FCA warning on title transfer collateral arrangements under CASS: what should firms do?
TTCAs are an exception to the normal obligation of firms that hold client cash to give that cash client money protection, and similarly to hold client securities in custody. TTCAs are permitted to the extent that the firm is holding the cash or securities as collateral for the obligations that the client owes or is expected to owe to the firm. MiFID II ushered in changes to the provisions of the FCA Client Asset sourcebook (CASS) in January 2018 governing TTCAs. The Dear CEO Letter is the first letter of its sort focusing on TTCAs since the new provisions.
FCA concerns on inappropriate use of TTCAs
Client cash and securities held under a TTCA can be freely used by a recipient firm in its own business. This benefit to the firm comes with the risk for its clients that they are exposed to the credit risk of the firm for the value of the cash and assets held under the TTCA should the firm default. The FCA letter notes that this risk to clients is an increased concern given the stresses of Covid-19 could mean a greater risk of firms defaulting.
In the letter, the FCA noted that it has recently identified examples of the inappropriate use of TTCAs, including:
- holding money or assets under a TTCA without meeting the requirement to consider client obligations;
- holding all of a client's money or assets under a TTCA in the absence of present, future, actual, contingent or prospective obligations to the firm;
- holding an inappropriate amount of money or assets under a TTCA compared to that client's present, future, actual, contingent or prospective obligations; and
- moving an increased amount of collateral from a segregated to a TTCA environment without a corresponding documented consideration demonstrating a connection between the collateral taken and the relevant client obligation.
In addition, the FCA raised the concern that firms lacked arrangements to promptly return collateral to clients or segregate it as required under the FCA Handbook.
FCA concerns on firms acting without the appropriate regulatory permissions
As a further concern, the FCA noted that firms must consider whether they have the correct regulatory permissions for the activity that they engage in. Firms which have a matched principal limitation on their permissions must ensure that they do not deal as principal outside this limitation as to do so will require them to hold more regulatory capital as well as requiring a variation of permission.
Under MIFID, a matched principal trade is a transaction where the facilitator interposes itself between the buyer and the seller to the transaction in such a way that it is never itself exposed to market risk throughout the execution of the transaction, with both sides executed simultaneously, and where the transaction is concluded at a price where the facilitator makes no profit or loss, other than a previously disclosed commission, fee or charge for the transaction.
Requirement to report to the FCA
The FCA requires firms that act as brokers to confirm to the FCA by 14 August 2020 that the senior manager with responsibility for client assets has considered the issues in the letter and will bring any issues to the attention of the firm’s board.
The regulatory background to the use of TTCAs
The FCA Handbook provides that a TTCA is: “an arrangement by which a client transfers full ownership of [money or safe custody assets] to a firm for the purpose of securing or otherwise covering present or future, actual, contingent or prospective obligations”.
CASS deals with the handling of client asset and cash. CASS 6 deals with client securities, which when required to be held in custody are known as safe custody assets. CASS 7 deals with client cash, and imposes a general requirement that firms that lack a banking licence to place with a suitable third party, such as a bank, all money that is received or held on account of a client. CASS 7 imposes a significant number of obligations on firms regarding their treatment of that client cash. CASS 7A deals with the return of client cash following a default of the firm or of a third party holding clients’ money. These CASS 7 and 7A rules are commonly described as the client money rules.
CASS 7.11 deals with the TTCA exception to the client money requirements on firms. (CASS 6.1.6D contains equivalent provisions regarding custody assets, such as securities.) CASS 7.11.4R provides that:
- “A firm must properly consider and document the use of TTCAs in the context of the relationship between the client’s obligation to the firm and the money subjected to TTCAs by the firm.
- A firm must be able to demonstrate that it has complied with the requirement under (1).
- When considering, and documenting, the appropriateness of the use of TTCAs, a firm must take into account the following factors:
a. whether there is only a very weak connection between the client’s obligation to the firm and the use of TTCAs, including whether the likelihood of a liability arising is low or negligible;
b. the extent by which the amount of money subject to a TTCA is in excess of the client’s obligations (including where the TTCA applies to all money from the point of receipt by the firm) and whether the client might have no obligations at all to the firm; and
c. whether all the client’s money is made subject to TTCAs, without consideration of what obligation the client has to the firm.
- Where a firm uses a TTCA, it must highlight to the client the risks involved and the effect of any TTCA on the client’s money.”
Implications for firms and their clients of limiting the use of TTCAs
Firms should review their policies regarding the use of TTCAs to ensure that they meet the requirements of the FCA Handbook and guidance in the FCA’s letter. In particular:
- a firm taking initial and variation margin under a TTCA as collateral for existing transaction exposures should in the ordinary course fall within the limits of the FCA Handbook. However, caution should be applied in this regard, as the firm must consider the extent by which the collateral is in excess of the client’s obligations. Firms should consider whether initial margin taken under a TTCA is set at a level that the firm’s exposure to the client could not reasonably be expected to reach;
- if a firm receives more cash from a client than is required to satisfy initial and variation margin requirements for current transactions then the firm must establish that the cash is to cover “prospective obligations”. In doing so, the firm must consider whether there is only a weak connection between the collateral and the obligation, whether the collateral is significantly in excess of the obligations and whether all cash, or all assets, are automatically placed in a TTCA on receipt; and
- firms should consider whether they need to actively monitor client cash and assets held under TTCAs, and whether clients that hold excessive cash and assets within TTCAs should be advised to move that excess either to a client money or safe custody account or away from the firm.
For clients of firms, if the FCA’s approach leads to increased limitations on firms’ use of TTCAs then this would have both benefits and costs. If a firm obliges its clients to hold cash and assets other than under a TTCA then this will reduce the credit risk that clients have on the firm, but the higher costs that the firm would suffer will in all probability be passed to its clients. Further, a firm that does not offer client money or safe custody of assets may oblige its clients to take administrative steps such as actively moving excess cash and assets away from the firm.