23. The basic types of protections available to clients whose assets are held by an insolvent investment firm are:

- legislative or other recognition that obligations to clients whose assets are held by the insolvent firm are to be treated differently from other obligations of the firm;

- provision for compensation to clients who sustain losses as a result of the holding of their assets by an insolvent firm; and

- measures taken by clients.

24. These mechanisms are not mutually exclusive and in many jurisdictions all play a part in minimising the risk of client losses.

25. The effectiveness of a particular technique may differ depending on the type of asset concerned (whether it is client money, securities or positions) and the insolvency legislation of the jurisdiction in which the assets are held.

PRESERVATION OF ASSETS IN INSOLVENCY

26. The method of meeting a defaulting firm's obligations will normally be dictated by a jurisdiction's insolvency legislation, or the interaction of its insolvency and financial services legislation.

27. In jurisdictions where client assets held by an insolvent investment firm are afforded differential treatment, two main mechanisms may be used:

- mechanisms which provide that clients whose assets are held by the insolvent firm are to be given preferential status as creditors; and

- mechanisms which require client assets to be held in such a way that they do not become the property of the firm, and are therefore not assets of the firm that can be used to meet the firm's obligations.

Preferential Creditor Status

28. Insolvency regimes often provide that some types of creditors rank ahead of others, so that some or all of the insolvent firm's assets are to be used to meet the claims of these preferred creditors before they are available for settling the claims of other creditors. In some jurisdictions, a firm's ability to meet its obligations to clients whose assets it holds or controls is secured by charges over general assets of the firm. Clients will thus receive preferential treatment by contrast with unsecured creditors of the firm. In certain jurisdictions, common law provides that assets which can be traced to a customer are held in trust by a firm. Although this does not generally apply to client money, it is possible that securities might be protected in this way.

Advantages and Disadvantages

29. The clear advantage of such an approach is that, subject to a possible change in statute, such a system can (but does not always) require little additional cost to firms (and therefore to investors), as it involves no operational changes while the firm is a going concern (with the possible exception of disclosure to creditors affected by such a policy) and is only effective upon the default of the firm.

30. A major disadvantage of systems relying solely on clients having preferential creditor status is that they can be ineffective where there is a shortfall in net assets of the insolvent firm. In that case, if this is the only method used to protect client assets, clients will be recompensed for the loss of their assets only to the extent that assets are available.

31. A second major disadvantage is that clients may in some jurisdictions be required to wait until the administration of the insolvency is advanced before it can be clear whether sufficient assets remain, which creditors have preference and in relation to what, and for other procedures prior to the distribution of assets to be completed.

32. This technique might also lead other creditors who would not be subject to preference to seek other means of safeguarding their assets, for example, liens and other charges or greater demands for collateral. An arrangement of this kind could reduce the pool of assets available for preferred creditors, including clients of the firm. Regulatory authorities can, however, make arrangements of this kind unattractive, for example by adjusting capital charges.

Continuing Client Ownership of Client Assets

33. Many regimes provide that, even though assets are held or controlled by an investment firm, they are not property of the firm available for distribution to the firm's creditors in the event of its insolvency. Under regimes of this kind, the authorised firm may physically hold the assets (for example, securities) or deposit them with another person (for example, by depositing funds with a bank), but the client retains title to the assets and can assert title against the firm or the firm's creditors. This separation of control of the assets from beneficial ownership of them can be achieved in a number of ways. In jurisdictions with a tradition of trust law, the regime often requires investment firms to hold client assets "in trust" for clients. In other regimes, the same effect can be achieved by legislation which provides specifically that client assets held by an authorised firm are not available to meet the claims of the firm's creditors.

34. These methods of protecting client assets are effective only if they are supported by measures that require client assets to be held so that they can readily be distinguished from proprietary assets of the firm. Measures of this kind include:

- the registration of securities in the name of the client or in a separate nominee company, for example with a regulated depository; or

- a requirement that client assets - or at least some types of asset, such as funds or securities - be held by a "custodian", often with an additional requirement that the custodian be independent of the firm or be a third party nominated by the client.

35. These measures usually also involve an obligation to make clear to the custodian that assets held by it are not the property of the investment firm, but are held by the firm with the custodian on behalf of the firm's clients.

