This is the latest installment of a regular column to answer questions from advisors who are considering transitioning to an RIA model. To see Brad’s previous articles, click here. To submit your question, please email Brad here.
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For the better part of a decade, this article was moot. Interest rates were so low that swept cash, no matter the custodian, received a return that rounded to zero.
With the changed rate environment, it is instructive to understand what drives interest rates in cash sweeps.
A few caveats: 1) This applies to broker/dealers as well. I am explaining how this works with RIAs and their custodians, but it applies similarly to how broker/dealers generate revenue; 2) This explanation applies to when a custodian sweeps idle client cash to an affiliated bank and/or series of banks. If cash is swept to an affiliated money market fund, the custodian generates revenue primarily from the fund's expense ratio.
A cash “sweep” is an account benefit where idle cash in an investment account is “swept” to an interest-generating solution. Whether cash is being held in an account for future investment, a result of dividends or bond coupon payments, a recent deposit, etc., there is utility to having idle cash effortlessly swept to an interest-bearing vehicle.
The revenue a custodian generates from cash sweeps is banking 101. Clients lend their cash to the custodian and are paid a rate of interest. The custodian then lends/invests the cash at a higher rate. The “spread” (a.k.a. “net interest income”) between the two rates is the revenue generated.
While the spread might only be a few hundred basis points, and each client might (under normal circumstances) only hold a single digit percentage of their account in cash, the aggregate dollar amount of the sweeps can be enormous. Invested properly, it is risk-free profit to the custodian.
The resulting spread revenue on cash sweeps is a custodian's single largest revenue driver by far!
But there is no such thing as “free” custodial services. Custodians provide an important and necessary function for RIAs. Yet, unlike the other required solutions needed to run an RIA (tech, compliance, etc.) advisors have not traditionally paid for custodial services themselves. While “free” to the advisor, the custodian generates revenue from the underlying investor clients as cash sweep revenue, trading costs, margin lending, mutual fund revenue share arrangements, etc.
(If you are at a broker/dealer, the payout retention by your firm is by no means the only way your broker/dealer generates revenue from you. Revenue drivers like cash sweeps are a meaningful contributor as well.)
With the reduction of trading fees over the past few years, in many cases to zero, cash-sweep revenue has reached a disproportionate (and arguably unsustainable) part of overall custodial revenues. Custodians have at times used basis-point custodian fees. I foresee that trend continuing, but that is a topic for another time.
With this backdrop of the importance of sweep revenue to custodians, consider how the interest rate paid to clients on their swept cash applies. A custodian desires to maximize the spread between the rate they pay for “borrowing” cash from clients and what they can lend/invest it at.
There is nothing nefarious about this. Banks have operated this way for hundreds of years.
As interest rates rise in the marketplace, a custodian is incentivized to limit the interest rate paid on swept cash as much as possible. The lower its borrowing costs, the greater the potential spread.
Because of the ease and utility of the sweep function for clients (it’s better to earn some than no interest), custodians have a degree of leverage over clients/advisors with how slowly they increase sweep rates.
That leverage is not absolute, though.
Clients, via their advisors, have recourse that custodians are mindful of.
Advisors, after all, can:
- Invest idle cash manually in a money market fund, CD, etc.
- Move the account (cash) to another custodian that pays a higher sweep rate.
- Have the client hold excess cash at another institution (bank) that pays a higher rate.
- Seek to hold less cash as an investable asset.
None of these are frictionless, let alone as effortless for the advisor/client as a simple sweep. Thus, a custodian plays a perpetual balancing act to maximize its revenue by providing the easiest solution, albeit at the lowest interest rate possible, while not losing cash balances in the process.
To set the rate they pay on swept cash, custodians continuously survey the competition (what interest rates are other custodians paying on swept cash), survey rates available to clients via other investment vehicles (e.g., money-market funds), factor what they’re earning on their reinvestment of the cash, all while monitoring for flight of the cash balances.
Custodians (and broker/dealers, banks, etc.) all monitor this extremely closely. With their largest revenue driver at stake, small changes in either interest paid and/or aggregate cash balances can be immense to their bottom line.
This is a fair dance to be played, though. Until/if RIAs are willing to pay for custodial services directly, and unless anyone wants to champion reversing the trend to low/free cost of trading, custodians must generate revenue somehow. It is logical (and necessary) for them to maximize their cash sweep revenue as much as possible.
Brad Wales is the founder of Transition To RIA, a consulting firm uniquely focused on helping established financial advisors understand everything there is to know about WHY and HOW to transition their practice to the RIA model. Brad utilizes his nearly 20 years of industry experience, including direct RIA related roles in compliance, finance and business development, to provide independent advice regarding how advisors can benefit from the advantages of the RIA model.
Read more articles by Brad Wales
This is the latest installment of a regular column to answer questions from advisors who are considering transitioning to an RIA model. To see Brad’s previous articles, click here. To submit your question, please email Brad here.
