What Is Custody-Only Trading?

Custody-only trading is a system in which shares must be registered to the holder by name and can only be traded in physical form. The adoption of custody-only trading requires any purchase or transfer of stock to be placed through the issuing company's transfer agent. The transfer agent cancels the shares received from the seller and issues a new share certificate for an equivalent number of shares to the buyer. While custody-only trading is a cumbersome process, some companies implement it to counter "naked" short selling.

Key Takeaways

  • Custody-only trading means shares must be registered by name, and can only be traded in physical form.
  • When shares are purchased, a stock certificate is created with the owner's name. When shares are sold to another buyer, the former stock certificates are canceled and new ones are issued to the buyer.
  • Custody-only trading curbs naked short-selling, but at the expensive or liquidity and efficiency since it takes more work and time to buy or sell shares.

Understanding Custody-Only Trading

While conventional short selling involves the sale of borrowed stock, "naked" short selling refers to short sales by traders who have no intention of borrowing and then selling the stock. Rather, they simply resort to short selling without borrowing the stock or ensuring that it can be borrowed, thereby driving down the price of the stock precipitously. Since custody-only trading requires purchase and sales of physical shares only, there is no stock for short-sellers to borrow or pretend to borrow, thereby discouraging naked shorting. In 2008, the SEC banned "abusive" naked short selling in the United States.

For certain types of investors, like a hedge fund or a buy-and-hold investor, they may prefer to hold investment securities that are not subject to the speculative intentions of short-sellers. Custody-only makes sense because it prohibits speculators from driving security prices around erratically with naked short sales.

In reality though, naked shorting is not a major problem on the vast majority of listed stocks. Although, it may be more of a problem for stocks that trade over-the-counter (OTC) or aren't listed on a major exchange. These are typically small companies or penny stocks which are already highly speculative in nature.

Drawbacks of Custody-Only Trading

The biggest drawback of custody-only trading is that it theoretically sacrifices some level of liquidity and efficiency. It takes more work to buy and sell shares. Investors with a particular strategy may find this downside is made up for by the prohibition against naked short selling.

Another issue arises because custody-only securities are not eligible for Depository Trust Company (DTC) nominee registration or for DTC book-entry services. However, DTC does allow for the deposit of securities under different methods; these apply to specialized asset classes such as customer-registered custodial assets, restricted shares, private placements, and limited partnership interests.

The Depository Trust Company (DTC) is the world's largest securities depository. Founded in 1973, it is a trust company that provides safekeeping through electronic recordkeeping of securities balances. It also acts as a clearinghouse to process and settle trades in corporate and municipal securities.

Example of Custody Only Trading

In a typical stock transaction made through an online brokerage account, the transaction is handled electronically. Share certificates can be requested, at a cost, but are not automatically provided to the stock buyer. Instead, the ownership of the shares is tracked and recorded electronically by the DTC.

When someone purchases custody-only shares, which are far less common than shares that can be traded electronically, share certificates are generated in the buyer's name. The share certificates that were in the seller's name are canceled.

If the owner of the shares wishes to sell them, they must contact the transfer agent who will facilitate the creation of new share certificates in the new owner's name, and cancel the prior owner's certificates.