By Alison Touhey
Many Americans are unaware of the significant and foundational role that custody banks play in the everyday operation of our financial markets. Custody banks provide services to institutional investors, including asset managers, mutual funds, retirement plans, insurance companies, governments, corporations, endowments, other financial institutions and large private investors. Typically, these services include settlement, safekeeping, payments and liquidity services and asset servicing (such as tax services and corporate action processing) at scale across multiple markets globally and at relatively low cost. These services are provided either directly or through other intermediaries to institutional investors to help protect their clients’ assets and support the accumulation of wealth for their end-investor clients, including those saving for retirement, college or other life events.
By providing the services, custody banks play a critical role in facilitating the smooth operation of the financial markets. Put another way, custody banks are a key part of the “plumbing” of our financial markets, and just like the plumbing in your home, you don’t think much about it as long as everything is functioning well. The SEC’s custody rule threatens to disrupt that.
One of the key changes under the proposed rule relates to how banks handle funds from customers. Custody banks are chartered banks that, just like any other bank. They accept cash deposits that are used to support key financial services and economic activities. For custody banks, this includes critical market functions such as clearing and settlement of securities transactions. Also, like other banks, custody banks are subject to stringent prudential regulations and supervisory oversight designed to ensure that their activities are conducted in a safe and sound manner. To comply with both regulatory and supervisory expectations, custody banks have implemented and operate robust risk-management and control frameworks that address, among other matters, liquidity risk management, the monitoring of counterparty credit risk, asset-liability management practices, interest rate risk and the oversight of third-party service providers.
The SEC’s proposed rule would impose new, unworkable requirements for handling deposits that would require custody banks to “segregate” client cash. Since banks are the only entities that can hold deposits, this would mean in effect that a custody bank would have to hold client deposits at another bank instead of on its own balance sheet, undermining choice and completely upending the custody bank business model. This will inevitably lead to higher costs for their clients and ultimately for the individual investors that they serve. Moreover, the proposed segregation of cash would also complicate the ability of custody banks to offer their clients access to credit used to facilitate the smooth and efficient operation of settlement and other market functions. The SEC proposal would also front-run the FDIC’s order of creditors, creating a class of depositors whose rights would exceed those of retail and other depositors in the event of a failure.
In addition to the new requirements for handling deposits, the rule would shift legal liability to custody banks, holding them accountable for actions of third parties well beyond their control. This includes financial market infrastructure, such as central securities depositories that serve as the book of record for issuers and the political risk that clients take when investing in overseas markets via a sub-custodian. One of the novel features of the Commission’s proposal is that it would require custody banks to hold insurance for the risks presented by their sub-custodians. Additionally, the SEC’s proposal raises significant questions as to how a custody bank would provide custody and segregation of assets with respect to assets that are not cash or securities, such as derivatives, which cannot currently be held in custody.
Beyond these and other requirements that would have acute implications for individual investors, the rule broadly oversteps the SEC’s regulatory authority. While the SEC lacks any statutory authority to regulate custody banks, the proposal effectively empowers the commission to insert itself into matters at the core of the prudential framework. The SEC lacks any statutory authority to regulate custody banks as contemplated by the proposal. Yet the proposal empowers the commission to unduly insert itself into matters at the core of the bank regulatory system, which conflicts with the statutory requirements governing bank safety and soundness.
This move is just the latest in a troubling trend of SEC overreach. In particular, the SEC has recently and intentionally undertaken an ambitious, unrelenting volume of rulemaking that could result in significant disruptive and distorting shifts in financial markets. These actions include proposals and requests for information regarding climate-related disclosures, money market funds, digital engagement practices, cybersecurity risk management, security-based swaps, beneficial ownership reporting, swing pricing and much more.
Moreover, while such initiatives often have broad implications for regulated institutions, there is very little indication that the SEC has coordinated or even meaningfully communicated with their banking agency counterparts to ensure sound and appropriately designed policy solutions.
When faced with capturing the crypto mouse in the house, the solution is to capture the mouse, not bulldoze the house. While we share the SEC’s goal of protecting investors, this proposal would inflict tremendous damage to the financial markets and cause significant and lasting harm to banks, their customers and the investing public.
Alison Touhey is SVP for bank funding policy at ABA.