Where are my assets?

For most investors, a planned and executed trade is the end of the affair. Once a counterparty has been found and the terms of the deal agreed, we assume we’ve addressed the risks we were looking to offset in changing the composition of the portfolio.

But what if risks lurk in the post-trade processing of our transaction? How do we know that securities and cash have moved correctly, that the change of ownership is recorded accurately and, once the movement has taken place, that our ownership rights are secure?

If investors once assumed that the answers to these questions were mere formalities, since the collapse of Lehman Brothers, the uncovering of the Madoff fraud and the 2011 failure of MF Global, all of which involved the loss of client money or the absence of assets apparently held for safekeeping, they have had reason to feel much less complacent.

More recently, repeated fines levied by the UK securities regulator on asset managers and custodians for breaches of the rules for the safe custody of client assets have raised additional worries. In April the Financial Conduct Authority fined BNY Mellon, the world’s largest custodian bank, £126 million for “failure to adequately record, reconcile and protect safe custody assets,” signalling heightened concern about industry practices.

So what do investors need to know about where their assets are held? And what questions do they need to ask their global custodian to ensure that their safekeeping policies follow best practice?

An obvious starting point in seeking to answer these questions is to look at the node in the financial market infrastructure where ownership rights are recorded.

The role of the CSD

Around the world, investors’ securities are held in central securities depositaries (CSDs). The role of a CSD is to settle securities transactions, where it credits the account of a buyer of securities with the relevant shares or bonds and debits the buyer’s cash account. Simultaneously, it performs the reverse transaction for the seller of the securities.

CSDs also have an important safekeeping role: once a transaction is settled, the rights and obligations linked to the securities must be managed. CSDs therefore “service” securities holdings over time, processing corporate actions such as dividend and interest payments and share voting rights.

All this sounds straightforward. But in practice CSDs have evolved in many different ways in different markets. In some countries a national CSD has a monopoly role in securities settlement, whereas in other countries or regions (for example Europe) there may be different CSDs competing for the same business. CSDs may be state-owned (and even run by the central bank), but increasingly they are commercial entities, with the competitive pressures this entails.

CSDs may specialise by type of financial instrument as well as geographical region and may operate under different legal systems. Importantly, CSDs differ internationally in the way in which investors’ ownership rights are recorded.

Holding account structures

Under a direct holding system, each final (or “beneficial”) owner of a security is known to the CSD. By contrast, under an indirect holding system investors are identified only at the level of their custodian, which may keep client assets in an “omnibus” client account, as part of a multi-tiered custody model.

Omnibus accounts were invented in the 1970s as a solution to a bottleneck in processing trades involving paper securities: by holding securities in the name of the custodian bank, settlement efficiency jumped. However, an indirect holding account structure clearly leaves greater scope for ambiguity regarding the ultimate ownership of securities than a system under which beneficial owners are recorded at the level of the CSD.

Four decades later, two of the failings identified by the FCA at BNY Mellon involved the inappropriate use of client assets held in omnibus accounts: first, the commingling of those client assets with assets belonging to the bank in omnibus accounts held with third parties; second, the unauthorised use of clients’ assets, held in omnibus accounts, to settle transactions before the proceeds of covering trades undertaken by other clients had been received. Both practices placed client assets held in safekeeping at risk.

In their 2012 Principles for Financial Market Infrastructures, the Basel Committee on Payment and Settlement Systems and the International Organization of Securities Commissions (CPSS-IOSCO) recognised that differences in CSD holding account structures and in the way custodians recognise client assets were unlikely to be ironed out soon, even if it preferred omnibus accounts to be wound down.

“Where supported by the legal framework,” said CPSS-IOSCO, “the CSD should also support operationally the segregation of securities belonging to a participant’s (i.e., a custodian’s) customers on the participant’s books.”

Under Europe’s CSD Regulation (CSDR), which came into force in September 2014, the region’s CSDs must now offer both individual and omnibus client segregation.

According to Luis Nino, associate director at Thomas Murray Data Services, even if CSDs do not recognise direct beneficial ownership of securities, advances in technology should enable custodians to offer full segregation to clients at the intermediary account level, whatever the legal environment or pre-existing market practices.

“Your mobile phone probably has four or five times the capacity and processing power of the best computer from the 1960s and 1970s, when omnibus accounts came about. There’s no technological reason nowadays why the ownership of client assets cannot be recorded individually,” says Nino.

Where individual markets around the world do not offer the option of direct beneficial owner accounts at the local CSD, the investor faces a choice, says Nino.

“If the custodian tells a pension fund client that there is no final beneficial owner model in a country they are looking to invest in, it’s then up to the client to decide whether to invest,” he adds.

Other CSD risks

Asset safety risk—the risk that assets held in custody at a CSD may be incorrectly recorded, misused or commingled with those of an insolvent third party—is only one of eight measures of risk used by Thomas Murray Data Services in its CSD Risk Assessment Ratings Service.

Other risks include asset commitment risk, liquidity risk, counterparty risk, asset servicing risk, financial risk, operational risk and governance and transparency risk.

In countries where investors are required to pre-fund purchases of securities, for example, asset commitment risk is higher, since an investor is out of pocket from the point at which cash is lodged with the CSD until the moment when settlement takes place.

Counterparty risk—the failure of a CSD participant—is usually reduced by the practice of settling securities transactions according to a delivery versus payment model, the screening of potential CSD members for financial stability and by the existence of a default guarantee fund. But excessive concentration in CSD membership may raise concerns.

And certain countries’ CSDs may score more highly in individual risk categories than others.

For example, CSDs in emerging market countries often receive better asset safety risk rankings than those in developed countries, since emerging markets often offer safer, designated segregated holding models to clients as a matter of course, whereas developed markets still rely heavily on omnibus holding account structures.

However, the operational performance of CSDs in developed countries is usually higher than that of emerging market CSDs. Most trades pass through the CSD’s accounts seamlessly in developed markets, while emerging countries see higher rates of manual post-trade intervention, which increases the chance of errors.

A composite CSD risk scoring methodology addresses all the major potential areas of concern for institutions using these important elements of the financial market infrastructure.

Do I need to worry?

Some of these safekeeping questions may seem moot to investors covered by European legislation on pooled investment funds.

Under the Alternative Investment Fund Managers Directive (AIFMD), which came into force in 2013, fund depositaries have to indemnify investors in the region’s hedge funds against possible losses caused by fraud or negligence at the level of the custodian or sub-custodian. And UCITS V, which covers traditional mutual funds (UCITS) and takes effect in 2016, contains an equivalent level of protection to AIFMD and is expected to extend the level of cover to include the central securities depositaries (CSDs) in the markets in which a UCITS invests.

It’s only investors in segregated mandates—pension funds, insurance companies, sovereign wealth funds and the like—that appear to need to ask their custodians what safekeeping risks they face.

However, whether or not they face those risks directly or have had them assumed by their fund manager and the manager’s depositary, investors are going to be paying for the risks somehow.

And with concerns over asset safety on the rise, asking your custodian where your assets are located and how they are held around the world is solid due diligence advice for any investor, suggests Thomas Murray’s Luis Nino.

“Clients need information. They can’t change the laws of a particular market. But they can be informed what to expect,” says Nino.