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Sune Sorensen
March 15, 2023

Never Has “How to Own” Been More Important for Protecting Wealth

After federal regulators in the US took over two failing banks in three days, and many us wondering if there are more to come, and the Fed getting close to a place it didn’t fancy itself being in – trying to resolve a bank instability issue while fighting inflation - we have been reminded again to the importance of the “how-to-own” part of protecting and growing your wealth is critical from both a risk and return perspective. Yet, it receives the least amount of focus. Not today!

This article is a result of a number of questions that arose following the Fireside Conversation with Sune H. Sorensen, which we published right at the end of 2022, titled, “Recalibrating to a multi-polar world”. And, now with the recent banking chaos, the subject of “custody” has become even more critical. To watch the excerpt from that Conversation which focusses on the importance of “How to Own”, click here.

No one wakes up in the morning and thinks to themselves “You know what I really would like to have in place when it comes to how I own my assets that I have worked my entire life to build up? I want the least transparent and indirect format possible so that I have limited visibility, control, and understanding of what is going on.”

However, in truth, if you just scrape the surface on most of your custodial and ownership formats, you will likely realize that this is in fact how you “own” most of your assets. You are not alone. This is true for most people.

Your always friendly ‘advisor’ from one of the 3 or 4 major financial service providers that by now control most of the market, did obviously not sell you the setup using these exact words. But that is what the small print is for.

Those advisors likely got your attention by highlighting that their setup had no upfront fees, no custody fees, and access to plenty of margin. Their setup also gave you access to hundreds of thousands of investment opportunities including the latest in financial innovation like leveraged inverted ETFs of other ETFs. Plus, if you were ok with them sharing your financial data and credit score within their group of companies and potentially selling such data to 3rd-parties, you would also get a free branded toaster and a lifetime supply of poorly constructed branded pens.

The how to own segment of protecting and growing your wealth is the key from both a risk and return perspective, yet it gets the least amount of focus. Do you know why? Because it’s kind of boring and a bit of a downer.

The first part of how to own is the planning structures you need in order to ensure effective wealth transfers between generations, asset protection, privacy, and tax optimization. A lot of those conversations start with things like “When you die…” or “if you are incapacitated” (friendly lawyer speak for if you are in a vegetative state as a result of a near mortal accident or illness). These terse emotional conversations are then followed by legal jargon that are an alphabet soup of different planning structures, and then hundreds of pages of legal documents that you are supposed to read, understand, initial (each page!), and sign.

By the end of that journey, it is only natural that you don’t really want to spend a lot of time and effort on the next, enormously important, piece of the how to own segment - the custody piece. By now you just want to get to the fun bit: investing and making money.

“Just give me something that is low on paperwork, easy to do and ideally with no cost and lots of toys that I can play around with on my smartphone.”

Grandad, a man of few words but much knowledge, told me some version of “The easy road often becomes hard, and the hard road tends become easy” when growing up. It took a while to understand what he meant. It is very true for the custody piece. We have seen examples of this in our work.

This piece is meant as a starting point for you to do the “hard work” needed to understand if your custodial setup meets the definition, and to ensure that what you have worked hard to build is really safe.

Risk management is about understanding what happens when things don’t go well, or when times are not “normal”. If you have created significant wealth and have sat through the hours of estate planning meetings, don’t skimp out on the final piece of the puzzle with the this ever-important “how to own” segment.

True custody is what connects your wealth with your planning structures…as such it should not be an afterthought.

Why Fractional Reserve-based banks should not be custodian of your wealthEverything is fine until it isn’t…

Source: @MaxfieldOnBanks

The general framework…

Before exploring how custody of assets works in the US, it is useful to define some key aspects.

In the USA, custody is generally held either with banks or with brokers and/or investment Advisors, with the latter being probably the most popular.

Custodian banks are regulated by the Federal Reserve Board and the Office of the Comptroller of the Currency. On the other hand, while there are some exceptions, under the US Investment Advisor’s Act of 1940, brokers and investment advisors are typically required to register with the SEC, and to hold client funds or securities with a “qualified custodian” in segregated accounts.

Let’s dig into what some of these phrases mean specifically.

Federal law defines a registered investment advisor (RIA) as someone who advises clients on investing in stocks, bonds, and other securities as a business. Investment advisors have the authority to make investment decisions for clients, such as what securities to buy or sell. This definition tends to include all hedge fund managers – especially managers of large hedge funds.

Who can we consider a qualified custodian? This term generally includes:

  • Banks
  • Broker-dealers
  • Futures commissions merchants
  • Certain foreign financial institutions that customarily hold and properly segregate financial assets for their customers

The purpose of this “Custody Rule,” as stated by the SEC, is to provide protection for client funds or securities against the possibility of “being lost, misused, misappropriated or subject to investment advisors’ financial reverses, including insolvency.”

Banks, under their stricter regulatory framework, are required to segregate clients’ assets from their own assets. That may not be the same for other types of custodians with more lean requirements when it comes to segregation of clients’ assets.

Throughout their history, the “US Investment Advisor’s Act” and the “Custody Rule” have regularly been broken, sometimes with dramatic and devastating affect for investors and creditors. They have both been amended and expanded upon to keep up with rule breakers and the times, in general. Most of the time, they have led overall to a well-functioning system.

Another factor to observe is whether the custodian charges an actual “custodian fee”. Banks usually do, as their business models are based on the custody of assets and generally have restrictions as to what they can do with the assets. Brokers could offer the custody service for free. This is because they can use the assets in their custody for their business purposes, as we’ll explain further below, or because they make their returns on trade commissions and mark-ups charged on trades.

