Financial services regulation and COVID-19 video diaries: The client money regime

Financial Services Regulation and COVID-19

Hannah Meakin

Partner

Hello everybody, I hope you're well. I'm Hannah Meakin and this is the next in our series of videos from the financial services team. Today we'd thought we'd look at the client money regime in the UK and what it does and doesn't do. It's obviously quite a complicated regime, so this will be a high-level summary only, but perhaps we can dig into particular aspects in future videos. So I think the starting point is to note that not all firms hold cash that they get from their clients as client money. For example, banks are not required to hold deposits as client money and firms which take collateral from their clients on a title transfer basis, for the purpose of securing their obligations, at least where those clients are professional clients or eligible counterparties, don't need to hold that as client money either.  In those two cases the client has a normal debtor creditor relationship with the firm.

So how is client money different? Well, where a firm holds cash as client money, it's acting as a trustee on behalf of its clients which are the beneficiaries. That means that the firm can't use the client money for its own benefit or that of anyone else. If the firm fails, then that client money does not form part of the estate of the firm and therefore isn't available to the normal creditors. In fact, the client money beneficiaries have proprietary interest in the client money pool which is distributed in accordance with the FCA rules and those rules are designed to ensure that there's a timely return of as much of the client money as possible.  And in fact, many of the changes that have been made to the client money regime in the aftermath of the financial crisis were designed to facilitate that.

I think the next thing to note is that a firm which holds client money does not actually hold the client money itself. In fact, it's required to deposit it with a bank or if it has the client's consent to place it in a money market fund. There are also circumstances where a firm can transfer client money to a third party and these include where the money constitutes margin that needs to be transferred to an intermediate broker or a central counterparty.

In all of these scenarios, the firm cannot transfer the client money to the third party until it has given that third party a client money acknowledgment letter in the FCA's prescribed format and the third party has signed that letter. The client money acknowledgment letter puts the third party on notice that the firm holds the cash as trustee for the client and the third party also has to agree that it only has limited rights against the cash that stands to the credit of that account and that in the event an insolvency practitioner requires its return that the firm will cooperate.

So what happens if a firm that is holding client money fails? Well that is known as a primary pooling event. Exactly what happens depends on the way that the firm was holding the client money but the basic idea is to pool the client money that was deposited with banks and transferred to intermediate brokers into a single notional pool. That pool is then distributed to each of the client beneficiaries in accordance with their entitlement.

Alternatively, the firm may choose to transfer the client money entitlements to a third party firm and it can do so without the prior consent of the clients provided that this would not prejudice the clients and the amount of money that they would ultimately recover, and provided that it gives them notice within 14 days of the event.

The client money rules also anticipate the possibility of a third party to which the firm has transferred client money failing and that's known as a secondary pooling event. However I think that is probably enough for this video and that we should revisit some of these in more detailed concepts in later videos.

In the meantime I hope you all stay fit and healthy and we look forward to catching up with you again soon.