What it means
The first and best-known use is the segregation of client assets. When you give money or securities to a broker, bank or investment manager, the rules in many countries require the firm to hold them in separate accounts from its own funds.
If the firm fails, client assets should not be used to pay the firm's creditors. The second use is segregation of duties, an internal control within a company.
The idea is that no single person should be able to start, approve, record and conceal a transaction alone. For example, the person who approves supplier payments should not be the person who releases the money or reconciles the bank account.
In regulated markets, client money rules set out the practical details. Firms must label accounts correctly, keep accurate records and regularly check that the money held matches what clients are owed.
Regulators in the United States and the United Kingdom, among others, have detailed rules for this. Segregation has costs and limits.
It takes time and, in small businesses, can be hard to achieve because there may be too few people to share tasks. Where complete separation is not possible, firms use compensating controls such as owner reviews, rotating duties and independent checks.
Segregation also appears in other contexts, such as keeping the funds of different entities in a group apart, and separating incompatible access rights in computer systems. Auditors test these controls closely.
A weakness in segregation is one of the most common findings in audit reports. Technology has changed how the control is applied.
Systems can restrict who may create a supplier, approve a payment or change a bank detail, and they keep logs of every action. Even so, access rights must be reviewed regularly, because staff change roles and old permissions are easy to forget.
In practice
Real-world examples.
Example
A brokerage holds $50,000,000 of client cash and shares. It keeps them in accounts that are clearly identified as belonging to clients, separate from the firm's own bank accounts. When a different brokerage later fails, the first firm's clients take comfort from this separation.
Example
A small manufacturer has a bookkeeper who both enters supplier invoices and prepares payments. The owner decides to split the roles so that the bookkeeper enters invoices but the owner approves and releases payments. This reduces the chance of fake invoices going unnoticed.
Example
A property manager collects rent on behalf of landlords. Rather than mixing the rent with the agency's own cash, the manager places it in a separate client account. The agency pays landlords from this account and reconciles it each month.
Case study
Seen in the real world.
Bluecrest Advisory is a fictional firm that held about $12,000,000 of client money. During a routine review, its compliance officer, Mei, found that client funds had been placed in the same account as the firm's operating cash for two weeks.
She moved the funds to a segregated client account, recorded the error and reported it as the rules required, and she also asked the bank to relabel the account so that its status was clear to anyone reading the statements. This is an illustrative story, but it reflects a real principle. A mix-up like this could have left clients exposed if the firm had failed during that period, and the fix took only a day.
The firm then added a daily check comparing client balances with the segregated account. It also trained staff on why the separation matters, and the next audit found no exceptions.
Watch out
Common mistakes.
- Assuming segregated assets are immune from all risk. Segregation lowers the risk of loss from a firm's failure but does not remove market risk or fraud entirely.
- Letting one person control a whole process. Without a second pair of eyes, errors and fraud can go unnoticed for a long time, and many large frauds have been found only when the person involved went on holiday.
- Treating segregation as a one-off task. It needs to be maintained with regular checks and reconciliations, because accounts and staff roles change over time and gaps can open without anyone noticing.
Questions
People also ask.
What does segregation of client assets mean?
It means a firm holds client money and securities separately from its own, so they are protected if the firm fails. The firm must also keep records that show exactly which client owns what.
What is segregation of duties?
It is an internal control that splits the steps of a process, such as approving, recording and paying, between different people.
What can a small business do if it cannot split duties fully?
It can use compensating controls, such as owner review of bank statements, rotation of tasks and independent checks. Even a monthly review by an outside accountant adds a useful layer of protection.
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