Seize the day (not the client assets)

‘Live each day as if it were your last’ - so goes the maxim. The idea is that we should make the most of our time, which is a positive and useful message. However, unless you know for certain that today really is your last day, it would be madness to act on that basis. If it were truly your last day, would you go to work, pay your rent or book your next holiday? There would be no point. But if it turns out that today wasn’t your last day after all, you’ve failed to plan for the future. So really we need to balance making the most of today with preparing for tomorrow.

There’s an element of this balancing act in the CASS rules. Firms need to manage their affairs so that clients will be protected if the firm fails, but also treat them fairly if it doesn’t. The two often conflict. Perhaps the best example is depositing client money. In 2013 FCA proposed that each client bank account used by a firm must be held on terms which allow withdrawals of client money within one business day of a request. This was a reaction to the discovery that some firms were placing client money in long term notice accounts, and was intended to ensure that all client money would be available for distribution in the event of a firm failing. The downside was that such money was not going to earn much, if any, interest in the meantime.  This was modified in PS 14/09 to allow 30-day notice accounts; and more recently amended again to permit some money to be held for up to 95 days. This is balancing the risk of a possible delay (if the firm does fail) against the probable benefits of enhanced income if the firm continues to operate.

A less straightforward area is record keeping and reconciliations for custody assets. Securities trading is not instantaneous. Even if the transaction is settled on a DvP basis, there will be a gap, typically  2 - 4 days, between trade date and settlement date. From the moment the trade is agreed, the buyer and seller are locked into the transaction at a fixed price, so the beneficial interest in any subsequent value change rests with the buyer. Equally, the seller is committed to deliver that security, so in practical terms it no longer forms part of their trading portfolio, rather they have a right to receive the agreed funds on settlement date.

There has been regular debate in the industry whether client custody records should be updated and maintained on trade date  or settlement date. Recording the purchase or sale of an asset on trade date reflects the economic reality: an investor is entitled to any gain on the asset they have acquired from trade date. Conversely, they no longer have rights over an asset they have contracted to sell. Recognising the traded position is an important control against over-selling a client position. Settlement date, on the other hand, shows the legal position; and there is always the risk that a trade will fail to settle - particularly in the event of a firm going into administration.If a client wants to know their position, then from a legal perspective a security which has been sold but not settled is still their property, but from a practical or economic perspective the asset is sold. Assuming that the firm continues in business, the trade date record is more useful to the client as it shows assets and cash that they have (or soon will have) at their disposal. The settled record by contrast is potentially misleading as it will include as an asset securities for which the client has already traded away their rights (and cash which is already committed to fund a purchase).It is only in the situation where a firm fails, and potentially any in-flight trades fail to settle, that the settled position becomes critical.

In the funds industry it’s a bit more complex as there are essentially three dates: the trade date when the investor instructs the purchase for a certain value; the contract date when the Fund Manager calculates and allocates the number of units being issued; and the settlement date when the cash is paid. There is nothing received in return: the register of units in issue maintained by the fund manager is the security. Once the fund Manager has updated the register (on contract date) the asset exists; and there’s a corresponding liability for the investor to settle.

In recent meetings with firms and industry representatives, the FCA has stated that investment firms must maintain their custody books and records on a settled basis, and perform external reconciliations on a settled basis. CASS 6.6.3 R requires a firm to “maintain its records and accounts in a way that ensures their accuracy, and in particular their correspondence to the safe custody assets held for clients”. The reconciliation rules similarly refer to custody assets held. FCA would argue that a security is not ‘held’ until the trade has settled. This is certainly the case for shares, but I’m not so sure on fund units. Once the fund Manager has updated the register (on contract date) the asset is as held as it’s ever going to be; and there’s a corresponding liability for the investor to settle.

The real message here is that no single record - trade, contract or settled - is the complete answer. Clients, firms (and administrators if it comes to that) need to have the full picture of all in-flight trades to understand each individual’s entitlements and commitments.

PwC has previously suggested that firms can define “held” for the purposes of CASS 6 as either being the date at which beneficial ownership transfers (trade date) or the date when legal ownership transfers (settlement date); and a number of firms have obtained legal advice which supports the use of trade date for reconciliations. The FCA’s statement contradicts this.

The FCA communication is very clear about their expectations. Investment firms (and their auditors) will need to consider the implications in three areas.

Books and records

Firms must maintain a record of the settled position in order to meet FCA requirements, and the traded positions in order to identify and manage each client’s committed positions. A single record will not be sufficient.

Reconciliations

To meet the FCA expectations, reconciliations will have to be conducted on a settled basis. Firms will need to consider whether this is achievable for external reconciliations where the custodian statement is received on another basis - either trade date or contract date. Typically most custodians or settlement venues report holdings based on trade/contract date. If a firm uses settlement date accounting, there will be a significant number of timing differences on the firm’s external custody reconciliation. The existence of these differences increases the risk that discrepancies which are not timing differences are not identified, increasing the risk of inadequate protection for clients.

Client reporting

Investment firms should take this opportunity to revisit the reporting of statements to their clients, and ensure that these provide complete clarity over both the positions held at any point in time and the commitments made in respect of in-flight trades.