Issue: March 2012 / May 2012
Keepers of the keys
Only when things go wrong are trustees inclined to worry about them. So far, so good.
So fault-free does the system of share custodianship usually work that it’s taken for granted, many trustees rarely bothering even to familiarise themselves with what it entails; let alone the costs for which they pay, the efficiences which they expect or the add-ons from which they can benefit.
Yet they certainly should. Come a computer blip or fraud of Madoff-type ingenuity, heaven forbid, and consequences can be chaotic. For the SA institutions that supply custodian services – Absa, FNB, Standard, Nedbank, Computershare, Societé General and more recently the Reserve Bank – are effectively the gatekeepers for the asset lists of investors, pension funds included.
The term “custodianship” is a relic of the paperbased share settlement system. Until a paperless system was introduced some 10 years ago by Strate, the licensed Central Securities Depository (CSD) for electronic settlement of financial instruments, every share transaction was settled by running bits of paper between banks and brokers.
Since then, the entire market has gone electronic. It started with dematerialisation of shares, then extended to bonds and later to the money market. Strate created a CSD for digital storage of locallyissued securities. By law, the function of CSD participants (CSDPs) is to keep a record of their clients’ listed holdings. The seven participating institutions each maintain CSD accounts where they ‘hold’ securities on behalf of their respective clients.
The CSDPs compete for such clients as asset managers, stockbrokers and pension funds. The latter, points out Tertius Vermeulen of Computershare, don’t usually have a direct relationship with their custodians. In practice, it’s more likely that the fund’s investment consultant or manager passes on instructions to the chosen custodian.
The custodian acts as a third party to verify investment managers’ activities. When the records of the custodian square with what the consultant or manager is telling the fund about the portfolio it holds, trustees can sleep easy.
There’s little to distinguish one CSDP from another because the technology they use is much of a muchness. Bennie van der Westhuizen of Absa believes that a main differentiator (in competitive fees and diverse packages) is in such complementary services as transactional banking and Regulation 28-compliant products that the CSDP’s bank might offer.
“What we saw as value-adds a decade ago are vanilla services today,” Vermeulen adds. “Latest service offerings include negotiated securitieslending contracts, global-custody solutions and assetmanagement reporting.”
In the paper environment, risk centred on the physical loss of a share certificate. With electronic settlement, this risk is eliminated.
Other risks are contained because custodians do not exercise any control over assets in the CSD. Client holdings are registered in the name of a nominee, segregating them from those of the custodian, explains Van der Westhuizen. Neither do custodians have discretion to act without explicit instruction from the client, and even then the custodian merely acts as a post box between the market and the fund to ensure that settlement happens.
In the article ‘To owe or be owed’ (TT March-May), the allegation was reported that Standard Bank -- in its capacity as custodian for the Chemical Industries National Provident Fund (CINPF) -- had made certain payments to erstwhile CINPF consultant Tristar Investments (now called Malaczynski Burn) on the instructions of Tristar and not of client CINPF.
Standard Bank disputes the allegation, saying that it had acted on a written instruction from CINPF: “The court is presiding on a totally unrelated matter between Tristar and the CINPF. If there had been an issue with the custodian bank, this would have been included in the court papers.”
According to Vermeulen, there remain operational, technology and people risks. They might escalate, for example, when the custodian’s client invests in over-the-counter (OTC) derivatives: “Custodians are not always provided with accurate or verifiable values from third parties.”
This happened abroad at Lehman Brothers and many other institutions afflicted in the 2008 financial crisis. These institutions were allowed to invest in OTC derivatives. But there were too many different ways of assigning value to the supposed underlying securities, and the valuations attributed them were seldom correct.
Be forewarned, just in case.
COST OF SAFE CUSTODY
Institutional investors pay an annual fee of 0,01% to 0,001% on the value of assets under custodianship. This fee covers the custodian’s fixed costs including reporting, corporate-event management, maintaining licences and insurance. Additional volume-based charges are levied per transaction.
The custodian also collects and pays over the Strate fee. Fees are kept low because most institutional investors use SWIFT technology to communicate between the custody system and their back offices with minimal manual intervention.
For private investors, the structure is slightly different because the issuer is required to cover the costs of basic services. These include maintenance of the register, corporate actions and dividends, and provision of two statements per year.