India, Pakistan and Venezuela are the most difficult countries in the world to provide global custody to institutional investors, the 1995 Pensions & Investments /Buttonwood International Group survey shows.
The second annual survey of global custodians picked India by a wide margin as the most troublesome securities market.
"In the case of India, a hold was placed on all new custody business due to the large backlogs experienced by local custodians," said one respondent.
The mountainous paperwork and the endless delays - for registration of share transfers - create an excellent opportunity for counterfeiting. And, in all this paper, if one signature should be missing, the trade does not settle on time.
"The settlement and registration mechanism is extremely inefficient in India, resulting in long delays in settlement and large backlogs at registrars and custodian banks," said Clarisse M. Persanyi, vice president-sales and marketing, Barclays Bank PLC, London.
Among the problems:
Obtaining government approval to invest in the country requires the preparation of extensive documentation. Approvals to invest usually are not granted for at least several months after applications are filed.
Stock certificates are typically issued in very small denominations. A trade of reasonable size usually will result in the exchange of a large number of physical certificates with associated transfer deeds, requiring many pieces of paper to be manually inspected prior to the completion of the settlement process. It is not uncommon for certificates to be stamped improperly, requiring return to a broker.
Registration of physical certificates takes up to three months, and shares cannot be traded until certificates are returned from registrars in proper title.
The settlement process requires investors to pay for shares several days in advance of receiving certificates, meaning broker exposure is unavoidable in the interim.
Foreign exchange is closely monitored by the central bank - Reserve Bank of India - and settlement of foreign exchange deals requires pre-funding in hard currency one day in advance of receiving rupees. Because rupee balances cannot earn interest and only 15% of all trades settle on time industrywide, lost use of funds for at least several days is typical.
A graduated capital gains tax must be paid annually after the filing of a tax return prepared by a local certified public accountant.
Structured as a retail market, India is suffering from a paper crisis and cannot effectively cope with current trading volumes.
There also is the concern of certificates being fraudulent because of the manual settlement and verification processes.
"This market continues to be difficult due to its physical nature," said Mark Brearley, vice president-network management at Chemical Bank, New York. "Registration of shares can take six to eight months, and there have been instances of fraudulent certificates. The market remains fairly illiquid as the use of jumbo certificates - institutional board lots - has not caught on," he said.
"The lack of infrastructure in this physical market makes it difficult to provide custody services that meet the standards of U.S. investors," said Wendy Lavoie, global network manager, Investors Bank and Trust Co., Boston.
Pakistan has many of the same complexities as India from a securities market operation, though it does not have the difficult and time-consuming investment approval process India maintains, said Chris DeLew, vice president-operations, The Northern Trust Co., Chicago.
Pakistan developed a unique problem during the past six months as a result of political strife and rioting in the financial center of Karachi. Labor unrest is pervasive and commuting difficulties for workers are common. Thus, the manual settlement process is often delayed because of manpower shortages.
"The high level of political uncertainty and instability creates frequent disruptions and market closure. There are no designated payment dates," said one custodian.
One custodian complained of the poor corporate events process: "Entitlements are declared without a pay date, and some companies take as long as a year to pay on entitlements."
The settlement process entails the exchange of high volumes of small-denomination physical certificates with transfer deeds for check payment. As in India, improperly endorsed certificates must be returned to brokers.
"Registration delays can range from 30 to 120 days. Issuers have different requirements and levels of sophistication," one custodian explained.
"The foremost operational difficulty faced in this market is the communication of information," said Investors Bank and Trust's Ms. Lavoie. "Communication via SWIFT (the Society for World Wide Interbank Financial Telecommunications) is not yet available with our subcustodian, and telephone lines are often unreliable. The central bank must approve all disbursements of dividends and bonus shares. This leads to considerable delays in the receipt of payment."
In Venezuela, trades often are not settled because of inefficiencies in the settlement and registration process. Set procedures for trade cancellations or buy-ins do not exist. As a result, a trade can stay in failed status indefinitely. In addition, foreign exchange controls are a troublesome issue.
"Currency controls are rigorous in that proceeds cannot be repatriated and all purchases of currency must receive pre-approval. All inflows and outflows must be documented as required in Brazil," one custodian noted.
