At the core of electronic-money and payment institutions’ regulatory obligations is the safeguarding of “user funds”. At its essence and in broad terms, funds received and held by such institutions for the provision of payment services and issuance of e-money should be protected in such a way that the insolvency of those institutions does not result in losses for their customers. As we have advised clients through their application processes with the Central Bank of Ireland and further through ongoing supervisory arrangements, it is clear that safeguarding is of critical importance to the Central Bank. The potential for users to lose money as a result of an institution’s failure represents key financial and conduct risks, in particular in the context of the expansion of fintech offerings in Ireland.
‘Safeguarding’ is a broad term that, in simple terms, means ‘protection’. It is often used synonymously with concepts of ‘segregation’, but segregation is simply one form of safeguarding and increasingly we are seeing firms pursue other means of safeguarding. Whatever means is chosen, the Central Bank is consistent in its robust scrutiny of arrangements and firms must justify the adequacy of the chosen method.
The two regulations that govern electronic-money and payment institutions provide for similar safeguarding options, which can be summarised, broadly, as follows:
- Segregation: essentially, firms can choose to segregate, on a daily basis, user funds from their own corporate funds, with user funds held in a client-asset account with a third-party credit institution and where such an account is bankruptcy remote from the firm;
- Insurance / Guarantee: firms can choose to move their clients’ credit risk to a third-party credit institution or insurance undertaking by using the insurance / guarantee bond method – this ensures that any losses users would otherwise face are covered by a regulated bank or insurer; and
- Low-risk investment method: increasingly examined in the face of a challenging interest-rate environment, another potential option is to invest user funds in “secure and low-risk” assets (in the context of e-money) and “secure, liquid and low-risk” (in the context of payment services).
We discuss below the challenges and opportunities with each method.
Segregation is the most commonly utilised safeguarding method in the market. At its essence, it requires segregation of corporate and user funds. In effect, this requires a daily reconciliation process whereby user funds’ balances are isolated from corporate funds into a client asset account.
From our experience, the segregation method is most appropriate for organisations with reasonably sophisticated treasury operations. The treasury operation does not necessarily have to be at an institution level (group treasury functions can be utilised), but intra-group treasury outsourcing needs to be carried out within the context of a robust governance process with sufficient expertise and resources within the institution itself to oversee and control key elements of the process.
The challenges we have seen when guiding clients through this process include embedding rigorous reconciliation policies and procedures and demonstrating control and oversight among senior management of the institution. Critical to this process is to map out each conceivable payment flow to ensure the institution is capable of identifying and segregating user funds at any point in time. As alluded to above – and depending on the variability and complexity of the payment flows – such an operation appears to be suited to larger organisations with group treasury operations capable of ongoing cash monitoring and movement.
Relative to other methods, the Central Bank has significant experience in approving and supervising this method and while it is undoubtedly robust in its assessment process, its lack of novelty can lead to relatively-smooth approval process.
Insurance / Guarantee
A safeguarding method that is often more suitable for smaller organisations or organisations with less sophisticated treasury operations, another option is for user funds to be covered by an insurance policy or some other comparable guarantee issued by an insurance company or a credit institution. The core benefit of this is that, while a firm must always be in a position to identify its user funds’ balance, the obligation to segregate that balance from corporate funds on an ongoing basis does not apply. From a commercial perspective, this must be balanced by the cost associated with such an option (typically an insurance premium or other fee associated with the credit risk incurred by the third-party credit institution or insurance undertaking).
From regulatory-approval and oversight perspectives, we have seen a number of challenges with this method, including the need to:
- Demonstrate that internal procedures are sufficiently robust to ensure user funds’ balances are identifiable at all times;
- Ensure insurance agreements are linked to client-asset accounts already established such that any payment under insurance / guarantee agreements are distributed to such client asset accounts; and
- Demonstrate sufficient flexibility in the arrangements to ensure that coverage is adequate to insure or guarantee user funds, on the basis that typically insurance amounts are fixed and user funds are variable.
In these regards, it is essential to demonstrate the adequacy of internal procedures including showing internal ledger records demonstrating user funds’ exposure (including in stress (high-volume) scenarios), in order to give comfort to the regulator that the balance will be sufficient at all times. It is often prudent to create a buffer in the coverage level to be in excess of any anticipated user funds’ balance and have a pre-agreed arrangement with the relevant insurer / guarantor whereby coverage levels can be increased quickly should the need arise.
Typically, we have seen such arrangements be in the form of letters of credit from a credit institution or tripartite guarantee bonds involving a group entity and a third-party insurer.
Notwithstanding the challenging interest-rate environment that has prevailed in recent years and while increasingly examined for feasibility, the investment method has been elected least, in our experience. The obvious benefits associated with this method include the potential to minimise interest-rate losses and to distribute credit risk which may otherwise be concentrated in one or more credit institutions. At its simplest, the investment method permits – with Central Bank approval – the investment of user funds in very particular instruments, being certain assets associated with a low level of credit risk and UCITS funds which are comprised solely of such assets. The wording of the legislation has proved challenging, in particular because it is difficult to reconcile some of the wording within the legislation with even the lowest-risk instruments available on capital markets.
Other challenges associated with this method include demonstrating robust segregation and custodial operations and ensuring governance and control at a local level.
This is certainly an area where further dialogue and engagement with the regulator (and wider European Union authorities) is warranted to establish an investment standard acceptable for this purpose.