In recent years, custody has be-come increasingly important to pension fund trustees, particularly in relation to asset security.

The Maxwell scandal has led to a focus on how well assets are protected. The focus on security has in some cases led to trustees employing an independent custodian.

More recently however, trust-ees' concerns have moved onto the issue of 'custody risk' - otherwise known as the risk of having all your eggs in one basket - which has led trustees to question whether one custodian is enough. I believe the answer to this question is yes. Mostly, pension plan trustees are concerned about the loss of as-sets. At the custodian level the two key risks are the risk of the custodian becoming insolvent and the risk of loss through custodian error or poor performance.

All assets other than cash are held by custodians in nominee accounts or in the name of the client itself. Either way, the assets are held separately from the bank. The asset that would really be affected by the collapse of a custodian is cash, which typically represents an asset on the bank's balance sheet. There are a couple of issues here. Firstly, as part of the process of selecting a custodian, it is likely that its financial strength would be a consideration.

Secondly, a custodian can diversify cash holdings across different banks, or put cash into short term investment funds which are completely separate from any bank's balance sheet. Therefore the sol-ution to managing custodian in-solvency risk is not to employ more than one custodian, as this risk can be managed using one. Instead, the solution is to select the right custodian in the first place and ensure that cash holdings are protected.

There is certainly a question over whether the risk of loss through custodian error or poor performance can be diversified by using more than one custodian. But the whole point of the custodian selection process is to find an organisation which is good enough so the likelihood of such losses is relatively low. Further protection comes from the custodian's own insurance cover which should be verified to ensure these losses are covered. Ultimately though, I believe an important way to manage this risk is through effective custody performance monitoring - but that's another story.

Mike Faulkner, is a consultant, asset consulting practice of Towers Perrin

Topics