4.1 What is asset segregation and the impact on the risk profile of an investment firm?

164. To have an effective form of asset segregation, investment firms must apply a form of legal and administrative segregation.1 Legal segregation entails a form of segregation which “makes clear, from a legal perspective, which funds or securities belong to which client. These funds or securities are legally attributed to a specific client and could therefore only be claimed by that specific client. Other clients cannot make a claim on those specific funds or securities”.2 Administrative segregation entails only an “operational segregation of client assets from the assets of other clients and of the investment firm itself”.3 To have a functioning legal method of asset segregation, a form of administrative segregation is usually required in addition to legal segregation.4 Legal segregation is required to ensure that, if an investment firm fails, the monies and securities belonging to its client legally do not fall within the bankruptcy estate of the investment firm. The creditors of the investment firm should not be able to effectuate their claim towards the investment firm with the monies and securities belonging to the clients of the investment firm.5 Administrative segregation is required to identify which monies and securities belong to which client. This is especially relevant if the investment firm applies on-balance sheet segregation. In that case, the investment firm needs to ensure that it administers all monies and securities belonging to its clients in a clear and effective manner, otherwise creditors of the investment firm might still be able to claim part of the monies and securities which belong to the client of the investment firm.

165. The need for an effective administrative segregation to have a functioning legal segregation method increases an investment firm’s operational risk. Administrative segregation requires that an investment firm administers “all relevant data and accounts that are needed for that investment firm to identify, at any moment, the funds and securities belonging to a specific client”.6 This, therefore, places a significant burden on the investment firm. It is required to have an administration that can identify at any moment which asset or cash belongs to which client. The operational risk of the investment firm therefore increases but is further increased depending on the applied form of legal segregation.

166. With regard to the methods in which an investment firm can apply legal and administrative asset segregation, two main methods of asset segregation can be identified. Firstly, an investment firm can use structural segregation in which the segregation is achieved by creating a structural separation between the entity that is safeguarding the client’s assets versus the investment firm itself. This can also be seen as off-balance sheet asset segregation, were the investment firm places the monies and securities belonging to its clients with a separate legal entity and thereby ensuring that a comingling of assets belonging to the investment firm with assets belonging to that investment firms’ clients cannot occur. Secondly, the investment firm can use statutory segregation in which the applicable law in a country allows for legal segregation of assets. This can also be seen as on-balance sheet asset segregation, were the legal structure of the respective country in which the investment firms have its registered office allows for a way the investment firm can segregate its own assets for its client’s assets within its own balance sheet. The following sections will explore these two methods of asset segregation in more detail.