It’s time to wake up and see the risks in custody contracts

John Gubert looks at the multiple risk attributed to custody contracts and subsequent reputational and financial costs, and asks whether the industry is truly awoken to these realities.

As we gear up to the now totemic Network Forum meeting in Athens, we should ask why there are some countries a bank would not lend to, even on a covered basis, but where it is willing to allow a custody arrangement. Is this because credit departments are unaware of the risks of the business? I see multiple risks, from cash risk through to country risk, that could be attributed to a custodian.

So what are the critical issues I would look at when assessing such risks and, to make life easier, with a huge health warning about my totally unscientific and horrifically conservative approach to the loss potential, what is the likelihood and quantum of those risks?

Let us start with the likelihood and quantum. I am assuming that the likelihood of a major loss occurs once every 25 years which ties in with Black Monday and Lehman, although data points are too few to give us any true actuarial measure of likelihood. I have also assumed the potential losses equal a minuscule one basis point on the portfolio. The latter figure is based on 1% of the portfolio being at high risk, mainly due to country of investment but also reflecting esoteric assets, and a potential loss on that 1% of just 1%. Given annual income yields and mean portfolio distribution, that is a conservative estimate and also implies no repeat of Lehman, Madoff or similar risks in developed markets where the quantum is so much higher. I estimate global assets under custody at around $150 trillion excluding double counting for sub custodians and thus a potential loss during my 25-year period of $15 billion. On a straight-line basis that would call for an annual provisioning of $600 million per annum across the industry, with the good news being that such a figure, although painful, is well within the profit absorption capacity of the industry. Occurring in a single year and without any prior capital allocation, it would be much more of an issue when set against any Group’s profitability, especially as the timing is likely to align with increased general banking risk and incremental provisioning.

Cash risk is a straight custodial hit. Accounts held with third party banks are accounts of the custodian and any shortfall needs to be made good by them. Cash accounts hold funds for pending settlement, income payments in course of collection and distribution, and other general float items including sale proceed realisations or cash from unsettled long positions. There may be a few exceptions to the liability rule but these are rare.

Legal risk relates to the mountain of documents now constituting a custody contract. There is often opaqueness around the liability of parties in a custody chain, whether it is liability for events in indigenous payment systems, stock market settlement vehicles, home country or investor CSDs.  Although custodians normally include an obligation to comply with local law and regulation, any loss due to an unforeseen event risk will definitely be challenged by clients on the basis that the custodian network management function are the experts and liable for failure to identify such risks.

Market practise risk is even opaquer. An agent needs to comply with market practise but often it is a surrogate for lax operational controls. If a market accepts fuzzy matches, surely the agent is liable for errors unless the client has given express consent? If a market and custodial documentation claims DvP is in place and, as a result of a failed settlement, a client loses stock or cash or even both, surely the agent has failed in their duty of care to the end investor by not explaining the precise mechanism used in cash and stock markets as well as the reliability of the chains between the two asset classes? Or if there are delays in matching or actual settlement due to failings of one or another party to the local settlement, who is liable for losses and how are they proved?

Investment portfolio risk can cover a series of issues. They revolve around safety of assets and client protection with fuzzy lines between investor and agent risk. Again, some would say that the agent as the local expert should have identified and assessed the risks around the critical matters of asset safety and pre-advised clients of grey areas. The reality is that some inkling of these shortcomings may be found in the different agent to client communications but the issue is whether they were adequately exposed. This also brings us to the core of the name on register issue, the value of custodian operator models and the structure of holding client assets, especially in markets where the concept of beneficial ownership is not clearly established in law. Investor risk is clearly with the beneficial owner or the asset manager, depending on the nature of their contract, but does investor risk really cover all country risk? Assets can be frozen; in which case they exist and the custodian and their client chain can only really wait for a more benign climate to occur to release them to normality. But assets can also be confiscated, although the ramifications are serious for the country concerned, but the question could arise in both cases whether they have been confiscated or frozen to penalise an investor or as an act against the local custodian? Liability would change in one or another case.

Agent and infrastructure risk are two that are most closely followed with agent risk centring around capital adequacy and the protection accorded to client assets in the event of the default of the custodian as well as the likelihood of such an event.  Infrastructure risk relates not only to the operational integrity of the infrastructures used but also to the legal structures of membership of those entities. As infrastructures seek to move into more revenue generative areas, they assume risk despite their normally modest capital base. In most cases, codified in some details in many CCPs but less clear among the CSD population, the direct members of the infrastructure are liable. The question arises whether the cost of such liability is attributable to them in their principal capacity or is a result of their agency role. The answer remains unclear and the implications differ according to the stance taken.

Classic country risk for our business ranges from expropriation of assets through to penalties on investors. As an example of such penalties, ownership laws, and especially maximum ownership limits, change regularly and the definition of ownership may be a function of the aggregate ownership of a counter by a local agent or by an end investor or anyone in their chain. Forced sellers may incur losses, or even the dreaded opportunity cost, and it is debateable who would be liable in such an event.

Regulation and law have moved over the last decades from a model that placed the buyer of services at a disadvantage to the seller to one where the seller will more likely than not be attributed with liability in the event of a disputed loss. Irrespective of the risk of holdings being frozen in a dispute, the reputational and financial costs of a challenge in the many grey areas of custody risk are concerning. There still needs to be more explicit liability clauses in custody contracts so that the debate around liability takes place before rather than after the event. And, as we talk of risk, we need to remember the ones I have focused on relate to custody contracts. Fund administration, transfer agency, prime services and asset finance are just a few more of the areas of risk that the industry faces, albeit in some cases capital allocations are made against exposures. We have to ask if it is not time to also rethink the capital allocations needed for the core competence of custody as well as the other activities of our securities services’ world.