January 10, 2000
Thomas M.J. Kerwin
Office of Regulatory Policy
Division of Investment Management
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
RE: File No. S7-15-99 -- Custody of Investment Company Assets Outside the United States/Investment Company Act Release No. 23815 (April 29, 1999)
Dear Mr. Kerwin:
During our telephone conversation on November 22, you raised several questions concerning certain views expressed in the July 15, 1999 comment letter submitted in the above-captioned proceeding by the Association of Global Custodians ("Association"). You suggested that the Association could address your questions, which relate to the status of transnational depositories under proposed Rule 17f-7, in a supplemental comment. This letter responds to that suggestion.
During our telephone discussion, you raised three issues --
1. The Association's comment letter states that the subcustodian banks used in local markets by a transnational depository should be subject to the same qualification, contract, care, and review requirements as any other subcustodian under Rule 17f-5. Would it be feasible to evaluate a transnational depository's subcustodians? Could sufficient information be obtained to perform such an evaluation?
2. It is the staff's understanding that central securities depositories in some local markets use the services of local banks to hold securities for the depository. Would the Association take the same position with respect to these banks as it does with respect to the subcustodians of a transnational depository? That is, if a depository in a particular market uses a bank as an agent, must that bank be evaluated under the requirements of Rule 17f-5?
3. The staff understands that it is possible, or may become possible, for U.S. funds to hold foreign assets through the Depository Trust Company ("DTC"). Should DTC be treated as a transnational depository under Rule 17f-7 in this situation? If an investment company holds foreign assets through DTC, should the fund be required to receive the same type of information about DTC as proposed Rule 17f-7 requires with respect to a foreign depository?
When a transnational depository acts as a global custodian, we believe that it will not be any more difficult for the transnational depository to evaluate its subcustodians than it would be for any other global custodian to evaluate its own network members. The Commission should make clear that it expects transnational depositories to assume responsibility for the Rule 17f-5 compliance of their networks and that fund Foreign Custody Managers ("FCMs") can rely on transnational depository representations concerning such compliance.
In the case of a central securities depository that serves a single market and does not provide cross-border custody services, we do not believe that a bank that acts as an agent for the depository should be subject to a separate evaluation under Rule 17f-5. When acting in that capacity, such a bank is, in effect, a component of the central depository. To the extent that risks associated with the activities of that bank need to be considered, these should be addressed as part of the Rule 17f-7(a)(2) risk analysis of the depository.
In light of the fact that DTC is subject to direct Commission regulation, it is not clear to the Association that requiring FCMs to conduct an analysis of the risks inherent in using DTC as a provider of cross-border custody would serve any useful purpose. However, to the extent that DTC were to provide foreign custody through subcustodian banks, DTC should be subject to the same obligations with respect to the Rule 17f-5 compliance of those banks as any other transnational depository.
Background -- Guiding Principles
As the Association has consistently stressed in its comments concerning the treatment of foreign securities depositories under Section 17(f) of the Investment Company Act, the use of most central securities depositories is, as a practical or legal matter, mandatory. In the vast majority of countries, the central depository is the only feasible method for an institutional investor to hold securities that trade in the local market. Therefore, evaluation of such a depository cannot be separated from the decision to purchase a security that trades in the market in question. The investment decision unavoidably entails a decision to use the facilities of the local depository.
The same approach should be applied to transnational depositories, such as Euroclear and Cedel. When such an entity serves as the depository for a "stateless" or "euro" security that does not trade in a local market, the transnational depository should be treated as a central securities depository. That is, the transnational depository should be subject to Rule 17f-7, and its eligibility should be determined under Rule 17f-7(b)(1).
In contrast, when a transnational depository acts as a conduit to a local securities market that is, in turn, served by its own central depository and local subcustodian banks, the transnational depository is performing both the functions of a depository and those of a global custodian bank. In this situation, the use of a transnational depository to hold securities that trade in the local market is merely one of many competing alternatives. Therefore, in addition to compliance with Rule 17f-7, use of the transnational depository should require that the depository's network, like any other global custodian's network, comply with Rule 17f-5.
With these principles in mind, we have considered the three questions you posed.
1. Feasibility of review of transnational depository subcustodians.
The first question is whether it would be feasible for a fund's FCM to evaluate and monitor the subcustodian banks in a transnational depository's network under the eligibility criteria in Rule 17f-5(a) and under the reasonable care, contract, and monitoring provisions of Rule 17f-5(c). In our view, the evaluation and monitoring of such subcustodians would be no different than the evaluation and monitoring of the subcustodian banks that are members of any other global custodian's network. Just as global custodians will be responsible for the Rule 17f-5 compliance of their networks, transnational depositories should assume similar responsibility.
