UK: FCA consults on changes to safeguarding regime

Why should I read this?

Authorised payment institutions, e-money institutions and credit unions that issue e-money (together “Payment Firms”) are all required to safeguard funds received from customers in connection with the provision of payment services, or the issuance of e-money, to those customers (such funds “relevant funds”).

The regime setting out these safeguarding requirements, which is set out in the Payment Services Regulations 2017 (“PSRs”) and the E-Money Regulations 2011 (“EMRs”), bolstered by guidance included in the FCA’s document “Payment Services and Electronic Money – Our Approach”, is designed to insulate customers from the failure of Payment Firms and ensure relevant funds can be retrieved and distributed quickly if a Payment Firm fails.

The FCAs safeguarding guidance has been updated various times, but the FCA has still, for some time, been concerned by poor practices by Payment Firms, having found significant and pervasive issues across the industry. It is perhaps also not insignificant that in 2022 the Court of Appeal disagreed with the FCA’s classification of safeguarded funds, leaving some uncertainty as to the appropriate legal treatment of those funds and the effectiveness of the safeguarding regime more generally.

Deficiencies in the current regime were also noted by HM Treasury in its Review and Call for Evidence on the PSRs, which commented that, in the context of the broader assimilation of EU law, responsibility for drafting detailed safeguarding requirements could be transferred to the FCA and that the FCA could consult on changes to the regime.

In its consultation paper CP24/20 “Changes to the safeguarding regime for payments and e-money firms” the FCA is consulting on these changes.

What do I need to know about the consultation?

Phasing

The FCA proposes to make changes to the safeguarding regime in two stages: an interim stage and an end-state.

The changes proposed in the interim stage are primarily focused on ensuring greater compliance with the existing regime and imposing additional record-keeping, reporting and monitoring requirements in respect of the same.

The end-state rules proposed are more fundamental in nature.  They would move the safeguarding regime towards a statutory trust-based regime, much the same as the client money regime contained in the FCA’s Client Assets Sourcebook (“CASS”).

Books and Records

Many of the proposals for the interim state regarding books and records will codify and build on the approach in Chapter 10 of the FCA’s Approach document.  The proposal is that requirements will be set out in a new Chapter 15 of CASS, with new rules also being added to a new Chapter 3A and sub-chapter in chapter 16 of the FCA’s Supervision Manual (“SUP”), to require Payment Firms to:

• have policies and procedures to help ensure compliance with the safeguarding requirements;
• have adequate records and accounts to enable it at any time and without delay to identify relevant funds and distinguish between those and any other funds;
• perform internal and external reconciliations of relevant funds at least once every business day;
• determine the reason for any discrepancy identified by a reconciliation and resolve that promptly;
• notify the FCA if:
  • the firm’s internal records are materially out of date, inaccurate or invalid;
  • the firm will be unable to perform an internal or external reconciliation;
  • the firm will be unable to remedy a discrepancy in its reconciliations; and
  • at any time in the previous year there was a material difference between the amount of relevant funds the firm was safeguarding and the amount it should have been safeguarding; and
• maintain a ‘resolution pack’ to include information that would help an insolvency practitioner, the FCA and/or a resolution authority in the event of the failure of the firm or another regulated firm.

The end-state requirements on books and records will largely replicate those in the interim state, updated for the broader changes proposed for the safeguarding regime in the end-state.

Monitoring and reporting

The FCA is proposing to impose a requirement on all Payment Firms (other than payment initiation service providers, small payment institutions (SPIs) and credit unions that issue e-money) to appoint an independent, qualified auditor to carry out an audit of its compliance with the safeguarding requirements on an annual basis. Such auditors will be required to co-operate with FCA and will also be required to provide a copy of their audit report to the FCA. While many firms currently undertake such an audit, provision of the report to the FCA will mark a significant change.

In the consultation paper the FCA is also proposing to introduce a new monthly regulatory return which will include information on the amount of relevant funds safeguarded, the methods, and details of accounts used to safeguard those funds, the reconciliations performed and any shortfall or excess, notifiable breaches and audit requirements.

Both the audit requirement and the reporting requirement would be applicable at both the interim stage and in the end state (with the only differences being to reflect the broader change in the regime applicable in the end state).

