Professor Shmuel Hauser, Chairperson of the Israel Securities Authority: "The global financial crisis increases the need to adopt measures to protect customers' assets, in light of the rise in the risk of the collapse of financial institutions around the world. The committee's conclusions will make Israel's capital market more attractive to foreign investors as an investment target."
The inter-ministerial committee established to regulate custodial services in Israel's capital market today published its final recommendations, following the interim report it submitted to the Minister of Finance in August 2010. The committee states that in order to bring Israel into line with the international standards in this field, basic norms should be formulated regarding custodial services, and steps taken to ensure their adoption and implementation in Israel's capital market.
The global financial crisis, which has not ended yet, erupted while the committee was engaged in its work, and there is great uncertainty about the implications of the crisis. Many financial institutions went bankrupt, required government aid, or became seriously unstable. These events highlighted the need to introduce comprehensive regulation in this area in Israel, and the international regulatory community focused its attention on the custody issue.
The committee was headed by Ms Yael Almog, Adv. Director of the International Department of the Israel Securities Authority, and its members were representatives of the Capital Market Division of the Ministry of Finance, the Bank of Israel, the Tax Authority, and the Securities Authority.
The Chairperson of the Israel Securities Authority, Professor Shmuel Hauser, said, "The global financial crisis increases the need to adopt measures to protect customers' assets, in light of the rise in the risk of the collapse of financial institutions around the world. The committee's conclusions reflect the productive cooperation between the regulatory authorities in Israel's capital market for the protection of the public's investments in Israel and abroad, and will make Israel's capital market more attractive to foreign investors as an investment target."
The Commissioner of the Capital Market, Insurance and Savings in the Ministry of Finance, Professor Oded Sarig, added, "The implementation of the recommendations in the report is another step in the improvement of the capital market and its functioning. The proposals will promote the interests of the investing public in Israel, as among other things it will oblige all financial intermediaries in Israel to take into consideration the quality of the service they offer, as well as price, when they deal with suppliers of custodial services."
The Supervisor of Banks, Mr. David Zaken, thanked the members of the committee, and said, "The recommendations calls for Israel to adopt the high standards accepted in the world's leading economies. This will improve the protection of Israeli investors, and reduce the chances of operational failures. Imposing the appropriate standards on all financial intermediaries in Israel will help Israel's capital market achieve these objectives."
General background
Custody service is a vital financial service in the operation of a proper capital market. A custodian provides a range of services, the most important of which is that of safekeeping – holding securities for their owners such that the investor's ownership rights are documented and protected, and enable the investor to benefit from those rights. One of the basic principles of proper safekeeping is that the securities are held in segregated accounts in order to ensure that ownership records are maintained and that the customer's assets are separated from those of the custodian. Other services include clearance and dealing with company events.
The objectives of the regulation
1. Constant protection of the public's assets: Ensuring proper custodial services is essential for protecting the investing public against operational, legal, and sometimes even credit risks, which could harm investments in Israel and abroad.
2. Protecting the public's assets in a financial crisis: The committee states that the financial crisis, which had a negative impact on the savings of financial institutions throughout the world, emphasizes the dangers inherent in custodial activity. The importance of proper custodial services that provide adequate protection for investors increases when financial institutions that provide such services encounter difficulties or become bankrupt. The significance of these principles was brought home very recently by the collapse of the MF Global investment bank in October 2011. On top of everything else, there was concern that the bank had not kept its own money separate from its customers' money, and that it had used the latter when it ran into difficulties.
3. Preventing fraud: Regulating custodial services and supervising their quality also reduces the risk of various types of fraud. For example, one of the main lessons learned from the Madoff affair was that his scam was possible because of the absence of adequate standards relating to the custody of assets managed by investment consultants. That deficiency enabled Madoff to present a false picture of assets to customers for a long time. This and other episodes stress the importance of applying proper norms to the conduct of intermediaries in the capital market in relation to custodial services, particularly with regard to proper registration of rights of asset ownership, reconciliation of records and constant verification of the records by internal and external audits.
4. Making Israel's capital market an attractive investment target: An important additional advantage deriving from the regulation of custodial services is its contribution to making the domestic capital market more attractive to foreign investors. Regulating custodial services in Israel will increase foreign investors' confidence to trade in the market. Most foreign investments on the Tel Aviv Stock Exchange are performed via large banks known to provide global services, and which are bound by strict rules in their investments in foreign markets. To ensure that they comply with those rules they check the level of regulation and the practices in every market in which they operate.
The committee's findings
1. At this time, custodial activity in Israel is not sufficiently or uniformly regulated, a situation that allows wide variation in the quality of services provided to investors. This is the case with regard to both Israeli securities (owned by Israelis and foreign investors) and foreign securities owned by Israelis. This was the background to the establishment of the committee, to examine the need for regulation in this area. The committee found that custodial services are controlled in developed economies by comprehensive regulation, including clear and strong legal means of enforcement.
2. In the last few years a clear trend of stricter regulation has been evident. The committee studies the legal arrangements in the US and Europe relating to custodial services, and the effect of the events of recent years on this legislation.
The committee's recommendations
The committee recommends imposing requirements on everyone who supplies, directly or indirectly, custodial services for securities and financial assets.
Summary of issues covered by the committee's recommendations:
1. Definition of custodial services and providers of such services for purposes of the report. The committee focused on the core services relating to custody, and defined the types of service providers to whom the recommendations apply.
2. Definition of the basic obligations of custodial service providers. These include ensuring the customers' ownership rights over assets and cash and ensuring the associated rights (such as rights when a dividend or interest is paid).
3. Separation of assets, registering and documenting, reconciliation and reporting requirements. The committee recommends imposing obligations that will enable customers' assets to be identified separately, and the existence of assets and their ownership rights to be monitored constantly.
4. The appointment of a third party custodian and continued supervision over him. In many cases customers do not communicate directly with the provider of the safekeeping service over his assets, but via an intermediary. The intermediary is in direct contact with the customer, and organizes the safekeeping for him with a third party custodian. The committee recommends applying regulatory provisions to the intermediary that will ensure the investor's rights. These provisions would include the obligation for the intermediary to take into consideration certain criteria when choosing a third party custodian which would ensure that the custodian can fulfill his function properly; would determine rules for implementing the criteria in the process of selecting the custodian; and would require the drawing up of a contract with the third party custodian setting out the legal relations between the parties, which would include provisions intended to ensure that the intermediary can meet the requirements imposed on him, such as the requirement to disclose the method used to select the custodian and how it was carried out.
5. Responsibility for failure or damage. The committee recommends that the legal relations between the intermediary and the custodian be fixed by an agreement to be signed by both of them, which would determine, among other things, the matter of responsibility for damage to the customer's assets should such occur. The committee also recommends that the question of legal responsibility should be one of the criteria used in the selection of the custodian by the intermediary.
6. External audit. The committee recommends that there should be an independent external audit of the custodian or intermediary, to be performed at least once a year, which would examine the systems used to register assets and cash held in safekeeping, as well as internal procedures and audits. The committee learned that such requirements were applied in international regulation as a result of the financial crisis.
7. Regulation, supervision and enforcement. The committee recommends that a regulator supervising the custodian or intermediary should ensure that the committee's recommendations are made into regulation, supervised and enforced.
For details please contact Ms Sharona Mazalian Levi, Spokesperson of the Israel Securities Authority - 050 6230453.
