Almost two years since the fall of Lehman Brothers, the UK regulator is assessing proposals that could see a major shake up of the way prime brokers handle their clients' assets. Writer Charlie Corbett

WHAT IS IT?

A consultation paper released by the UK's Financial Services Authority (FSA) that proposes new rules on how financial institutions manage their holdings of client assets. If enforced, it could require all client-orientated businesses, in particular the UK's 35 or so prime brokers, to give daily reports to their clients about how their assets are being managed. Institutions will also be prohibited from putting more than 20% of clients' cash into affiliated banks.

WHO DREAMED IT UP?

This consultation is the result of a nightmare rather than a dream. The UK's regulator has been spurred into action by fall-out from the 2008 bankruptcy of Lehman Brothers. The FSA wants to put a structure in place that protects the clients of prime brokers in case of another Lehman-style collapse. According to the FSA, this is "the first of many" papers that are due to be released concerning treatment of client assets.

WHAT'S IN THE SMALL PRINT?

Given that this is just the start of a lengthy consultation process, which aims to cover all manner of former ills in client asset management, the small print is likely to be extensive. Here are some of the other proposals:

- The FSA will require that all prime brokerage agreements contain a disclosure annex that highlights relevant definitions and the contractual limit on re-hypothecation, which is the practice of taking title of client assets in order to reuse them for raising further funds.

- The FSA says it considers it unacceptable that a client's assets held with a custodian be subject to a lien exercised because of the debt of a completely unrelated group to the relevant custodian. This emerged as part of the Lehman insolvency and contributed to long delays in the insolvency practitioners' ability to recover assets from deposits not under their direct control.

- The FSA also wants firms to create a post and job title that allows for the employment of an individual to oversee, control and be responsible for client money and assets.

- The FSA will introduce a 'client money and assets return' ratio. This return will be reviewed and authorised on a monthly basis for medium and large firms and twice a year for small firms.

WHAT DOES THE INDUSTRY SAY?

To some extent the industry is still digesting the potential consequences of the FSA's proposals. On the whole, there is broad agreement that something needs to change if the industry is to avoid another Lehman-style debacle in the future. Others, however, take the view that this is just tinkering around the edges and could potentially lead to yet more onerous regulation that does not get to the heart of the problem. "As with many of the current proposals for regulatory reform in the finance sector, what we need is not new regulations but banks that comply with the existing regulations and regulators that are prepared to make the banks comply," says Michael Wainwright a partner at law firm Eversheds.

HOW MUCH WILL IT COST?

One potential cost could be a loss of liquidity in the system [see unintended consequences].

WHAT DO THE REGULATORS SAY?

Paul Sharma, FSA director of prudential policy, says the proposals are not just about Lehman, but aim to go far wider than that. "We are keen to learn the lessons of the recent crisis and this paper is the first of many that we will publish on the subject of client money and assets. It outlines a number of areas where we believe the client assets sourcebook can be strengthened to ensure greater protection of client assets and financial stability as a whole."

THE LAW OF UNINTENDED CONSEQUENCES

A recent International Monetary Fund working paper has warned that less re-hypothecation could lead to a loss of liquidity. "Following Lehman's bankruptcy the extent of re-hypothecation has declined substantially, in part because investment firms fear losing collateral if their prime broker becomes insolvent," the report says. "But while less re-hypothecation reduces counterparty risk in the system it also reduces market liquidity."

COULD WE LIVE WITHOUT IT?

That depends on whether you believe the rules already out there are adequate, but just were not enforced before the crisis, or whether there needs to be a full rewrite of the financial regulation rulebook, if another crisis is to be averted.

b>WHAT NEXT?

The FSA's consultation closes in June and a policy statement is expected during the third quarter of 2010.

 

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