Custody is “largely unseen by the public”, according to a new Financial Markets Authority (FMA) discussion paper, except when something goes wrong. Some things have gone wrong. As namechecked in the FMA paper, the 21st century has featured several infamous custody-related debacles in NZ such as Ross Asset Management, Barry Kloogh and Halifax. But the comprehensive regulatory review of NZ custody settings also brings a few previously invisible current examples of back-office failures into view for the first time. The FMA list of screw-ups, some
still under investigation, includes “failure to segregate assets held in custody, apparent fraud, not obtaining an assurance engagement, failing to report to investors, and failure to exercise due care diligence and skill contributing to loss of client assets”. For instance, an as-yet anonymous retail investment platform apparently lost a non-specific amount of ‘unallocated’ funds through employee fraud. “The employee exploited processes they were directly responsible for overseeing,” the FMA paper says. “Their role and system access allowed the employee to manipulate internal controls and carry
out unauthorised transactions without immediate detection.” Elsewhere on the financial frontier, a peer-to-peer lending platform was pinged by the regulator for skipping on formal custody assurances for five years in succession. “The reason for the failures appeared to be that [the peer-to-peer lender] was unaware that it was a custodian and therefore that it needed to comply with this obligation,” the FMA notes. While the most recent breaches might be relatively minor, the cases highlight gaps in the NZ custody regime that the regulator variously
describes as ‘complex, fragmented, uneven’ and outmoded. And the local custody universe is surprisingly vast. The FMA found some 274 custodial entities logged on the Financial Services Providers Register, split into: 29 registered scheme custodians; 14 linked to discretionary investment management services (DIMS); 125 in the retail market; and, 106 classed as wholesale. Despite some likely double-counting (for example, supervisors establish separate entities for each scheme they monitor), the scale and lumpy nature of the NZ custody backdrop create problems for regulators and investors. The
FMA admits, for example, that it “has very little sense of the size, structure, practices or risks in the wholesale sector”. “Wholesale custodians have no New Zealand law requirements to hold assets in trust or segregated from their own assets,” the discussion paper says. “While we understand anecdotally that wholesale funds are typically established under a unit trust structure and their trust deeds would generally stipulate that underlying investments should be held with a specialist custodian, this is a matter of business practice and not
a regulatory requirement.” In its first take on the FMA release, legal firm Dentons suggests the regulator would do best to focus attention on the wholesale grey areas and the jargon-heavy negative spaces of “non-MIS [managed investment scheme] /non-DIMS CMPS” – the latter abbreviation, of course, standing in for ‘client money or property services’. “That is where the more serious issues of concern have arisen in the past, and where the lightness of our regulatory settings creates an environment where problems may continue to surface,”
the analysis says. By contrast, Dentons says the MIS and DIMS custody world is less problematic. “The constraints placed on licensed MIS and DIMS providers are effectively achieving most of the outcomes the FMA appears to be seeking, with clear avenues for the FMA to exercise oversight.” Regardless, the regulator is seeking industry input rather than offering solutions to a custody conundrum that has vexed the market for at least the better part of a decade after the International Monetary Fund (IMF) called on NZ
to introduce a licensing regime in 2017. “This recommendation has not yet been addressed,” the FMA paper says. “IMF is due to complete a further review in 2027-28. It is likely that custody regulation will be a focus of this, which makes a review of custody regulation timely.” Aside from finally addressing the IMF concerns (that also included loose wholesale fund regulations), the FMA says the influx of ‘digital assets’ has added further urgency for a refresh of NZ custody arrangements. Custody is a top-line
issue for the regulator this financial year with its findings to feed into Ministry of Business, Innovation and Employment policy design – and possible new legislation. Submissions are due in by close-of-business on July 27. Look here for further information.
Financial Markets Authority, FMA, custody, New Zealand, client assets, investor reporting, asset segregation, peer-to-peer lending, retail investment platform, wholesale custodians, IMF licensing recommendation, digital assets, July 27 submissions