It would, of course, be difficult for an FCM to evaluate a transnational depository's subcustodians without the cooperation of the transnational depository. Exactly the same problems would exist if a multi-national bank that specializes in providing global custody services were to take the position that it would not take any responsibility for determining the Rule 17f-5 compliance of its network.1 In short, an entity that elects to enter the business of providing global custody services to registered investment companies must be prepared to assume responsibility for its network's compliance with Rule 17f-5. We are aware of no principled reason why transnational depositories, especially those which are, in fact, merely private custodial and record-keeping systems operated by commercial banks, should enjoy an exception.2
There is, of course, one important practical difference between a transnational depository and a global custodian bank. While Rule 17f-5 does not require it, in most cases a fund's FCM will be its global custodian bank. Presumably, however, trans-national depositories will not accept FCM responsibilities.3 Therefore, in the case of transnational depositories, the evaluation function and the global custodian function will be performed by different entities.
For this reason, the Commission should make clear, in the release adopting Rule 17f-7, that a transnational depository should assume these responsibilities and that an FCM should be able to rely on the transnational depository's representations that --
Further, in making these representations, transnational depositories should adhere to the standard of care in Rule 17f-5(b)(2).
We recognize that a transnational depository may provide a direct link to a local depository without the use of a subcustodian bank in the local market.4 In these circumstances, the transnational depository should be expected to cooperate with a fund's primary custodian in the primary custodian's risk assessment and monitoring of the local depository under proposed Rule 17f-7(a)(2)(i). Because of its direct link with the local depository, the transnational depository may have access to information relevant to Rule 17f-7(a)(2) that the primary custodian cannot otherwise obtain. We urge the Commission to recognize this point in the adopting release.
As discussed at the outset of this letter, where a transnational depository is the depository for a particular class of stateless or euro securities, different considerations apply. In this situation, the transnational depository is comparable to a local market's central securities depository. If the transnational depository uses the services of an agent bank in performing central depository functions, no useful purpose would be served by requiring evaluation of the agent bank under Rule 17f-5. It is not possible to decline to use the facilities of the bank while continuing to use those of the transnational depository. In this circumstance, the decision to purchase the security held in the transnational depository is, in effect, also a decision to utilize the transnational depository, including its agent bank.5
2. Application to Central Securities Depositories
The second question is whether an agent bank of a central depository should be subject to evaluation under Rule 17f-5. We believe that a Rule 17f-5 evaluation of a bank employed by a central depository should not be required. Any risk associated with such an agent bank is part-and-parcel of the risk associated with the depository itself and is properly addressed under Rule 17f-7(a)(2), not under Rule 17f-5.
In those cases where a central securities depository uses a bank to assist the depository in performing its functions (such as by holding custody of physical certificates representing securities that are handled by the depository), that bank should be viewed as a component of the depository. Depository participants have no choice concerning the use of the agent bank; they cannot "select" or "reject" the services of the agent bank separately from those of the depository. Therefore, the bank should not be viewed, for Rule 17f-5 purposes, as an entity separate from the depository.6 To require a Rule 17f-5 evaluation of such a bank would resurrect the problems that Rule 17f-7 was designed to solve.
We believe it is self-evident that there is nothing inconsistent about treating a central depository's agent bank as outside of Rule 17f-5 while requiring that a transnational depository's subcustodian banks be evaluated under that rule when the transnational depository uses those subcustodians to provide global custody services. In the later situation, use of the transnational depository would be only one alternative among many. If one of a transnational depository's subcustodians does not satisfy the requirements of Rule 17f-5, a U.S. fund's manager can use an alternative method of accessing the market in question.
In contrast, where a transnational depository is the only method of holding custody of a particular security, any agent banks employed by that transnational depository should be treated as a component of the transnational depository's system and should be outside of Rule 17f-5. This approach affords transnational depositories and their agent banks equal treatment with central securities depositories when they act as central depositories and affords them equal treatment with global custody banks when they act as global custodians.
