Whose liability should it be any way?

John Gubert looks at how asset safety concerns for CSDs are set to pan out.
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.The logic says, as indeed does the law in Europe for UCITS and, I am sure, if a case came to judgement, for AIFs as well, that it lies with the Global Custodian or Fund Administrator. Technically the Fund Manager, or even Fund Sponsor if different, is also liable but, in most jurisdictions, only if there is a failure at those agents. The liability of the Global Custodian and Fund Administrator, where applicable, as well as that of the Fund Manager and Sponsor, ought to be much more clearly codified than currently in legally binding documentation, identifying exactly when liability is assumed.. And that liability structure should be extended to other fund types, including insurance, family office and retail. The Sponsor, Fund Manager or other institutional entity, as well as the individual, must have some liability for loss, either contingent or through an excess approach to compensation. Caveat emptor is a sensible mechanism to ensure price does not override risk in this area, thus creating moral hazard for all.

As the bulk of capital support is in the banking sector and they provide the majority of custody and related risk functions, it is logical that they should assume the risk of loss both through their own actions or downstream. For again caveat emptor should prevail and they, through the governance structure of their sub agent links and through their influence on infrastructures within the jurisdictions in which they operate as direct members, should ensure the risks downstream are acceptable. The scope creep of several CSDs and CCPs into higher risk activities is one they should seriously consider halting. CSDs can be limited purpose banks for settlement purposes or triparty arrangers on an agency basis but any alternative loan portfolios or principal activities in asset financing are to be avoided. And despite the encouragement of authorities to move to Central Clearing, questions should be raised around the scale, concentration risk and scope of the instruments handled as well as the risks of a single point of user failure destroying multiple CCPs.

In order to avoid any concerns downstream the markets should look at leveraging on laws such as the excellent German Depotgesetz. Quite simply, if there is a dispute over ownership between a bank as principal and one of their clients and the client can be shown to be an injured party, then the asset in question should automatically default to the client to the extent of their losses. And that raises an interesting question around the morality of the privileges granted many CCPs. It is debateable whether their priority rights over assets held as collateral is justifiable or whether they should have liability in the event of fraud or operational failure at one of their members. This would require enhanced risk management and oversight by CCP management and, for any harmed professional or institutional clients, a loss sharing arrangement may be justifiable. But the current blanket exemptions may be systemically justified. They are not morally right.

I strongly believe we need to re-examine the legal and risk process in markets. We need to clearly identify the rights and obligations of intermediaries. And we need to agree on the roles and responsibilities of all parties in the process. It all goes back to caveat emptor and recognition of, and thus payment for, risks assumed by parties across the securities processing value chain.