CMI In Focus: Asset segregation in CSDs

Concerns around Asset Safety have increased substantially during the global financial crisis as the full and ugly consequences of high-profile defaults (e.g. Lehman Bros and MF Global) and fraud in financial services companies (e.g. Madoff) have crystallised. Although losses were mainly in cash and collateral, the increased concerns of the investment community are such that they now extend even to the simplest of custodied securities held in the local Central Securities Depositories (CSDs). To what extent can the CSDs mitigate this risk? The risk essentially comes down to losing or having loss of use over assets and the following factors commonly act as the trigger points for exposures arising:

  • Assets may not be clearly identifiable or book-keeping records may be inaccurate
  • Assets could be mis-appropriated or misused
  • Assets may be commingled with that of an insolvent party
  • Assets may be frozen or their ‘portability’ inhibited
  • The legal framework may be inadequate to protect assets

In protecting against the difficulties of retrieving or porting assets in the event of the default of an intermediary, the account structure and naming convention is of paramount importance which talks primarily to asset segregation and whether nominees are supported in the market.

Asset Segregation

There are essentially three main ways of holding client securities at the local market level:

  1. Omnibus account – assets of one scheme are co-mingled with the assets of other investors
  2. Segregation – the beneficial owner’s name is on the account at the sub-custodian
  3. Designated Segregation – the beneficial owner’s name is on the account at the registrar/CSD

Omnibus account

An omnibus account is one which holds the securities of a number of different clients without separating out ownership. The benefits include convenience for the global custodian as all clients’ securities can be held in one account at the sub-custodian, and only one account needs be maintained at the CSD. This facilitates reconciliation. In practice, the sub-custodian, acting for a series of global custodians, may further pool all the securities held in its accounts into a single account at the CSD. This pooling at the sub-custodian and CSD is only possible where securities are fungible. Another advantage of the omnibus arrangement is that it also facilitates the lending of securities from a single pooled account, rather than from multiple individual accounts. Care needs to be taken over the actual legal ownership in an omnibus account – sometimes it will just be an equitable share in the interests of the account (i.e. a fungible pool). This is a model often employed in bearer markets such as Germany, Switzerland, Austria and Benelux. If there is a shortfall, this is born pro- rata with the other owners, irrespective of how the shortfall arose. Although this is often explicitly spelled out in the global custody agreement between the global custodian and the client, the reality remains that different clients have different risk profiles (e.g. a low risk pension fund versus a toxic hedge fund), yet all their assets are bundled together. Fig. 1 – Omnibus Holding Model

Segregation - Beneficial owner name at the agent bank

To avoid the issues of pooling at the sub-custodian level, it is often possible to hold securities in an owner’s individual account at the sub-custodian. This is clearly less efficient from the sub-custodian’s point of view and there may be a cost impact and loss of revenue from stock lending for an investor, but can reduce the legal risk. In this model, however, the sub-custodian does not maintain beneficial owner segregated accounts at the CSD level but only maintains a client omnibus account (it is assumed that any proprietary assets belonging to the global custodian or sub-custodian (if any) are segregated out into other accounts at the CSD). The choice of offering between segregation or designated segregation (see below) for clients will be largely determined by whether or not the CSD supports [foreign] beneficial owner account holders (e.g. SIX SIS in Switzerland does not while NSDL in India makes it mandatory). Some sub-custodians offer this service where possible, others do not. Fig. 2 – Segregated Holding Model

Designated Segregation - Beneficial owner name at the CSD

In Thomas Murray’s opinion, this method of ownership offers the highest level of asset safety. In some countries (e.g. Norway) some asset owners insist on this method of entitlement, despite the associated costs. There would be no need to re-register ownership if the custodian were to be changed, so many of the problems associated with put-throughs in the market on change of custodian would be avoided. There are disadvantages, e.g. a custodian may miss a corporate event where securities are registered in the beneficial owner’s name because the issuer contacts the beneficial owner, not the custodian. Similarly, where securities are held in the beneficial owner’s name, any proxy voting by the agent bank will require a power of attorney and this may need to be renewed on an annual basis. There are still many emerging markets where the broker obtains control of the securities prior to placing an order in the market. Where securities are held in the beneficial owner’s name this is an added complication and the risk of the broker selling assets without the client knowing (a problem that is still common in some Middle East and African markets) is ultimately borne by the asset owner. Fig. 3 – Designated Segregated Holding Model

