The UK financial regulator is proposing direct changes to the custody rules in relation to client money, custody assets and mandates.
The proposal follows the Financial Conduct Authority’s (FCA) review of the industry where it identified weaknesses in some firms’ client assets following recent insolvencies including the Lehman Brothers collapse.
The changes are applicable to firms that are subject to the client assets sourcebook (CASS) because they hold client money, custody assets, collateral and/or mandates (or rely on exemptions contained within CASS) in relation to investment business.
Specifically the work covers custody, reconciliations delivery versus payment (DVP) exclusions, and reporting.
The FCA proposes introducing new disclosure requirements that would see firms report to their clients at least annually on the client assets protections they provide them. It is also proposing to increase the scope of the mandate rules by requiring firms to establish and maintain adequate records and internal controls for all mandates, including those not obtained in written form.
In relation to the European Market Infrastructure Regulation (EMIR), the FCA is proposing changes to client money rules and client money distribution rules to comply with the EMIR Regulatory Technical Standards (RTS) regarding indirect client clearing.
In relation to reconciliations, a firm must carry out an internal client money reconciliation each business day, says the FCA. “If following a non-standard method, a firm must be able to demonstrate that its proposed non-standard method provides an equivalent degree of protection to clients as the standard methods and must provide a written confirmation to the FCA from the firm’s auditor that it has systems and controls adequate to enable it to use the non-standard method effectively,” said the regulator.
The FCA also requires firms to carry out external client money reconciliations (i.e. a reconciliation between internal accounts and records and those of third parties where client money is held) ‘as regularly as is necessary’.
On recordkeeping, the FCA intends also to introduce more detailed recordkeeping requirements. This includes proposed requirements for firms to retain copies of reconciliations conducted and each review the firm undertakes of its arrangements for recordkeeping and reconciliations (including decisions on frequency of external client money reconciliations).
In relation to DVP exclusions, the FCA is proposing to amend the rules to clarify the meaning of ‘commercial settlement system’ and setting out exactly when the DvP Window begins and ends to ensure that firms are aware that they must be able to comply with the CASS 6 and 7 rules should a transaction fail to settle within the DvP Window.
The FCA proposes to define ‘commercial settlement system’ as ‘a system that is commercially available to firms that are qualified to act as participants, the purpose of which is to facilitate the settlement of transactions using money or assets held on a settlement account.’ An example of a commercial settlement system is CREST.
The FCA is also proposing that clients should agree that their client money or custody assets may cease to be protected in this way. This may be, for example, included in the terms of business between the firm and the client.
Also proposed is the expansion of the record keeping requirement to include details of the relevant client to whom the safe custody assets were allocated, as well as details of the original firm with which the client initially contracted and if relevant, details of subsequent firms to which the safe custody had been transferred.
A firm may currently register or record legal title to its own applicable assets in the same name as that in which legal title to a client’s safe custody asset is registered or recorded, under a number of specific conditions. To address these risks, enhance client protection and promote the speedier return of custody assets should a firm fail, the FCA proposes to remove the ability of firms to register their own assets in the same name as safe custody assets they hold, save where the safe custody assets are registered in the name of the firm itself. Registering safe custody assets in the name of the firm will continue to be permitted only in specified circumstances, namely where the asset is subject to local law or market practice outside the UK and with the client’s agreement, will remain.
The FCA proposes to introduce an explicit requirement for firms to have in place a written agreement whenever they place custody assets with a third party. It also intends to provide further clarification on the terms and details that a firm might include in such an agreement.
Historically, says the FCA, it has identified instances of poor reconciliation practices and inadequate internal and external reconciliation frequencies being set by firms.
It is therefore proposing to amend and clarify the existing custody reconciliation requirements, setting out that firms should undertake the following types of reconciliations:
• reconciliation of internal records
• reconciliation of any physical custody assets that are held, and
• reconciliation of firms records against third party records where custody assets are held
The FCA is proposing further changes in respect of reconciliation frequencies, handling discrepancies and the policies and procedures that need to be in place for custody reconciliations.
