Custody Banking
ORIGINAL POST DESCRIPTION: I go for an hour-long walk every day… through the woods… behind my house. Not– as Thoreau wrote– “in the spirit of undying adventure, never to return”... but because I have a bad back. Walking helps.
On yesterday’s walk, I shot this video… all in one take. So lower your expectations.
It’s 59 minutes of me– Mr. ShakyHands– talking into my iPhone about what a custody bank does.
I am *no* threat to TikTok! To Nyquil maybe.
So… why’d I do it? And worse, why am I posting it?
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At the start of your career, you get paid for what you can learn. In the middle, you get paid for what you know and what you can teach. If you’re lucky, towards the end of your career, it stops being about what you know. It becomes about who you are.
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So… why am I posting it?
If you’re an engineer at a bank– any bank… whether you aspire to be a CIO one day or not… don’t watch the video for its content. Watch it to understand what you need to learn… how deep you need to go… to become a better engineer, a better partner… an honest-to-god business contributor.
Short answer: #BusinessDepth. Tech learning is secondary.
Longer answer: Know more about your business than your business partners!
#LifeGoal: Get to the point where the awful videos *you* cut on your daily walks are pure, unadulterated chloroform.
At the start of your career, you’ll get paid for what you can learn. In the middle, you’ll get paid for what you know and what you can teach. If you’re lucky, you’ll get paid to change all the things you’ve learned that are wrong– not just the things that are inefficient but the ones that are inequitable, cold. And if you get all that right, at the end of your career, you’ll get paid for who you are. But at that point, you won’t be doing it to get paid. You’ll be doing it to hang out with the people you’ve met along the way; to enjoy their company and learn from them. That’s how I think of the word company.
I might edit that out when I get home.
Here’s why I’m making this video. As my team knows, I usually go for an hour-long walk at lunch-time. When I use that walk poorly, I join a meeting with dozens of others. When I use it well, I’m connecting one-on-one with them. Today, I’m using it to teach you about custody banking. Hopefully, today’s walk will be useful to three audiences.
First, if you’re joining a custody bank– like the Bank of NY, JP Morgan, Northern Trust, State Street– as a new employee, it’s good to know the role they play in the financial markets… and I mean in great detail.
Second, watch this if you’re an engineer at a custody bank. Why? Because your path to becoming a CIO isn’t simply about increasing your engineering knowledge. Your path to the c-suite is entirely based on how deeply you understand the business. The full business… end-to-end.
Third, if you’re an entrepreneur or an intrapreneur, you’ll want to understand– intimately– the space you need to disrupt. And trust me, custody banking needs serious disruption.
So… it’s a beautiful day… let’s get to it.
First, let’s talk about what custody means and why we need custodians in financial markets. Towards the middle of the walk, we’ll go into more nitty gritty details where I'll talk about products and services within custody and sprinkled through it all will be a discussion on how other asset servicing products intersect with and even build on a custodian's core offering.
So let's define some terms. I'm gonna be using the term security throughout this walk. Let's talk for a minute about what a security is. It’s a tradeable financial instrument that can take many, many forms right now. This might be a roundabout way of explaining it but there is a lot of talk in the world about tokenization. If you don’t understand that word, there are many assets that I personally would love to own, but could never afford. Here's a crazy example. I'm a big fan of Picasso's artwork.
I could never afford to buy his Women of Algiers painting, but boy would I love to own a tiny little piece. The Women of Algiers was last sold in 2015 for what was then I think $179 million. It was sold by an owner who paid just $32 million for it back in 1997. So in that 18 year period, it appreciated $147 million, which works out to about 10% growth per year.
That's a solid return. If that painting were tokenized, or split into a thousand pieces. You could own 0.1% of it for just shy of about $150,000. You'd benefit as the artwork appreciates in value or share in the risk of it if it got stolen. But tokenization would allow you to say that you own Picasso. Not “a Picasso.” But Picasso. Like it’s a stock.
Anything can be tokenized, a building like Frank Gehry's Guggenheim, a sports team, like the New York jets. Although I don't see why you would want to own a piece of that. A movie like Avengers, infinity war, a musical act like lady Gaga. In all of those cases, you're buying a small portion of the future revenue or future appreciation of that thing.
So tokenization is what companies do when they sell stocks. They're raising capital by selling pieces of the company into small digestible chunks that anyone can buy and sell. This is similar to what a town does when it needs to, for instance, build a new high school. Assuming it doesn't have millions of dollars just sitting around.
The town will sell what are called municipal bonds to raise that capital. A bond is a little bit different than a stock though. In exchange for your investment in a bond, you don't own a part of the high school. Instead, you’re promised steady income in the form of a dividend, a dividend is like an interest payment.
Stocks and bonds are two types of securities, which is where we started. So a security is defined as a tradeable financial instrument. Like anything that has value, securities need to be protected. You need to have a way to buy and sell them that you can trust, and you need a place to store them and know with confidence that they are safe.
