Michael Beaton managing director, Derivatives Risk Solutions LLP summarises the recent FSA consultation paper on proposed changes to the client assets (CASS) regime.
Introduction
On 6 September 2012, the Financial Services Authority (FSA) published CP12/22, a combined Consultation Paper and Discussion Paper regarding:
• changes to the client assets (CASS) regime necessary to comply with the segregation and porting requirements of European Market Infrastructure Regulation (EMIR);
• possible changes to the client money rules applicable to investment firms to facilitate the concept of ‘multiple client money pools’; and
• the wider review of the CASS regime which is currently under way.
Porting under EMIR
Porting refers to the transfer of client transactions (and associated margin) from an insolvent clearing member to a back-up clearing member. On the failure of a clearing member, Article 48 of EMIR requires a central counterparty (CCP) to port affected transactions or return margin directly back to underlying clients. In turn, this implies a degree of segregation of client monies. However, under current CASS rules, the failure of a firm triggers a “primary pooling event”, following which all client money held by that firm is pooled pending distribution. Any shortfall in this pool is shared pro rata among all affected clients. As such, the pooling requirements of CASS are incompatible with the porting (or money return) obligations under EMIR.
In order to facilitate porting or return of client money under EMIR, the FSA is proposing to amend Chapters 7 and 7A of the Client Assets Sourcebook to exclude from the pooling arrangements client money that is held by a clearing member firm on an ‘individual client segregation’ basis in a client transaction account at a CCP.
The deadline for comments on this part of the FSA document is 16 October 2012. A feedback statement and final rules will be published in December 2012. The new CASS rules will come into force on 1 January 2013, allowing CCPs to be able to apply for authorisation early in 2013, in accordance with the expected EMIR timetable.
“Multiple Client Money Pools”
Optional Pooling
The FSA sees the introduction of multiple client money pools as “the most significant change that has been made to the client money regime in over 20 years”. Broadly, under the new proposals, firms would be allowed to operate multiple legally and operationally separate client money pools and sub-pools. In the event of insolvency, each pool would be distributed rateably to its particular beneficiaries. All client money not held in a pool would form part of a general client money pool, in accordance with current CASS rules.
The FSA believes that multiple pools would allow firms to insulate clients from other clients with a greater risk appetite, or from the risks associated with more complex business lines. As such, clients could be protected from exposure to delays in the return of client money and the potential for shortfalls in the general client money pool.
It is intended that there should be a great amount of flexibility in the way in which the pools are created. So, for example, a firm could establish pools by reference to a business unit, such as Prime Brokerage. Alternatively, a clearing member could operate separate pools of client money comprising:
• the margin held for a client in a client account at a CCP; and
• the client money held for that client by the clearing member itself.
If the clearing member subsequently became insolvent, the pooling would allow an insolvency practitioner to make the margin held by the clearing member available to facilitate porting. In the absence of this type of arrangement the porting of client positions is likely to be difficult as a back-up clearing member could not confirm that it would have sufficient margin to cover its exposure. Accordingly, it may require a ‘top up’ of margin by the relevant clients, with the result that affected clients effectively pay ‘double margin’.
Mandatory Pooling
The FSA is also considering several mandatory options with respect to the creation of sub-pools. It believes that, in general, retail clients have a lower risk appetite than wholesale clients and often are not aware of the type, or risks associated with, business that a firm conducts on behalf of a wholesale client or the impact it may have on the return of client money. Accordingly, one proposal would require firms to establish, at the very least, two client money pools, one being for retail clients and the other for non-retail clients.
Another FSA proposal is to require the separation of client money along business lines. Specifically, firms would be required to hold the client money in relation to any margined business separately from non-margined business on account of the FSA’s belief that margined business deals with volatile trades and so is inherently more risky than non-margined business. The hope is that separating the two may result in fewer contentious issues and the more speedy return of some client money.
