Changes to the safeguarding regime for payments and e-money firms: Strengthening elements of safeguarding practices – segregation of relevant funds

In September 2024, the FCA released a consultation paper which proposes significant enhancements to the safeguarding rules for payments and e-money firms. The new rules are designed to protect customers of these firms, particularly as a result of an insolvency event.

In this update, we cover the proposed changes, both at the interim and end state, that seek to strengthen the procedures over the segregation of relevant funds – a key area of the safeguarding rules.

Current safeguarding requirements

Under the current safeguarding requirements in the Payment Services Regulations (PSRs) and the Electronic Money Regulations (EMRs), firms are allowed to safeguard relevant funds by either segregating them or protecting them through an insurance policy or comparable guarantee. Firms can use both methods simultaneously.

The segregation route

When safeguarding through the segregation route, firms must keep the relevant funds segregated from any other funds they hold. This means holding the relevant funds in an account separate from accounts used to hold the firm’s own money when held electronically. For relevant funds held physically such as through bank notes and coins, the funds should be physically segregated. The requirement to segregate in this manner starts from the moment the funds are received, and continues until the safeguarding obligation ends, which is typically once the funds have been transferred to another party.

Relevant funds still held by the firm at the end of the business day after the day of receipt (D+1), must be placed into a designated safeguarding account with an authorised credit institution or the Bank of England. Alternatively, the firm can invest these funds into secure, liquid assets. 

Under the current rules, payments firms can hold relevant funds in accounts that are not designated safeguarding accounts provided by authorised credit institutions before the end of D+1. For example, a firm may keep such funds in transactional accounts that are held with electronic money firms, or place them in an account that is not a safeguarding account held with an authorised credit institution.

This poses the following risks:

• Relevant funds not held with authorised credit institutions, e.g. those held with electronic money  firms, are at a relatively higher risk.

This is because  electronic money firms are not covered by depositor protection under the Financial Services Compensation Scheme(FSCS). This means that should an insolvency event occur and the firm does not have sufficient funds held in its safeguarding accounts, customers of the firm may lose their funds as there is no protection under the FSCS. Since electronic money firms have significantly lower regulatory capital requirements than authorised credit institutions, this makes the credit  risk for payments firms using e-money firms for segregation much higher.  

• Payment and e-money firms can have their relevant funds held by another payments firm, or there could be a chain of firms holding relevant funds on behalf of other firms.

In such an environment, it becomes very likely that if one payments firm fails, all the other firms linked to that firm will also be affected. Given that payments firms in general have a higher risk of failure compared to authorised credit institutions, this increases the risk of loss of funds under the current rules.

• There is no requirement for such accounts to be named in a way that shows they are safeguarding accounts, making the funds less likely to be promptly identified as relevant funds by an insolvency practitioner if the firm fails.

This will most likely result in delays in returning funds to customers in the event of an insolvency.

• The current rules do not prohibit third parties from having an interest in, or rights over, relevant funds held in accounts with electronic money institutions or non- safeguarding accounts with credit institutions during the D + 1 period. This makes it difficult for an insolvency practitioner to return these funds to customers of the firm.   

Proposals for the interim state

Exercising due skill, care and diligence when appointing third parties

The proposed rules will require firms to exercise due skill, care and diligence when appointing third parties that:

• provide accounts where relevant funds or assets are either received or deposited
• manage relevant assets
• or provide insurance or comparable guarantees.

The current rules only require the exercise of due skill care and diligence when appointing credit institutions. The proposed rules extend this requirement to third parties and so will cover electronic money firms.

Periodic reviews of the use of third parties

Firms will be required to periodically review their use of these third parties. Such reviews are necessary to ensure the firm is able to identify changes in the risk associated with partnering with the third party since their initial appointment. Firms will need to carry out such reviews at least annually but also whenever the firm identifies the need to do so, e.g. where the firm believes there has been a change in the associated risk.

Consider diversification

There will be a requirement for firms to consider whether to diversify their use of these third parties. This is similar to the current rules and discourages firms from concentrating their risk in one or a few third parties. Diversification will have the impact of spreading the risk in the event of a third party failing.

