IN SHORT: In the financial world, the word ‘custody’ refers to a highly specialised service where a financial institution, such as a bank, safeguards the assets of institutional investors, such as retirement funds or insurance companies. When this service extends over different countries and time zones, it is referred to as a global custody service.
Among other functions, a custody service sees to it that the millions of rands in an investor’s portfolio are kept safe and that all transactions are securely processed. (Click here to read more about the core functions of a custody service.)
But what if these transactions take place on the global market, between companies operating in different countries and time zones? The volume of global assets under custody has indeed grown rapidly in recent years as investors have looked to foreign countries for additional investment opportunities.
Meet the global custodian. Global custodians provide custody services for all cross-border securities transactions. They typically provide services such as executing foreign exchange transactions and processing tax reclaims. They do this through a network of their local branches or a trusted sub-custodian, or agent bank, in each country.
Local custody services already involve sophisticated administrative tasks with a high level of risk. Global transactions pose even more risk as they can involve trillions of dollars. Let’s look at some of the risks global custodians have to navigate.
1 Transaction risk
Transaction risk may be magnified where transactions occur around the clock in a variety of different markets. For example, if a retirement fund in South Africa buys shares in a company based in Asia. A global custodian must consider a range of factors – from different market rules and conventions and the degree of automation in the foreign market to different types of securities, capital or currency restrictions.
2 Compliance risk
In various parts of the world, there are different sets of rules and laws that govern how financial markets work. Global custodians need to have expert knowledge of the various regulatory environments in which they operate, i.e. they have to keep up with the compliance rules of every country. This poses a huge challenge, also known as compliance risk, as these rules can change at any time. In foreign countries, the global custodian will typically rely on its sub-custodian to understand and comply with the local laws and regulations.
3 Credit risk
Global custodians may be exposed to credit risk from several sources. Many of the sub-custodian entities used by the global custodians are not rated by the main credit rating agencies. It’s crucial for the global custodian to understand the creditworthiness of the sub-custody network during the selection process and to constantly monitor changes as they occur. If the sub-custodian defaults on its obligations, it could lead to potential financial losses for the global custodian, particularly in cases of derivative transactions and securities lending.
Also, not all markets use the delivery versus payment (DVP) settlement method. DVP stipulates that the buyer’s cash payment for securities must be made prior to or at the same time as the delivery of the security. Not using this method could lead to a sub-custodian failing to conclude a transaction, and the global custodian may have difficulty obtaining its customers’ securities.
Questions to ask when choosing a global custodian service provider
1 How large is the global custodian’s network? According to Regulation 28, retirement funds are allowed to invest 45% of their assets offshore. Make sure the global custodian can offer your retirement fund access to a variety of foreign markets, affording your fund a wide range of choices in Africa as well as on other continents and in mature and emerging markets.
2 How is its due diligence conducted when choosing a sub-custodian in a foreign country? Your retirement fund may not have direct credit-risk exposure to a sub-custodian but, when selecting a global custodian, reviewing the strength and creditworthiness of its sub-custodial network is crucial. The safety of your assets depends upon it.
3 Ask whether the global custodian offers indemnification against borrower default or other credit risks when the bank offers securities lending. In short, how will the global custodian ensure the retirement fund does not lose any assets during offshore transactions?