In February last year, the Securities and Exchange Commission (SEC) proposed changes to the custody rule with the aim to “enhance protections of customer assets managed by registered investment advisers (RIA)”. Many in the industry have since voiced their concerns with the amendments. In an opinion piece for Asset Servicing Times, Stephen Isgar, head of network management for the Americas at the Royal Bank of Canada (RBC) Investor Services, argues that it may have unintended consequences.
A fundamental shift
The amendments could result in “a fundamental shift in practice that could impact liquidity management, funding and credit provision”, writes Isgar. This is due to a requirement for custodians to hold cash, client securities, and other forms of assets in segregated, bankruptcy-remote accounts.
He gives an example of overnight cash sweeps from custodians to third-party banks becoming necessary, which would cause 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,” he points out.
“Troubling” inclusions
Also a part of the proposed amendments is an expansion of the custody rule to include “virtually all assets held in client portfolios”, which Isgar describes as “troubling”. The inclusion would cover digital assets, loans, derivatives, FX contracts, collateral posted on swap contracts and short positions, as well as physical assets such as real estate, precious metals, and artwork.
This may “discourage qualified custodians from agreeing to provide custody services for certain types of assets”, limiting investment options that are available to advisers and their clients, says Isgar. Potentially, the pool of qualified custodians may shrink, leading to an overall increase in costs for clients.
Need for nuance
The lack of nuance in the amendments is another cause for concern. In particular, the requirement that custodians “indemnify their clients against losses that result from ‘negligence, recklessness or willful misconduct’ across the entire custody chain”, including even the sub-custodians and CSDs.
Isgar points out that this change “does not account for structural differences between depositories and sub-custodians”. The use of a securities depository is usually determined by what an investor chooses to invest in – for example, securities that are immobilised in the market’s depository. “There is no element of choice on the part of the custodian or sub-custodian regarding the investment decision”.
There is also no distinction made between risk that “can be controlled by the custodian”, and risk that “exists regardless of the care that is taken by the custodian to select an agent in a particular market”. An example of the former is in the monitoring of sub-custodians. Examples of the latter include systemic, geopolitical, economic, structural and market risks.
“As a result, custodians may decide not to support clients with exposure to riskier frontier markets or esoteric financial instruments” – a move that, according to the Securities Industry and Financial Markets Association (SIFMA), could “adversely impact investor returns and their ability to achieve portfolio diversification”.
Based on these points, Isgar concludes that “several of the proposed SEC rule changes may have unintended consequences, potentially creating additional risk and costs for investors and their custodians”.