4.1.1 Structural or off-balance sheet asset segregation

167. Structural asset segregation relies on the actual separation of the assets of the investment firm and the client into two (or multiple) separate legal entities.1 This separate legal entity can take many forms, but the main identifying factor is that it ensures that any custody risks and operational risks of the investment firm cannot affect the assets of the clients and that there is a clear separation of property rights between clients and the firm.

168. If the investment firm uses a tripartite agreement2 in which the investment firm receives a mandate from its client to operate on behalf of the client that client’s bank account held at a separate credit institution, the investment firm’s operational risk will only reflect the risk inherent in applying the administrative segregation. However, as the bank will probably also have an administration covering the funds of its clients, the client is effectively ‘protected’ by both the administration of the investment firm and the administration of the bank. In this instance, both the investment firm and the credit institution maintain an administration covering the funds and securities belonging to a client. But since the investment firm uses a bank account in the name of its client, there is no risk of the funds or securities of that client comingling with the assets of the investment firm.3 This form of asset segregation effectively outsources the safekeeping of the client’s assets to the bank. To fulfil its own responsibilities to protect its clients, the bank will also make sure that it can identify at all times which funds or securities belong to which client. Despite this, the investment firm can still be held liable for any errors by the bank, especially if these bank errors are caused by errors in the administration of the investment firm. A tripartite agreement, therefore, does not mean the investment firm has no operational risk stemming from the applied asset segregation. There are no specifics in this form of asset segregation, however, that increase the operational risk of the investment firm further.

169. If an investment firm uses a separate legal entity, it can, as in the case of the tripartite agreement, be an unrelated legal entity (for instance a bank that is a specialized custodian or depositary). In this case the investment firm’s operational risk will change in a manner similar to that described above for the tripartite agreement. When using such a depositary bank, the investment firm will open a bank account in the name of the clients with its depositary bank, effectively setting up a tripartite agreement for its clients. The investment firm can also apply other forms of asset segregation in which there is a greater role for the investment firm itself. In these instances, the investment firm applies a form of asset segregation in which the investment firm itself is fully responsible for all aspects of asset segregation.

170. When an investment firm uses a separate legal entity4 which is controlled by the investment firm itself, the operational risk will increase. In the Netherlands, for instance, investment firms can use a depositary foundation which is created by the investment firm specifically to fulfil the legal and structural segregation requirements.5 However, since it is related to the investment firm (in the Netherlands the obligations of these foundations are required to be guaranteed by the investment firm6), the investment firm increases its operational risk as it also bears the operational risks of that separate legal entity. The investment firm, therefore, faces an operational risk not only in the administrative segregation, but also in the legal segregation. Errors made by the separate legal entity will impact the investment firm’s operational risk, especially in those cases where an explicit guarantee by the investment firm is required. But an implicit guarantee by the investment firm may also exist. As the investment firm is responsible for the legal and administrative segregation of assets, and uses the form of a separate legal entity, one could argue that such a separate legal entity, especially if set up and controlled by the investment firm, is in fact an extension of the investment firm and therefore the investment firm should be responsible for any errors made by that separate legal entity.

171. It should be noted that, depending on the national laws governing the asset segregation, using such a separate legal entity might result in a legal and administrative segregation of the assets of the investment firm and the assets belonging to the clients of that investment firm, the segregation itself will not apply for the assets (of the clients) held by the separate legal entity.7 The separate legal entity (the depositary entity) will hold all financial instruments belonging to the clients of the investment firm and as such have those financial instruments legally separated from the investment firm. However, the financial instruments of those clients are not legally separated from the assets of the separate legal entity.8 The separate legal entity should thus be a risk averse entity.9 The clients of the investment firm have “substituted their insolvency risk on the investment firm with the much smaller (and almost theoretical) insolvency risk on the separate legal entity”.10