Custody | B2B Finance Glossary

Aug 31, 2023 by Zazil Martinez

What is Custody?

Custody is a service provided by a financial institution to keep customer assets and securities safe, but custody services also include the settlement and reporting of customers’ securities and funds. This process ultimately reduces the risk for the customer since it mitigates the chance that a customer's assets might be stolen or lost. Securities lending helps customers make additional income on custody assets by allowing approved borrowers to borrow their securities short-term.

What is a Custodian?

Custody services are made possible by a custodian: a financial institution that holds assets for customers for safekeeping. Custodians charge a fee for holding customer assets and minimizing the risk of these assets being lost or stolen. Custodians can hold funds, stocks, bonds, cryptocurrency, and other digital assets; all of these different types of assets are typically held at one of the custodian's premises, a sub-custodian facility, or an outside depository.

On top of that, custodians can manage customers’ accounts and transactions, handle settlements, and ensure that all financial activity complies with the IRS and regulators.


Why Can Custodians Be Trusted to Protect Their Customers’ Assets?

All custodians are regulated by the Securities and Exchange Commission (SEC). Still, depending on their registration level, some custodians are regulated by the Federal and State Security and Treasury Departments or Departments of Finance. These government entities are responsible for ensuring that the custodians comply with regulations.

Regulations require custodians to behave in the best interest of their beneficiaries – in other words, they must be their clients’ fiduciaries. As a result, custodians provide security and liquidity to the market.

Additionally, even if clients are working with financial advisors or investment managers, the Financial Industry Regulatory Authority (FINRA) requires that these clients’ assets still need to be held with a custodian. This ensures that the identity and intention of the relationship between the client and the financial advisor or investment manager are sound. Executing transactions through a custodian adds another layer of security to the client's funds because custodians operate as fiduciaries to their clients.

Additionally, some custodians do more than validate investments made with outgoing funds; they also do due diligence, which allows them to qualify outgoing transactions to help reduce risk tied to specific investments. This added due diligence is typically the job of the financial advisor or investment manager, so it's not usual for a custodian to do this regularly. However, there is a chance that your custodian offers these services, so it's essential to understand your custodian's capabilities in case you need to enlist their support when engaging in due diligence processes.


What is the Difference Between a Depository and a Custodian?

A depository is a vault part of a facility or institution that holds assets and securities for safekeeping. Depositories take additional ownership, control, and liability over assets and securities; they use the funds deposited into them to lend to others and invest in securities. However, they always ensure that anything they receive is returned in the same condition it was initially deposited.

Broker-dealers and banks are both examples of depositories. A broker-dealer can hold securities for a client and then lend out those securities if they return them in the same condition they were deposited in. A bank holds clients’ funds and allows clients to withdraw them as needed. However, banks have a great deal of freedom regarding what they do with their clients’ funds: they can lend them to others as a business or mortgage loan and use them in other ways while holding them.

Unlike a custodian, banks and other depositories are not responsible for being fiduciary to their clients. Being fiduciary means being accountable for the beneficiary's well-being, so custodians can only move funds according to their beneficiary's instructions. As a result, they usually do not assume responsibility for investment losses.


Why do Clients Need Custodians?

Custodians are essential because they provide security services to both individuals and institutions. On top of that, custodians are also vital to handling reporting and ensuring that securities are cleared and settled promptly. This is very helpful for asset owners who need help to handle the day-to-day tasks of managing their accounts.

Additionally, custodians can be used to manage financial accounts held by minors or adults who cannot manage their assets due to their age, well-being, or limits to their physical ability.