Investment Management Update

A round-up of recent legal and regulatory developments of interest to the investment management sector.

This issue includes items under the following headings:


FCA warnings on MAR surveillance practices: Market Watch 56

In its latest newsletter on market conduct and transaction reporting issues (Market Watch 56), the Financial Conduct Authority (FCA) highlights recent observations about firms' surveillance systems. Following previous publications on the topics and the implementation of MiFID II, firms should treat this paper as a clear warning that the FCA will not tolerate non-compliance. The FCA flags the following issues:

  • in the calibration of surveillance systems, the FCA reminds firms that every business and client base is unique and, therefore, relying on peer standards, such as 'out of the box' alert settings, average peer parameters and average peer output volumes, will not necessarily satisfy the requirements under the Market Abuse Regulation (MAR). Each firm is responsible for making its own judgements about alert calibration, and firms risk failing to comply with MAR if they assume that because a certain calibration is appropriate for their peers, it must be appropriate for them;
  • when assessing the risk of market abuse, firms are reminded that the lists of indicators in MAR, and legislation made under it, are not exhaustive;
  • submission of suspicious transaction and order reports (STORs) across asset classes remains inconsistent and submissions in fixed income products are lower than they should be;
  • in the context of fixed income products, the FCA stresses that consideration of (1) trading activity in correlated products, and (2) yield, are an important part of surveillance. Where transaction data is sparse, it could be helpful to carry on further analysis of larger trades; trades that resulted in large positions in an instrument or that were not booked in a timely manner; trades in related financial instruments; and orders and trades in instruments with pre-existing large positions; and
  • the FCA notes that some firms are falsely trying to justify their MAR failings. If the FCA takes no action against one firm, it is not an assurance that it will not take action against a different firm as many factors are taken into consideration. Also, lack of compliance with the STOR regime cannot be mitigated by the fact that an employee has only recently joined the firm and does not feel they are responsible for a predecessor's arrangements.

Firms would be well-advised to continually evaluate their MAR risk assessments and the surveillance they have in place to ensure they are fit for purpose.

FCA Handbook Notice 58

The FCA has published Handbook Notice 58 which reflects the changes introduced to the Handbook by a number of instruments made by the FCA board on 26 July 2018 and 27 September 2018 including the Individual Accountability (Dual-Regulated Firms) Instrument 2018 (FCA 2018/45).

This instrument makes changes to the Handbook to enhance and embed a culture of individual accountability and personal responsibility within firms by reinforcing governance requirements, encouraging clear articulation by firms of their allocations of responsibilities and establishing fitness and propriety as a responsibility of each firm. It makes a number of changes to the sourcebooks in the Handbook, including:

  • Senior Management Arrangements, Systems and Controls (SYSC);
  • Supervision manual (SUP); and
  • Fit and Proper test for Approved Persons (FIT), which is also renamed the Fit and Proper test for Employees and Senior Personnel sourcebook.

The FCA’s Policy Statements PS18/14 and PS18/15 contained its near-final rules and feedback to previous accountability consultations. The FCA indicates that there have been some minor changes to the versions of the new rules published in the Policy Statements, particularly in the transitional provisions. These changes reflect the fact that statutory instruments made by HM Treasury now provide for some matters that in the near-final rules were dealt with by FCA rules. However, the FCA states that the changes to the near-final rules do not alter its underlying policy position as set out in its Policy Statements.

The instrument has a staggered implementation date, with most rules coming into force on 10 December 2018, but some others coming into force on 28 September 2018, 1 November 2018 and 10 December 2019.

Cycle of deregulation, crisis and regulation: FCA Chair speech

The FCA has published a speech ‘Rolling the rock: The cycle of deregulation, crisis and regulation’, given by Charles Randell, Chair of the FCA at the Association for Financial Markets in Europe Annual Conference on 2 October 2018. Key messages from Mr Randell’s speech include:

  • the cycle of deregulation, crisis and regulation is particularly damaging;
  • the most important way to avoid a damaging cycle of deregulation, crisis and regulation is to keep an open mind about the shortcomings of our existing rules;
  • the FCA needs to have the humility and the confidence to acknowledge that it does not always know best and that its past decisions have not always been optimal;
  • the FCA should try to ensure that the total programme of regulatory change is phased and coordinated in a proportionate way; and
  • the FCA does not see the UK’s withdrawal from the European Union as an opportunity to join a race to the bottom in regulatory standards. On the contrary, engagement with policymaking and regulatory colleagues in Europe and across the world should be further strengthened in order to continue to influence global standards of financial regulation.

