Custodian

A fund has two entirely different jobs inside it. One is deciding what to buy. The other is holding the thing that was bought.

If the same person does both, an investor has no independent evidence that the portfolio described in the quarterly report actually exists. The custodian is the separation: the manager instructs, the custodian holds and settles, and the securities account is the custodian's record, not the manager's spreadsheet.

That is the whole idea. Everything else — settlement, corporate actions, tax withholding, regulatory reporting — is work the custodian ends up doing because it is the one entity that can see every position at all times.

Custodians register with SEBI under the SEBI (Custodian) Regulations, 1996. Under the SEBI (AIF) Regulations the appointment is made by the sponsor or the manager, and since the SEBI (AIF) (Amendment) Regulations, 2024 (with effect from 5 January 2024) it is compulsory for every AIF, whatever the corpus and whatever the category.

Timing is specific: the custodian for a scheme must be appointed before the date of the scheme's first investment — not before first close, and not "sometime in year one". A custodial agreement is executed between the parties, and the custodian shall not be a related party to the sponsor or the designated partners unless specific conditions are met.

Because AIF securities are held in dematerialised form, the custodian is responsible for settlement and for ensuring the fund's demat accounts show the correct position at any time. It commonly also does tax withholding, proxy voting, and tracking of dividends, bonus and rights issues. For Category III AIFs it additionally keeps custody of goods received on physical settlement of commodity derivatives.

The custodian is also a reporting node for SEBI, not just a warehouse:

• Leverage breach (Category III): the AIF reports end-of-day leverage to the custodian by the end of the next working day and reports any intra-day breach. On a breach the AIF tells investors before 10:00 AM the next working day and squares off the excess by the end of that day; the custodian reports the fund's name, the extent of the breach and the reasons to SEBI before 10:00 AM the next working day, and confirms the square-off to SEBI the same day it happens.
• Credit default swaps: CDS exposures are reported to the custodian by the next working day; where earmarked securities fall below the CDS exposure and the AIF fails to rectify by the end of the next trading day, the custodian reports the breach to SEBI on the next working day.
• Specific due diligence: an investment taking a scheme to 10 percent or more of an investee company's equity on a fully diluted basis is reported to the custodian within 30 days, and the custodian compiles and reports to SEBI.
• FPI records: KYC records are kept in original for a minimum of 5 years from the cessation of transactions, longer if litigation is pending.

What the custodian does not do is protect the investor from the manager's judgement. Segregation protects against misappropriation and against the manager's own insolvency — the SEBI (AIF) Regulations separately require that the assets, liabilities, bank accounts and securities accounts of each scheme be segregated and ring-fenced from every other scheme. If the manager goes bankrupt or dissolves, the assets are identifiable and the fund is wound up through the liquidation route; they do not become part of the manager's estate. A portfolio that simply loses money is a different problem, and custody does nothing about it.

Growth Fund I, a close-ended Category III AIF, declares first close on 15 November with a corpus of Rs 240 crore. Before it buys its first security the manager appoints a SEBI-registered custodian and signs the custodial agreement.

The cost. Take the workbook's own fee illustration — a fund with committed capital of Rs 98 crore paying annual custodian fees of Rs 51,10,000:

That is roughly 62 basis points of committed capital, and it sits inside transaction and operating expenses rather than inside the management fee. GST at 18% applies to the custodian, the administrator, the auditor, the legal adviser and the investment adviser alike.

The reporting. Growth Fund I runs leverage of 1.8 times NAV against a cap of 2 times NAV. On a Tuesday a derivative position moves and gross exposure closes at Rs 500 crore against an NAV of Rs 240 crore — a ratio of 2.08 times. The clock then runs:

The manager never reports the breach to SEBI itself. The custodian does, because the custodian is the only party that can see the positions without taking the manager's word for them.

Chapter 7 (Alternative Investment Funds Ecosystem), section 7.1.4.3 introduces the custodian among the service providers, and Chapter 17 (Regulatory Framework) carries the obligations — appointment, leverage-breach reporting, CDS reporting and the specific due-diligence reporting. Expect questions on who appoints the custodian (sponsor or manager), by when (before the scheme's first investment), whether it is optional (it is not, for any AIF), and the leverage-breach sequence, where the examinable point is that the custodian reports to SEBI while the AIF reports to investors.

• The custodian is appointed by the sponsor or the manager — not by the trustee. The trustee appoints nobody here; it executes the trust deed and signs the Investment Management Agreement.
• There is no corpus threshold any more. Since the 2024 amendment every AIF must appoint a custodian. An answer of the form "only if the corpus exceeds X crore" is the trap, not the rule.
• The deadline is the scheme's first investment, not its first close. A fund can hold a first close without a custodian; it cannot invest without one.
• Custodian is not fund administrator. The administrator keeps the books, computes NAV, allocates income and expense accruals and produces investor statements. The custodian holds securities and settles. Custodians usually sell administration too, which is why candidates merge them.
• The custodian cannot be a related party to the sponsor or designated partners unless specific conditions are fulfilled — the segregation is pointless otherwise.
• Segregation is not a guarantee against loss. Deposits of securities or cash with a custodian still carry counterparty risk, and custody does nothing about a portfolio that simply performs badly.