The unsung heroes of exchange-traded funds

March 23, 2023

What is the role of custodians in exchange-traded funds? Although most of their work occurs behind the scenes, custodians can be crucial to the success of ETFs. Learn how this unassuming player maintains process integrity and investor security against a variety of risks.

 

When financial advisors and their clients seek an investment vehicle, they usually want to know their investment will be secure in the care of a custodian. This consideration applies to exchange-traded funds (ETFs) just as it does to more traditional vehicles. In this article, we’ll examine some of a custodian’s major duties related to ETFs, and we’ll help you understand what qualities to look for in this important partner.

 

Safekeeping ETF assets

The primary role of custodians is to provide safekeeping for ETF assets.

The custodian will create an account for the ETF where they’ll hold the fund’s assets. There, the fund adviser can manage them for the benefit of its shareholders. Assets move in and out of the fund by means of creation and redemption – a process the custodian and transfer agent work in tandem to facilitate.

The transfer agent and authorized participants (APs) use the creation and redemption process to ensure accurate valuation and delivery of shares between parties. Most ETFs employ in-kind creation and redemption. This means shares of the ETF are exchanged in-kind for shares of the stocks the manager, or index, has chosen for the ETF.

This in-kind process follows a standardized and streamlined protocol to mitigate risk and provide operational and cost efficiencies. Here’s an example of how it works:

  • An AP brings shares of the ETF’s basket, or actual holdings of the ETF, to the custodian and transfer agent for the ETF’s custody account.
  • In return, the custodian and transfer agent give newly created shares of the ETF to the AP.
  • The AP then gives these newly created ETF shares to the party for whom they performed the in-kind creation.

The custodian also coordinates with the fund’s administrator, accountant and distributor, all of whom help ensure the process goes as planned.

Read more: Understanding the role of authorized participants in exchange-traded funds

 

Providing other valuable services

Beyond safekeeping, an ETF custodian can provide additional services to the fund (e.g., securities lending, cash management). These responsibilities will be defined in the prospectus and approved and overseen by the fund board.

When an ETF institutes a securities lending program, the lending agent and the fund’s shareholders are usually the only recipients of its proceeds. The custodian will work with the fund to balance risk and reward related to pursuing additional shareholder revenue.

For example, a lending agent might keep 15%-20% of the securities lending revenue as facilitator and return the balance to the fund. These proceeds will add to the total return of the ETF realized by the shareholders.

Additionally, a custodian might take on the role of managing the ETF’s uninvested cash – offering the fund manager investment choices that strike the right balance between risk and reward.

 

Regulatory and security considerations

Most custodians are federally registered banks. In cases where they’re not, further oversight may be imposed, including, but not limited to, surprise audits.

Either way, a custodian must have an existing service model for ETFs that includes the proper tools, experience, operational efficiency and cost efficiency. They must also be nimble enough to adapt to the ongoing changes in the regulatory environment.

A robust cybersecurity program and a well-run compliance program are equally essential. ETFs will likely continue to move into new asset classes and regions of the globe. Custodians must be able to keep pace with the needs of the fund manager and the requirements of varied regulatory regimes.

Read more: Protecting client data through industry best practices

Overall, when an investment vehicle skillfully utilizes custodial services, it provides a greater sense of security to financial advisors and their clients. While nothing in the investment world is certain, choosing the right custodian for your ETF can mitigate unnecessary risks and improve confidence for all parties.

 

Regardless of your fund structure or strategy, U.S. Bank is ready to provide tailored support so you can achieve your business goals. Learn more about our custody solutions and other ETF products and services. For additional information, connect with our fund services experts.

Related content

What is CSDR, and how will you be affected?

How much money do I need to start investing?

What are alternative investments?

Do I need a financial advisor?

At your service: outsourcing loan agency work

Employee benefit plan management: trustee vs. custodian

Rethinking European ETFs: Strategy wrappers and a means to an end

Avoiding the pitfalls of warehouse lending

Investment strategies by age

How does inflation affect investments?

OCIO: An expanding trend in the investment industry

Bank vs. brokerage custody

How do interest rates work?

