Evolution and demise?
The simple definition of custody embraces the idea of guardianship; keeping something or holding it in care and is based on the Latin ‘custodia’ simply meaning watchman. In a modern banking context the term custody is understood to cover the service of holding (and normally administering) securities on behalf of third parties and has its roots in physical safekeeping. In the days when securities only existed in paper form, investors needed a safe place to keep these certificates of value. They could either do this themselves or place the certificates with a third party with appropriate security arrangements in place. Banks of course were the obvious choice.
As the Global economy developed throughout the twentieth century and the volume of trading increased, the physical movement of securities associated with trading activity started to result in delayed settlement. As a result of this, at the urging of national authorities, the first central securities depositories ("CSD") were established to immobilise the securities certificates for the whole market thus eliminating physical movements. Advances in technology subsequently enabled markets to dematerialise securities so that they only existed in electronic form, transferred from one holder to another by ’book entry settlement’.
The result of this was that large volumes of securities could be traded with minimal administrative hassle. The impact on the traditional concept of custody however was that safekeeping was effectively reduced to a reconciliation activity, whereby a custodian’s task is to ensure that its holdings at the CSD are equivalent at all times to the amount of securities owned by its customers.
In moving towards a centralised book entry settlement system therefore, the custody industry had created maximum efficiency but arguably at the expense of the role of the custody banks themselves. Through the creation of central CSD’s which effectively held the immobilised or dematerialised title documents, the custody banks subtly changed their role from primary custodian to intermediary bookkeeper, with responsibility principally for providing access to the CSD and ensuring that the records of their clients’ holdings of the centrally held assets were accurate.
Of course, custody banks have survived this change as they continue to provide complementary services (banking, for example); can provide a single point of access to the world’s settlement systems; can provide expertise/economies of scale in dealing with multiple assets and, for the vast majority, the concept of what amounts to custody and the question of what is the service that is actually provided is never considered.
The relevance of AIFMD to the debate
With the introduction of AIFMD, the concept of custody became immediately relevant for any fund (and the depositary of that fund) wishing to acquire dematerialised assets as under Article 21(8)(a) a ‘…financial instrument that can be registered in a financial instruments account…’ must be held in custody.
For the purposes of AIFMD, ‘financial instruments’ are given their MiFID definition, but whether or not they constitute an asset to which the custody provisions of AIFMD apply ("Custody Assets") depends on how they are held and by whom.
As mentioned above, following the moves in the twentieth century to immobilise/dematerialise Custody Assets, these assets are now generally settled in custody by an issuer with a CSD as set out below in the illustration of simplified ownership chain for dematerialised assets.
In this scenario, as soon as the CSD dematerialises the assets (i.e., converts them into book entries in the CSD’s books) they fall within the MiFID definition which is applicable to AIFMD and become Custody Assets. The CSD remains the holder of the relevant assets and allows member organisations (custody banks and so on) to open accounts in its books in which ownership of the underlying assets can be recorded. In the event that a member organisation (on behalf of the holder) wishes to acquire any of the assets that the CSD holds, rather than transferring the assets to the relevant counterparty, the CSD provides a book entry in the relevant counterparty’s account. The relevant counterparty then provides a back to back book entry in the holders account with the counterparty. To the extent that there are multiple intermediary counterparties between the CSD and the holder, the process is repeated.
In this sense, the CSD is always the holder of the relevant assets and can be treated as the custodian in the traditional sense and by reference to the provisions of AIFMD.
If we begin to accept that the CSD is always the custodian of Custody Assets, the question arises as to what each counterparty in the chain of ownership actually holds. In this context, helpful guidance can be found in the new Securities Financing Transactions Regulation (EU 2015/2365; the "SFTR") which came into force on 12 January 2016.
The SFTR applies to securities financing transactions relating to securities, commodities or guaranteed rights and it is the definition of guaranteed rights which helps to explain what in fact each counterparty is holding. Pursuant to the provisions of the SFTR, ‘guaranteed rights’ constitute:
‘…rights relating to title to securities or commodities where that guarantee is issued by a recognised exchange which holds the rights to the securities or commodities and the agreement does not allow a counterparty to transfer or pledge a security or commodity to more than one counterparty at one time.’
