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It’s been quiet on the prudent segregation front over the last couple of years, but recently discussions have flared up in the CASS world with the topic being discussed in industry events again. This means it’s worth going through the considerations of using prudent segregation, and what industry challenges lie ahead.
What is prudent segregation and when should it be used?
The purpose of prudent segregation is to prevent a shortfall in client money or relevant funds should a firm become insolvent. To achieve this, firms can consider paying firm money and subsequently retaining that money into the client money bank account. Those moneys need to cover for anticipated risks that could lead to a shortfall, meaning firms must define these risks and set out a method for quantifying their anticipated impact.
Prudent segregation vs pre-funding: walking the fine line
There are circumstances where firms know in advance that a shortfall will occur, and are able to accurately assess the precise timing and value of the shortfall. In these instances, using prudent segregation may not be appropriate, as it focuses on anticipated risks. Instead, firms should consider using pre-funding, for example where a client performs back-to-back trading activities. In these instances, the client uses proceeds from sale of positions to make further purchases.
It’s important to note, however, that there’s a timing difference between the sale proceeds arrival, the commitment for the purchase, and when moneys are exchanged to enable purchase completion. In those circumstances, to avoid one client using another client’s money to settle transactions and a breach the CASS rules, firms can pre-fund the client money bank account. Firms can then remove the funding once the sale proceeds from the original transaction have arrived.
When using pre-funding too liberally firms may find themselves straying into lending activities for which they don’t have permissions. As such, we advise firms to consider the:
- frequency and volumes of firms’ pre-funding activities
- concentration of specific clients for which pre-funding is used
- perception of the client and the service provided (i.e., are there clients relying on this funding to ensure their liquidity on the market and ongoing ability to enter into these trades)
- fee arrangements when clients become overdrawn (i.e., are there fees that can be perceived as “interest” in the same way that banks would receive interest on loans).
The CASS 7 rules also specifically state that one clients’ money shouldn’t be used to settle another client’s transactions. If amounts are not pre-funded, firms risk breaching these rules, as in effect to complete one client’s transaction firms will be pulling from the existing money pool held for other clients. It’s inevitable that these instances can sometimes occur. However, firms’ business models shouldn’t allow clients to become overdrawn by design, as this will breach the CASS rules.
Emerging risks and how to prevent them
Over the last few years, we’ve seen both the FCA and auditors focus on the use of payment service providers within the CASS cashflow process, IT general controls, change initiatives and cyber security as part of the wider focus on industry co-dependencies and financial sector resilience. Would any of these give rise to a risk of client money shortfalls?
Use of payment service providers
Where using payment service providers to collect moneys from clients, most arrangements lead to a breach of the normal approach to client money segregation, as moneys are not received directly into the client money bank account. The risk is that, while the moneys are held by the payment institution and are in transit between the client and the client money bank account, these aren’t protected under a statutory trust. Should the payment institution fail at that time, there’s a risk that a client’s moneys won’t arrive in the client money bank account and a shortfall will materialise.
The prudent segregation amount wouldn’t resolve the breach of the normal approach but would mitigate the potential negative impact of a payment institution failure, and reduce a potential shortfall and the overall risk to consumer harm.
Change management
Whenever firms are undergoing system changes, there’s a risk that calculations may be incorrect, and systems may be inaccessible. This could prevent firms from arriving at the appropriate client money requirement balance, which could result in a shortfall.
In such circumstances, firms need to consider the nature of the change and assess if running parallel processes is more appropriate than using a prudent segregation buffer. This way, firms can still address the risk associated with the change without sacrificing liquidity. Firms will be able to adopt the new solution only once testing has confirmed that it yields the appropriate result within the parallel running stage. Therefore, it’s worth having the option to roll back change, so that if something was to go wrong, it wouldn’t impact the CASS environment long-term.
System failure
Sometimes systems fail, which can prevent the performance of reconciliations. Firms must consider what to do in these events, and make contingency arrangements as part of their operational resilience work. This should to enable them either to perform these reconciliations manually, or where the data itself becomes unavailable to be able to use a prudent segregation buffer that is appropriate to address the potential risk of shortfall for that day.
It is always worth remembering that using prudent segregation needs to be carefully considered and targeted at specific risks, as it is only one of the tools available for firms to use. It should not be used as a tool for masking operational deficiencies. When thinking of individual risks, focus on how these can be prevented and the options available to resolve them without the use of prudent segregation. Aim to only use prudent segregation if the risks identified are not remediated. Remember, risks change and with them so should your prudent segregation policy and wider arrangements.
When using pre-funding or prudent segregation firms need to have the appropriate documentation ready and available. This should include:
- detailed policy and procedure document
- the outcome of the prudent segregation calculation
- the amounts paid into and withdrawn from the client money bank account to reflect the changes in the prudent segregation amount and the rationale as to why the movement is made
- the up-to-date amount held under prudent segregation.
How can Bovill Newgate help you with your prudent segregation?
Our team of CASS specialists is made up of ICAEW chartered accountants with CASS audit experience across several large audit firms.
Our expertise in auditing firms, paired with industry and in-house experience, allows us to understand the risks you face and relay them clearly within policies, procedures and processes, ensuring these align with CASS requirements.
This support includes:
- creation of bespoke policies, procedures, processes and controls
- pre – audit support and preparation
- remediation of auditor breaches
- review of CASS auditor findings
- CASS health checks
- change management advice and support.
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