On 25 September 2024, the FCA announced that it was consulting on proposed changes to the safeguarding regime for payments and e-money Payment Firms.
The Financial Conduct Authority (FCA) has published a detailed consultation paper outlining its plans to introduce new:
(1) interim rules designed to improve compliance with the existing statutory safeguarding regime and to come into force after a six-month transitional period from their publication, which is expected to occur by the end of June 2025; and
(2) end-state rules which will replace the existing safeguarding regime with an improved regime which will incorporate the interim rules improvements and add (principally) two key new elements of protection. These will come into force after a 12-month transitional period from their publication, but their likely publication date is currently uncertain.
Background to the proposals
Payment institutions, e-money institutions and credit unions which issue e-money (collectively Payment Firms) are required to safeguard “relevant funds” (being monies received in connection with their payment services or in exchange for the issue of e-money) and to do so immediately upon their receipt. Payment Firms handle large amounts of customer monies and the intention of the safeguarding rules is to ensure that, if a firm fails, the customer monies it is holding can be: (1) identified separately from the firm’s own funds; and (2) rapidly applied to discharging its customer obligations rather than in payment of the costs of the firm’s insolvency and then by distribution to its creditors generally.
The current safeguarding requirements are set out in the Payment Services Regulations 2017 (PSRs) and the Electronic Money Regulations 2011 (EMRs) and supplemented by Chapter 10 of the FCA’s Approach Document. However, according to the consultation paper: (1) they are really not working well enough, and (2) this is causing “significant consumer harm”.
Somewhat surprisingly, for the twelve Payment Firms which failed between 2018 and the first half of 2023, the average shortfall in relevant funds returned to customers was 65% and two had shortfalls in excess of £20 million. The return of customer funds was also often severely delayed – sometimes until more than three years after the firm’s collapse.
Furthermore, the FCA mentions in the Consultation Paper that, in 2023, it opened supervisory cases regarding approximately 15% of firms which related to concerns about their safeguarding arrangements, suggesting that the firms which have failed with safeguarding deficits may not just be outliers.
The potential for consumer harm here is exacerbated by the increasing consumer popularity of e-money accounts. While only 1% of consumers held such an account in 2017, this figure had risen to 7% by 2022. The FCA notes that around £18 billion was being held in e-money issuer safeguarding accounts in 2023, with Payment Firms accounting for another £5 billion.
To make matters worse, the FCA identifies that the affected consumers are often disproportionately vulnerable – apparently 40% of e-money account holders in 2022 had at least one characteristic of vulnerability – meaning that they will be particularly badly harmed by funds needed to discharge their household bills being lost altogether or tied up in lengthy insolvency proceedings.
These concerns have obviously motivated the FCA to introduce the proposed new regime and, in the interim, to mandate changes to improve the operation of the existing one. It has been enabled to so by virtue of the rule-making powers conferred upon it by the Electronic Money, Payment Card Interchange Fee and Payment Services (Amendment) Regulations 2023.
Improving the existing safeguarding regime
There are obviously three ways in which relevant funds can be safeguarded by a Payment Firm, being one or a combination of:
- the segregation method (holding relevant funds separately from the firm’s own assets and, if still held after a short interim period, transferring them into a specially designated account);
- the insurance/guarantee method (under which a suitably authorised institution undertakes to provide a pay-out sufficient to cover the relevant funds obligation of the firm in the event of its insolvency); and
- holding secure liquid assets (e.g. government bonds) in an account with a value at least equal to the amount of the firm’s relevant funds obligations.
While it is our impression that the latter two methods are gaining ground, the Consultation Paper says that more than 95% of Payment Firms rely on the segregation method. Where this is relied on, when a Payment Firm receives relevant funds:
(1) it must keep them segregated from its own funds from the time of receipt; and
(2) if they are still held at the end of the business day following receipt (D+1), the Payment Firm must place the funds into a specially designated safeguarding account with an authorised credit institution.
Practically, this means that Payment Firms can hold relevant funds in accounts which are not designated safeguarding accounts until the D+1 deadline. This concept is built into the PSRs and EMRs and derives from the EU legislation on which they are based.
The FCA has clearly concluded (no doubt in large part on the basis of the relevant funds shortfalls, and payout delays, on Payment Firm insolvencies and its supervisory investigations) that there are some significant flaws in the ways these arrangements are working in practice. Key FCA concerns would appear to be:
(1) when relevant funds are received, Payment Firms are not always segregating the right amount of them from their own funds at the right time;
(2) when relevant funds have been segregated. but not yet moved to a designated safeguarding account, the segregation may not be done effectively, so compromising (or at least delaying) the availability of the funds to meet the claims of payment service users on insolvency in priority to the claims of other firm creditors;
(3) Payment Firms are not always transferring the correct amount of relevant funds into a designated safeguarding account, leaving relevant funds exposed for longer than they should be either in a merely segregated form or, worse still, not even segregated satisfactorily; and
(4) even when in a designated safeguarding account, relevant funds may not be as secure as they should be. For example, such security could be compromised by the Payment Firm not mitigating credit risk by conducting appropriate due diligence on safeguarding account providers and using a sufficient spread of such providers to achieve adequate risk diversification.
