The Financial Markets Authority (FMA) has put the call to licence custody in NZ on hold in the wake of its long-awaited ‘thematic review’ of the sector published last week.
However, the FMA would keep the licensing option open as it seeks to tidy up a few flaws in NZ custody arrangements identified in an external study carried out by consultancy firm, PwC.
Liam Mason, FMA director regulation, said in a release that the PwC report “identified potential weaknesses in the way custodians and supervisors have implemented certain provisions of the legislation”.
“We will engage with the industry to clarify and reinforce our expectations and we’ll continue to assess if further legal reform is required to license custodians,” Mason said.
In 2017, the International Monetary Fund (IMF) recommended licensing of NZ custodians in line with most other jurisdictions, sparking a long-running FMA review.
The PwC study, which focused on custody arrangements in the retail managed investment scheme (MIS) sector, “did not suggest that client money is currently at risk, but noted some practices that could be improved to strengthen the safeguarding of client money”, the FMA report says.
Notably, the regulator says some custodial duties outsourced to licensed supervisors can be handed back to managers, creating potential leaks in the chain of asset security.
“The review found one model that involves supervisors delegating much of the administration of custody to the fund manager. This reduces the degree of actual separation between custody and management, and increases custody risk,” the FMA report says. “The review also found there was insufficient oversight of custody in some cases where duties were delegated back to fund managers, which further raises risk.”
As well, the review found that a couple of asset classes, including derivatives and some term deposits, could be improperly excluded from custodial protection.
PwC identified just three licensed supervisors – while not named in the report they are Public Trust, Guardian Trust and Trustees Executors – as providing custody in NZ along with 10 ‘specialist custodians’ such as BNP Paribas, Northern Trust and JP Morgan.
According to PwC, supervisors act as custodians for over 60 per cent of retail MIS assets with the remainder held by specialists.
Mason said the FMA has already engaged with supervisors on improving practices with further guidance due next year that will also cover due diligence on underlying wholesale fund custody services.
“We expect retail MIS managers to perform and document due diligence on the custodial arrangements of the wholesale funds they consider investing in, to ensure that retail scheme property held by the other managers is secured to the level required under the [Financial Markets Conduct] FMC Act,” the FMA review says. “We expect supervisors to provide oversight of these practices.”
About 70 per cent of all NZ financial assets were ultimately held in wholesale funds that fall outside the purview of the FMA, he said.
The IMF also flagged the NZ wholesale investment sector as a potential regulatory risk.
“We will need to think further about the visibility of custody in the wholesale fund sector,” Mason said.
But any extension of regulatory power into the wholesale fund universe would require a law change.
He said the regulator was also pondering how the custody findings might fit with other sectors such as discretionary investment management services (DIMS), financial advisers and platforms.
“Similar issues apply in those areas where safety and custody of assets is fundamental,” Mason said.
In particular, the FMA is currently researching investment platforms, which fall into a regulatory grey area in NZ.
“Platforms don’t fall neatly into our regulatory system,” he said. “We’re looking at them right now… including how they interplay with custody.”
The FMA will ramp up its engagement with fund managers and supervisors (specialist custodians escaped unscathed in the review) early next year.
“Following this, we will consider any remaining policy questions and, in the longer term, whether there is a case to seek a requirement for licensing of custodians,” the review says.
Mason said there was no timeline set to reboot licensing if industry engagement on custody falls short of expectations.
Last week the FMA also confirmed green is not white in the fixed income world: or not usually. In a note, the FMA says issuers can’t recolour ‘vanilla’ bonds as ‘green’ under its same-class exemption rules (which reduce compliance costs), quashing some fixed income marketing strategies.
“… in the FMA’s view, the same class exclusion is not available to an offer of green bonds off the back of an existing quoted vanilla bond,” the regulator says. “This is because the green features of a green bond are rights, powers, privileges or limitations that attach specifically to the green bond, making it of a different class from a vanilla bond.”
However, the ruling wasn’t quite black-and-white: green (or vanilla) bond issuers could apply for a same-class exemption on a case-by-case basis, the FMA note says.