution, that will make the algorithm better over time. We’re not using machine learning for that yet, but I could definitely see that being the next stage as we move from automation to robotics and then toward artificial intelligence and machine learning.
BAER: Let’s turn to distributed ledger technology (DLT). It does seem like Northern Trust’s business will be well-suited for blockchain. Are you making progress with DLT?
O’GRADY: Yes. We definitely believe that DLT has applications for what we do. And to date, we’ve experimented with a number of different applications. One where we’ve had a significant amount of success has been in fund administration for private equity funds. This is an area where we have a business, a global business, but as part of that there is a business in Guernsey where we do administration for private equity funds that are domiciled there.
In order to test the technology and develop something that has a practical and commercial use, you need the whole ecosystem to be part of the test. So, even if we develop that as the fund administrator, if the clients, regulators, auditors, and lawyers don’t accept what you’re doing, then you don’t actually have something commercially viable. That’s why we chose Guernsey, because we had that ecosystem that was interested in doing something that was innovative. If you step back to compare private equity to the capital markets, it’s highly inefficient on a relative basis.
We had a good position as both the custodian for asset owners that are investing in private equity and the administrator on the other side for the general partner (GP). We could see pain points for the system because, for example, the GP has to work with the lawyers in order to put the documents together. They send the documents to all the limited partners (LPs), the LPs have their lawyers look at the documents, and send them back. With every capital call, you go through the exercise again. We work on behalf of these LPs to do that process, and it is very paper based and takes time to do, which then has a cost of capital implication.
If you can put that on distributed ledger technology, now you have something that is transparent to all the appropriate players and is something that you can automate for the process of capital calls.
The auditor can also work with the system. We worked with PwC to make sure it is an auditable trail. So far, we have certain process patents on that application. And now the next stage is, how do we scale it up? That’s what we are investigating right now.
We’re also working with the ASX (Australian Securities Exchange) because it’s in the process of replacing its settlement system (CHESS), and it’s looking for market participants interested in developing DLT. We are also looking at custody to determine the future for custody infrastructure overall. And there are other areas where we would look to partner with various market participants that are already further down the path, whether it’s foreign exchange or derivatives, for example. How can we be a part of what’s happening there? Right now, DLT is both a risk and an opportunity.
BAER: There has been a lot of discussion recently about bank deposits, and Northern Trust is obviously a huge deposit taker. How do you approach deposits at Northern Trust, and what do you focus on when you are determining your strategy?
O’GRADY: We are in a transition period with regard to deposits. If you go back three or four years ago when short-term rates were zero, the value of the deposits could be negative because of capital requirements. Now we’re in a different time period, but we still look at the economics. So, for example, if one of our institutional clients has liquidity needs, we provide it with a number of alternatives.
If it says it wants to be on the Northern Trust balance sheet, we can offer that, but we need to know the cost of capital and the level of profitability. If it wants to be in U.S. Treasuries, we can offer that as well; that’s priced a certain way and has certain economic implications to us. And then, more broadly, it may be part of services that figure into asset servicing fees. However, I would say we don’t really look to subsidize one product over another. We’re looking for the entire package to be attractive, but also the individual services to be relatively aligned with the cost and the value that we’re providing.
BAER: The Fed recently released its prudential regulation tailoring proposal, and Northern Trust appears to have a greater level of regulatory scrutiny due to your cross-jurisdictional activity. Could you walk us through what your cross-jurisdictional activity is and how that translates, or doesn’t translate, directly to systemic risk?
O’GRADY: We appreciate our position as a global custodian, and that is how we’re positioned in the marketplace. We offer services to large asset owners and managers, and we do look to do it in a very low-risk way. The cross-jurisdictional aspect of it is primarily where we have large asset owner clients outside the U.S. that have dollar-denominated assets that then are left on our balance sheet. Since it is on the balance sheet of a non-U.S. branch or subsidiary of a U.S. bank, it will be viewed as a cross-jurisdictional asset or liability – or, in some cases, both. That would be the case even though these are stable assets or liabilities related to our clients’ asset-servicing needs.
