This article is written by Ms. Sushree Surekha Choudhury from KIIT School of Law. The article gives a brief overview of the custodial services that financial institutions provide to their customers. It speaks about the custodial services in India as well as global custodial services. The article further details the risks involved in the business model of these services. 

It has been published by Rachit Garg.

Introduction 

Custodial services are the services provided by banks and financial institutions to their customers for the safekeeping of their financial assets. The customers can choose any bank, which shall then be known as their custodian/custodian bank, and they can opt for custodial services. Banks and financial institutions provide a wide range of services. Not just safekeeping, but also other services like fund management, investments, extending that money under loan and gaining interests, and forex services, while maintaining accounting records of all these services which a customer has availed. Customers who open a dematerialized account for trading in the capital market can also avail of custodial services. Here, the custodian is usually an individual who keeps all the records and ensures safe keeping and other trading settlements. In this case, the financial assets can be in physical form or electronic form, and physical assets can be converted into dematerialized form as well. 

What is a custodial service 

A custodial service is a form of service usually extended by banks and other financial institutions. It is the process in which the bank or financial institution becomes the custodian for the goods or products that the customer may wish to extend custodial services to. Banks become custodians for their customers and take legal responsibility for the products that the customers have put into custody. They perform the role of caretaker for these products. When a customer opens a “DEMAT Ac.” (Dematerialized Account), the bank becomes a custodian for its customers. While the customer remains the sole owner of the products, they are merely held by the banks or financial institutions on behalf of the customers for safekeeping. The main purpose behind availing of a custodial service is the safekeeping of financial products. It reduces the risk of theft or compromise of these products. Investment service providers like mutual funds, depository institutions, etc., keep the accounts created with them under custody. They even hire a custodian to do so. The financial assets put under custodial services can be stored either in physical form or in electronic form and are usually interconvertible. In this case, the custodian has to comply with the Security and Exchange Board of India (Custodian of Securities) Regulations, 1996

Different types of custodial services 

Custodial services can differ from customer to customer, and it is usually done on a contractual basis. Banks and financial institutions extend these services to a wide range of customers, starting from regular customers to investment service providers.

They extend custodial services of the following kinds: 

  • Collection of financial assets and settlement of service for customers
  • Safekeeping of these  collected and settled assets
  • Keeping track and reporting customers’ securities, assets, and marketable financial products
  • Clearing and settlement services
  • Exchange-traded derivatives clearing services
  • Depository services
  • Forex services including international investments and returns
  • Custodial services are also extended to accounts whose beneficiary is a minor. Usually, an individual becomes the custodian for a minor beneficiary account. He/she takes responsibility and accountability for that account and makes decisions in favor of the minor. Ultimately, the proceeds of the account are all for the minor beneficiary.
  • Global custodial services: These services are extended across borders.
  • Security lending services for the assets under custodial services. This service is provided by banks or financial institutions to their customers, through which they allow the customers to lend these assets and securities to gain profits from those assets.
  • Value-added services on the assets under custody.

Core custodial services

Though custodial services range across  wide service areas, its core services or most basic functions can be seen as the following:

Trade settlement 

These services are primarily focused on the money market and money market instruments. The banks provide settlement for trades in equity or debt securities via a channel of clearing houses and also via Delivery Versus Payments (DVS) services. It also processes primary market subscriptions. It processes various services for buy-back of shares, rights issues, etc.

Safekeeping

One of the most basic services under custodial services is the safekeeping of financial assets. The banks and financial institutions ensure the customers’ securities are safe and secure. It can be in physical form or electronic form and is usually interconvertible. When customers open a DEMAT account with market intermediaries and service providers, they automatically sign up for the safekeeping of their securities.

Monitoring and collection

As a core service principle, banks provide monitoring, collection, and recording of various benefits, like corporate benefits, entitlement benefits, etc. They collect these benefits as due and also ensure that it is up to date. 

Accounting of funds

Banks maintain accounting records of the assets under custody. It conducts proper valuation and accounting for and when the account owner makes investments, lends securities in custody, or makes any other transaction.

Reporting

It conducts and adheres to proper reporting standards for every minute transaction. Banks make reports on regular statements, securities valuation, and their saleability, corporate actions, trading, forex, etc. 

