UK: MiFID - Analysis of FSA´s July consultation paper: Client assets

FSA's latest consultation paper (CP06/14 - Implementing MiFID for Firms and Markets) was published on 31 July 2006. Here we look at the client assets/money section of the consultation paper which covers:

• New CASS rules for MiFID business

• UK implementation and the FSA's extensive "gold plating"

• Key changes- loss of professional opt out

• Other significant changes

• Additional information to be provided to retail clients

• Outstanding issues

Full Article

FSA’s latest consultation paper (CP06/14 - Implementing MiFID for Firms and Markets) was published on 31 July 2006. Here we look at the client assets/money section of the consultation paper which covers:

• New CASS rules for MiFID business

• UK implementation and the FSA’s extensive "gold plating"

• Key changes- loss of professional opt out

• Other significant changes

• Additional information to be provided to retail clients

• Outstanding issues

MiFID’s rules on safeguarding of client financial instruments and funds will be implemented by the introduction of 2 new chapters in the FSA’s Client Assets ("CASS") Handbook: CASS 6 (MiFID custody rules) and CASS 7 (MiFID client money). Amendments will be made to the existing CASS 1- 5, as a result of the new CASS chapters (often to reflect the new terminology and scope). CASS 2 (custody) and CASS 4 (client money) will continue to apply to non-MiFID designated investment business. The draft FSA Handbook rules and amendments to the existing CASS chapters were published with the consultation paper (Annex 5, CP06/14).

Many firms would therefore be subject to two sets of rules for non-MiFID and MiFID business and would have to operate separate accounts and systems for each. However, investment firms, which would be subject to both CASS 2 and 6 can opt to be subject only to CASS 6. This election would mean that the firm would operate a single system under CASS 6 for all financial instruments held by the firm for both MiFID or all non-MiFID business. Similarly, those firms, which would be subject to CASS 4 (the FSA is currently considering whether this would also extend to CASS 5) and CASS 7 can opt to be subject only to CASS 7. Again, this election would mean that the firm operates a single system of client money/bank accounts under the CASS 7 rules for both MiFID and all non-MiFID business.

As is presently the case under CASS 4, CASS 7 will not apply to a credit institution in so far as it holds monies as a deposit.

The current CASS 3 (collateral) and CASS 8 (mandates) will apply in relation to MiFID and non-MiFID business.

Firms will have to comply with the new rules from 1 November 2007.

In contrast to other areas of FSA’s implementation of MiFID, the terms of the new CASS chapters retain, to a large extent, the existing CASS rules. This results in extensive gold plating, as the CASS chapters go well beyond the requirements of MiFID (and the Implementing Directive). The FSA itself has recognised this and justifies its approach (as it must) under Articles 16(2) and 4 of the Implementing Directive. Article 16(2) acknowledges that the laws of individual Member States will differ in areas such as the law on property and insolvency and it therefore gives specific discretion to Member States to adopt any necessary additional rules. Thus, for example, client money held under CASS 7 will be held under a statutory trust, which is considered to be the most effective mechanism for protecting the funds against the firm’s insolvency. In addition, Article 4 allows Member States, in exceptional and objectively justified cases, to impose requirements in those areas not specifically addressed by the Directive. The FSA will have to notify and justify to the Commission those requirements that it seeks to impose on the basis of Article 4.

At present, a firm can agree with a professional client (i.e. intermediate customers/market counterparty) to waive client money protection under CASS 4. That opt out is not compatible with MiFID and is therefore not carried forward into CASS 7. This is a significant change for those firms (estimated by the FSA to be around 50- 75 firms in total) that rely on the opt out to increase their ‘working capital’ or as a means of avoiding the extra costs associated with complying with client money rules.

CASS 6 and CASS 7 of the draft Handbook, however, provide for another exclusion, based on MiFID recital 27. This states that the custody rules do not apply where a client transfers full ownership of a financial instrument or funds to a firm for the purposes of securing or otherwise covering an obligation. The FSA suggests that some of the affected firms will adapt their client relationships in order to bring them within this exclusion ("title transfer collateral arrangements"). FSA suggests that firms may need to be more cautious in adopting this approach with retail clients (their guidance refers to COB obligations to act in the best interests of the client when structuring their business); however, the exclusion is equally applicable to all client categories.

4.1 Money market funds

MiFID and CASS 7 specifically permit firms to hold client monies in qualifying money market funds. This will make it easier to do so, but individual clients can prevent their monies from being held in this way.

4.2 Securities financing transactions

Financial instruments held by the firm on behalf of a client can only be used in securities financing transactions if the client has given its express consent and the use is consistent with the terms approved by the client. In the case of a retail client, this consent has to be evidenced by his/her signature or an equivalent alternative mechanism.

In similar arrangements in respect of financial instruments held in an omnibus account with a third party, firms will have to ensure that each client in the omnibus account gives his/her express consent and the firm has in place systems and controls to ensure that only the financial instruments of consenting clients are used.

4.3 Unregulated custodians

CASS 6 requires firms to use only custodians that are regulated when operating in a jurisdiction that specifically regulates the safekeeping of financial instruments. In a non-EEA jurisdiction that does not regulate the safekeeping of financial instruments, the firm may only deposit financial instruments where their nature so requires or, in the case of a professional client, if they so request in writing.

4.4 Reconciliation/Client money calculations

CASS 6 and 7 requires firms to undertake internal and external reconciliation in relation to client investments and client funds. The time limits for reconciliation under the new CASS chapters, however, are less prescriptive than those under CASS 2 and 4 as it requires firms to carry out internal reconciliation only ‘as often as necessary’. This, in theory, gives firms greater flexibility, but FSA notes that firms may continue as they do now because of the general requirement to have systems which enable the firm to distinguish client assets without delay.

4.5 Systems

The Implementing Directive also requires firms to adopt adequate organisational systems to minimise the risk of the loss or diminution of client assets, which arise from the misuse of the assets, fraud, poor administration, inadequate record keeping or negligence. This rule, expressly stated for the first time, is copied out from the text of the Implementing Directive.

The Implementing Directive places an obligation on firms to provide retail clients with certain specified information concerning the safeguarding of their financial instruments and funds. It is anticipated that these rules will be implemented in chapter 12 of the new COB Sourcebook. The draft text of should be published in October 2006.

The FSA highlights three outstanding issues - the application of client money rules to solicitors, assessing whether any changes will be required to the Commodity Futures Trading Commission Part 30 exemption order and carrying out a cost benefit analysis of the MiFID requirement to keep records for at least 5 years (which is up from the current 3 years). These topics will be covered in the 4th quarter of 2006. The consultation period for the July CP will end on 31 October 2006 with final rules and guidance expected in January 2007.

This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq

The original publication date for this article was 08/08/2006.