Introduction

On 28 June the Australian Securities and Investment Commission (ASIC) issued two new Class Orders (CO 13/760 and CO 13/761) increasing the existing financial requirements for Australian Financial Services (AFS) Licensees that operate custodial and depository services.

These Class Orders introduce significant changes for responsible entities, investor directed portfolio service providers and custodial and depository service providers (Custodial Providers). The new requirements came into effect on 1 July 2013 for new AFS Licensees and will apply to existing AFS Licensees from 1 July 2014.

The new requirements are designed to ensure that Custodial Providers have adequate financial resources to undertake the custodial and depository activities that they are licenced to conduct. The requirements move away from the general obligation for AFS Licensees to “have available adequate resources (including financial … ) to provide the financial services covered by [the relevant AFS Licence]” and impose specific financial threshold requirements. In addition, new reporting and auditing requirements apply to facilitate compliance with the financial obligations.

The New Requirements

Application

The new requirements apply to Custodial Providers that are not “market participants”, “clearing participants” or certain bodies regulated by APRA, because alternative requirements apply to those entities under the Corporations Act 2011 (the Act). 

Net Tangible Assets Requirement

The new Class Orders require relevant Custodial Providers to hold minimum net tangible assets (adjusted assets minus adjusted liabilities) being the greater of:

  • $10 million; or
  • for responsible entities or IDPS providers, 10 per cent of average responsible entity and IDPS revenue; or
  • for depository and custodial service providers, 10 per cent of average revenue.

The required holdings may be significantly reduced for certain AFS Licensees that either reasonably believe that they are “incidental providers” for the purposes of the Act, that are sub-custodians appointed by the AFS Licensees or that are “eligible custodians” in accordance with the Act (partially exempt custodians). Partially exempt custodians are required to hold minimum net tangible assets being the greater of:

  • $150,000; or
  • for responsible entities or IDPS providers:
    • an amount of up to $5 million, being 5 per cent of the average value of scheme and IDPS property of registered schemes and IDPSs operated by the AFS Licensee; or
    • 10 per cent of average responsible entity and IDPS revenue; and
  • for depository and custodial service providers, 10 per cent of average revenue.

In order to comply with these new financial requirements, relevant Custodial Providers are required to hold at least 50 per cent of net tangible assets in “cash or cash equivalents” or 100 per cent in “liquid assets” (which does not include encumbered assets).

Reporting Requirements

Custodial Providers will be required to prepare and lodge details of projected compliance with the new net tangible assets requirements, and audited reports showing historical compliance with those requirements and the accuracy of prior projections.

The relevant Custodial Provider is required to prepare projections of the AFS Licensee’s cash flows covering at least the next 12 months, based on the AFS Licensee’s reasonable estimate of what is likely to happen over that period. These projections will also be required to:

  • be approved in writing by the directors, partners or natural persons (as relevant) for the entity;
  • document the calculations and assumptions used in preparing the projections;
  • be updated if the projection ceases to cover at least the next 12 months or there is reason to suspect that an updated projection would differ materially from the current projection; and
  • document whether, based on the projections, the AFS Licensee will:
    • have access when needed to adequate financial resources to meet its liabilities over the next 12 months; and
    • hold at all times during that period in cash or cash equivalents, an amount equal to or greater than the current amount that the AFS Licensee is required to hold under the net tangible assets requirements.

The AFS Licensee will also be required to lodge with ASIC an audit opinion prepared by a registered company auditor for each financial year (and any other period that ASIC directs). The audit opinion must state whether the AFS Licensee has complied with certain of the above forward-looking reporting requirements and with its net tangible assets obligations.

The auditor will also be required to state whether it has reason to believe, among other things, that the relevant Custodial Provider did not have in place adequate risk management systems to manage the risk of non-compliance with those asset holding obligations.

What are the implications for Custodial Providers

ASIC has stated that the new requirements are designed to address weaknesses under the existing system by ensuring that the financial requirements placed upon Custodial Providers reflect more accurately the risks associated with providing custodial and depository services. These new financial requirements are considered necessary because of the role of the custodial and depository services sector in financial markets in Australia and the expectation of rapid growth in this sector ($6.4 trillion expected to be held under custodial arrangements by 2028).

The new requirements for Custodial Providers mark a significant change in the approach to the regulation of this sector and is consistent with a continued post-financial crisis push by regulators for custodians to have tangible assets and greater liquidity so as to underpin the activities of financial service providers.

As with all regulatory change, existing and prospective Custodial Providers and their customers should seek quickly to understand how the new requirements will affect their business and any ongoing obligations. Ultimately, non-compliance could imperil an AFS Licensee’s position vis-à-vis ASIC and the maintenance of its licence.