Sub-Custody

Sub-custody is the practice by which a custodian delegates the safekeeping and servicing of client assets in a particular market to another institution, known as the sub-custodian. Securities are generally held in the country where they are issued, in the local depository, and only institutions that are members of that depository can hold them there directly. A custodian serving international investors therefore appoints a local agent in each market it does not cover itself.

The arrangement is the basis of global custody. The investor has a single contract with its global custodian, which in turn has contracts with a sub-custodian in each country. The full set of agents makes up the custodian's custody network, and each appointment adds a link to the custody chain between the investor and the issuer. Seen from the local market's side, the same service is local custody.

The sub-custodian is the global custodian's operational presence in the market. Its main tasks are:

• Safekeeping. Holding securities in accounts at the local central securities depository or registrar on behalf of the global custodian's clients.
• Settlement. Receiving instructions, matching them with local brokers and settling trades in the local system and currency.
• Asset servicing. Collecting dividends and interest, notifying and processing corporate actions and passing on voting instructions, as described under asset servicing.
• Tax. Applying local withholding tax rates and supporting tax reclaim processing with the local tax authority.
• Cash and foreign exchange. Operating local currency accounts and, in restricted markets, handling currency conversion and repatriation.
• Market information. Reporting changes in local rules, market practice and infrastructure.

In markets that require investors to be registered or to hold an identification number, the sub-custodian also handles account opening and documentation with the local authorities.

How the assets are recorded at the sub-custodian matters for both efficiency and protection. The global custodian may hold all its clients' securities together in one omnibus account in its own name, keeping the breakdown by client in its own books, or it may open a segregated account for an individual client. Some markets require segregation down to the end investor at the depository. In every case, client assets must be kept separate from the proprietary assets of both the global custodian and the sub-custodian, so that they are not available to the creditors of either if one becomes insolvent.

A global custodian chooses its agents through a formal process, usually by inviting proposals from the banks active in a market. It assesses financial strength, operational capability, technology, regulatory standing and price. After appointment, it monitors the agent through service-level measures, regular reviews, on-site visits and questionnaires covering controls and legal protections, a programme often called network management. This due diligence is repeated periodically, and legal opinions are obtained on how client assets would be treated in a local insolvency.

Daily control rests on custody account reconciliation: the global custodian compares its own records of positions and cash with statements from each sub-custodian and investigates differences. Custodians also maintain plans for moving assets to another agent if a sub-custodian fails or withdraws from the market. In some countries only one or two banks offer the service, which limits choice and creates concentration.

The central legal question is who bears the loss if assets held by a sub-custodian go missing. Under a traditional custody contract, the global custodian is liable for its own negligence and for taking reasonable care in selecting and monitoring agents, but not necessarily for every failure of an agent. Regulation has tightened this for investment funds in the European Union. Under the rules for alternative investment funds and for UCITS, the fund's depositary must return a financial instrument held in custody that is lost, even where the loss occurred at a sub-custodian, unless it can show that the loss resulted from an external event beyond its reasonable control. The depositary's wider duties are described under depositary oversight.

In the United States, rules made by the Securities and Exchange Commission govern how registered investment companies may place assets with foreign custodians and depositories, requiring a finding that the assets will receive reasonable care. Client asset rules in the United Kingdom and elsewhere impose similar duties to assess and review third parties holding client assets.

The risks specific to sub-custody are forms of custody risk. They include the insolvency of the agent, especially in jurisdictions where the legal separation of client assets is uncertain; fraud or error in the agent's records; operational failure; and country risks such as capital controls, sanctions or the closure of a market, any of which can leave assets inaccessible. Cash held with a sub-custodian is usually a deposit and therefore an unsecured claim on that bank, unlike the securities. Fees charged by agents are passed through to clients in the custody fee schedule, which is why holding assets in smaller or more complex markets costs more.