Custody Chains and Remoteness - Disconnecting Investors from Issuers

Abstract

The article shows that the current market infrastructure systemically prevents investors, both shareholders and bondholders, from exercising their rights against issuers. Equity and debt securities are now normally held through a chain of custodians. These custodians are connected with each other through contract law. There also exists legislation determining the relationship between custodians and their clients. It will be shown in the paper that custody chains have become independent from investors and issuers. Neither issuers nor investors are able to control the length of the chain or the content of the legal arrangements that governs the custody chain. Custodians are connected through a series of bilateral links that are independent of each other. This erodes the rights of investors. The paper will illustrate this by reference to the liability of custodians for their services and by reference to the ability of custodians to contract with sub-custodians on terms that are independent from the terms that they have entered into with their customers. Custody chains affect securities markets at a very fundamental level. Securities are a bundle of rights that investor have against issuers. Market participants assume that these rights are enforceable against the issuer. There is always a risk that an issuer defaults and becomes unable to meet claims. Otherwise, however, the market is entitled to expect that its infrastructure will make it possible to enforce claims where an investor takes the view that the issuer does not comply with the terms of an issue.

If the enforcement of claims is significantly compromised this can affect the value of securities. Investors will only enforce claims if the cost of enforcement is outweighed by the benefits. If the market infrastructure is set up in way that makes enforcement systematically very expensive investors will refrain from enforcing claims and that has implication for the value of those claims. This can have systemic implications. Custody chains not only affect securities values in the portfolios of investors. They also cause problems for issuers. They pose a significant hurdle preventing individual and institutional investors from exercising rights against issuers when they wish to do so and as a result deprive issuers of oversight from the shareholders. This problem cannot be overcome by contract law, corporate law or property law. The thesis of this paper is that structural reform is required to reduce the number of intermediaries that operate between issuers and investors. A central, direct and transparent mechanism should be created through which investors hold securities. The paper observes that in the past incumbent market participants have lobbying intensively to preserve the exiting structure and predicts that they are likely to oppose any change that will be proposed in the future.