On internal custody reconciliation the FCA is requiring all firms to carry out internal custody reconciliations in the form of ‘internal custody records checks’. An internal custody record check is a check as to whether the firm’s internal records and accounts of the safe custody assets held by the firm correspond with the firm’s obligations to its clients to hold those safe custody assets, which is performed using one of the following two methods: the internal reconciliation method, whereby the firm will be required to; identify the safe custody assets held for each individual client to calculate a ‘total assets held for clients’ figure; separately identify (i.e. using a separate record) the aggregate total of safe custody assets that the firm holds on its premises and/or deposits with third parties to calculate a ‘total assets held for clients’ figure; and the internal evaluation method, whereby the firm will be required to evaluate the completeness and accuracy of its internal records systems in order to assess whether it records the safe custody assets belonging to each client and the total of safe custody assets held by the firm and to investigate and resolve any discrepancies identified.
The FCA proposes that before making use of the internal evaluation of custody records system method, a firm should document the system design to show and explain the evaluation it will make of its internal records systems.
The FCA proposes to require a firm, before using the internal evaluation of custody records system method, to first send to the FCA a written report from an auditor. This report should be prepared on the basis of a reasonable assurance engagement and provide an opinion of the adequacy of the design of the proposed method.
The FCA proposes to require firms to conduct a separate reconciliation specifically for safe custody assets a firm holds in its physical custody in addition to carrying out an internal custody reconciliation. This will require firms to count the safe custody assets using one of two methods already prescribed in the rules (‘the total count’ method or ‘the rolling stock’ method) and reconcile the total number of safe custody assets held with a firm’s internal records of the physical stock it holds.
The FCA is clarifying the current requirement as to how external custody reconciliations should be carried out. The purpose of the external custody reconciliation is to check the firm’s internal records against those of third parties.
Firms must ensure their records are correct to appropriately safeguard their clients’ assets. Firms have better understanding of the complexity of their business and the risks posed to the custody assets they hold and so are best placed to determine the frequency with which they should conduct reconciliations. The FCA therefore proposes to require firms to set the frequencies of their reconciliations, subject to minimum requirements and to clarify that a firm should, when setting the frequencies of their reconciliations, consider the risks to which the safe custody assets are exposed, such as the nature, volume and complexity of their business.
The proposed prescribed frequency for physical custody reconciliation would be as often as necessary but at least every six months.
Firms will have an obligation to review the frequency of their custody reconciliations at least annually and keep appropriate records of these reviews, the decisions made and the reasons for the decisions.
Where a reconciliation has highlighted a shortfall in the safe custody assets held by the firm, the firm must resolve the shortfall. If it is unable to do so immediately it must ensure client protection by segregating an equivalent amount of the firm’s own assets or by segregating client money to the value of and in respect of the shortfall.
Along with the relevant procedures, firms will also be required to maintain records of each reconciliation conducted. The proposed changes to internal and physical custody reconciliations rules, frequencies and the requirement for written policies and procedures for some firms may require significant internal review, preparation and engagement with auditors where necessary.
It is therefore proposed that if these rules are implemented after consultation, they come into effect six months from the date they are made.
The FCA plans to also require firms to report to their clients on their holdings of client assets more frequently if a client so requests. In these circumstances, the regulator intend to clarify that any charges associated with these requests must reasonably correspond to the firm’s actual costs for providing the relevant report. These proposals are aimed at ensuring that clients are provided sufficient and timely information about their holdings of client assets so that clients can adequately manage their own arrangements.
The FCA is also proposing to introduce a requirement for all firms subject to either the custody rules (CASS 6) or client money rules (CASS 7) to highlight to their clients in the form of a stand-alone disclosure document a summary of the key provisions within their client agreements which modify rights or protections, which would otherwise be available to the client under the custody rules or client money rules (‘Client Assets Disclosure Document’).
In relation to mandates, the FCA is proposing to extend the definition of a mandate to include all mandates that a firm receives that are not in written form.
The regulator is requesting feedback to its proposals on EMIR by Aug. 12 2013 and to all other CASS proposals by Oct. 11 2013.
To view the proposals in full, click here.