3. Clients are dependent on investment firms to conduct a range of activities on their behalf. Authorised firms hold and control client assets, transfer client assets and may use one type of asset (for example, cash) to acquire another (for example, securities) in the course of providing client asset protection. It is, therefore, critical to the confidence of customers and the markets generally that these assets should be safe when they are held or controlled by an investment firm.

4. In addition to the investor protection concern of taking reasonable steps to avoid loss to clients, if the public lack confidence in the client protection mechanisms, then inefficiencies in the respective markets may arise. Clients may incur additional costs and time to ensure that they can negate or minimise the effects of the insolvency of an investment firm that operates in the market on their behalf. Alternatively, clients may determine not to participate in the market if they consider that the risk of loss of their assets as a result of the fraud, carelessness, unclear responsibilities or insolvency of investment firms is too high.

5. The ultimate objective of client asset protection is to enhance investor protection and public confidence in financial markets. This objective is achieved by the public having confidence that, as far as possible, their assets will be properly handled and accounted for and that they will not be adversely affected by the insolvency of firms which control assets on their behalf.

The Relevance of Insolvency

6. There are a number of ways in which client assets can be endangered. These include fraud or misappropriation by the firm or its employees, and inadequate controls and accounting procedures at authorised firms. Many of the techniques discussed in this paper are useful in reducing these risks. However, while important in themselves, the risk to the customer becomes most acute when the firm is not in a position to compensate clients for losses because of its own insolvency. The principal focus of this paper is therefore on the insolvency of the investment firm to which the customer entrusts its assets.

7. Where an investment firm becomes insolvent, there is potential for conflict between those who have an interest in maximising the value of the firm's assets available generally to creditors and those whose assets are held or controlled by the firm. Client asset protection regimes endeavour to resolve some of these conflicting claims by ensuring that, as far as possible, client assets held by authorised firms are not exposed to the insolvency of those firms.

8. It should, however, be noted that the insolvency of other firms within a chain of relationships may also prejudice the safety of customer assets. This may arise because the firm does not accept full responsibility for assets held with third parties, or because the insolvency of that other firm threatens the solvency of the firm itself.

9. Insolvency law generally reflects two basic premises - the maximisation of the value of the insolvent firm and an appropriate allocation of the realisation of assets between those affected by the insolvency. The way in which these basic premises are reflected in national legislation can vary substantially. It is important to recognise the role played in this respect by public policy and to recognise that, as a result of differing policy, the scope and techniques of client asset protection might vary from jurisdiction to jurisdiction.

Recommendation 1:

Regulatory authorities should recognise the benefits for investor protection and confidence in financial markets of effective mechanisms to protect client assets from the risk of loss and the insolvency of investment firms.

A VARIETY OF MECHANISMS

10. It is important to note that effective client asset protection can be achieved in a number of ways, often through a combination of methods. The specific methods to be used may vary considerably from jurisdiction to jurisdiction, reflecting different market traditions, political influences and legal and regulatory systems. In particular, variations in client asset protection regimes might arise from differing approaches to:

- the public policy underlying a jurisdiction's insolvency law;

- the relative importance given to the protection of individual investors or to overall market integrity;

- differing legal concepts, such as the existence of trust law; or

- different requirements for members of organised markets.

11. One aspect of public policy which may differ between jurisdictions is whether the concern within financial markets is to protect the investor or to protect the integrity and efficiency of markets by ensuring the smooth operation of settlement and payment systems. In many markets, both are important, and the two ends do not need to be seen as mutually exclusive in the ability of authorities to achieve them. The balance of emphasis between these two objectives can, however, affect the approach to client asset protection adopted in particular markets.

12. Cultural and public policy differences might make the framing of minimum, global standards for client asset protection more difficult to achieve. Nevertheless, there is value in attempting such an exercise and in promoting greater awareness of the policy and techniques adopted in the major financial centres of the world. The need to examine the legal basis underpinning insolvency practice in a specific jurisdiction should not prevent serious analysis of the questions raised in this paper.

Cost Considerations

13. It should be recognised that costs incurred in providing greater protection for investors will often ultimately be borne by the investors themselves. While measures which enhance market integrity and heighten the security of client assets are advantageous and might very well more than compensate for the associated costs, it is important that national supervisors should take cost considerations into account in establishing a client asset protection regime.

Recommendation 2:

Regulatory authorities should choose within their jurisdictions those mechanisms which best achieve the overall objective of client asset protection, taking into account their national insolvency and investment services laws, regulations and practices; the needs of market efficiency and investor protection; and the costs of any such measures.

