66. This section deals with issues relating to client asset protection as it applies to different types of asset.

CLIENT FUNDS

Banks Acting as Brokers

67. In most jurisdictions, the regulatory arrangements for the protection of client money are designed to apply to money placed with a broker rather than with a bank. Where a bank receives money from customers in the course of undertaking investment services business, it will usually hold these funds as deposits rather than as client money, and banking protections will apply to these funds. This paper does not set out to compare the protections available to money held by banks and investment firms, merely to state the importance of recognising and disclosing where necessary that there are differences in this respect.

68. Nevertheless, an important issue which arises from this difference between banks and investment firms is the question of whether, where there is a bank involved as broker in a chain of dealing, the bank concerned should require segregation of any client money which it passes to intermediate brokers, exchanges or clearing houses. There are clear advantages in requiring banks, where they act as brokers, to be subject to the same client asset protection regime where client assets are passed by them to another authorised firm. The protection would not fail part of the way along a chain merely because an investment firm chooses to deal with a bank as intermediary rather than another investment firm.

Recommendation 14:

Regulatory authorities should ensure that when a bank passes clients' money to a third party in the course of undertaking investment business on behalf of clients,

i) it separately identifies the funds as relating to dealings on behalf of clients; and
ii) to the extent possible it seeks client asset protection from the third party to whom such monies are sent.

CLIENT SECURITIES

69. In discussing issues relating specifically to client securities, it is important to recognise that investment firms either hold or control client securities of increasingly significant value, far greater than in the case of client money. As settlement periods become shorter and book-entry systems become even more widely used, the value will continue to grow. This fact makes the issues relating specifically to securities that much more significant. Custody as a Regulated Activity

70. Jurisdictions vary as to whether the safe custody of securities is subject to overview by the regulatory authorities, whether in the context of investment services or of banking business.

71. There has been significant debate among regulators and major custodians on this issue. In favour of the regulation of custody is the argument that huge amounts of securities are entrusted by customers to custodians, who represent that they will handle those securities and account for them in accordance with the legitimate instructions of the owners of the securities. The purpose of regulation in this situation is to help minimise the risk that those expectations will be disappointed. This is, of course, a very persuasive objective. Against that lies the argument as stated above that much of the international custody activity is already regulated. Indeed, in addition to supervision by the regulatory bodies, it has been argued that many of the customers, especially large institutions such as pension funds and major corporations, insist on high levels of internal control being demonstrated to themselves or their auditors.

72. A major aspect of the discussion on the regulation of custody activities has to be that of cost and the need for careful definition as to what constitutes custody, and the use of appropriate supervisory techniques to oversee firms which undertake this activity.

Recommendation 15:

Regulatory authorities should review the regulatory and supervisory arrangements for custody in their jurisdictions.

Stock Lending

73. As a result of shorter settlement periods, the risks inherent in physically holding securities and the prevalence of dematerialised or immobilised securities, a large proportion of customers' securities are held or controlled by investment firms or banks. In addition, many investors seek to maximise the return on their holdings and the firms wish to provide additional services, such as stock lending. There are a number of additional risks arising out of the lending by firms of customers' securities. The main one to be emphasised in this paper is the need for legal certainty as to the owner of the securities and who takes the responsibility for completing stock lending transactions and for the default of counterparties to such transactions. It is essential that securities lending transactions should be subject to clear, preferably industry-standard, legal documentation.

Recommendation 16:

Regulatory authorities should ensure that regulations provide for:

i) the prior authorisation by customers of securities lending activity;
ii) clarity as to who is assuming the risks in securities lending transactions;

iii) the need for clear, industry standard documentation; and

iv) adequate regulation and appropriate supervision of securities lending activity.

Settlement Accounts

74. Much of the securities business conducted worldwide is settled on a delivery-versus-payment basis. Although the vast majority of DVP transactions settle without any difficulty, it can happen that there are timing differences between receipt of securities and passing of cash. Clearly if both do not occur simultaneously, one party to the transaction will be at significant, albeit usually short-term, risk. The risk to clients would be the default of an investment firm at a time when client assets are in the course of settlement. In such a scenario, clients' securities may have been delivered to a clearing house or the investment firm's custodian. In either case, if the client has not been paid for the securities, the client is at risk unless there is specific treatment of client assets in the course of settlement, such as the maintenance of separate settlement accounts at custodians and clearing houses which ensure that clients' securities are not mixed with those of the firm.

Recommendation 17:

Regulatory authorities should review the adequacy of arrangements within their jurisdiction for ensuring that client securities in the course of settlement are not unnecessarily mixed with those belonging to the investment firm.

CLIENT POSITIONS

Agency / Security Interests

75. Most of the world's derivatives markets operate on a principal-to-principal basis. In certain cases, however, most notably where an investment firm is dealing on behalf of a client, the substance of the transaction is more of an agency transaction. In order to protect client positions arising from such transactions, there needs to be the ability (in law and in practice) to recognise the interest of the client in the transaction and, more importantly, to remove a defaulting investment firm from the chain where it is effectively dealing as agent.

76. The disadvantages of an arrangement which allows the removal of the firm are, however, twofold:

a) As most of the world's derivatives markets are principal-to-principal, it may not be possible to change the legal structure of a transaction without legal or regulatory support;

b) It is not possible simply to remove an agent from a transaction if any of the assets (e.g. margin) belonging to any party to the transaction have been lodged with the defaulting firm and are no longer available.

Recommendation 18:

Regulatory authorities should ensure that there is clarity as to the arrangements for protecting client positions held as a result of transactions entered into in their jurisdictions.

Consistency of Provisions Applying to Firms and Clearing Houses

77. In the event of an investment firm's default, it is common for the liquidators to freeze not only the assets of the firm, but also any outstanding positions. In the absence of any separate identification of clients' positions, it is likely that those will also be frozen, not only by liquidators but also by exchanges. Segregation (i.e. separate identification) of positions is designed to ensure that transactions can be transferred or closed out speedily by the exchange or clearing house (unless the default is due to severe market action) without the need for the delay of remitting further funds.

78. In the event of an insolvency, the priority for many clients is either to transfer or liquidate their positions as quickly as possible. Any transfer of client positions will be frustrated if the firm holding the position cannot be compelled to transfer them to a solvent firm. Furthermore, clearing house rules will not bind a firm which is not a member. This is a particular problem in the case of related party transactions, as both the exchange member and non-member are likely to be in default.

Recommendation 19:

Within each jurisdiction, to the extent possible, the regulatory regime should facilitate the transfer of positions from firms including related party firms which have become insolvent. Arrangements at clearing houses should be consistent with the objective of client asset protection at authorised firms and in particular have arrangements which permit the separate identification of client and proprietary positions.

Margin Segregation

79. A very effective way of protecting clients' positions is to ensure that all positions are effectively margined and that client positions are margined separately from those of the firm and non-segregated clients. Although this does not necessarily prevent positions from being frozen upon the default of the firm, it is designed to ensure that customer transactions do not offset firms' liabilities and thus their transactions can be transferred or closed out speedily by the exchange or clearing house (unless the default is due to severe market action) without the need for the delay of remitting further funds.

Recommendation 20:

Regulatory authorities should ensure that the provision of margin is the subject of clear, written agreements between the firm and its clients and that the firm should operate appropriate internal controls to ensure that margin posted for client positions is properly accounted for and segregated on behalf of such clients.