The Cyprus Securities and Exchange Commission (CySEC) recently issued a draft circular for consultation with Cyprus Investment Firms (CIFs) and other stakeholders. The paper sets out the proposed changes to, and clarifications of, the detailed procedures that CIFs must follow to fulfil their obligations to safeguard clients' funds. The consultation period ran until November 18 2016; the new guidance is expected to be issued early in 2017.
Article 18(2)(j) of the Investment Services and Activities and Regulated Markets Law of 2007, as amended, provides that: a CIF must, when holding funds belonging to clients, make adequate arrangements to safeguard the clients' rights and, except in the case of credit institutions, prevent the use of client funds for its own account. Part VI of CySEC Directive DI144-2007-01 of 2012 sets out the current detailed procedures.
According to section 18(1)(e) of the Directive, CIFs must ensure that clients' funds are held in accounts identified separately from any accounts used to hold funds belonging to the CIF. To comply with this requirement, and in particular to safeguard against clients' funds being used to offset other obligations under so-called banking set-off arrangements, CIFs may not deposit clients' funds in an account with any person in any jurisdiction unless they have a written confirmation from the person concerned acknowledging that all funds standing to the credit of the account are held by the CIF as trustee (or if relevant, as agent) and that the person is not entitled to combine the account with any other account or to exercise any right of set-off or counterclaim against money in that account in respect of any sum owed to it on any other account of the CIF. CySEC will publish the wording required. In addition, the title of the clients' account must sufficiently distinguish it from any account used to hold funds belonging to the CIF.
If the law of the jurisdiction in which the client funds are held prevents the CIF from complying with these requirements, the CIF must satisfy CySEC that it had no other alternative but to conduct such business, given the risk to clients' funds in the event of the person's insolvency. It must also satisfy CySEC that it did everything in its power to obtain separately titled accounts, including using another third party. If it is not satisfied that clients' interests are adequately safeguarded, CySEC may require the CIF to set aside an equivalent amount of its own funds in a segregated account.
Clients' funds may only be transferred to another person (such as an exchange, a clearing house, a liquidity provider or market maker, or an intermediate broker) if the recipient is appropriately licenced and regulated in its home country, and the funds are transferred for the purposes of a transaction on behalf of the client carried out through or with that person; or, to meet the client's obligation to provide collateral for a transaction. Before transferring the client's funds, the CIF must notify the proposed recipient that the CIF is obliged to keep clients' funds separate from its own funds. It must also instruct the recipient that any funds paid to it in respect of that transaction must be credited to the client's transaction account.
The CIF must obtain written confirmation from the proposed recipient that the client's transaction account is not to be combined with any other account. No right of set-off can be exercised by that person against funds credited to the client's transaction account in respect of any sum owed to that person on any other account. Retail clients should also be notified in advance that their funds may be transferred to another person. This must be done by way of an appropriate disclosure in the CIF's terms of business or a specific notification. The CIF remains responsible for its clients' funds, irrespective of having transferred them to another person.
CIFs may not use clients' initial margin as collateral when they transact in their own name or hedge their open trade positions. If collateral is required, CIFs must use their own funds.
CIFs must put in place robust and adequate administrative and internal control procedures to safeguard clients' funds. They must exercise due skill, care and diligence in the selection, appointment and periodic review of the person to whom clients' funds are entrusted and in the arrangements established for holding the funds. There must be adequate segregation of duties; at least two signatories are required.
CIFs must also perform regular reconciliations between their own accounts and records of client funds and the records provided by any third parties by whom those assets are held. In determining the appropriate frequency of reconciliations, CIFs should take account of the risks to which their business is exposed. If transactions are undertaken on a daily basis, reconciliations of clients' funds should be conducted each business day to ensure that funds held are equal to amounts owned by clients. CIFs must report client balances to CySEC in the prescribed form at the end of each quarter. The reports for the quarters ended June 30 and December 31 must be supported by a report from the CIF's external auditor.