Changes to the FCA client asset protection regime
Amendments to the UK's client asset protection regime, contained in the Client Assets Sourcebook (CASS) of the UK Financial Conduct Authority (FCA), have been anticipated and consulted upon at some length since the failure of Lehman Brothers illustrated various perceived shortcomings in the regime at that time.
While certain issues which were at the centre of the Lehman client money litigation in the UK, in particular regarding the distribution of client money, remain a work-in-progress, the FCA's recently published policy statement PS14/9 still marks a significant change to CASS as it relates to the holding of client cash and non-cash assets.
The changes will affect all FCA-regulated financial institutions who are either: (i) incorporated in the UK; or (ii) in the case of non-EEA firms, operate by way of a branch in the UK, and hold money or custody assets on behalf of clients in connection with investment business. Since CASS does not apply to EEA firms operating in the UK on the basis of the EEA passport (whether on a cross-border basis or through a UK branch), the changes will not apply to such firms.
1 July 2014 − Limiting placement of client money in new unbreakable term deposits, clarifying certain existing requirements (eg the right to use client assets) and planning any optional arrangements.
1 December 2014 – processes and documentation relating to all new clients and counterparties (that came on board post-30 November 2014) need to be compliant with the new rules.
1 June 2015 – need to be fully compliant with the new rules for both new and existing clients and counterparties and in relation to systems.
What are the major changes?
PS14/9 introduces a wide range of changes to collateral, custody, client money and mandate rules as well as requiring firms to provide more detailed information to clients in relation to custody assets and client money held for term.
Major changes include the following:
- More detailed reconciliation requirements including in relation to addressing discrepancies/shortfalls: firms are already required to keep records and accounts and to perform internal and external reconciliations. The FCA has included more prescription as to the nature of these records and reconciliations, particularly as to internal reconciliations.
- A new form of banking exemption notification for use by banks who intend to hold money on behalf of clients as banker rather than as client money. It has been clarified that credit institutions who hold money for clients in relation to investment business are assumed to do so under the banking exemption (and hence are not subject to client money protections) unless they expressly agree otherwise. Related disclosure requirements to this effect have been updated.
- Use of DvP exemption. A firm's ability to utilise the "delivery versus payment" (DvP) exemption from certain CASS requirement in relation to cash and non-cash assets has been limited and is subject to new conditions.
- Use of a standard template form of client money acknowledgement of trust letters. This includes a requirement to repaper existing notification and acknowledgement letters.
- Pressure on "alternative approach" for holding client money. The alternative approach to segregation was designed for use by firms operating in a multi-product and multi-currency environment, for whom adopting the normal approach would be unduly burdensome and would not achieve the client protection objective. Under the alternative approach, client money may be received into, and paid out of, a firm's own bank accounts rather than client bank accounts. This creates a number of potential risks to client protection that have led to the FCA circumscribing the availability of the alternative approach going forwards and setting more onerous conditions before a firm is permitted to use it. There is a clear intention to disincentive use of the alternative approach in general.
- Limited introduction of multiple client money pools – net omnibus client clearing. For those firms offering central counterparty clearing services to clients, the FCA has introduced the possibility, where a firm so chooses, to establish and operate discrete "pools" of client money such that in the event of a firm's failure each pool of client money would be distributed separately from any other pool of client money and only to those clients beneficially entitled to share in that pool. To date, the client money pool has operated on the basis of a single shared pool for all clients upon a firm's failure.
However, following consultation, this mechanism has been limited so that it is only available in relation to client positions cleared through net omnibus client accounts at EMIR-authorised or recognised CCPs. In this context, cash collateral which is posted by a client to a clearing firm but not passed on in full to the relevant CCP (which will generally be the case for net omnibus client-clearing arrangements) may be retained in a separate "pool" from general client money holdings of the firm. The intention is to facilitate as far as possible the porting (ie the process by which, when a clearing member defaults, that member's client positions and the margin supporting those positions may be transferred to another clearing member's account) of net omnibus client accounts pursuant to EMIR.
- More detailed record keeping, policies and procedures requirements.
- Increased information and reporting requirements with respect to clients generally.
What are the implementation consequences for affected firms?
While many of the changes are not material in themselves, in practice they will require a significant implementation project addressing, in a short timescale, systems, processes, internal policies and procedures and changes to client and counterparty standard documentation. In particular, we expect firms will need to address the following:
- Interpretation of the new rules as they relate to existing business practices.
- For firms operating the "alternative approach" to the holding of client money, assessing how far and for which business line to pursue continuation of the alternative approach (which will require application to the FCA). Any resulting transition of business from one approach to another will in itself be a material systems and compliance project.
- Updated training for legal, compliance, operational and business teams.
- Revisions to client-facing template documentation and consideration of the need for repapering for existing clients.
- Reviewing current client assets procedures and updating where necessary − in particular, procedures and policies around reconciliations, shortfalls and discrepancies.
- Consideration of the use of "buffers" – firm cash posted as client money in order to address various prudential and other client protection objectives.