TRANSPARENCY

14. An important part of client asset protection is clients' awareness of what assets the firm is holding on their behalf, and of the arrangements which exist for their protection. Only if clients are aware of the level and type of risk to which their assets might be exposed can they make fully informed decisions about authorised firms and markets. Regular and timely reporting by firms to their customers about assets held on their behalf together with appropriate information about the arrangements for client asset protection, for example through the use of agreed standard forms of disclosure, will also assist investors to take action themselves to protect their assets. However, while reporting and disclosure about the way in which client assets are protected is a crucial part of effective client asset protection regimes, such disclosure alone should not be taken to be a substitute for other measures discussed in this paper.

15. Because of the way in which protections may be affected as a result of cross border dealings, especially where a number of firms are involved, disclosure of the risk of loss of protection of client assets should be a responsibility of the investment firm with whom the investor deals directly.

Recommendation 3:

Regulatory authorities should seek to ensure that investors are adequately informed about the arrangements for client asset protection within their jurisdictions. In particular, they should require that authorised firms report on a regular basis to their clients as to the assets which they hold on their behalf, and to make appropriate disclosure to clients about the way in which client assets which the firm holds are protected within their jurisdiction. Where client assets are to be held in another jurisdiction, and different client protection arrangements apply to those assets, the firm should be required to inform the client of that fact.

PREVENTATIVE MEASURES

16. In the day to day handling of client assets, the importance of preventative measures should be the first priority. Avoidance of the circumstances where client asset protection or compensation mechanisms must be relied upon in an insolvency affords the best protection for client assets.

Internal Controls

17. Firms should have robust systems of internal controls to ensure that the risk of loss of client assets through the firm's insolvency is kept to a minimum. For this purpose, the most important controls are those that ensure that:

- proper books and records are kept at all times;

- assets held for clients, and dealings on their behalf, are clearly accounted for and safeguarded;

- internal and external audits are undertaken of key aspects of the firm's business, including compliance with rules relating to client asset protection;

- accruals, rights and other entitlements are properly recorded; and

- there is regular reporting to external authorities on the operation of the internal controls dealing with the handling of client assets;

- there is appropriate segregation of duties between front office staff and staff responsible for administering client assets.

18. Many of these controls are also a prerequisite to effective protection or restitution of client assets in the event of insolvency. For example, the effective operation of trust arrangements, customer preference in insolvency or industry compensation schemes depends on the maintenance of records which correctly identify and account for client assets.

Recommendation 4:

Regulatory authorities and authorised firms should recognise that effective internal controls for identifying, accounting for and safeguarding client assets are essential prerequisites for effective client asset protection.

Regulatory Supervision

19. The importance of the effective protection of client assets held by authorised firms should also be recognised in the way that regulatory authorities plan and carry out their supervisory responsibilities. The question of whether an authorised firm holds or controls client assets should be an important factor in determining the intensity of regulatory supervision to which the firm is subjected. Inspection and reporting arrangements should give particular attention to the internal controls noted above. For example in those jurisdictions which rely on the work of external auditors, a review of the firm's controls and procedures for handling client assets should be included in the scope of the auditors' work. In addition, regulatory authorities should ensure that capital adequacy requirements for investment firms which hold client assets are sufficiently prudent, reflect the risks to such assets and are effectively monitored.

20. Regulatory supervision of this kind may also assist in identifying firms which are at risk of becoming insolvent so that appropriate measures may be taken to avoid potential losses to client assets.

21. Action may be needed by regulatory or market authorities when they become aware that a firm's insolvency is likely or imminent. In some jurisdictions, authorities have power to take client assets out of the hands of a firm when they believe that the firm may fail or otherwise be unable to meet its obligations relating to client assets.

22. Many jurisdictions have insolvency regimes which require client assets, including positions, to be frozen upon the default of the investment firm. Not only can this adversely affect the clients involved, but can also affect overall market liquidity and the efficiency of settlement systems. It is important that any action taken in the course of the insolvency proceedings does not prejudice the ability of market authorities to deal quickly and effectively in unwinding or transferring client assets or positions to solvent market members or to the underlying clients.

Recommendation 5:

Regulatory authorities should:

i) recognise the need for appropriately intensive supervision of firms that hold or control client assets; and

ii) review the techniques and powers of intervention available to regulators or other relevant authorities both before and after the default of a firm which holds client assets.