What are Custodians?
Custodians are financial institutions that hold customers’ securities for safekeeping so as to minimise the risk of their theft or loss. A custodian holds securities and other assets in electronic or physical form. Since they are responsible for the safety of assets and securities that may be worth hundreds of millions or even billions of dollars, custodians tend to be large and reputable firms usually banks.
A custodian in the case of hedge funds is a trust company, bank or similar financial institution responsible for holding and safeguarding the securities owned by a hedge fund. Since a hedge fund is essentially a large pool of funds from different investors, it requires a third-party custodian to hold and safeguard the securities that are owned by all the fund’s investors. Custodians reduce the risk of fraudulent activity by separating the fund managers from the physical securities and investor records.
General Functions of Custodians
On top of holding securities for safekeeping, custodians also provide the following services:
- Arrange settlement of any purchases and sales and deliveries in/out of such securities and currency.
- Collect information on and income from such assets (dividends in the case of stocks/equities and coupons or interest payments in the case of bonds) and administer related tax withholding documents and foreign tax reclamation.
- Administer voluntary and involuntary corporate actions on securities held such as but not limited to stock dividends, splits, business combinations (mergers), tender offers, and bond calls.
- Provide information on the securities and their issuers such as annual general meetings and related proxies.
- Maintain currency/cash bank accounts, effect deposits and withdrawals and manage other cash transactions.
- Perform foreign exchange transactions.
- Often perform additional services for particular clients such as mutual funds; examples include fund accounting, administration, legal, compliance and tax support services.
It is important to note that custodians are prohibited from offering clients financial/investment advice, selling of investment products and collecting any form of compensation from financial advisors.
When banks provide custody services in multiple markets through one service agreement with customers, they are called “global custodian” banks.
If an investor holds foreign securities, their global custodian will contract with custodians in foreign countries to provide local custody services. These custodians are called Sub-Custodians.
Origin of Custody
“Custody – in essence, is a service consisting in holding (and normally administering) securities on behalf of third parties – has its roots in physical safekeeping. In the days when securities existed only in paper form, investors needed a safe place to keep these certificates of value. That safe place could either be their own premises (which however then needed to be adequately protected) or those of a safekeeping service provider (banks with their vaults were a natural choice at that time)”. (Diana Chan et al.; article, The Securities Custody Industry, www.ecb.int)
Development of Custodian’s Roles in Hedge Funds
The growth of the independent alternative investment industry (which includes hedge funds and private equity) and 2008 financial crisis have led to the rise in custodian services in hedge funds. The financial markets (especially in the hedge fund industry) over the past five years have experienced a rise in government intervention via the financial services regulations, for example, the Dodd-Frank Financial Reform Act in America and the FSB Fais Act in South Africa. Concerns around counter-party risk (Lehman Brothers and others) as well as many other factors have contributed to the increase in custodian duties among hedge funds. (Justin Perun, Emerging Role of the Custodian).
Roles of Custodians in Hedge Funds
Custodial services are more complicated for hedge funds than for mutual funds. Hedge funds will take long and short positions in securities, which will require ready access to securities lending and financing facilities. Hedge funds typically have more elaborate derivative strategies than long-only funds; in turn, this implies more complicated custody and collateral arrangements. As a result, a hedge fund will usually engage a prime broker to take care of many of the custodial services required, which is in contrast to the long-only mutual fund business.
When securities are bought or sold, the custodian takes care of the delivery and receipt of securities against the agreed amount of cash. “Settlement” is the exchange of securities against funds. The Custodian role will be to keep records of assets, trade affirmation and settlement, cash clearing, asset servicing, reporting services, tax calculation, proxy voting and foreign exchange.
Securities Borrowing and Lending
Custodians act as the ‘Lending Agent’ (LA) for all securities lending transactions. The LA has direct contact with both the lender and borrower and is responsible for management of collateral throughout the term of the loan, including mark to market and margins calls. The LA ensures that the lender receives its rights to all interest payments or dividends arising from loaned stock.
Exchange Traded Funds (ETF) Creation/Redemption
Custodians facilitate the creation/redemption of ETF units after the market maker’s purchase/sale of the equities. Custodians facilitate the custody of ETF underlying shares, settle the market trades, and reconcile issued ETF units with its proportionate number of shares. (Omar Iskandarani, Custodian Role in Market Development, Needs and Benefits)
Asset Services entails custodians ensuring investors receive rights and benefits which ought to accrue to them. These services usually fall into several broad categories: collection of dividends and interest; corporate actions such as rights issues, re-denominations or corporate reorganisations; payment and/or reclaim of tax; voting at shareholders’ meetings by proxy.
Much of the work done by custodians consists of asset servicing and acting as an information intermediary, communicating between issuers and securities holders. While the investing customer could have performed the related work itself, it is more convenient for it to entrust these activities to a specialist because custodian banks have developed economies of scale to provide services to their customers at a cost less than the customers would incur. (Diana Chan et al.; article, The Securities Custody Industry, www.ecb.int)