The documentation for investors entails submitting in English and Spanish a power of attorney that is notarized and approved by a consulate, a certificate of good standing and a company or fund model application. The investor must receive approval from the exchange's governing body as well as open an account on the exchange.
"An area of concern to investors is the tracking of corporate actions and dividends," said Charles Dwyer, vice president-global products, Bankers Trust Corp., New York. "This is a very difficult process and can lead to the overstatement of portfolios as some companies may announce that an action is going to take place or a dividend has been declared and either not pay or withdraw the announcement altogether."
Taxpayer ID numbers must be obtained prior to trading. Obtaining a tax ID requires the submission of various documents and about six weeks of processing time. A local CPA is required to file a tax return, after which a graduated capital gains tax must be paid annually.
Separate documentation must be filed with exchange control authorities in order to secure repatriation of funds, which again is a lengthy process and not guaranteed.
The securities market is physical in nature, and during periods of heavy volume, the market is known for lengthy settlement delays.
Other hot spots
Other countries with major global custody issues for investors are Brazil, Chile, Colombia, Indonesia, Israel, the Philippines, Russia, Sri Lanka and the sub-Saharan African countries, survey respondents said. Common problems centered around the approval of the investor's application document, trading restrictions, asset repatriation, settlement practices and legal considerations.
Brazil: The documentation process requires the investor present a certificate of eligibility that is notarized and sealed by a Brazilian consulate; receive approval from the Comissao de Valores Mobiliarios - the Brazilian securities commission - to open an account on the exchange; and appoint a local administrator. If the investor wishes to either change the local administrator or the omnibus account through which it trades, the documentation process is repeated again by the investor, who is viewed as a first-time market entrant.
One custodian singles out the registration process with the CVM for identifying foreign beneficial owners of Brazilian securities: "There are often delays in the registration process, and the likelihood of fails increases if trade settlement date occurs before registration is complete."
"The tight settlement period of (trade date plus three) causes issues with settlements due to there being two exchanges - Rio de Janeiro and Sao Paulo," said Bankers' Mr. Dwyer. "This is compounded with the high penalties for fails of 1% of the trade on sales. The account of the investor is automatically debited for penalties by the exchange, even though a petition may have been filed by the local administrator onthe investor's behalf. Though this may be advantageous and not require claims to be filed, a client that has been debited wrongly loses the use of funds."
Chile: Restrictions abound in Chile's market. For example, depending on the method used, investors commit to certain minimum investments and a time period of years during which the principal cannot be repatriated.
"Complicated account opening procedures are prevalent," said one custodian. "Many applications to various agencies and numerous documents and statements are required from the client. The process can take months."
Tax payments are required to be paid in advance as frequently as monthly. Some taxes paid are credited toward annual overall taxes due, others are not.
Monthly reporting to authorities and the initial investment authorization process may be prohibitively expensive for most investors. The documentation process is rigorous, extensive and can cost between $10,000 and $15,000. The market is not SWIFT compatible, thus the receipt and delivery of information is not standardized.
Colombia: "The legal representative aids the investor through the documentation process and in obtaining approvals. The investor must also choose a local administrator. The local administrator provides trading support to the investors for the flow of funds. The choosing of the legal representative as well as the local administrator have costs associated with them that an investor must be aware of and consider in their analysis for potential return," said Bankers Trust's Mr. Dwyer.
In addition, the investor obtains approval to trade through an omnibus account, must open an investor specific subaccount and must open a cash account. The process can take from six to nine months.
In regards to trading, the market imposes restrictions on the ownership of securities. For example, no omnibus account can own more than 40% of a company and no single investor subaccount can own more than 10%.
Transfer of shares free of payment is not permitted, thus an investor must ensure funds are available for each transaction.
For each trade, two sets of instructions are required. One instruction is from the subaccount to the omnibus account; the second is from the omnibus account to the counterparty in the local market. The procedure is necessary because a buy or sale to the market takes place only through an omnibus account, yet only a subaccount can hold assets.
Indonesia: Indonesia is an overregulated market with significant restrictions that create problems.
Various industries and individual companies are either off-limits to foreign investors or have limitations on the percentage of foreign owners allowed.
Israel: Securities traded on the Tel Aviv Stock Exchange are cleared and settled at the end of the day, effectively a trade-date-plus-zero settlement period. And, currency restrictions are said to create a cumbersome process of repatriation.
