The FSA today published Consultation Paper 10/9 which includes the following proposals for enhancing its Client Assets Sourcebook (CASS):

  • Prime brokerage agreements to include mandatory disclosure annex summarising rehypothecation provisions
  • Daily reporting to be offered to all clients of UK authorised prime brokers
  • Intra-group client money deposits to be restricted to 20% of the firm's total client money held in client bank accounts
  • Certain liens to be prohibited in custodian agreements
  • New CASS oversight controlled function to be introduced
  • A new client money and assets return framework, CMAR, to be introduced
  • The consultation closes on 30 June and a policy statement is expected to be published during the third quarter of 2010.

The proposals

Disclosure annex

The collapse of Lehman Brothers International (Europe) (LBIE) showed that many prime brokers' clients were unaware of how their prime brokers' insolvency could impact the ability to recover their assets. Although the FSA has observed an increase in understanding since LBIE's collapse, it believes that mandated disclosure on the practice and legal implications of re-hypothecation is necessary.

The FSA proposes to introduce contractual re-hypothecation provisions which will be summarised in a disclosure annex to each prime brokerage agreement. The disclosure annex will highlight relevant definitions, including that of net client indebtedness and the contractual limit on re-hypothecation. It will include a statement setting out the risk to the client upon the prime broker's default and cross-reference detailed provisions in the prime brokerage agreement.

The FSA has rejected for now a proposal to create a standardised definition of net client indebtedness and a maximum percentage cap to be applied to this formula. However, it has warned that where the FSA identifies issues with a firm's compliance with the rules, it may vary the firm's permission with a view to restricting its ability to re-hypothecate clients' assets.

This proposal will require firms to review and re-paper existing documentation, exercise version control and ensure that agreements are signed and dated. The FSA pointed out that there are similar disclosure requirements in the proposed Alternative Investment Fund Managers Directive (AIFMD). This may be the case, but it is likely that firms will need to re-paper again once the AIFMD is finalised and implemented in the UK.

Daily reporting to be offered to all clients of UK authorised prime brokers

Since the collapse of LBIE, the FSA observes that many prime brokers now offer their clients daily reporting. Although this appears to have become market practice, the FSA is proposing to introduce mandatory daily reporting to be offered to all clients to help them manage exposures. For those firms which do not at present offer daily reporting to clients, this proposal is likely to result in a need to upgrade their IT systems.

Restricting the placement of client money deposits within a group

This proposal only applies to UK authorised firms that place client money in client bank accounts held with a group bank, credit institution or qualifying money market fund. The FSA is concerned that where funds are held within a group, there is an increased risk of both the investment firm and the group bank failing at the same time. Clients may be exposed to an inappropriate level of credit risk, especially when firms favour placing a large proportion of client money within the group for funding reasons or when firms within a failing group deposit additional client money intra-group to bolster funds on a group-wide basis. The LBIE insolvency highlights the risks - approximately $1 billion was held intra-group with Lehman Brothers Bankhaus AG which also became insolvent.

To counter these risks, the FSA is proposing the introduction of a 20% limit on the amount of client money which can be deposited in intra-group bank accounts. The FSA will review firms' requests to go above the 20% limit on a case by case basis, so it acknowledges that a degree of flexibility may be permitted.

This proposal may have an impact on banks' liquidity as well as increasing the cost of investment firms' services (as client money held with third party banks will command lower interest rates than funds held intra-group). Firms will also need to search for third party banks and conduct the necessary due diligence, both initially and on an on-going basis, to ensure the soundness of these third party institutions.

Prohibiting the use of general liens in custodian agreements

The proposals will affect all UK authorised investment firms and overseas branches of such firms holding safe custody assets under CASS 6. The FSA is concerned that some firms have allowed custodians and sub-custodians to include general liens in custodian agreements. Although there is existing guidance in CASS dealing with this issue, the FSA is keen to introduce a rule to prohibit the use of general liens in custodian agreements except to cover the situation where the firm or the client does not pay custodian fees and charges.

New CASS controlled function

Many firms have several people across different departments overseeing client money and assets. The FSA is keen to ensure that one person at each firm is responsible for the following:

  • ultimate oversight of the firm's compliance with CASS
  • reporting to the firm's governing body on CASS compliance
  • submitting the client money and asset return (see below) to the FSA

The FSA is proposing to introduce a stratification of firms to ensure a proportionate approach to the supervision of individuals responsible for CASS compliance within firms. Firms will be divided into large, medium and small firms depending on the size of the firm and the highest amount of client money and custody assets held by the firm in the previous year.

Small firms may continue to allocate responsibility for CASS oversight to a specific director. This director will be deemed to carry out the CASS oversight controlled function even though he will not be specifically approved to do so. Medium-sized and large firms will need to appoint a new CASS oversight approved person, although only the CASS oversight approved person at large firms will be subject to the FSA's competency-based interview process.

Client money and assets return

The CASS oversight approved person will be required to submit the client money and assets return, CMAR, on a monthly basis at large and medium-sized firms. At smaller firms, the CMAR will need to be submitted by the relevant director with CASS responsibility twice a year. The CMAR is not a new concept as some pre-N2 regulators had previously required firms to report on client asset positions. Annex 4 of Consultation Paper 10/9 contains a copy of the proposed CMAR.

What next?

  • The consultation on the proposals in Consultation Paper 10/9 closes on 30 June 2010 and a policy statement is expected during the third quarter of 2010.
  • The Lehman client money appeal is expected to start in June 2010. Click here to view a detailed briefing on the judgment. It is likely that the FSA will consider whether or not to review the provisions of CASS 7 once the outcome of the appeal is known.
  • The FSA proposes to clarify relevant provisions relating to title transfer arrangements in a quarterly consultation paper in July 2010.
  • The FSA will publish a consultation paper refining the scope and increasing the standard of audit reporting in September 2010.
  • The FSA will review the effectiveness of special purpose vehicles designed to enable client assets to be released to clients promptly upon a firm's insolvency in the course of 2010.
  • The FSA will develop policies and supervisory arrangements to create a client money and assets trustee and/or agency in 2010/11.
  • CASS 5 which relates to insurance mediation activity is due to be reviewed in the first quarter of 2011 and the FSA will consider whether or not some of the proposals above should apply to general insurance intermediaries.
  • Following the publication of the Client Money and Assets Report in January 2010, the FSA has taken steps to rectify procedures at firms that have fallen short of its requirements. It will increase targeted supervision and regulatory intervention throughout 2010.