An RIA custodian is an institution that maintains the client assets and holdings of a registered investment advisor (RIA). RIAs give their clients financial advice, which may include direction on investments, but they do not carry out the trades involved in their plan. Under the custody rule of the Investment Advisers Act of 1940, an independent bank or other qualified institution must be appointed to do this. The rule is meant to protect client funds from loss or misuse.
The Securities and Exchange Commission (SEC) updated the rule in 2009 as a response to the Bernie Madoff Ponzi scheme.
Examples of RIA custodians
Qualified custodians generally fall into one of four categories:
- Banks or similar institutions with deposits guaranteed by the Federal Deposit Insurance Corporation (FDIC)
- Registered broker-dealers
- Futures commission merchants
- Foreign financial companies, if the company segregates client funds from its own assets
Custodians must keep each of the RIA's client accounts separate, although in some cases it may designate the RIA as an agent or trustee for the funds.
The RIA-custodian relationship
RIAs must depend on qualified custodians to operationalize their client's investment plans, so the relationship between advisory firm and custodian is an essential one. The choice of custodian is therefore critical for RIAs, especially given that the custodian often interacts directly with the RIA's clients.
The majority of RIAs use the Big Four broker-dealer firms: Schwab, TD Ameritrade, Fidelity, and Pershing Advisor Solutions. Some RIAs choose so-called second-tier firms that focus on services that are relevant to their niche. For example, some custodians specialize in alternative or socially responsible investing, while others tailor their approach to trusts.1
With so much on the line, RIAs usually seek custodians whose approach is consistent with the RIA's own goals, strategies, models, and technologies.
Is a custodian always necessary?
Because of the different kinds of fee arrangements used by RIAs and the huge variety of investors, not every client requires the use of a custodian. Some RIAs prepare financial plans for investors who have no assets under management (AUM) or clients who direct their own investments. In these cases, the RIA typically receives a fee for their advice, and no custodian is needed.
Sometimes, however, knowing who actually controls the client's funds — and therefore, who is subject to the custody rule — can be far less than straightforward.
In February 2017, the SEC struck down a common practice used by RIAs to transfer client funds. Typically, the RIA would secure a client authorization letter to transfer funds from one account to another, but the SEC said such letters would subject RIAs to its custody rules.
In its ruling, the SEC sought to maintain the separation between RIAs who have a fiduciary duty to render advice in the client's best interest and the broker-dealers or bankers who make trades in a client's portfolio and are paid on commission.
Qualified custodians reflect RIA diversity
RIA firms vary in their size and focus: some direct an organization's investments of tens of millions of dollars, while others help retail clients prepare for retirement. The same is true of custodians, which vary in their size, specialization, and market focus.
Finding the right fit between an RIA and custodian is a critical step in an RIA firm's potential success.
1. https://www.kitces.com/blog/best-ria-custodian-top-4-independent-platforms-and-second-tier-niche-providers/
TD Ameritrade Institutional, Division of TD Ameritrade, Inc., member FINRA/SIPC.
TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2019 TD Ameritrade.