The vital role that custodian banks play in the global economy

What are custodian banks?

These financial institutions aren’t the same as commercial banks that offer savings accounts, loans and other traditional banking products to the public. While the name sounds similar, they don’t have branches around the country that members of the public can enter to open an account or make withdrawals. Instead, they provide specialized security services that are sought after by banks, asset managers, sovereign wealth funds and other asset owners.

This book by the European Central Bank about the history of custody services traces some of the elements back to 19th-century Europe, but points out that they became hugely popular in the US in the latter half of the 20th century. This was partly due to the paperwork crisis in the securities industry that developed in the 1960s. To get a better idea of their role, we can look at how this crisis affected the market and the solutions that were obtained by the introduction of custodian banks.

Trading volume on the New York Stock Exchange increased greatly during the 1960s, leading to a huge backlog of trades that needed to be cleared and settled. In fact, there was a period when the exchange had to remain closed every Wednesday to give the brokers a chance to try to catch up with this work. The outdated system also led to a worrying amount of securities theft being committed, so it was clear that changes were needed.

The introduction of computers helped them to some degree, but it became obvious that central depositories were required to enable financial institutions to store their paperwork. A change included in the Securities Act Amendments in the mid-1970s allowed banks and other institutions to use central depositories. This provided a safe, trustworthy way of storing documents and other assets that relieved the workload from the brokers.

More recent changes

In the beginning, custodian banks carried out the sole business of the custody and administration of certain types of security. This could involve areas such as safekeeping and settlement. However, recent years have seen range of services offered by custodian banks. For example, digital assets, data and analytics, and financing and liquidity are some of the solutions that we can see offered by the Bank of New York Mellon, the world’s largest custodian bank.

Some of the most recent figures suggest a huge growth rate of 8% leading to a total custody market valuation of $24bn in 2020. Exchange-traded funds (ETFs) and cryptocurrencies are among the leading types of assets that are changing the way that this market operates.

What can we expect in the future?

The way that custodian banks have expanded in the last few decades without losing sight of this industry’s original purpose gives us some clues as to how they might change in the future. It’s clear that emerging technology has already played a role in the most recent changes as digital assets and new ways of investing become more commonplace.

As the value of digital assets such as cryptocurrencies continues to grow, this is going to represent one of the main challenges. The safekeeping of those tokens is a huge issue as the overall market capitalization of the crypto market has reached more than $2tn in recent times.

New types of investment can only really achieve acceptance among institutional investors if they have a high level of confidence in the safekeeping of their assets. Therefore, as technology continues to progress and new types of investment emerge, this is going to become an ever more important point. Most people will carry on watching the ups and downs of Wall Street and other markets without realizing the role played by custodian banks.

To help custodian banks adapt to this changing financial world, many of them may need to update their platforms to include the latest digital investments. A combination of speed and scalability is required to help them meet client needs without losing any of the flexibility that is needed in this sector.

It’s interesting to see that custodian banks have emerged due to a growing need in the securities industry and how they continue to adapt to the new challenges and opportunities presented by the digital transformation of our world.