It seems likely that this covers the situation where an issuer has settled securities into the custody of a CSD which issues back to back book entries / receipts to its various members. Guaranteed rights are not covered by the MiFID ‘financial instruments’ definition and as such do not constitute Custody Assets for the purposes of AIFMD.
By this analysis therefore, the CSD becomes the true custodian of the assets, being the only counterparty in the ownership chain that actually holds ‘financial instruments’. We have tried to test this analysis with the FCA but unfortunately they were unable to provide any guidance on point.
Liability in the context of CSD custody
Under Article 21(12) of AIFMD ‘The depositary shall be [strictly] liable to the AIF or to the investors of the AIF, for the loss…of financial instruments held in custody…’
Based on the above analysis, the only Custody Assets to which Article 21(12) of AIFMD applies are those held by the CSD; the back to back book entries held by the intermediary counterparties constituting ‘guaranteed rights’ rather than ‘financial instruments’.
This conclusion raises two important points in a liability context:
+ Strict liability will only attach to the loss of Custody Assets. As these are held by the CSD it is difficult to see how this could happen unless there was a systemic failure or some sort.
+ The delegation provisions of Article 21(11) of AIFMD do not apply.
Under Article 21(11) of AIFMD:
‘For the purposes of this paragraph, the provision of services as specified by Directive 98/26/EC by securities settlement systems as designated for the purposes of that Directive or the provision of similar services by third-country securities settlement systems shall not be considered a delegation of its custody functions.’
This wording is supplemented by recital 41 of AIFMD which states that:
‘Entrusting the custody of assets to the operator of a securities settlement system as designated for the purposes of Directive 98/26/EC…or entrusting the provision of similar services to third-country securities settlement systems should not be considered to be a delegation of custody functions.’
The result of this legislation is unusual insofar as by the letter of the law the depositary will not be considered to be delegating the custody of any assets which are held by the CSD and as a result of this, the provisions of Article 21(11) of AIFMD (concerning the fitness and proprietary of the delegate) will not apply to the arrangements. At the same time however, as a private equity depositary does not have the ability to hold the assets in custody itself, when reading the provisions of AIFMD, these must be construed such that the CSD is considered to be the custodian as it is the only party holding Custody Assets. This makes absolute sense in the light of the above analysis and it is important to note that recent ESMA Q&A confirms that a CSD can act as custodian in these cases which further supports this construction.
Following this interpretation it is possible to conclude that legally, in cases where dematerialised assets are held by the CSD, only the provisions of the Article 21(8) of AIFMD and Regulation 89 of the supporting Level II regulations (the "Relevant Provisions") need to be considered (i.e. the delegation provisions in Article 21(11) of AIFMD can be ignored) and when interpreting the Relevant Provisions, the CSD should be considered to be the ‘custodian’ so no strict liability should attach to any book entry guaranteed rights created by intermediary counterparties.
This is of course a sensible result as the purpose of the custody provisions is to ensure that listed assets are properly held and that investor interests are protected. Strict liability continues to apply to CSD held Custody Assets, but as mentioned above, in reality it is hard to see how losses could ever be incurred as the CSD’s make up the market infrastructure.
What does it all mean?
The core provisions of AIFMD are essentially based on the UCITS model which is a controlled retail savings product. Proper control (including custody) is effectively underwritten by a banking institution. In a commercial context though, this control function is fatuous and gives rise to systemic risk. The private equity depositary, therefore, was a sophisticated compromise that accommodates all alternative investment funds where neither custody nor retail protections are required.
This custody issue once again illustrates the ambiguities of the new regulatory framework. Whilst the custody industry moved away from traditional notions of safekeeping with the dematerialisation of assets in the 1980s, it seems as though legislators and regulators failed to keep up and industry is left to puzzle its own solutions. Such uncertainty cannot be good for anyone.
If you would like to discuss outsourcing to the Aztec Group or are considering migrating a fund or SPV, please call James Duffield, Head of Business Development, on +44 20 3818 0250.
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