What is a custodial participant?

Custodial participants are important members of financial markets. They not only facilitate securities trading for their clients but also provide safeguards against fraudulent activities.

In the US, registered investment advisors are required to maintain the client in custodian accounts. This is a check put in place by regulators to prevent theft and misappropriation of client funds.

What does a custodial participant mean and why is it important to investors? Let’s find out below.

Key takeaways:

What is a custodial participant?

Custodial participants are stock exchange partners responsible for settling trades on behalf of their clients. They are classified as clearing members and not trading members by stock exchanges. 

During a trade settlement, the custodial participant confirms the validity on behalf of his client thereby allowing the trade to take place.

Custodial participants are required to register with financial market regulators in their operating regions. Typically, custodian participants are commercial and investment banks. 

Custodial participant explained 

How does a custodial participant work? To understand this, we need to learn about custodians.

A custodian is a regulated financial institution primarily responsible for safekeeping its client’s assets. They hold stocks, bonds, commodities and other assets in physical or electronic form on behalf of their customers.

With regards to securities trading, a custodian may be responsible for handling investment activities for its clients. In such a case, a custodian will place buy or sell orders via partner brokerages to trade client assets, facilitate transfer of funds and even distribute dividends.

A custodian may also offer tax filing services for its clients’ investments. 

High-wealth individuals, mutual funds, investment managers, insurance companies and retirement funds are the main clientele for custodian participants.

Individuals and firms also use custodians to gain exposure to foreign markets or alternative assets, which may not be available through the local brokerage firm.

BNY Mellon: The world’s largest custodian bank

The best example of a custodial participant is BNY Mellon, the largest custodian bank in the world. It was founded as the Bank of New York by Alexander Hamilton, the first US Secretary of the Treasury, in 1784.

According to BNY Mellon’s website, as of September 2022 it had $42.2trn in assets under custody. BNY Mellon is operational in 35 countries. 

Some of the services provided by BNY Mellon as a custodian participant include:

• Matching of trades

• Reporting of failed transactions

• Cross-border trades

• Late instruction trades

• Intra-day trade management 

• End-of-day trade confirmation

• Active monitoring of pending trades

Other custodial services offered by the custodian bank related to securities market trading and investment are:

• Proxy voting services

• Collection of foreign tax reclaims

• Tax compliances

• Account maintenance

• Access to capital and treasury markets   

Why are custodians important?

In 2013, the SEC designed the ‘Custody Rule’ to safeguards investors against the possibility of theft or misappropriation by investment advisers.

According to Custody Rule, SEC-registered investment advisors are required to maintain client funds and securities with a “qualified custodian”. 

The rule added that the investment advisor must notify clients in writing of the qualified custodian’s name, address, and the manner in which the funds or securities are maintained after opening a custodial account.

Under the rule, custodian banks are required to send account statements on a quarterly basis to investment advisor’s clients directly.

What investors need to know?

According to the US SEC, investors need to remain vigilant despite the protections of the Custody Rule.

Here are the few points investors need to consider regarding their custody arrangements :

• Investors should enquire about custody arrangements at their brokerages or financial advisors. 

• Check the account holder’s name. According to the SEC, investment advisors are not permitted to name themselves as the principal on an account that has been created for a client.

• Enquire if you do not receive quarterly account statements from the custodian.

• Contact both investment adviser and the custodian on any discrepancies in the accounts.

• Consider advisor fees before making investment decisions.

FAQs