Eternity Law International — News — Protection of accounts and financial assets: basic methods and their implementation in practice

Protection of accounts and financial assets: basic methods and their implementation in practice

Published:
November 1, 2021

Safeguards are used by payment companies and electronic money issuers (PIs and EMIs) to ensure that in case of liquidation the funds are protected. The rules that relate to the protection of finances are spelled out in the section of frequently asked questions. The purpose of this article is to provide a disclosed description of defense mechanisms and an examination of the rules by the practitioner.

The information below will be useful for anyone who wishes to learn more about the mechanisms for protecting financial assets and the general principle of operation of such systems.

Purpose and methodology of security techniques

The availability of such methods and their implementation provides a guarantee that the funds will be used exclusively for making payments in accordance with the general instructions. If this cannot be done (for example, if the PI/EMI ceases to function due to forced liquidation before the transaction is carried out), the funds are returned to the payer.

UK offers two protection options

Segregation of finance, applied everywhere, as well as insurance, on the real cases of which there is no information. Other jurisdictions also have “under warranty” methods, but such protection is not popular in the UK. In accordance with the adopted regulations, PI/EMI is the payment service provider (PSP), and the main customer is the payment service user (PSU). There may be other PSPs in this payment chain.

The importance of the results of the implementation of protective systems

FCA carries out general financial regulation based on how useful the results were directly to users. The implementation of the rules for the safe handling of financial assets yields certain results on which the protection of finances given by a PI or EMI client is based. Security assurance is a central factor in the security chain by which:

  • a security account is opened by a respective credit institution;
  • there is often no additional PI/EMI between the company that has a bank account and the PSU, but this is not prohibited;
  • in accordance with the rules, funds in the company’s operating accounts with the bank (not protected by security measures) can be seized and withheld upon liquidation. In such a case, the courts can force the banking institution to stop trading, and any residual money will be treated as assets that are transferred to creditors;
  • however, if the bank provides security accounts, it agrees with the rule that the money in these accounts cannot be seized or withheld.

The side agreement, which is binding on the contract, effectively recognizes that PSU holds beneficial ownership of the monetary assets. This means that the finance related to this PSU can be used exclusively to execute payment instructions or must go back to the original PSU.

At the same time, PI/EMI must agree that they will not use accounts to store their funds, because this can spoil security and put the protection of finances at risk.

Excessive funding of the account provides additional protection and prevents a gap in day funding from happening, during the period when commissions come and go. Nevertheless, these accounts are often created to avoid such problems, to ensure that there is no need for overfunding when it is more important to protect the integrity of the security and thus the beneficial ownership of the PSU. To this end, the PSU has beneficial ownership of the finances until the payment transaction is completed. The end of the transaction is the moment when the money will be paid to the recipient (or PSP of the recipient).

Regulations

The Payment Services Regulations (2017) state that PI/EMIs must implement correct and well-managed safeguards to ensure that client money is not subject to other claims and in case of insolvency, the client must be returned to the client in full. This is detailed in PSR rule 23.

The current PSRs are UK laws that were moved to UK law from the Payment Services Directive 2 (PSD2) in 2017 (hence, the date the law was founded). PSR (2017) superseded PSR (2007) derived from the first PSD (PSD1).

Not all EU directives are equally enshrined in legislation in every state. UK regulation has long been known to support PI / EMI. Perhaps this is due to the nuance that the country’s parliament and regulator want to break the general monopoly and prevent the anti-competitive behavior of large banking institutions. In fact, some of the changes required in PSD2 have already been introduced in the UK through Banking Reform and various Competition and Markets Authority initiatives.

Implementation of protective mechanisms in practice

Bank partners must provide assurances (in an additional letter to the regular Account Terms and Conditions) that the protected money will not be used to offset any other obligations, including those imposed directly on PI/EMI. If PSU’s payment instructions cannot be executed, the bank must make a refund to the original source. If it is impossible to carry out this due to the liquidation of the company, then this operation is subject to the control of the person in charge of bankruptcy issues.

PI/EMI does not create a security account individually for each customer. They have complex accounts for users “[PI name] Customer accounts” in each currency to provide payment services.

Individual customer funds are stored in security accounts using a register of virtual account numbers and/or virtual reference codes. These entries are used for ongoing reconciliation of credit, debit and balance transactions, so that the items recorded for an individual customer personally identify how much of the total balance belongs to him. All amounts that are on virtual accounts should eventually make up the full balance of this account.

PI and EMI will arrange for funds to be transferred from the security account to the personal transaction account, as they must do this at least every day.

Received and retained funds

In the PSR, safeguards are applied to funds received and retained, defined as amounts received:

  • from the User of payment services or in his interests to make a payment;
  • from another payment service provider (bank or non-bank institution) to make a payment on behalf of the payment service user.

Eligible funds do not include financial assets that were withdrawn from the safeguard account in settlement of the FX trade. After the moment when the profit from a currency transaction returns to protective accounts (and provided that this money is used to make a payment), they will again become protected.

PI/EMI must protect any finance with which a transaction occurs, including money that has been transferred to their payment account, as well as funds intended for withdrawal. As soon as finances are received, protective mechanisms are immediately applied to them. This continues until the funds are dispensed to the ultimate beneficiary or the beneficiary’s payment service provider. Protection is always provided to the base user and not to intermediaries. Thus, the base PSU is the beneficiary of protection in the event that the main or intermediate PSP ceases to be solvent.

Reconciliation

The FCA requires mandatory internal and external reconciliation.

