On 22 May 2020, the Financial Conduct Authority (FCA) launched a Consultation on additional guidance for payment firms to strengthen the way they safeguard customer funds.
The Consultation will last for two weeks and closes on 5 June 2020. If confirmed, the final guidance will be published at the end of June 2020.
FCA Focus on Payments Firms
The payments sector is a priority area for the FCA.
This Consultation is part of a broader programme of work that the FCA was planning on consulting on later this year. This Consultation has been brought forward due to the pressures the coronavirus pandemic is placing on payment firms’ finances.
This programme of work has involved the FCA identifying issues and problems with non-bank payments firms (being authorised payment institutions and electronic money institutions) meeting the requirements of the Electronic Money Regulation 2011 and the Payment Services Regulations 2017 (the Regulations).
Customer money held at UK-authorised banks, building societies or credit unions are protected by the Financial Services Compensation Scheme (FSCS). If one of those firms becomes insolvent, the FSCS protects up to GBP85,000 per eligible depositor. Conversely, customer money held at payment firms is not protected by the FSCS. The Regulations do require payment firms to safeguard customer funds, either by segregating these funds from house monies or having in place appropriate insurance policies or guarantees.
In July 2019, the FCA set out these issues in a Dear CEO Letter, stating that it had identified significant shortcomings in that payment firms had a poor understanding of which funds are “relevant” funds under the Regulations and should be segregated from house funds. The Letter also noted that there were delays in segregating funds on receipt and that payment firms had failed to check that correct amounts are being segregated frequently enough via the reconciliation process.
Impact of the COVID-19 Pandemic
According to the FCA, the Consultation was pushed forward as a result of the potential impact of the COVID-19 pandemic on payment firms.
The payments sector has been developing rapidly and there are an increasing number of firms entering the market. Some of these firms are relatively small FinTechs with more limited access to capital than larger players.
The FCA notes that some payments firms are unprofitable in the early stages while they seek to grow market share and many also rely on investor funds to remain solvent in the short-term. Firms may also be facing decreased revenues because of coronavirus and this might be impacting their ability to operate as well as their growth plans.
Accordingly, the FCA considered the guidance in the Consultation necessary to provide additional direction to payment firms to safeguard customer funds and also for these firms to put in place more robust plans for winding down, should a firm fail, so that customer funds are returned in a timely manner.
Content of the Consultation
a. Keeping records and accounts and making reconciliations
The FCA state that under no circumstances would it be acceptable for a payment firm to undertake a reconciliation of safeguarded funds less than once each business day. The FCA Consultation also notes that firms should carry out reconciliations as often as is practicable.
The FCA expects payment firms to notify the FCA should they fail to keep up-to-date records of relevant funds and safeguarded accounts.
b. Safeguarding Accounts and acknowledgement letters
The segregated account that the payment firm holds at a bank should be appropriately designated in the account name with either “safeguarding” or “client”. Where the bank cannot make the necessary designation evident in the name of the account, the FCA expects the payment firm to provide evidence, such as a letter from the relevant credit institution or custodian, confirming the appropriate designation.
Payment firms should have an acknowledgement letter from the bank or custodian stating that the bank/custodian does not have an interest in, recourse against, or right over the relevant funds or assets in the safeguarded account. As part of this Consultation, the FCA has supplied a template letter for this purpose.
This letter also explicitly seeks to create a trust over the funds noting that the firm holds all the relevant funds or assets in the safeguarded account as trustee. As part of the Consultation, the FCA states its view that the safeguarding rules as found in the Regulations implicitly gives customers a beneficial interest in the funds in a safeguarding account.
Payment firms are required to ask their safeguarding institution nor custodian to sign the letter as soon as practicable. Alternatively, firms should be able to demonstrate that the credit institution or custodian has no such interest in, recourse against, or right over the relevant funds or assets in that account.
c. Selecting, appointing and reviewing third parties
The FCA Consultation requires payment firms to undertake periodic reviews of their banks, custodians and insurers. These reviews should also be carried out whenever a firm believes that anything affecting the appointment decision has materially changed, such as a credit downgrade, and in any event, at least once in each financial year.
d. When the safeguarding obligation starts
In respect to Electronic Money Institutions that allow customers to use their electronic-money to make payment transactions before the customer’s funds are credited to the firm’s payment account, the FCA Consultation clarifies that these firms do not need to treat these funds as safeguarded funds where they are available to meet the commitments it has to a card scheme or another third party to settle these payment transactions.
e. Unallocated funds
Where firms are unable to identify the customer to which funds it has received belong, it cannot issue electronic money or provide a payment service. This could happen, for example, where the funds are received with an incorrect unique identifier such as an account name or number.
