Why are you highlighting custody agreements as an overlooked risk area?

In the financial press the focus is mainly on counterparty risk on bank deposits and obligations pursuant to loans, other financing arrangements, derivative transactions or debt securities. What is often easily overlooked is that similar risks can arise even where assets are custodied with banks.

Why should there be any counterparty risk for custodian agreements?

Where the bank is custodian, it assumes responsibility for the safekeeping and administration of deposits and investments. Typically, as custodian, the bank will hold equities, bonds and other forms of investments, as a nominee. It may be surprising to know that in some instances title to the custodied assets can pass to the custodian leaving the client very exposed in the event of insolvency.

If the custodian holds as nominee for the client, who retains beneficial ownership of the assets, doesn't this minimise risk from counterparty exposure?

Yes, but there are three main areas where there may be risk exposure, summarised below, and we would advise that the terms of custody agreements be reviewed in this context.

(i) Security. In many custody agreements the custodian is entitled to take title to some or all of the custodied assets where there is any lending to the client (lending can arise in a wide range of circumstances, including collateralised transactions, swaps, derivatives and loan arrangements). Depending on the terms of the agreement, the custodian may be allowed to take ownership of all the assets as its own, notwithstanding that they may be worth far more than the amounts loaned. Were the custodian to become insolvent, all of those assets could be at risk. In the first instance the position should be checked under the relevant custody agreement, and then it may be possible to limit the value of the custodied assets to which the custodian can take title.

(ii) Pooling. Typically the custodian aggregates fungible assets such as cash or securities of a particular issue which it holds for its various clients in one commingled account. While the custodian is generally required (subject to regulatory requirements and market practice in the custodian's jurisdiction) to maintain proper records showing each client's title to the pooled assets, if these records are not properly maintained complications would inevitably arise in the event of the custodian's insolvency. It is often possible to agree that assets will not be pooled, but this may well come at the cost of not then being able to undertake transactions which involve any element of lending by the custodian. Restrictions on lending transactions may be dealt with in other ways. As regards stock lending transactions, greater security can be obtained by cash-collateralising the arrangement through a repo.

(iii) Typically all investments in foreign equities or securities, will involve the appointment of a sub-custodian. Concerns arise if any of the sub-custodians are based in jurisdictions where the custodians do not operate as nominee for the client but may take title to the custodied assets. If the sub-custodian becomes insolvent, clients will simply rank as unsecured creditors of the foreign custodian in a foreign insolvency proceeding rather than having a right to reclaim the assets. Custodians will be able to provide details to clients as to whether any assets are held by sub-custodians in jurisdictions where the assets are not held by the custodian as nominees.

While it may be entirely appropriate to take the view that a number of investments remain desirable notwithstanding potential risk exposure these decisions are best taken on an informed basis.

Are there any further potential pitfalls?

Yes: counterparty exposure inevitably arises beyond the sphere of custody agreements, for example:

(i) Products designed to replicate investment exposure to a broad range of markets or indices, in particular emerging markets, without direct investment. This is often achieved by placing the investment with one counterparty. These arrangements may achieve economic efficiency but with the downside of exposure to a single counterparty.

(ii) Where investments are made through insurance structures, the investor is entirely exposed to the insurance provider as counterparty.

(iii) Custody agreements and accidental remittances: please see next question and answer

Do you believe there are tax risks?

Custody agreements can also give rise to UK tax problems if there are UK non-domiciled but resident persons as a result of the Finance Act 2008, leading in some circumstances to offshore assets being accidentally remitted to the UK leading to potential UK tax charges of up to 40%.

Where lending transactions take place in the context of custody agreements, this can give rise to unexpected tax consequences for non-domiciled clients using the remittance basis. Depending on the structure of the transaction, these arrangements can result in an unintentional remittance of offshore funds to the UK. This could trigger UK tax at up to 40% on the amounts treated as remitted.

This risk may be mitigated by limiting the assets over which security can be taken to only those assets which could be remitted without triggering a UK tax charge. Of course, the precise amendments required will vary according to factors including the nature of the custodied assets and whether they are directly held or held in trust.

Are there any particular Hong Kong aspects to this?

Not in the contractual sense: all of the above points apply equally in Hong Kong as in London and it makes good sense to review custodian agreements. The SFC issued a circular reminding senior management of licensed entities of the need to maintain good practices in supervision and risk management, which was followed on November 27 by a letter which amongst other things highlighted monitoring custodians. The SFC made specific mention of verifying segregation of assets by custodians and heightened monitoring of trustees and custodians based overseas.