Comments on this part of the FSA document are to be received by 30 November 2012. A feedback statement and final rules are expected in the first half of 2013.
Review of the CASS Regime
The FSA is currently conducting a fundamental review of the CASS regime, the purposes of which are to:
• improve the speed of return of client assets following the insolvency of an investment firm;
• reduce the market impact of an insolvency of an investment firm that holds client assets; and
• achieve a greater return of client assets following the insolvency of an investment firm.
Improving the speed of return of client assets
The FSA highlights the trade off between speed of return and the accuracy of the amount returned and asks for feedback on the preference of the market between these two options and whether retail and wholesale clients should be treated differently. Specific measures to improve the speed of return of client assets include:
• a requirement for regular client statements, setting out clients’ money and asset balances and any right of use granted over those assets;
• establishing a client assets regime which emphasises actual segregation and firms’ records over the current regime which is focused on protecting in insolvency all clients who ‘should’ have received client money protection;
• additional disclosure requirements to clients which have consented to absolute title transfer arrangements;
• the establishment of lock-in or cooling-off periods to reduce the possibility of switching of client assets in the days leading up to a firm failure;
• ways to incentivise firms to make greater use of operating via mandates rather than physically holding assets;
• whether to require insolvency practitioners to liquidate all assets and require creditors to share pro-rata in any shortfall, rather than to perform comprehensive reconciliations of assets to understand beneficial ownership and apportion losses on that basis, as is currently the case; and
• whether anything can be done to discourage the inappropriate use of term deposits, where client money is deposited for extended periods without any ability to require its return before the end of the term.
Reducing the market impact of an insolvency of a firm that holds client assets
The current client assets regime is focused on freezing client assets (to protect clients) and returning those assets to clients, rather than continuing service or investment positions. In order to minimise market impact, the FSA is considering the following measures:
• whether to dislocate ‘primary pooling events’ and firm failures, thus allowing an insolvency practitioner to have the option not to constitute the client money pool and distribute client money and custody assets immediately. This might improve the prospect of a sale of the business post failure; and
• whether to allow firms to gain client pre-consent to the transfer of their client assets to enable, at a later date, the transfer of their business to other firms while still a going concern.
Achieving a greater client assets return
With a view of achieving a greater client asset return, the FSA is considering:
• requiring firms to hold a ‘buffer’ in client bank accounts to cover the costs of distribution by an insolvency practitioner and/or potent losses arising as a result of a firm’s failings;
• requiring firms to seek private sector insurance against losses in client assets;
• requiring firms to hold in client bank accounts an amount of money equivalent to the approximation of the monies at risk in house accounts because of the period between the last reconciliation/segregation and the failure of the firm; or
• whether to prioritise one set of clients (e.g. retail) over another set of clients, allocating any shortfalls to those client with a lower priority.
Comments on this part of the FSA document are to be received by 30 November 2012. A feedback statement and final rules are expected in the first half of 2013.
Conclusion
The value of some of the FSA proposals, such as prioritising the return of assets to one type of client over another, is questionable. Others, particularly the proposed pooling rules, are both welcome and necessary. Nonetheless, they all imply a degree of cost and administrative burden. By way of example, firms will be required to ensure that the segregation provisions of CASS 7.4 and the record keeping and reconciliation (both internal and external) requirements of CASS 7.6 apply to the general pool and to each sub-pool created. The FSA’s own cost benefit analysis estimates that the one-off cost of establishing a pool ranges from £30,000 to £5,500,000 for the first pool and up to £1,400,000 for each subsequent pool. In addition, ongoing administrative costs associated with each pool range from £7,000 to £300,000. Moreover, one-off costs are calculated to increase as firms offer more bespoke solutions, such as individual client sub-pools. In the current environment, it seems reasonable to assume that the demand among clients for separate pooling will be high. As a result, the aggregate cost will be material and in light of this firms should take the opportunity to make the FSA aware of any issues they have with the proposals.
