On September 25, 2024, the FCA published CP24/20 setting out its proposed changes to the safeguarding regime for payments and e-money firms. The consultation closes to comments in December.

The changes are likely to present a high compliance burden for many firms. While many of the requirements are examples of the FCA codifying existing guidance, they are no longer subject to risk-based and scale qualifications, meaning smaller firms are likely to need to implement much more substantive systems and controls than they currently have in place, and senior managers of all firms will become much more accountable for their firms’ approaches.

Background

Payment institutions, e-money institutions and credit unions that issue e-money (referred to in the CP collectively as “Payments Firms”) are required to protect funds received in connection with making a payment or in exchange for e-money issued (referred to in the CP as “relevant funds”). They must do so immediately on receiving the funds. These requirements are designed to protect consumers, so that if a firm fails, consumers receive the maximum value of their funds as quickly as possible.

The current requirements are set out in the Payment Services Regulations 2017 (PSRs) and E-Money Regulations 2011 (EMRs) and the FCA has issued guidance in its Approach Document. The FCA is concerned that guidance in its Approach Document has not been implemented effectively and that this has resulted in significant consumer harm where firms have failed and entered insolvency. 

Additionally, the huge growth in numbers of consumers serviced by the sector and in the amount of safeguarded funds held by Payments Firms means that a greater share of the UK population is likely to be exposed to harm if there is a shortfall in safeguarded funds, or a delay in their return to consumers. The FCA is also particularly concerned about the risk of harm to vulnerable customers who are more likely to rely on e-money funds for accessing salaries or paying household bills and may go into debt if they are unable to access their funds for an extended period.

The FCA sent a Dear CEO Letter to payments and e-money firms in March 2023 setting out common failings in firms’ safeguarding and wind-down arrangements The FCA has since opened supervisory cases relating to approximately 15% of firms that safeguard to address its concerns.

Also, HMT’s Payment Services Regulations Review and Call for Evidence invited the FCA to consult on changes to the current regime as part of the Smarter Regulatory Framework repeal of assimilated law.

Who will the new rules apply to?

The new rules will apply to all:

• Authorized payment institutions;
• E-money institutions;
• Small e-money institutions (in relation to issuing e-money only, unless they opt-in for unconnected payments as outlined below);
• Credit unions who issue e-money in the UK under the PSRs and EMRs;
• EEA firms in supervised run-off under the financial services contracts regime, but not firms subject to unsupervised “contract run off”.

Small payment institutions (SPIs) will continue to be able to opt-in to comply with safeguarding on a voluntary basis. Small e-money institutions and credit unions (that are required to safeguard funds received in exchange for e-money) will also continue to be able to opt-in to the safeguarding requirements for any payment services they provide which are unconnected with issuing e-money.

What are the proposed rule changes?

Under the FCA’s proposals, the existing e-money safeguarding regime will be replaced with a client assets (CASS) style regime.  The changes will be made in two stages: (1) the interim state; and (2) the end state. The FCA is making interim changes to address some of its concerns around safeguarding now while it waits for HMT to revoke the safeguarding requirements in the PSRs and EMRs. The interim state rules will be made in advance of legislative change and will supplement the current safeguarding requirements in the PSRs and EMRs and move the relevant material into the FCA’s Handbook. Where the interim rules cover the same ground, Chapter 10 of the FCA’s Approach Document will be removed or amended.

The end state will be implemented when the PSRs and EMRs are revoked and will address the remaining shortcomings of the regime. The end state rules will entirely replace the current safeguarding requirements in the PSRs and EMRs when their revocation is commenced. The FCA says it has designed the end state to build on the changes made at the interim stage to minimize disruption for firms so far as possible.  

This is a summary of the FCA’s main proposals.

Interim state rules

Firms will be required to:

