“A f irm must arrange adequate protection for Client Assets when it is responsible for them.” The insolvencies of Lehman Brothers International (Europe) Limited and MF Global UK Limited as well as the Madoff scandal have been painful reminders of the importance of this simple but far-reaching principle of the Financial Conduct Authority’s2 (FCA) Handbook.
To enforce this principle, since 2008 the UK has increased the level of supervisory action towards firms holding Client Assets such as banks, investment man-agers, broker-dealers and custodians.
The FCA has issued fines for a total of over £40m, most of them due to controls failures creating risks to Client Assets as opposed to actual Client Assets losses.
The FCA’s Client Assets team has now reached a headcount of around 40 people, which in recent last months are said to have followed up on hundreds of issues with the firms they regulate giving an indication of the enforcement activity to be expected.
Family offices should generally welcome these changes. Given the importance of the UK financial services sector (for example, the vast majority of EU derivatives trade is through London), it is likely they will benefit from a greater level of Client Assets protec-tion in the UK overall.
However, some of these changes may at times also create additional risks and costs, which is why keeping track of developments in relation to the Client Assets regime is crucial.
The following highlights some of the supervisory issues and key changes to the UK Client Assets regime (CASS) that family offices should be aware of.
Supervisory action
Challenge of banks’ use of the Banking Exemption: Historically, most banks relied on the use of the so-called “Banking Exemption” when carrying out investment business, which means money placed on deposit with them was not segregated under the Client Assets rules.
The FCA recently started to challenge the wide-spread use of this practice to ensure the use of the exemption is adequately disclosed in client’s contracts (look for a sentence stating that “the bank is acting as a custodian and not as a trustee”) and that it is only applied to money held in the bank’s ledger (and not, for example, with a third party, even if it is an affiliate). This bears important practical implications as today’s complex money f lows mean clients may have expo-sures to entities they have not contracted with and these exposures need to be adequately protected.
Trust letters: Investment managers are required to obtain a written confirmation from the entities with whom they deposit client money to confirm this money is held on a trust basis separately from the invest-ment manager’s money. Because the FCA has identi-fied numerous situations where this confirmation was inadequate, causing a risk to the effective segregation of Client Assets, family offices should confirm that firms they are contracting with have the necessary trust let-ters in place.
Latest changes
Designation of an Operational Oversight Officer responsible for Client Assets: Supervisory concerns that inadequate or split senior management oversight was often the underlying cause of more serious CASS breaches led to the introduction of this new controlled function (“CF10a” based on the FCA’s Controlled Func-tions’ nomenclature). CASS Operational Oversight Officers are responsible for overseeing their firm’s operational compliance with the Client Assets rules and as such should be the primary contact for any CASS-related issues. It is very likely future enforcement action by the FCA will question their personal responsibility in relation to issues identified.
Compilation of a specific Resolution Pack for Client Assets: A younger brother to banks’ livings wills; the Resolution Pack is a repository of information intended to help an insolvency practitioner return assets to cli-ents in a timely manner following a firm’s insolvency. While the Resolution Pack is a firm’s internal docu-ment, sophisticated clients are increasingly asking to see a summary of their banks or investment manager’s Resolution Pack to obtain assurance their assets are safe and will be returned within a reasonable timeframe in an insolvency scenario.
Clarification of the mandates rules: There are specific FCA rules creating obligations for firms who do not hold Client Assets, but control them. These rules have often been misinterpreted. The FCA therefore decided to clarify them, with the onus on firms to maintain suf-ficient records to prevent the misuse of the authority given by the client. These rules may impact family offices directly (when they hold a discretionary man-date over assets held with a third-party custodian) as well as indirectly (when they use for example, an invest-ment manager). Their impact should therefore be well understood.
Choice of client segregation at central counterpar-ties (CCP): Under the European Markets Infrastructure Regulation (EMIR), which requires mandatory cen-tral clearing of OTC derivatives, firms entering into a transaction on behalf of their clients must offer them the choice between individual and omnibus client seg-regation at the CCP.
Importantly, firms which offer both client money protection and title transfer collateral arrangements3 to their clients must have different client transaction accounts so as to never co-mingle money for these two types of clients.
New concept of porting at CCP: EMIR also intro-duced the concept of ‘porting’. ‘This porting’ occurs when the positions and margins held in a client account at a CCP by a defaulting clearing member are transferred to another client account held by a back-up clearing member. It is important to note client money held by an investment firm in a client transaction account with a CCP will not form part of the client money pool if it is ported.