So liquidity and safety are what owners of securities need. Enter custody. That's what custody means. Custody is the safe keeping of a client's assets. What does it mean to keep a client's assets safe? To explain this in a way that will eventually make some sense.. Humor me and let’s jump into a time machine and travel back to the 20th century, little bit of history.
It used to be that securities– stocks and bonds– were little pieces of paper. When you bought stock, you would get a stock certificate. Oftentimes with an embossed seal, colorful watermarks, fancy fonts but paper like money. Each piece of paper was denominated into a value. Each bond– for instance– showed its dollar amount, just like money. Each stock certificate showed the number of shares in a company that that piece of paper represented. When I get back to the house I’ll edit in a picture of one. On the back of a stock certificate, there would be a handwritten ledger.
The ledger showed past owners of that security and at the bottom, the current owner of that certificate– very much like library books back in the day in high school. Remember, securities are tradeable BUT unlike cash, possession of a stock certificate is not the same as the ownership of that stock.
Registering ownership had real financial implications when it wasn’t done properly. So securities were stored back in the day in gigantic vaults and custodians were in the business of protecting these paper based securities. Custodians were safeguards against theft, fire, or water damage.
When you bought a stock, the ledger on the back of this certificate would be updated and the security would be mailed or delivered to a new owner or more often the owner's broker. And again, stored back in the vault.
And… just like storing and moving physical cash around these days is inefficient, the process back then begged for disruption. So just as payments have become digitized with credit cards, wire transfers, mobile payments, cryptocurrencies… securities too were digitized.
The process where physical paper-based securities are turned into electronic or digital form is called dematerialization.. a tough word you don’t need to remember– but dematerialization was introduced in the 1960s. And in the 1980s and 1990s, almost all securities were fully digitized. Dematerialization led to the formation of what we call depositories.
Formally they're called CSDs, which stands for central securities depositories. They are the bookkeepers of all securities in a particular geography. In the US for example there are two depositories. I actually worked at one for a year– the DTCC– the depository trusting clearing corporation. They hold all public company stocks and some bonds.
The other is the Fed– which you've all heard about on the news given all the talk about inflation. The Fed also acts as a depository but for government debt. Like the example we talked about before, when the town wanted to build a high school, this would be the federal government raising funds to finance large programs… like a major infrastructure build out
So the DTCC and the Fed are the two US depositories. In Europe they have ClearStream and EuroClear. In Japan, there's jazz-deck. In India, there’s the NSDL– National Securities Depositories and the CDSL– the Central Securities Depositories.
So… a good next question to ask would be: how does a depository, like the DTCC– keep track of all US-based securities on its books. Aren't there millions and millions of shareholders with securities changing hands every second of every day? Yeah, there are. So the way the depository handles this is by distributing its record keeping. The depository only holds accounts for what are called participants. These are very large financial entities, like major banks and broker dealers.
Each large custodian in the US is a participant at DTCC, meaning that they have an account at DTCC and all of that custodian’s clients do business through their custodian, meaning that main-street clients never transact directly with a depository like DTCC.
So it's kind of like a pyramid structure where investors have stock and cash accounts with participants and participants have accounts with depositories. And that is what we call the federated model.
Right. So here's an example. Let's say CustodyCorp– a fictitious custody bank– has three clients and each holds 5 million shares of apple common stock. Each client holds 5 million shares in their segregated accounts, but you won't find those shares in the name of those clients at DTCC.
DTCC will show that CustodyCorp is the legal owner of 15 million shares of apple stock. The kind of account that CustodyCorp has at the depository is called an omnibus account. Here’s where we get into the details.
So what is the depository doing with those omnibus accounts? When stocks are bought and sold, they're treated just like transfers from one omnibus account to another.
If one of CustodyCorps's clients sells apple stock to another custodian's client at the depository– at DTCC– there would be a book transfer from CustodyCorps’s omnibus account to the other custodians accounts. And in CustodyCorps’s ledger, the client's apple position would be reduced by the number of shares sold and the cash position would be increased by whatever the proceeds from that sale are.
Let’s get deeper.
Custodians provide a number of services to clients. There are three core custody services, settlement, safekeeping, cash management. One role of the custodian is to facilitate the settlement of transactions on behalf of its clients. When an investor buys or sells a stock or bond or any kind of security, they need to settle up with the other party. One party is getting stock. The other party is getting cash from the sale of that stock. So one of the services that a custodian typically offers is the ability to settle trades of different types of securities in different markets around the world. That’s called safekeeping.
Let's go back to the example we talked about, where there were three clients who hold apple common stock shares. The depository would store the aggregate of those clients' holdings under CustodyCorp's omnibus account. We already mentioned that CustodyCorp in turn is responsible for the safekeeping of each of their clients' holdings.
