Mar 20, 2020
In 2017 the International Monetary Fund (IMF) published a Financial System Stability Assessment (FSSA) on New Zealand. The report was based on prior IMF Financial Sector Assessment Program (FSAP) missions to our country conducted in 2016. Following from point 35 of the FSSA (pp. 33-4), the IMF recommended introduction of a regulated licensing and supervision regime for asset custodial services in New Zealand (p. 8) within one to three years.
The FMA picked up on the FSSA recommendation concerning custodians in its Strategic Risk Outlook 2019 (p. 19). Potentially regulating custodians flowed through into the FMA’s Annual Corporate Plan 2019/20 (p. 13), and culminated in a document published in December 2019, the Thematic review of MIS custody arrangements – summary findings.
Research required for the FMA’s thematic review was carried out by PricewaterhouseCoopers (PwC) over late 2018 to early 2019. The initial survey focus group was constrained to include only retail managed funds, meaning unrestricted KiwiSaver schemes and non-KiwiSaver retail managed funds, with a sample size of 54 managed investment scheme (MIS) licensed managers. Follow up interviews were conducted with 15 of the MIS managers surveyed as well as custodians, supervisors, administrators, and assurance providers.
The FMA airs it concerns
As a spoiler, contra to the IMF, the FMA has decided not to proceed with licensing custodians any time soon, although the regulator has reserved the right to revisit the matter at a later stage. In its thematic review the FMA draws a fundamental distinction between two types of corporate custodians operating in New Zealand: specialist custodians versus supervisor custodians. This same differentiation is also recognised implicitly in the FSSA at points 34 and 35 (ibid.).
Supervisor custodians arise from terms of the Financial Markets Conduct Act 2013 (FMCA). Apart from some limited exceptions, section 156 provides that the supervisor’s role automatically includes being the custodian holding scheme property belonging to any registered scheme it supervises. This section permits the supervisor to delegate its custody functions to an external specialist custodian provided that this other party is a suitable body corporate and not associated with the manager of the scheme. The specialist custodian can in turn delegate these custody functions to a third party – the “nominee” - to perform. The core idea is that the manager of a registered MIS should not also operate as the custodian of the scheme’s property. However, even if the specialist custodian does delegate its custodial functions off to a nominee, it nonetheless must monitor and retain full legal responsibility for how that nominee performs those functions. In other words, the specialist custodian cannot contract out of its custodial duties and obligations under the FMCA by appointing another party to perform them.
Because supervisors are directly licensed and supervised by the FMA under the provisions of the FMCA, it follows that they are licensed and supervised custodians by virtue of section 156. Accordingly, there is something a bit odd about the assertion in the FSSA in point 35 that, “provision of custody services does not require a license in New Zealand and, therefore, falls outside of direct supervision by the FMA” (ibid.)
In the FSSA’s own findings it is acknowledged in point 34 that:
“Under the new regulatory framework, MIS offered to retail investors are required to appoint a Supervisor [sic.]. These are private companies licensed by the FMA to carry out certain statutory supervisory activities, including primary oversight of significant features of the MIS framework, such as monitoring the adequacy and use of … custody [our emphasis] ….”
The FSSA equivocates how an FMA-licensed-and-supervised supervisor is also a custodian under the FMCA when it refers to “primary oversight” over custody, which suggests that the IMF has focused more on the delegation than the retention of the custodial function by the supervisor. Yet clearly at least part of the custodial services sector operating in New Zealand is in fact licensed and supervised by the FMA by virtue of being licensed supervisors.
The FSSA has muddied the waters by generalising that no custody services in New Zealand are regulated by the FMA. It would have been better for the FSSA to have expressed qualified remarks stating that custody taken in isolation (e.g., specialist custodians) does not presently need to be licensed and supervised by the FMA or some other authority. Thus, the relevant question arising should be whether, in New Zealand, specialised custodians and other non-supervisors who are delegated custody-related functions by supervisors have adequate regulatory oversight.
The thematic review describes specialist custodians as typically purpose-built and staffed to perform the entire range of custodial functions. These specialists are expected to have more capabilities in custody than supervisors, who are usually not set up to provide full custodial services and accordingly often delegate custody responsibilities to such external entities. Accordingly, a symbiotic commercial relationship has evolved between supervisors and specialist custodians. How supervisor custodians also delegate custody-related functions such as recording scheme property to other parties such as MIS managers is critiqued by the FMA in its thematic review.
The FMA identifies two high-level issues from the PwC survey of MIS and other entities. Both relate to ways in which supervisors exercise their section 156 option to delegate custody functions to external parties. First, it is stated that supervisor custodians are delegating certain custody administration functions, described elsewhere in the thematic review as “the recording of scheme property”, to MIS managers, which allegedly decreases separation between the manager and custody at a cost of increased custody risk. Secondly, concern is expressed that supervisor custodians do not have sufficient oversight of custody-related duties “delegated back” to fund managers, adding to the risk.
More specifically, the FMA came up with four topics concerning custody that it was uneasy about:
Wholesale funds are another worry described in point 35 of the FSSA as needing more FMA oversight and this additional theme has been taken up by the regulator in its current work programme. A significant part of the managed funds industry in New Zealand is based around managing assets through wholesale funds, with retail MIS often set up as “feeder funds” investing into them. But whereas retail funds come under direct regulatory purview of the FMA via the MIS regime, presently wholesale funds do not. One aspect of this regulatory bifurcation criticised by the FMA is that custody practices of wholesale funds are unregulated except for the FMCA’s fair dealing provisions. The thematic review states that it expects retail MIS managers to perform adequate due diligence on custodial practices of wholesale funds that they invest scheme property into in order to ensure that such practices meet FMCA standards, and that supervisors must provide oversight of MIS managers’ satisfactory performance in this respect.
