Enhancing customer funds protection: Strengthening safeguards in payment firms

In 2021, we discussed the need for a more prescriptive regulatory framework to better safeguard customers' funds. Three years later, and aided by the repeal of assimilated EU legislation, the FCA has introduced proposals (Consultation Paper 24/20) to replace the current safeguarding requirements with a new Client Assets Sourcebook (CASS) –  style regime, known as ‘CASS 15’.

Many aspects of these proposals will be familiar to those with experience working with CASS – regulated firms, including the introduction of an operational oversight function, a resolution pack, more detailed reconciliation obligations, and strengthened FCA oversight through an annual audit and a new monthly data return.

The case for change

These proposals mark a significant change for the sector, with the FCA introducing new rules that significantly mirror the existing regulatory framework found in CASS.

The primary purpose of the safeguarding regime remains unchanged: to ensure that, in the event of a payment firm’s insolvency, consumers can recover the maximum value of their funds as quickly and cost-effectively as possible.

The existing safeguarding requirements, however, have proven insufficient to meet this goal. Under the Payment Services Regulations 2017 and the E-Money Regulations 2011, firms have lacked clarity on the precise steps needed to comply with safeguarding requirements, leading to poor or inconsistent implementation practices.

This has resulted in significant shortfalls for customers when firms have failed, with an average shortfall of 65% in funds owed to clients between Q1 2018 and Q2 2023.

In response, the FCA’s new proposals aim to address these shortcomings. The introduction of a more prescriptive regulatory framework, similar to that applying to other CASS firms, is seen as a necessary step to bolster consumer protection.

Key proposals: a two-phase implementation

The FCA’s proposals are designed to be implemented in two phases, giving firms time to adapt. The final interim rules are expected within the first six months of 2025, after which firms will have six months to implement interim rules and twelve months to transition to the end-state rules.

Interim rules

The interim rules are primarily focused on improving clarity and standardisation across the sector:

Establishing a level playing field

Firms will need to maintain a ‘resolution pack’ containing key information necessary for winding down the business and designate an individual responsible for overseeing compliance with safeguarding requirements – which may also be seen as a precursor for the eventual introduction of the Senior Managers And Certification Regime (SM&CR) to payment firms.

Accurate record-keeping and reconciliations

Firms will need to ensure they hold the correct amount of safeguarded funds at all times through enhanced record-keeping and more prescriptive reconciliation requirements.

Enhanced FCA oversight

The FCA’s ability to supervise firms will be strengthened, with the introduction of a new monthly data return and the requirement for an annual audit report, both to be submitted to the regulator.

End-state rules

The final, more comprehensive set of rules will impose greater legal clarity and obligations on payment firms:

Statutory trust over safeguarded funds

The end-state rules will introduce a statutory trust over safeguarded funds, offering stronger legal protections for customers. Payment firms will need to obtain revised acknowledgment letters that refer to a statutory trust over relevant funds and assets.

Trustee responsibilities

 As trustees, payment firms will assume fiduciary duties, including acting in the best interests of their customers

This aligns payment firms with other CASS-regulated firms and applies trust law principles to protect funds from the claims of other creditors during insolvency.

Potential challenges ahead

While the proposals represent a necessary re-alignment of safeguarding standards, payment firms will face challenges in implementation. 

1. Increased resources and compliance costs

Firms in the competitive payments industry will face higher compliance costs, which may either be absorbed or passed on to customers.

However, payment firms must remember the FCA’s expectation of fair value assessments, particularly in light of its recent multi-firm review on the implementation of the Consumer Duty for retail customers – an integral part of the FCA’s three-year strategy.

2. Challenge to legal certainty

As trustee under the new rules, payment firms will have fiduciary duties, including acting in the best interest of beneficiaries.

This change introduces potential legal complexities for directors, especially during financial distress. However, ambiguity remains around trust status following earlier court rulings.

The proposed extension of a statutory trust to any investments in secure, liquid assets (purchased with safeguarded funds) is a novel and untested convention under which payment firms will also need to consider whether they have the necessary regulatory permissions.

Additionally, while the optional payment and e-money special administration regime (PESAR) aims to expedite the distribution process, its effectiveness is yet to be fully tested and proven.

3. Limited population of providers of safeguarding accounts and insurance

Many payment firms remain outside the risk appetite of major credit institutions, which limits options for safeguarding accounts. The interim rules will require firms to diversify their third-party providers and conduct enhanced due diligence, with periodic reviews of these relationships.

Under the proposed rules, firms will need to use designated safeguarding accounts for the receipt of relevant funds (pre- D+1, including switching from segregated accounts where they have been used previously).

4. Determination of relevant funds

The concept of 'prudent segregation' is introduced under the new rules, allowing firms some discretion to deposit their own funds into safeguarding accounts to prevent shortfalls. However, shortfalls may go undetected when safeguarding is based on estimated relevant funds held by agents and distributors.

5. Potential exclusions from new requirements

Firms must clearly define when their safeguarding obligations begin and end. To address operational challenges, the proposed rules offer partial exclusions for ‘immediate segregation,’ particularly when funds are received through a merchant acquirer or into an account used for participation in payment systems.

6. Need for a common audit standard

Payment firms will be required to appoint an independent and appropriately qualified auditor.

Until the Financial Reporting Council (FRC) develops a common audit standard, current inconsistencies in audit approaches will likely persist. Industry bodies will play a key role in promoting adherence to common standards and best practices.

7. FSCS protection

Customers will remain without Financial Services Compensation Scheme (FSCS) protection in the event of a payment firm’s failure.

Payment firms are also subject to less stringent prudential requirements compared to banks, making them generally more vulnerable to financial instability.

8. Insolvency costs

Despite robust safeguarding arrangements, customers may still face significant shortfalls due to the deduction of insolvency costs, which have historically averaged around 7% of total client claims.

Next steps for payment firms

To ensure a smooth transition to the new rules, payment firms should take the following steps:

Assign accountable individuals

Identify key individuals responsible for compliance, operational oversight, and systems that support safeguarding arrangements.

Conduct an impact assessment

Assess the implications of the proposed rules and determine the necessary resources and actions required for compliance.

Evaluate resource adequacy

Ensure that sufficient resources are available to meet daily reconciliation requirements, resolve discrepancies, cover shortfalls, and maintain a resolution pack for the FCA.

Review IT and operational systems

Assess existing systems and determine any necessary changes to support immediate segregation of relevant funds and new reconciliation processes.

Develop a project plan

Prioritise actions and develop a phased project plan to manage the implementation of the new requirements.

Engage with external stakeholders

Collaborate with providers of safeguarding accounts, custodians, insurance providers, and auditors to meet the enhanced due diligence and safeguarding requirements.

The FCA’s new safeguarding proposals represent a significant change for payment firms, aligning them more closely with existing CASS rules.

While the new rules aim to provide greater protection for consumers, payment firms will face several challenges as they adapt to the increased demands of the new regime.

With a phased implementation timeline, firms should begin preparing now to ensure compliance with the FCA’s strengthened safeguarding requirements.

For more insight and guidance, contact Paul Staples.