Improving safeguarding

Segregation

Under the current safeguarding regime, if a Payment Firm is safeguarding relevant funds by the segregation method (as 95% of firms do), those relevant funds must be segregated from the Payment Firm’s own funds on receipt, but only need to be kept in a designated safeguarding account if they are still held at the end of the business day after the day of receipt.  The FCA has identified risks arising from this approach and is proposing that:

• at the interim stage Payment Firms would need to:
  • exercise due skill, care and diligence when appointing third parties to be involved in their safeguarding arrangements;
  • regularly review the use of such third parties and consider whether to diversify such use;
  • consider how relevant funds not held in a designated safeguarding account might be clearly identifiable, potentially by appending ‘safeguarding’ to the name of the account; and
  • obtain acknowledgement letters from the provider of an account or custodian, putting them on notice that the funds constitute relevant funds, or the assets are being used for safeguarding purposes, respectively; and
• in the end state Payment Firms would:
  • be required to, if using the segregation method, receive relevant funds directly into a designated safeguarding account with an approved bank or the Bank of England;
  • be required to use a template acknowledgement letter to ensure the relevant third party acknowledges the trust over the relevant funds or assets;
  • be able to pay own funds into a designated safeguarding account (but such funds would then become relevant funds and be irretrievable); and
  • allow a Payment Firm to treat funds as relevant funds if it is unable to identify whether they are relevant funds or its own funds.

Agents and distributors

In addition, the FCA is proposing that, if a Payment Firm has agents and distributors and use the segregation method, in the end state either that firm will have to receive relevant funds directly into its designated safeguarding account (i.e. not through an agent or distributor) or set aside an amount of its own funds equal to the maximum amount it estimates might be held by its agents or distributors, which amount will be relevant funds.

Liquid assets

Payment Firms which safeguard relevant funds by investing them in liquid assets will be subject to additional controls.  In the interim state, new rules will require such firms to ensure that there is a suitable spread of investments, that the assets are selected in line with an appropriate liquidity strategy and that any foreign exchange risks arising are prudently managed.

In the end state, because of the proposed revised status of those assets, a Payment Firm seeking to invest relevant funds in liquid assets will need to be authorised to do so on behalf of its customers, which is likely to require it to become authorised to manage investments and either safeguard and administer assets or arrange for such assets to be safeguarded and administered.   Any assets so held will be subject to the rules in CASS 6.  These requirements are likely to discourage the vast majority of Payment Firms from this method of safeguarding.

Insurance and comparable guarantees

Payment Firms can select to safeguard relevant funds by putting in place insurance, or one or more relevant guarantees, to cover such amounts.

The FCA doesn’t yet propose to remove this option, although slightly ominously it has said that it will keep that under review.  In the interim, the FCA will formalise the guidance on the use of this option, currently contained in its Approach Document, into rules.  It will also include additional obligations around assessments of operational risk and solvency when using this method.  In the end state, the FCA would make clear that the rights under and proceeds of an insurance policy or guarantee used for safeguarding will be included in the statutory trust.

Imposition of a statutory trust

The Court of Appeal has made it clear that there is no statutory trust over the safeguarded asset pool of a Payment Firm, although there is a special type of priority interest in those assets/that pool for customers of such a firm in its insolvency.  Combined with the fact that, when the PSRs and EMRs are revoked and incorporated into the FCA’s rulebook, the current legal treatment will fall away, the FCA considers that imposing a statutory trust over relevant funds, much the same as the one imposed over ‘client money’ is the only way it can ensure adequate customer protection.

This will not involve any change in the interim state, but in the end state will involve the imposition of a statutory trust over all relevant funds, however held, including segregated funds, liquid assets and rights and proceeds under insurance policies and comparable guarantees.

One of the effects of this will be that Payment Firms will be trustees of their customers’ funds and will owe fiduciary duties to those customers (i.e. as beneficiaries of the trust).  This will make the considerations such a firm has in certain circumstances, such as insolvency, considerably more involved.  It will also require Payment Firms to obtain acknowledgement letters from relevant third parties, acknowledging the existence of the trust.

Further proposals

The FCA is also proposing that:

• if an e-money institution also provides payment services, rather than having to hold relevant funds received in respect of (i) issuing e-money, and (ii) provision of payment services, separately, they would be able to hold them in a single asset pool, with customers of both types of service being beneficiaries in the same statutory trust; and
• it will be possible for e-money institutions to give unclaimed relevant funds to charity sooner than the six years for which they are currently required to hold them, if they have made reasonable efforts to trace the consumer and unconditionally undertake to repay consumers if the amounts were in excess of certain thresholds.

How Eversheds Sutherland can help

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