For any UK fintech business involved with payments of electronic money (e-money) and any (experienced) investor in these businesses, safeguarding client funds is a key regulatory issue.
The Financial Conduct Authority (FCA) consultation on changes to the safeguarding rules for FCA-authorised payments and e-money firms, “CP24/20: Changes to the safeguarding regime for payments and e-money firms“ (Consultation), is therefore noteworthy.
What is The Consultation about?
The Consultation, which closes on 17 December 2024, sets out the FCA’s plans for changes to the safeguarding rules. The existing e-money safeguarding regime in the Electronic Money Regulations (EMRs) will be replaced with rules in the FCA’s client assets sourcebook (CASS) designed to work with payments and e-money firms’ business models.
When Will The Changes Take Place?
The Consultation lays out a two-stage change to the rules, recognising that some rules, including those for statutory trusts, will require legislative change to the Payment Services Regulations (PSRs) and EMRs:
- The interim state rules will supplement the current safeguarding requirements. These are expected to be put in place in the first or second quarter of 2025.
- The end state rules will entirely replace the current safeguarding requirements and will come into effect upon repeal of the rules in the PSRs and EMRs.
What Are The Safeguarding Rules Designed To Do?
The safeguarding rules identify the duties of a firm to ensure the money it owes to its clients in connection with the payments or e-money services it provides is identified separately from the firm’s own money (i.e., segregated) and adequately protected via payment into a bank account or by insurance or guarantee.
Who Will The Changes Apply To?
The changes will apply to authorised payment institutions, small payment institutions that voluntarily safeguard client funds, and e-money institutions.1 The FCA is also proposing rules for auditors when providing annual reports. This highlights that, as operation of the CASS regimes for investments demonstrate, firms will have to justify compliance decisions to the auditors more than the FCA.
What Are The Likely Impacts And Action Points For Firms?
As is often the case, the full impact resulting from a change in rules is difficult to determine at the consultation stage . That said, the substance of rules seldom changes materially between a consultation and final policy statement. There are five specific points for firms to consider (also highlighted in the cost-benefit statement):
1. Consider what operational changes are required to ensure client funds are directly received into a designated segregated account (DSA), noting that currently, relevant funds have to be placed in a DSA by the end of the business day following the day on which they were received.
2. Revisit oversight and reconciliation process and internal structures (e.g., committees), noting the need to appoint an individually accountable person and file a safeguarding monthly return as well as principles such as prudential segregation, which permits a firm to use its own funds to cover any likely client fund shortfalls (familiar for investment firms under the CASS regime).
3. Consider documentary requirements, including changes to customer terms to reflect rights and corresponding protections as well as internal documents, including a CASS resolution pack.
4. Revisit arrangements with third-party providers, including the following:
- Auditors, noting the revisions to the annual audit reports and effect of more stringent FCA requirements on auditors’ opinions
- DSA providers, such as banks, noting the requirement for a DSA provider to provide acknowledgment letters and the restrictions on fixed-term accounts
- Insurers, where the insurance or guarantee method is used, noting the restrictions and requirements on policy terms
5. Prepare training as required to explain the new regime and be in a position to demonstrate competence connected with the new regime
The Proposed Changes in Summary
The changes can be broken down into four main areas, with the specific proposals in each:
1. Improving books and records (interim state rules)
- More detailed recordkeeping and reconciliation requirements for safeguarding, building on existing guidance and similar to existing requirements set out in CASS 7 for investment firms to ensure firms carry out accurate and consistent reconciliations
- Requirement to maintain a resolution pack, including requirements on the types of documents and records to be included for an insolvency practitioner to achieve timely return of funds to clients
2. Enhancing monitoring and reporting (interim state rules)
- Requirement to complete a new monthly regulatory return to submit to the FCA covering safeguarded funds and safeguarding arrangements
- Requirement to have compliance with safeguarding requirements audited annually, with the audit submitted to the FCA
- Requirement to allocate oversight of compliance with the safeguarding requirements to an individual in the firm
3A. Strengthening elements of safeguarding practices (interim state rules)
- Requirements to consider diversification of DSA providers, with whom firms hold, deposit, insure, or guarantee relevant funds and undertake adequate due diligence on those third parties; includes the requirement to have acknowledgement letters from banks in place with a template acknowledgement letter, except for accounts with acquirers and used solely to access a payment system
- Additional safeguards where firms invest relevant funds in secure liquid assets
- Additional safeguards and more detailed requirements on how firms can safeguard relevant funds by insurance or comparable guarantee, with a requirement that insurers only can cancel policies for nonpayment of the premium and are required to give 90 days’ notice
3b. Strengthening elements of safeguarding practices (final state rules)
- Requirements on segregating relevant funds, with firms required to ensure that all client funds they receive are paid directly into a DSA with DSA provider, such as a central bank, an authorised credit institution, or a bank authorised in a third country
- Requirements on agents and distributors to deposit any client funds directly into the principal firm’s safeguarding client account and for principal firms to segregate the maximum value of estimated funds agents or distributors will likely hold in the principal’s own DSA
- More stringent requirements for insurance or comparable guarantees that need to be satisfied by this safeguarding method and ensure the policy is written in trust
- Restrictions on fixed-term accounts applying additional safeguards in which funds can only be withdrawn with 31 to 95 days’ notice
4. Holding funds under a statutory trust (final state rules)
- Imposition of a statutory trust over relevant funds held by a firm and relevant assets, insurance policies or guarantees, and cheques
- Additional detail to clarify when the safeguarding obligation begins and ends with more prescriptive rules and guidance
Why The Change?
Understanding the reasons for the change should help firms in addressing their implementation. The FCA states lack of detail in the current regime does not allow for sufficient oversight. This can lead to shortfalls before and after insolvency where firms do not follow appropriate safeguarding practices and systemic risks where firms hold funds on behalf of other firms.
Similar to the FCA rules governing the custody of securities and investments and money owed to client in connection with securities and investments, the new rules are aimed at reducing the risk of loss and ensuring speed of return of a client’s money in the event of a firm’s failure. These twin concerns have been highlighted in the various FCA enforcement actions in the decade following the failure of Lehman Brothers.
The regime addresses the defect in the current regime highlighted in Ipagoo LLP [2022] EWCA Civ 302, in which the Court of Appeal ruled that the current law did not create a statutory trust over money an e-money firm (now insolvent) had received from its clients. This was different from the position for client money an investment firm receives, which changes to FCA rules following the Lehman Brothers Supreme Court decision have reinforced.
[1] In the Consultation, payments and e-money firms refer to firms that provide (a) services related to the issuance and use of e-money, (b) money remittance services to facilitate the transfer of money from one person to another, and (c) merchant acquiring to enable merchants to accept payment by credit and debit cards. The changes will also apply credit unions that issue e-money.
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