Template:Subcustodian risk

Subcustodian risk

Custodians and depositaries will try to disclaim all risks of the failure of their custody network, as indeed they will try to disclaim all other risks, real and phantasmagorical. Be watchful of this.

Custody risks ought to be fairly minimal: Unless the sub-custodian is in a weird jurisdiction, it should never take beneficial title to the assets it holds, and should have segregated them from its own assets, therefore beyond the putative reach of its ordinary creditors — so the assets remain the client’s at all times — so they should return to the client even on the custodian’s insolvency. It follows that, if client assets are not where they are meant to be on a custodian’s insolvency, there must have been some kind of operational mismanagement, negligence or fraud on the custodian’s behalf (and its insolvency). Since the operating cause of the loss is the mismanagement, not the insolvency itself, any capital charge should reflect operational risk and not credit risk.

None of this will stop custodians invoking the “Lehman” horcrux, of course.

Now if a sub-custodian profoundly breaches its custody obligations — which it owes to the main custodian, of course — should that custodian be able to pass its loss back to its innocent client?

It will say “yes” — of course it will — but to what degree has it been complicit in its delegate’s failure? Was it properly monitoring the sub-custodian’s performance? Was it duly diligent in appointing it? The custodian will wail, chomp and complain that it can’t be expected to price flakiness of unaffiliated third parties in far-flung locales into its business offering. Fair, perhaps — but then it did hold itself out as being in some way competent in the safe-keeping of customer assets didn’t it? Wouldn’t that include being diligent in monitoring the performance and capabilities of its custody network? After all the custodian is usually a sophisticated global multinational with experience managing sub-custodians in far-flung locales and it does have contractual privity with them.

The one place it makes some sense is in one of those weird jurisdictions where, by law or market convention, one cannot isolate custody assets from a local custodian’s insolvency. There, it is fair for the client to bear that risk (as it is the client’s choice to take on that “country” risk, and the main custodian cannot avoid it however prudent or diligent it is).

In most jurisdictions, exposure to a custodian for the return of client assets is not a solvency risk as such, seeing as the custodian should not beneficially own client assets and should have segregated them from its own assets, therefore beyond the putative reach of its ordinary creditors. It follows that, if client assets are not where they are meant to be on a custodian’s insolvency, there must have been some kind of operational mismanagement, negligence or fraud on the custodian’s behalf (and its insolvency). Since the operating cause of the loss is the mismanagement, not the insolvency itself, any capital charge should reflect operational risk and not credit risk.