Variable Market Practice

The variance of holding models throughout the world may seem random, but the prevalence of omnibus, designated segregated or mixed holding models can be seen to generally track the emergence of markets over time and particularly the introduction of electronic record keeping via CSDs. The omnibus holding model was introduced in the USA and much of the developed world after the paper crunch of the early 1970s when settlements were still via physical paper across individual holders accounts. As volumes exploded in the boom time of the early 1980’s following the rise of electronic trading systems, the back offices were unable to keep pace and the result were terrible settlement bottlenecks. The solution was the use of omnibus holding models via “street names” (as in the USA) or the name of the custodian. This increased settlement efficiency (and kept costs down) and made sense as a solution to the paper crunch, but it ignored the legal risks that this settlement model created. In addition, technology was expensive in the 1970s/80s – they were not able to contemplate the retail databases that operate cheaply and efficiently today. As a consequence of the export of this Anglo-Saxon model to much of the developed world, much of Europe, the developed markets of Asia Pacific and North America retain the omnibus holding model to this day (see Fig 4. below). The mature markets have a historical legacy that they can’t shake off due to the evolution of the legal and tax frameworks to only support this model. Because most of the global custodians built their businesses and systems during this period, they were designed around omnibus holding models with the result that even today where the global custodians operate in designated segregated markets, they still prefer to offer only omnibus accounts at the CSD wherever they can get away with it. Fig. 4 Market Practice of Account Structure at CSDs Moving into the developing world we can see a completely different story. Many of these markets only really opened up and established the necessary market infrastructure in the 1990’s, by which time the technology behind accounting and settlement systems was much more sophisticated and cost-effective. Developing countries also had the opportunity to objectively analyse the risks behind establishing good title through a string of intermediaries, and many opted to establish their markets on designated segregated holding models. Much of Latin America, most of the Middle East, and the rising economies of Asia Pacific use a model whereby beneficial owner holding at the CSD is mandatory. The Chinese CSD (SD&C) holds well in excess of 150 million accounts and settles on T+1 (for RMB onshore payments), the Indian CSDs hold similar numbers of account and settle T+2. Modern markets have been able to take advantage of cheap technology to operate the beneficial owner model. A break in this general pattern has occurred fairly recently, primarily in Europe and growing into Asia Pacific in the availability of segregation down to beneficial owner as an option in CSDs that have traditionally supported omnibus holding models only. This choice will become an obligation on all European CSDs to offer if the present form of the proposed CSD Regulation (CSDR) is passed and MIFID II/MIFIR follow similarly. The proposed CSDR goes further than MiFID in enshrining designated segregation as a choice for end investors. This is an important move also in relation to the way Central Counterparties (CCPs) are moving. In the event of a default (e.g. MF Global), the CCP is obliged to offer individual segregation under the European Market Infrastructure Regulation (EMIR) (just like the CSD will have to) but also portability. The issue is that to offer portability it is much more operationally practical to have individual segregation and hence it is essential that the CSD and CCP are in synch – both need to offer portability and by association beneficial owner segregation. Fig. 5 Availability of Account Structures in CSDs Apart from preparing for this eventuality, there are also commercial opportunities surrounding the holding of beneficial owner information. This allows CSDs to offer direct custody services to end clients, the so-called ‘Investor CSD’ model, which is one of the survival strategies envisaged for European CSDs post-Target 2 for Securities (T2S) as their core revenues are stripped away and they are forced into a competitive marketplace. Other CSDs, most notably NSDL in India, are taking less confrontational strategies by recognising that their capabilities to manage huge databases can be leveraged to provide services outside of the traditional CSD core competencies. NSDL are offering a variety of value added services that don’t talk to traditional financial market services such as:

  • Warehouse receipts and commodities in dematerialised form
  • Tax Information Network
  • National Skills registry (database for CVs)
  • Central Record Keeping Agency for Pensions
  • Goods and Services Tax (ensuring high and more transparent collection of taxes by the government and checking tax evasion down to individual person level)
  • Special Economic Zones (solution for administration of special economic zones of India)
  • Unique Identification Number

Use of Nominee

The term “Omnibus” refers to the processing arrangements. The legal ownership will often be via a nominee company (in countries where nominees are recognised). This will usually be a legal entity owned by the global custodian or its sub-custodian. The assets in the nominee account will usually be segregated from the proprietary assets of the global custodian and sub-custodian so that, at the CSD, the sub-custodian holds securities in the name of e.g. “ABC Bank Nominee Ltd segregated client account”. All clients’ securities are segregated from those of ABC Bank Ltd, but not from each other. In many markets there is nothing to prevent a subsidiary of ABC Bank Ltd holding securities that are managed in-house by the bank in the nominee account, as will often occur where a global custodian is also an asset manager. In this way, it is wrong to believe that this kind of structure provides proper segregation. In countries where the nominee concept is not recognised, the asset protection is generally achieved by the account naming convention at the sub-custodian (e.g. “ABC Bank Ltd client omnibus YYYY account”). In practice, global custodians may operate several omnibus accounts with the sub-custodian. This will involve separating out client assets of different tax status in the market and, for example, separating client securities in the securities lending programme from those that are not. Fig. 6 Legal Recognition of Nominees – Developed/Developing Markets As can be seen above in Fig.6, the legal frameworks of ‘developing’ markets are much less likely to have specifically defined the concept of nominees and the differentiation of legal and beneficial owners in their securities market legislation. This can be ascribed to less robust quality of this kind of legislation in general in these markets, but also the decreased need for such account naming mechanisms because of the adoption of designated segregation of accounts. Fig. 7 Legal Recognition of Nominees – Regional Figure 7 above very much bears this out, particularly in the example of Middle East in which the beneficial holding model is standard in the region.


The advantages of the beneficial owner holding model outweigh the advantages of the omnibus holding model. The issues with the beneficial owner holding model are operational in nature, the issues with the wholesale model are legal in nature. Technology exists to minimise the operational issues; the legal issues will take much longer to resolve. From a purely CSD perspective the choice is obvious, as can be evidenced by the wide adoption of the model by the more recently evolved market infrastructures, but the role of the CSD is to support the capital markets, not to determine their structure. That responsibility resides with the regulators (hopefully in full consultation with the market participants) and it appears that in the wake of the losses experienced by asset owners during the last few years, regulators are finally waking up to the advantages of the beneficial holding model as a solution for asset safety and investor protection concerns. Thomas Murray Data Services maintains risk profiles of CSDs worldwide, and are currently adding Asset Safety Risk to the risk methodology and reports for the Depository Risk Ratings and Capital Market Infrastructure Risk Ratings (‘CMIRR’). Full analysis of the results across 140 CSDs and 90 markets will be released to clients at the end of Q1 2013.

For further information contact:

Jim Micklethwaite
Director, Capital Markets
Thomas Murray Data Services
+44 (0) 20 8600 2309

Tags: CSDAsset ManagementCMI in Focus