In the financial industry, changes to regulations and oversight often trigger significant shifts in how business is conducted. One such potential change on the horizon relates to the Securities and Exchange Commission’s (SEC) “custody rule” and how it applies to investment advisors and custodians.
To understand the implications of this shift, let’s first look at what the custody rule is and how it functions within the current financial landscape.
Officially known as rule 206(4)-2 under the Investment Advisers Act of 1940, the custody rule is a regulatory stipulation designed to protect clients’ assets. It ensures that investment advisors do not misuse or misplace the assets entrusted to them by clients. It does so by mandating that all client assets be held by a “qualified custodian” – usually a bank or broker-dealer.
The rule also includes provisions requiring advisors to undergo surprise examinations by an independent public accountant to verify client assets.
Proposed changes to the custody rule
The SEC recently proposed modifications to the rule, broadening its scope and intensifying its protections. The proposal seeks to extend the rule’s application beyond client funds and securities to any client assets in an investment advisor’s possession or under their control. Here’s how SEC Chairman Gary Gensler describes the changes in an SEC news release earlier this year:
“Congress gave us authority to expand the advisers’ custody rule to apply to all assets, not just funds or securities. Further, investors would benefit from the proposal’s changes to enhance the protections that qualified custodians provide. Thus, through this expanded custody rule, investors working with advisers would receive the time-tested protections that they deserve for all of their assets, including crypto assets, consistent with what Congress envisioned.”
This expansion would include non-traditional assets like private debt, private equity securities, cryptocurrencies, real estate, and derivatives. The idea is to ensure these assets are properly segregated and held in accounts to protect them even in the event of a custodian bankruptcy or insolvency. Additionally, the SEC aims to improve the accuracy of custody-related data available to the Commission, its staff, and the public.
Potential challenges
While some stakeholders appreciate the rule’s intention to enhance investor protection, many have raised concerns about the implementation challenges that the changes could bring. One main worry revolves around the proposal’s stipulation that investment managers would have to interface with custodians to trade in expanded areas, such as derivatives and digital assets, which will make trading more difficult and markets less efficient. Most asset managers don’t have direct relationships with custodians, making this a potentially significant operational change.
Moreover, the proposed rule would require investment advisors and custodians to enter into a written agreement concerning the care of assets. This provision could lead to a substantial increase in legal agreements and oversight, as highlighted by the Investment Company Institute (ICI) in its response to the proposed changes.
Monitoring developments
The comment period for the proposed changes closed in the first part of 2023, and the SEC is considering next steps. There is a possibility that the SEC will have a ruling by the third quarter of this year, but this could change. Once the rule is passed, a one-year implementation period is expected. Therefore, the earliest we could see these changes in effect would be 2024. Until then, investment advisors, custodians, and other industry stakeholders will continue to assess the implications of these proposed changes and prepare accordingly.
At UMB, we’re monitoring the situation and, regardless of the outcome, currently offer a robust global and domestic custody model for several of the asset types the SEC is specifically addressing, including private equity, private debt, real estate and more.