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The Financial Conduct Authority’s (FCA) long-anticipated proposals for overhauling the payment and e-money sector’s safeguarding requirements offer no shocks, yet experts warn that adapting to the changes will not be easy.
The regulator unveiled its safeguarding plans, which will apply to the majority of the UK’s payments and e-money institutions, at the end of last month.
Both interim and long-term rules are included, with interim measures focusing on strengthening compliance with existing regulations, improving record-keeping and enhancing monitoring.
In the long term, the introduction of a statutory trust over relevant funds will prioritise consumer claims over creditors in the event of insolvency.
Key provisions include mandatory annual safeguarding audits, improved reporting and the submission of safeguarding returns.
A challenge for firms to implement
Although the sector has been waiting for these reforms for some time, that does not mean they will be easy for payment and e-money firms to get their heads around.
"This is a complex consultation, and its impact will unfold over the next two to three years. It marks the beginning of significant reform in how payments firms are regulated,” explained Simon Treacy, senior associate at Linklaters.
According to Treacy, the FCA has become increasingly dissatisfied with the current high-level safeguarding framework, which it feels lacks sufficient standards.
Over the years, it has issued guidance to improve industry practices, which this consultation aims to formalise.
“Now, with more authority to set rules over payments firms, the FCA aims to use the repeal of existing safeguarding requirements in legislation to replace them with its own rules,” he said.
“Some of these new rules will take effect sooner, aiming to drive up standards while ensuring a smooth transition."
Part of a larger whole
Speaking to Vixio, Omar Salem, a partner at Fox Williams, said that “what is most significant is what’s missing.”
“The FCA’s consultation is just one piece of the puzzle in relation to safeguarding,” he explained.
For example, there is also HM Treasury's review of Payment Services and Electronic Money Regulations, closed in April 2023, which has an outcome still pending, as well as a promised review of insolvency rules for payment firms, due by July 2023, which is also delayed.
As a result, the FCA has proposed interim and final rules in the absence of HM Treasury's confirmed approach.
"This is an example of fragmented, not joined up, policy-making,” he said. “If a payments firm becomes insolvent then the FCA’s rules and insolvency legislation will interact to determine how funds are returned, but it seems that policy is being developed in silos.”
According to Salem, the result of this is a lack of a strategic approach, which means that the FCA is not really addressing some of the key drawbacks of the current safeguarding regime, including how long it takes for funds to be paid out to customers.
For example, if protected by the Financial Services Compensation Scheme, payouts are usually within seven working days. However, the FCA notes in its consultation that the average time to return funds in insolvency cases is two years.
“Waiting two years is a significant delay, and on top of that, administration fees will be deducted from the funds,” he said.
According to Salem, the current regime was designed for smaller payment and e-money firms with customers who used their accounts in a more limited way than now.
“People are now holding significantly more funds in these firms than before and using them for different things, such as receiving salaries or student loan payments, and paying mortgages or rent.”
Salem pointed out that this is why a strategic and comprehensive approach is needed to reconsider the overall regime, something that both the UK Payments Association and UK Finance suggested in their responses to HM Treasury’s PSRs consultation.
No easy thing
"Safeguarding is rarely easy because of the dynamic nature of payments and the multi-corridor, 24/7 nature of most businesses,” said Alison Donnelly, director at advisory firm fscom.
Donnelly pointed out that some firms in the sector have still not grasped how the rules and the FCA’s guidance apply to their business model.
She also noted that interpretations of key concepts, such as segregation on receipt, the segregation window, and internal as well as external reconciliations, have not been built into safeguarding arrangements from the ground up.
“Unlike Consumer Duty, which is a principle, the FCA intends to be as explicit and clear as possible about how safeguarding should be done, but the models are complex and costs will increase for those who have to overhaul their arrangements and increase liquidity,” she said.
“This is a low-margin sector, and with other costs rising, navigating these requirements will become even more complicated."