So in this example, CustodyCorp’s internal books and record systems would track the breakout of those apple shares by client. And it's not just for stocks. CustodyCorp would be responsible for the safekeeping of all of its clients' positions and the securities they own across different asset classes and in different jurisdictions around the world.
Ah… jurisdictions!! Now’s a good time to mention one caveat about depositories. I talked about omnibus accounts where CustodyCorp is the entity on record with the depository– the legal owner of its client's positions. There are some countries or jurisdictions that require end beneficiaries or owners to be recorded in the local jurisdiction.
In those cases, a CustodyCorp omnibus account can't be used at the local depository. Instead segregated accounts would need to be opened for each of the CustodyCorp clients. This is just something to be aware of. Most depositories do allow for the use of omnibus accounts, but it's good to note in the back of your head.
The important point is to understand that all client positions, regardless of whether securities are held in omnibus accounts or segregated accounts, regardless of which depository they're held in… are accounted for in the software systems of CustodyCorp.
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The third core service that a custodian provides for clients is managing their cash.
When a client buys a security, they need to pay cash and to offset the risk of settlement. Usually the transfer of cash and security happens at the same time. As securities come in, cash needs to go out. So custodians manage cash on behalf of clients for their buy and sell transactions, which means they maintain a cash balance with the custodian.
Custodians typically offer a number of services to manage excess cash. And there are other services outside of the core custody function that might extend credit to clients based on trading activity or the kinds of trades they engage. Similarly on the securities side, a custodian might have a securities lending service– which is exactly what it sounds like.
I'm only mentioning these services to make a point that a core custody business is the backbone that supports a large number of value added services for clients like collateral management or security lending or liquidity management… each one of which deserves its own hour-long walk.
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Custodians typically have very large financial institutions as their clients and, and these clients tend to do business globally.
A custodian as a participant might hold direct accounts in depositories in certain geographies. However, to service any client who may want to do business in a different geography, a custodian would need to determine whether it makes economic sense to open accounts in that country's depository or to outsource it… and instead leverage the services of a local custodian in that market who would already have accounts in that country's depository.
These subcontracted or outsourced entities are called sub-custodians. They are operating on behalf of the custodian in a given country or jurisdiction. So let's say CustodyCorp is the custodian for client ABC and client ABC really wants to trade in Jakarta.
Would it make sense for CustodyCorp to set up an office in Indonesia? Maybe it might. If CustodyCorp has a lot of clients who wanna do business there, but if that's not the case, Or if the economics don't make sense for CustodyCorp to open its own facility, the company could enter into an agreement with a local Indonesian sub-custodian, which would provide those products and services locally.
However– and this is important– just because CustodyCorp owns the outsourcing agreement with an Indonesian sub-custodian or any sub-custodian– the full responsibility to CustodyCorps' clients reside solely with CustodyCorp. From the client's perspective, CustodyCorp is its custodian and the buck stops with CustodyCorp (not the sub-custodian)..
So CustodyCorp needs to make sure that when it selects the sub custodian, it has very clear arrangements to cover things like how instructions will be sent and handled between CustodyCorp, clients and Jakarta. And how the custodian will capture and store copies of these instructions and activity happening in Jakarta for auditability, reconciliation, reporting purposes–
Details like this are critical to ensure that at the end of the day, CustodyCorp clients have one number to call anytime they need help.
A custodian might have a network of sub custodians around the world handling securities and activities locally but again, from a client’s perspective, CustodCorp is where the buck stops
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Just like what custodians do for securities. They could similarly have arrangements on the cash side as well. A custodian might have a banking presence (for cash) in certain geographies, but not in others.
And in that case, there could be an arrangement made with a local bank where CustodyCorp would maintain an account. This kind of account is called a nostro. So when clients want to move from US dollars to Thai Baht, CustodyCorp doesn't have to have a local presence in Bangkok. Instructions can be sent to its nostro agent– that bank in Bangkok– to say debit our account in Bangkok and pay whoever we need to pay– maybe an exchange, maybe a depository, or another party.
And that is how CustodyCorp’s clients have their transactions executed seamlessly, even though neither the client nor CustodyCorp has a local presence in the country.
These kinds of relationships– sub custodians and nostro agents– allow custodians to operate around the world without having to set up offices and keep staff in every country where clients want to conduct business.
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Securities are never static. Prices are constantly changing. Positions are constantly changing. Custodians have a unique view into their clients' positions, all around the world on a near real time basis.
So let's recap what we’ve talked about so far in the walk. We talked about what it means to be a custodian. You are an intermediary between clients and depositories. And for the entrepreneurs listening, what happens to all intermediaries eventually? We talked about what kinds of services typically are offered by custodians: safe keeping, settlement, cash management. We talked about how operating globally requires close coordination, tracking and reporting for clients. That was our talk about nostros and sub custodians.