Different systems and solutions…

Everyone is different – we all have different objectives and priorities - but a combination of Swiss and US solutions is most likely the optimal framework if you are a US-based wealth creator.

With a pure model Swiss custodial bank, you get the following key solutions:

Swiss banks have a long-standing reputation for providing high levels of security for their clients' assets, including securities held in custody. This reputation is largely based on several factors, including strict banking regulation, political stability, strong economic system, or strong property rights, to name a few.

Swiss banks are regulated by FINMA, a member of the Basel Committee on Banking Supervision that regulates and supervises all banks in Switzerland according to the Basel Committee’s standards. These standards cover not only equity and capital adequacy but also the entire scope of prudential and conduct rules. As an additional safety measure, Swiss law demands capital adequacy standards that are even higher than those required by the Basel Capital Accord. Swiss banks can therefore certainly be counted among the safest in the world.

Title-held assets are segregated from the banks’ balance sheets. Also, the segregation extends to sub-custodians by Swiss regulation.

The Swiss banking infrastructure is one of the most sophisticated in the world. It provides for the ability to hold a multitude of assets within the same account for seamless and relatively frictionless operations. You can hold most listed global securities be it equities or bonds as well as multiple currencies, derivatives, physical precious metals, and in some cases, crypto.

In the event of a bank failure, the securities are protected following the segregation requirement, while credit balances are protected via the Swiss deposit insurance system, which covers the amount of CHF 100,000 per bank and per account holder.

If you are not a Swiss resident, by using a Swiss custodian, you get the added value of jurisdictional diversification.

Due to Swiss data and privacy laws, you also get additional protection on these fronts…the cherry on top of the cake!

In the US it works differently

First, you tend to need a number of different “custodians” to operate a diversified cross-asset portfolio.

Then, the business models are more muddled and proprietary risk-taking at the firm level is the norm. However, there are less forms to fill in, and most setups are easy to use, with lower direct fee structures coming with the many options available. For very active trading activities, especially where the use of leverage is involved, US frameworks are often superior across the different asset classes:

Precious metals - It is properly the most commonly understood and discussed asset in the context of custody. Again, it ranges between the “too good to be true” to “paper gold”, and from there, to gradients of true physical title-held assets.

Cash - Most US Custodian banks operate under the fractional reserve banking system, a system in which only a fraction of bank deposits are required to be available for withdrawal. This works well during the good times, but less so in bad times. These banks’ business is to lend; there is risk in that model. The Federal Deposit Insurance Corporation (FDIC) generally steps in when a member bank goes bankrupt, as they tend to do at regular intervals towards the end of the credit cycle, and they are mandated to cover up to $250,000 per depositor, per insured bank. These types of banks may be good for getting a mortgage with but not for holding significant wealth as their business model is not focused on providing custody but on speculating in credit.

Listed securities - Within many of the popular online brokers and Registered Investment Advisor turn-key platforms, with the handful of brokers who dominate the space, the aspect of title-held assets is often more of an accounting definition than a legal one. Furthermore, securities are generally not custodied with the broker but with one or more sub-custodians, or layers thereof. Most broker custodian solutions are built for ease of use over security and have margin lending as a key line of business which brings added layers of risk. Brokers also typically demand the right to rehypothecate all assets - check the small print! - although some jurisdictions, including the US, impose limits. Rehypothecation exacerbates prime broker insolvency risk by increasing the likelihood that the prime broker will have insufficient assets to satisfy customers’ claims. The SEC recently finalized rules that will focus on reducing the two-day window for settling share deals, an initiative that gained urgency after brokers such as Robinhood were shaken by a surge in trading during the 2021 meme stocks frenzy and had issues with consolidating trades. The Securities Investor Protection Corp (SIPC) - a non-governmental industry led institution - oversees the liquidation of its member firms if they get into trouble. SIPC protects up to $500,000 in cash and securities; of that, $250,000 may be in cash. Some firms have additional insurance. This might be fine for smaller investors and those doing a bit of trading, but clearly should not be the framework within which you hold significant wealth.

Crypto - This can range from your being an unsecured creditor to a risk taking, often unregulated, financial corporation at its worst, to having actual title-held assets via the few chartered trust banks currently in operation. The SEC has been in reactive mode recently in this space in light of several high-profile failures where companies promoted assets as segregated and separate, only for consumers to discover in a bankruptcy that their holdings were treated as unsecured assets and part of the estate of the collapsed company. With all the uncertainty there are currently few good comprehensive options for holding crypto in the US and many reasons why Swiss or Liechtenstein based solutions are at this point in time superior.

The key things to focus on in the “How to Own” area are

  1. Hold your assets via optimal planning structures for estate and tax planning, asset protection and privacy perspectives.
  2. Focus on the “Return OF money” before getting tempted by dreams of the return ON money. Getting the custody piece right tends to be the key component of getting that part right, as it will generally bring some guard rails into place.

With this foundation of the right planning structures and secure custody solutions in place, you can then go on to focus on solving for the next question: What to Own?!?!

Hear more about “How to Own” by listening to this excerpt from the Fireside Conversation, “Recalibrating to a multi-polar world” with Sune.

For more details, and to listen to the full Conversation, we invite you to have a look at our new ,Spotify ,Channel, where you’ll be able listen to and watch this and all previous and future Fireside Conversations, or check it out at ,YouTube.

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