by Stephen Isgar, Head of Network Management for the Americas
Changes proposed by the Securities and Exchange Commission (SEC) to enhance investor protection could pose challenges for custodians, investment funds and advisors alike. First drafted in early 2023, amendments to the Custody Rule under the 1940 Investment Advisors Act are currently pending further discussion.
Segregation of assets
Today, client cash is held on a custodian’s balance sheet to support intraday liquidity, foreign exchange transactions and settlement costs. The SEC proposal would require qualified custodians to hold cash—as well as client securities and other forms of assets—in segregated, bankruptcy-remote accounts. This represents a fundamental shift in practice that could impact liquidity management, funding and credit provision.
The changes would necessitate a shift to pre-funded settlement
For example, the changes would require overnight cash sweeps from the custodian to third-party banks, necessitating a shift from end-of-day funding to pre-funded settlement. The potential for default among the designated cash banks would offset any accompanying risk reduction, and it would be necessary for custodians to restructure their technology platforms and operating models to facilitate the cash segregation.
Expansion of the Custody Rule
Another troubling aspect of the SEC plan, likely sparked by the recent succession of crypto failures, is the proposal to expand the Custody Rule to include virtually all assets held in client portfolios.1 The change would require qualified custodians to maintain exclusive possession and control over a much broader range of securities. This includes digital assets, loans, derivatives, FX contracts, collateral posted on swap contracts and short positions, as well as physical assets like real estate, precious metals, artwork and commodities.2
The expanded Custody Rule could limit investment options
The expanded Custody Rule may discourage qualified custodians from agreeing to provide custody services for certain types of assets. This could limit the investment options available to advisers and their clients. The change also has the potential to result in a smaller pool of qualified custodians, leading to an overall increase in costs for clients.
Regardless, custodians would continue to face the need to determine whether a particular asset qualifies to be “held in custody.” Typically, this is based on demonstration that the custodian has possession of the asset; it has control over the asset, including the ability to move the asset; and it administers the asset through recordkeeping, asset servicing or reconciliation.
The asset generally must satisfy two of the three criteria for the custodian to assume the obligations of the custody standard of care. However, even if two of the tests are met, the custodian may still determine that the associated risk of an asset (e.g., cryptocurrencies) is too high to be held in custody.
Indemnification against losses
The SEC proposal would require qualified custodians to indemnify their clients against losses that result from “negligence, recklessness or willful misconduct" across the entire custody chain—right down to sub-custodians and central securities depositories.2
The plan to indemnify does not account for structural differences
The plan to indemnify clients does not account for structural differences between depositories and sub-custodians. For example, the use of a securities depository is generally determined by the investor’s decision to invest in securities that are immobilized in the market’s depository. There is no element of choice on the part of the custodian or sub-custodian regarding the investment decision.
Additionally, the SEC indemnification proposal makes no distinction between risk that can be controlled by the qualified custodian (e.g., selection and monitoring of sub-custodians) and risk that exists regardless of the care that is taken by the custodian to select an agent in a particular market (e.g., systemic, geopolitical, economic, structural and market risk). This is evidenced by market restrictions that investors are facing in Russia—restrictions that are largely being enforced by local sub-custodians at the behest of the Russian Federation and are outside the qualified custodian’s control.
Custodians may decide not to support clients with riskier assets
As a result, custodians may decide not to support clients with exposure to riskier frontier markets or esoteric financial instruments. According to the Securities Industry and Financial Markets Association (SIFMA), this has the potential to adversely impact investor returns and their ability to achieve portfolio diversification.3 Also, if custodians agree to serve clients that trade in higher-risk instruments or operate in riskier markets, the indemnification requirement could translate into higher charges to clients.
The potential for added cost and risk
There is broad industry support for regulatory efforts to increase investor protection. However, several of the proposed SEC rule changes may have unintended consequences, potentially creating additional risk and costs for investors and their custodians in the midst of what are already particularly tumultuous times.