Client Asset Requirements under the microscope as holdings by entities rise

Last December, the Central Bank issued a consultation on proposed enhancements to the Client Asset Requirements (the Consultation).

The Central Bank is proposing that the guidance be updated by enhancing existing obligations relating to some of the seven core principles set out in the guidance. These include segregation, designation and registration, reconciliation, daily calculation, client disclosure and consent, risk management; and client asset examination.

An overview of the proposed enhancements in each of the areas are outlined below:

1. Segregation

The principle of segregation is considered central to ensuring client funds are sufficiently safeguarded in the event of the insolvency of an investment firm. The requirements state that client funds should be held separately to the investment firm’s assets, with accounting segregation maintained between these assets, thereby ensuring that client funds are protected.

The Central Bank is proposing to clarify in the guidance previously issued its expectation that client funds must be deposited directly into a third-party client asset account, thereby ensuring immediate segregation and further strengthening the safeguards around client assets held.

2. Designation and registration

Under this principle, the investment firm must ensure that all client assets are clearly identified in both internal and third parties’ records, allowing them to be easily distinguished from the investment firm’s own assets.

No enhancements have been proposed by Central Bank in this area.

3. Reconciliation

The principle of reconciliation requires investment firms to, firstly, keep accurate records and books to enable it at any time, and without undue delay, to provide an accurate record of the client assets held and the total held in each client asset account. Secondly, conduct regular reconciliations between its internal records and those external records of a third party with whom client assets are deposited.

Several enhancements are proposed by Central Bank in respect of this section, with these changes being a combination of new requirements, with some enhancements adopted to place existing CAR guidance on a legislative footing.

The key amendments are outlined below:

• A new requirement is proposed in which investment firms will be obligated to perform an internal reconciliation of client financial instruments monthly, reconciling its internal client ledger to its internal custodian ledger.
• Investment firms will also be required to reconcile, for those client financial instruments which have not been deposited with a third party, internal records and accounts with those of the parties responsible for maintaining the record of legal entitlement to those client financial instruments on at least a monthly basis. This would effectively place CAR guidance G5 (1)(b) on a legislative footing.
• In addition, investment firms will also need to perform a reconciliation of physical client financial instruments on at least a monthly basis. This would effectively place CAR guidance G5 (1)(d) on a legislative footing.
• In considering new reconciliations, it is proposed that the same requirement to investigate, identify the cause of, and resolve any differences or discrepancies as set out in Regulation 57(7) will apply to such additional reconciliations described above.
• A new requirement is also proposed in which an investment firm will be required to maintain a record of the actions it has taken to remediate any client asset reconciliation difference or discrepancy identified through the performance of a reconciliation process.

The overarching objective of these proposed enhancements is to ensure that investment firms maintain complete and accurate records, thereby ensuring that the correct amount of client assets are held and safeguarded by investment firms on behalf of their clients.

4. Daily calculation

Under this principle, the investment firm must conduct a daily check to ensure that the aggregate of client assets held is equal to the amount of funds that should be held.

The Central Bank is proposing to align the process for the remediation of client fund differences or discrepancies, identified through the performance of the daily calculation, with the process for remediating reconciliation differences, as set out in Regulation 57(7) of the Client Asset Requirements. This would require investment firms to investigate, within one working day, the cause of any difference or discrepancy, identify the cause of the difference or discrepancy within five working days and resolve the difference or discrepancy as soon as practicable.

The objective of this amendment is to ensure that the internal records an investment firm uses in the performance of the daily calculation are accurate.

5. Client disclosure and consent

This principle governs the requirements surrounding the provision of information to clients on how and where their client assets are held and the resulting risks.

The enhancements proposed have been prompted by the increase seen in client asset holdings reported to the Central Bank by Irish regulated entities, including new and evolving market entrants.

Central Bank has identified many areas where enhancements could be made to this area, with the Central Bank proposing to introduce new provisions:

• To require investment firms to maintain a copy of all relevant material to evidence that prior express consent has been received from a client, allowing the investment firm to enter into arrangements for securities financing or otherwise use that client’s financial instruments.
• Regarding the establishment and termination of Title Transfer Collateral Arrangements (TTCAs), including ensuring they are subject to, or form part of, a written agreement between the investment firm and the client and are of a durable medium. In addition, the TTCAs will be required to include certain prescribed information as outlined in the proposal, including terms relating to the transfer of ownership and termination of the agreement. Lastly, requirements are also proposed in relation to termination of TTCA’s, including requirements relating to record-keeping, treatment of assets and client notifications in this scenario.
• For investment firms holding client assets while providing prime brokerage services in which they will be required to provide clients with access to up-to-date information in the form of a statement, with such information required to be updated daily (unless a statement is already provided to a depositary under Article 91 of the AIFMD Delegated Regulation). In addition, investment firms providing such services will be required to include an annex to the relevant client agreement, summarising key prime brokerage provisions.

The purpose of these proposals is to enhance investor protection further and provide a standardised approach to more frequent reporting to clients.

6. Risk management

Investment firms are required to ensure that systems and controls appropriate to identify risks in relation to client assets are established, and any mitigants to address these risks implemented.

Under this principle, firms are also required to develop and maintain a Client Asset Management Plan (CAMP), with Central Bank proposing some additions to the CAMP with the most significant points including:

• Inclusion of a Client Asset Applicability Matrix in the CAMP to ensure investment firms carry out a robust assessment of where client assets arise across its business lines and services.
• Inclusion of prescribed details where an investment firm outsources any activity relating to the safeguarding of client assets, and the way an investment firm will exercise oversight over the outsourced activity.
• Inclusion of the location of its internal client asset breach and incident log in the CAMP.

The enhancements proposed have been driven by good practices and issues identified by Central Bank through direct client asset supervision and authorisation work.

7. Client asset examination

The regulations require an external auditor to provide an assurance report annually on the investment firm’s safeguarding of client assets.

No enhancements have been proposed by Central Bank in respect of this principle.

The most significant proposed change that the consultation paper outlines for widening the scope of the client asset regulations to now includes Credit Institutions who are providing Mifid Investment Services. Currently, the Client Asset Requirements apply to a range of regulated entities authorised under several different regulatory frameworks. These include MiFID investment firms, non-MiFID investment firms, UCITS management companies and alternative investment fund managers who are also permitted to provide MiFID services. To date credit institutions are subject to the safeguarding requirements under the Irish MiFID Regulations when holding client financial instruments, so the CBI’s desire is now to expand the remit of credit institutions undertaking MIFID investment business to be fully subject to the Client Asset Requirements.

The Consultation will close on 10 March 2021, and following this, the Central Bank will publish a Feedback Statement on the Consultation, which will set out its final proposals. Once those proposals become law, the Central Bank plans to give in-scope regulated firms a 12-month transitional period to allow for timely preparation for compliance with the enhanced Client Asset Requirements.

This article first appeared in Finance Dublin in February 2021.