Identification of relevant funds held with third parties

Currently, where relevant funds are held with authorised credit institutions, the designated accounts are named in a manner that helps identify that these are relevant funds. The new rules propose that firms should consider the use of the word ‘safeguarding’ in the naming of accounts for relevant funds held with all third parties wherever possible. This differs from the current rules and will make it easier for an insolvency practitioner to identify safeguarded funds during an insolvency event. Consequently, this should also mean less time will be involved in returning relevant funds to customers.

Use of acknowledgement letters

An acknowledgement letter is a letter from an authorised credit institution, authorised custodian or other third party stating that they have no interest in (e.g. a charge), recourse against, or right (e.g. a right of set off) over the relevant funds or assets in the segregated account that is used for holding funds. The use of acknowledgement letters will become mandatory for both segregated accounts used during the D+ 1 period and safeguarding accounts. Under the current rules, firms using banks or authorised custodians to hold relevant funds have the option to either have an acknowledgment letter in place or to  demonstrate, through other means, that funds held with the bank or custodian were safeguarded. There was no requirement for firms using segregated accounts to hold relevant funds during the D + 1 period to obtain an acknowledgement letter.  

Prompt allocation of relevant funds to individual customers

Firms will be required to promptly allocate relevant funds to individual consumers. This requirement is similar to the current rules which require firms to “use reasonable endeavours to identify the customer to whom the funds relate”. This places a burden on firms to strive to identify the customer that any relevant funds relate to without delay, rather than keeping them as unallocated relevant funds. In some cases, it may be necessary for the firm to return such funds to the person or the institution that has sent the funds. This rule underpins the FCA’s requirement to make it easy for an insolvency practitioner to be able to identify the specific customers that relevant funds relate to in a short space of time for prompt return of such funds.

Proposals for the end state

Under the proposed rules, firms applying the segregation method will be required to receive relevant funds directly into a designated safeguarding account with an approved bank or the Bank of England. This significant change will reduce the risk across the sector as relevant funds will be held in accounts that offer the maximum protection as soon as they are received. This means that firms will no longer be able to deposit relevant funds in segregated accounts  that are not safeguarding accounts.

There will be exceptions 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
• the firm receives relevant funds as cash.

These exceptions are intended to help firms that would face operational challenges in receiving relevant funds directly into a designated safeguarding account. Once relevant funds have been received, they would need to be deposited into designated safeguarding accounts by the end of the business day after the day they were received (D+1), similar to the current requirements under the EMRs and PSRs.

The option in the current PSRs and EMRs that allow payments firms to have designated safeguarding accounts with approved foreign credit institutions will be retained. This includes those in a member state of the Organisation for Economic Co-operation and Development.

Acknowledgement letters

The wording in the current acknowledgement letter templates will be updated to refer to the statutory trust over relevant funds and assets. In other words, the acknowledgement letter will now have to expressly state that the funds are being held under trust to avoid any confusion on the occurrence of an insolvency event. This amendment to the wording in the template is meant to address the issues raised in the Ipagoo LLP court case, where it was not clear to the insolvency practitioner whether such funds should be included in the general pool of funds to pay the firm’s own creditors. In addition, the new rules will not allow firms to use accounts for holding relevant funds when an acknowledgement letter has not been obtained. 

Prudent segregation

New prudent segregation rules will be introduced to allow firms to pay their own funds into designated safeguarding accounts to prevent a shortfall in relevant funds. Such funds will be treated as relevant funds and the statutory trust, record-keeping, reconciliation, and governance requirements will apply.

Treatment of unidentified receipts of funds

Firms will be allowed to treat funds as relevant funds where they are unable to identify whether the received funds belong to their consumers or to the firm itself. The current rules do not provide specific guidance on how such funds are to be treated. The proposed rules will require firms to record funds, which the firm is not immediately able to identify as relevant funds in its books as “unidentified relevant funds” while it investigates whether the funds are relevant funds or not.

How we can help

At PKF, we are aware that these proposals will have a significant impact on payments and electronic (e-money) firms and are here to help. If you have any queries on the impact of new regime on your firm or safeguarding in general, then please contact Azhar Rana or Knowledge Muchemwa.

About our Payment Services team

Our specialist Payment Services team advise money remittance, payment processing and electronic money firms across the sector. Our services include statutory audit, financial reporting, regulatory advice and assurance, safeguarding audits, external finance and transactional support, as well as structuring, tax compliance and advice on a range of complex issues.

Read our series of articles on the upcoming changes to the safeguarding regime for payment services and electronic money firms.