Consumers and service providers should take note of some of the enhanced risks upon an e-money institution’s insolvency.
By Hongbei Li
Technology is rapidly changing the way customers and businesses interact with financial systems. Fintech companies are a driving force behind the disruption of traditional banking and payment services, with regulatory innovation close behind.
In the 12 months to June 2021, electronic money institutions (EMIs) in the UK processed more than £500 billion of transactions, according to Financial Conduct Authority (FCA) data. In 2019, UK EMIs held £10 billion in customer funds, the UK government estimates. By 2025, more than seven in 10 smartphone owners will be mobile P2P payment users. As a major remittance source country, the UK has seen a 30% growth in its digital remittance market in 2021. According to Statista, this market is predicted to grow to more than $4.6 billion by 2025. These trends are fuelling the UK’s ambition to become a world leader in payments innovation.
Changes in the Payment Services Landscape
In 2017, the Bank of England accelerated payments services innovation by extending real-time gross settlement (RTGS) service to non-bank payment service providers (PSPs). That measure opened direct access to the UK’s sterling payment systems that settle in sterling central bank money, including Faster Payments, BACS, CHAPS (Clearing House Automated Payment System), LINK (UK’s largest cash machine network), and Visa. This change was part of a broader strategy to open up access to the UK’s payment systems to allow new entrants such as fintech payment firms to compete on a more level playing field with incumbent banks. This move has encouraged the implementation of new technologies that have been developed to satisfy the demands of consumers and financial intermediaries for faster, simpler, cheaper, and more flexible ways to make payments.
Another important regulatory change within the payments and banking space is the open banking regime, in which the UK was one of the early pioneers. Open banking enables third-party payment services and financial service providers to access consumer banking information such as transactions and payment history. Consumers can thus decide if they want to share their payment history from their high street bank account to a third-party payments app on their smartphones.
The new payments technology requires careful regulation. The UK legislation underpinning the regime is based on the EU’s Second Electronic Money Directive (2EMD) and the Revised Payment Services Directive (PSD2). The Electronic Money Regulations 2011 (EMRs) implemented 2EMD and the Payment Services Regulations 2017 (PSRs) implemented PSD2, under which the FCA is the competent authority. In addition to removing market barriers, the EMRs also introduced conduct requirements for all electronic money issuers, and authorisation, registration, and prudential standards for EMIs.
E-money is defined in the EMRs as monetary value as represented by a claim on the issuer which is stored electronically, including magnetically, and issued on receipt of funds to make a payment transaction, and which is accepted by persons other than the electronic money issuer. An EMI is an institution authorised to issue e-money, and is often engaged in the business of providing payment services. From a consumer’s point of view, an EMI may appear indistinguishable from a bank. The key difference is an EMI’s inability to on-lend consumer funds. Importantly, an EMI is not covered by the Financial Services Compensation Scheme.
EMIs face less regulation than banks and therefore the safeguarding requirements and rules related to insolvency in the EMRs are critical for the protection of EMI customers. An EMI must safeguard funds received in exchange for e-money (relevant funds). Relevant funds must be segregated from any other funds the EMI holds, and either placed in a separate account held by the EMI with an authorised credit institution, or invested in secure, liquid, low-risk assets. If the latter, the EMI must place those assets in a separate account with an authorised custodian, and no person other than the EMI may have an interest in the relevant funds or relevant assets. Further, an EMI must ensure that relevant funds are covered by an insurance policy with an authorised insurer, or a comparable guarantee from an authorised insurer or credit institution.
In an EMI insolvency, the claims of the e-money holders must be paid from the asset pool in priority to all other creditors. Until all those claims have been paid, no right of set-off or security right may be exercised in respect of the asset pool (except to the extent that the right of set-off relates to fees and expenses in relation to operating an account). Further, the claims of the e-money holders shall not be diluted by insolvency proceeding expenses (except in respect of costs of distributing the asset pool).
Ipagoo: A Limitless Asset Pool?
The nature of the statutory “super priority” given to e-money holder claims and the capacity in which the relevant funds were held were considered in the recent Court of Appeal decision in Ipagoo.
Ipagoo was authorised and supervised by the FCA to issue e-money and provide payment services, and was the first non-bank to gain direct access to CHAPS. Ipagoo entered into administration in July 2019. At that time, it held sums which had been paid by e-money holders in exchange for e-money and the administrators soon realised it was not possible to establish whether the relevant funds had been safeguarded as required by the EMR. The administrators asked two questions in seeking directions from the court as to the distribution of assets in the administration under the EMRs:
- Do the EMRs create a statutory trust over the asset pool for the benefit of e-money holders?
- Do the relevant funds, which should have been safeguarded but were not, form part of the asset pool?
At first instance, the court held the EMRs did not create a statutory trust over safeguarded funds. The court, however, found that the asset pool should nonetheless be treated as holding a sum equivalent to all relevant funds which ought to have been safeguarded, even if the funds that should have been safeguarded did not form part of the actual asset pool. The FCA appealed the decision and the administrators cross-appealed to put the argument on behalf of non-e-money holder unsecured creditors, whose position was adversely affected by the court’s expanded scope of the asset pool. The Court of Appeal dismissed both the appeal and cross-appeal, endorsing the lower court’s view that:
- the EMRs did not impose a statutory trust in relation to funds received from e-money holders;
- a statutory trust need not be imposed to fulfil the requirements of the EU directives (2EMD or PSD); and
- the asset pool should include funds which have not been properly safeguarded.
The court reasoned that the relationship between an EMI and its customers was purely contractual: the customers have a claim against the EMI represented by the e-money that the EMI issued, but no proprietary interest in the relevant funds the EMI holds for them.
The Implications of Ipagoo
While it is helpful that the decision has removed any doubt about the legal basis on which an EMI holds assets, it raises difficult compliance questions if the legal consequences of not properly ring-fencing assets not being properly ring-fenced upon an insolvency are no different from the position had they been so. Ordinary unsecured creditors (which may include payment intermediaries) would appear to be taking an enhanced credit risk on an EMI if the EMI is in serious non-compliance of the type the court found in Ipagoo. Given the exponential growth of the EMI market and its projected further expansion, this enhanced risk is no small change for any consumer or service provider to ignore.
 Ipagoo LLP (in administration)  EWCA Civ 302.