The U.K.’s Financial Services Authority is finally cracking down on how prime brokers protect client assets.

Eighteen months after Lehman Brothers went bankrupt on both sides of the Atlantic, the United Kingdom securities watchdog published a consultation paper setting out issues involving in protecting a fund's assets when the holder of those assets disappears. Comments on "Enhancing the Client Assets Sourcebook" are due by June 30th.

The consultation paper follows stern letters the FSA sent out in March 2009 to compliance officers in the City of London urging them to follow basic client protection rules. Some of the recommendations in the document issued last month also elaborate on the U.K. Treasury's guidelines for what large, systemically-important financial firms should include in their "living wills" in the event of their insolvency.

Client assets are assets that belong to a fund manager but are held by a brokerage firm. They should ideally be held in a trust which would segregate them from the proprietary assets of the prime brokerage. In the event of the firm's bankruptcy, they then can be immediately returned to their rightful owners – the fund managers.

At least that's what fund managers believed would happen in the case of Lehman Brothers bankruptcy in Europe. It didn't. Hedge funds which pledged collateral with Lehman Brothers International Europe eventually realized that the terms of their prime brokerage agreements with that arm of Lehman Brothers weren't quite the same as those of Lehman Brothers in the U.S. where prime brokerages have a limited ability to rehypothecate customer assets on margin accounts.

The difference meant that Lehman Brothers in London, which acted as both a prime brokerage and sub-custodian, could also far more easily rehypothecate or reuse their assets as though they belonged to the firm. And Lehman in London could also move assets to other affiliates.

End result: Lehman's counterparties are now standing in line, scrambling to get their monies back.

While those customers – and their attorneys – could be blamed for not correctly interpreting U.K. law, some U.S. legal experts have also argued that the FSA's policies were unclear.

The following represent the top six provisions of the FSA's consultation paper and their potential impact to prime brokers. These are based on telephone interviews with operations executives at five prime brokerages who declined to be identified.

1-  More disclosure: Prime brokers would have to include a disclosure statement in each of their agreements with hedge fund clients that would explain the risks involved when the client deposits assets with the prime broker. The statement would be added as an annex, clearly defining (a) any contractual limit to rehypothecation, where the fund's assets could be used by the broker as collateral to raise a loan even though the assets are owned by the customer, and, (b) that the broker could become insolvent, putting assets at risk.

Impact: Creating these disclosure annexes will spell lots of additional revenue for London-based attorneys. And make a lot of customers realize their assets might be rehypothecated which could reduce the amount of collateral prime brokers get to use for their own investing activities. "If customers know how we are rehypothecating the assets, they may just decline for us to do so, so we would have to look for other sources of working capital," said one operations executive at a London-based brokerage firm.

2-  Daily Reporting: Prime brokers must provide close of business day statements to their customers which will include daily valuations of all loans, collateral and margin amounts, any mark-to-market or model on over-the-counter derivative contracts and the location of the assets. Those reports will also show which and how many of their assets have been rehypothecated.

Impact: "Prime brokers will need to come up with pricing models and standardized reports for all clients," said another operations executive at a prime brokerage shop.

3-  Dedicated Client Asset Officer: Prime brokers will be divided into three categories: small, medium and large. Small firms are defined as firms with assets under custody of fewer than 10 million British pounds the previous year while large firms will have more than 100 billion. All must designate an executive dedicated to protecting client assets instead of allocating the function across operations, compliance and finance departments. For small firms, the executive can be an existing director but medium-sized and large firms must appoint a new director. The designated official at the large firm must be approved by the FSA.

Impact: Winning FSA approval could be costly for large firms, say operations executives.

4-  Restricting Transfer of Client Monies: The FSA wants to limit the amount of client money that can be deposited by any firm with other related companies to 20% of the total value of the money held by the firm. While the FSA acknowledges that all client money will ultimately be held in a trust there is always the risk that the institution holding the funds will fail.

This proposal is intended to eliminate the "contagion risk" that several affiliates will go bankrupt simultaneously. In such a scenario, customers would unfairly bear the risk of the group as a whole rather than just the individual firm.

Impact: Firms will be less likely to use client money as a cheap source of liquidity and will have to use other external sources of funding at a higher cost of capital

5-  Prohibiting general liens: The FSA says it is unacceptable that a client's assets held by a custodian be allowed to cover a prime broker's indebtedness to the custodian. Wide-ranging liens of this sort can delay the distribution of client assets in the event of the prime broker's bankruptcy.

Impact: Client assets can no longer be used by custodian banks to cover debts owed by a prime brokerage firm or its group.

6-  Re-introducing breakouts of where client assets are held and how they will get returned: The FSA has proposed bringing back the Client Money and Assets Return reporting framework used by the FSA's predecessor, the Securities and Futures Authority. These reports must be submitted to the FSA monthly for medium-sized and large prime brokers and twice a year for small ones. The reports must include information on how much client assets and monies are being held, where they are held and the top five banks used for holding the money. Impact: Prime brokers will have major data aggregation responsibilities to give the FSA a micro and macro view of client asset holdings in the UK.

So what are the costs involved with compliance?  Here are just a few of the figures thrown out by the FSA.

The U.K. regulator says that a survey of 35 prime brokers showed that changing prime brokerage agreements would collectively come to about 610,000 British pounds, or about $943,000. That amounts to about $27,000 per prime broker. That's about the same cost in revamping contracts with custodial banks to prohibit the use of general liens.

In completing the client money and assets return document, the FSA projected that small firms would need to spend about $246.30 a year based on an hourly rate of $30.80 for a compliance specialist to complete the form. Medium and large size firms would spend about $1,478.20 per year, assuming the same hourly rate. The FSA's presumption? Firms already have the data on hand somewhere so it won't cost them anything to find it.

Technology changes required for daily reporting appear to be a lot more expensive to implement than hiring a good old fashioned lawyer or sporadically filling out forms. Prime brokers which don't provide daily reporting would need to spend an initial $232,000. For firms that already provide daily reporting, the bill would come to about $77,000 annually, the FSA estimates.

The most difficult cost to calculate would well end up being the highest – restricting transfer of client monies. That is because it depends partly on funding costs, says the FSA. But those funding costs may ultimately be passed along to customers.

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