A draft of recent legislation has marked a number of changes affecting global custody services. Propo...
According to Derek Duggan, analyst at Thomas Murray, a specialist custody research consultancy firm based in London, the new rules will force the industry to accept greater responsibility for risks associated with maintaining investments with a foreign securities depository.
Depositories exist in most securities markets and act as a facility for holding equity and/or debt instruments. A depository safeguards and records securities either physically or electronically and may record ownership of these securities. Pressure has been building for some time on investors and industry participants to analyse and better understand them and the risks associated with local market settlement and custody.
Until now custodians, through their local sub-agents, have monitored depositories but have not accepted responsibility for the selection or ongoing use of these entities. Responsibility for the risk of loss has traditionally been regarded as an investment risk assumed by an investment adviser on behalf of a fund. Yet, says Duggan, the adviser is often in a poor position to gather information on depositories. Global custodians, via local sub-agents, are better able to analyse and monitor depositories, but do not accept responsibility for the selection or ongoing use of these entities.
This has led to disagreement between global custodians and investment advisors over who should be responsible for risks associated with transaction processing and custody involving local market depositories. In response, Thomas Murray has teamed up with Standard & Poor's to provide a depository review and risk evaluation service. Aimed at custodian banks, ICSDs and the investment community, the service will be structured to provide information relating to asset safety, risk minimisation, service quality, technology and communication.
Another area of global custody that has been subject to legislative changes on the tax side is securities lending. Changes announced in the Irish Finance Bill on 10 February broadened the tax exemption measures affecting stock borrowing. The proposals extend the authorised lending period from three to six months. Stock repo transactions will alsobe exempted from the 1% stamp duty. Norway and Italy are also believed to be looking at specific legislation that would enable securities lending by domestic institutions.
According to Shravan Sood, head of technical sales of Citibank's securities lending product, the introduction of specific legislation in support of securities lending should further increase demand for such services. But introducing favourable legislation does present a dilemma. On the one hand, authorities face losing much needed revenue, particularly as levels of securities lending increases, on the other hand, by encouraging securities lending they are deepening equity markets, for example by facilitating short-selling. This, says Sood, will assist the development of hedge fund markets, an area many securities markets are keen to encourage.
This is particularly true of Europe, where growth in cross-border securities lending has been spurred on by the arrival of the euro zone. According to Sood, it has created a larger market that has the potential to rival the size and liquidity of the US market, which at $1 trillion is the world's largest securities lending market. A euro zone market of equivalent size would facilitate significantly lending opportunities and introduce greater variety of derivative instruments.
Tax arbitrage strategies have been responsible for a lot of the equities lending activity in certain markets. The tax treatment of securities lending transaction depends whether the transaction is deemed to be a secured loan or a sale (and purchase) of the securities and whether securities lending transactions receive beneficial tax treatment in the relevant jurisdiction.
The ability to apply a tax arbitrage strategy was not always the case. Tax constraints were quite severe in the early years of securities lending. Many jurisdictions applied stamp duty on both legs of the transaction, effectively stymieing the market. But as the market has developed, so has the tax treatment. Although the standardisation of tax laws throughout Europe may at the same time lessen the reasons for borrowing in the shorter term, as tax and arbitrage opportunities are reduced. Sood believes this should be more than offset by increased demand from other activities.
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