SEC’s Proposed New Custody Rule Fails Industry Litmus Test

Fund management and custodian operations and legal experts are warning the US Securities and Exchange Commission that its proposed changes to its custody rule, which requires registered investment advisers to select a qualified custodian to safeguard their assets, are far too impractical and costly.

“The new proposed rule is contrary to existing business practice and creates additional burdens for RIAs and custodians without a clear explanation for why changes are needed,” Genna Garver, a partner in the law firm of Troutman Pepper in New York tells FinOps Report. The SEC’s proposed amendments to its custody rule– Rule 206(4)-2– would effectively create new Rule 223-1. The original rule, adopted in 1962 as part of the Investment Advisers Act of 1940, was last changed in 2009. The SEC published its proposed new custody rule in the Federal Register on February 15 and comments were due by May 8, but there was plenty of feedback trickling into the regulatory agency in June and July. RIAs with at least US$1 billion in regulatory assets under management would have one year to get ready from the new rule’s effective date while smaller RIAs would have 18 months.

Although the SEC could tweak some of its new custody rule’s provisions based on industry opposition, the phase-in period for potential implementation any changes doesn’t give RIAs and custodians much time to prepare. Therefore, a proactive approach is warranted, caution legal experts. “RIAs need to evaluate whether their existing custodians meet the SEC’s definition of qualified custodian and whether they can fulfill the SEC’s proposed requirements, particularly if they invest in digital assets.” Richard Levin, who chairs the fintech and regulation practice at the law firm of Nelson, Mullins & Scarborough tells FinOps Report.

Among the possible new burdens for RIAs would be the requirement for them to draft contracts with qualified custodians and to ensure that their service providers comply with new operational rules. Currently, the funds themselves handle any agreements with custodians. “The legal departments of RIAs would have to renegotiate the terms of dozens of agreements with custodians,” David Dickstein, a partner at the law firm of Katten Muchin Rosenman LLP in New York tells FinOps Report.  Why the change? Fund management firms and custodians believe the SEC’s new approach is a way of indirectly regulating the custody industry through RIAs. The problem with that idea, they assert, is that investors would pay the price because RIAs would have fewer custodian willing to take on their business with those remaining would be forced to increase their fees. “Custodians would be assessing their increased business risks associated with providing their services and assurances required under the rule, which would include the likelihood of any advisory client making the claim for indemnification,” says Garver.

The indemnification of a RIA in the event of the loss of an asset even if the loss were the fault of a third-party subcustodian or securities depository is one of the five potential alterations to the current custody rule causing the most consternation among respondents and others to the US regulatory agency’s request for comment. The others are the expansion of the types of assets covered to include all positions held in a client’s account, a narrower exemption for privately held assets, the inclusion of discretionary trading authority, and new operating responsibilities for RIAs and custodians.

Some digital asset experts oppose digital assets falling under the SEC’s new custody rule, because it is unclear whether all digital assets are securities and whether a custodian for digital assets could fulfill the potential new requirements. The qualified custodian would have to prove it has “possession or control” of the RIA’s assets– a condition which the SEC defines as being required to participate in any change in beneficial ownership. Unlike custodians for traditional assets, digital asset trading platforms which offer custody services rely on private keys or codes to provide clients with access to their holdings. In some cases, the custodian holds the entire key while in other circumstances shards or parts of the key are held by the custodian and by its RIA clients. Qualified custodians of digital assets would also have to comply with the same new operational requirements as those for traditional assets.

“Should the proposed safeguarding rule be adopted, we have serious concerns about the willingness of qualified custodians to custody digital assets– and those that are wiling may charge prohibitive fees,” writes the law firm of Linklaters in its letter to the SEC. “Such a shift in supply and demand is likely to result in increased costs to investment advisers, which, in turn, may determine to pass along to customers such costs or to cease providing investment advisory services with respect to certain asset types deemed too risky.” The law firm recommends that the SEC exempt certain digital assets from the amended custody rule under some circumstances.