3. Application of Rules 17f-5 and 17-7 to DTC
The third question is how DTC should be treated under Rules 17f-5 and 17f-7. This question seems to have two components -- (i) whether DTC itself should be subject to Rule 17f-7 evaluation when it acts as a custodian for securities that trade outside the United States; and (ii) whether the subcustodians through which DTC holds such securities (i.e. foreign banks and central securities depositories) should be subject to the same evaluation process as would be imposed by Rule 17f-5 and Rule 17f-7 where the securities are held through a global custodian bank's network.
The first part of the question raises an issue of Commission regulatory policy on which the Association expresses no view. We note, however, that investment companies are currently permitted to hold assets through DTC pursuant to Rule 17f-4. Rule 17f-4 permits an investment company to deposit securities in a clearing agency that acts as a securities depository, provided the clearing agency is registered with the Commission under Section 17A of the Securities Exchange Act of 1934. The requirements of Section 17A registration are more stringent than the eligibility standards for a securities depository under proposed Rule 17f-7. Nothing in Rule 17f-4 requires a risk assessment comparable to that in proposed Rule 17f-7(a)(2). It is not clear that requiring a risk assessment of DTC would serve any useful purpose, in light of the fact that it already operates under SEC regulatory supervision. If the Commission has reason to believe that investor assets held through DTC are subject to undue risk, the solution would appear to be for the Commission to use its statutory authority to strengthen the regulatory regime to which DTC is subject, not to require DTC users to perform their own risk assessments.
As to the second part of the question, we believe that, if DTC steps out of its role as a central securities depository for securities that trade in the United States and instead offers to provide cross-border global custody services, DTC's subcustody network should be treated in the same fashion as any other transnational depository's network. Further, DTC should be subject to the same obligations as any other transnational depository. Therefore, if DTC were to use subcustodian banks in other markets, DTC should be required to provide the same representations, and adhere to the same standard of care, as set forth above in response to Question #1. Where DTC provides a direct link to a foreign depository, DTC should be required to cooperate in the Rule 17f-7(a)(2)(i) analysis and monitoring of that depository, to the extent it has relevant information that is not otherwise available to the primary custodian.7
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We appreciate the opportunity to amplify our views on these important topics. If the Commission or staff have further questions, or would like to discuss these matters, please contact the undersigned at 202/452-7013.
Daniel L. Goelzer
cc: Paul F. Roye
Division of Investment Management
Robert E. Plaze
Regulatory Policy and Investment
C. Hunter Jones
Office of Regulatory Policy
Jonathan G. Katz
1 If a transnational depository offers to hold, through a network of local banks, securities that trade in the securities markets of, for example, Mexico, Hungary, and Norway, the particular Mexican, Hungarian, and Norwegian subcustodian banks that the transnational depository uses to provide that service should be subject to Rule 17f-5 evaluation. The same evaluation would be necessary if those banks were part of any other global custodian bank's network.
2 For example, although both Euroclear and Cedel are commonly referred to as "depositories," they have more in common with global custodian banks than with central securities depositories. Unlike most central depositories, the depository facilities operated by Euroclear and Cedel are not instrumentalities of any government, nor are their depository functions under the type of direct regulatory control to which a central securities depository is typically subject. Like global custodians, Euroclear's and Cedel's depositories are custody facilities that are operated by commercial banks. Under these circumstances, we question the rationale for affording these entities any special regulatory status that is not also afforded to competing global custody providers.
3 An investment company does not generally have a direct relationship with a transnational depository, but rather contracts with its global custodian which, in turn, directly (or through a subcustodian) uses Euroclear or Cedel under operating agreements that are unlike standard subcustody contracts and are not generally negotiable.
4 See, e.g., Euroclear, The Hub and Spokes Clearance and Settlement Model (May 1999).
5 The risks associated with these banks are simply one element of the risk associated with the use of the transnational depository and must be addressed under the risk analysis of the transnational depository pursuant to proposed Rule 17f-7(a)(2). The same reasoning applies to these banks as applies to agent banks for central securities depositories, as discussed in response to Question #2.
6 As we have previously argued at length, depositories are components of the market infrastructure in their jurisdictions, and they are often governmental or quasi-governmental entities. Further, the liability of the depository to a participant for losses would normally be the same, regardless of whether the loss was caused by the actions of the depository itself or by a bank acting as the depository's agent.
7 DTC has begun to establish such linkages with foreign securities depositories. See, e.g., Securities Exchange Act Release No. 40660 (November 10, 1998) (Commission approval of "enhanced" link between DTC and Deutsche Börse Clearing AG); Securities Exchange Act Release No. 40523 (October 6, 1998) (same; link between DTC and the Canadian Depository for Securities Ltd.).