Securities and Exchange Board of India (Custodian of Securities) Regulations, 1996

The Securities and Exchange Board of India (SEBI) prescribed the SEBI (Custodian of Securities) Regulations in the year 1996 (hereinafter referred to as ‘the regulations’) via the power vested on it under Section 30 of the SEBI Act, 1992. It has since then undergone several amendments until the last amendment in the year 2009. Under the current framework, certain essential regulations are: 

Definition of custodial services

Custodial services have been defined under Chapter I, Regulation 2(e) of the Regulations. Under various legislations, such as the SEBI (Mutual Funds) Regulations, 1996, assets and other securities, gold, and gold-related instruments, etc., custodial services mean the safekeeping of these assets and securities and include other related activities like maintaining customers’ accounts, depository services for companies, gathering customers’ benefits and rights arising from these securities, keeping records, maintaining accounts, accounting, and keeping the customers well informed. 

Registration of custodial services

One who wishes to legally carry out custodial services in India has to register itself with SEBI under these regulations (Chapter II of the regulations)  and in the following manner:

  1. Such a person has to make an application to SEBI for a grant of certificate. 
  2. Any person who has been carrying out custodial services before the commencement of this regulation has to make an application for registration and obtain a certificate within 3 months from the date of commencement.
  3. The application has to be made on Form A.
  4. A prescribed fee has to be paid as specified in Part A of Schedule II of the regulations.
  5. The manner of payment has to be followed as specified in Part B.
  6. Failure to register and obtain a certificate within the prescribed time frame can result in SEBI ceasing the business activities of such a person and asking for a transfer of customers’ records and documents. 
  7. Before granting a certificate, SEBI takes into account various factors to check the credibility and eligibility of a person wanting to carry out custodial services. Such eligibility may be verified by checking the availability of proper infrastructure, meeting capital requirements (INR 50 crores), security and privacy standards, etc. This verification is referred to in Schedule II of SEBI (Intermediaries) Regulations, 2008.
  8. If all the criteria are met, SEBI grants a certificate after the payment of a prescribed fee. A Certificate is granted in Form B of the regulations. This certificate will be valid for 3 years and can be renewed. 
  9. SEBI can reject an application for certification for stated reasons, and the same has to be communicated within 30 days. 
  10. Aggrieved parties can apply to SEBI for reconsideration of their application within 30 days from the date of communication of rejection. 

General obligations and responsibilities of custodians

When a certificate is granted to a person or corporation for carrying out custodial services, such custodians have to follow a prescribed set of obligations and responsibilities while carrying out the business. Such obligations and responsibilities are mentioned in Chapter III of the regulations. These are:

  1. Every custodian has to follow the prescribed code of conduct as it is under Schedule III
  2. When a custodian carries any other business other than custodial services, the office, infrastructure, and employees have to be separated entirely.
  3. Custodians of services have to be inspected annually and a report must be given to SEBI regarding the same within 3 months from the date of inspection.
  4. A custodian of services cannot delegate his duties and responsibilities to any other person other than another custodian for safekeeping. This is done with restrictions. The custodian remains responsible for the customers’ securities. A satisfactory record of the services availed from the other custodian has to be kept in the primary custodian’s office. 
  5. The custodian must maintain separate custodian accounts for each client.
  6. The custodian has to enter into a clear and descriptive agreement with the customer whose assets the custodian has agreed to safe keep. 
  7. The custodian must make provisions for safety, security, privacy, and internal control and monitoring for the safekeeping of customers’ securities. 
  8. The custodian must protect the securities from natural hazards, theft, or any other kind of mishap.
  9. The custodian must maintain detailed documents of customers, books of accounts of its business, and reports on every legal and corporate affair.
  10. The custodian must keep SEBI informed about these records and documents.
  11. The custodian is required to maintain these records and documents for at least five years. 
  12. The custodian must appoint a compliance officer to look after the regulations being complied with by the custodial services provided. He has to be diligent and independent. 

Global custodial services 

This refers to the expansion of services in the global market. Banks and other financial institutions provide custodial services for cross-boundary transactions, foreign securities, and foreign market investments. It provides all the core custodial services but in an international market. Usually, these banks and financial institutions (custodians) establish connections with domestic custodians or local custodians across all the countries they extend their services to. It is then through these agent custodians that they perform custodial services simultaneously in local as well as international markets for local and international clients. Its core services include safekeeping of assets; management of assets; keeping records of these assets; accounting of securities; and trade settlements in multiple markets. The greater task in providing satisfactory global custodial services is to comply with the regulatory requirements of different countries while keeping pace with the needs and demands of the customers in every market. Coordination, cooperation, and acting in good faith between the custodians and their agents or sub-custodians are essential for the efficient delivery of services.

