DEFINITION of 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 purchases or transfers 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.
BREAKING DOWN 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, say a hedge fund or a long term, 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.
Drawbacks of Custody-Only Trading
The biggest drawback of custody-only trading is that it theoretically sacrifices some level of liquidity. Investors with a particular strategy may find this downside is more than made up by the prohibition against naked short selling.
Another issue arises because custody-only securities are not eligible for 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 one of, if not, the world's largest securities depositories. Founded in 1973 and based in New York City, it is organized as a limited purpose trust company and provides safekeeping through electronic recordkeeping of securities balances. It also acts as a clearinghouse to process and settle trades in corporate and municipal securities.