At the heart of the regulatory obligations of electronic money and payment institutions is the safeguarding of “user funds”. In essence and in general terms, the funds received and held by these institutions for the provision of payment services and the issuance of electronic money should be protected in such a way that the insolvency of these institutions does not lead to losses for their customers. As we have advised our clients throughout their application processes with the Central Bank of Ireland and subsequently under ongoing supervisory arrangements, it is clear that protection is of crucial importance to the Central bank. The potential for users to lose money as an institution fails poses major financial and behavioral risks, particularly in the context of the expansion of fintech offerings in Ireland.
‘Backup’ is a broad term which, in simple terms, means ‘protection’. It is often used as a synonym for “segregation” concepts, but segregation is only one form of protection and we are seeing more and more companies looking for other means of protection. Regardless of the means chosen, the Central Bank is consistent in its scrutiny of the arrangements and companies must justify the suitability of the chosen method.
The two regulations governing e-money and payment institutions provide similar safeguard options, which can be summarized, broadly, as follows:
- Segregation: Essentially, companies can choose to segregate, on a day-to-day basis, user funds from their own corporate funds, where user funds are held in a customer account with a third-party credit institution and where such account is in bankruptcy distant from the company;
- Insurance / Guarantee: businesses can choose to transfer their customers’ credit risk to a third-party credit institution or insurance company using the insurance/bonding method – this ensures that any losses users would otherwise face are covered by a regulated bank or insurer; and
- Low risk investment method: increasingly under scrutiny in the face of a challenging interest rate environment, another potential option is to invest users’ funds in “safe and low-risk” (in the context of e-money) and “secure, low-risk” assets. liquid and low risk” (in the context of payment services).
We discuss the challenges and opportunities of each method below.
Segregation is the most commonly used protection method on the market. Essentially, it requires the separation of corporate and user funds. In effect, this requires a daily reconciliation process whereby user fund balances are isolated from company funds in a client asset account.
In our experience, the segregation method is most appropriate for organizations with reasonably sophisticated treasury operations. The treasury operation does not have to be done at the institution level (group treasury functions can be used), but the outsourcing of intra-group treasury should be done under a strong governance process with sufficient expertise and resources within the institution itself. to oversee and control the key elements of the process.
The challenges we have encountered in guiding clients through this process include incorporating strong reconciliation policies and procedures and demonstrating control and oversight among the institution’s senior management. In this process, it is essential to map every payment flow imaginable to ensure that the institution is able to identify and separate user funds at all times. As mentioned above – and based on the variability and complexity of payment flows – such an operation seems suitable for large organizations with group treasury operations that can constantly monitor and move cash.
Compared to other methods, the Central Bank has significant experience in approving and overseeing this method and while it is undoubtedly robust in its evaluation process, its lack of novelty may lead to a relatively smooth approval process.
Insurance / Guarantee
A backup method that is often more suited to smaller organizations or organizations with less sophisticated treasury operations, another option is to have user funds covered by an insurance policy or other comparable guarantee issued by a insurance company or credit institution. The main advantage of this is that although a business should still be able to
identify balance of its user funds, the requirement to segregate that balance from company funds on an ongoing basis does not apply. From a commercial point of view, this must be balanced against the cost associated with such an option (generally an insurance premium or other cost related to the credit risk incurred by the third-party credit institution or the ‘assurance).
From a regulatory approval and oversight perspective, we have seen a number of challenges with this method, including the need to:
- Demonstrate that internal procedures are robust enough to ensure that user fund balances are identifiable at all times;
- Ensure that insurance agreements are linked to already established client asset accounts such that any payments under insurance/guarantee agreements are distributed to these client asset accounts; and
- Demonstrate sufficient flexibility in arrangements to ensure coverage is adequate to insure or secure user funds, given that insurance amounts are generally fixed and user funds are variable.
In this respect, it is essential to demonstrate the adequacy of internal procedures, in particular by showing internal records demonstrating the exposure of users’ funds (including in stress scenarios (high volume)), in order to reassure the regulator on the fact that the balance will be sufficient at all times. It is often prudent to create a buffer in the level of cover to exceed the user’s anticipated funds balance and to have a prior agreement with the relevant insurer/guarantor that the levels of cover can be increased rapidly by if needed.
Typically, we have seen such agreements take the form of letters of credit from a lending institution or tri-party bonds involving a group entity and a third-party insurer.
Despite the difficult interest rate environment that has prevailed in recent years and although the feasibility is increasingly examined, the investment method has been the least chosen, in our experience. The obvious advantages associated with this method include the ability to minimize interest rate losses and spread credit risk that might otherwise be concentrated in one or more lending institutions. In its simplest form, the investment method allows – with the approval of the Central Bank – the investment of users’ funds in very particular instruments, namely certain assets associated with a low level of credit risk and UCITS funds composed solely of such assets. The wording of the legislation has proven to be difficult, in particular because it is difficult to reconcile some of the wording of the legislation with even the least risky instruments available in the capital markets.
Other challenges associated with this method include demonstrating robust segregation and custody operations and ensuring governance and control at the local level.
This is certainly an area where further dialogue and engagement with the regulator (and wider European Union authorities) is warranted to establish an acceptable investment standard for this purpose.
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.