4.1.3 Concluding remarks on the methods of asset segregation and their implications for the risk profile of an investment firm

176. All types of asset segregation require the investment firm to have an adequate form of administrative segregation. This administrative process can, however, be prone to operational errors through incompetence, human error or fraud. The investment firm’s operational risk is thus directly linked to the administrative segregation employed and will be further increased if the investment firm is fully responsible for all aspects of asset segregation when using on- balance sheet segregation, through a legal segregation system, or using off- balance sheet segregation through separate legal entities (but controlled by the investment firm). Even when making use of legal structures defined in national law, the functioning of this method of asset segregation is only effective if and when the investment firm has an adequate administrative process to administer all transactions of its clients and can identify on a single asset level (or on the level of fractions of assets if the investment firm allows its clients to trade in fractions) who the ultimate owner of each asset is.

177. Both the structural and statutory methods of asset segregation require an effective and meticulous administrative process from the investment firm. The investment firm is therefore exposed to an operational risk in these segregation processes, which should require an appropriate prudential regulatory framework to address such risks. So, although asset segregation reduces the risk for investment firms’ clients, it increases the operational risk of the investment firm itself. This increase in operational risk, which itself is further influenced by the type of asset segregation applied, should be included in the prudential requirements for an investment firm.

178. Prudential regulation for the operational risks of asset segregation should thus be focused on the situation where an investment firm is fully responsible for the administrative segregation. The prudential regulatory response should be driven by an estimate of operational errors and the resulting liability risk of the investment firm.