By Louise Courtman at Crossbridge
Throughout 2011 and 2012, the FSA has introduced a number of enhancements to the UK client assets regime, from the Client Money and Asset Return (CMAR) and the creation of the CF10a (CASS Operational Oversight Function), to increased requirements for auditors and the CASS Resolution Pack.How far-reaching and effective have these changes been and what lies ahead in 2013 for CASS compliance? Following the demise of MF Global, the protracted return of clients’ assets to them in the UK, compared to the speed of return experienced in the US, suggests a long road to improving the regime still lies ahead.
Back to basics
Whilst client asset issues have moved higher up the agenda of firms’ senior management, with investment in systems and staff to make firms’ control environments more robust, the FSA is clear in its view, it is still seeing firms getting the basics wrong; Blackrock’s fine last year for failure to have valid trust letters in place is just one example. The regulator has re-affirmed its commitment to the level of increased scrutiny and supervision the industry has witnessed it adopt since early 2009 and sent a strong message that there is a significant amount of work to be done for firms to embed the foundations of basic compliance.
In the autumn of 2012, the FSA consulted on a number of proposed changes to the regulations. The primary objectives of the FSA’s Consultation are threefold: to increase the speed of return of client assets following a firm’s failure, increase the proportion of assets that are returned and reduce the market impact of the failure of firms holding client assets.The introduction of multiple client money sub-pools is intended to fulfil these goals, but will the most radical change proposed to the regime in twenty years, hit the mark?
Speed versus accuracy
In line with the European Market Infrastructure Regulation (EMIR), certain changes must be made to the CASS regulations, to accommodate the different segregation models central clearing counter parties (CCPs) must now offer to clients and to facilitate the transfer, ‘porting’, of clients’ funds to a back-up clearing member, in the event of one clearing member’s default. In part to fully address these requirements and also prompted by the greater protection that clients opting for an individual segregation model can be afforded, the FSA is considering the possibility of introducing multiple client money sub-pools and providing that level of increased protection to a broader range of clients.
Under the proposals, investment firms will have the option of establishing legally and operationally separate sub-pools of client money that may be split along client type or business line (retail versus non-retail, margined versus non-margined business). Whereas the current client assets regime prioritises accuracy over speed, the ability to split out riskier types of business would likely render it easier to resolve and pay out individual claims more quickly. The client money return to some clients should also be maximised, as any client money shortfall would be restricted to beneficiaries of that sub-pool.
It is important, however, not to overlook the degree of operational complexity involved in managing multiple sub-pools and the potential increase in operational errors that may result. Each client money sub-pool would require its own client money bank and transaction accounts, with separate client money reconciliations and segregation to be performed for each pool.Whilst these risks can be mitigated with appropriate operational controls, the cost of set up and ongoing maintenance of the sub-pools is also estimated to be significant. Costs would include record-keeping requirements(client documentation, client on boarding, agent network management, account set up, client reporting and additional staff required to carry out these processes)updates to policies, procedures, systems and controls, legal requirements, staff training, internal and external audit and project management costs. Industry respondents to the FSA’s consultation estimated the one off costs of establishing a first sub-pool to be in the region of £30,000-£5,500,000 and ongoing maintenance costs to be £60,000 to £300,000. One off costs for establishing subsequent pools are estimated to range from £0 to £1,400,000 and ongoing costs from £7,000-£230,000.
Whilst it appears that the introduction of multiple pools would result in a swifter return of funds, without too significant a detriment to accuracy, as well as bringing flexibility to the regime,can the change be extensive enough, given the legislative framework on which the UK regime is based?
Too radical or not radical enough?
The UK client assets regime is based on UK insolvency and company legislation. Not all of the criticism levied at the UK system, in the wake of MF Global, is entirely well informed, as there are important structural differences between the US and UK regimes that enable a more rapid return of assets in the U.S. Firstly, the US benefits from the Securities Investor Protection Corporation (SIPC), an industry funded insurance scheme established for clients of failed brokerage firms, covering them up to $500,000 each. Secondly and most significantly, US insolvency practitioners are not exposed to the same personal liabilities and litigation fears as UK practitioners.
Without a fundamental change to the legislative framework, the impact of enhancements to the regulations, such as multiple pools, can only ever go so far. There is also the question of how an equivalent UK insurance scheme would be funded and how feasible it would be to overhaul the legislative framework. Multiple pools are not the only proposal on the table from the FSA, however, so what are the other options to improve the regime?
Is the alternative better?
It has long been hinted at that the FSA is considering revoking the ‘alternative approach’ and certainly the Lehman Supreme Court ruling of February last year, which determined that the statutory trust over client money arises on receipt of the funds from a client, rather than at the moment of their segregation, brought in to question the value of its existence.
Under the alternative approach, whereby banks are able to receive funds in to their house account and segregate client money based on the close of business balance the previous day, there is an element of exposure that exists for money that is due to be segregated, but has not yet been. There is no guarantee, however, if the ‘normal approach’ were to be adopted across the board, that the calculation of funds to be segregated would be more accurate, given the complex multi-product, multi-currency operating environment of banks. Is it worth the FSA abolishing the alternative approach and creating serious practical difficulties for complex investment firms; difficulties the alternative approach was originally designed to mitigate?
If the alternative approach were to be retained, there are other possibilities – firms could be obliged to keep a balance in any account(s) used under the approach that is at least equal to the amount of client money to be segregated,or to hold a buffer in accounts to cover the cost of any potential losses incurred through the firm’s failings. Firms could even seek private sector mutual insurance to cover potential losses. It remains to be seen if the alternative approach will survive the current review of the regulations that is underway, though the same can also be said for the ‘banking exemption’.
Do not bank on it
There is a widely held view across the industry that the FSA is also considering revoking the ‘banking exemption’. The banking exemption permits licensed deposit taking institutions to hold funds as deposits, instead of under the client money rules. It is easy to make the assumption that all clients are seeking CASS protection and that this is the best possible form of protection for all clients, but is this actually something of a misnomer?
Under the CASS rules, client money must be diversified across a number of agent banks, so that a maximum of 20% of a firm’s client money can be held intra-group or with group related entities. It is rare that the identity of agent banks with which funds are held is disclosed to clients and what the potential credit exposure therefore is. Conversely, under the banking exemption, clients knowingly place their funds with an institution, the credit risk of which they are aware. Whilst the Financial Services Compensation Scheme only covers clients up to a certain threshold for deposits, if the banking exemption were to be removed, would that limit the options open to clients for protection of their funds?
If changes such as the removal of the alternative approach or the banking exemption were to be introduced, the path to implementation for investment firms currently operating these would be long, complicated and costly and furthermore, restricted by the UK legislative framework, alone may not fulfil the FSA’s objectives for CASS compliance. Is it actually a different type of client assets regime that is in fact needed?
Time for regime change?
It is important to remember the speed of return of assets to clients fundamentally depends on the complexity of issues at the time of a firm’s failure. The current CASS rules give primary focus to protection in the event of insolvency. Should the industry instead be working towards a regime that places greater emphasis on compliance when firms are solvent entities?
With the current market share in the UK at over £100 billion for client money and £9.7 trillion for client assets, and with the potential for that share to grow further still with the segregation models CCPs are now obliged to offer under EMIR, client asset protection will remain central to the FSA’s agenda.
Changes have been and are still being made to move towards an improved regime, but the fundamental overhaul that is required is not possible without the co-operation of government and the industry. Whether there will be a brave new regime is not yet clear, but the path ahead is definitely not a short one and the beginning of the end of a new era of CASS compliance is certainly not around the corner quite yet.