Are client funds protected? EU reviews Deposit Guarantee Scheme Directive

In a move that may surprise some market participants, the European Commission – in its current review of the Deposit Guarantee Scheme Directive (‘the Directive’) – intends to clarify that client funds of e-money institutions, payment institutions and investment firms deposited with credit institutions should be protected by a deposit guarantee scheme (‘DGS‘) in all member states.

Who is this relevant to?

E-money institutions, payment institutions and investment firms are required to safeguard clients assets. They can do this in various ways but by far the most common is placing client funds into a safeguarding account with a credit institution in their own name. (Other permissible safeguarding methods – such as investing in secure, liquid, low-risk assets or coverage by an insurance policy – are rarely used.)

Client funds deposited in a credit institution could benefit from DGS protection should the credit institution become insolvent.

Are client funds not already protected under the Directive?

Deposits of e-money institutions, payment institutions and investment firms are excluded from protection under the Directive.

However, Article 7(3) of the Directive says that: ‘Where the depositor is not absolutely entitled to the sums held in an account, the person who is absolutely entitled shall be covered by the guarantee’ (emphasis added), which suggests that persons other than the account holder may be entitled to funds held in an account.

What does it mean to be ‘absolutely entitled’? Currently, that is for member states to decide, which they do so differently: the European Banking Authority (EBA) has found that, in more than one-third of member states, it is unclear whether this provision applies to clients whose funds are placed in a safeguarding account.

Challenges multiply and complexity increases in cross-border scenarios. Suppose a Luxembourg e-money institution holds its client funds with the Dutch branch of a German credit institution. While the Luxembourg implementation of the E-Money Directive dictates how the Luxembourg e-money institution must safeguard its client funds, the German interpretation of ‘absolutely entitled’ is decisive in determining whether the funds held in a Dutch account benefit from deposit protection.

What will change?

Whether amendments to the Directive will actually be made and what form they will take is not yet clear.

As part of its digital finance strategy, the Commission has asked the EBA to propose concrete amendments to the Directive’s framework and deliver a final report by 31 October 2021. The recent summary of the public consultation on the review of the Directive resulted in 50 per cent of respondents disagreeing that client funds should be protected in any potential reform.

If amendments are introduced, they will likely form part of the Directive review package planned for the fourth quarter of 2021.

What to do?

Relevant market participants are well advised to keep track of the reform to the Directive.

Investment firms (including ‘neo-brokers’), e-money institutions and payment institutions 

These organisations should scrutinise their current client fund/client money setups, particularly for cross-border scenarios, to establish which clients may benefit from deposit protection and gauge the impact of a revised framework on their relation to credit institutions and clients.

Credit institutions offering safeguarding accounts 

Such credit institutions should, in particular, consider deposit reporting and contributions to their DGS:

• If changes to the Directive affect current DGS eligibility criteria, it may also affect the amount of DGS contributions to be paid by the credit institution. (the amounts placed on safeguarding accounts may be substantial.)
• Reporting to the DGS may become more burdensome.
• Credit institutions sometimes do not know the identity of the end-customer for funds held in a safeguarding account. Any new requirements for identifying the person absolutely entitled to client funds to ensure deposit protection may also mean revisiting ‘know your customer’ (KYC) processes.