Keeping your assets safe
Custody is the mechanism whereby clients’ wealth is protected. But how does it work and how should it affect your choice of asset manager? (First published on the Dolfin website on 17 April 2017.)
Investors’ awareness about the importance of custodians has risen since the financial crisis in 2008. But many still have misconceptions about exactly how custody arrangements work and how to make sure their assets are safe. Most investments made through an asset manager are held for safekeeping by a financial institution, such as a large bank, known as a custodian. Among other things, this minimises the risk of theft or loss through error. But it also adds the small risk that something could go wrong at the custodian itself.
Georgios Ercan, Head of Sales at Dolfin, says a common misunderstanding among investors is that they question whether using a small asset manager would increase custody risk, and what would happen to their assets if the manager closed suddenly.
“The size of the manager is not important.” — Georgios Ercan, Dolfin
“Asset managers use banks, acting as custodians, for safekeeping,” he explains. “Often the manager will use one of the largest banks in the world, with a top credit rating.
“This is with good reason as it shifts the custody risk to the larger institution, thus reducing the risk of default. If the asset manager went under, the liquidator would simply distribute the client’s money from the sub-custodian. The money doesn’t sit with the manager, so the size of the manager is not important.”
Eva Micheler, Associate Professor, Law Department, London School of Economics, says that given the widespread use of sub-custodians, the most important questions investors should ask are which companies are involved, who holds the assets, and are they sufficiently safe and trustworthy.
“They especially need to look at whether there is a chain of custody providers,” she says. “Problems have occurred when companies have outsourced certain functions again and the chains become too long. So does the sub-custodian delegate to other custodians? If so, who are the other custodians and who bears the risk?”
Amir Nabi, Chief Operating Officer, Dolfin, says: “When benchmarking custodians, there are many questions you can ask to establish how safe they are, such as: what is their credit rating? What is their reputation? Do they have industry-standard audits such as SOC1 reports and what do those reports look like?”
Micheler believes that investors should also watch out for so-called service bundling. “Custodians may charge less or not charge at all for the custody itself,” she says. “But if they bundle it with foreign exchange or some other services, you could end up paying more in total or taking more risk. Bundling also makes it difficult to compare services.”
Nabi agrees, and adds: “If the fee structure is non-bundled, you only pay for the service you receive from the custodian. That takes out the different layers, ensures full transparency and gives the investor a better deal.”
“Segregation is important; it makes it easy to move those assets out if necessary.” — Amir Nabi, Dolfin
Another thing to check is whether the custodian ringfences assets in your name, a practice known as segregation. The alternative is that they pool them with other investors’ assets, which could make it harder to recover the assets in the event of a liquidation.
“Segregation is important as it makes it easy to move those assets out if necessary,” says Nabi. “It reassures the client that if something happened to the manager, their assets would not be used to wind up the company — they would be protected.”
Best of breed
What if your asset manager has its own custody licence? This is rare among smaller managers but it can be useful, says Nabi, even if the manager still uses sub-custodians.
“If a manager has a custody licence, then it can do all the necessary ‘know your customer’ and anti-money laundering checks needed to satisfy the regulator itself,” he says. “That can make onboarding the customer much quicker and easier compared to a larger bank.
“Also a manager with a licence has more control over selection of sub-custodians. It can benchmark them according to a range of metrics and due diligence, and offer best of breed based on the client’s requirements.”
For example, it can choose a sub-custodian with specialist knowledge about a certain jurisdiction, or one that offers additional services that the client may need, such as account administration, transaction settlement, financing, tax support, and foreign exchange.
“Technology also plays a big part,” adds Nabi. “Can I get the information I need as securely and efficiently as possible? Can my asset manager provide live real-time reporting as opposed to just monthly or quarterly? These are the questions that savvy investors need to ask.”
Before it’s here, it’s on the Dolfin website.