SEBI’s Consultation Paper: Revisiting Custodian Regulations, 1996

Posted On - 22 November, 2024 • By - Akash Pingley

Introduction:

The Securities and Exchange Board of India (“SEBI”) has issued a consultation paper[1] outlining proposed amendments to the SEBI (Custodian) Regulations, 1996. These changes aim to modernize the regulatory framework for custodians, making it more robust and aligned with the evolving dynamics of the Indian securities market. With the exponential growth in the scope and volume of custodial services, SEBI has recognized the need to update existing regulations to address emerging challenges and risks. 

Role of Custodians:

Custodians are integral to the Indian securities market, ensuring the safekeeping of assets and enabling smooth transactions for institutional clients such as foreign portfolio investors (“FPIs”), mutual funds, and alternative investment funds (“AIFs”). They also handle responsibilities as Designated Depository Participants (“DDPs”), overseeing FPI registrations and ensuring adherence to investment norms. These services, while critical, expose custodians to risks such as operational failures and potential fraud. Given their crucial role, any inefficiency or disruption in custodial operations can have far-reaching implications for market stability.

Proposals for Custodian Regulations:

The Working Group (“WG”) reviewed the requirement for custodians to obtain SEBI’s prior approval in cases of a change in control, as stipulated under Regulation 9(aa) of the Custodian Regulations, 1996. The WG recommended adopting a framework similar to that used for stockbrokers, depository participants, investment advisers, research analysts, registrars to an issue and share transfer agents, and know your customer registration agencies. SEBI has proposed aligning custodians’ processes with these intermediaries by requiring online applications through the Intermediary Portal, submission of detailed information about the applicant, acquirers, and their directors or partners, and setting a six-month validity for approvals.

Changes in Control: SEBI has proposed a structured framework for custodians seeking approval for changes in control. This includes: 

  1. Mandatory prior approval from SEBI. 
  2. Online applications through SEBI’s Intermediary Portal. 
  3. Submission of detailed information about the applicant, acquirers, directors, and other relevant entities. 
  4. To ensure timely execution, SEBI has proposed a six-month validity period for these approvals.

Updated Code of Conduct: SEBI has emphasized the importance of updating the Code of Conduct for custodians to ensure uniformity and accountability. The Working Group has suggested several updates to the Code of Conduct for custodians to align it with market practices and the frameworks applicable to other intermediaries. The new clauses emphasize compliance with laws and regulations, fair competition, truthful communication, robust corporate governance, and effective client grievance redressal mechanisms. Custodians must maintain internal controls and ensure that directors and key personnel remain fit and proper individuals. Custodians will be required to cooperate with SEBI, promptly submit requested documents, and report legal or regulatory actions against them. Additional measures include holding custodians accountable for the actions of their employees and agents, acting in the best interest of clients, and empowering compliance officers to carry.  

Business Continuity and Disaster Recovery: The Working Group has proposed integrating a comprehensive Business Continuity Plan and Disaster Recovery (“BCP-DR”) framework into Custodian Regulations. This framework requires custodians to establish a BCP-DR policy approved by their Board or relevant committee, with periodic reviews every six months or following a disaster event. Key elements include defining disaster scenarios, implementing standard operating procedures, setting escalation hierarchies, and maintaining detailed communication protocols for internal and external stakeholders during crises. Additionally, custodians must document disaster recovery drills, prepare for disruptions in critical systems, and manage trading halts at stock exchanges. With institutional investors significantly contributing to market turnover, any custodian service disruptions could undermine market stability and investor confidence.

Contingency Planning: It has been proposed that custodians establish a framework to manage temporary disruptions through a Business Continuity Plan and, in cases of permanent failures, follow an orderly winding-down process similar to those mandated for depositories and clearing corporations. Such a policy would safeguard client assets, maintain operational resilience, and uphold investor confidence. Custodians, in collaboration with SEBI, will develop detailed guidelines on contingency planning and orderly wind-down procedures, adopting these through standard operating protocols.

Separation of activities: The Working Group reviewed the regulations concerning custodians’ scope of activities, particularly those requiring segregation of custodial services from other financial services. Recognizing that institutional investors often prefer a single entity for comprehensive services, the WG recommended allowing custodians to provide related or allied services—such as fund accounting, clearing services for derivatives, escrow services, designated depository services, and middle-office support—without segregation for their custody clients. However, for non-custody clients or activities not regulated by a specific authority, such services must be handled through separate legal entities to mitigate risks and potential conflicts of interest, especially in scenarios where commercial considerations of custodial services might conflict with regulatory obligations like those of a DDP.