Advantages and Disadvantages

36. Legislation that specifically provides that client assets held with or controlled by an authorised firm remain the property of the firm's clients can provide a very effective means of protecting client assets. It may not, however, be without problems, which include:

- unless a jurisdiction's insolvency legislation expressly deals with client assets, conflict between the jurisdiction's insolvency regime and its securities or derivatives regime may undermine the protection of client assets;

- fraud by the firm, or by a custodian or trustee, can still take place;

- even where there are requirements for client assets and proprietary assets to be held separately from one another, assets may be commingled and it may be difficult to determine which are client assets and which are the firm's proprietary assets;

- the costs of maintaining such a system, especially if it requires that assets be held by a third party such as a custodian, may be significant;

- in some jurisdictions, there may be indirect cost consequences for the firm, for example if the firm is required to pre-fund margin calls.

37. In the case of regimes which rely on the jurisdiction's general trust law, the following drawbacks may also exist:

- a non-statutory trust is enforceable only in certain jurisdictions;

- for a trust to be fully effective in protecting client assets, it may be necessary for a third party receiving the assets (such as a custodian) to be aware that the firm is merely a trustee of those assets; and

- a trust can be ineffective, as a matter of law or in practice, if the firm's money is inadvertently mixed with the client money in the trust account, although in some cases (for example the US and the UK) firms are permitted in certain clearly defined circumstances to add their own funds to the segregated pool.

38. The main advantage of using a custodian is the safeguard to investors of having their securities lodged there, which, in the event of the investment firm's default, enables them to be readily identified and isolated from assets of the insolvent firm. It should be noted, however, that clients in these circumstances are exposed to the risk of insolvency of the custodian, so that these measures only add to the protection of clients if the custodian or other third party by whom client assets are held is at least of the same credit standing as the authorised firm.

39. The disadvantages of assets being held by a custodian include the additional time and cost involved in maintaining separate accounts in order to distinguish between the firm's and its clients' assets and, most importantly, the risk that it might not be legally effective, especially in overseas jurisdictions. Effective separation of firm and client assets can in these circumstances depend critically on the quality of the records at both the firm and the custodian, as poor records can prejudice the ability to prevent a liquidator from claiming uncertainty over the ownership of the assets. Subject to the insolvency law in each jurisdiction, it may be that certain other measures might have to be taken to ensure that, in respect of their assets held by an investment firm with a custodian, clients have preference and do not merely rank equally with other creditors of the defaulting investment firm or custodian.

40. A requirement to hold assets with a third party subject to the control of the customer may also disadvantage the firm by reducing its operational liquidity, and may have a detrimental effect on the speed and efficiency of settlement processes.

41. The effectiveness of separate holding of assets may also vary according to the nature of the asset. Where an asset is separately identifiable as client property (for example a registered security), separation may be a far more effective technique for protection than in the case of cash, where the deposit will ordinarily lead to a debtor/creditor relationship with the custodian concerned.

Securitisation of Money

42. The established way of depositing client money is with banks. Various issues concerned with the relative risks of depositing money with banks as opposed to investment firms are discussed elsewhere in this paper. Additionally, banks are prohibited in certain jurisdictions from paying interest to non-residents. In some jurisdictions, an alternative to deposits with banks is to deposit funds with specialist money funds. Securitisation need not, of course, be restricted to the use of money funds, although such funds would normally have an enhanced credit rating attractive to investment firms wishing to deposit client money with them.

Advantages and Disadvantages

43. Authorised firms and investors should be aware that there might be an element of market risk inherent in the use of money funds. It is important to note the investment objectives of a specific fund in order to measure such risk. A further issue relating to securitisation is that it would normally involve the pooling of client money, rather than the maintenance of individually designated client money accounts, which some clients find more attractive. The risks inherent in pooling client money are discussed elsewhere in this paper.

COMPENSATION ARRANGEMENTS

44. The main methods used to ensure that clients are adequately compensated for losses include:

- establishment of schemes to compensate clients who lose assets as a result of the insolvency of an investment firm; and

- a mandatory requirement for securities firms to obtain private insurance against the risk of loss of, or a shortfall in, client assets.

Compensation Schemes

45. Compensation schemes are commonly used to compensate clients for losses arising from misappropriation of assets by a firm or its employees, as well as being available to meet shortfalls in client assets held by an insolvent firm. They normally involve arrangements established by legislation, or by regulatory or market rules, which provide for funds to be available to compensate investors who suffer losses of this kind. Schemes of this kind may be organised on a jurisdictional or industry basis and may depend on some other connection, such as membership of an exchange. Funds to meet investor claims are normally contributed by industry participants or classes of participants (such as members of securities or futures exchanges).