And given where we are in the hour-long walk, it looks like we should jump into the world of corporate actions.
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We can cover what corporate actions are high level– what the different types of corporate actions are– who is involved in a corporate action– what some of the key dates are for a corporate action– how communications take place– and how a custody bank handles each kind of corporate action.
So let's assume someone bought a security… which we defined earlier as one of many different types of stocks or bonds or tokenized asset. Once that security is cleared and settled (the processes we talked about earlier– the owner then becomes what’s called the beneficial owner of that security… which means that the owner accrues all benefits that the issuer of the security wants to share with them.
When the issuer of a security institutes in action all holders of that security potentially benefit. see potential because actions taken by the issuer are not always beneficial to owners so it's safe to assume that most of the time they are intended to be.
corporate actions have different flavors.
for example an issuer like Apple or i b m might declare a dividend, say 5%. The Beneficial owners would receive that dividend payment in cash or stock.
Other examples would be:
the company could want to change its name
the assure could announce a stock split where the company might determine stock is traded at a very high level and therefore cannot be afforded by many different types of investors. Therefore they would split each share of stock into multiple shares and adjust the share price down to make the per-unit cost more attractive to all investors
the company might want to merge with 4 wire another company
another example the company may want to spin off part of its business into a completely separate and independent company
these are examples of the kinds of corporate actions we see regular
there are also three different types of corporate actions
some corporate actions are mandatory. which means that as a beneficial owner you don't have a choice. Whatever the issue word decides you are stuck with that outcome
second type is called for voluntary means that you as a beneficial owner can either participate or choose to ignore it
A third type it's called mandatory with an option for example company declares a 3% dividend and gives each investor the option to receive that dividend in the form of either cash or additional Company stock
until now we've covered with a corporate action is and what the different types of corporate actions are let's talk about why is Shores announce corporate actions to start could be many reasons
some comment ones
The issuer of the security wants to share its profits with shareholders. the excess of income over expenses that they have realized over a certain period in a quarter at year end if you want to share that with investors
Coupon payments on debt are more defined corporate actions but they are more like income processing because you are buying a bond, the terms of the payment schedule are already laid out in a prospectus. Interest is determined to be paid out monthly, quarterly, bi-annually or annually.
Companies May undertake a corporate action in order to change the capital structure: have more debt and less Equity or more equity and less debt. the company could issue corporate action announcing it will be converting such-and-such debt into stock for example.
the company's goal might be to influence the stock price in the market by declaring a higher dividend. the thought is that the income stream makes the equity attractive to other investors which would raise its stock price. not at this is a guaranteed outcome.
These are some of the reasons why a company issues a corporate action. Now let’s talk about who is involved in a corporate action.
first time we talked about this group a bunch already is the issuer. the issuer is the body shoot the security any local government Sovereign Nation.
next there are the registrar and transfer agent. these are institutions that are hired by an insurer to keep track who is holding that issuers of securities
There are Banks who act as custodians
There are also sub custodians who– as we discussed are regional players.
And the most important who– are the investors themselves.
it's good to note here the data vendors play a critical role in corporate actions. the RV specialize in collecting corporate actions from different issue has been creating data files that they share with– really sell to– custodians and other interested parties.
now that we know that the why and the who… let’s talk about the when.
a corporate action doesn't happen in one single instance of time. the only thing that happens in an instant of time is the issuance– what’s called the announcement– of the corporate action.
after the announcement there are critical dates that come into play up until final settlement takes place. and it could take days weeks even months the disposition of corporate action. So let's take a few minutes to talk about some of these dates.
Let’s say Apple is announcing a dividend on its stock. Apple stock change his hand every day through normal buying and selling. there has to be a line in the sand that identifies who those Dividends are paid to: the buyer or the seller.
there are two dates that determine this:
the first is called the record date. The record date set by the issuer and refers to the date by which you registered as official holders Security in order to be entitled to the corporate action in this example to receive a dividend payment from Apple.
the second X date. the ex date is the trade date on and after which the benefits of a corporate action are not conveyed to a new buyer of the security. next 8 is usually a day or two before the record date.
the dates to be aware of:
the response date. response date comes into play when there is a corporate action that requires the user to do something for example if the board of directors of a company calls for a shareholder vote this is the deadline by which votes must be received
another date is the payment date which is as the name suggests the date on which dividends or interest are paid out to Holders of that security
those are the 4 dates.
if the date is missed if something is not processed correctly Dire consequences. Essentially corporate action is not considered legal by the issuer.
now that we have the hang of what corporate actions are Who's involved what are the key dates what are the different types let's go into the next level of detail in terms of what the typical process is.
Let’s break this process into parts.
as we already covered first part is the announcement of the corporate action by the issuer.
given the nature of the markets for shareholder might be in Tokyo and the issuer may be in London they may not even speak the same language so when announcement becomes critical in terms of How It's captured and distributed to all shareholders given the multiple parties involved in between the issuer and security holders. There are data vendors custodians asset managers, etc..
