This whitepaper discusses how a properly drafted custodial agreement in a “Hold-In-Custody” (HIC) environment captures the benefits of a “Tri-Party” arrangement without its burdens. At the conclusion of this paper, you will understand how a well-designed custodial agreement provides the depository with greater operational flexibility, while providing the public-entity depositor the same safeguards as a tri-party agreement, but at a lesser burden to them as well.

1 Executive summary

When a paired with a properly drafted “Hold-In-Custody” collateralization agreement between a depository and a public entity, a properly drafted “Hold-In-Custody” custodial agreement preserves the protections of tri-party custodial agreement while materially improving how a bank allocates, substitutes, and reports collateral.

Public deposit balances above applicable FDIC insurance limits are commonly secured with collateral identified as eligible under state law. The FDIC has confirmed that it will honor a collateralization agreement in a bank failure only when the agreement is valid and enforceable under applicable state law. As such, deposit collateralization itself does not expand deposit insurance, nor does it guarantee that the provided collateral value will be sufficient.

The central design principle of a well-designed HIC agreement: functional equivalence, not document equivalence

In short, the public entity does not need to be a party to the custodian agreement for every safeguard to exist. However, the public entity must have a perfected security interest – created by an agreement between the public entity and the bank, with clear third party-beneficiary and control provisions. The custodian then agrees to act as the public entity’s agent to identify, protect, value, and deliver the pledged interest in accordance with the governing legal structure.

What this paper recommends

Use a Hold-In-Custody type of custodian agreement in those jurisdictions, and for those public entities, whose laws, policies, and deposit agreements permit it.
Treat fractional collateral allocation as a legal and operational capability. Confirmations must be provided to the public entity and custodian (and to the state treasurer where applicable) that identify the beneficiary, security, quantity or percentage, value, and the haircut/over-allocation (if applicable).
Replace transaction-by-transaction consent with defined rules and permissions, automated coverage algorithms, provide user and review controls with exception approvals.
Obtain legal, accounting, and regulatory reporting conclusions before changing custodian agreements.

2 Why traditional tri-party custodial agreements can become a constraint

At first blush, tri-party custodian agreements suggest they provide more protection. We now live in a world where decision criteria can be programmed automatically into a workflow rather than remembered . . . or forgotten. However, the reality is that a tri-party arrangement’s need for ongoing human involvement not only allows more opportunities for error, it does so inefficiently and without the ability to scale.

What the tri-party model does well

A traditional tri-party agreement places the pledging bank, the public depositor or public collateral authority, and the independent custodian in a single contract. That direct relationship can make duties, default instructions, and acknowledgement of the public entity interest easier to see.

Where inefficiencies and excess labor often appear

3 Types of custodian agreement structures

The difference is not whether collateral is held by a third party. It is how the contractual parties, beneficiary rights, and operating authority are organized.

The contract stack in a sound “Hold-In-Custody” custodian agreement

Why substitution can coexist with protection

Article 8 of the UCC allows a purchaser to retain “control” of a security entitlement while the holder may substitute or otherwise “deal with the position.” While this language supports rules-based substitutions, it alone does not perfect a public entity’s interest. Perfection, however, requires possession by the secured party or a custodian acting on their behalf.

4 Business benefits for the bank

The strongest value proposition is not simply fewer signatures. It is the combination of collateral efficiency, operating scale, and portfolio flexibility.

Call Report Implications

The June 2026 FFIEC 031/041 instructions for Schedule RC-B, Memorandum item 1, require banks to report the amortized cost or fair value of securities pledged to secure deposits and other obligations, regardless of the balance of the deposits or liabilities being secured. A whole CUSIP pledged to a smaller public deposit will therefore cause the full reported amount of that security to be captured as pledged. A fractional-interest structure can reduce the legally encumbered amount.

5 Illustrative economics: whole securities versus fractional allocation

The following example illustrates the differences between allocating whole CUSIPs versus fractional CUSIPs to collateralize a public deposit. Actual results will depend on the collateral type used, market value, haircuts (if any), state required collateral percentages, additional buffers, and agreed-to terms.

Assume three public entities require a combined $6.75 million of eligible collateral value after all FDIC

insurance calculations and statutory haircuts. The bank’s custodian agreement forces it to dedicate $11M, under a Tri-Party – whole-security, one-entity-per-CUSIP agreement.

What the bank can do with released collateral

> Support additional public deposits without purchasing more securities.

> Preserve unencumbered liquidity for contingent funding and broader balance-sheet management.

> Reduce forced substitutions when a dedicated security matures, prepays, or becomes ineligible.

> Improve the accuracy of internal encumbrance reporting and collateral forecasts.

Jurisdiction considerations

State requirements regarding the collateralization of public deposits vary widely and change frequently. For example, the state of Washington currently requires securities to be pledged under a fully executed tri-party depositary pledge agreement. The state of Virginia requires that qualified depositories choose either a “pooled” or dedicated method and place eligible collateral with a qualified (state approved) custodian. It is important for each bank to periodically review the applicable laws for those states they operate in.

6 Conclusion: Protect the depositor, free the collateral

For many banks, the choice may not be between safety and flexibility. It may be an issue between a legacy control architecture and a modern control architecture.

A tri-party custodian agreement is appropriate – and sometimes mandatory – when the governing law, public entity, or the bank’s collateral program requires direct contractual participation. A hold-in-custodian agreement is appropriate when there are documented/enforceable beneficiary rights and a clearly defined agreement. A HIC can remove transactional signatures, support fractional interests, accelerate substitutions, and improve the utilization of the securities portfolio.

The strongest implementation does not ask public entities to accept less protection. It gives them clearer evidence of coverage while the bank replaces manual approvals with documented authority, independent custody, automated prevention, precise beneficiary records, and defined rights.