Asset Custody is the ability to hold financial assets. To dive a bit deeper, we must first talk about Custodians.
Custodian definition
A Custodian is a financial institution that holds and protects physical, paper and digital assets. Custodians hold the key to your stored assets and can move your assets, but only when receiving explicit instructions from you, the Beneficiary. If you don't want to be the next rich duck storing truckloads of gold bars in your living room, a custodian is necessary.
How can we trust custodians?
Custodians are regulated by the Securities and Exchange Commission (SEC). Depending on their level of registration they also are regulated by Federal and State Security and Treasury Departments or Departments of Finance.
Regulation requires Custodians to be their client's Fiduciary, which means that they are required by law to behave in the beneficiaries' best interest.
If you would like to review a list of regulatory bodies a good place to start is by visiting the North American Securities Administrators Association (NASAA) website which represents state and provincial securities regulators in the United States, Canada and Mexico.
When Do You Need a Custodian? Why Would You Leave Your Assets With a Custodian?
We all work hard to build and accumulate assets. However, assets can tend to “walk away” when you are not looking, so it is necessary to have someone watch over your securities. Why not just dig a pit and bury all your goods in an undisclosed location? Well, we all want our assets to work for us. This means that occasionally we need to give other parties access to our assets, and clandestine pits are by design, largely inconvenient. No risk, no reward.
This is where Custodians come in, by providing security and liquidity to the market. Custodians have the duty and responsibility to protect the assets consigned to them and the ability to strike a valuable balance between security and convenience.
While working with Financial Advisors or Investments Managers, you might be privy to the fact that they are not -and cannot be- Custodians. This is because they are an entity that is allowed (with your signed consent) to direct your assets to various investments. While they are registered and regulated entities, having a single party being able to move your funds around can leave you holding a bag of worthless investments. This presents a very real risk for you and your assets.
Therefore, FINRA requires Financial Advisors and Investment Managers to hold your Assets with a Custodian; a third-party that verifies the identity and intention of the relationship between the Beneficiary and the Investment Manager or Advisor. Advisors and Managers must execute transactions through a reputable third-party that is a Fiduciary to you -the Beneficiary- adding additional layer of security to the movement of your funds.
Custodians typically only report on the validity of the investments made with outgoing funds, but some Custodians will also offer due-diligence, meaning they not only validate but also qualify outgoing transactions as an added service to reduce risk incurred by investments (which is really the job of the Manager or Advisor).
Depository vs Custodian
Depositories are institutions that accept deposits while taking additional ownership, control and liability over assets and securities. Any deposit received must be returned in the same condition.
A bank is a one example of a Depository, it holds the client's funds with the intention of returning it later.
A downside to banks is that they have greater variety of Asset Classes and have more liberty on what to do with their funds. In simple terms, banks can play games with your assets. Often, they exercise the ability to lend your funds to others in the form of a mortgage or business loans, in exchange for this they might pay the Beneficiary interest over time.
Another example of a Depository is a broker-dealer. Broker-dealers can hold securities on behalf of a client and while doing so they are able to lend out the securities out if they are able to return them in the same condition as the deposit.
You can think of a Depository as a vault -and sometimes they are- as vaults hold physical and/or paper assets and securities for safeguarding. Vaults can charge a storage fee but depending on the agreement they might instead pay interest if the Beneficiary agrees to lend out the contents of the vault as long as an identical copy is returned to the vault when the Beneficiary requests a withdrawal.
What happens to your assets while they are in the vault is often out of your control. Banks other Depositories are not always fiduciary to their clients, they are not forced to behave in a way that is for the benefit of their client, you.
The lines do somewhat blur between Custodians and Depositories but remember that even though a Custodian also holds possession of the assets, all the ownership and control remain with the Beneficiary. Again, Custodians can only move funds in accordance with their Beneficiary's explicit instructions with reasonable understanding that it is for their Beneficiary's... well, benefit. Because of this, they typically assume no responsibility for investment losses.
