56. Given the volume of client assets held with unrelated custodians, it is of utmost importance that attention be paid to selecting appropriate custodians. Failure to do so may reduce the protection available to client assets where they are required to be held with third parties. For example, if an authorised firm has a high credit rating, holding its clients' assets with a poorly rated third party may effectively expose them to increased risk. In addition, the consequences of selecting particular types of third party should be made clear. For example, if the third party is a bank, it is important to note that different compensation arrangements might apply on its default and this could impact either the firm or the customer, depending on the jurisdiction, particularly as banking industry compensation schemes may cover just money, not securities.

Recommendation 6:

Regulatory authorities which require the use of third parties to hold client assets should, where appropriate to their client asset protection regimes, set criteria for the selection of such custodians with the objective that the level of protection enjoyed by clients should be maintained, if not enhanced, and the nature of any risks adequately disclosed.

THE USE OF RELATED FIRMS AS CUSTODIANS

57. While there is a widespread commercial practice by investment firms of using related parties for the safekeeping of client assets, the risk to the clients through intra-group contagion can be increased. The default of an investment firm is rendered much more likely, for example, by the default of a related custodian bank than by an independent third party. It is important for clear criteria to be set for permitting the practice of using related parties for the safekeeping of client assets. This is particularly relevant when the regulatory regime for client asset protection requires that assets be held with a separate custodian.

Recommendation 7:

Regulatory authorities should carefully consider the circumstances in which authorised firms may be permitted to meet the requirements of a client asset protection regime by holding client assets with a related custodian. Where they are, there should be clearly defined criteria for the practice of selecting those related third parties. These should include clear disclosure of any different risks to clients, particularly the implications, if any, for compensation schemes.

RESPONSIBILITY FOR THIRD PARTIES

58. Although it is increasingly the case that clients elect to use a specific third party for the deposit of funds or securities, it is still common for an investment firm to make that choice. Concern has recently been expressed about the lack of formal responsibility on the part of investment firms for the acts or omissions of their own nominee companies, and custodians and about the level of due diligence which should be exercised by investment firms in the choice and ongoing monitoring of such third parties. The issues here relate to the need for transparency of the risks associated with holding assets in different jurisdictions, the need to determine who carries those risks (the investors, the firm or the custodian) and the need to determine liability in the event of the default of the custodian.

Recommendation 8:

Regulatory authorities should as far as possible decide on and clarify the extent to which investment firms should accept responsibility for the choice and conduct of banks and custodians which hold client assets on their behalf and the extent to which the client will be liable on the default of that third party. If responsibility is not accepted by the investment firm, that fact should be made clear in client documentation.

DEALING THROUGH UNRELATED FIRMS

59. Much securities and derivatives business involves a number of parties to a chain of transactions in order for a client's instructions to be fulfilled. For example, a client wishing to buy securities might need to use a broker through which to purchase or sell securities or to gain access to an exchange member for dealing in derivatives. In dealing with a chain of firms, clients run the risk that any assets passed to an investment firm might lose the character of client assets if passed to an investment firm which is not subject to the type of rules envisaged by this paper. The integrity of client assets is only preserved if they are passed to a firm which itself extends broadly similar protection for client assets. This can only be achieved if client assets are clearly identified as such when passed to another firm. In this context, particular attention should be paid to the regulatory arrangements which apply when a firm receives client assets from another market professional. If such market professionals are not afforded client asset protection in their own right, retail clients dealing through such professionals might not be protected.

Recommendation 9:

Regulatory authorities should ensure that, where a firm deals with an unrelated firm within their jurisdiction, client assets are identified as such to that third party and equivalent protection is afforded to any such assets.

DEALING THROUGH RELATED FIRMS

60. The issues relating to dealing through a chain are exacerbated when parties in the chain are related firms. Client asset protection might be lost because a firm is not permitted to treat a related firm as a client for client asset protection purposes. For example, in some jurisdictions client assets received from related firms are treated as intra group balances and thus do not benefit from client asset protection arrangements. In addition, the risk to clients is different because of the likelihood of related parties becoming insolvent at the same time. Client assets may, therefore, be lost wherever they are held in the chain.

Recommendation 10:

Regulatory authorities should ensure as far as practicable that where an investment firm deals through a chain of related parties within its jurisdiction client assets are separately identified from the proprietary assets of the group, and client asset protection arrangements available at the initial point of dealing are preserved throughout the chain.

