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On 25 September 2024, the UK Financial Conduct Authority (FCA) published its long-awaited Consultation Paper (CP24/20) setting out proposed changes to the safeguarding rules applicable to electronic money institutions (EMIs) and payment institutions (PIs) (together, Payments Firms).
If the reforms are implemented as proposed, this will be the most significant set of changes since the rules were created. In addition to needing to update policies and procedures, many firms may need to make significant operational changes, including to their funds flows. The changes are also expected to lead to increased risks of supervisory and enforcement actions, as well as extended liability to customers.
CURRENT REGIME
The current safeguarding requirements are set out in the UK Electronic Money Regulations 2011 (EMRs) and the UK Payment Services Regulations 2017 (PSRs), and are supplemented by detailed guidance in Chapter 10 of the FCA Approach Document1. Payments Firms are generally required to safeguard funds received (i) in exchange for e-money that has been issued, and (ii) from, on behalf of, or for the benefit of customers in respect of the execution of payment transactions (relevant funds). EMIs and PIs can use a segregation method and/or an insurance or comparable guarantee method to safeguard relevant funds.
TWO-STAGE APPROACH FOR REFORMS
The FCA intends to implement changes to the safeguarding requirements in two stages:
- Interim-state — The proposed interim-state rules will supplement the current safeguarding provisions in the EMRs and PSRs. Prescriptive rules will be set out in the FCA’s Supervision Manual (SUP) and a new Chapter 15 of the FCA’s Client Assets Sourcebook (CASS). During this interim period, the guidance on safeguarding in the FCA Approach Document will be removed or amended where it covers the same ground as the interim-state rules.
- End-state — Building on the interim-state rules, the rules in CASS and SUP will replace the safeguarding provisions set out in the PSRs and EMRs, as well as the remaining guidance in the FCA Approach Document. This will require the UK government to amend the PSRs and EMRs, and so is subject to a related review by the UK finance ministry, His Majesty’s (HM) Treasury. See our previous Sidley Update on that review.
See below for details of the proposed implementation timeline.
INTERIM-STATE RULES
Diversification and review of third-party arrangements
The FCA plans to codify into rules and supplement much of its existing guidance on the use of third parties in relation to holding, investing, insuring, and guaranteeing relevant funds. In particular, a Payments Firm will be required to consider and review periodically whether it is appropriate to diversify the third parties through which it safeguards relevant funds.
A Payments Firm will also be required to review periodically the third parties it involves in its safeguarding processes and the terms of their engagement as well as to keep records of such reviews.
What does this mean for Payments Firms?
While the FCA’s existing guidance in its Approach Document requires Payments Firms to consider the diversification of risks, the new rules raise questions about whether the FCA will take a more proactive approach to supervising and enforcing diversification requirements. If the FCA expects more firms to diversify their safeguarding methods, this could create a significant operational burden for many firms. In particular, it could be complex and expensive to open and operate relevant funds accounts2 with multiple banks or to start to insure or guarantee relevant funds where this is not currently done.
Extended requirements for resolution planning, reporting, audit, and governance
The interim-state rules will require Payments Firms to:
- Maintain a resolution pack that can be retrieved within 48 hours, containing detailed and practical information to assist an insolvency practitioner and the FCA with ensuring that customers receive funds in a timely fashion in the event of the firm’s insolvency;
- Submit a monthly safeguarding regulatory return to the FCA within 15 business days of the end of each month, covering arrangements for safeguarded funds and assets, including data on volumes and locations, as well as any breaches or shortfalls;
- Undergo an annual audit by an independent external qualified auditor in respect of which the auditor must submit its audit report to the FCA within four months of the end of the period to which it relates;
- Allocate responsibility for oversight of operational compliance with safeguarding requirements to an individual in the firm with sufficient skill and authority; and
- Ensure safeguarding compliance through more detailed policies and recordkeeping.
What does this mean for Payments Firms?
These extended and more prescriptive requirements will mean Payments Firms will need to update and supplement their existing policies and procedures. Payments Firms will also need to update their governance arrangements and train relevant staff on the updated requirements and procedures. Some firms may need to recruit additional staff to ensure that the extended administrative and reporting requirements can be met on an ongoing basis.
Payments Firms are currently required to maintain a wind-down plan to prepare for various scenarios that may cause the firm to fail. Firms may be able to draw from these to create their resolution pack under the new rules. However, the introduction of a resolution pack will be a separate and more extensive contingency plan dealing with the return of safeguarded funds to customers, and firms will need to address various specific requirements under the new safeguarding rules.
