As the world's biggest custodian bank faces a hefty fine for failing to meet rules that protect client assets, Stephanie Baxter asks if alarm bells should be ringing.
At a glance
- BNY Mellon was fined £126m for a series of failures to safeguard client assets over six years
- The bank apologised and took remedial action but schemes are concerned this could happen again
Many trustees will remember the scenario following prime broker Lehman Brothers' downfall, when insolvency processes were slowed down by the painfully long task of figuring out who the funds belonged to.
Having entity-specific records and accounts in place is absolutely crucial during bankruptcy as they are used to identify clients whose assets are safeguarded and must be returned. This is a key feature of the Financial Conduct Authority's (FCA) rules for custodian banks that safeguard assets on behalf of investors.
Its custody rules are designed to protect custody assets if a firm becomes insolvent and to ensure they can be returned to clients as quickly and easily as possible.
The revelation that the world's biggest custodian Bank of New York (BNY) Mellon failed to abide by the watchdog's rules over almost six years has concerned UK pension schemes, many of which are clients of the bank. The failings occurred between 1 November 2007 and 12 August 2013 at the US bank's London and international branches.
Although no clients lost any assets, the FCA fined the bank a whopping £126m –hich would have been £180m if it had not agreed to settle at an early stage. The regulator said the failures were particularly serious given BNY Mellon's systemically important nature and that safeguarding assets is essentially its business.
If the firms had become insolvent, the value of safe custody assets at risk would have been significant, and this risk was compounded by the fact the breaches occurred when there was considerable stress in the market.
Many schemes are understandably asking their lawyers and consultants: "are my assets safe and will this happen again?"
Mercer head of custody consulting Jessica Hynes, who has been fielding calls from concerned schemes, says: "Some of the press coverage has been quite inflammatory and it's important to understand what happened. This is not an endemic problem in the custody industry at all so let's not make a meal of this."
She explains there was no concern over asset safety at any time and that it was largely an issue with record keeping and operational compliance not in keeping with the FCA's rules.
The rules say that records and conduct reconciliations must be kept at regular intervals on a legal entity-specific basis, which BNY Mellon failed to do.
It was not able to identify at an individual customer level which legal entity owed obligations – assets or cash – to individual investors. Instead it used global platforms to manage clients' safe custody assets, which did not record what clients had contracted.
Hynes says: "All client assets were completely and accurately held at the high level. The issue was that in the omnibus account there was no legal identifier tag to specifically say a client belonged to the London branch and that another client belonged to the international branch, for example."
BNY Mellon's compliance monitoring failed to pick up the issues that were discovered by the FCA, although the bank pro-actively assisted with the investigation upon learning of the failures. BNY Mellon has since implemented a new legal entity tagging system to resolve the issue and has enhanced its specialist resources to reinforce compliance with the rules.
The FCA pointed out that during insolvency proceedings the most important thing is to identify client assets and repay those assets as quickly as possible.
"In a worst-case scenario during insolvency, BNY Mellon wouldn't have been able to return assets to clients in a very efficient way. The fine sounds harsh as an insolvency didn't happen but a hypothetical line has been taken here," says Squire Patton Boggs pension fund investment group head Clifford Sims.
The investigation uncovered other failings, including not taking necessary steps to prevent the commingling of safe custody assets with firm assets from 13 proprietary accounts, which were deposited into client omnibus accounts.
Hynes says this is less of an issue than it may seem given it appears to have happened on a small scale. "It's important but it's not as if all of the bank's balance sheet was mingled with client accounts, so let's not blow it out of proportion." She has asked the bank to explain how this happened and is waiting for a response.
It is rare that trustees would take such an interest in custody but this case has resulted in many asking questions about what happened. Sims says it serves as a reminder of how important it is for trustees to know what a custodian can and cannot do with pension fund money and assets.
Despite that he believes there has been an "overreaction" to the case and that this is "thankfully very rare".
He adds: "I cannot envisage that having been through this process and regulatory scrutiny that it's likely to happen again with BNY Mellon."
While FCA acknowledged that BNY Mellon did not act "deliberately or recklessly", the failings uncovered are still a serious matter and must not occur again at any bank in future.
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