Changing Focus on CASS

CASS appears to have quickly dominated dominated the regulatory agenda in the UK’s investment industry. I’m sure many executive boards feel frustrated at the amount of time taken up in discussing just this one aspect of regulation whilst also bemoaning the lack of return on investment.

In other words, the more money spent on CASS compliance the more issues appear to be found.

This article examines the current CASS compliance landscape and proposes a future in which the basics of client asset protection become the focus.

The FRC CASS Assurance Standard

One of the unique aspects of CASS compliance is the requirement for an annual independent audit for all firms holding custody assets or client money (“the CASS audit”).

In November 2015, the Financial Reporting Council (“FRC”), the auditing profession’s own regulator, issued its standard for “Providing Assurance on Client Assets to the Financial Conduct Authority” (“Client Asset Assurance Standard” or “the Standard”). The key objectives of the Client Asset Assurance Standard are to:

• Improve the quality of CASS audits and other CASS assurance engagements
• Adequately support and challenge CASS auditors when undertaking CASS assurance engagements
• Support the objectives of the FCA’s Client Asset Regime
• Manage the expectations of the management of firms that hold client assets and Third party administrators when a CASS auditor is engaged to provide assurance to the FCA on client assets that they handle or account for
• Support the effective training of CASS auditors by both the accounting bodies and other training organisations
• Help to establish realistic expectations regarding the integrity of the UK CASS regime with the beneficial owners of client assets
• Underpin the effectiveness of the FRC’s enforcement and disciplinary activities with respect to CASS assurance engagements

In reality the Client Asset Assurance Standard was a response to historic criticism of the performance of auditors in delivering CASS audits which, in some cases, led to the FRC imposing fines on the audit firm itself. The new Standard laid out around 100 pages of detailed requirements and expectations for auditors and took effect for reporting periods commencing on 1 January 2016 giving auditors and the firms they audit very little time to prepare.

"The cost of CASS audits has also risen considerably and in some cases exceeds the cost of the financial statement audit for the firm in question".

Almost three years later, the effect of the Standard on the investment industry has been dramatic, perhaps even greater than the overhaul of the CASS rules which preceeded it in 2015. The cost of CASS audits has also risen considerably and in some cases exceeds the cost of the financial statement audit for the firm in question. Why has this been the case?

To some extent, it highlights the inconsistent and in some cases “light touch” approach to CASS audits which auditors had adopted previously. It may also point to the reliance that many firms may have historically placed on their auditors to identify CASS compliance issues rather than implementing effective controls and assurance frameworks themselves.

Nevertheless, the new Standard implicitly laid out some specific requirements for firms including:

• Documenting in detail how the CASS rules impact the firm, which has become commonly known as “rules mapping”.
• Documenting how applicable CASS rules are complied through the operation of processes and controls and demonstrating how effectively these controls have operated throughout the period being audited.
• Documenting why certain CASS rules are not applicable to the firm.

Whilst the effort required to meet these requirements may have been considerable for some firms, it cannot be disputed that these are sensible things to have in place and indeed should form the basis of any effective CASS compliance approach.

What may be disputed is the focus auditors have placed on these documents themselves rather than, for instance, the effectiveness of the most critical CASS controls (which I will talk about later in this article). An example of this from my own experience was when I was asked why the firm I was the CASS Oversight Officer for, had not documented why the rules in CASS 7.10.28 relating to Solicitors were not deemed applicable. My response was simply to point out that the firm had been a bank for 500 years and not a firm of solicitors!

Overall, the Client Asset Assurance Standard and the new CASS audit regime which it has brought into being has resulted in an unprecedented and granular focus on CASS within many firms which is set to continue.

 Pre-funding or prudent segregation?

As well as coping with the new CASS audit regime, investment firms have had to deal with the aftermath of the CASS rule changes in 2015.

One of the key changes was the focus on mitigating intra day client money shortfalls, or “using Peter’s money to pay Paul” as the FCA put it. In practice, firms’ responses to this have differed widely and have no doubt been hampered by a lack of clarity on the rules themselves.

"If the firm is using its own money to fund market settlement instead of clients’ money, would it not be sensible to have that documented as a policy approved by the firm’s board"?

One area in particular which has created much heated debate is the funding of market trade settlements by the firm ahead of corresponding client settlements. Should this be considered pre-funding or prudent segregation?

