FCA reforms clarify e-money customer fund protection requirements

The rapid rise in popularity of non-traditional financial institutions in recent years has exposed the gaps in the current regulatory framework that governs how payment and e-money firms protect customer funds.

There are approximately 1,280 payment firms in the UK covering payments, e-money and open banking. Some of these firms have entered insolvency processes in recent years, and there have been multiple examples of poor practices around safeguarding of customer funds, leading to insolvency practitioners having to carry out complex and lengthy reconciliation exercises following their appointment in order to identify and distribute these.

In response, the Financial Conduct Authority (FCA) recently issued a consultation paper (259 pages / 2.38 MB) proposing changes to the safeguarding regime for such firms, in a significant development for insolvency practitioners. The new rules should result in better practices across the market.

The proposed rules will apply to:

• authorised payment institutions (APIs) – firms authorised to provide payment services
• e-money institutions (EMIs) – firms that issue electronic money, which can be stored on a pre-paid card, in an online account or wallet
• small e-money institutions – these small EMIs cannot provide account information or payment initiation services and have limits on the amount of funds that they can handle
• small payment institutions – these provide payment services similar to those offered by APIs, but on a smaller scale and for this reason can opt-in to the safeguarding requirements on a voluntary basis
• credit institutions, credit unions and municipal banks that issue e-money in the UK.

The current regulatory regime applicable to these firms includes the Electronic Money Regulations 2011 and the Payment Servies Regulations 2017. The firms described above are not authorised to hold deposits for their customers, and instead the regime requires them to safeguard money received in exchange for e-money or for the purpose of executing a payment transaction via the “segregation” or “insurance” method. “Segregation” is to place the funds in a separate account or to invest them in secure, liquid, low risk assets kept in a separate account to the firm’s general funds while “insurance” is to ensure the funds are covered by a relevant insurance policy or guarantee.

Historically, it was the position of the FCA that firms that followed the “segregation” method and held safeguarded funds on trust for their customers. However, this position was not tested by the courts until 2022 in the administration of Ipagoo, which was an EMI. The administrators of Ipagoo applied to the court for directions as to how to distribute funds under their control after it had become apparent that Ipagoo had, in breach of the Electronic Money Regulations (EMRs), failed to properly safeguard its customers’ money.

On appeal from the FCA, the court considered two questions. First, whether the EMRs create a statutory trust over safeguarded funds and second, if customer funds were only partially safeguarded, or not safeguarded at all, whether customer priority claims extend to the general estate of the administration.

The court ruled that there was no statutory trust over customer funds, and instead, that customers had priority claims over the general asset pool equal to the amount which should have been safeguarded. This decision was upheld in the context of payment firms and the Payment Services Regulations (PSRs).

The FCA has since argued that the judgments caused ambiguity, particularly in circumstances where a shortfall arises between safeguarded funds and the claims of customers – by way of an example, whether the “super priority” afforded to customers trump the claim of a fixed charge holder. As it stands, there is uncertainty at law.

The FCA is attempting to provide clarity through its proposed changes, which would come into effect in two stages – the interim stage and the end stage. The interim stage aims to enhance compliance with current regulations and improve record-keeping.

In the interim stage, the proposed rules would include requirements to maintain clear and comprehensive records so that an insolvency practitioner could achieve a timely return of funds to customers upon appointment. Firms would be obliged to perform daily reconciliation of monies paid by customers against safeguarded funds, with any discrepancies between those amounts reported promptly to the FCA. The rules also include a need to strengthen safeguarding requirements, with payment firms being asked to enhance due diligence of third-party providers and to ensure their approach is appropriately diversified.

In the end state, the FCA would introduce an entirely new regime, which would involve the replacement of the safeguarding rules under the PSRs and EMRs with the rules in the CASS and SUP Sourcebooks of the FCA Handbook. It aims to create a trust through new legislation, this would be a statutory trust. The statutory trust would be over customer funds, the assets in which those funds are invested, any insurance proceeds and payable instruments received by firms for the execution of a payment transaction or purchase of electronic money.

For firms that safeguard using the “segregation” method, money received by customers will need to be paid directly into a designated account which is kept separate from any other services offered by the firm. Certain permissions from customers will be necessary before any of the segregated funds are invested. Under the current rules, customer money can be held in an account other than the designated safeguarding account until the end of the business day following the day of receipt.

The aim of these changes is to avoid the need to top-up safeguarded funds from the general asset pool in an insolvency scenario.

If followed by payment and e-money firms, the proposed rules should make it easier for appointed insolvency practitioners to identify and promptly distribute customer funds.

While the new rules should be welcomed, there will inevitably be a number of firms that enter into insolvency processes where funds have not been properly safeguarded, particularly those that utilise those funds to make non-cash investments.

The statutory trust that is intended to be imposed by the end state would widen the scope of assets over which customers of the firm have priority and reduce the scope of assets over which other creditors of the firm have priority. This is likely to lead to lesser realisations for secured creditors, preferential creditors such as HM Revenue and Customs and employees, and trade creditors. An insolvency practitioner is entitled to deduct from customer assets their costs in distributing such assets.

More broadly, the end-state proposal to create a statutory trust over customer funds, will result in APIs and EMIs acting as trustees over those funds. As trustee, APIs and EMIs will have well-established fiduciary duties, such as acting in the best interests of the beneficiaries. This will enhance consumer protection, giving customers the ability to file claims against APIs or EMIs if they can show that the firm failed to act in their best interest or if there was a conflict of interest between the firm's duty to its customers and its own interests regarding the relevant funds.

The deadline to provide the FCA with responses to the consultation paper is 17 December.

Co-written by Emily Shaw and Ann Zheng of Pinsent Masons.