Hidden risks of disruptive change due to regulatory evolution or shifts in servicing conventions: The global custodian liability example

Abstract

Global custodians perform three primary functions: they hold assets, they facilitate the settlement of transactions and they service client assets, eg by collecting income. A global custodian has a responsibility to perform its duties properly and typically bears liability for its own negligence. In addition, it must exercise due care in selecting and monitoring third-party agents. Forces have emerged to promote the introduction of strict global custodian liability — not necessarily based on fault or matters within the custodian’s control — coupled with the proposed imposition of responsibility for a wide variety of ‘losses’ of assets or value, and a remedial duty to replace ‘lost’ assets, regardless of the source or nature of the loss. This paper serves as a case study of the hidden risks of disruptive changes in the level or extent of liability a market participant is exposed to at any given link in the securities services chain. The case study in point here involves the implications and dynamics of changes in custodians’ standards of care and liability. Significantly, the implications of change and the array of risks associated with change can be hidden from traditional risk management models and paradigms. The current standard of care observed by global custodians and fund depositaries has evolved over a long period of time. Changing these standards to increase custodian liability significantly will inevitably produce unintended consequences, potentially leading to unpredictable, possibly dramatic, ripple effects.