Circular D4/EB/126: Control of Securities Deposit Activity in Brokerage Firms

COMMISSION BANCAIRE ET FINANCIERE Prudential supervision of investment firms 99 Louise Avenue, B-1050 Brussels telephone +32(2)535.22.11 - fax +32(2)535.23.08 Brussels, January 31, 2001. D4/EB/126 CIRCULAR LETTER TO BROKERAGE FIRMS CONTROL OF THE SECURITIES DEPOSIT ACTIVITY IN BROKERAGE FIRMS

Madam, Sir,

In its circular of March 17, 2000, the Commission requested that the statutory auditors of brokerage firms conduct a thorough examination of the securities deposit activity at the firms where they serve as statutory auditors. The examination of the reports transmitted by the auditors to the Commission and their correlation with the data already available to the Commission within the framework of its own control, allowed for an in-depth analysis of the issues surrounding securities custody. In order to derive the greatest benefit from the controls carried out, the Commission deemed it appropriate to communicate its findings to the brokerage firms and their auditors.

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Analysis and treatment of reports

Initially, the situation of each firm was assessed separately and, if necessary, examined with the brokerage firm and its statutory auditor. Where appropriate, the Commission requested the firm to remedy, within a specified deadline, the significant gaps and shortcomings observed in its organization and internal control. In certain cases, it requested the statutory auditor to carry out a new assessment of the adequacy and effectiveness of the measures taken and, if this had not yet been done, to grant the requested certification. The special reports were also analyzed at the sectoral level. This examination made it possible to identify a series of useful findings concerning the organization of securities circulation by brokerage firms, as well as its impact on the individual and sectoral risk profile.

COMMISSION BANCAIRE ET FINANCIERE Circular Letter D4/EB/126 2 Securities custody activity in the investment firm sector

Although the authorization of brokerage firms may cover the activity of client securities custody, 15% of brokerage firms prefer not to exercise this activity. This trend, which significantly reduces their risk profile, has the corollary that currently, only half of Belgian investment firms still provide custody of securities for third parties.1 The vast majority of brokerage firms that hold their clients' securities actively encourage investors to keep their securities on an account and not to request them in physical form. This trend not only reduces costs for all parties but also induces a decrease in physical securities movements and the associated risks. It thus appears that currently, less than 5% of securities deposited with brokerage firms are kept in safes or in transit zones. Some firms, however, significantly exceed this percentage. They will be invited to assess their situation in light of sector averages and, if necessary, to take adequate regulatory measures.

Assessment of the deposit activity by auditors as of March 31, 2000

Eight out of ten brokerage firms obtained certification of their securities ledger from the auditor as of March 31, 2000. This means, however, that one in five firms did not obtain immediate certification for reasons including, in particular, that the auditor had noted shortcomings in the internal control of the deposit activity or the functioning of management systems, or had remarks to make regarding the preparation of the securities ledger. These reports were subject to in-depth analysis and were examined with the concerned firm and its statutory auditor to remedy the observed gaps and allow the auditor to grant the requested certification of the securities ledger. Even for brokerage firms that obtained certification of their securities ledger, the auditor often observed that internal control procedures were susceptible to improvement. In many cases, it explicitly mentioned that the small size of the firm constituted a significant obstacle to achieving sufficient separation of functions in securities monitoring.

Evolution of accounting and control instruments

The instrument constituted by the securities ledger - which represents the situation of assets and liabilities, rights and commitments in securities as they appear in the securities accounting2

• has become the cornerstone of the administration and internal control of brokerage firms regarding securities movements, and also constitutes an extremely valuable tool available to external controllers.

1 Investment firms authorized as wealth management companies, financial instrument brokerage companies, or financial instrument order placement companies are not authorized to provide custody of cash or securities assets of their clients. 2 See Circular 91/7 of December 18, 1991 concerning the securities ledger of brokerage firms.

COMMISSION BANCAIRE ET FINANCIERE Circular Letter D4/EB/126 3 Indeed, the Commission is aware that the regulations governing the maintenance of securities accounting and the preparation of the securities ledger will, on certain points, need to be updated in light of significant changes observed in securities trading in general and in securities exchanges in particular. The accounting and management systems used by brokerage firms and developed either by the firm itself or by third-party suppliers will also need to evolve. Although these systems, overall, are increasingly mastering this complex subject, the examination reveals that the development of certain software is lacking. The observed shortcomings will need to be remedied within an adequate timeframe.

Risk management

Finally, the examination shows that there is still considerable room for improvement in managing risks related to securities custody, or even reducing these risks, by implementing a control and security plan. This plan may consist of taking or coordinating a set of measures intended to adequately regulate the securities custody activity. In this regard, particular attention must be paid not only to accounting and management instruments but also to the security of physical locations for securities storage, as well as to the assessment and coverage, through insurance, of risks of securities loss due to third parties or fraud within the brokerage firm.

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The control performed allows the Commission to conclude that the efforts of the sector and external controllers - which have undoubtedly borne fruit in terms of the development of accounting and management instruments - must still be intensified and, in particular, focused on the organization and internal control of securities movements, whose proper functioning, adequacy, and efficiency are examined and evaluated using an adequate internal audit function. The Commission requests that each brokerage firm exercising a securities deposit activity take, in light of the findings stated above, appropriate measures to strengthen its policy regarding the control and security of securities movements. Particular attention will be paid to the following points: ◊ the policy regarding physical securities movements (safes, transit, branches, and delegated agents) and in particular the coverage of associated risks through the subscription of adequate insurance policies (notably regarding losses in case of transport, storage, or fraud); ◊ the design and development of accounting and management systems; ◊ the policy implemented regarding internal control, the establishment of a separation of functions, and the development of an internal audit function.

COMMISSION BANCAIRE ET FINANCIERE Circular Letter D4/EB/126 4 The approved auditors will be called upon to assess the adequacy of these measures in their periodic report to the Commission. Regarding the internal audit function, the Commission intends to clarify shortly in a circular the principles to which the internal control and internal audit of investment firms must respond with regard to Article 62 of the Law of April 6, 1995.

I beg you to accept, Madam, Sir, the expression of my distinguished sentiments.

F. T’KINT, Acting President