On 24 July 2020, the FCA published a Dear CEO letter to authorised firms acting as brokers in wholesale financial markets, who currently, or may in the future, offer services (including clearing broker and prime broker services) that involve holding clients’ cash or securities as collateral. The Dear CEO letter concerns the inappropriate use of title transfer collateral arrangements (TTCAs) and regulatory permissions for financing transactions. The FCA have seen recent inappropriate use of TTCA that has amounted to a failure in firms CASS obligations. There are a number of areas that the FCA require firms to review by the 14thAugust 2020.
Why are the FCA concerned?
Protection of client money and custody assets is a long-standing priority for the FCA and it is particularly important during the current coronavirus situation given that there is an increased risk of client defaults and firm failures.
Clients whose assets are subject to TTCA will usually rank as general creditors of the failed firm’s estate in respect of their claims for repayment of collateral. Consequently, they may experience a shortfall or delay in having their assets returned, rather than benefitting from the protections afforded by CASS.
By using TTCAs firms may hold less resources than necessary which means that there is a greater risk of disorderly failure and resultant potential harm to consumers and markets.
Senior Management Responsibility
CEOs are asked to reply to the Dear CEO letter by 14th August 2020, confirming that the senior manager with responsibility for client assets, or alternatively the senior manager responsible for compliance, has considered the issues in the appendix of the letter and will bring any issues to the attention of the firm’s board. Where rule breaches are identified the firm needs to take immediate steps to rectify them and then notify the FCA. We foresee the FCA taking individual action against SMF16s or those individuals holding the client money responsibility. It is essential that firms are acting in accordance with the rules and that they have adequate oversight of the way client funds and assets are treated.
What is a TTCA?
Defined in CASS 6 and CASS 7, a TTCA is an arrangement between the firm and its client whereby the client transfers full ownership of assets or money to the firm to cover its liabilities which can be actual, prospective, future or contingent.
What does compliance with TTCA look like?
Firms wishing to implement or maintain the use of TTCAs must consider guidance in the CASS rulebook as well as the overarching ‘client best interest’ principle according to COBS. If a firm has active TTCAs with clients and relies on them to exempt money or assets from segregation and record keeping, or use of funds restrictions, it is important to address the guidance coherently in any response to the regulator. Additionally, if a firm relies on the classification of certain transactions as ‘matched principal’ this will require careful consideration, particularly if the firm’s permissions do not allow trading as a principal.
Nothing in the TTCA provisions supersedes the overriding onus on the firm to act in the client’s best interests, as outlined in CASS 7.11.7G and reinforced throughout the handbook.
A written agreement is required for any situation where a TTCA is deemed to be in force. It should outline in detail the terms under which the client agrees to transfer ownership of money and assets to the firm, as well as under what circumstances the client may reclaim such ownership.
The agreement should also discuss the circumstances where the TTCA is not in force, such as when money or assets become client money or client assets and require a different treatment. This is especially relevant when a third party’s actions trigger such a scenario.
Note also, the firm has an obligation to outline to the client how the TTCA may be terminated.
A firm may not implement or act on a TTCA under all circumstances. It must consider if the level of funds or assets is proportionate to the actual liability, as well as whether the arrangement is in the client’s best interests. To do this it is necessary to have the correct processes in place to determine this proportionality and document those processes as such. Additionally, the firm needs to demonstrate the ability to modify the amount segregated under CASS rules in a timely fashion where the terms of the TTCA stipulate a requirement.
The FCA expects all firms using TTCA to have a robust process in place when a client wishes to terminate the TTCA agreement.
Any client termination request must be acted on in a timely fashion and processes must exist that demonstrate to the FCA that the firm can segregate funds effectively and reliably from the business day following the termination.
Whilst this does not need to affect other agreements between the client and the firm, any termination process must be coherent with the terms of the original agreement and the intended actions must be communicated to the client in a durable medium.
New Prudential Regulation and TTCA
The FCA references DP20/2 ‘A new prudential regime for MiFID investment firms’ an example of where investment firms should consider the potential for harm to clients that could arise from the inappropriate control of TTCA arrangements under the a new prudential regime.
Match Principle Exemption
The FCA has seen some firms seeking to classify particular types of financing arrangements as matched principal trading in order to rely on the modified prudential treatment in BIPRU 1.1.23R or IFPRU 1.1.12R(commonly referred to as the prudential ‘matched principal exemption’ or ‘MPE’). The FCA believes in some cases this is an incorrect classification. A firm that is genuinely relying on the MPE will need permission to deal as principal.
If firms hold collateral for leveraged trading and enters into a financial transaction, such as repos, the FCA believes that this is a:
…mischaracterisation of the nature of the funding transaction and that such arrangements are unlikely to satisfy the conditions for the exemption.
Firms offering margin trading by dealing in their own name (or even on behalf of a client) can be exposed to market and price risks, particularly in situations where clients default on margin calls. In these cases the regulator does not believe this meets the MPE requirements.
Under the new prudential regime DP20/2 proposes there will no longer be an MPE.
Changes to permissions
Where firms are holding client assets or monies in excess of those directly linked to client obligations, they should look at whether permission is required to safeguard client assets and apply CASS to those assets. Likewise, if firms are entering into financing arrangements, which do not satisfy the tests for the matched principal exemption they may need to seek permission to deal as principal without the current matched principal restriction. Consequently, firms may need to change their regulatory permissions.
What firms need to do
Given the current FCA focus on this topic, all wholesale brokers should review their arrangements and determine whether they are consistent with the FCA requirements. Firms should:
- Ensure that their regulatory permissions reflect their business model. If they act under MPE are they able to genuinely rely on the matched principal exemption for prudential categorisation purposes;
- Ensure that they are only holding client funds or assets under TTCA where there is a present, future, actual, contingent or prospective obligation to the firm;
- Assess whether the funds or assets that they are holding under TTCA is appropriate for present, future, actual, contingent or prospective obligation to the firm;
- Review TTCA documentation;
- Discuss the Dear CEO letter at board level, record the outcome and any action that the firm needs to take;
- Report any breaches as soon as possible to the FCA; and
- Ensure that a response is made to the FCA by the 14th August 2020.
Firms should seriously consider the implication of the new regime which suggests removing the MPE and a reduction on a firm’s reliance on client assets under TTCA.
How we can help
We can work with your firm to draft a response to the FCA by the 14th August 2020 deadline, review your current business model to ensure that it is in line with the CASS rules or where you are currently dealing under the MPE, this has been applied correctly.