The much-anticipated FCA consultation on its safeguarding requirements for payments firms was released at the end of September. In their current form, the proposals are set to have significant impact on the UK payments industry, particularly for some smaller
firms and certain business models.
What are the safeguarding rules?
The safeguarding requirements are a cornerstone of payments regulation and are, in essence, an 100% reserve requirement. At a high level, they require payments firms to hold customer funds in a designated account with a bank over which no third-party interests
may be granted. Alternative safeguarding measures are limited, such as putting insurance coverage in place or investing customer funds in secure liquid assets. Firms must also conduct regular reconciliations to check that the amounts they safeguard reflect
the liability that they have to customers.
Accounts held with payments firms do not benefit from protection from the Financial Services Compensation Scheme (FSCS). The FSCS will compensate eligible claimants for up to £85,000 if their bank fails. The rationale behind the safeguarding rules is to
ensure that customers holding funds with payments firms, as opposed to banks, are not exposed to loss where such firms fail. Customer funds should be ringfenced and easily identifiable to enable their prompt return to customers on a firm’s insolvency.
For some time, the FCA has been concerned that the safeguarding arrangements that UK payments firms currently have in place are inadequate and pose a material risk to customer funds. The FCA’s view is that the current rules are too high level and that supervisors
receive insufficient information to properly monitor whether firms are meeting expectations. These concerns are the underlying drivers for the proposals.
The proposals are broken down into interim state rules and end state rules. The interim rules are intended to tighten up safeguarding arrangements and raise the current standard by building on the rules and guidance that firms are already subject to. The
end state rules represent a more significant shift and may fundamentally undermine the viability of international business models involving multicurrency payments.
In this article we step through the key proposals and their potential impact. While it might seem unusual to start at the end, rather than the beginning, we look at the end state rules first as they are generating material concern within the industry.
The end state rules
Once the revocation of the current safeguarding legislation takes effect, a more fulsome regime will apply to payments firms which will be similar in style to the existing prescriptive regime for investment firms. However, the new regime has the potential
to be very disruptive for the payments industry and we have outlined the key issues below.
Receipt into a safeguarding account
The requirement which poses the greatest challenge to the industry is the requirement for firms to receive customer funds directly into a safeguarding account. Compliance with this requirement presents several issues:
- It depletes firms’ liquidity. For electronic money issuers that provide customers with multicurrency wallets, the requirement will constrain or even eliminate their ability to perform currency conversions. This is because they will no longer
be able to receive customer funds into a business account and make payments from that account to FX providers before sweeping funds into a safeguarding account the business day after their receipt.
- It makes using intraday credit lines for liquidity purposes challenging for card scheme acquirers. Card schemes settle and pay out at a certain time of day. Card scheme acquirers need to be able to make payments irrespective of when funds
are received from the card scheme. The solution for some acquirers is to enter into credit agreements to provide coverage before scheme funds arrive. These credit lines are often secured on the account into which scheme funds flow. The FCA’s requirement for
receipt of customer funds into a safeguarding account over which third party interests cannot be granted means that this structure will no longer be workable.
- It makes operating a network of international collection accounts potentially challenging from an operational perspective. Many global payment firms operate by using affiliate accounts to collect funds in multiple jurisdictions. The proposed
rules would require those collection accounts to be safeguarded accounts. The principle underlying safeguarded accounts is that they must be in the name of the payments firm providing the customer with payment services. Accounts belonging to a group affiliate
will not meet this requirement. In practice this means that where a jurisdiction requires that payment accounts are held by an entity in that jurisdiction, a UK payments firm will find it very difficult to collect funds in that jurisdiction.
- An agency structure, whereby a firm appoints its affiliate as its agent,
may be a workaround where a jurisdiction requires that payment accounts must be held by an entity in the jurisdiction. However, this route will lock up further liquidity for the UK payments firm. Firms using an agency structure must estimate
the amount of funds that their agent will receive and safeguard an equivalent amount in advance.
A requirement for new permissions
While the majority of firms safeguard by segregating funds into a designated bank account, a smaller proportion safeguard by investing funds in secure liquid assets. The key proposal of note for firms using this method of safeguarding is that firms that
invest in secure liquid assets:
- will need permission to manage investments if they manage the investment of relevant funds with discretion; and
- will need permission to safeguard and administer investments if they hold the relevant assets directly.
