Payment institutions, e-money institutions and credit unions that issue e-money (together, “Payments Firms”) are required to protect funds received in connection with making a payment or in exchange for e-money issued through safeguarding (“Relevant Funds”). This is a different approach from banks, the deposits of which are covered by the Financial Services Compensation Scheme (FSCS).
The current safeguarding requirements are contained in the Payment Services Regulations 2017 (“PSRs”) and the Electronic Money Regulations 2011 (“EMRs”). Currently, Payment Firms can choose to safeguard Relevant Funds by either (i) segregating them; or (ii) protecting them through an insurance policy or comparable guarantee. The FCA says that segregation is used by more than 95% of firms.
In January 2023, HM Treasury issued the “Payment Services Regulations: Review and Call for Evidence” (“HM Treasury PSRs Review”). In the review, HM Treasury indicated that the detailed requirements in the PSRs and EMRs could be transferred to the FCA rulebook, in line with the Future Regulatory Framework, and that this could be particularly beneficial in relation to safeguarding. The government invited the FCA to consult on the safeguarding regime later in 2023. In the event, the outcome of HM Treasury PSRs Review has not been published and the FCA is now consulting on it safeguarding proposals.
The HM Treasury PSRs Review also stated that there would be an independent review of the Payment and Electronic Money Institution Insolvency Regulations (“PESAR”) within two years of these coming into force. The PESAR came into force in July 2021, so the review is now more than a year past being due. The FCA says that the PESAR is “intended to reduce loss in client funds through lower IP costs and speed up the distribution of funds to clients” but that “it does not affect safeguarding practices prior to insolvency”. Nonetheless, the interaction of segregation requirements and insolvency law is often a key focus on insolvencies and has been subject to significant consideration by the courts, including by the Supreme Court in relation to the insolvency of Lehman Brothers International (Europe). It is therefore critical that segregation rules are designed to complement insolvency law, such as PESAR, and it is not currently clear how this will be ensured for the FCA’s proposals.
What problem is the FCA seeking to address?
The main problem that the FCA says it is addressing is the current standards of safeguarding by payment and e-money firms. For firms that became insolvent between Q1 2018 and Q2 2023, there was an average shortfall of 65% in funds owed to clients (i.e. the difference between funds owed and funds safeguarded). The FCA wants to make the safeguarding rules stronger and clearer to tackle this problem.
A key question is to what extent the problem is whether firms are following the rules properly or, alternatively, that there is a problem with the rules themselves. The FCA’s view is that both the current rules are not being followed properly and that the rules need improvement.
Common shortcomings the FCA has identified in safeguarding include:
- a lack of documented processes for consistently identifying which funds must be safeguarded;
- inadequate reconciliation procedures to ensure that the correct sums are protected on an ongoing basis; and
- a lack of due diligence and acknowledgement of segregation from credit institutions providing safeguarding accounts.
In relation to the current rules, the FCA says “there is insufficient detail in the requirements to ensure consistent standards across the industry, help firms properly implement the requirements in a way that achieves intended outcomes or provide adequate data for us to effectively monitor firms’ safeguarding arrangements”.
Besides poor practice by firms and deficiencies in the current requirements, the FCA also considers that there is considerable legal uncertainty following the Court of Appeal judgment in Ipagoo LLP [2022] EWCA Civ 302 regarding the legal status of Relevant Funds on an insolvency.
In addition to helping ensure safeguarding is done correctly, the FCA also says that its rules will help speed up and reduce the cost of distributions on insolvencies. However, interestingly, unlike for shortfalls, it has not identified improvements of these as ‘measures of success’ for the new rules, which gives the impression that it is not confident the rules will not make much difference on these points. The FCA says that for insolvencies over the period Q1 2018 – Q2 2023, there was an average time to first distribution of client funds of more than 2 years, a very significant period of time.
Who is impacted?
The proposed rules will affect:
- authorised payment institutions;
- e-money institutions;
- small e-money institutions;
- credit unions issuing e-money under the PSRs and EMRs; and
- some other firms who can voluntarily opt in the safeguarding requirements.
