One emerging market specialist recalls how he helped to raise $1 million by way of a capital increase for a Romanian company. “Taking delivery of the allotted securities,” he recalls, “meant standing at the factory gates, holding a bag to put them in, with a couple of heavies for protection, and bringing the securities back on the plane.” In transactions such as these there is a form of custody called broker custody which means that the broker will deposit the securities in a local bank. But whether such arrangements qualify as good custody is questionable since the securities cannot be easily accessed. In some cases the securities are held by the issuing company itself – hardly a prudential arrangement by western standards.
Custody requirements emanate from the US. The Investment Company Act 1940 and the Employee Retirement Income Security Act (ERISA) 1974 each provide a set of rules. The 1940 Act applies to mutual funds; ERISA to corporate pension plans. The two sets of rules say, broadly, that custodians of these funds’ assets must be of high calibre, good conduct and adequate capitalization. These requirements are referred to collquially as “17(f)5” after the particular rule in the 1940 Act.
“The base issue is whether, in the country in which you want to invest, there is a custodian able to secure and hold the assets, who is blessed by the regulations,” says Albert Francke, a funds specialist and partner in New York law firm Curtis, Mallet-Prevost, Colt & Mosle. The more obscure the market, the more likely that a fund’s master custodian will have a sub-custodian arrangement with a local bank, as opposed to a branch of its own or the branch of another major bank. But that sub-custodian must also meet the rules. The stumbling block is usually one of capitalization: the local bank is likely to be insufficiently capitalized to qualify. Equally, the local branch of an international bank may have the necessary capitalization but lack sufficient custody expertise to qualify.
In the UK, there is no equivalent legislation to the 1940 or 1974 Acts. However, the Maxwell case – in which pension assets were moved around at the whim of the sponsoring company – has prompted the Treasury and the Securities and Investments Board to look afresh at the need for regulation. That review is ongoing. “Custody implies knowledge of where the assets are, the ability to obtain accurate information and report it back to your client,” says Tim Cornick, financial services specialist and partner at London law firm MacFarlanes. It follows that a custodian or sub-custodian that is unable to report the status of a stock transaction may be failing in its duty, a problem exacerbated in some emerging markets where, as Cornick notes, “settlement seems to take place on the pavements”.
With every emerging market there is delay before adequate sub-custodian arrangements become available. Some North African markets, for example, have recently been caught in this trap. “The only solution is to send a man across the desert, Lawrence of Arabia-style, to collect the securities and bring them back on a motorbike,” says Francke, who is on the board of a number of investment companies. “In other words to take physical delivery and possession, and return the securities to an approved custodian.”
Global custodians will put in place sub-custodian arrangements – a time-consuming and expensive project in an emerging market – if the investment is likely to pay off. “We did that in Russia where we could see there would be a great deal of demand. We worked closely both with local registrars and with US mutual funds,” says Peter Cameron, a risk manager in Global Investment Services at Chase. “However, there can be delays while you obtain the necessary regulatory approvals, and the lack of local law – for instance on the ring-fencing of customers’ assets – can be a real drawback. You need to be in a position where customers’ assets cannot be seized by the liquidator of the sub-custodian, or the customer acknowledges and takes the market risks involved.”
Apart from this impact of 17(f)5, there are three other considerations that Cameron has to take into account. The first is government prohibition against trade with certain countries such as Cuba, North Korea, Iran and Iraq – the very countries which may be the next pre-emerging markets to attract investor interest. “It took a long time for the US ban against Vietnam to be removed,” says Cameron. “The UK doesn’t have as many and tends to lift them more quickly.”
The second is boycott action at fund level. For example, some funds maintained a boycott against anyone doing business with South Africa – a difficulty for investment managers which might have inadvertently invested in a company which was doing business there, even if the investment was not made on that fund’s behalf.
Finally, the third consideration is the straightforward application of country and credit risk. “If a country’s infrastructure is weak, the chances are that its banking structure is too,” says Cameron. “The credit rating of local banks offering sub-custody to global banks may be in question, even though they may have a dematerialized settlement system and adequate custody. We may have large balances washing across our nostro account [the custodian’s account with the sub-custodian] from settlement cash we have sent out, plus proceeds from settlement of sales and income that has still to be repatriated.” In that context, credit risk is critical.
The same credit risk concerns can present what the emerging market specialist sees as obstacles to pursuing the most attractive deals. “That is where fundamental analysis, a real knowledge of the local market and an ability to put your case is crucial,” says Guy Czartoryski, an analyst who covers eastern European markets at Deutsche Morgan Grenfell.
