4 Safeguarding client money and asset segregation

157. Asset segregation is an important instrument to provide protection to clients of investment firms. When providing investment services for its clients, the investment firm can handle both cash and financial instruments belonging to its clients. In order to “protect an investor’s ownership and other similar rights in respect of securities and the investor’s rights in respect of funds entrusted to an [investment firm], those rights should be kept distinct from those of the [investment firm]”.1 To achieve this, the European legislator has included asset segregation requirements in the MiFID II directive, although the actual way these requirements are implemented in the national law of the various European member states can differ significantly.2 This Chapter will discuss the overarching concepts and methods applied in the European Union for achieving asset segregation.

158. The asset segregation requirements ensure that the client is protected from the bankruptcy of the investment firm. On the basis of the asset segregation requirements, the financial instruments and funds belonging to a client should not be comingled with the assets and funds belonging to the investment firm. Asset segregation requirements protect the client from the failure of the investment firm.3 Asset segregation requirements are therefore aimed at increasing the protection of the investor,4 not the investment firm. This will mean that some asset segregation requirements might increase the risks for the investment firm itself, either through an increase in operational risk (by having the investment firm responsible for the administrative tasks of asset segregation) or through an explicit or implicit liability claim5 for the investment firm for any shortfalls in the funds or securities belonging to the client.

159. This increase in the risk profile for an investment firm by applying the asset segregation requirements is what will be discussed in this Chapter. Does the chosen method of asset segregation result in a risk or additional risk for the investment firm itself? What is the operational risk or liability risk associated with the applied method of asset segregation that can have an impact on the financial solidity of the investment firm? Which consequences follow from a prudential rules perspective?

160. It should be noted that asset segregation itself (or safekeeping of investor assets) is part of a larger framework “of securities custody that […] serves the facilitation of transfers of securities”.6 Haentjens identified four steps that need to be completed “in order to come to a complete or perfected transfer of (rights in) securities: trade, confirmation, clearing and settlement”.7 In all operational processes included in this larger framework by Haentjens, comingling of client assets with the assets of the investment firm can occur if the asset segregation methods employed are ineffective. Asset segregation is therefore not only needed after the final step of this framework (settlement) has been completed, but the investment firm will also need to ensure that its clients’ assets are appropriately safeguarded during the other steps needed to conclude a transaction. By being part of this larger framework, the activity of asset segregation exposes the investment firm to operational risks as all the operational processes required in this entire framework to complete a transfer of (rights in) securities requires a precise and meticulous execution and administration by the investment firm. These operational processes are therefore susceptible to human error and hence operational errors and risks. Haentjens further applies the concept of what he calls “custody risk” to this process, which entails “the risk of loss of securities held by intermediaries because of theft, fraud in general or other causes. As more intermediaries are interposed, […], the risk becomes both greater and more difficult to assess”.8 To reduce this custody risk, Haentjens states that “it can be countered by an adequate legal framework and the strict enforcement of regulatory supervision, which might include a requirement that intermediaries separate their own assets from the assets they hold for clients”.9 The reduction of risk Haentjens is referring to, is the reduction of risk for the client of the investment firm and not so much the reduction of risk for the investment firm itself. This places more emphasis on the need for the investment firm to have an operational control environment within its business that can adequately administer the assets belonging to its clients. It, therefore, increases the operational risk that arises from “deficiencies in systems and controls, human error or management failure”10 on the part of the investment firm.

161. In their Recommendations for Securities Settlement Systems, CPSS and IOSCO highlighted the need for effective asset segregation. “Ideally, a customer’s securities are immune from claims made by third-party creditors of the custodian. Although the ideal is not realized in all circumstances, when the entities through which securities are held are performing their responsibilities effectively, the likelihood of a successful legal claim made on a customer’s securities by a third-party creditor is minimized. In addition, in the event of a custodian’s or subcustodian’s insolvency, it should be highly improbable that a customer’s securities could be frozen or made unavailable for an extended period of time. If that were to happen, the customer could come under liquidity pressures, suffer price losses or fail to meet its obligations. Segregation is a common device that facilitates the movement of a customer’s position by a receiver to a solvent custodian, thereby enabling customers to manage their positions and meet their settlement obligations”.11 This analysis by CPSS and IOSCO touches upon several aspects that impact the risk profile of the investment firm performing this asset segregation function. Firstly, CPSS and IOSCO state that client assets should be immune from claims by third parties, and that the likelihood of a successful claim by a third party is minimized if all involved intermediaries “perform their responsibilities effectively”. This assumption of intermediaries performing their responsibilities effectively places a burden on the operations of the investment firm, both in the aforementioned framework of concluding transactions but also in the administrative requirements for an effective asset segregation placed on the investment firm itself. Only by having an effective and meticulous segregation process can clients’ rights be properly protected. This would thus imply that an investment firm that makes operational errors in this segregation process should be liable to its client for any losses in the assets segregated for clients as its segregation processes are not as effective or meticulous as required.

162. Secondly, however, this liability goes beyond merely being liable for the loss of a financial instrument, as the second part of the statement by CPSS and IOSCO indicates. The insolvency of an investment firm could, if no effective asset segregation processes are in place, expose the clients of that investment firm to “frozen assets”, which could lead that client to “suffer price losses” or “liquidity pressure”. If these would lead to losses for the client caused by the investment firm’s ineffective asset segregation or administration, that investment firm’s liability risk should also include these costs that a client of the investment firm12 can be faced with. The need for an effective operational process that strives to mitigate or minimize operational risks should, therefore, be emphasized in the prudential regulatory response for investment firms.

163. This Chapter will discuss the prudential risk that can occur as a consequence of asset segregation and the various methods that can be used to achieve this. Although the effectiveness of an asset segregation method can also have an impact on the financial solidity of an investment firm, that effectiveness assessment itself is not part of this study.13 This Chapter will discuss the prudential risk for an investment firm of having to apply asset segregation requirements. This study will not discuss the specifics of the asset segregation requirements included in MiFID II, as these are focused on reducing the risk for the client. For this Chapter, the impact on the investment firm itself is more relevant.