Jumping back to our example where Apple declares a 5% dividend. The 5% dividend doesn't tell us what that equals in dollars. 5 million dollars or $500 or $0.50? point being that someone needs to compute how much of that security is shareholder owns and then some math needs to happen in terms of converting that corporate action into a dollar value. In the industry, we call this process entitlement. It’s a process only rich white males can relate to.
Once entitlement is done a custodian or sub-custodian will communicate to each holder of the security letting them know what the corporate action was and the impact of the entitlement. In the industry, we call this notification.
there are other cases where the corporate action asks shareholders to reply back to a certain deadline. an example would be with voting rights. A voting right is the right of shareholders to vote on matters of corporate policy. there could be a vote on who should belong to the board of directors, on whether the company should issue new securities, or even on changes to the way the company operates.
each shareholder selection from the different options offered– or may choose not to respond at all. in any event all responses need to be collected and tabulated.
if the corporate action is voluntary (that’s an important word) meaning there is an option to respond with a choice the security owner would send a response (another important word) back to the custodian. obviously if the corporate action falls into the mandatory category this step is skipped.
once all responses are processed instructions (keyword there) need to be sent out two custodians, sub-custodians and the issuer in terms of what the results were and how the corporate action needs to be processed
last but not least, Title Max need to be processed. how is a shareholder going to be paid? what are the standing instructions for that investor or asset manager? custodians would figure out the domicile of the investor or asset manager, in what currency the entitlement needs to be paid out, What are the tax implications, etc.
this collectively is called processing of entitlements. some corporate actions acquire all the steps others only use some.
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We've talked about the multiple roles involved in a corporate action from the fact that they can be distributed across the globe. how does all of this data move back and forth? how do announcements arrive, how do we distribute them, how do we collect responses?
It can be done in multiple ways
Back in the day companies used faxes to do this. sadly many still do.
Most of it though is done through electronic messages– mainly through the Swift Network. Swift is a Global Network that connects about 10000 different banks around the world. It’s useful because it also enforces certain standards of communication.
Swift has defined formats for a number of message types – among them standards for different types of corporate action messages. If I was losing you with jargon before, get ready for the bottomless pit of jargon… SWIFT codes… MTs or message types.
Every step in the process that we’ve talked about has a message type.
There is the MT 564… which is a notification message.
There is an MT 565… which is an instruction message. it can be sent from an account holder to a servicer or custodian who processes it.
A 566 is a confirmation saying that yep we received your transmission we're going to process it and do x with it
A 567 is a status message. here is the status of the corporate action. here is the instruction we received. here is what we're doing with it.
A 568 is a narrative. like a blob message that gives details in terms of what has been done in a particular corporate action
I could go on with SWIFT messaging but I'm afraid most of you are already asleep.
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So let's be clear– it’s not always or even usually the case that a corporate action generates *a* message sent to *an* investor. it's much more common that many many messages are sent back and forth and back and forth from party to party just for one corporate action.
Why? because nothing ever stops in the Securities industry. Securities are traded every day.
Ex-dates and record dates need to be tracked for each security where there is an announced corporate action and securities are changing hands often many times everyday as they're being bought and sold. this requires constant messaging to ensure we have the right inputs To process the corporate action correctly
What kind of tech supports corporate action processing within a custody bank?
Let's quickly Define a few terms. the first is the system of record which is the golden source of different kinds of data within an Enterprise.
The second term is a security Master. this is the system of record for all Securities and instruments that a custodian interacts with. the data is sourced from different vendors like Bloomberg or ID see and that data is constantly scrubbed and normalized.
we also catalog corporate events in a security Master and retain a history. So if we wanted to see all corporate actions from Apple for the past three months we can query the security master and come up with a list. because keep in mind Apple may not comprise just one security– Apple common stock– it may cover many different types of Securities or instruments issued by Apple.
Calculating entitlements requires data from key systems of record, a security Master and several industry data providers. students also utilize third-party platforms to send out announcements and notifications, gather responses back, process, and send messages out to custodians and sub-custodians. These systems traffic mainly and Swift messages as we noted Legacy fax usage is still quite High throughout the industry.
there are a host of servicing systems that calculate entitlements and because there are many many inputs custodians do exhaustive reconciliation to ensure no errors have been made,
The need for constant reconciliation across the industry is the best evidence yet that blockchain and decentralized finance have yet to disrupt the sector.
Once entitlements are computed and reconciled, different systems at every custodian execute payments. Yet another space aching for disruption.
To recap, so far on the second leg of this walk, we've covered some of the who, the what, the when, and the why questions around corporate actions. now let's dive into an example– dividends– and talk through the mechanics of how that type of corporate action is processed.