Changes to the safeguarding regime
As noted above, the remedial measures proposed by the FCA fall into two categories, being the interim rules changes and, later, the end-state rules implementation.
The proposed interim rules
The interim rules as outlined in the Consultation Paper cover a wide range of topics related to mitigating the FCA concerns, including:
- Improved books and records: under this category, Payment Firms will be required to:
- have adequate policies and procedures to ensure compliance with the safeguarding regime;
- maintain accurate records and accounts to enable them, at any time and without delay, to distinguish between relevant funds and other funds;
- perform reconciliations based on the values contained in their internal records and ledgers at least once each business day to ensure they are safeguarding the correct amount of relevant funds;
- perform reconciliations comparing their internal records of balances against those of third parties;
- ascertain the reason for any discrepancies or differences identified in their reconciliations and resolve any excess or shortfall (as appropriate); and
- notify the FCA (in writing and without delay) if: (i) their internal records are materially out of date, inaccurate or invalid; (ii) they will be unable to perform a reconciliation; (iii) they cannot resolve a discrepancy arising out of a reconciliation; or (iv) if, at any time during the previous year, there was a material difference between the amount which the firm should have been but actually was safeguarding.
- Resolution pack: Payment Firms will be required to maintain a “resolution pack” to improve their ability to retrieve information helpful (including to the FCA) to the timely return of relevant funds to payment service users in the event of their insolvency (mirroring to a limited extent the concept of mandating banks and financial institution to maintain recovery and resolution plans).
- Enhanced monitoring and reporting: under this category, Payment Firms will become bound under the interim rules by:
- additional provisions covering the appointment of the external safeguarding auditor including a specific duty to cooperate with the auditor in relation to the safeguarding audit and a prescribed format for the annual audit report to be submitted to the FCA in relation to safeguarding;
- a requirement to submit a new monthly regulatory return to the FCA in relation to safeguarding processes. The proposed monthly regulatory return will require Payment Firms to disclose data on safeguarding audit requirements, safeguarding method(s) used, the amounts safeguarded, reconciliations conducted (and any excess or shortfall and subsequent rectification), the frequency of these reconciliations, bank and assets accounts for relevant funds, and notifiable breaches; and
- a requirement to allocate oversight of compliance with safeguarding requirements to a specific individual within the firm.
- Strengthening segregation of funds: under this category, Payment Firms will be required to:
- exercise due skill, care and diligence in appointing third-party account providers with which relevant funds are received or deposited, or third parties which manage relevant assets or provide insurance or comparable guarantees;
- periodically review their use of these third parties;
- consider whether or not to (further) diversify their use of such third parties;
- consider methods for ensuring the relevant funds not held in a designated safeguarding accounts are clearly identifiable;
- use acknowledgment letters putting any relevant bank or custodian on notice that they are holding relevant funds, and how these funds should be treated; and
- promptly allocate relevant funds to individual consumers.
- Investing relevant funds in secure liquid assets: where a Payment Firm safeguards relevant funds using this method, it will be required to ensure that there is a suitable spread of investments, that assets are selected appropriately, and that any foreign exchange risks are prudently managed.
The proposed end-state rules
The end-state rules are intended to replace the current safeguarding rules under the PSRs and EMRs with a new regime in the style of the FCA’s existing Client Asset Sourcebook rules (CASS) as already applied to banks and other financial institutions handling client money.
The end-state rules will incorporate and build on the existing rules as amended by the interim rules, but will also add certain new measures, the two most significant of which are:
- a requirement that Payment Firms using the segregation method receive relevant funds directly into the designated safeguarding account; and
- the imposition of a statutory trust over all of the following assets:
- relevant funds
- secure liquid assets into which relevant funds have been invested
- the proceeds of any claim under safeguarding insurance policies or comparable guarantees procured to satisfy safeguarding requirements; and
- any cheques and other payable instruments received for the execution of a payment transaction or the purchase of electronic money.
Payment of relevant funds directly into a designated safeguarding account
This requirement is relatively radical, because it effectively ends (with only limited exceptions) the D+1 principle that has been applied to the safeguarding of relevant funds right from its introduction in the first (2007) Payment Services Directive of 2007. The D+1 principle appears to be retained by the latest draft of PSD3 (Article 9), so the FCA approach represents a deviation from EU law principles.
The change obviously reflects the facts that:
- relevant funds are significantly more likely to be available to meet the relevant funds claims of payment service users on a timely basis on a Payment Firm insolvency if they are in the designated safeguarding account at the commencement of the insolvency than if they are being (or even supposedly being) segregated elsewhere; and
- the correct amount of relevant funds is more likely to be found in the designated safeguarding account in an insolvency if all relevant funds automatically go there first.