2-stage rules
The outcome of the HM Treasury PSRs Review has not been published and the revocation of the safeguarding requirements in the PSRs and EMRs by the Financial Services and Markets Act 2023 has not commenced, the FCA is not currently able to implement its “end-state” proposals to introduce a “CASS style” regime, modelled on the CASS client money rules that apply to investment firms.
The FCA is therefore consulting on both interim-state rules, focussed on improving compliance with the existing requirements in the PSRs and EMRs, and “end-state” rules that, amongst other things, would introduce a “CASS style” regime. This approach introduces additional complexity as well as uncertainty, as the approach of HM Treasury is not currently known.
Interim-state rules
The FCA is proposing interim-state rules covering the following areas:
Improved books and records
- More detailed record-keeping and reconciliation requirements for safeguarding, building on existing guidance and similar to existing requirements set out in CASS 7, which contains the client money rules for investment firms.
- Requirement to maintain a resolution pack, including requirements on the types of documents and records to be included.
Enhanced monitoring and reporting
- Requirement to complete a new monthly regulatory return to be submitted to the FCA covering safeguarded funds and safeguarding arrangements.
- Requirement to have compliance with safeguarding requirements audited annually, with the audit submitted to the FCA.
- Requirement to allocate oversight of compliance with the safeguarding requirements to an individual in the Payments Firm.
Strengthening elements of safeguarding practices
- Additional safeguards where Payments Firms invest Relevant Funds in secure liquid assets.
- Requirements to consider diversification of third parties with which Payments Firms hold, deposit, insure or guarantee Relevant Funds that it is required to safeguard and due diligence requirements.
- Additional safeguards and more detailed requirements on how Payments Firms can safeguard Relevant Funds by insurance or comparable guarantee.
End-state rules
The FCA’s is proposing end-state rules covering the following areas:
Strengthening elements of safeguarding practices
- More robust requirements on how Payments Firms must segregate and handle Relevant Funds. This will include requiring that Payments Firms receive Relevant Funds directly into an appropriately designated account at an approved bank, except where funds are received through an acquirer or an account used to participate in a payment system.
- Agents and distributors cannot receive Relevant Funds unless their principal Payments Firm safeguards sufficient funds in designated safeguarding accounts to cover the funds expected to be received and held by their agents or distributors.
Holding funds under a statutory trust
- Imposition of a statutory trust over Relevant Funds held by a Payments Firm, and relevant assets, insurance policies/guarantees and cheques. This is intended to address the legal uncertainty that the FCA considers there is about how Relevant Funds should be distributed on an insolvency.
- Additional detail around when the safeguarding obligation starts and funds become subject to the trust.
Implementation timeline
The FCA’s implementation timelines is as follows:
- H1 2025: Publish the final interim-state rules.
- 6 months after publication of final interim-state rules: Interim-state rules come into force.
- Publication of end-state rules: The date of this is dependent on the HM Treasury PSRs review outcome being published.
- 12 months after publication of final end-state rules: End-state rules come into force.
Cost benefit analysis
The FCA published a Cost Benefit Analysis (“CBA”) in Annex 2 of the Consultation Paper and consulted its independent CBA Panel in preparing it. The FCA estimated a £150.8m (present value adjusted) benefits and £106.2m (present value adjusted) costs from the proposals, leading to a net PV-adjusted benefit of £44.6m over a 10-year appraisal period.
The CBA Panel concluded that it “considered the CBA to be a carefully detailed piece of work that aimed to understand the impact of the policy proposals, and makes the following high-level recommendations” and made some high level recommendations.
Next steps
This consultation is open until 17 December 2024. If you have any questions or would like to discuss any aspects of the consultation paper, please contact our financial services team.
Authors
Omar Salem
Partner
Peter Finch
Partner
Mardi MacGregor
Partner
Chris Hill
Partner
Romans Vikis
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