The Philippines: One custodian discusses a process referred to as LGT settlements. "The LGT is a promissory note that the (fungible) transfer deed will be delivered in due course. Buy trades are generally settled via LGT rather than fungible securities. The LGT is not guaranteed by anyone other than the issuing broker, and there are no legal restrictions on the maximum amount of time a broker may take to complete delivery. Additionally, trades are settled by check, not (deliver vs. payment), increasing the risk of fails."
The custodian added: "Philippine authorities will not allow repatriation of Philippine pesos unless the investor displays proper proof that funds related to the original transaction were brought into the Philippines by legitimate means. This normally takes the form of a central bank registration documentation."
Market practice dictates registration is the responsibility of the broker delivering or receiving stock from the transfer agent. Because of strict settlement regulations, brokers normally register stock in their own names prior to re-registration in the name of the subcustodian, said Chemical's Mr. Brearley. The practice enables brokers to pay for stock on settlement date, irrespective of whether the subcustodians have received instructions from their clients. The market practice forces subcustodians to settle trades against a letter of guarantee. With registration taking up to several months, any trade undertaken in this market now carries additional broker risk, Mr. Brearley said.
Russia: "Although we have seen interest in this market, even our most sophisticated emerging market investors are approaching Russia with caution," said Ms. Persanyi of Barclays.
Another custodian agrees: "Russia presents a very high settlement risk, in part because of the very manual, labor intensive and expensive environment."
Another custodian mentioned the problems of "registration integrity and the absence of (a) deliver-vs-payment settlement mechanism."
Sri Lanka: Settling block trades is difficult here. The counterparties may recognize a block trade due for settlement, but multiple small trades are used to satisfy the block. The smaller trades, however, might have different trade and settlement dates, which complicates the process of entitlements for income and corporate actions due the investor.
Sub-Saharan Africa: Botswana, Kenya, Ghana, Nigeria, Swaziland, Zambia and Zimbabwe present their own problems.
"These are small, newly emerging capital markets with illiquid currencies, generally lacking electronic payment systems and/or SWIFT access," said Chemical's Mr. Brearley. "There are few local providers to choose from, leaving the global custodian with little bargaining power in terms of fees paid and service levels. Lack of SWIFT also makes timely confirmations and communications hard to come by."
Advice for the global investor
In many of the emerging markets, the custodians offered sage advice for global investors wanting to minimize operational risks associated with an investment.
Most custodians suggested the global investor follow these guidelines:
Know your counterparties. (Is the broker a leader in the market> Will he act in your best interests?)
Select counterparties with a good reputation.
Ensure your information chain with your global custodian is short and as efficient as possible.
Understand the market mechanics.
Manage your currency. Understand the market and its operational constraints.
Understand the market and sovereign risks.
"We have urged clients to enter these markets only after a thorough review of the inherent risks incurred in securities investment," said one custodian.
Custodians perform due diligence in the initial market evaluation and make reassessments frequently. But, one custodian warns, "other 'investment decision' risks are assumed by the investor. Risks associated with market occurrences such as a governmental overthrow, negligence on the part of the counterparty broker, the devaluation of a market and risks qualifying as systematic or force majeure are assumed by the investor making the decision to invest in a country or do business with a particular broker."
Specific country-by-country advice for the investor was offered by the global custodians.
Brazil: The investor and the custodian should ensure the title of the beneficial owner is correct on all documentation.
Select the subcustodian in the market as the local administrator; this eliminates the trilateral relationship and reduces the number of parties involved in a transaction. Consider repatriating all sale proceeds to reduce currency risk and fund each foreign exchange indi
Bank of New York
For U.S. clients1,480,000
The bank network covers 58 countries, of which 2 are proprietary subcustodians.
After the conversion of J.P. Morgan and BankAmerica, BONY estimates custody assets of $3 trillion.
State Street Bank
For U.S. clients1,800,000
The bank network covers 71 countries, of which 2 are proprietary subcustodians.
Chase Manhattan Bank
For U.S. clients1,449,000
The bank network covers 60 countries, of which 18 are proprietary subcustodians.
Chemical Bank Geoserve
For U.S. clients600,000
The bank network covers 63 countries, of which 2 are proprietary subcustodians.
Chase and Chemical plan to merge
For U.S. clients1,000,000
The bank network covers 58 countries, of which 3 are proprietary subcustodians.