LegCo Subcommittee on MPF System
Information Note
Custodial Arrangement

Purpose

This paper describes the criteria of approval that approved trustees should follow in the selection of custodians, the minimum functions that custodians must be able to perform, and the standard provisions to be included in custodial and sub-custodial arrangements, comprising:

  1. qualified institutions (paragraphs 2 and 3 below);
  2. committed Hong Kong presence (paragraph 4 below);
  3. independence from the investment manager (paragraph 5 below);
  4. minimum custodial functions (paragraphs 6 and 7 below);
  5. custodial agreement (paragraph 8 below);
  6. sub-custodial arrangement (paragraph 9 below); and
  7. central securities depository (paragraph 10 below).

Proposal

Qualified Institutions

2. We propose that the custodian should be:

  1. an authorised banking institution in Hong Kong, or
  2. a registered trust company incorporated in Hong Kong which has a minimum of HK$50 million paid-up capital and net assets, and whose parent company is either :-
    1. an authorized banking institution or authorized insurer in Hong Kong with minimum paid up capital and net assets of HK$150 million; or
    2. an offshore financial institution with shareholder’s equity in excess of US$200 million and rated A-1 by Standard & Poor’s.

3. The custodian should be subject to annual audit by external auditors and the trustee should have a rigorous selection process for engaging the custodian.

Committed Hong Kong presence

4. We propose that the custodian should commit its presence in Hong Kong in the form of:

  1. substantial facilities and resources in Hong Kong; and
  2. resident chief executive and other key staff in Hong Kong.

Independence from the Investment Manager

5. We propose that the custodian should be independent from the investment manager.

Minimum Custodial Functions

6. We propose that the custodian should be capable of performing its custodial functions, including -

  1. transaction processing, clearing and settlement;
  2. competent cash management and custody of securities; and
  3. provision of accounting, pricing, tax withholding/reclaim, corporate action processing, interest/dividend collection, and other services relevant to the custody of assets.

7. Where the custodian acts as a master/global custodian, it should also have the ability to perform global servicing of scheme assets. Subject to proposal in paragraph 8 (a) being observed, the custodian may delegate to sub-custodians who meet the requirements in paragraph 9.

Custodial Agreement

8. We propose that the custodial agreement or related service agreement between the trustee and the custodian should contain the following key features :

  1. all MPF scheme assets be maintained or held separate from the custodian’s own property;
  2. the employment of sub-custodians does not release the custodian of its MPF scheme responsibilities and liabilities;
  3. the custodian agreement will be governed by Hong Kong law;
  4. the custodian will be responsible or liable for losses caused by its own failure to exercise reasonable care; and
  5. the trustee or its representatives have the right of access to relevant records of the custodian with respect to MPF business for audit or other purposes.

Sub-Custodial Arrangement

9. We propose that any sub-custodian outside Hong Kong should be :

  1. a banking institution or trust companies authorized and regulated by the government or an agency thereof in its country of operation with parent company shareholders’ equity in excess of US$200 million;
  2. capable of carrying out the custodial functions described in paragraph 6;
  3. engaged as a sub-custodian following a rigorous selection process which includes examination of its credit rating, financial stability, systems and risk controls; and
  4. subject to annual audit by external auditors, annual master custodian audit, and audit by regulator agency as required.

Central Securities Depository

10. We propose that approved trustees, custodians and sub-custodians be able to use the services of a central securities depository (CSD) for the custody and transfer of scheme assets.

Justification

Qualified Institutions

11. The custody of retirement funds is usually undertaken by regulated financial institutions (e.g. bank or trust companies) because of the need to assure the security of scheme assets and the need to have custodial service providers with the experience and capacity to perform their custodial functions at a high level of competence.

12. The requirement to have a locally regulated financial institution as custodian of institutional funds is not without precedent. For instance, U.S. mutual fund law requires that assets of their funds be under the custody of a substantial local custodian. However, even a substantial local custodian capable of acting as custodian of a U.S. mutual fund may need to delegate the custody of offshore assets to sub-custodians in order to offer global custody services, U.S. mutual fund law also allows the use of offshore sub-custodians provided that such sub-custodians are both substantial and adequately regulated by offshore law.

13. The proposal of paragraph 2 adopts a similar approach by allowing custodians of scheme assets to either be an institution which is locally regulated and substantial in its own right (i.e. an authorized banking institutions in Hong Kong); or be a local trust subsidiary of either (i) an authorized banking institution in Hong Kong or an authorized insurer in Hong Kong, or (ii) a substantial offshore financial institution. The proposal in paragraph 3 above is to ensure that only qualified candidates are selected as custodians for scheme assets and that they are under prudent monitoring.

Committed Hong Kong Presence

14. The capacity for an approved trustee to receive services in Hong Kong, and to deal with and have ready access to a local institution will promote quality of services provided to MPF schemes. This requirement also facilitates site assessment of control and processing, and provides some additional asset protection safeguard. The requirement regarding the residence of the chief executive and sufficiency of local staff is consistent with the commitment to Hong Kong presence applicable to trustees.

Independence from the Investment Manager

15. This proposal is in line with SFC requirement in respect of the custodian of authorized unit trusts and mutual funds.

Minimum Custodial Functions

16. The proposals in paragraph 6 above is intended to list out the basic functions that a custodian must perform for the custody of scheme assets.

Custodial Agreement

17. The proposed key features to be included in custody agreements relate to asset security. These features emphasize the trustee’s continued responsibilities and liabilities for proper control over the scheme assets, as well as for the acts and omissions of the trustee’s custodian.

Sub-Custodial Arrangement

18. The employment of a sub-custodian does not relieve the custodian of its responsibilities and liabilities in respect of its MPF assets. It is important, however, to ensure the custodian selects its sub-custody agents with care and that its continuous monitoring system safeguards the standards and security of scheme assets. The proposed criteria should ensure the participation of international sub-custodians of substance and which are adequately regulated by offshore law.

Central Securities Custody

19. The custody of scheme assets invested internationally is subject to various custody practices. More and more international markets have replaced the physical delivery of securities certificates by the introduction of systems of central deposit and transfer of certificates, generically referred as "Central Securities Depository" (CSD). Certificates of securities are centrally deposited with a CSD which handles the transfer of the legal title of these certificates by way of a central registry. In some markets, the efficiency and risk management advantages of CSDs are seen as so valuable that securities can only be transferred through a CSD (e.g. U.S. government securities are now totally un-certificated and can only be transferred on a book-entry basis using the Federal Reserve system). The use of CSDs is endorsed by many international regulators (e.g. in the US and Canada under mutual fund law and pension law) and international advisory bodies (e.g. G-30 recommendation). The proposal in paragraph 10 above is intended to allow approved trustees, their custodians and sub-custodians to transfer scheme assets in markets where the use of CSD is required or is the established market practice.

Mandatory Provident Fund Office
Financial Services Branch
13 November 1996
[Ref. : Paper/MPF/SC-4]

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