Max Savoie, partner at Sidley Austin, agreed, pointing out that there is a “substantial set of reforms on the table”, and that the draft rules will require firms to implement changes.
According to Savoie, the proposed rules relating to diversification of how firms safeguard funds could be a significant development.
“While the FCA’s existing guidance includes provisions on diversification, their inclusion in the new rules raises questions about whether the FCA will take a more proactive approach to their supervision and enforcement,” he said.
For example, if the FCA expects firms to diversify safeguarding methods, it could create significant operational — particularly with the added complexity and cost of managing multiple bank accounts or insuring funds.
Savoie added that the requirement for relevant funds to be received directly into a relevant funds bank account will pose challenges for some firms that currently receive customer funds into other accounts and sweep those funds into safeguarding accounts on an intra-day basis.
“There are often very good reasons for firms to operate in that way, particularly for firms handling cross-border payments in multiple currencies.”
“While the draft rules include certain limited exemptions from this requirement, if those are not broadened, this rule could create serious operational issues for some firms, which may not be in the interests of end-users,” he cautioned.
In addition, the requirement for agents and distributors to maintain a relevant funds bank account may create liquidity issues for firms, as existing business models often rely on agents or distributors to segregate funds.
“If firms must also safeguard the same amounts in their own accounts, they will effectively be required to hold additional funds beyond those received from or for their customers,” said Savoie.
The lawyer suggested that this could be problematic, as it means such firms will need to summon additional liquidity.
“The requirements may also have the unintended adverse consequence of forcing some firms to rely on external credit to fund their relevant funds bank account, which may increase their risk of insolvency in the event of financial stress.”
Moving forward
As the payments and e-money sector moves into a new territory, the “materiality of the proposed changes will vary”, fscom's Donnelly said.
“Firms that have been well-advised and compliant with the existing regime will not be significantly impacted by the majority of proposed changes, but there are some proposed changes that have significant impact,” she said.
For example, firms will need to deposit relevant funds into a safeguarding account by pre-D+1, removing the segregation window, and appoint a statutory auditor for annual safeguarding audits.
“The former will require additional funds for those impacted and the latter will be a significant additional cost for all."
"This has been anticipated for over a year, so there are few surprises,” Treacy pointed out, adding that the proposals align closely with what the FCA already imposes on other institutions, such as client money rules, with key points from these client asset sourcebook (CASS) rules being replicated for payments firms.
Anticipated themes, but significant risks
According to Treacy, the themes of the consultation were expected.
“For firms that are confident that they already comply with FCA guidance, there should not be too much of a gap between current practices and the new requirements. The FCA is embedding best practices into its rulebook, so firms meeting these high standards should go into this process with confidence.”
However, he added that firms that have already identified shortcomings with their safeguarding compliance will likely be more concerned, as the new rules will be stricter and more heavily enforced.
“As the guidance turns into prescriptive rules, it will bring increased legal and regulatory risks for firms."
Savoie agreed that there could be risks for firms, such as de-risking problems with credit institutions, as has been an issue across Europe since the rise of payments and e-money firms, which need to safeguard funds with sometimes reluctant banks.
“Some aspects of the reforms may incentivise banks to adopt a more conservative approach, particularly regarding statutory trusts, which could impact how they hold funds and their risk exposure,” he said.
Savoie added that in light of certain non-bank payment service provider insolvencies, there are still concerns among banks regarding their exposure when servicing certain non-bank payment service providers.
“If safeguarding measures are not implemented properly by a non-bank payment service provider, this can pose a risk to the bank.”
“Given that the safeguarding rules are set to become more prescriptive, and in certain areas more restrictive, there is a potential risk that this could shift the balance of incentives, making it more difficult for non-bank payment service providers to access bank accounts,” he said.
Feedback on the consultation is open until December 17, 2024, with final rules expected in early 2025 and a six-month transition period for implementation.
