Treatment of shortfalls - CASS Provision

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CASS Anatomy

6.6.54 in a Nutshell (CASS edition)

CASS 6.6.54R applies where there is an unresolved shortfall. Until it is resolved the firm must:

If the shortfall is a third party’s fault the firm must take all reasonable steps to quickly resolve the situation. Until it is resolved the firm must consider whether it should notify the affected clients, and may take steps for the treatment of shortfalls until that discrepancy is resolved.

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IMPORTANT: CASS changed quite a bit after MiFID II. This resource therefore may well be out of date, even if it was accurate once, which it might not have been.

This is an article about the FCA’s custody and client money rules — client assets — and is fondly known by its chapter in the FCA Sourcebook Table of Contents | 1 | 1A | 3 | 5 | 6 (custody rules) | 7 (client money rules) | 7A | 8 | 9 (PBDA) | 10

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The equivalent provision under CASS 7 (for client money discrepancies) is CASS 7.15.29
The famous CASS shortfalls provision: should you have some settlement fails into your custody business — quite likely, if you offer contractual settlement — such that at any time you hold fewer custody assets than your records suggest you ought to, you must put aside your owncash or assets to cover that shortfall, and mark it to market until the shortfall is resolved, to mitigate your client’s exposure.

Yours truly reads that to mean you cannot simply put aside some of your own assets and grant a security interest over those assets in favour of clients, thereby maintaining legal ownership of them, even though that is plainly the most sensible way to resolve the implied credit risk to yourself presented by a temporary shortfall which you expect quickly to resolve. No, you must actually pass title to those assets outright to the clients, but somehow confect an unspecified reversionary right to the assets which, in the theory, you no longer own, should the happy day come — expected to be tomorrow — when the shortfall is resolved.

Giving clients outright ownership of assets they didn’t ask for and didn’t really want seems an odd tool to pick from the box, but there you have it. Life wasn’t meant to be easy.

Here is FCA Policy Statement PS14/9, which explains much of the great CASS rewrite.

Upon a shortfall arising a custodian or prime broker must set aside “applicable assets” in an omnibus custody account to cover the potential loss each client would suffer if the custodian were to go insolvent before resolving the shortfall.

And this could happen how, exactly?

Given typical omnibus structure where:

  • a counterparty to a hedge fund fails to settle an open trade into that hedge fund’s prime broker; while simultaneously ...
  • the prime broker delivers a quantity of the same security to the market on behalf of a different customer, relying to do so on that first purchase trade settling as intended ...
  • there may be a temporary shortfall in the prime broker’s omnibus client custody account, pending resolution of the fail.

Usually the fail will be quickly remedied, but if it isn’t the prime broker must reduce its customers’ credit exposure as a result of the shortfall. It does this by putting its own assets (or money) aside, on trust, for the affected clients.

Qualifying money market funds to fulfill the shortfall?

Setting aside cash with client money banks can be expensive init so vigilant prime brokers may wish to deploy money market funds. If they wish to do this as client money under CASS 7 they must comply with the particular rules as to qualifying money market funds, including (cassprov|7.13.28}} (under which the client has the right to decline such an arrangement).

You could apply money market funds to plug a shortfall without relying on the client money rules and all this “qualifying” malarkey: CASS 6.6.54 allows a custodian to set aside its own assets, so one could deposit money market funds as custody under CASS 6, and would not be subject to the qualifying money market funds regime which only applies under CASS 7.

Careful when mixing client money and client assets

Client money behaves differently to client assets when entities start going bust. In a nutshell, unless you have set up separate pools, client money losses are mutualised across all clients benefiting from client money protection; client asset losses are (a) a lot less likely—even if your custodian has blown up you should still get all your custody assets back (unless there is a shortfall!), and (b) even where you don’t, and the assets have somehow been lost or stolen, losses are mutualised across only those clients who had an interest in the particular ISIN which has been lost.

Another weird outcome is that if you have posted client money against a custody shortfall, and there is a secondary pooling event amongst your client money banks, that shortfall cash will be mutualised across all beneficiaries of client money across your organisation—it isn’t pegged away and held for the poor punter suffering the shortfall.

But sir sir what about CASS 6.4.1?

Warning: tedious passage approaching
The Jolly Contrarian’s view is that shortfalls arising through settlement failures into an omnibus account are covered by CASS 6.6.54 and are not an example of “omnibus use” in 6.4.1(2) and therefore do not require a client’s express prior consent:

  • Shortfalls arise as a result of inbound settlement failures. There is no question of using one clients assets (even inadvertently) to satisfy another’s obligations. The custodian correctly transfers out the account a client’s own assets in accordance with that client’s instructions. A subsequent settlement failure into the account results in the omnibus account being underfunded — there is a “shortfall”. This is not in the nature of deliberate, or even “inadvertent” use of client assets: it is (instead) covered by the Shortfalls language introduced after PS14/9 by CASS 6.6.54 R.
  • As shortfalls, they have been subject to comprehensive review (PS14/9) and detailed specific provisions (CASS 6.6.54R) which do not require prior express consent.
  • The “express prior consent” requirement of 6.4.1 applies to all clients (not just retail ones – simply the earlier text specified precisely how that prior express consent was to be evidenced for retail clients) has substantively been in place since 2007 (MiFID I) and was not materially been changed either by PS 14/9 or MiFID II.
  • The meaning of “prior express consent[1] in the context of MiFID was discussed by then regulator CESR in 2007 a discussion paper (albeit in the context of best execution) and said: “Where MiFID requires “prior express consent”, CESR considers that this entails an actual demonstration of consent by the client which may be provided by signature in writing or an equivalent means (electronic signature), by a click on a web page or orally by telephone or in person, with appropriate record keeping in each case.”

See also

  1. Is it the same thing as express prior consent though???