Segregation of client money & Rehypothecation

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Created on Saturday, 14 May 2024 14:29

The official FSA guidance on the segregation of client money for companies such as spread betting companies is included in the Client Assets Sourcebook. However, for those of you who don’t speak legal jargon, we’ve pulled out some of the key information to help you understand these rules in the context of spread betting companies:

 

What exactly is segregation of client money? and What does rehypothecation actually mean?

 

Segregation of client assets

Essentially, section 7.4 of the CASS states that when spread betting companies receive your money, they need to put it into a ‘safe’ place in a reasonable amount of time from the date they receive it. Because logistically spread betting companies could be receiving money from numerous different clients across numerous locations, they can opt to get client money deposited into their own bank accounts, so long as they can quickly identify client money and shift it into a separate client account quickly. If they do opt to do this, they need to get a letter from their auditors sent to the FSA confirming that they have adequate processes and checks in place to ensure that they’re able to do this sufficiently. This is why WorldSpreads’ auditors Ersnt & Young could find themselves in trouble if legal action from people such as the WorldSpreads Action Group is successful in proving that WorldSpreads were not adequately able to perform these tasks.

 

Hypothecation and Rehypothecation

Hypothecation and rehypothecation relate to practices that broker-dealers (such as spread betting companies) are permitted to perform in the UK with client assets. So, essentially, even though section 7.4 of the CASS states that client money needs to be segregated, section 3.1 states that client money that is being held on behalf of the clients, IS permitted to be used as collateral by the company for them to borrow with.

• Say you have an individual margin account that you’re using to trade.
• Now, say you deposited £100k, have positions requiring margin of £80k, and therefore have a remaining balance of £20k.
• In the US, the broker (a spread betting company for example) can take 140% of the debit balance as collateral for the margin account.
• That is hypothecating. The customer hypothecates the account to the broker they have the margin account with.
• The broker can then take those assets that have been hypothecated to them, and then rehypothecate these to support their own trading with a third party. And that third party can then do the same and so on.
• If one of the members of this chain gets into financial difficulty, then this can cause issues for you as the initial customer, as you can become an unsecured creditor of the defaulted party.
• In the US rehypothecation is limited to 140%, however in the UK, it is currently unlimited, which can mean that when things go wrong, large amounts of the money supply can go missing, and companies/individuals can find themselves in sticky situations.

 

This is an over simplified example, as there are restrictions and regulations the collateral can be used for, however it was allegedly used by both MF Global and WorldSpreads to fund their own trading activity (which is not uncommon). The problem however arises when their own trading activity becomes loss making, and they are forced to make payments to the third party.

In the scenario above for example, if a Spread betting company uses the collateral to put on their own trades, and the trades are loss making, if the spread betting company does not have its own cash to start with, the client money becomes at risk. The situation is a particular issue if to cover their losses, even though it is not permitted, the spread betting company actually uses the money you deposited to pay the third party, meaning that they would not have enough money to pay you if you requested your money to be returned.

In attempt to reassure spread betting clients, companies such as London Capital Group (owner of Capital Spreads) have made the following information clear on their website:

"London Capital Group Ltd (LCG) fully complies with the strict rules on client money set down by the FSA so our retail clients can rest assured that their funds are fully segregated and ring fenced.  This means that not only funds deposited with us but total net available funds (the net position on any open trades calculated on a mark to market basis plus account balance) are held completely separately from our own.  Consequently, any money which we hold for our clients would not be used to satisfy the claims of any creditors should they arise. Even the bank cannot use the funds to offset against debt on any other bank account.

The segregation of client money from the firm’s money does not protect the client if the bank that holds the client money goes into administration."

 

Client Assets Sourcebook extracts

For info, a list of some of the actual relevant CASS guidelines from the FSA website:

 

Segregation of Client Assets

CASS 7.4.1:

A firm, on receiving any client money, must promptly place this money into one or more accounts opened with any of the following:

(1) a central bank;

(2) a BCD credit institution;

(3) a bank authorised in a third country;

(4) a qualifying money market fund.

CASS 7.4.14 01/01/2009:

Two approaches that a firm can adopt in discharging its obligations under the1 client money segregation requirements are:

(1) the 'normal approach'; or

(2) the 'alternative approach'.

CASS 7.4.15 01/11/2007

A firm that does not adopt the normal approach must first send a written confirmation to the FSA from the firm's auditor that the firm has in place systems and controls which are adequate to enable it to operate another approach effectively.

CASS 7.4.16 01/11/2007

The alternative approach would be appropriate for a firm that operates in a multi-product, multi-currency environment for which adopting the normal approach would be unduly burdensome and would not achieve the client protection objective. Under the alternative approach, client money is received into and paid out of a firm's own bank accounts; consequently the firm should have systems and controls that are capable of monitoring the client money flows so that the firm can comply with its obligations to perform reconciliations of records and accounts (see CASS 7.6.2 R). A firm that adopts the alternative approach will segregate client money into a client bank account on a daily basis, after having performed a reconciliation of records and accounts of the entitlement of each client for whom the firm holds client money with the records and accounts of the client money the firm holds in client bank accounts and client transaction accounts to determine what the client money requirement was at the close of the previous business day.

CASS 7.4.18 06/04/2010

Under the alternative approach, a firm that receives client money should:

(1) 

(a) pay any money to or on behalf of clients out of its own account; and

(b) perform a reconciliation of records and accounts required under CASS 7.6.2 R (Records and accounts), and where relevant 1SYSC 4.1.1 R (General requirements)2 and SYSC 6.1.1 R (Compliance),2 adjust the balance held in its client bank accounts and then segregate the money in the client bank account until the calculation is re-performed on the next business day; or

(2) pay it out in accordance with the rule regarding the discharge of a firm's fiduciary duty to the client (see CASS 7.2.15 R).

 

Collateral/Hypothecation

CASS 3.1.1 01/11/2007

This chapter applies to a firm when it receives or holds assets in connection with an arrangement to secure the obligation of a client in the course of, or in connection with, its designated investment business, including MiFID business1.

ASS 3.1.5 01/11/2007

The purpose of this chapter is to ensure that an appropriate level of protection is provided for those assets over which a client gives a firm certain rights. The arrangements covered by this chapter are those under which the firm is given a right to use the asset, and the firm treats the asset as if legal title and associated rights to that asset had been transferred to the firm subject only to an obligation to return equivalent assets to the client upon satisfaction of the client's obligation to the firm. The rights covered in this chapter do not include those arrangements by which the firm has only a bare security interest in the client's asset (in which case the custody rules or client money rules apply).

CASS 3.1.6 01/11/2007

Examples of the arrangements covered by this chapter include the taking of collateral by a firm, under the ISDA English Law (transfer of title) and the New York Law Credit Support Annexes (assuming the right to rehypothecate has not been disapplied).