I have been present at industry fora on several occasions when this subject has been discussed at length without really tackling the key issues. For example, if the firm is using its own money to fund market settlement instead of clients’ money, would it not be sensible to have that documented as a policy approved by the firm’s board? Would it not be sensible to keep records of such funding? Would it not be appropriate to return funding to the firm when settlement is received from the client? For me, the answer to all of these questions is “yes” but I don’t know whether that represents pre-funding or prudent settlement and quite frankly I’m not sure that it matters.

Outsourcing oversight

On 5 October 2016, the FCA announced that it had fined Aviva Pension Trustees UK Limited and Aviva Wrap UK Limited (“Aviva”) £8.25 million for failings in its oversight of outsourced providers (“third party administrators” or “TPAs”) in relation to the protection of client assets.

In its final notice the FCA highlighted that a heightened CASS compliance risk may arise from outsourcing and that a firm outsourcing CASS functions must ensure that it has adequate CASS skills, expertise and resources to carry out effective oversight of the TPA. The FCA’s specific findings included informality and inconsistency in the checks undertaken by Aviva in respect of reconciliation processes performed by its TPA and a failure to include resolution dates for actions in MI provided to senior management.

"Some firms may feel that, as a result of oversight resource expectations, outsourcing is no longer economically viable".

This fine highlights the focus placed by the FCA over the last 3 years on outsourced CASS related processes (eg. dealing, settlement, record keeping and reconciliations). Indeed, two of the largest TPAs in the investment industry and their many client firms have been subject to deep FCA investigations involving thousands of hours of senior management and advisor time and several £ millions in cost. The general conclusion from the FCA’s point of view is that firms outsourcing CASS related processes are not doing enough or allocating insufficient resource to the monitoring and oversight of their TPAs.

The impact is that some firms may feel that, as a result of oversight resource expectations, outsourcing is no longer economically viable. This in turn could have a disruptive effect on the investment industry as a whole.

Settled or traded custody position reconciliations?

Perhaps the hottest debate in the world of CASS at the moment is whether custody records and reconciliations should be based on settled or traded positions. It now appears that the FCA have decreed, and without conducting due process such as consultation, that firms holding custody assets on behalf of clients should maintain records and perform reconciliations based on settled positions.

The problem is that the majority of firms use traded positions to maintain records and perform reconciliations instead. And for good reason – reconciling traded positions provides the earliest possible indication of any trade matching and subsequent settlement issues which has to be good for the operation of markets. It also acknowledges the fact that trades are binding commitments and effective records and controls are generally in place over the settlement process.

The implications of the FCA’s “settled not traded” decree are huge for the investment industry. In particular, major changes would be required to systems and market data transmission and this would all need to be properly co-ordinated industry wide, something which is probably unprecedented. And the net benefit of all of this? Even the FCA have struggled to articulate that.

Back to basics…..

There is no disputing the fact that many individuals responsible for CASS compliance within investment firms have been overwhelmed over the last three years, not just by the Client Asset Assurance Standard but by a number of “hot topics” which consume time and bandwidth. However, perhaps it’s now time to re-focus on the fundamentals of client asset protection.

"Most firms can improve the accuracy and timeliness of client assets records if they are truly honest with themselves".

What do I mean? Well let’s start by asking ourselves the question of when have clients actually suffered loss of their assets historically? The answer will probably be where a firm has illegally plundered client assets for its own enrichment (or survival) or otherwise poor record keeping. Whilst no amount of effort can stop malicious intent of personal or corporate enrichment, most firms can improve the accuracy and timeliness of client assets records if they are truly honest with themselves.

Let’s start by looking at the custody and client money reconciliations which are performed (in most cases) every day. Why are there breaks? Is it down to errors or timing differences on the firm’s behalf or the 3^rd party holding the assets and, if the 3^rd party is to blame, wasn’t it the firm that appointed the 3^rd party? And do timing differences matter? Of course they do, especially if the firm was to become insolvent.

If firms are to be truly CASS compliant then the reconciliation process needs to extend beyond simply the identification of breaks into effective root cause analysis and remedial action, including rapid rectification of process and system issues.

And there are issues which need to be addressed by the industry working together as a whole, including improving data exchange to support real time record keeping, reducing the level of failed market settlements through better management of positions, increasing the speed of stock transfer processing, etc.

All of this will take time of course but there needs to be effort towards, and tangible measurement of, continuous improvement with a common goal of strengthening client asset protection.

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