Although there are a handful of firms offering safekeeping services for digital assets, they may not meet the SEC’s definition of a qualified custodian even if they insist they do. In March SEC Chairman Gary Gensler announced that “based on how crypto trading and leading platforms generally operate, investment advisers cannot rely on them today as qualified custodians.” In its proposal for changes to its custody rule, the regulatory agency also implies that state-approved cryptoasset custodians are not as reliable as federally endorsed ones. “On balance, we view the proposal as demonstrating the SEC’s willingness to push back on the notion that state chartered trusts custodying crypto could be qualified custodians,” write Alexandra Steinberg Barrage and Matthew Comstock, partners in the law firm of Davis Wright Tremaine in Washington, DC in a recent client blog. “The proposal could have provided clear guidance on how state-chartered trusts could meet the qualified custodian requirements but did not.”

Most digital asset platforms offer custody services under state-chartered trusts following the laws of either New York, South Dakota, or Wyoming. Paxos operates under a New York license, while BitGo relies on licenses in New York and South Dakota and Kingdom Trust operates under a license only in South Dakota. Coinbase operates under a New York license while Kraken Bank operates as a special purpose depository institution in Wyoming. That state’s Division of Banking has claimed that its digital asset legislation is written in such a way that custodians with licenses as trust companies in Wisconsin fulfill the SEC’s requirements for qualified custodians. However, the SEC disagrees, saying only it has the ability to decide who is a qualified custodian.

In its letter to the SEC Securitize, which operates a trading digital asset platform registered as a broker-dealer and a registered transfer agent, says it wants the SEC to include registered transfer agents in the category of qualified custodians. As long as the transfer agent meets the definition of “possession and control,” write Carlos Domingo, Securitize’s chief executive officer and Tom Eidt, general counsel, digital assets on permissionless or public blockchains should be considered privately held assets the same way digital assets on permissioned blockchains are. “The SEC’s distinction between permissioned and permissionless blockchains is flawed,” Levin tells FinOps Report. “The SEC should be more concerned about whether a blockchain-based platform is registered with the SEC and has suitable cybersecurity measures.” Permissionless blockchains can prevent some types of cyberattacks even better than permissioned blockchains and can reduce the likelihood of users manipulating the network, says Levin who advised Securitize on its letter.

The conditions to exempt RIAs of privately held assets from needing to safekeep those assets with a qualified custodian would be a lot stricter than is currently the case. One of those conditions is for the RIA to reasonably determine and document that ownership cannot be recorded and maintained in a manner in which a qualified custodian can maintain possession or control transfers of beneficial ownership of assets. “Practically speaking, the RIA would have to show it could not find a qualified custodian for privately held assets capable of fulfilling the SEC’s requirements,” says Dickstein. Proving a negative is no easy task and there is no guarantee the SEC will agree with the RIA’s judgement no matter how much documentation is provided.

Other respondents to the SEC’s request for comment about the proposed new custody rule don’t want over-the-counter and other derivatives falling under its purview. They argue that the inability of a counterparty to a swaps contract to perform the functions of a qualified custodian would require the counterparties to use a third-party custodian, whose responsibilities would be far greater than those of custodians today. As a result, custodians would be reluctant to take on the additional obligation and risks.

“To comply with the proposed rule, the investment advisers would seemingly be dependent on QCs agreeing to be party to each ISDA Master Agreement and trade confirmation,” writes Scott O’Malia, chief executive of the International Swaps and Derivatives Association in its letter to the SEC. “This would transform the traditional role of a custodian, making it an overseer of bilateral derivatives markets by entrusting it with the power to delay, alter, or even veto transactions or amendments, which would materially alter the nature of swap transactions between such counterparties.”  Currently custodians are not parties to ISDA Master Agreements which govern the terms of the interactions between counterparties, nor are custodians involved with trade confirmation. ISDA wants the SEC to omit bilateral derivatives and related credit support– collateral– from its new definition of assets.

