ISDA Warns of "Destabilizing Impact" of SEC Proposal to Expand IA Custody Rule

ISDA warned of the "destabilizing impact" of an SEC proposal to expand requirements under the Advisers Act Rule 206(4)-2 ("Custody of Funds or Securities of Clients by Investment Advisers") for derivatives markets.

As previously covered, the proposed changes would require the safekeeping of virtually all client assets by "qualified custodians" - a term that generally includes U.S. financial institutions and certain foreign financial institutions - at all times (including during the trade settlement process). The rule would apply to (i) customer assets that are not funds or securities, as well as (ii) digital assets that the SEC has said are securities but that it generally does not permit to be held by a broker-dealer. The proposed rule would cover all "positions held in a client account" to the extent that the adviser has control over the account.

ISDA Comments

ISDA expressed concern that the SEC proposal would expand the definition of "assets" in an "overly broad manner" for derivatives markets which are already being subject to extensive regulatory oversight. ISDA urged the SEC to provide clarity on products and transactions beyond "funds and securities" that would benefit from additional requirements instead of pursuing its current "kitchen sink" approach to defining "asset." ISDA highlighted several ways the SEC’s proposal would negatively affect derivatives markets, such as:

• including products under the definition of "assets" that do not require the protections of the proposed rule (e.g., financial contracts used for investment purposes, collateral posted in connection with a swap contract for a client, or assets that do not clearly fall under the current definitions of "funds" and "securities");
• creating "significant challenges and uncertainty" for investment advisers that handle futures and cleared swaps for their clients by not allowing futures commissions merchants to act as qualified custodians for cleared derivatives contracts;
• imposing new operational and compliance burdens for investment advisers handling separately managed accounts by reducing returns and increasing hedging costs for clients; and
• "substantially" raising transaction costs associated with prime brokerage arrangements.

ISDA also said that the SEC’s cost benefit analysis included in its proposal underestimates the burden of maintaining financial contracts with a qualified custodian and segregating variation margin and initial margin.