CP24/20 - The FCA consultation paper on the safeguarding

The FCA has issued its long anticipated consultation paper (CP) on changes to the safeguarding regime for payments and e-money firms CP24-20.

“Game changer” is a bit of an overused phrase but, in this case, should the proposals in the CP in their current form be implemented in anything like their original state, it is an accurate descriptiom or ‘le mot juste’.

In this article we outline some of the key elements of the consultation paper and our early thoughts on the proposals. However, in short, the direction of travel is towards an end-state CASS-style solution, at least for those firms that choose the “segregation method”. It also signals a significantly more intrusive and interventionist stance on the part of the FCA.

Who does it apply to?

The proposals apply to Authorised Payments Institutions (APIs), Electronic Money Institutions (EMIs), Small Electronic Money Institutions (SEMIs) and credit unions who issue e-money under the Payment Services Regulations 2017 (PSRs) and Electronic Money Regulations 2011 (EMRs).

In addition, Small Payments Institutions (SPIs) will continue to be able to opt-in to comply with safeguarding requirements on a voluntary basis.

What is addressed and what is the timeline?

The proposals seek to address concerns, on the part of the FCA, that there are poor practices across the industry due to poor implementation of the regulatory framework.

The paper cites some compelling evidence for the proposed changes: in 2023, the FCA opened supervisory cases to address concerns about a firm’s safeguarding arrangements to around 15% of firms that carry out safeguarding. The paper goes on to note that for firms that became insolvent between Q1 2018 and Q2 2023, there was on average a shortfall of 65% in funds owed to clients (i.e. difference between funds owed and funds actually safeguarded).

Unsurprisingly, FCA wants to do something about this and have proposed making changes to the safeguarding regime in two stages. Firstly, there is the proposed ‘Interim State’ where the PSRs and EMRs will continue to apply - albeit with significant enhancements. The second stage begins at commencement of ‘End State’, when the safeguarding requirements in the PSRs and EMRs will be revoked, and a new safeguarding regime (effectively a CASS model) will come in to play.

The FCA proposes to give firms a transition period of six months to implement the changes required for the interim rules from when the final version is published (estimated to be “within the first six months of 2025”). When the revocation of the safeguarding requirements in the EMRs and PSRs is commenced, the FCA will publish the final end-state rules (including new rules for when a payments firm fails or where a third-party used for safeguarding purposes fails), and firms will have another 12 months to implement these additional changes.

The key proposals

1. Interim State Proposals

There are three broad headings under the Interim State Proposals:

Improved books and records: here proposals for record keeping build on existing guidance and similar to requirements under CASS. There will also be a requirement to have a CASS ‘resolution pack’.

Enhanced Monitoring and reporting: here key features are proposed such as a new monthly return to the FCA, and a requirement that compliance with safeguarding is allocated to a named individual (the next step on the road to SMCR for payments firms).

Strengthening elements of safeguarding practices: this includes additional safeguards where payment firms invest relevant funds in secure liquid assets and requirements to consider the diversification of third parties with which payment firms hold, deposit, insure or guarantee relevant funds.

2. End State Proposals

There are two broad headings under the End State Proposals:

Strengthening elements of safeguarding practices: this is to include more robust requirements on how firms must segregate and handle relevant funds and includes a requirement that 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).

Holding funds under a statutory trust: this is an issue that has frustrated the FCA for many years and will involve the imposition of a statutory trust over relevant funds/assets held by a firm. There will also be additional detail around when the safeguarding obligation starts and when funds become subject to the trust.

What does the CP say about the insurance/guarantee method?

Whilst the FCA sees the utility of the insurance policy or guarantee method, it has some concerns. These come at a cost when a firm is unable to renew its policy because the arranger declines or the firm does not want to renew due to higher premiums. The FCA also cites the risk of a delay in pay-out by the insurer or guarantor.

Thus, in the Interim State, the FCA wants firms to ensure that there are, inter alia;

• no conditions on prompt payment;
• firms must decide whether to renew or extend the policy at least three months prior to expiry; and
• more focus on operational risk, including consideration of whether restrictions on access to funds, held outside a safeguarding account, could adversely impact the institution’s short-term liquidity.

In the End State, the FCA will maintain the option for firms to safeguard relevant funds through insurance or comparable guarantee. However, it will continue to monitor this option, including its risk to consumers and markets and consult before making any future change to its rules on safeguarding in this regard.

Agents and distributors

The FCA raises concerns about timing and complexity in the event of a firm failure where agents and distributors are used, as well as oversight by the firm.

