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Wondering What Custody Is? It's More Complex Than it Looks

Who looks after the money we invest? And where does it go when we hand it over?

James Gard 11 August, 2022 | 4:48AM
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Quis custodiet ipsos custodes? That's a phrase attributed to Roman poet Juvenal, and roughly translates as "who will watch the watchmen?" or "who will guard the guardians?"

Although originally talking about senators’ infidelities, Juvenal’s phrase has rebounded through history, spawning comic book The Watchmen and even appearing as graffiti in Washington during the protests over George Floyd murder in 2020. In essence, it’s a call to hold the powerful to account.

The Latin word "custodes" is echoed in the investing world when we talk about "custodians", a precisely defined role in institutional investing. But the wider concept of "custody" is an important one for investors, particularly in the light of recent crypto collapses, and fraud.

When I, as an investor, give my money to institution, who makes sure it’s "safe", and who do I turn to when things turn sour? Many governments now backstop savings up to a certain level, as long as the savings/investing products are regulated.

Once Burned

Let’s start with the narrow definition of custody services. Fund managers are a busy bunch so have essentially outsourced the back-office elements of their jobs to multinational banks.

These admin tasks involve claiming tax rebates, managing cash (of which more later), voting at AGMs and collecting dividends. This is the less glamorous side of asset management but an important one because it’s built on trust and competency.

From retail investors’ perspective, it’s an added layer of security because a fund manager may have billions of assets under management (AUM) but this money isn’t sitting in their bank accounts (and theoretically can’t vanish to the Caribbean). Fraud is rare in finance but can have a huge impact, as the Wirecard and Bernie Madoff examples show.

In many countries, having client and company money separate is a legal and/or regulatory requirement, although even the biggest banks sometimes fall foul of these rules and get fined (then make the same mistakes again).

Bear this concept in mind as we look at the recent Celsius case, a crypto lending network that “paused” investor withdrawals in June and then filed for bankruptcy in July.

Its users have been warned to expect the worst in this process, especially as Celsius "owes" them $4.7 billion. In the filing itself, there’s a specific reference to the "Celsius Custody Service", a product made available to US users in April 2022.

It’s described as the "central hub of their digital asset account", a sort of holding pen of money (not cash) before it gets moved to more exciting opportunities – in this case, the "Earn" programme that offered some tantalisingly high yields.

Quoting the company’s user agreement, the court document notes: "crypto assets held in custody shall 'at all times remain with the [user]' and 'Celsius will not transfer, sell, loan or otherwise rehypothecate' digital assets in custody unless 'specifically instructed by [users], except as required by valid court order, competent regulatory agency, government agency or applicable law'".

At the time of the company’s collapse, 58,000 people used this custody service, holding $180 million – a liability that is matched by assets in the balance sheet. The heart of this and future crypto controversies is the issue: where is my money held and can I get it back?

Another question that Celsius users are now asking is: what did you do with my money? This sentence in the filing is a stark reminder of the power users handed over to the platform: "Once cryptocurrency is transferred to Celsius, except assets transferred pursuant to Custody Service, Celsius has title to the asset and the complete authority to use the asset as it sees fit." (My italics).

This legal case is complicated but we will perhaps get some clarity about the inner workings of one of the world’s largest crypto networks and why it collapsed. This wasn’t an isolated example, either. Listed crypto platform Coinbase warned its users earlier in the year that, in the event that the company went bust, their crypto assets may be in peril.

This came as a shock to many, who had assumed that, like any other trading platform, the company was "hosting" their money – effectively acting as a custodian on their coins. In early August, a hack of crypto network Solano whisked $6 million from 8,000 digital wallets.

Picking Through The Wreckage

The financial services industry has a history of scandals, which, understandably, has eroded trust among its users Bitcoin was a child of the great financial crisis and came partly from a loss of faith in central banks and Wall Street).

But we have no choice to use intermediaries who act as custodians of our money – from the bank account your wages are paid into, to the pension company looking after your retirement savings.

Even when regulated firms collapse, customers generally get some of their money back. Crypto has moved to the edge of the financial mainstream but the industry has proved to be a poor custodian of investors’ money (as I discussed in this piece).

Authorities warned people that these were high risk investments with the chance of losing all your money. This advice wasn’t heeded, leaving financial regulators – the original watchmen – to pick their way through the wreckage.

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James Gard

James Gard  James Gard is senior editor for Morningstar.co.uk.

 

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