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Let's talk through an example of a corporate action: specifically cash dividend. what are the steps that a custodian takes when an issuer wants to provide a dividend? Lets say that IBM has declared a cash dividend of $1.62 on its common stock. Meaning that if you hold one share of IBM, you’ll get $1.62.
I want to make up some dates here just a flesh out the details. the critical dates for this dividend are its x-date let's say February 7th– And it's record date— let's say February 10th.. and it's payment date: March 10th. I’ll put up these details up as a slide when i get home.
this means:
#1 purchases of the stock on February 7th or later are not eligible to benefit from the corporate action. In other words, stop change his hands on February 7th or later it's the seller not the new buyer was entitled to the dividend.
#2 all stock Holdings on record as of February 10th are entitled to the dividend and
#3 the dividend will be paid out on March 10th
the corporate action announcement could be transmitted from a data provider like a Bloomberg or an ID see or I could come from see SD a central Securities depository or sub-custodian. key Point here is that corporate action announcements come from multiple sources.
once received the corporate action is checked for validity and to make sure that key pieces of information are captured– like the dates just mentioned the ex-date record date and payment date– the unique identifier of the security, etc..
once validated the corporate action is stored in the custodian's security master.
That stop 1 capturing validating and storing corporate action information.
in this example lets say that the corporate action was received on January 29th. on January 30th for luminary notification is sent out to all customers of the custodian asset managers who hold that IBM stock
I used to qualifier “that IBM stock” because I B M may have issued more than one security there could be preferred shares warrants and other types of securities issued in addition to common stock shares even bonds
so only those holders of the security identifier stipulated in the corporate action are entitled to receive the dividend, each security has a unique ISIN or CUSIP– ISIN is spelled ISIN and CUSIP is spelled CUSIP. Part of the validation to make sure the custodian is acting on the right security.
preliminary notification is sent out using a swift message type MT564 H2 all clients who hold that security– and for those not on Swift they will be sent notifications via email or fax.
the second step is entitlement.
entitlement is the process of calculating who will receive what dividend amounts. systems of record that maintain client positions are sourced. And entitlements are calculated based on the number of shares held.
Again only holders of the specific security identifiers are eligible.
on or around January 31st in this pretend time line, a detailed notification is sent out to all clients.
the detailed notification includes a listing of the client's Holdings in the security at that point in time along with its dividend entitlement in exact dollar value.
honor around February 7th the ex date again a detailed notification on the cash dividend corporate action– it sent out to all clients who hold that security of the February 6th.
these dates are critical. Because a lot of the custodian’s clients will be getting into and out of the security over and over again– some buying some selling.
from the custodians perspective they just need to make sure that by that date:
#1 they have a correct list of holders of that security and in what amounts
#2 they have computed entitlements and
#3 they send out detailed notifications
on February 11th a detailed notification is again sent out with the cash dividend corporate action entitlements to all clients who hold stock As of February 10th– the record date
on the 3rd of March advice is sent all clients who held the security as of the record date payments will be posted to their accounts on March 10th
they are sent advance notice so they know what to expect and this is sent through Swift message type MT567. those not on the Swift Network or advised by e-mail or fax
on March 10th Custodian credits the accounts of security holders with the amounts they are entitled to as per the cash dividend corporate action.
so you may wonder where did the custodian get its money from an order to pay the clients? let's assume our clients own a million shares collectively. the bank is paying out 1.62 million dollars out of pocket. The custodian need to receive a cash.
the answer is that the custodian gets its cash from the issue or in this case IBM. part of the job of a custodian to take a bulk payment from an issue or Indy bulk it in two payments to their clients accounts on a pro-rata basis based on the number of shares held
sometimes there is a timing difference between when funds are received from the issuer and when they are paid to client accounts
when all is said and done reconciliations are performed. there are controls in place to make sure sodium isn't paying out more than it receives or vice versa.
some clients may have what are called standing instructions with the bank I think I mentioned this before but I didn't explain it, Mike for example expect any income that comes into their accounts for the Securities they hold to be put in a currency that is different than that of the stock.
for instance the IBM dividend in our example was denominated in US dollars but a dollar 62 per share. a client may want that dividend to be paid into their account in Swiss Francs for Japanese Yen or Euros
Clear Lake another FX transaction needs to take place to convert that dollar value into the currency expected as per the client’s instructions… their “standing instructions”
that is one element that is outside of the usual corporate action processing what is part of the corporate action settlement
oh and let's not forget tax. some clients of the custodian maybe located in different domiciles. meaning there is a potential that the payments have tax implications depending on the jurisdiction of the Client.
some jurisdictions may impose a withholding tax some a consumption tax. whatever the tax is that has to be computed and tax forms need to be issued by the custodian.
in the case of the US 1099s need to be issued. whatever the equivalent requirements are in the jurisdiction or jurisdictions line operates need to be followed.