In addition to the administrative burden of obtaining additional permissions, holding such permissions will also switch on other FCA requirements for UK payments firms. Firms holding assets directly will be required to comply with the FCA’s custody rules
which is likely to prove challenging as the custody rule record keeping requirements do not apply neatly to payments firms investing customer funds.
Imposition of a statutory trust
The end state rules also bring to a close the debate between the FCA and the industry over whether customer funds are held on trust by payments firms. Having been unsuccessful in persuading the courts that a trust exists under the current regime, the FCA
is working with HM Treasury to introduce one. Payments firms will become subject to fiduciary duties as a result of the imposition of a statutory trust over relevant funds. Thus, a cross-industry exercise will accordingly be required to familiarise firms with
these duties and the consequences of the application of these duties to their operations.
The big picture impact
UK payments firms will need to assess their current safeguarding arrangements against the new rules as currently drafted. A key part of this assessment will be to determine whether payment flows should change to comply with the new requirements. For payments
firms, payments flows are not part of a business, they are the business, and changes may require significant operational changes and substantial additional costs. If restructuring payment flows to comply with the FCA’s rules is essentially
operationally unworkable, it could prompt firms to move outside of the UK in favour of less prescriptive regimes.
The interim state rules
The interim rules do not herald fundamental change, albeit they come with a price tag in the form of an increased compliance cost. While the consultation includes a number of proposals, we expect the following three changes to be of particular interest to
the industry from a resources and cost perspective.
Audits
Under the new rules payments firms will be required to undergo an annual audit by an independent external auditor. The auditor must submit their report to the FCA. The FCA has chosen to restrict the role to auditors, rather than allowing a broader group
of professionals, such as those permitted for 'skilled person investigations'. If the supply of qualified auditors does not increase with market demand, there is a risk that the cost of audits will materially increase and that some may not be completed on
time.
Resolution packs
One of the main aims of the current client assets regime is to support the swift return of assets to clients if a firm fails. To achieve this, firms subject to the regime today must maintain a CASS resolution pack. The interim proposals require payments
firms to do the same. Were the firm to fail, the pack should help an insolvency practitioner return relevant funds to clients in a timely manner.
The FCA prescribes the documents and records that should be in the pack. These include acknowledgement letters, relevant policies and procedures, customer contracts and up-to-date records and accounts. Collating this information and ensuring it is readily
retrievable will be particularly burdensome for larger and fast-growing payments businesses.
Firms must review the pack’s contents on an ongoing basis and promptly correct any inaccuracies. The board must receive a report on the pack at least once a year.
Reporting
One of the FCA’s frustrations about the current regime is that it receives insufficient information from payments firms about their safeguarded funds. The FCA proposes updating the Supervision (SUP) part of its rulebook to require payments firms to submit
a similar monthly return, detailing the amount of relevant funds it is safeguarding.
The expectation is that firms will have systems in place that allow them to extract this information relatively easily. However, this is one more report to keep on top of and there is a question of how useful such data is, especially in the context of large
volumes of data being submitted to the FCA.
The wider context
Imposing the FCA’s rules as currently drafted would result in the UK demanding a significantly higher standard in this area than the EU, even taking into account future changes under PSD3. In addition to the risk that the rules make the UK a less attractive
place to do payments business, there is also the possibility that changes could impact the UK’s access to SEPA. This access is founded on an 'equivalence' of applicable UK payments services laws and regulations with those in the EU. Any deviation from EU laws
potentially risks this access.
The prescriptive nature of the rules and their potential to drive business away from the UK also seems at odds with the recently published National Payments Vision. The National Payments Vision is focused on growth and making the UK a “world-leading payments
ecosystem”. In particular, the Government intends to relieve some of the congestion in UK payments regulation because it views it as hampering innovation.
The tension between the wider strategic vision and the detail of the safeguarding rules is challenging to reconcile. Feedback on the safeguarding consultation is due on 17 December 2024 and it will be interesting to see what direction the FCA decides to
take in 2025.