Custodian banks play an important role in financial markets by increasing trust and serving investors by protecting their assets. The existing practices in the custody business have a long tradition and work excellently.
Still, the Securities and Exchange Commission (SEC) wants a sweeping expansion of its custody rules that currently apply to funds and securities managed by investment advisers. If adopted, the Commission's proposed changes would disrupt the entire custody ecosystem, increase costs for investors and limit their access to professional investment advice.
Introducing unnecessary complications
The SEC's proposed changes would expand its custody oversight to all assets in advisory accounts, including a variety of financial instruments that are not assets in the traditional sense. This creates serious complications because, unlike funds and ordinary stocks and bonds, some financial instruments – such as direct loans, mortgages and derivatives – are live contracts between buyers and sellers, making them extremely difficult to keep safe.
If the SEC adopts its proposal, custodians will likely refuse to manage these financial instruments in advisory accounts, creating complex challenges and higher costs for investors.
Difficult access to emerging markets
The SEC also risks displacing key custody and advisory services and even acknowledges this in its proposed disclosure. Unfortunately, the Commission is not clear about the damage this would cause to investors and the markets as a whole.
For example, custodian banks would likely reject advisory assets invested in some emerging markets. That's because the proposal would force custodian banks to assume liability for central securities depositories (CSDs) – market providers that process transactions.
While this requirement would not impact trading in developed markets such as the US, it would impact trading in less stable markets as custodians in areas with significant geopolitical and other risks would be unlikely to assume CSD liability. If some custodians accept this liability, the price of holding these emerging market assets will likely be many times higher than today.
A look into the safe
- Verification of ownership
- Accounting and valuation
- Collection and distribution of income
- Trade settlement
- Tax reporting
Abolition of important market-relevant services
Finally, while the SEC's desire to improve the integrity of client assets is laudable, its apparent misunderstanding of custodian banks' operations is problematic. The proposal would force depository institutions, particularly banks and credit unions, to divide their customers' assets into individual accounts – a change that would be difficult, if not impossible, to implement.
The requirements would impact depository institutions' ability to pool investors' deposits, a vital function that allows depository institutions to provide key market-related services, including short-term loans, overdrafts and intraday liquidity, to facilitate securities settlement. As a result, essential services on which all investors rely would become more expensive and liquidity and settlement efficiency in securities markets would decrease.
Understand the real-world implications
While we appreciate the SEC's attention to existing rules given the evolution of financial markets, the current custody regime is working well for investors. Unfortunately, the Commission has not demonstrated that the actual costs of its proposal would outweigh the theoretical benefits.
The SEC must consider how the custodial business operates and how it impacts everyday investors. If this is not the case, Americans who want to invest with the help of a professional will have to pay a heavy price.
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