A Primer on the Role of Custodians
A custodian is a specialized financial institution (typically, a regulated entity with granted authority like a bank) that holds customers’ securities for safekeeping in order to minimize the risk of their misappropriation, misuse, theft, and/or loss.
(Estimated reading time: 2 min 45 sec)
A custodian has three primary responsibilities:
- Safekeeping of Assets: maintaining proper indicia of ownership, valuation, accounting, and reporting of assets owned by a plan/fund sponsor or an institutional investor
- Trade Processing: tracking, settling, and reconciling assets that are acquired and disposed of by the investor—either directly or indirectly—through delegated authority with an asset manager
- Asset Servicing: maintaining all economic benefits of ownership such as income collection, corporate actions, and proxy issues
The custodian holds securities and other assets in electronic (e.g., the DTC, Fed Book Entry, CLEARSTREAM, CEDEL) or physical form (e.g., vaulting of actual physical certificates or precious metals). Given the size and value of assets and securities held by a custodian on behalf of clients, custodians tend to be large, well-capitalized, and reputable firms. A custodian is sometimes referred to as a “custodian bank.”
A custodian is often used by institutional investors, mutual funds, investment managers offering collective investment funds, commingled vehicles (like UCITs, SICAVs, and SIFs), private equity funds and other private investment funds, ERISA plans, sovereign wealth funds, public funds, nonprofits, high net worth investors, and retail investors for the safekeeping of assets. A true custodian bank would have assets under custody separate from the bank’s balance sheet and maintained as distinct from bank assets not subject to bank creditors. Assets under custody by a qualified custodian are different and should not be construed as a bank deposit and/or brokerage account. Protection against bankruptcy or insolvency of the adviser or custodian is established by segregating the assets and identifying them as being held on the client’s behalf.
In cases where investment advisers are responsible for customer funds, the adviser must follow the “Custody Rule” set forth by the Securities and Exchange Commission (SEC). (Please refer to the SEC Investor Bulletin: Custody of Your Investment Assets for more information.)
There are also nuances to qualified entities offering custodian services. A common misconception is that all custodians are the same. Understanding the difference between a depository and non-depository custodian is imperative.
Depository custodian banks are regulated by the Federal Reserve and subject to a higher standard on compliance, capitalization requirements, and overall code of conduct. A non-depository custodian would technically require a true depository custodian bank to conduct money movement. A depository custodian bank under the regulatory oversight of the Federal Reserve and the FDIC would have the necessary infrastructure to use the ABA wire platform and appropriate bank routing protocol. This would then ensure that the custodian bank would be able to track all money movements into and out of the client accounts. The federal oversight also ensures that proper regulatory checks (i.e., Anti-Money Laundering and Patriot Act requirements) are met without much burden on the client. Custodian banks are depository institutions, meaning they have to comply with Federal Reserve standards and possess the proven infrastructure for all non-negotiable requirements based on federally mandated wiring protocols.
The custodian is often referred to as the gatekeeper of assets whose function is to track monies and assets moving into and out of the account; and they are entrusted to render regular financial valuation of such assets held in custody.