Mentioned below is a list of banks that provide global custodial services:

Custodial services for minors

If a minor opens an account, he/she is in the position of a beneficiary. Even though he is the account holder, he is not allowed to directly operate the account for the reason of being a minor. In such a circumstance, a custodian is appointed to operate the account on behalf of the minor, who is the ultimate beneficiary. It is understood as:

  1. The account of the minor is known as a custodial account.
  2. The appointed custodian here is usually a person rather than a corporation or institution. 
  3. This custodian makes all necessary decisions regarding the management of funds in the account. 
  4. He has the discretion to make investment decisions for the securities in the account. 
  5. He must do so in good faith and for the benefit of the minor beneficiary. 
  6. Such a custodian account is thus accessible to two individuals—the minor beneficiary and the custodian.
  7. However, the custodian can access the account only to make investments on behalf of the minor and other related activities. He can not avail himself of the securities or assets.
  8. There can be only one beneficiary per custodial account. 
  9. When the minor reaches the age of 18 years or above, he can operate the account by himself and discontinue the custodial services on his account. 

Risks of opting for custodial services 

With providing a wide range of custodial services across borders, there are also certain risks involved that need to be considered and mitigated. Some primary risks include:

Risk of compliance

While extending custodial services, especially in global custodial services, a host of laws, policies, and regulations need to be complied with. Every nation has its own set of rules, procedural requirements, ethics, standards, and policies that have to be adhered to. Violation of any prerequisite shall attract penalties and punishments. There is always a high risk of non-conformity, which is not only punishable by law but also causes significant reputation damage to the erring party. 

Risk in conducting transactions

Banks and financial institutions that provide custodial services need to constantly keep up with the demands of their customers; they have to act quickly and maintain time frames and regulatory compliance. Any kind of mistake or delay can result in transactional defaults. There is also a risk of fraud by corrupt employees or fraudulent customers. There is a risk of information asymmetry. 

Risk of credit 

It is a typical case of default. When any party to whom the services are extended, in the form of deposits, investments, loans, or returns, and they make defaults or breaches in terms of the contract, it leads to default in credit. Credit risk is higher as these services include customers from a wide range of geopolitical backgrounds and multiple markets. 

Risk in strategy implementation

Banks and financial institutions that extend custodial services must formulate their business model and international connections in a manner that complies with industry standards and also ensures customer benefit. Any failure in the proper and efficient implementation of a relevant business model, chains of connections, sub-custodian or agency services, travel, cross-border regulatory compliance, etc., increases the risk of failure of strategy formulation and implementation, thus weakening the basis of service. 

Reputational risk

Any of the abovementioned risks or any other transactional failure, non-compliance, or misrepresentations are all collateral to reputational risks. The service provider loses public confidence and faith in their services. This fails business operations and also hampers the bank’s creditworthiness as a whole. It may result in losses, and dissatisfied customers, and can also result in litigation.

Risks in global custodial services

While organizing, maintaining, and providing services in multiple markets, there are several risks. Some of these are the risks associated with complying with different laws; risks in currency conversions; trading rules; agency risks, etc.

Liquidity risk

Several factors can cause a liquidity crunch. It is when the bank or financial institution has a hard time maintaining liquidity, assets valuations, debts increase, and cash flow statements do not look convincing. The organization as a whole might face a liquidity crisis, and the customers might lose confidence and withdraw services. This further increases losses and negative margins. 

Conclusion 

In a fast-growing world economy, the competition for custodial service providers has seen rapid growth, and so does the growth in the industry as a whole. While there are several risks attributed to the services, there is also a huge market that wants these services. Mitigating risks and providing services efficiently while taking care of regulatory compliance is the task. When done so, the results can be promising. Multiple market players have to play in good faith and harmony. The ultimate goal has to be customer satisfaction and benefit. 

Frequently Asked Questions (FAQs) 

Do banks provide custodial services?

Yes. Banks provide custodial services to their customers for financial assets and help them with safekeeping as well as putting those assets into transactions. 

Can I opt for custodial services beyond my territorial jurisdiction?

Yes. If a person wants to avail of custodial services for multiple jurisdictions, they can do so by availing of global custodial services. This is usually done in the case of foreign investments and trading in multiple markets. 

Which banks provide these global custodial services?

Banks like BNY Mellon, Royal Bank of Canada, Citibank, etc., provide global custodial services.

Can I trade or loan my assets that are under custody?

Yes. Financial assets under custody are not only meant for safekeeping. They can also be utilized for a host of other services, which include trading and lending these assets.

Is it risky to opt for custodial services?

No. Opting for custodial services is risk-free. It is meant for the safekeeping of assets. However, the banks are not responsible for any loss the customer may incur due to their doing. 

References 


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