Syndicated loans is another type of asset class which industry players say should not be subject to the new custody rule. For starters, a qualified custodian for syndicated loans might not be able to meet the SEC’s definition of “possession and control.” The SEC’s proposed alternative approach for an independent public accountant to verify any purchase, sale, or any other transfer of beneficial ownership within one day is also not feasible because it would require the accountant to do a “trade-by-trade verification.

“{The SEC] ignores the multi-faceted and well-documented settlement process where more than one third party– independent of the adviser– verifies trade information, records changes in beneficial ownership, and reconciles the receipt of interest payments and loan interest proceeds,” writes the LSTA’s Elliot Ganz, head of advocacy and co-head of public policy. The third-parties are the administrative agent and settlement platform not affiliated with the buyer, seller or RIA. The controls they have implemented are more than adequate to protect clients from theft, loss, and misappropriation, according to Ganz. Therefore, by including syndicated loans under its new custody rule the SEC would be imposing additional costs without providing additional benefits to investors.

Including discretionary trading authority under the new custody rule is also problematic, say respondents to the SEC’s request for comment on its proposed amendments. The SEC defines discretionary trading authority as the authority to issue instructions to a broker-dealer to effect or settle trades. “Equating discretionary trading authority with custody could cause advisers to be deemed to have custody over thousands of additional client accounts despite no change in the adviser’s relationship with the client,” writes the Dorothy Donahue, deputy general counsel of the Investment Company Institute in its letter to the SEC.  The trade group for the US mutual fund industry also argues that the extra costs associated with the expanded definition of custody to include discretionary trading authority will put US advisory businesses at a competitive disadvantage to foreign advisers not subject to the burdens for foreign mandates. Donahue recommends that the SEC exclude discretionary trading authority from the definition of custody as long as a RIA designs policies and procedures to reduce the risk of the loss of client assets.

Other respondents to the SEC’s request for comment are concerned about the potential for European fund companies– such as UCITS and CITS– to be included in the definition of discretionary trading authority if the funds were managed by US investment managers. “The proposed rule would extend largely redundant yet expensive protections to funds and would disincentivize them from appointing domestic US investment managers or discretionary investment from services resulting in substantially increased compliance costs for European funds and less foreign investment into the United States,” writes Tanguy van de Werde, director of the European Fund and Asset Management Association. “The proposed rule would also likely deprive many non-US investors of the investment expertise of US investment advisers.”

As if expanding the pool of assets and situations covered by the new custody rule wouldn’t be hard enough for RIAs and custodians to handle, they must now interact directly with each other under more stringent terms. A RIA, according to the US regulatory agency, would need to have “reasonable assurances” from the qualified custodian and an ongoing “reasonable belief” that the custodian is complying with a “standard of care” to safeguard the advisory firm’s assets. Among the most challenging new operational requirements for qualified custodians is that they must segregate all client assets — including cash–from their proprietary assets and liabilities.

For fund managers and custodians, the new contractual agreements are an anathema. Fund managers complain that interfering with what has historically been a relationship between the advisory client and its custodian bank is impractical and will do more harm than good. “Investment advisers do not have the necessary negotiating power to ensure that all qualified custodians engaged by investors comply with the proposal and will have no ability, or desire, to require investors to replace their qualified custodian when negotiations between the two break down,” writes Jonathan Chiel, general counsel of Fidelity Investments, in its letter to the SEC. What’s more, the additional operational burdens, as proposed, will prompt some custodians to leave the business and give the remaining few even more control over the terms of their agreements with RIAs.