CROSS-BORDER DEALINGS

61. When dealings involve assets crossing into other jurisdictions, additional risks arise for clients. The most important of these is the risk that assets passing from one jurisdiction to another might not be classified as client assets in the jurisdiction in which they are received, and will therefore not receive protection as client assets. Confusion can arise as to where the account resides and therefore which client asset protection regime applies.

62. There are positive advantages in reducing these risks by ensuring that client assets, where passed to another investment firm, are clearly identified as such. This process of seeking protection along a chain of cross-border transactions would, of course, be further facilitated if receiving firms were also required by their regulators to apply protection to any assets received from another investment firm bearing the identification as client assets.

Recommendation 11:

Regulatory authorities should:

i) consider extending client asset protection within their own jurisdiction to assets received by investment firms which are classified as client assets in the jurisdiction of the firm from which the assets are received; and

ii) should require that client assets are identified as such and appropriate protection is requested for them by firms in their jurisdiction when these assets are passed to firms in other jurisdictions.

OMNIBUS ACCOUNTS

63. For the purposes of this paper, an omnibus account is defined as an account held by an investment firm with a third party in which client assets are held in aggregate, rather than in individually designated accounts by client, but which nevertheless ensures that the assets are segregated from those of the firm. Omnibus accounts may play an important part in ensuring the effectiveness of market settlement systems, for example by enabling clearing houses in futures markets to guarantee fully the settlement of all trades, whether or not all clients have met their margin obligations. While the operation of an omnibus client account is effective in many jurisdictions, that is not universally the case. In certain countries, the liquidator of an investment firm does not have any obligation to treat the assets held in an omnibus client account as distinct from the firm's own assets if the client accounts remain designated in the name of the firm. In other words, an account entitled "XYZ and Co-Client Account" might be ineffective and only individually designated clients' accounts with the bank or custodian in question would be safeguarded in the event of the investment firm's (but not necessarily the bank's) default. Individually designated accounts offer the advantage of protecting clients not only from the default of the firm, but also from that of other clients. This distinction becomes particularly significant where a firm defaults because of losses arising on a particular client's account. Nevertheless, a number of mechanisms, such as the requirement to balance the omnibus account with clients' positions on a daily basis, can be employed to minimise the risks associated with such accounts.

Recommendation 12:

Regulatory authorities should consider measures to ensure that the use of omnibus accounts does not unduly prejudice the overall objectives of client asset protection within their jurisdictions. Investors should be made aware of the risks inherent in the use by authorised firms of omnibus accounts.

OPTING OUT

64. The importance of public policy has been mentioned several times in this paper and it is especially relevant to the issue of opting out of client asset protection. The question has arisen in many jurisdictions as to whether the same degree of protection should be provided for all types of investor - or indeed whether certain investors should be given protection at all. In jurisdictions where client asset protection is seen only as customer and not market protection, it is often accepted that clients who are market professionals require no client asset protection and that private or "retail" investors do. For other investors, perhaps more financially aware than many private investors, but without the detailed knowledge of the financial markets assumed on the part of market professionals, the question is less clear-cut. While the advantages of client asset protection are clear, it is worth outlining the advantages of permitting such investors to opt out. If an investment firm is not required to provide asset protection to professional clients, it can reduce its operational costs accordingly. As long as such cost reductions are reflected in reduced costs for investors, there can be a benefit as well as a cost attached to a lack of client asset protection. In order for investors to make such a cost / benefit decision, they must be adequately informed about the nature of the protections foregone, the nature and credit standing of the firm with which they are dealing and the bank with which their money will be deposited, the compensation arrangements applicable to their money and the relative cost considerations of opting out.

65. If client asset protection is deemed to be an important factor in overall market confidence and integrity and in facilitating the transition of funds from and the isolation of risk to a failing firm, some might argue that such protection should apply regardless of the status of the client. Others argue that it is important to analyse the different types of protection which are combined within an overall framework and to decide to apply such protections to different types of client as appropriate.

Recommendation 13:

Where regulatory authorities permit opting out of client asset protection, they should establish clear criteria under which particular classes of investors are able to do so and ensure that any material consequences of so doing are made clear to those investors.