another consideration is that certain entities might be tax exempt. certain Pension funds for example. the client would have to submit documentation proving tax exemption and the custodian which as part of its standard process would have deducted appropriate taxes can help with the submission of tax refunds or reclaims
tax processing is an integral part of that and as I said foreign currency conversion– FX.
the important Point here is that corporate action processing doesn't end with calculating the Entitlement. the reality is that this is just the beginning.
the entire settlement process of a corporate action in the case of a dividend example includes:
– how the dividend is paid out– can u.s. dollars or a foreign currency
– Computing the tax impacts and
– Facilitating any reclaims or refunds on taxes paid
all are integral to corporate action processing
and by the way that raises two additional points of concern:
#1 does the custodian have all the domicile and tax documentation on hand? And
#2 assuming that they do, data and documentation might have to be fetched from different systems. some may be collected through a client onboarding platform, some might live in a central database, some might be in a separate tax processing custom elsewhere,
so that broadly how a cash dividend is processed:
from its initial announcement into the marketplace… so how the data was sourced… to what happens on different dates… how they're settled and what controls need to be in place to ensure that processing is successful.
we still have a bit of a walk so let's do one more example of a corporate action: tender offer.
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So what is a tender offer? Tender offer is a public, open offer to all stockholders of a publicly traded corporation to tender their stock for sale at a specified price.. during a specified time.
There could be a different reason– lots of different reasons– why a tender is made.
The key is that the issuing company wants to buy back their shares from investors.
This could be for different reasons.. like it could be because the company has excess cash and wants to reinvest in itself. It could be for corporate structuring and restructuring reasons or to improve its financial ratios.
It could be even be because the company believes the market has discounted its shares too much. Whatever the reason… when a company makes a tender offer to repurchase shares from its shareholders, that's called a buyback.
Another different example of a tender would be where another company is looking to acquire the issuing company. The acquiring company could make a tender offer to investors to purchase their shares in a target company stock. This is what's known as a public takeover.
Regardless of the motivation, the term “tender offer” means that the company wants to buy shares from shareholders at a price that may be lower, equal to, or even higher than the market price.
When the tender is announced varies… depending on the circumstances, the tender offer will have key dates– just like the other corporate action we covered– an announcement date, and then some deadline dates from the response.
From a response perspective. It will stipulate the number of shares they’re looking to purchase.
Like we wanna buy back X number of shares at Y price.
It'll also list conditions. If the offer were to become oversubscribed as an example, which is fancy talk for, if the offer generates too much interest, what happens? As an example, if a company makes a tender offer to purchase 1 million shares of a stock and shareholders collectively tender two million shares.
There might be conditions to stipulate that X percent will be accepted from each shareholder in order to make the offer equitable to all its shareholders. If that were to happen, the difference would be returned to each shareholder.
Again, that's just an example of a condition that could be included in a tender offer to put this all together.
Let’s walk through an example. A firm– let's call it WidgetCo– announces that on June 13th, they will buy back 3 million shares at $15 per share, starting on June 18th. So June 18th becomes the announcement date.
The offer further states that it will be withdrawn as of midnight, July 16th. And unless it's otherwise extended, it’ll be terminated on July nine.
Now let’s assume that the company's transfer agency announces that they have received 4 million shares as a part of the tender offer.
In this example where the demand for the shares was 3 million from the company. And the supply was 4 million from the shareholders. 75% of the offered shares would be tendered on a prorata basis, meaning that the company would accept 75% of the offered amount from each shareholder who participated.
so that's what happens from a shareholder's perspective.
Let's look at what happens from the point of view of a custodian.
The process begins on June 13th with a tender offer announcement from the company. That information is possibly picked up by the media and various data providers like Bloomberg or IDC or even a sub custodian might capture that information and send it to the custodian.
the custodian receives that information and stores it in their security master database.
This all happens on June 13th or 14th. On June 14th, the custodian sends out a preliminary notification to all shareholders on record that says, Hey, there's a new corporate action on a security identifier that you own. The company has issued a tender offer with such and such– just like in the dividend example– an Mt564–
Remember: that's a swift message type that’s used to deliver this notification or not to sound like a broken record but if the asset manager is not on swift or the swift network, they would receive the notification through email or fax…. whatever means of communication has been agreed between the custodian and the client.
There is a long period of time between the tender offer when it's announced and the deadline by which shareholders would need to act. If they choose to participate.
In our example, the announcement was June 18th and the deadline was July 16th, roughly a month. During this period, a custodian's clients could be buying and selling shares, increasing or decreasing their positions in this security or even buying for the first time.
Which means that the initial notifications sent out by the custodian wouldn't have reached new investors in the security. So every time there is a change in a client position for that specific security, new notifications (MT564s) need to go out to clients of the custodian. They need to be continually reminded that there is a tender offer pending.