Future developments
The limits of the reforms described above were high-lighted recently in the failure of MF Global, where the administration of MF Global Limited in the UK, under the Special Administration Regime, had achieved pay-ments to clients on 26% of claims at the end of 2012 while in the US, customers of MF Global Inc. received 60% or more of their account value within one month.
In the light of these deficiencies, in September 2012 the FCA issued a consultation document discussing what could be, in its own words, the “most radical change that has been made to the client money regime in over 20 years.”
The most radical change proposed is the possibility for firms to set up “sub-pools” for clients or groups of clients rather than pooling all Client Assets together in the case of insolvency.
As with other proposals discussed (see box on next page), while the aim to make the Client Assets safer and speed up their return in the case of insolvency is to be welcomed, the resulting greater risks (litigation, oper-ational errors) and costs (likely to be charged back to clients) make the overall impact of the introduction of these changes uncertain.
High-level impacts from FCA proposals in relation to Client Assets
Proposal: Clearing firms to be able to create ‘sub-pools’ for defined beneficiaries, or groups of beneficiaries, or defined products, to speed and potentially prioritise return of particular client money funds in the event of a firm’s insolvency. - Good for family offices
Impact 1: On insolvency, each sub-pool would be pooled separately, allowing clearing firms to localise client money losses to particular sub-pools, and possibly to accelerate the distribution of client monies where it is non-contentious. Creating sub-pools should make clients more confident their balances can survive the insolvency of an individual clearing member. However, the use of sub-pools could lead to greater risk of litigation and delay in the return of client money and assets to institutional inves-tors or those undertaking more complex trades, particularly as the legal basis for sub-pools is not entirely clear. - Maybe
Impact 2: The operational and treasury management implications of having to create separate record keeping, ledger accounts, bank accounts and monitoring procedures over bank accounts for multiple sub-pools are likely to be onerous. Furthermore, the 20% restriction on the holding of client money with group banks will apply at a sub-pool and general pool level. This restriction is likely to impact more often on firms where the initial client money sub-pool is smaller. Costs of additional diversification are likely to be passed on to clients. - No
Impact 3: Clients must be informed of material changes to the sub-pool three months in advance. Creating and updating disclosure documents will initially be time consuming and expensive. Firms will need to weigh up whether the advantages of creating sub-pools outweigh the additional costs in practice. - Yes
Impact 4: The FCA is considering lock-in or cooling-off periods to reduce switching of client funds from segregated into non-segregated accounts in the frantic days leading up to firms becoming insolvent. This would make client money safer, but at the cost of flexibility to change client money status. Yes
Discussion: Is the balance between the speed and accuracy of client money return right? Are alternative approaches to client money segregation now endangered?
Impact 5: The FCA is considering the impact of more pragmatic insolvency provisions, as in some other jurisdic-tions, where all assets may be liquidated and all beneficiaries share in the shortfall rather than performing comprehen-sive reconciliations to establish individual beneficiaries’ assets and entitlements. This option will, however, depend on changes in the underlying insolvency law and a modification to the personal liability provisions for administrators. - Maybe
Impact 6: The FCA is considering whether investment firms should, like banks, have a target of returning client monies within seven days, and no later than 20 days, in an effort to balance speed of return with accuracy of recording. - Yes
Impact 7: The FCA is also considering whether claimants should be split into different categories of client and whether to mandate retail client preference in the return of client money and custody assets. - Maybe
Impact 8: The proposed regime will place more emphasis on firms’ records, and their ability to identify specific client money and assets, and will be coupled with the requirement for regular and more detailed statements to be sent to clients. - Yes
Impact 9: The FCA is concerned about the alternative approach, under which firms can legitimately make use of client funds during the trading day. One option could be intra-day segregation of balances at risk, by means of a buffer in the client money requirement. This would make clients’ money safer, but potentially at additional funding cost to the firms. These costs are likely to be passed on to clients. - Maybe
Impact 10: The FCA is concerned firms put client money resources on term deposit, thus rending it inaccessible immedi-ately in insolvency. The FCA is considering mandating break clauses in deposit agreements. This could reduce the return firms earn on deposits. This reduction in income is likely to be passed on to the client, either directly or indirectly. - No
Impact 11: The FCA is considering whether firms should hold a buffer in client money accounts to cover the costs of distribution by the insolvency practitioner and/or losses in insolvency. - Maybe
Impact 12: Banks are allowed to hold client money related to investment business as deposits under the so-called ‘banking exemption’. The FCA is likely to reconsider this in 2013, which will either likely end in the restriction of use, or the removal, of the banking exemption in whole or in part. If banks are required to hold more client money as a result, this could increase operational costs, which would likely be passed on to the customer. - Maybe