Scheme property not being held in custody as required by the FMCA is not a major problem, according to the FMA’s thematic review, with an estimated 0.05% of MIS assets falling into this category in New Zealand. The most common assets outside custody (AOC) include call accounts and term deposits held with trading banks, and bespoke assets such as over-the-counter (OTC) derivatives. AOC tend to be contractual arrangements. The thematic review notes that in overseas jurisdictions AOC may be permitted, but that under New Zealand law no such exceptions are allowed, and therefore the FMA intends to issue guidance on the subject.
Supervisory oversight of custodial arrangements performed by external parties is a weightier issue raised by the thematic report. The FMA states that it expects supervisors to maintain oversight of outsourced custodial functions sufficiently to ensure that external parties operate to the same standards as the FMCA requires of supervisors themselves. In practice, it found that supervisors frequently delegate daily settlement, record-keeping, and reconciliation activities externally to specialist custodians, MIS managers, and administrators. These arrangements can potentially bring MIS managers closer to performing custody-related functions than the FMCA envisages, the FMA asserts. In particular, the thematic review raises concerns that supervisors are relying too much on external parties correctly complying with custodial requirements and not performing their own adequate in-house record-keeping, analysis, reconciliation, ongoing assurance, and independent controls concerning scheme property of which they are supervisor custodians. Guidance is to be forthcoming on these matters from the FMA.
FMCA regulations 87 and 88 pertain to the requirement for custodians to obtain an annual assurance engagement. The thematic review comments favourably on trends observed from reviewing assurance reports, but notes certain areas where improvement is needed. Cases were found where different MISs had inconsistent custodial arrangements with the same custodian. Reliance by custodians on external administrators created complications that could necessitate scheme-level assurance reviews. No common standards are set and used across assurance providers, requiring greater cooperation with supervisors to rectify. Moreover, New Zealand does not compel asset verification reviews to be undertaken despite such checks being standard practice overseas. Once more, the FMA intends to issue guidance on the matters raised.
Considerations arising from the thematic review
In the thematic review, the FMA has taken what might be termed a “black letter law” stance on the application of the FMCA to custody. In particular, the regulator has focused on the legislative intention to impose strict segregation between the manager and the custodian of an MIS (including both the supervisor custodian and (if any) the specialist custodian). The regulator does recognise that arguments can be made concerning business practicalities and savings on costs to investors to defend the status quo. Nonetheless the thrust of its critique is that custody-related functions are often sitting too close to MIS managers and too far away from supervisor custodians when viewed through the prism of the FMCA. The FMA has announced through its thematic review that it intends to engage with supervisors and MIS managers on this subject.
On the face of it, some reasonable replies to the FMA’s critique may be based upon using a “black letter law” interpretation of the FMCA. The FMA itself states in the thematic review that:
“We recognise that the legislation requires the custodian to “ensure” that accurate records are kept, rather than requiring the custodian to keep all records itself. We are concerned that delegating the recording of scheme property back to the manager undermines the separation of functions and duties that the legislation seeks to achieve. We will be looking into this further with supervisors.” (pp. 1-2)
Delving more closely into relevant sections of the FMCA, section 156 states in part:
(1) The supervisor of a registered scheme (A) must hold the scheme property or, if authorised by the governing document, contract the holding of the scheme property to another person (B) who meets the external custodianship requirements …
(4) To meet the external custodianship requirements, a person must … (b) not be the same person as, or be associated with, the manager …
This section speaks only of custodial requirements and not of other separable functions that a supervisor might delegate out such as record keeping, for example. In any event, an MIS manager needs to undertake record keeping concerning scheme property in order to run its own business properly and comply with its duties and obligations under the FMCA.
Section 157(1) states that, “The custodian for a registered scheme holds the scheme property on trust for the scheme.” Thus holding scheme property on trust is the essential role performed by a custodian and serves the primary purpose of providing investor protection from manager fraud or insolvency. Who keeps records of scheme property is not of essence concerning custody.
Section 158 contains some important qualifications to how records of scheme property are to be kept. The section states in part:
158 Custodian must keep records of scheme property
(1) The custodian for a registered scheme must keep, or ensure that there are kept [our emphasis], records that—
(a) identify the scheme property; and
(b) show when the scheme property was received; and
(c) if the scheme property has been disposed of, show when the scheme property was disposed of and to whom…
(3) The custodian for a registered scheme must—
(a) keep the records required by this section, or ensure that they are kept [our emphasis], in a manner that enables those records to be conveniently inspected by the manager and the supervisor [our emphasis] and conveniently and properly audited or reviewed….
This section is silent on the question of whether the supervisor can delegate (“ensure”) scheme property record keeping to the MIS manager, who is carrying out such record-keeping anyway. Certainly, the section carries no active prohibition on the supervisor delegating record keeping to the manager or some other external party such as an administrator. If the manager does that task, then so long as the records can be “conveniently inspected” by the supervisor, then the purposes of the section are apparently met. If Parliament had intended differently, then surely the wording of section 158 would have been different.
Taken together, the above considerations suggest that there is no need for a supervisor custodian to maintain a separate set of scheme records parallel to those that are kept by another party such as an MIS manager or an administrator. Not needing to maintain a second set of records reduces custodial costs for supervisors to the benefit of investors yet complies with the letter of the FMCA. It remains to be seen whether upon further reflection the FMA will adopt this interpretation of the FMCA.