The Growing Need for Sub-Custodian Monitoring

What is the question?

Many people watch the movement of stock market indices, and perhaps also interest rate changes, and possibly even foreign exchange movements: but who considers with much frequency or depth how a corporate issuer paying its dividend or interest rate coupon figures out how much to send to each beneficiary, or how it gets paid out and finds its way to their individual accounts in some far-off country? For those who do not particularly think about what is behind a light switch such that a room is well lit at night, or ask themselves about how clean water arrives at their tap, both hot and cold, they are also not likely to consider how stocks and bonds are looked after when their savings are invested in them. Most of the time, all of this infrastructure works without further consideration.

Who, indeed, records and tracks ownership and the benefits of capital held in financial instruments?

With the very beautifully printed physical certificates of shares and bonds consigned to museums for several decades now, one would have thought that the dematerialization of ownership, and its replacement by book-entry electronic records, would have led to greater awareness of the complexities entailed in the question, or at least some concern as to how it would function. Given the tens of trillions of dollars and their equivalent invested across the world in securities and public funds, who does keep track and how do they do it? This is even more the case with more of us investing yet more across borders – how in fact do bank custodians keep track of us, and actually find us when needed for a corporate event?

What is a custodian?

The Oxford English Dictionary tells us that a custodian is ‘a person who has responsibility for or looks after something.’ When one buys securities or funds, one does not have them delivered physically; they are instead looked after by a custodian, in most instances these days, specialized banks locally or else somewhere in the structure of the world’s largest banks, which have extensive networks to link into multiple markets.

But even the world’s most extensive networks do not usually accommodate the needs of complex financial products, which often have smatterings of securities holdings in well over 100 markets. However small those bits, they too need tending to for their ultimate owners. In these cases, the large global network will contract with banks in those remote markets to assure that assets held there are properly looked after, and that this service contracted will be set to the standard of the parent company. These banks are known as sub-custodians. With the business need comes the corresponding fiduciary responsibility. The technologies and market evolution around the world enables ever more complex portfolio diversification, all of which needs tending to just as much as if the assets were in the owner’s home market.

What is sub-custodian monitoring?

One of Thomas Murray’s base services was the review of custody banking nearly two decades ago, to assure that assets were being looked after safely and efficiently. As those portfolios went into more and more markets and the global banks had the responsibility but not the scale needed to follow with local operations everywhere, the network managers turned to Thomas Murray for independent monitoring of those third-party contractual arrangements. The fit was natural.

Today, 27 custody banks of various sizes have turned to Thomas Murray for monitoring of those sub-custodians, including several of the world’s very largest actors in this segment. This year, TM verified the services provided by 294 banks which serve those custodians, a number which will be well over 300 in 2018.

It is efficient for large banks’ network managers to establish sub-custody ties; it is also efficient for them to contract with Thomas Murray for independent monitoring of those extensive networks both direct and indirect. TM has recently been contracted by one of the world’s leading institutions to review the quality of custody services throughout its internal branch network. As those chains have grown more complex over the past several decades, the regulators stepped in with requirements to make sure the whole structure works: depositary banks actually have an obligation towards the funds that are their clients to monitor the custodians. If a custodian goes bankrupt, the depositary bank could be liable for the losses.

The key regulatory drivers for the firm’s European bank work are the European Union’s Alternative Investment Fund Managers Directive (‘AIFMD’) and the fifth regulation on public unit trusts (‘UCITS V’), which together stipulate that the depositary banks truly must prove that they have done everything they could to monitor these sub-custodians to which safe keep their clients’ assets. Other regulatory drivers underpin this work elsewhere in the world, and in any case it makes good business sense to have careful third-party reviews.

Some Thomas Murray clients are relatively new to the complexities of network management, and for them the firm still does a portion of that work, slowly transferring expertise to the client.

Sub-custodian monitoring is based upon a standardized annual questionnaire, and on-site due diligence reviews to discuss and verify those responses, usually once every two years. In many cases, the standard questionnaire is adapted to meet particular requirements.

What does one ask?

The questionnaire has the following points in common:

  1. Credentials – the respondent’s information, exact bank name, description of the regulatory environment, the bank’s group businesses, insurance policy for custody, a description of the department, and its business performance.
  2. Asset Safety and Custody – regulations, laws, and market practices for custody, the account structure, information on the national central securities depository, control and reconciliation practices, and descriptions of any physical holdings.
  3. Risk Mitigation – operational controls, audit, IT disaster recovery, business continuity, cyber security, financial crime prevention and know-your-client checks, and data protection
  4. Systems – reporting, protection of systems integrity, plans for system development, and IT performance.
  5. Core Services – settlements, asset servicing, taxation, cash, securities lending and borrowing, and client service management.
  6. Client questions – can also be of a more general nature

Why Thomas Murray for Sub-Custodian Monitoring?

The point of it all is for TM analysts to identify any potential weaknesses in the sub-custodian that might compromise the service. Custody services do continue to evolve, like everything else in the industry: the third-party, neutral vetting is critical in assuring that the sub-custodian keeps up. As the scale of sub-custodian monitoring increases, TM actually enables cost reductions, too.

Finally, in response to client demand, TM has gone on to provide related monitoring services, including:

- Sub-Custodian and capital market infrastructure call reports

- Sub-Custodian Risk Assessments

- Sub-Custodian Capability Assessment Reports

- Sub-Custodian Quality Assessment

- Monitoring of the AFME questionnaire in this field. More about this last service will be discussed in future postings.


The author, Thomas Krantz, is Senior Advisor, Capital markets, in the firm of Thomas Murray; and served as Secretary General of the World Federation of Exchanges (2000-2012). The views expressed are his own, and not necessarily those of the firm.

Tags: sub-custodian monitoringCustodiansub-custodiansCustody BanksDepository BanksAIFMDUCITS VmonitoringRegulationNetwork Managementdue diligenceCredentialsAsset Safety and CustodyRisk Mitigation

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