Other respondents to the SEC’s request for comment on proposed changes to its custody rule point also out that the SEC has previously been unsuccessful in persuading custodians to involve RIAs in their contracts with fund clients. “The 2017 attempt to force negotiation between advisers and custodians in the context of inadvertent custody guidance failed,” explains the New York City Bar Association’s Committees on Private Investment Funds and Compliance in their joint letter to the SEC. That year the SEC’s staff wrote a no-action letter to the Investment Adviser Association clarifying that a standing letter of authorization (SLOA) established between a fund client and a RIA allowing a RIA to disburse funds to a third-party could subject the RIA to the custody rule. In that letter, the SEC’s staff also explained the agency would not take enforcement action against a RIA if the client instructed its RIA, in writing, either on a custodian’s form or separately to direct transfers on specified schedules or from time to time.  In their letter, the New York City Bar Association’s committees claim that at that time custodians balked at making any contractual changes.

When it comes to complying with potential new operational rules, global custodian banks appear to be the most worried about segregating a RIA’s cash from their own. Because a RIA’s cash account is now included on a custodian bank’s balance sheet, the bank can use the funds to extend credit to an advisory client if it doesn’t have sufficient cash to meet its settlement obligations. The bank can also invest the money in liquid interest-generating assets to earn additional revenues it shares with a RIA. The problem: If a custodian bank can’t extend credit or earn money from clients’ cash, investors will face higher fees and/or penalties. “Absent this banking service provided to custody clients, all client disbursements would need to be fully prefunded, slowing securities settlement and other investment activities and creating the high risk of securities trading fails which may involve penalties and even the suspension of trading authority under various settlement regimes,” writes David Phelan, State Street’s executive vice president and general counsel in its letter to the SEC. He recommends that the SEC exempt cash segregation from any new custody rule requiring any type of client funds and assets by a qualified custodian.

The US regulatory agency has mandated that the US reduce its settlement cycle from two days to one day on May 28, 2024 and Europe may eventually follow suit. Europe’s Central Securities Depository Regulation requires European national securities depositories to fine bank and brokerage members who fail to settle their transactions within two days of trade execution using a consistent methodology. Those banks and broker-dealers can then pass along those fines to their fund manager clients. The US’ national securities depository, Depository Trust Company, cannot penalize member firms for failing to meet the US’ required settlement deadline, but firms do incur costs for rectifying settlement fails.

Global custodians are also angry with the SEC for wanting to hold them accountable for the mistakes of subcustodians and securities depositories. The SEC is misinformed about how global custody works, they say. Global custodians do not select the foreign securities depository in which client assets are safekept and must use subcustodians as intermediaries if the global custodians cannot be direct members of a securities depository. The global custodian has no way of controlling the operations of the depository. Likewise, if the subcustodian isn’t an affiliate of the global custodian, the global custodian has no way of controlling the operations of the non-affiliated agent bank.

“Imposing liability on global custody banks for losses arising at a CSD [central securities depository] would shift part of the country risk of the investment from the investor to the custodian,” writes Steve Wager, chair of the Association of Global Custodians’ Americas Focus Committee in its letter to the SEC. “Even in the case of subcustodians selected by the global custody bank, losses may occur, such as from insolvency, force majeure or some other external cause, which are beyond the control of the global custodian and not the result of its failure to exercise due care.” If the SEC were to make global custodians financially responsible for losses in the custody chain at third-party firms, global custodians would likely not want to do business in some foreign markets or would increase their fees, writes Wager.  The AGC wants the SEC to eliminate any provision in its new custody rule which would hold a global custodian liable for any advisory client losses due to the actions of subcustodians or foreign CSDs.

Despite the plethora of criticism to the SEC’s proposed changes to its custody rule, RIAs and custodians have one thing to be hopeful for. It is uncertain whether the amended rule will ever become effective. The House of Representatives Financial Services Committee, which approves of the SEC’s operating budget, has demanded the SEC withdraw the revised custody rule. A subcommittee has passed a bill forbidding the SEC from adopting the new custody rule, among others, as part of its fiscal 2024 budget.