Using Safekeeping and Third-Party Custodian Services

The safety of public funds should be the primary investment objective of all governments.  One of the most important protections and a control against fraud is the separation of the safekeeping function from the investment function.  Investment policies should include a section regarding safekeeping and custody that defines how the government should have its securities held by an independent third-party for safekeeping to minimize the risk of a fraudulent transaction.  An independent third-party in a safekeeping arrangement may be a financial institution completely separate from where the depository cash assets are being held, or it may be a separate division of that same named institution.  Governments should ensure that if they are using the same institution for both trading their assets and engaging in safekeeping services, that there are proper firewalls and protections in place to safeguard your entity’s money.   Governments should also be aware of and incorporate state and local laws related to custody and safekeeping.

It is also important to be aware that banks and financial institutions may use the terms of custody and safekeeping interchangeably.  However, as discussed below and in the Procurement of Safekeeping and Custodial Services Resource, these agreements have different protections and offerings, and the government needs to determine what is the best service level.

UNDERSTANDING SAFEKEEPING SERVICES

In a typical safekeeping agreement, the government arranges for a firm other than the party that is selling the investment to provide for the transfer and safekeeping of securities.  This allows for investment transactions to be settled on a delivery-versus-payment (DVP) basis, wherein a secure delivery and payment occur simultaneously. A safekeeping account does not protect the government from making a bad investment choice or acquiring a defaulted or improper security.

There are generally two types of safekeeping services (arrangements) that a government will encounter:

• Basic Safekeeping Provider, a brokerage firm or banking institution
• Custodial Safekeeping Provider, usually a banking institution

Basic Safekeeping Provider

Under this arrangement, many times the fees are nominal or the service is provided at no direct cost as part of a broader relationship. Governments need to understand what services are being provided and how the investment assets are being held. General elements of a basic safekeeping arrangement are as follows:

• The investment assets are held in the safekeeping firm’s name for the benefit of the government.
• The assets are considered general assets of the firm and may not be protected from being used to help pay the safekeeping firm’s creditors.
• Broker/Dealer accounts may be covered by SIPC Insurance, which is limited to $500,000 and does not cover any changes in the market value of securities.  
• May allow the ability to use any broker-dealer, depending on the contract arrangement. 
• May have limited capability related to the sweep of funds to other accounts, such as only allowing accounts held at the same financial institution.
• Most operate on an actual receipt of funds basis, subject to delayed credit.
• Reporting is provided for account on a basic level, generally with limited detail and no roll-up capabilities.
• Basic safekeeping arrangements may affect the government’s ability to access its assets timely.

 Custodial Safekeeping Provider

A Custodial Safekeeping Provider has a fiduciary responsibility to its clients and usually charges a set fee based on asset volume. Custodial arrangements with these providers are often referred to as a special type of safekeeping service that is held within a Trust Department of the custodial bank, thus creating and independence from the regular commercial or retail bank. The elements of a Custodial Safekeeping Provider arrangement are as follows:

• Investment assets are protected from the claims of creditors, as the assets are considered legally separate from the bank or financial institution.
• Investment assets are held directly in the government’s account
• Usually includes an automated overnight cash sweep system to the investment vehicle of the government’s choice.
• Ability to use any broker/dealer for trades that settle into account.
• Comprehensive reporting, including roll-ups and customizable reporting options.
• Income is generally posted to account on payable date