In the Consultation Paper, the FCA has acknowledged that the direct receipt requirement might be operationally difficult in some circumstances and so proposes exceptions for where relevant funds are received: (1) through a merchant acquirer; (2) into an account which is only used to participate in a payment system; or (3) in cash. Where relevant funds are received by agents or distributors of e-money, this will still be permitted but only on the basis that the firm must safeguard in the designated safeguarding account (prior to such receipt so using its own monies) sufficient funds to cover the anticipated agent/distributor receipts.
The FCA has recognised that this proposal will have costs implications for Payment Firms, but its view is that the extra costs involved are proportionate to the risks that will be mitigated.
Imposition of a Statutory Trust
The purpose of introducing such a trust is to increase the likelihood that the assets over which it is created will, on an insolvency of the relevant Payment Firm, be available to meet the relevant funds claims of the firm’s payment service users. The idea is that those payment service users will be the primary beneficiaries of the trust and that the imposition of a trust structure will definitively keep the trust assets out of the general insolvency estate of a failed Payment Firm (i.e. the assets available for distribution pari passu to all creditors). Although any costs of distributing the trust assets will rank ahead of the claims of payment service users, other costs of insolvency proceedings related to the failed Payment Firm will not. Only once all claims of payment service users related to the trust assets have been met in full will any remaining trust assets become held on trust for the Payment Firm (and so fall back into its insolvency estate).
There is actually a certain amount of legal history to the FCA’s introduction of the statutory trust concept. Regulation 23(14) of the PSRs (for payment institutions) and Regulation 24(1) of the EMRs (for electronic money institutions) provides that the claims of payment service users/e-money holders will, on an insolvency of the relevant Payment Firm, be paid from the “asset pool” in priority to all other creditors of the firm. For these purposes, the asset pool consists of essentially the same assets as will be covered by the proposed statutory trust. In the case of Re Supercapital Ltd (in liquidation) [2020] EWHC 1685 (Ch), it was held that the Regulation 23(14) of the PSRs created a statutory trust over the asset pool and the FCA incorporated that into their guidance materials.
However, in the later case of Re Ipagoo LLP (In Administration) [2022] EWCA Civ 302, the Court of Appeal found that no statutory trust was created by Regulation 24(1) of the EMRs, and this was then applied to Regulation 23(14) of the PSRs by Allied Wallet [2022] EWHC 1877 (Ch).
In any event, the FCA has concluded that the imposition of a statutory trust supplements the above regulations in useful ways (e.g. by enabling the “tracing”, and then recovery into the trust assets, of funds wrongly removed from a safeguarding account) when a Payment Firm is in insolvency proceedings and so will help achieve better protection for payment service users/electronic money holders.
Finally on this point, the FCA proposes that, where a Payment Firm both issues electronic money and also provides payment services not related to the issue of electronic money, all relevant funds derived from either activity will constitute a single asset pool which is then available to discharge all relevant funds claims. This is an important change from the current requirement to maintain separate safeguarding accounts for each type of customer’s relevant funds.
Other elements of the end-state rules
The Consultation Paper also contains some further FCA proposals related to certain specific safeguarding issues, including:
- its view that firms should continue to be permitted (both for the interim and end-state rules) to rely on an insurance policy or a comparable guarantee in lieu of segregation, but subject to compliance with certain detailed requirements (such as timely renewals, payment of the proceeds of any claim into a safeguarding account and satisfactory reflection of the policy in safeguarding reconciliations);
- acknowledgment letters to be exchanged with the providers of safeguarding accounts to be updated to refer to the statutory trust;
- provisions relating to Payment Firms injecting their own funds into safeguarding accounts to prevent or remedy any shortfall; and
- the rules relating to when the obligation to safeguard relevant funds begins and ends. In particular, it appears that the existing rules in Chapter 10 of the Approach Document will be mirrored but with an additional clarification that, where payments out are made through a payment system, the funds used will cease to be relevant funds when the Payment Firm’s account with the payment system is debited.
How will the changes be implemented?
As noted above, the interim rules are intended to come into force after a transitional period of six months from their publication in final form and the FCA says that it is targeting the first half of 2025 for such publication. Some rules benefit from a short additional period before full compliance is required.
Also as noted above, the end-state rules will come into force after a 12-month transitional period from their publication, but their likely publication date is currently uncertain.
Next steps
The consultation will close on 17 December 2024. If you believe that any of the proposed rules requires any clarification or revision or should not be implemented as proposed at all, it is very important to respond before the deadline.
Our Payment Services Regulatory team will be monitoring next steps and will keep you up-to-speed with the latest developments. We are here to help, so please do get in touch with the team if you have any questions or would like any assistance with formulating a response to the consultation.
For further information, please contact:
Gavin Punia, Partner, Bird & Bird
gavin.punia@twobirds.com