Outsourcing of activities: SEBI’s circular from December 15, 2011, already outlines outsourcing guidelines for intermediaries, including custodians, incorporating the principles recommended by the WG. Regarding the classification of core and non-core activities for custodians, SEBI has decided not to issue an exhaustive list, as such categorization does not exist for other intermediaries and may not align with the dynamic nature of custodial operations. Instead, for consistent interpretation within the industry, it is suggested that the Custodians and DDPs Standards Setting Forum develop and formalize a categorization framework. This framework would be created in consultation with SEBI and subject to its approval, ensuring alignment with regulatory standards.

Safekeeping of Physical Securities: SEBI’s consultation paper addresses the safekeeping of physical securities, proposing the following: 

  1. Custodians with no physical securities need not maintain vaults. 
  2. Custodians holding physical securities must maintain vaults or equivalent storage facilities, with informed client consent. 

The paper explicitly rejects the recommendation for custodians to rely on warehouse service providers for physical securities, reinforcing that safekeeping is a core custodial function. 

Simplification of Reporting Requirements: The Working Group recommended streamlining reporting requirements for custodians by discontinuing several reports currently submitted to SEBI. Reports such as Report A (category-wise AUC data for clients like FPIs, FDIs, and MFs), Report B (category-wise AUC data for FPIs), Report D (country-wise AUC data for FPIs), and Report G (change of custodian details) were suggested for removal, as the required information is already shared with NSDL or CDSL. The proposal also includes discontinuing the fortnightly ISIN-wise AUC details report for FPIs. Custodians will continue submitting essential reports, like Report E (short sales by FPIs) and Report F (ADR/GDR dual fungibility data).

Global Custodians: The Working Group had suggested including a provision in the Custodian Regulations to formally recognize the role of Global Custodians in facilitating services for foreign investors. However, since the term “Foreign Investor” encompasses a broad range of entities, such as FPIs, FDIs, NRIs, and FVCIs, implementing this clause could inadvertently extend SEBI’s jurisdiction to activities outside its regulatory scope. Therefore, it has been proposed to reject this recommendation. It is also worth noting that the reliance on KYC processes conducted by Global Custodians has already been addressed for Foreign Venture Capital Investors through a SEBI circular issued on September 26, 2024, ensuring such provisions are selectively applied where necessary.

Revised Net Worth Requirements: One of the proposals is to increase the net worth requirement for custodians from ₹50 crore to ₹100 crore. This revision is driven by: 

  1. The growth in custodial services and associated operational risks. 
  2. The need to safeguard against potential fraud and financial losses. 

Custodians will have a three-year transition period to meet the revised requirement. Additionally, SEBI has clarified that the net worth requirement will be independent of capital adequacy requirements for other activities undertaken by custodians. 

Enhanced Obligations and Responsibilities: SEBI has proposed additional obligations for custodians, aligning them with those for Qualified Stock Brokers. These include: 

  1. Establishing scalable infrastructure and technical capacity. 
  2. Developing robust governance structures and risk management frameworks. 
  3. Creating contingency plans for operational disruptions and orderly winding down of businesses. 

Outsourcing and Categorization of Activities 

SEBI has highlighted that custodians must comply with existing outsourcing guidelines, as per the 2011 circular applicable to intermediaries. While SEBI does not propose categorizing core and non-core activities, it has suggested that the Custodians and DDPs Standards Setting Forum collaborate with industry participants to develop a harmonized approach, subject to SEBI’s approval. 

Conclusion:

SEBI has invited public comments[2] on these proposals. Stakeholders have been given until November 28, 2024, to provide their feedback, ensuring that the final regulations reflect the interests of all market participants. SEBI’s proposed amendments to the Custodian Regulations represent a proactive step toward modernizing and strengthening the custodial ecosystem.

[1] https://www.sebi.gov.in/reports-and-statistics/reports/nov-2024/consultation-paper-on-review-of-sebi-custodian-regulations-1996_88439.html

[2] https://www.sebi.gov.in/sebiweb/publiccommentv2/PublicCommentAction.do?doPublicComments=yes

King Stubb & Kasiva,
Advocates & Attorneys

Click Here to Get in Touch

New Delhi | Mumbai | Bangalore | Chennai | Hyderabad | Mangalore | Pune | Kochi
Tel: +91 11 41032969 | Email: info@ksandk.com