4.2 Ambiguity in European prudential requirements for investment firms with regard to “holding client money or securities”

179. What is important to note is that these operational risks for inadequate segregation processes go beyond ‘normal’ operational risks that every business faces in its daily operations. Operational risks can occur in every business process for every firm, regulated or non-regulated. However, operational risks that occur within the processes for asset segregation can have a bigger impact on the clients of an investment firm than an error in other business processes of the investment firm. Loss of financial instruments for a client due to inadequate segregation processes can have a significant impact on the client, and as such the regulatory response from both a prudential and a market conduct perspective has been substantial. The prudential regulatory response, however, lacks in clarity and substance in the current regulatory framework in the European Union.

180. A large part of the regulatory response aimed at addressing these operational risks emanating from asset segregation are addressed within the market conduct requirements included in MiFID II.1 However, there has not been a clear prudential regulatory response to address the financial implications of these operational risks in asset segregation. The current prudential framework in the European Union until the 26th of June 2021, the CRD 2013 and the CRR, contains two provisions which mention “holding client money or securities” but do not really contain a clear treatment and assessment of the risk associated with this “holding of client money or securities”, nor do the CRD 2013 and the CRR contain a definition of what “holding of client money or securities” actually means. The first provision that mentions holding client money or securities is the definition of an investment firm in the CRR,2 which states that an investment firm that is not allowed to hold client money or securities is excluded from the definition3 of investment firm within the context of the CRR. This exclusion from the definition of investment firm in the CRR results in large parts of the (prudential) requirements of the CRR not being applicable to those investment firms that do not hold client money or securities.4 The second provision which mentions holding client money or securities is article 29 of the CRD 2013 which gives European member states the option5 to apply a lower initial capital requirement for those firms which are not authorized to hold client money or securities.

181. One can, therefore, infer from this definition in the CRR and Article 29 of the CRD 2013, that the European legislators concluded that investment firms not holding client money would pose significantly less risk than those that do hold client money and securities. The CRR and the CRD 2013, however, contain no clear reasoning and argumentation to this effect. It is also striking that the CRR and the CRD 2013 do not contain a definition of what should be construed as actually “holding client money or securities”. It is, therefore, a difficult provision to apply, especially since MiFID II does not explicitly prohibit investment firms from holding client money or securities. In fact, Articles 18 (8) and 18(9) of MiFID II, for securities and funds respectively, merely state that if an investment firm holds securities or funds belonging to a client, it should have in place adequate arrangements to safeguard the (ownership) rights of clients.

182. As the CRR, the CRD 2013 and MiFID II use the same terminology, i.e. “holding client funds or securities”, it would seem logical if all three legislative texts referred to the same activity. This would then mean that the European legislator, implicitly and in line with the reasoning above, acknowledges that the operational requirements of MiFID II intended to safeguard the (ownership) rights of clients with regard to funds or securities will not prevent the investment firm from being subject to operational risks that require a prudential regulatory response.

183. Holding client money or securities should refer to those instances where the investment firm is responsible for the safekeeping of those monies or securities. This aspect of actually being responsible for the holding of these monies and securities is something the European legislator has included in the new prudential regime for investment firms, the IFD and IFR, which will be discussed in Chapter 9 in detail. In the new prudential regime, investment firms should capitalize for the risk they incur when safeguarding client assets or holding client monies. In the recitals of the IFR the European legislators state that investment firms should capitalize “the risk of safeguarding and administering client assets, and ensures that investment firms hold capital in proportion to such [safeguarded and administered] balances, regardless of whether they are on its own balance sheet or in third-party accounts”.6 Holding client money by an investment firm “captures the risk of potential for harm where an investment firm holds the money of its clients, taking into account whether they are on its own balance sheet or in third-party accounts and arrangements under applicable national law provide that client money is safeguarded in the event of bankruptcy, insolvency, or entry into resolution or administration of the investment firm. [This] excludes client money that is deposited on a (custodian) bank account in the name of the client itself, where the investment firm has access to these client funds via a third-party mandate”.7 In these recitals, the European Commission further defines when an investment firm is holding client money or securities. As such, the requirements in the IFR will better align with the risks associated with asset segregation described above in Section 4.1. These new requirements still contain shortcomings, however, that do not fully encompass the specific risks of asset segregation methods, as will be further discussed in Section 9.2.3. If an investment firm is responsible for the administrative segregation of client monies and securities, that investment firm is thus also exposed to the operational risk of having an effective and complete administrative process. If that investment firm is also responsible for implementing the legal asset segregation, by either applying statutory segregation or by managing a separate legal entity, the investment firm will incur further operational risk as it not only needs to have an adequate administrative process, but will also need to ensure that its legal segregation structure is indeed fully compliant with the applicable laws and implemented in such a manner that it is an effective segregation method.

184. Holding client money or securities should refer to those situations where the investment firm is responsible for adequately safeguarding and administrating those monies or securities belonging to its clients. If the actual task of safeguarding the monies or securities is performed by a separate entity such as a depositary bank or another investment firm, those entities should incur the resulting operational risk. The investment firm should only incur the operational risk of safeguarding client monies and securities when it is itself fully responsible for that safeguarding task.