TCH recently published a white paper entitled “The Custody Services of Banks” that provides an overview of the unique role that certain banks play in providing crucial custody services in our financial system. In particular, the white paper focuses on three key things:
- Describing the custody and related services that U.S.-based banking organizations provide on a global scale;
- Distinguishing the services provided by custodians from the services provided by other kinds of firms in the multi-tiered system for safekeeping, clearing and settling securities that keep financial markets functioning smoothly; and
- Clarifying certain common assumptions and misconceptions about the risks custody and related services may present.
Here are three key takeaways from that paper:
1. If you have invested in securities, a custodian likely helped to facilitate that transaction.
- Investors who invest in financial assets such as equity or debt securities need someone to process purchases and sales of those assets, to hold and safekeep those assets, receive dividends or interest payments on their behalf, and to alert the investor as to any votes or other actions the investor needs to take with respect to the security.
- Bank-chartered custodians provide all of these custody services primarily to institutional investor clients, including U.S. mutual funds and their non-U.S. equivalents, corporate and public retirement plans, sovereign wealth funds, central banks, alternative investment funds, insurance company general and separate accounts, charitable foundations and endowments, and personal and family trusts.
- In the United States, some bank-chartered custodians offer custody services on a global scale, as well as asset management, wealth management, and other securities processing services such as brokerage and corporate trust, but do not have a significant commercial banking business. Other providers offer some or all of these services in addition to a broader traditional commercial or investment banking business.
- Although some custody services could be provided by non-banks, clients generally prefer to use banking entities that can provide traditional banking services, cash deposit accounts and access to payment systems and that are subject to robust prudential regulation and oversight.
2. Custody services differ from the services provided by asset managers and financial market utilities (FMUs).
- Asset managers typically have discretion over investments made with, and the use and reuse of, client assets under its management.
- By contrast, in providing custody services, custodians act solely on instructions from their clients and do not exercise any discretion over the use or reuse of client assets under custody, or use them for proprietary purposes.
- FMUs provide the necessary financial market infrastructure to clear and settle transactions in, and act as the ultimate holders of, investment assets.
- By contrast, custodians are not themselves FMUs, but rather, they act as intermediaries between investors in securities (and other investment assets) and FMUs.
—In particular, as described further below, through their relationships with central securities depositories (“CSDs”) and international central securities depositories (“ICSDs”), which are FMUs, the activities of custodians help to link investors to securities issuers.
3. The custody services provided by banks have evolved over time.
- Historically, banks have provided services designed to safeguard clients’ assets, including the physical securities certificates once commonly issued to investors that represented the investors’ ownership interest in the issuer.
- However, to eliminate logistical burdens and reduce operational risk associated with issuing, transmitting, exchanging and safekeeping physical securities certificates, securities are now generally represented either by a single global certificate representing the entire issuance or by an electronic book-entry, which are held at CSDs and ICSDs.
–CSDs and ICSDs maintain the list of the owners of securities on behalf of issuers and also recognize changes in ownership among account holders following the purchase or sale of a security and, thus, ultimately settle transactions on their books.
–By contrast, custodians typically are members of, and thus have accounts with, CSDs and ICSDs.
- The role of a custodian in processing securities transactions is typically a post-trade role.
–After the execution of the trade and notification of the custodian by the client, the custodian will transmit the purchase or sale settlement instructions to the relevant CSD or ICSD, which will effect the settlement and credit or debit the custodian’s account the cash or securities, as applicable.
–Typically, the settlement of securities transactions involves the movement of securities and cash from a custodian’s account with a CSD or ICSD to another custodian’s or broker’s account with that CSD or ICSD.
- Thus, custodians no longer safeguard physical securities certificates in their vaults, but rather, a custodian must confirm that its book-entry credits at a CSD or ICSD are equivalent to the book-entry credits held by its clients in their securities accounts on the books of the custodian. In doing so, a custodian thus facilitates the delivery of securities owned by its clients at a client’s request.