Internal reconciliation

Ensures confidence in the clarity of the internal accounts as to how many should be kept. It is done by comparing:

  • general funds that belong to customers that appear in the internal system of the company;
  • general funds, which, in the opinion of the company, are kept in its protective accounts (taking into account only received and stored finances, without commissions that are withdrawn from the account).

This enables the company to verify the accuracy of its own accounts by comparing the internal balances of users with the personal accounts of clients’ funds that are held in a secure account. This comparison should give a clear match, taking into account the time difference.

External reconciliation

Unlike the internal version, the external reconciliation takes into account the total actual balance on the security accounts, together with irrelevant money (fees).

Double protection

The FCA provides separate provisions on the issue of the existing ambiguity in the description of the PSR approach document, but as a general list of rules.

Saving funds as a debt to PSU

Funds protection systems work from the moment the money was received and ends when they have already been paid for by the PSU (or their PSP). Double protection implies that the user’s money has been previously split, and the PSP must also provide the same amount of its personal funds when transferring the client’s funds. Ambiguity or some kind of ambiguity appears now when there is an intermediate PSP. However, the guarantee of safety rests with the PSU, not the intermediaries.

In addition, the intermediate PSP is liable in the event of losses incurred for the first PSP. Regulators in this area view dual protection as an overly zealous implementation of safeguards, but expect clarification of such use in the future.

PI/EMI with accounts held at the appropriate bank can store money that has been sent by another PSP intermediary. The first PI/EMI is also allowed to hold funds for the intermediate PSP as a PSU (e.g. fees). In this case, funds are protected in two different ways:

  • assurance that the first PSP has drawn up documentation in its bank and is liable to the underlying PSU (in the amount that is sent to the PSU);
  • providing protection for an intermediate PSP (acting as a PSU) for an amount that was provided separately.

These amounts are not aggregated, as the amount held for the main client acting as a PSU is not used to regulate or offset the obligations of the intermediary (regardless of whether they operate as a PSP or as a PSU).

Funds received as a result of currency exchange

The money that is received in the process of currency exchange is significant for security purposes after it reaches the client’s accounts. Foreign currency exchange is not an activity subject to a security requirement. On the practical side, it implies that when a client conducts an exchange transaction, his existing balance will become smaller at the time of the transaction. Further, the funds from the currency transaction will be received. There may be a slight delay in the process of the two stages of the transaction, during which the money will not be protected. At this point, funds are transferred using a foreign exchange liquidity provider.

Differences between payment and bank accounts

Often, PSUs use PI and EMI because banking institutions do not have the flexibility of a product or pricing structure to fully meet their needs. The customer’s PI/EMI account is a payment account. A billing account should not be described or viewed as a bank account, as PI/EMI is not a banking institution. If PSU wishes to work with a bank, it is necessary to open and manage a bank account.

Key differences between PI/EMI payment accounts and bank accounts

If PI is eligible and can offer billing accounts, they will not be listed as bank accounts. Now bank accounts are considered deposit and payment at the same time. Banks do not consider the money on the deposit (including the current account) neither as client funds, nor as guaranteed funds. A deposit to a bank account is considered a “loan” to a banking institution. Banks do not have the same restrictions on the sharing of funds.

PI or EMI cannot issue interest on balances. Nevertheless, even if the percentage were higher:

  • lost interest, compared with the current account, for the most part zero;
  • money transferred by PI is subject to payment instructions, therefore the time for receiving interest at the bank is shorter;
  • savings in PI/EMI, rather than in a banking institution, are often much greater than the interest earned on deposits.

PI/EMI funds are not eligible for investor protection with FSCS financial services compensation. However, at the same time, FSCS is suitable exclusively for retailers and small businesses. The main purpose of the protection is that the PSU is not exposed to the risk of PI/EMI default, but there is a high risk of default by the banking organization that provides the protection account. Nevertheless, it should be noted that there is also a risk that the protective measures are applied incorrectly or they are not reliable enough. Returning money to PSU as a payer incurs certain costs (for example, the cost of a PI/EMI bankruptcy specialist), so the PSU may not receive the full amount back.

Protective audit

PI/EMIs are required to conduct a PSR 2017 compliance audit each year for the provision of security systems. Security controls ensure formal validation and assurance that funds are secure and that assets are in fact protected.

The audit reveals that the PI/EMI has updated guidance on security and control systems, maintains records that show and explain decisions to provide security, and is fully meeting its security responsibilities, as appropriate with PSR requirements.

Violations and inconsistencies

In the payment field, the occurrence of irregularities and inconsistencies, of course, is not welcome – they can put a stigma on the institution.

Wirecard

In 2019 and 2020, Wirecard AG showed the quality of regulation in the country for the PSP, providing an almost perfect (albeit tragic) explanation for how poorly structured and ill conceived the regulatory environment in Germany is.

Wirecard had several business lines; however, regulators had to make sure that everything worked in harmony for the convenience of its customers. Alas, this did not happen. Journalists actually knew the situation only after a large investigation. The story is “truly” intriguing not only because the German regulator did not notice important evidence of misconduct, but also wanted to derail the journalists’ investigation. The former CEO, former chief operating officer, two other former board members, and the rest of the executives have been featured in criminal cases and litigation.

These fraudulent and duplicate activities are grounds and reasons for collaborating with a PI/EMI with a scale and structure suitable for division of responsibility, and which will persist in seeking confirmation through defensive audits, rather than just sending and receiving funds.

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