- Category
- Funds Talk
- Date
- April 03, 2017
- Title
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Client Asset Protection at Prime Brokers Under US and UK Rules: Comparison Chart
New York and London account for the vast majority of the prime brokerage market. Notwithstanding governing law provisions, a significant portion of prime brokerage regulation is based on where assets are located. The transfer of assets under TTCA clauses and a lack of a statutory cap on rehypothecation under U.K. prime brokerage arrangements are somewhat less protective to a customer than is the U.S. framework. Although U.K. market practices provide customer protections such as daily sweeps, whereas a U.S. prime brokerage agreement permits the transfer of assets to a U.K. broker-dealer, documentation should be sufficiently robust to offset the U.K.'s more limited regulatory protections. It should also be considered whether the inclusion of “affiliates” of the broker-dealer in the prime brokerage documentation may permit nonregulated affiliates to rehypothecate assets, as those affiliates would not be subject to the U.S. regulatory 140% cap.
The table below highlights the main differences between the U.S. and U.K. client asset protection regimes and presents some practical considerations for those negotiating prime brokerage agreements potentially exposed to cross-border transfers of assets.
| United States | United Kingdom |
| Rehypothecation | Title transfer |
| Rehypothecation allows the customer to retain title to its assets posted under the prime brokerage agreement, with the broker-dealer obtaining a security interest over such assets to satisfy any liabilities of the customer to the broker-dealer as well as a right to use such assets in the course of its business. In the insolvency of the broker-dealer the trustee will endeavor to make in-kind distributions of the assets. | Rehypothecation in the U.S. sense does not exist under English law. Either the customer retains title to the assets, and the broker-dealer obtains a security interest in them, or the title to assets transfers outright to the broker-dealer through a title transfer collateral arrangement (TTCA). In the latter (far more common) scenario, the customer has a contractual right to the return of those assets. |
| Maintenance of fully paid and excess margin securities under Rule 15c3-3 of the Exchange Act | Protection of client assets under the CASS Rules |
| Rule 15c3-3 requires a broker-dealer to maintain possession of all fully paid and excess margin securities held on behalf of a customer and prevents use of the securities for proprietary activities. However, under Rule 15c3-3(b)(3), a broker-dealer may borrow securities from a customer pursuant to a written agreement if the broker-dealer provides collateral covering 100% of the market value of the securities loaned to customers. Borrowed securities and collateral must be marked to market daily. |
Where assets are held by the broker-dealer but the client retains title, Principle 10 of the FCA Handbook prohibits firms from comingling customer assets with firm assets, whether or not such assets are used (i.e., any sweep of such assets into broker-dealer accounts at affiliate/parent entities would breach CASS rules). However, when title is transferred under a title transfer collateral arrangement (TTCA), the broker-dealer may use the assets as it wishes, subject to any contractual limitations in the prime brokerage agreement. |
| Limitations on hypothecation under Rule 15c3-1 of the Exchange Act | Limitations on use of client assets |
| Rule 15c3-1 requires a U.S. broker-dealer to retain control of any fully paid and excess margin securities in excess of 140% of a customer’s debit balance. Because certain prime brokerage arrangements may expose the customer to the risk that these protections do not always apply (e.g., if the broker-dealer is allowed to freely transfer assets to an offshore account), a customer may wish to negotiate contractual protections. | U.K. broker-dealers face no statutory or regulatory threshold limitations on the use of client assets, although the CASS rules require explicit contractual rights to use assets that remain “client assets.” In the event that a TTCA clause has been included in the prime brokerage agreement, any assets are property of the broker-dealer and no limitations on use exist. Assets transferred to a U.K. broker-dealer under an “all asset” rehypothecation provision forfeit Rule 15c3-1 protection. Any limitations on use must be contractually negotiated. |
| Risk upon prime broker default – Securities Investor Protection Act (SIPA) | Risk upon prime broker default – Prudential Regulation Authority (PRA) bail-in |
| In the event of a SIPA liquidation of a broker-dealer, each customer is eligible for a distribution from SIPC funds of up to $500,000. Typically, a prime brokerage customer’s exposure would be far higher than $500,000. The core protection afforded to prime brokerage customers therefore remains the 140% rehypothecation cap under Rule 15c3-1. | Assuming a TTCA is in place, the customer has only an unsecured contractual claim for the return of assets. The customer is therefore exposed to the PRA bail-in powers, whereby unsecured liabilities are either canceled (imposing immediate losses on unsecured creditors) or converted to equity (placing unsecured creditors on a par with shareholders in an insolvent entity). To mitigate these risks, customers have implemented daily cash sweeps to their accounts and the daily return of any securities posted in excess of amounts lent. |
| Reporting – contractual | Reporting – CASS rules |
| A U.S. broker-dealer does not owe the customer any duty to report on the assets held at the broker-dealer or the extent to which such assets have hypothecated. It is not uncommon, however, for customers to seek to mitigate risk by requesting periodic status reports of their prime brokerage accounts and assets. | CASS rules require broker-dealers to report on a daily basis customer transactions, open positions and the extent to which customer assets have been used as collateral. Given the potentially unlimited use of assets under a TTCA, however, customers are increasingly requiring daily sweeps of excess cash or securities to client custody accounts. |
Authors and Editors
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Fabien Carruzzo
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- Partner
- Co-author
- New York
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