Whose liability should it be any way?

John Gubert looks at how asset safety concerns for CSDs are set to pan out.

By John Gubert editors@globalcustodian.com 
The debate about asset safety and designation rolls on. As reported recently in Global Custodian, there is concern that the issue will detract from some of the benefits of T2S. But, this is no new story. In the UK, when I started in the custody business, there were violent disagreements between the protagonists for designation at beneficial owner level and the proponents of omnibus account holdings. CREST, the precursor of Euroclear UK and Ireland, operated sponsored accounts to support designation. Investors were allowed, in the UK, to maintain paper certificates, even in the early electronic age; these would be emblazoned with the name of the beneficial owner. The account structure of the CSD also enabled, at a cost, multiple sub-accounts.

The reality is that asset safety should not need designation although there are subtleties of law that need examining. Designation is only needed to ensure asset safety. Assets are always designated at the fund manager and global custodian or administrator level. They are normally held in omnibus accounts at a CSD or with a sub custodian. They may or may not be commingled at a CCP. And designation depends on operational perfection; the more complex the market structure the less likely this is to occur.

Designation at CSD level would lead to an explosion in the volume of records held and require a material change in IT architectures to enable additional data storage and a material increase in settlement and other transactional related activities. It would complicate reconciliations even if there were strict adoption of LEI and other relevant client identifiers. At a legal level, it would create a de facto relationship between the CSD and the beneficial owner which could lead to liability although the law is far from clear in such instances.

Designation at sub custodian level would have similar impacts, although the major markets could most likely accommodate volumes. However there could be questions around the nature of the resultant relationship between the sub custodian and the designated investor and this could give rise to requirements around the KYC obligations of that sub custodian depending on the jurisdiction.

In both cases, CSD and sub custodian, there would be a material adverse business impact on all securities lending or collateral management processes. Although technically there appears no consideration of treating cash accounts in a similar fashion to possible designations at stock level, that option is a next step that undoubtedly the technical purists are likely to consider.

For the CCPs, the process could result in an increase in accounts. EMIR requires European CCPs to provide segregated individual client and segregated omnibus accounts. A segregated omnibus account follows normal CSD practice of distinguishing between client accounts and principal accounts although this segregation is far from universal. The key advantage of the individual segregation rests in the portability of the accounts in the event of a Clearing Member delinquency. In omnibus accounts liabilities are commingled, the sum total of collateral is lower than the sum of the debits and the excess will be held by the Clearing Member and, although portability at omnibus level is possible, a recalibration of positions would be needed were any investor within such an account to request porting to another intermediary.

In reality, designation reduces legal risk but increases operational risk and reduces market efficiency. The question to be asked is what are the alternatives? First is a question of caveat emptor. Second there is a question of the rights of the beneficiary under law. And third is a question of capital versus risk. The alternative option to designation, whilst ensuring asset safety, is surely a clear acceptance of liability by custodians and administrators, as well as fund managers and sponsors, and adequate financial backing for such a covenant which cannot continue to be treated as a de facto zero risk obligation.