Preparing for your custodian conversion

Asset classes explained: Cash, bonds, real estate and equities

How digital platforms streamline client onboarding for investment funds

Understanding yield vs. return

What type of investor are you?

3 European market trends to watch

How liquid asset secured financing helps with cash flow

The ongoing evolution of custody: Tips for renewing your custody contract

Ask an expert Q&A: 3 US ETF trends and their impact in Europe

Case study: U.S. asset manager expands to Europe

Key considerations for launching an ILP

A first look at the new fund of funds rule

Interval funds find growing popularity

Alternative assets: Advice for advisors

What are exchange-traded funds?

MSTs: An efficient and cost-effective solution for operating a mutual fund

Ask an expert Q&A: 3 US ETF trends and their impact in Europe

Mutual fund to ETF conversions: challenges and considerations

The role of a custodian

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

ESG-focused investing: A closer look at the disclosure regulation

5 questions you should ask your custodian about outsourcing

10 ways a global custodian can support your growth

The reciprocal benefits of a custodial partnership: A case study

The benefits of a full-service warehouse custodian

The unsung heroes of exchange-traded funds

4 questions you should ask about your custodian

Refining your search for an insurance custodian

Inherent flexibility and other benefits of collective investment trusts

Webinar replay - The view from Europe: UCITS and ETFs in a changing world

Webinar: Approaching international payment strategies in today’s unpredictable markets.

Protecting cash balances with sweep vehicles

Delivering powerful results with SWIFT messaging and services

Understanding the role of authorized participants in exchange-traded funds

Look to your custodian in times of change

How institutional investors can meet demand for ESG investing

4 benefits of independent loan agents

Middle-market direct lending: Obstacles and opportunities

How RIAs can embrace technology to enhance personal touch

Retirement income planning: 4 steps to take

Year end tax planning tips

A guide to tax diversification in investing

Bull vs. bear market: What do they mean for you?

Start a Roth IRA for kids

Investing myths: Separating fact from fiction in investing

What Is a 401(k)?

ETF vs. mutual fund: What’s the difference?

4 times to consider rebalancing your portfolio

7 diversification strategies for your investment portfolio

Why compound annual growth matters

How to start investing: A beginner’s guide

5 questions to help you determine your investment risk tolerance

How grandparents can contribute to college funds instead of buying gifts

How to open and invest in a 529 plan

4 ways to free up your budget (and your life) with a smaller home

Get more home for your money with these tips

Can you take advantage of the dead equity in your home?

4 questions to ask before you buy an investment property

Disclosures

U.S. Bank Global Fund Services is a wholly owned subsidiary of U.S. Bank, N. A.

U.S. Bank Global Fund Services (Ireland) Limited is registered in Ireland, Company Number 413707. Registered Office at 24 - 26 City Quay, Dublin 2, Ireland. Directors: Eimear Cowhey, Ken Somerville, Brett Meili (USA), James Hutterer (USA), Hosni Shadid (USA). U.S. Bank Global Fund Services (Ireland) Limited is regulated by the Central Bank of Ireland.

U.S. Bank Global Fund Services (Guernsey) Limited is licensed under the Protection of Investors (Bailiwick of Guernsey) Law, 2020, as amended, by the Guernsey Financial Services Commission to conduct controlled investment business in the Bailiwick of Guernsey.

U.S. Bank Global Fund Services (Luxembourg) S.a.r.l. is registered in Luxembourg with RCS number B238278 and Registered Office: Floor 3, K2 Ballade, 4, rue Albert Borschette, L 1246 Luxembourg . U.S. Bank Global Fund Services (Luxembourg) S.a.r.l. is authorised and regulated by the Commission de Surveillance du Secteur Financier.Investment products and services are:

NOT A DEPOSIT • NOT FDIC INSURED • MAY LOSE VALUE • NOT BANK GUARANTEED • NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY

U.S. Bank does not guarantee products, services or performance of its affiliates and third-party providers.

Start of disclosure content

Loan approval is subject to credit approval and program guidelines. Not all loan programs are available in all states for all loan amounts. Interest rate and program terms are subject to change without notice. Mortgage, Home Equity and Credit products are offered through U.S. Bank National Association. Deposit products are offered through U.S. Bank National Association. Member FDIC.