The UK’s regulator, the Financial Services Authority (“FSA”), has recently published its latest policy statement1 on enhancing the client asset rules in the Client Assets sourcebook (“CASS”). The changes being implemented are, in part, the FSA’s response to issues highlighted by the global financial crisis and a number of insolvency appointments, most notably those relating to the insolvency of Lehman Brothers International (Europe) (“LBIE”).

The policy statement generally implements the proposals on which the FSA consulted2 in March 2010. The principal changes to CASS that the FSA will implement relate to:

  • A requirement for prime brokerage agreements to contain a new annex summarising rehypothecation3 clauses in simple, plain English;
  • Daily reporting by prime brokers to their clients;
  • New rules on intra-group holdings of client money by prime brokers;
  • The prohibition of general liens in custodian agreements;
  • The introduction of a new CASS operational oversight approved-persons function for all FSA-regulated firms holding client money and/or assets; and
  • The introduction of a client-money and assets return for all FSA-regulated firms holding client money and/or assets. The policy statement also contains commentary from the FSA on insolvency remote special purpose vehicle (“SPV”) custodians.

These changes will impact the way in which prime brokers authorised by the FSA operate, will necessitate some changes to their documentation and should benefit hedge funds using UK prime brokerage services to the extent that they have not already negotiated equivalent or better protection. However, the new requirements do not obviate the need for hedge funds to monitor their exposures to their prime broker.

Scope — Definition of Prime Brokerage

In defining the scope and applicability of the new rules, the FSA defined, for the first time, the terms "prime brokerage firm," "prime brokerage services" and a "prime brokerage agreement". The new definitions coming into force on 1 January 2011 are:

Prime brokerage firm — A firm that provides prime brokerage services to a client and may do so acting as principal.

Prime brokerage services — A package of services provided under a prime brokerage agreement that gives a prime brokerage firm a right to use safe custody assets for its own account and that comprises each of the following:

  • Custody or arranging safeguarding and administration of assets;
  • Clearing services; and
  • Financing, the provision of which includes one or more of the following:
    • Capital introduction;
    • Margin financing;
    • Stock lending;
    • Stock borrowing;
    • Entering into repurchase or reverse repurchase transactions; and, in addition, may comprise consolidated reporting and other operational support.

Prime brokerage agreement — An agreement between a prime brokerage firm and a client for prime brokerage services.

Prime Brokerage Disclosure Annex (“PB Annex”)

Prime brokers will be required to include a brief PB Annex at the end of the prime brokerage agreement with any client. The PB Annex must contain a summary of the rehypothecation provisions in the prime brokerage agreement and should be drafted in a short, informative and easily understandable way rather than simply repeating the clauses from the prime brokerage agreement. The PB Annex should also include a statement setting out the risk to the client's rehypothecated assets in the event of a failure of the prime broker.

The requirement for a PB Annex at the end of the prime brokerage agreement will apply to existing prime brokerage agreements as well as all new ones. The FSA notes in the policy statement that issuing existing clients with their relevant PB Annexes must take place by 1 March 2011, with all new prime brokerage agreements to contain the PB Annex from this date.4

Daily Reporting

Although the EU rules5 on client reporting by prime brokers only require annual reporting, many hedge funds have sought daily reporting by prime brokers since the collapse of LBIE. However, the FSA notes in the policy statement that a new rule was required “to level the playing field for the buy side, who face an inequality in bargaining power in their relationship with their prime broker”. Therefore, even hedge funds with limited bargaining power (such as new start-ups) will now be able to obtain daily reporting. The daily report to clients (which must be made available by the end of the next working day by reference to the end of day position the previous working day) must contain, among other things, information setting out the extent to which the prime broker may have exercised its right of rehypothecation, exposure in respect of over-the-counter derivative positions, the location of all safe custody assets, including assets held with sub-custodians, and a list of the institutions that are holding any client money. The FSA comments in the policy statement that they do not anticipate that the introduction of this rule will have a great impact on most prime brokerage firms as they already have a full suite of online reporting tools for their clients, which are usually accessed through an online portal. This information will, however, assist hedge funds in monitoring their exposures.

Intra-Group Client Money Deposits

CASS has always contained rules and guidance from the FSA constraining where client money can be deposited. The current rule requires that a firm should exercise all due skill, care and diligence in selecting, appointing and periodically reviewing both the institution where the client money is deposited and the arrangements for holding this money. The policy statement now also provides that a maximum of 20% of total client money may be placed with an intra-group bank. The FSA comments in the policy statement that the policy rationale for this rule is to prevent losses created by intra-group contagion. The FSA uses the example of the placement by LBIE of approximately 50% of client money with a group bank, Lehman Brothers Bankhaus AG (which is currently subject to German insolvency proceedings) as one of the main rationales for the introduction of this new 20% limit.

Prohibition on Use of General Liens in Custody Agreements

The FSA found in its recent reviews of the sector that prime brokers who appointed sub-custodians to custody clients’ non-cash assets6 had allowed the inclusion of a general or omnibus liens covering, for example, group indebtedness to the custodian or sub-custodian in contractual agreements, or had failed to pay due regard to this issue in negotiating their agreements. Experience during the financial crisis showed that this can result in significant delays or obstacles in the ability of insolvency practitioners to recover assets from custody deposits not under their direct control. To counter this issue, the FSA has now introduced a new restriction on the use of general liens in custody agreements. However, the FSA’s final rules contain three clearly defined exceptions to the prohibition on general or omnibus liens:

  • The prohibition does not apply to liens relating to charges and liabilities properly incurred as a result of the provision of custody services to a particular client and that client’s safe custody assets. This would cover, for example, charges and liabilities arising directly from the provision of custody and custody-related services, such as intra-day payments, contractual settlement and standing credit lines. Since the exception relates to the provision of services to a particular client, it is not yet clear how this will relate to omnibus (pooled) custody accounts where the services are not provided to any particular client.
  • Also excluded from the prohibition are liens created in favour of international securities depositories, central securities depositories and securities settlement systems, provided the lien in question arises only for the purpose of settling that client’s trades.
  • Liens that arise in jurisdictions as a result of local regulatory requirements or market practice where the firm has determined that holding assets in that jurisdiction is in the best interests of the client are also exempted from the general prohibition.

