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The Custody Services of Banks

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The Custody Services of Banks The Custody Services of Banks July 2016 Preface This white paper seeks to (i) describe the and the institutions that engage in them, services provided by U.S.-based banking appropriately reflect the particular risks organizations with regard to the provision they are intended to address. This paper of custody and related services on a global does not seek to prescribe any particular scale; (ii) distinguish the services provided regulatory framework for custody businesses by custodians from the services provided by or the institutions that engage in them, but other entities in the multi-tiered system for is rather intended to provide lawmakers, safekeeping, clearing and settling securities; regulators, and the public a comprehensive (iii) describe how the balance sheets and look at the activities and risks of the custody risk profiles of custody businesses differ services provided by banks, with a view to from those of other banking activities; and informing future decisions about the manner (iv) clarify certain misconceptions regarding in which these institutions are regulated. the risks presented by the custody and related services. This paper is one in a continuing series of Clearing House research reports and As international and national regulatory working papers focused on financial bodies continue to increase their focus on institutions and regulation, and in particular, macroprudential supervision, The Clearing the role of large banks in the financial House believes that it is important to system and the costs and benefits of ensure that all supervisory policies, tools regulating such banks.1 It was prepared and regulatory frameworks, including with the assistance of The Clearing House’s those that apply to custody businesses special counsel, Davis Polk & Wardwell LLP. i THE CUSTODY SERVICES OF BANKS Executive Summary An investor—whether a retail investor, an corporate trust, but do not have a significant employee pension fund, a mutual fund or commercial banking business.3† Other any other kind of institutional investor—who providers offer some or all of these services in invests in a financial asset such as an equity addition to a broader traditional commercial or debt security needs someone to hold and or investment banking business. safekeep the asset on its behalf; receive on its behalf any dividends or interest payments This paper explains the nature and risks of made by the company that issued the security; the custody services provided by U.S. banks alert the investor of any votes or other actions and considers the role of the custodian in the the investor needs to take with respect to the financial system, including the extent to which security (such as responding to an offer by the their activities are similar to or different from issuer to exchange the security for another those of other entities involved in the multi- security); and, if the investor wishes to sell tiered framework for holding, servicing, and the security or purchase another security, settling transactions in client securities. process the transaction on the investor’s behalf. Custodians provide all of these custody services to investors by contracting with the PROVISION OF CUSTODY SERVICES investor either directly or with an agent of the Custody services involve the holding and investor, such as an investment manager. In servicing of assets on behalf of others. To short, a custodian provides custody and related facilitate the provision of these services, services to investors—broadly characterized as custodians operate securities accounts and the safekeeping and servicing of an investor’s cash accounts for their clients. Securities assets—and in this respect plays a critical role in accounts are used to record and safekeep helping investors to build and maintain wealth. investments in securities made by clients, while cash accounts reflect clients’ cash holdings, Bank-chartered custodians2* provide asset often in multiple currencies, which are placed safekeeping and other related custody on deposit with a bank that provides custody services to large institutional investors, services. Custodian’s safekeep and segregate including asset owners, asset managers, clients’ investment assets, or the investment and official institutions, as well as private assets of their clients’ own clients, and provide wealth clients. In the United States, some a broad range of related financial services. providers offer custody services on a Custodians, in turn, are members of, or have global scale, as well as asset management, relationships with local institutions that are wealth management, and other securities processing services such as brokerage and † The Bank of New York Mellon (“BNY Mellon”), Northern Trust Corporation (“Northern Trust”), and State Street Corporation * Other market participants, such as broker-dealers, can also (“State Street”) are prime examples of such providers, and provide custodial services, but this paper focuses solely on the information about the business of these entities is included in services provided by bank-chartered custodians. various places in this white paper for illustrative purposes. ii THE CUSTODY SERVICES OF BANKS members of, central securities depositories THE ROLE OF CUSTODIANS (“CSDs”) or international central securities The provision of custody and other asset depositories (“ICSDs”), which are financial services by custodians, facilitates client market utilities (“FMUs”) that hold securities access to and participation in global financial that are either immobilized or in uncertificated markets, including interactions with other (dematerialized) form, enabling ownership market participants. In this regard, these changes to be tracked and recorded through services are critical to the functioning of “book-entry settlement” rather than through financial markets, and, in fact, the use of these the transfer of physical certificates. CSDs custody services is often required by law or and ICSDs serve as the official registrar of the regulation in order to protect investors from issuers of corporate securities by maintaining potential misappropriation of their assets by the lists of the owners of securities on behalf funds and other vehicles in which they have of the issuers, while custodians, through their invested.5 The activities of custodians help relationships with CSDs and ICSDs, report and to link investors to issuers of securities and track ownership changes in securities holdings thereby facilitate the infrastructure investment on behalf of their clients. Although some and physical capital formation necessary custody services could be provided by non- for economic growth and the accumulation banks, clients generally prefer to use banking of retirement and other long-term savings. entities that can provide traditional banking However, while the services provided by services, cash deposit accounts and access custodians are critical to the functioning of to payment systems and that are subject to the global financial system, it is important robust prudential regulation and oversight. to recognize that these services represent just one tier in the multi-tiered system for Custodians also offer various administrative safekeeping, clearing and settling securities. services related to clients’ assets, including the As discussed further herein, custodians help processing of income and interest payments, facilitate client access to other tiers within corporate action processing, proxy voting, the global financial system, such as central client reporting, depository receipts services, counterparties (“CCPs”), CSDs, ICSDs, payment transfer agency services and facilitating client systems, and national central banks (in their subscriptions and redemptions of fund shares, role as operators of payment systems or and fund administration and accounting settlement systems), without which clients services. In addition, custodians provide clients could not conduct transactions across global with ancillary services related to core custody financial markets.6 For example, when a activities, including agency securities lending client engages in the purchase or sale of a and foreign exchange services.4‡ security, a custodian facilitates the delivery or receipt of the security and the related cash ‡ This paper focuses on the custody and related services offered by custodians and does not discuss other business lines consideration at the direction of the client. in which they may engage. For example, this paper will not As noted above, it is the CSDs and ICSDs address analytics, asset management, brokerage, corporate trust, transition management, treasury management, tri-party that hold the immobilized global certificates repo, or wealth management business lines in which custodians representing issuances of securities or whose may engage. iii THE CUSTODY SERVICES OF BANKS electronic book entries represent issuances is frequently used to refer to the value of of dematerialized or uncertificated securities, client assets held by a custodian, for which and consequently it is the relevant CSD or the custodian provides safekeeping services ICSD that ultimately settles the transaction on and assumes recordkeeping, segregation, its books. The role of a custodian in settling reconciliation and monitoring responsibilities. client securities transactions is typically a post- The term “AUC” is intended to distinguish a trade role. After the execution of the trade custodian’s pure agency role in holding and and notification of the custodian by
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