The additional reporting and enhanced audit requirements may also result in increased supervisory and enforcement action from the FCA, which will have more data that it will likely aim to use to identify and take action against firms failing to meet its requirements.
The proposed requirement for auditors to submit a report to the FCA within four months of the period to which it relates may create challenges. In particular, this period may be insufficient for the auditor to fully interrogate the findings of the report and for the firm to respond to and remediate the auditor’s findings before submission to the FCA.
Enhanced reconciliation requirements
Under the interim-state rules, Payments Firms will be required to perform internal and external reconciliations of relevant funds at least once each business day to ensure they are safeguarding the required amount of funds. Firms must determine a reason for any discrepancies identified by reconciliations and notify the FCA of any material issues.
What does this mean for Payments Firms?
Payments Firms will need to review their existing reconciliation processes, particularly in relation to circumstances where notification to the FCA is required.
Changes to insurance and comparable guarantee requirements
As noted, Payments Firms can safeguard relevant funds by insurance or a comparable guarantee, subject to certain conditions. The proposed rules extend the existing conditions and requirements. In particular, firms must ensure that providers are able to cancel insurance policies or guarantees only for nonpayment of the premium or on less than 90 days’ prior notice and to provide such termination notice to the FCA, as well as to the firm.
What does this mean for Payments Firms?
Payments Firms using the insurance or comparable guarantee method may need to renegotiate their agreements with insurers and guarantee providers to ensure that these satisfy the extended requirements.
END-STATE RULES
Imposition of a statutory trust
In certain recent cases, English courts have concluded that the EMRs and PSRs do not create a statutory trust over relevant funds. Instead, in the event of the insolvency of a PI or an EMI, customers are considered to have a priority interest over all other creditors. In addition, any shortfall in an insolvent firm’s safeguarded asset pool should be topped-up. Significant legal uncertainty remains, particularly as to whether secured creditors may challenge the priority given to the top-up of safeguarded funds.
The FCA has proposed a statutory trust over relevant funds, relevant assets in which those funds are invested, and insurance policies and guarantees used for safeguarding. On this basis, a Payments Firm will have legal ownership of relevant funds, but these will remain beneficially owned by its customer. This will result in Payments Firms having additional fiduciary duties to their customers in relation to relevant funds.
The FCA proposes to provide further guidance on when the safeguarding obligation starts and ends, and when funds become subject to the statutory trust.
What does this mean for Payments Firms?
The imposition of a statutory trust could simplify payouts on insolvency, with funds held on trust generally falling outside the estate of an insolvent Payments Firm and therefore being generally unavailable to other creditors.
However, the statutory trust is not only relevant when a Payments Firm enters insolvency. It will also subject the firm to ongoing fiduciary duties to its customers. This could increase a firm’s direct liability to its customers in the event that a customer were to claim the firm had not acted prudently or in the best interests of the customer in relation to relevant funds.
Receipt of funds
Payments Firms will be required to receive relevant funds directly into a relevant funds bank account, except where funds are received through an acquirer or an account used by the firm to participate in a payment system.
What does this mean for Payments Firms?
This requirement will pose challenges for some firms that currently receive relevant funds into operational or general settlement accounts and sweep those funds into safeguarding accounts on an intraday basis. There are often very good reasons for firms to operate in this way, particularly for firms that are part of broader international corporate groups with multiple regulated entities and firms handling cross-border payments in multiple currencies across multiple time zones. While the draft rules contain exemptions for firms receiving funds via an acquirer or payment system, these will not cover the full range of circumstances in which firms may currently receive relevant funds into an operational account. As such, this rule could necessitate substantial operational changes for some firms.
Agents and distributors
Payments Firms will no longer be able to rely on agents or distributors to segregate funds on their behalf. Instead, relevant funds will either need to be paid directly into a relevant funds bank account (see above) or the Payments Firm will need to top up its relevant funds bank account with the estimated value of relevant funds held by its agents and distributors.
What does this mean for Payments Firms?
A Payments Firm that currently relies on agents or distributors to segregate funds on receipt will need to either (a) take its agents and distributors out of the funds flows so that funds are transmitted directly to the firm’s relevant funds bank account, or (b) top up that account with the firm’s own funds. The former option could be highly disruptive and may not be operationally feasible for all firms using agents and distributors. The latter option could also be problematic, as the firm may need to source and tie up additional liquidity.
IMPLEMENTATION TIMELINE
WHAT SHOULD FIRMS DO NEXT?
Responses to the Consultation Paper are due by 17 December 2024. Payments Firms should consider how the FCA’s proposals may affect their businesses. Based on these considerations, firms may wish to respond to the Consultation Paper directly and/or through relevant trade associations.