Now, it is important to have very strong capital and, maybe even more importantly, strong liquidity. We have both with regard to capital and liquidity ratios. It’s also important to have the infrastructure and analytics to go with that, and we have that as well. We’ve invested in both the infrastructure and analytics over the last seven years. It’s at a level that clearly can serve clients appropriately and also is low-risk.
BAER: Corporate social responsibility is something for which Northern Trust is certainly known. How are you innovating in that area as the industry moves beyond the traditional charitable giving model?
O’GRADY: As you point out, Northern Trust has a long tradition of corporate social responsibility. We make significant contributions to the global communities in which we operate. In addition to making grants to support organizations that meet our guidelines, we have been innovative in our approach to community development investments. We invest in strategies focused on comprehensive community development as well as issue areas such as housing, education, health, and community development. Our investments are long-term, patient capital with a primary focus of creating positive impacts in underserved communities. We focus on capital gaps in underserved areas and look for new ways to fill those gaps that will create sustainable positive change.
For example, we may make a direct investment into an organization with performance-based measures for the terms of that debt. We have made an investment in a social impact fund in Denver that provides wraparound social services for formerly chronically homeless individuals. We have closed a total of seven of these types of transactions.
BAER: I assume your private wealth clients also are philanthropic, and I think you provide them philanthropic services as well. How do you work with them?
O’GRADY: Our clients are incredibly active in terms of philanthropy. We have philanthropic advisory services that we offer to our wealthy clients. We help them think through how they want to pursue their philanthropic objectives. One interesting trend is the crossover between impact investing and their philanthropic activities. Often when we then talk about what we’re doing in impact investing, they’ll ask how they can participate in that as well. We’ve collaborated with larger clients as part of these impact investing issues. I think there will be more of that going forward.
BAER: How do you differentiate Northern Trust in the wealth management space?
O’GRADY: For Northern Trust, the more complex a client’s needs are, the more we can help. Those are the opportunities that we’re looking for, where our holistic approach to wealth management shines. It tends to be clients with a greater amount of wealth. Part of serving high and ultra-high net worth clients requires having advisers with deep expertise. You need estate planning lawyers, tax strategists, fiduciary expertise, trust administration, philanthropic services, family business advisory, oil and gas advisory, and many other types of specialized areas of expertise. Generally speaking, you wouldn’t say that these types of expertise lend themselves to automation or technology. At a certain level, it’s true. We have not pursued a robo adviser – the part of the market where you answer five questions and it will give you an asset allocation.
However, we have been integrating powerful technology in such a way that it provides a better client experience, and also enables us to scale this expertise. That’s really exciting because otherwise your opportunities for growth are limited. We built an iPad application that was a combination of Northern Trust technology and work from a top outside technology firm. It’s called Goals Driven Wealth Management. It’s easy to say Goals Driven Wealth Management, and a number of firms hold themselves out this way.
But what happens is the Northern Trust team members – the wealth strategist and the portfolio manager and other experts as needed – sit down with the client or potential client and go through a number of questions about financial assets and objectives. Our unique platform leverages industry-leading algorithms and a mobile app that allows clients to visualize their assets as they align with their life goals – such as to fund a grandchild’s education, donate to charitable organizations, or buy a second home.
Each goal has a customized portfolio of assets that takes into account the specific time horizon and is applied a unique risk tolerance designed to ensure the aspiration can be met. Each aspiration is a piece of plan, and every asset has a purpose. The technology, coupled with the expertise of Northern Trust’s wealth and investment advisers, allows for the plan to be changed in real time to accommodate real life.
BAER: There has been a lot of focus over the last couple of years on liquidity, particularly in corporate bonds. There is a widespread recognition that there is not the depth to the market that there used to be. How does this change your behavior as an asset manager, knowing you may not be able to sell in blocks the way you used to be able to?
O’GRADY: I would say that although there is some additional volatility in the market, we haven’t changed our investment strategy. In other words, we haven’t necessarily said we’re going to have higher levels of liquidity in the fund in order to make up for less inventory in the market. That said, we have enhanced our analytics about liquidity in the market. It is something that we closely monitor because it’s a different marketplace than it was five or 10 years ago.