In this case, the FCA note that these funds are not “relevant funds” under the Regulations but that firms are still required to protect these funds under Principle 10 of the FCA’s Principles for Business.
The FCA also clarified that for firms that issue electronic money on low value pre-paid gift cards, where the identity of the ultimate card holder is not known, the funds received from customers are relevant funds, even though the identity of the electronic money holder might not be known.
f. Annual Audit of Compliance with safeguarding requirements
The FCA now expects payments firms to arrange specific annual audits of their compliance with the safeguarding requirements under the Regulations. These audits should also occur whenever there are changes to the firm business model which would materially affect their safeguarding arrangements. For example, should an electronic-money issuer begin providing payment services unrelated to the issued e-money, an audit would need to be undertaken.
g. Small payment institutions
The FCA is not proposing to extend the safeguarding requirements in the Regulations to “small” payment institutions but does expect them to keep appropriate records. The FCA encourages these firms to opt-into the safeguarding requirements in the Regulations.
h. Disclosing information on treatment of funds on insolvency to customers
The FCA stated its expectation that payment firms should avoid giving customers misleading impressions about how much protection they will get from the safeguarding requirements.
This is both in terms of the services to which the safeguarding requirements apply or by implying that the claims of customers would be paid in priority to the costs of distributing the safeguarded funds.
The FCA suggest that this is necessary for firms to comply with the Consumer Protection for Unfair Trading Regulations 2008.
2. Prudent Risk Management
a. Governance and controls
Payment firms should ensure they have robust governance arrangements, effective procedures, and adequate internal control mechanisms, in accordance with their conditions of authorisation. A firm’s senior management should ensure that the firm regularly reviews its systems and controls, including its governance arrangements.
b. Capital adequacy
The FCA Consultation provides that to reduce intra-group risk, the FCA considers it best practice for firms to deduct any assets representing intra-group receivables from their own funds. However, if there are legally enforceable netting arrangements in place, a firm could deduct only the net receivable amount (i.e. taking into account any intra-group amounts payable by the firm covered by those netting arrangements).
c. Liquidity and capital stress testing
The FCA expects payment firms to conduct liquidity and capital stress testing to analyse their exposure to severe business disruptions and assess their potential impact, using internal and/or external data and scenario analysis.
This mirrors the FCA’s consultation on operational resilience which would also require payments firms to stress test the impact on operational resiliency of severe business disruptions. Payment firms should be aware, however, that the consultation on operational resilience has been delayed as a result of COVID-19. The FCA is only requiring liquidity and capital stress testing, and not stress testing operational resilience, at this time. This approach is reasonable, given that firms are encountering real business impact at present as a result of COVID-19.
d. Risk-management arrangements
The FCA expects firms to consider their own liquid resources and available funding options to meet their liabilities as they fall due, and whether they need access to committed credit lines to manage their exposures.
To reduce exposure to intra-group risk, the FCA considers it best practice for firms not to include any uncommitted intra-group liquidity facilities when assessing whether they have adequate resources in place to cover the liquidity risk to which they are exposed.
e. Wind-down plans
The FCA Consultation provides that, in order to satisfy the FCA, payment firms must have a wind-down plan in place to manage their liquidity and resolution risks. The wind-down plan should consider the winding-down of the firm’s business under different scenarios, including a solvent and insolvent scenario. The wind-down plan should address the following:
- funding to cover the solvent wind-down of the firm, including the return of all customer funds;
- realistic triggers to start a solvent wind-down;
- the need for any counterparties (i.e. merchants) to find alternative providers;
- realistic triggers to seek advice on entering an insolvency process; and
- information which would help an administrator or liquidator to quickly identify customer funds and return them as a priority.
Following this Consultation, the FCA plans to publish a further letter to CEOs of payment firms. This letter will include the guidance as amended in light of the responses to the consultation.
The FCA will then conduct a full consultation later in the year on changes to the FCA Approach Document. This further consultation will likely include a proposal to incorporate the guidance of this Consultation into the Approach Document.
The guidance as found in the present Consultation will remain in place until the Approach Document is updated following the full consultation later in 2020.