Hi,
As far as I understand a malicious custodian might create a fake Holding of an Instrument X.
exercise accountRefCid Account.Credit with quantity
How could we detect a fake Holding like that?
Thanks!
Jose
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The legitimacy of creating a holding depends on what X represents.
If X is a Cash IOU (or other instrument) issued by the custodian itself, then it is usually considered legitimate for the custodian to create a holding (similar to how a promise to pay on a piece of paper can be legally binding). Of course you need to trust that the custodian will provide the promised payment when demanded or that it can be enforced by legal means, and a custodian would never credit you with something without getting something in return.
If X represents an intermediated security, such as a security in book-entry form, the parties involved are regulated entities. A holding of an equity, for instance, is typically represented by a chain of bilateral holding instances from the Depository where the security has been deposited, through intermediaries, to you. It is important to note that if an intermediary creates a holding out of thin air, it is considered fake and has no backing, and regulated entities would lose their license if caught doing so.
If X is a DLT security, where an issuer has issued a bearer token on-ledger, then a malicious custodian cannot create such a token out of thin air as the issuer is a signatory on the contract. However, the custodian might keep such a token in custody on behalf of its clients thereby spawning an intermediated security or depository receipt for the client. In such a case, typically nothing prevents a malicious custodian from spending the bearer token (unless some extra workflows are put on top such as also locking the asset to the owner or so).
In conclusion, unless you keep the security in custody yourself (or put some extra customized workflows in place for locking), it is typically necessary to trust that your custodian (and all other intermediaries for that matter) will act properly and segregate your assets from theirs. Failure to do so could have significant consequences for both you and your custodian.
I hope this clarifies the matter.
Johan
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@jvelasco.intellecteu just adding an additional point regarding intermediated securities.
It’s worth noting that for certain securities, such as registered shares and bonds, the issuer or their delegated party must maintain a separate register of legal owners, i.e., in addition to the book-entries kept by the custodial hierarchy that make up the intermediated security. If a custodian were to create a fake book-entry, they typically wouldn’t be able to get the issuer to update the share register accordingly, as this would violate the preservation of quantities. However, it’s worth noting that the legal owner may not necessarily be the same as the ultimate beneficial owner (UBO), as the latter might only be reflected in the internal books of a custodian. In this situation, the custodian is holding the security on behalf of the UBO and could potentially transfer the holding to another client and update the share register accordingly, although doing so would be illegal without the UBO’s consent. While it is generally safe to trust your regulated custodian, it’s probably safest if clients register as the legal owner (if possible) to protect themselves also against this behaviour.
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