Custodians vs Broker-Dealers: Why It Matters For Cannabis ETFs

Early in December, exchange-traded fund (ETF) issuer Innovation Shares filed a registration statement for a new exchange-traded fund focused on the marijuana industry. As is common for funds of this type, Innovation Shares has had to make arrangements for the custody of the stocks in its fund's underlying portfolio. What sets this product apart from other potential marijuana ETFs, however, is the fact that this new fund would utilize a broker-dealer instead of a bank custodian. The distinction between broker-dealer and custodian is subtle, but it turns out that in the case of marijuana ETFs, that small difference can have big implications.

Innovation Shares suggests utilizing a broker-dealer in lieu of a custodian. When it comes to ETFs, custodians are designated to hold onto fund's securities and cash. They take care of much of the nitty-gritty for the underlying holdings of the fund. Broker-dealers can hold stocks just like a bank custodian can, and they are also free from federal banking laws. Indeed, some broker-dealers already hold cannabis stocks themselves, suggesting that managing the custody of a marijuana ETF's holdings would not be a problem.

Historically, custodial risk has been a significant issue for marijuana ETFs. Questions of custody have been crucial for marijuana ETFs, in part because many major U.S. banks have been reluctant to serve as custodians of funds invested in cannabis. Although cannabis is recreationally legal in 10 states and medically available in many others, the specifics of legalization policy vary from state to state (to say nothing of how marijuana is still illegal from a federal perspective). That's all to say that it's difficult for a potential custodian bank to assess exactly what this role looks like when dealing with a group of marijuana companies. Even if the cannabis companies were headquartered in Canada, where marijuana enjoys full legalization, U.S. banks still assume responsibility when dealing with the U.S. Department of Justice.

The question of custody has been a big one for ETF issuers considering marijuana products. Indeed, the only marijuana ETF in the U.S., called the ETFMG Alternative Harvest ETF (MJ), has already run into issues of custody. MJ came about through the transformation of one of ETF Managers Group's preexisting funds. The issuer simply swapped out indexes, circumventing the need for a new custodian. However, U.S. Bank, the custodian of the original fund, reacted against the change, forcing MJ to seek out a new custodian after all.

Should Innovation Shares' product come to fruition, investors should watch out for the potential of added costs involved in participating in this fund. This may happen because of additional audits required by the SEC depending upon the status of the broker-dealer. The SEC requires custodians for investment vehicles like ETFs to submit to an annual audit of the assets contained in those funds if they are not already subject to annual audits. A privately-traded broker-dealer would not normally be subjected to these audits, so that would increase the cost of auditing requirements significantly.

Currently, ETFMG's MJ fund has an expense ratio of 0.75%. While Innovation Shares has yet to specify its expense ratio, that seems to be the figure to beat from the perspective of cost to investors.