And here are actions that need to be taken. If they want to participate, the custodian might set a deadline for clients to reply back to the tender offer, which could be something like X number of hours prior to the issuers deadline. Now, why would that be? in order to meet the issuers deadline, the custodian needs to make sure that all client responses were received.
All of these responses then need to be processed with any discrepancy. by the time of the tender offers deadline, the custodian will need to respond collectively on behalf of all of its clients, back to the issuer. no small task. So the custodian, for example, might set its own deadline as 48 hours prior to the issuer's deadline date.
So that's one important thing to note.
Second important thing to remember is that while clients have an option to either tender shares for this corporate action or take no action at all, they still have the freedom to buy and sell shares. However, after they have tendered their shares, they can no longer sell those tendered shares.
So something has to be done to control that activity. Otherwise, a client could pledge 20,000 shares against the offer, and then a day later put in order to sell those same 20,000 shares.
And all of this could happen prior to the issuer's deadline date.
To avoid that scenario from happening, the custodian puts a lien on those tender shares.
All sale activity is restricted to the extent that the offer has been accepted by the client.
That lien stays in place until the corporate action is settled.
So those are two important points to keep in mind in the tender offer corporate action.
Remember, again, this is a voluntary corporate action, meaning that the client has the option either to participate in the tender or not.
So the tender notification goes out to all clients who hold the security and let's assume they're all on swift network. That means that the custodian sends each client an MT564 message.
Clients will respond back with an MT565. Again, if they're not on swift communications will be done by email or fax.
So based on the responses they received, the custodian will lock activity on the number of shares each client has chosen to tend.
As the custodian approaches the deadline– which again is before the issuer deadline– client instructions are processed and a message is sent to the issuer, informing them how many shares a custodian has tendered, assuming again, that this number falls within any pro rating parameters.
The corporate action are subsequently settled. Advice is then sent out to all the account holders, all asset managers, all shareholders on record of the execution of the corporate action.
Next, there is cash owed from the sale of the stock. As with our last example, there may be foreign exchange implications and there might be tax implications based on the domicile of the shareholder on record,
taxes are processed post settlement cash flows from the issuer to the custodian and then to shareholders. But this timing might not be sequential.
The custodian might extend cash flows to clients before the issuers funds arrive. So there is an element of reconciliation that kicks in to ensure that when all is said and done the custodian isn't short changed, and neither is the client.
All of these accounts and holdings are maintained in the custodian's internal systems of record.
So for a client who has tendered shares, the number of shares would be subtracted from their holding balances and the cash proceeds would be added to their cash account. Finally, liens are removed from the accounts of the shareholders on record, who tendered shares and they are then free to trade on that security again.
So in this example we dived into another corporate action type– the tender offer.
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I got lucky with the timing. Because it looks like our walk is coming to an end.
Let me close by thanking you for watching… and encourage you to keep learning.
I’m here if you have questions.
Be well!
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Depending on how quickly I can walk and talk, we might go into another one - a dividend with option.
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Just like some of the other types of corporate actions we've discussed– a dividend with option has an X date, a record date, a deadline date for response and a payment date. As we just covered, a custodian would source all of this information from a data provider, like a Bloomberg or, and IDC. And all the data would be stored internally in its security master.
For that specific security identifier notifications would be sent. To all shareholders on record using an Mt. 564 swift message, or via an email or via a fax. Everything from a process standpoint happens exactly as it does for cash dividends or tender offers. There are two key differences in terms of one how shareholder instructions come back to the custodian.
And two, how a corporate action is processed for those clients who already have standing instructions. At the custodian standing instructions. Let's, let's talk about what that means. When a client is initially onboarded with a custodian, they typically provide what are called standing instructions. Think of these as default settings.
For example, whenever there is a corporate action that offers a dividend with options, we want to receive the cash payout and not reinvest in the security. That's an example of a standing instruction, or it could be the. Another instruction could be like, I always want our corporate actions to be paid in Swiss, Franks.
Standing instructions are generally at the portfolio level for the client. Most of the time standing instructions are useful because they reduce the need for processing and the need for back and forth communications with clients. However, As the custodian is notifying each client of an UN upcoming corporate action.
They also can help them evaluate whether their standing instruction is favorable or unfavorable to them for this specific corporate action. Let's try to understand that a little bit further. In the example we talk through, it's possible that reinvesting in a company might not be the most beneficial.
For the client. One possibility is that the market price is lower than the discounted price being offered by the issuer. Let's say this client's standing instruction is to reinvest when given the option, when the Mt 5 64 notification is sent out or notification is sent out via email or. The custodian can restate that the client's standing instruction is to reinvest, but that proceeds with this option might not be in its favor.
Based on that information, the client may decide to respond to this specific corporate action differently. Other than that, though, the corporate action follows the same pattern we've talked about before the same systems are used. The same swift message types are sent back and forth. The same settle. And post settlement processes take place.