Custody or safekeeping: What’s the right solution for government investments?

March 13, 2023

Government treasurers have pivotal choices to make when investing and preserving public funds. Learn how custody or safekeeping options between brokerage firms and banks can mitigate risk and impact portfolios.

Governments have a fundamental duty to spend public funds wisely. They’re responsible for protecting the safety of investments that have been made to meet various obligations to constituents.

Public employees and first responders trust that their benefits and pensions will be safeguarded while they serve and protect their communities. That confidence empowers treasurers and controllers to manage billions of dollars in state budgets, county retirement accounts and city entitlements.

Separating safekeeping functions from investment functions provides a clear separation of duties and provides for controls that satisfy the requirements of auditors. An independent third-party in a safekeeping arrangement may be a different financial institution from where the depository cash assets are being held. Or it may be a distinct division of that same named institution.

Some entities may use the terms custody and safekeeping interchangeably without clarifying the different protections and offerings of each service.

Deciding where to hold public money is a critical choice that may hinge on portfolio objectives and regulations. But there also are important nuances for governments to consider when picking the right guardian for the community purse.

How safe is safekeeping?

Overseeing large pools of capital and operating assets in the public interest, such as pension funds, requires financial officers to choose how they want to invest and account for those securities.

Governments typically hire a bank or brokerage firm to hold and protect those assets behind firewalls that separate safekeeping and investing functions.

Key distinctions of brokerage firms:

  • They can provide basic safekeeping for nominal fees or no direct charge at all as part of a suite of financial services. Firms can pool client assets on their balance sheets and leverage them in a variety of investment transactions. Most safekeeping entities operate on an actual receipt of funds basis, subject to delayed credit until securities transactions actually settle. Bank custodians typically operate on a contractual settlement basis and offer comprehensive reporting, including roll-ups and customizable reporting options.
  • They also are regulated by the Securities and Exchange Commission. Funds may be insured, but there are coverage limits. Reporting is provided for an account on a basic level, generally with limited detail and no roll-up capabilities. Basic safekeeping arrangements may affect the government’s ability to timely access its assets.

Most government investment portfolios are invested conservatively to protect against a catastrophic loss that can destroy budgets and lives. Mitigating risk should motivate public money managers, who can have greater access to investment assets and rely on comprehensive reporting if they place them in the custody of a bank.

Why bank custody is a more secure option

Unlike brokerage firms, banks offer more built-in protections for holding investments and settling transactions.

Key distinctions of bank custody:

  • Government assets are legally separated from the bank’s balance sheet, shielding them from creditor claims. If a bank becomes insolvent, custodied securities should be returned to each investor.
  • Because investment assets are protected from the claims of creditors, the assets are considered legally separate from the bank or financial institution. Investment assets are held directly with depositories in the name of the bank for its government customer’s account.

The Government Finance Officers Association (GFOA) recommended in a recent report that governments use an independent third-party custodial service for safekeeping of investments:

“Governments need to weigh the risks versus the costs of the services and understand exactly how the failure of a safekeeping provider would impact the government’s ability to access its investment assets.”

Broker-dealer accounts may be covered by SIPC Insurance, which is limited to $500,000 and does not cover any changes in the market value of securities. Safekeeping assets at a broker-dealer are considered general assets of the firm and may not be protected from being used to help pay the safekeeping firm’s creditors.

The Office of the Comptroller (OCC) is among several regulators who supervise and examine national bank custodians to ensure compliance with federal banking and consumer laws.

In addition to OCC oversight, deposits at an FDIC member bank are insured by the Federal Deposit Insurance Corporation, generally up to coverage limits set by law. The FDIC has high standards for minimum bank capital levels – standards designed to strengthen bank capital and promote a stronger financial industry that is more resilient to economic stress.

“Selecting a custodian to safeguard your investment assets is an important task that should include proper firewalls and protections,” says Karl Wilson, senior vice president and national head of sales for the Institutional Trust and Custody division at U.S. Bank.

“An independent third party can separate public funds from commercial or retail bank assets and provide comprehensive reporting under state and local custody laws.”

Protecting your community’s future

Governments have an enormous responsibility to manage public funds safely and efficiently. Maintaining the public trust with a private partner requires prudent decision making.

Treasurers who hire a brokerage firm that may use customer assets as part of margin and repurchase agreement transactions to further leverage public fund assets accept greater risk than working with a bank custodian dedicated to holding and protecting securities apart from any company transaction.

It’s not only about today’s investments and operating costs, but the preservation of assets for future generations.

To choose the custody option right for your specific asset pool, look for a partner with the capabilities, expertise and track record you can trust.

 

At U.S. Bank, our custodial structure provides safeguards for your assets, and our experts provide solutions that are tailored to your needs. Contact us to learn more about the services we offer.

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