• Implement adequate policies and procedures to help ensure compliance with the safeguarding provisions.
• Maintain accurate records and accounts to enable them to distinguish between relevant funds and other funds.
• Perform internal and external reconciliations at least once each business day and in line with the method set out in the proposed rules.
• Determine the reason for any discrepancy identified by reconciliations and ensure that any shortfall is paid into a relevant funds bank account, or any excess is withdrawn by the end of the business day. For external reconciliations, discrepancies must be investigated and resolved.
• Notify the FCA if their records are out of date, they are unable to perform a reconciliation or remedy any discrepancies, or there is a material difference between the amount of safeguarded funds and the amount they should have been safeguarding.
• Maintain a resolution pack.
• Appoint an independent auditor to carry out a safeguarding audit and submit an annual report to the FCA. An auditor can be appointed for a firm if it fails to appoint one within 28 days of being required to do so. The application of the current rules will be extended to all Payments Firms other than payment initiation service providers, SPIs and credit unions that issue e-money.  The rules will apply to SPIs and credit unions that issue e-money as guidance.
• Appoint a director or senior manager to have oversight of the firm’s safeguarding compliance and make reports to the firm’s governing body. This has strong similarities to the SMCR regime, albeit Payment Firms will remain outside of that for the time being.
• Submit a new monthly regulatory return electronically giving information about safeguarded funds.
• Exercise due skill, care and diligence when appointing third parties that provide accounts for relevant funds or provide insurance or comparable guarantees. Firms will need to periodically review their use of third parties and consider whether they should diversify their arrangements.
• Obtain acknowledgement letters which put the bank or custodian on notice that they are holding relevant funds or assets and promptly allocate funds to individual customers. This builds upon the existing guidance in the FCA’s Approach Document, but firms will need to get new acknowledgement letters at the interim rules stage to reflect the new terminology in the FCA rules. A repapering exercise will also need to be carried out under the end state rules to reflect that relevant funds are now held on trust.

Firms will be able to invest in the same range of secure, liquid assets as they can now but will be required to ensure that:

1. there is a suitable spread of investments;
2. assets are selected in line with an appropriate liquidity strategy and credit risk policy; and
3. any foreign exchange risks are prudently managed.

The rules also address how these assets should be reflected in a firm’s reconciliations.

End state rules

Statutory trust: A statutory trust will be imposed over:

• relevant funds;
• secure, liquid assets those funds are invested in;
• the rights and proceeds under insurance policies and guarantees; and
• cheques and other payable instruments received for the execution of a payment transaction or purchase of electronic money.

As a trustee, the Payments Firm will have well-established fiduciary duties, such as acting in the best interests of the beneficiaries. The trust will also give greater certainty when a firm fails. Anything in the trust will fall outside the firm’s general estate, so will not be available to other creditors.

Although imposing a statutory trust is legally a significant change to the current regime, the FCA does not think it will require firms to make significant changes to the way they protect funds.

Creation of a single asset pool comprising all relevant funds: Firms would be able to safeguard funds in a single relevant funds bank account, subject to the new diversification requirement.

Unclaimed relevant funds: The requirement that firms must safeguard unclaimed balances for at least 6 years will be retained. However, the statutory trust terms would give firms the option to gift unclaimed balances to charity if certain conditions were met, including taking reasonable steps to trace the consumer.

The firm would still be subject to any legal right of the consumer to return of funds and firms must unconditionally undertake to repay consumers where the relevant funds are more than £25 ($34) for retail consumers or £100 ($134) for other customers.

Segregation of relevant funds: Payments Firms using the segregation method will need to receive relevant funds directly into a designated safeguarding account with an approved bank or the Bank of England. Exceptions to this include: (1) where relevant funds are received either through a merchant acquirer or into an account that is held only to participate in a payment system; or (2) the firm receives relevant funds as cash.

As currently, these relevant funds will need to be deposited in designated safeguarding accounts by the end of the business day after the day they were received (D+1). Payments Firms will still be able to have accounts with approved foreign credit institutions, including those in an OECD member state.

Investing relevant funds in secure liquid assets: Relevant funds (and the assets purchased with them) will be included in the statutory trust.  Firms investing in secure liquid assets will need to ensure they have necessary permissions to do so. They are likely to need permission to manage investments if they manage the investment of relevant funds with discretion. This is an important consideration, and firms will need to think carefully about whether they want to use the liquid assets method given the consequences of taking on the managing investments permission.

If the firm does not have permission to safeguard and administer investments, it will need to deposit the assets with a custodian firm that does. If a Payments Firm holds the assets they invest in, they will need to comply with CASS 6 custody rules. The FCA will consult separately on the range of assets firms should be able to invest in under the end state rules.

What’s next?

In relation to the interim state, the FCA plans to publish the final rules during the first half of next year and firms will have 6 months to implement the changes. The new regime is expected to be in force before the end of 2025.

In relation to the end state, when revocation of the safeguarding requirements in the EMRs and PSRs is commenced, the FCA will publish the final end state rules and will give firms another 12-months to implement the additional changes. No timing has been given for HMT’s revocation of the PSRs and EMRs.

HMT and the FCA are also planning to work together on a number of reviews and consultations relating to connected areas, including rules to mitigate the impact of the failure of a third party used for safeguarding purposes and to move more of the PSRs and EMRs regimes into the FCA Handbook.