Custodian Banks: How Much Risk is Too Much to Accept
Custodian banks and other securities services providers need to pay close attention to six types of risk and avoid taking on liabilities for errors and fraud not in their control.
That's the overriding message of a committee of some of the world's largest asset servicing providers working under the umbrella of the Zurich-based securities services trade group International Securities Services Association (ISSA). They are worried over whether custodian banks and others will ultimately be compelled by regulators to take on mistakes made by third parties far from their jurisdiction which will ultimately lead to unintentional systemic risk.
The ISSA committee recommends that custodian banks and other service providers do check out the validity of third parties but do not accept any responsibility for any of their wrongdoings or errors that are out of their control through a contractual agreement or delegation. The third parties include fund administrators; brokers; transfer agents and registrars.
The ISSA's forty page document entitled "Hidden Risks in the Securities Services Industry" is one of four released at the ISSA's annual meeting in May. It was just posted on the ISSA's website www.issanet.org/html/wgs.html.
"As the document's title implies, the risks in the securities services business may be hidden, or less understood by market participants. But for custodian banks and others the risks are only too great and we need to be proactive about what we should assume, not assume or mitigate," says Ed Neeck, managing director at JP Morgan Chase who led the ISSA committee. Other participating securities services providers include Citi; UBS; Canada's central securities depository CDS; Deposito Central de Valores; Deutsche Bank; Schroders and international messaging network provider SWIFT.
Among the six types of errors two appear to be the most worrisome: administrative risks related to hedge funds, funds of funds and complex master feeders; and servicing out of network assets. The European Commission has recommended that custodian banks be on the hook for errors and even worse fraud committed by third parties such as stealing or missing client assets. Two regulatory measures: the Alternative Investment Funds Management Directive (AIFMD) and UCITS V, a new incarnation of traditional investment fund legislation, could very well end up requiring custodian banks to prove they performed due diligence on brokers they did not select and have no control over. "Prudent service providers have spent considerable time and effort reflecting on the direct and ancillary risks associated with servicing hedge funds; funds of funds; and relationships in master feeder funds. They have established and evolved various procedures and processes to mitigate the operational and reputational risks that continue to arise," says the ISSA committee but it also cautions that investors are ultimately responsible to do their own due diligence.
When it comes to servicing out of network assets -- or non-depository eligible securities -- such as bank loans, money market funds, swaps or private equity funds, custodian banks do not have effective control of the assets, and records on who owns shares; instead, those are held by transfer agents, registrars and other non-depository entities. The ISSA recommends that the securities industry come up with a way to require "out of network" assets be held in central depositories much the same way as exchange traded securities are today.
Among the other risks custodian banks must face are risks of not disclosing the potential for financial loss for cash collateral reinvestment in securities lending; errors in valuing financial instruments; and relying on third parties for recordkeeping.
Written by Chris Kentouris, Editor-in-chief (Chris can be contacted through Chris.Kentouris@hotmail.com).