The FSA notes in the policy statement that these exceptions should allow clients to enjoy a full range of custody services and should support the efficient functioning of securities markets and allow clients to undertake overseas business in countries where liens operate as a result of statutory requirement and/or market practice.

New CASS Operational Oversight Approved-Persons Function

From 1 January 2011, all FSA-authorised firms that hold client money and/or client assets will be required to apportion CASS operational oversight to a senior manager or director. Firms will also need to determine whether they are a small, medium or large CASS firm based on the following new criteria: please see table.

Medium and large CASS firms will have until 1 October 2011 to apply for and receive approval from the FSA for an individual to perform the CASS operational oversight approved persons function (to be referred to as "CF10a." The FSA anticipates that this will generally be the same individual that currently is approved by the FSA as the firm’s CF10 – the compliance oversight function, which is the function of acting in the capacity of a director or senior manager who is allocated responsibility for compliance). Small CASS firms will be able to rely on their apportionment of the CASS operational oversight function without applying for FSA approval. This is unlikely to affect the vast majority of UK hedge fund managers who do not generally hold client money or assets.

Client Money and Assets Return (“CMAR”)

The FSA will introduce a new reporting framework for all firms that hold client money and/or client assets. The CMAR must be reviewed and approved by the holder of the CF10a approved persons function on a monthly basis for medium and large firms and by the individual who has responsibility for CASS operational oversight on a half-yearly basis for smaller firms. The CMAR, which must be submitted to the FSA, is intended to give an overview of firm-specific client asset positions and holdings. The first CMAR will need to be completed in July 2011, reporting to the FSA all appropriate data on June 2011 holdings by the firm of client money and assets. Again, this is unlikely to affect the vast majority of UK hedge fund managers who do not generally hold client money or assets.

Insolvency Remote SPV Custodians

Although the final section of the policy statement does not contain new rules on "insolvency remote" SPV custody structures, it does contain a high-level commentary from the FSA on these structures that some prime brokers established as a result of the fall-out from the collapse of LBIE. The comments derive from a review that the FSA conducted of a sample of the SPV custody models and informal consultations with buy-side firms. The FSA’s conclusion is that there is a small but growing market trend in producing special purpose entities designed to hold the assets of prime brokerage clients without putting them at risk in the event of the prime broker’s insolvency. Prime brokers that have created these entities are confident that they are sound and there has been some buy-side support. None of these SPVs has, however, been tested in real insolvency proceedings or in court. The FSA found varying underlying investor interest in these structures depending on the nature of the fund and that some funds reported that their investors were pleased to hear that SPVs were available as an option but were often discouraged by the cost of using the vehicle. The FSA’s final comment is that buy-side participants should consider whether such services are suitable for their own needs and those of their clients.

Further Changes

The changes set out in the policy statement are not the last that the FSA intends to make to its client money rules. The FSA comments in the policy statement that the client money rules will be comprehensively reviewed following the final determination in the LBIE client-money litigation. Further changes are to be expected in the short to medium term as the FSA plans to consult on a number of areas to ensure that the CASS regime delivers the desired level of client protection, financial stability and market confidence. In particular, firms can expect future consultations to focus upon:

  • Improvements to the FSA authorisation regime for firms that hold and control client money;
  • The effectiveness of CASS rules on notification and acknowledgement of trust; and
  • A review of CASS rules in connection with insurance mediation activity.


The FSA’s new rules will come into force over the course of 2011. The FSA’s timetable is:

January 2011 - The FSA will be contacting FSA-authorised firms that hold client money and/or client assets in January 2011 and will request that they confirm their largest monthly client-money balance and value of client assets held during 2010 by the end of January 2011.

1 March 2011 - The majority of the new rules come into force.

1 June 2011 - The FSA’s new system for categorisation of firms as small, medium or large for the purpose of the CMAR comes into force, as does the intra-group client-money restriction.

July 2011 - Firms to whom the CMAR requirements are applicable must report their June 2011 holdings of client money/assets.

1 October 2011 - Expiration of FSA transitional provisions – firms must have completed any necessary re-papering of client agreements, and large CASS firms and medium CASS firms must have applied for and received approval for the new CF10a controlled function.

Recommended Action

FSA-authorised firms that hold client money or assets should be assessing whether they are a large, medium or small CASS firm and making preparations with the FSA to get their CF10 compliance-approved person approved for the additional role/responsibility of the CF10a approved-persons function. This is by no means an urgent task, since large and medium CASS firms have until 1 October 2011 to receive approval. More pressing will be preparations for the first CMAR to be submitted in July 2011, reporting to the FSA all appropriate data on June 2011 holdings by the firm of client money and assets.

With regard to the changes to prime brokerage arrangements, there is no specific action that firms that are not prime brokers need to take, as all clients of prime brokers should be receiving a PB Annex and daily reporting from their prime brokers with effect from 1 March 2011. However, given that many prime brokers are already offering daily reporting to some clients, those firms who wish to receive daily reporting in advance of 1 March 2011 may wish to contact their prime broker to request this service in advance of this date.