46. Compensation schemes are, therefore, a way in which market participants collectively contribute to a fund used to compensate clients of a failed firm. The scope of these compensation schemes can vary considerably. Some schemes provide compensation only in the case of fraud or theft of client assets, where the authorised firm concerned is unable to make good the losses, or quite simply a deficit of client assets upon the default of the firm. The timing involved in settling compensation claims varies from scheme to scheme and according to the complexity of both the insolvency and the claim.

Advantages and Disadvantages

47. An important advantage of compensation schemes is that their operation is separate from the insolvent firm. Furthermore, their costs are spread across a wide range of market participants.

48. Disadvantages inherent in compensation schemes include the fact that usually only cover up to a specified amount and there may be different levels and types of cover across different jurisdictions, so that, for example, persons eligible for compensation as "clients" in one jurisdiction may not qualify as clients in another. Moreover, such schemes are not ordinarily designed to prevent the resultant freezing of clients' assets and positions upon insolvency. Compensation schemes are simply designed to repair the damage at a later date. They impose a cost on firms which are not likely to fail, although proponents of compensation schemes contend that all firms benefit from the increased confidence which such schemes create in markets.

Insurance

49. While not directly protecting the assets of investors, various forms of private insurance can protect the interests of investors by providing indemnification against losses involving client assets. In some jurisdictions, regulatory authorities require authorised firms - whether individually or collectively - to take out insurance of this kind. One such form of insurance is a mutual insurance policy subscribed to by all users of a particular market. This would involve all market participants undertaking to stand behind the transactions or liabilities of the other participants. This is similar to a form of compensation fund. Another form of insurance is commercial insurance, whereby market participants obtain default cover either individually or collectively from the insurance market. This might cover fraud, faulty execution, loss of documents or unauthorised trading by a firm's employees.

Advantages and Disadvantages

50. Insurance has the same advantages as preference in insolvency, namely those of simplicity and a lack of operational involvement of the firm. In addition, it can improve the standard of control within a firm, as insurers generally require a firm to perform a comprehensive review of its internal control structure before confirming cover. The disadvantages of insurance include those of cost, the fact that most insurance policies involve a maximum level of cover and, in practice, the various exclusions from any insurance policy. For example, in some jurisdictions and with certain products, it might not be possible to obtain cover for default losses. There is also the possibility that a firm which is approaching default might not comply with the strict conditions of an insurance policy designed to protect the firm's investors. In many insurance markets there is also the problem of capacity, especially with a specialist risk such as investment firms.

MEASURES TAKEN BY CLIENTS

51. It should also be recognised that clients dealing with investment firms may themselves take measures for the protection of assets held by the firm on their behalf. Needless to say, the ability to negotiate such arrangements with a firm will vary from client to client. It may also be the case that such schemes will not work in jurisdictions where clients are required to be treated equivalently upon the default of the firm. Nevertheless, some examples of this type of arrangement are where:

- investment firms provide their own securitisation by the payment of client money into a money fund operated by the firm;

- the client enters into an arrangement with the investment firm to collateralise a cash balance;

- clients establish accounts in their own name at banks or custodians and permit an investment firm to exercise control over those accounts;

- clients protect their assets through the use of letters of credit or other arrangements with their bankers, so that money is only provided against proper documentation;

- clients require special arrangements to recognise or preserve their right to a particular asset; or

- the effective execution of transfer of positions by clients in certain jurisdictions upon the insolvency of the firm.

Advantages and Disadvantages

52. Private arrangements for client protection may be tailored to address specific risks identified by the parties to a transaction. For example, clients who are creditors without the benefit of preferential status may seek other means of safeguarding their assets, for example by liens and other charges or the greater use of collateral.

53. However, private arrangements of this kind have a number of limitations. Among the most important are:

- the time and cost of negotiating appropriate protections may be prohibitive;

- the cost of enforcing them may be substantial;
- the relative bargaining position of the parties may mean that clients are unable to negotiate effective protections; and

- unless expressly provided for in a jurisdiction's insolvency regime, some of these arrangements may not be fully effective if the investment firm becomes insolvent.

54. In view of these limitations, private arrangements should not be regarded as a complete substitute for protections provided through the normal regulatory process, even in the case of "professional" clients.

55. Nonetheless, securities and insolvency regimes should not impede clients of investment firms from taking prudent steps to protect their assets, unless it would be inconsistent with policy objectives related to protection of the markets or equivalent treatment of customers in default.. This is another reason why transparency of the various asset protection techniques is so important.