In the Interim State, the FCA is not proposing any changes. However, at the End State where a firm has agents and distributors, and uses segregation, it will have to either:

• receive relevant funds directly into its designated safeguarding account; or
• segregate an amount of its own funds, based on historical transaction data, equal to the maximum estimated value of relevant funds that would be held by agents or distributors (electronically or as cash).

This is referred to as ‘agent and distributor segregation’. Any funds that a firm segregates in this way will be relevant funds, and consequently form part of the statutory trust.

Interesting features of the proposals

1. Monthly reporting: the proposals would see a new Regulatory Return introduced. We believe that this will focus firms on how they record and monitor daily reconciliation processes as “what gets measured, gets done”. Certainly, viewing the proposed return this will represent a step change in the way in which safeguarding records are maintained, and may be more of a challenge for some firms than others.

2. Named individual responsible for safeguarding: we have long warned that the FCA’s Accountability regime would be rolled out for the payments sector. This looks like the next first step in this direction (with Consumer Duty champion and MLRO being other ‘required’ roles).

3. The consideration to diversify safeguarding providers: for larger payment firms this makes sense; for smaller ones perhaps less so. There might be a case for setting a relevant fund threshold beyond which diversity of provider is required. However, we question what the incentive for this is, given that it applies under an interim regime and the historic challenge of remittance firms (in particular) to become/remain ‘banked’. Also, it is important that the FCA has considers the concentration risk on the part of the providers who are particularly prevalent in this area.

4. A wider range of assets that firms can invest in under end-state rules: the CP suggests that the FCA is reviewing the range of assets firms should be able to invest in under end-state rules. This is welcomed, although we hope caution is applied to how wide this range should be. Although the analogy is not exact, the example of Northern Rock which thought it could expand its business model on the back of short term institutional and foreign investors, rather than more traditional long-term sources of funding (such as customer deposits), comes to mind!

5. Resolution pack: this requirement makes eminent sense and well-organised firms with a defined wind-down plan will not find this unduly onerous. It has the additional positive impact of forcing firms to focus on whether their wind-down plan is fit for purpose.

6. Insurance/guarantee method: the FCA seems broadly content to see this method of safeguarding continue and to exist as an alternative to the segregation method. As we have said though, it has raised legitimate concerns and what we view as sensible solutions in terms of addressing “cliff edge” issues.

7. Agents and distributors: while nothing will happen in the interim period, tightening the provisions around agents and distributors at End State, with the requirements related to how funds should be calculated and specific reference to the fact that such funds would be relevant and thus part of any trust, is welcome clarity.

8. Audits: ‘Audits for all!’ is the message, with all APIs that come into possession of funds required to undertake an annual safeguarding audit, regardless whether they are obliged to undertake a statutory audit. The FCA says an audit standard will be produced by the Financial Reporting Council and that auditors will be required to specify which standard and guidance was used to carry it. Auditors will be required to submit the safeguarding audit report to the FCA within four months of the end of the period to which it relates, whether or not the audit reveals an issue. There is also a tightening of the present requirements that merely talks about an auditor or “another independent external firm or consultant”. While we may acknowledge a vested interest in a narrowing of audit providers, will it raise capacity and capability issues?

The bottom line…

The general direction of the proposals appears, to us, sensible and proportionate. As the paper states, it aligns with the desire to prevent consumer harm that could arise if a large payments firm, with poor safeguarding practices, fails. The paper also points out that “failure of a Payments Firm could cause wider harm to the market if it held funds on behalf of other regulated firms, which in turn could see those firms fail”. Moreover, the proposals go hand in hand with the Consumer Duty which requires firms to act to deliver good outcomes for their retail consumers to keep consumer money safe.

However, while we generally welcome the proposals, with the FCA stating that the proposals will support competition within the wider payments market and that more detailed rules will help “level the playing field by removing inconsistencies in their approaches and allowing [firms] to understand more easily what is required”, there is a point around the practicality of implementing the new rules.

They will increase the regulatory cost burden on firms and may have the impact of reducing entrants to the market and drive out perfectly legitimate and sustainable businesses as well.

As always, and as the late Sir Eddie George was fond of saying, “the Devil lies in the detail” and we would encourage interested parties to respond to the proposals with their concerns and/or suggestions: the FCA genuinely wants to hear from firms. Firms have until 17th December to submit responses to the questions posed in the CP.

As a final point, if you are exempt (an SPI etc.) then we recommend you opt in. FCA requirements are often subject to ‘mission creep’ so get on the front foot now (if you can obtain a safeguarding bank account that is).

If you wish to discuss your firm’s safeguarding requirements and the possible implications of the proposals on your firm, please contact us below.

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