Mr Randell also highlighted that:

  • the FCA is committed to review its Handbook for overall coherence and consistency in the post-Brexit landscape;
  • ex-post evaluation of the impact of regulatory changes will give valuable insight to the FCA, giving evidence of where it may need to change its approach; and
  • the FCA has committed to publishing an annual statement about perimeter issues.

KIDs for PRIIPs: Joint Committee of the ESAs letter flags concerns to the European Commission

The Joint Committee of the European Supervisory Authorities (ESAs) has published a letter to the European Commission outlining its concerns about key information documents (KIDs) for packaged retail and insurance-based investment products (PRIIPs).

 ESMA’s key concerns

  • It is unsatisfactory that retail investors will receive both the PRIIPs KID and a KID under the UCITS Directive from 1 January 2020.  The Joint Committee believes this undermines the aims of the PRIIPs Regulation.
  • Rather than helping investors make an informed decision, overlapping disclosure documents could in fact deter investors from using them.
  • There is a risk that the information on the PRIIPs KID and the UCITS KID will be inconsistent due to technical differences in the methodologies used for information on risks, performance and costs. For example, the UCITS synthetic risk reward indicator and the PRIIPs summary risk indicator will result in different risk indicators for a material number of PRIIPs.

ESMA’s suggested solutions

  • There is a need for legislative change to avoid duplicate information requirements from 1 January 2020.
  • In Q4 of 2018, the Joint Committee will conduct a targeted review of the PRIIPs Commission Delegated Regulation 2017/653, including a public consultation. It intends to conclude the review as soon as possible and to submit proposed amendments the European Commission in Q1 of 2019.
  • The Joint Committee expects to examine issues relating to performance scenarios and other specific issues addressed in Q&As published by the ESAs.

AIFMD: updated ESMA Q&As

ESMA has updated its Q&As on the application of the Alternative Investment Fund Managers Directive (AIFMD). A new Q&A is added to clarify the application of the AIFMD notification requirement to AIFMs managing umbrella AIFs on a cross-border basis:

Q5: An AIFM intends to manage an EU umbrella AIF on a cross-border basis by way of the AIF management passport (Article 33 of AIFMD). Does the AIFM have to identify all the compartments of the umbrella AIF in the notification?
A5: Yes. In the notification, the AIFM has to identify the umbrella AIF, as well as the name and investment strategy of its compartments, to facilitate administrative procedure in home and host Member States. Any change in the composition of an umbrella AIF that is managed on a cross-border basis has to be notified to the competent authorities pursuant to Article 33(6) of AIFMD.

Depositaries’ safe-keeping obligations under AIFMD and UCITS IV: Council adopts amending delegated regulations

The Economic and Financial Affairs Council of the Council of the EU (ECOFIN) has published minutes indicating that it has decided not to object to the supplementing Commission delegated regulations amending the AIFMD and the UCITS Directive. The amendments aim to clarify the obligations of depositaries where they delegate safe-keeping functions to third parties, in particular as regards asset segregation.

The amending delegated regulations were adopted by the EU Commission in July. The European Parliament will now consider the amending delegated regulations. If there is no objection, the Regulations will be published in the Official Journal of the EU and will enter into force 20 days after publication and will apply 18 months from that date.


Draft Brexit SI: Markets in Financial Instruments (Amendment) (EU Exit) Regulations 2018

HM Treasury has published a draft Brexit statutory instrument (SI) and an accompanying explanatory memorandum relating to the “onshoring” of the MiFID II Directive and MiFIR (collectively, MiFID II). The SI will ensure that the MiFID II regime continues to operate effectively and that investors are afforded the same level of protection in a post-Brexit landscape. The Treasury highlights that MiFID investment firms and market operators should also have regard to amendments made to the Financial Services and Markets Act 2000, Regulated Activities Order 2001 and Recognition Requirements for Investment Exchanges and Clearing Houses Regulations 2001, through separate statutory instruments, which will be published in due course.

The MiFID II statutory instrument:

  • transfers the functions of ESAs to the FCA and / or the PRA;
  • transfers the functions of the EU Commission to HM Treasury;
  • enables HM Treasury to transfer the responsibility for making and amending binding technical standards under MiFID II to the FCA and the PRA;
  • deletes certain provisions on information sharing and cooperation requirements between UK and EEA regulators;
  • enables HM Treasury to take on the EU Commission's function of making equivalence decisions for third-country regimes.  Where the Commission has made equivalence decisions before exit day, these will be incorporated into UK law;
  • makes special provisions for EEA firms which intend to operate in the UK under the Temporary Permissions Regime (TPR) by introducing the possibility of “substituted compliance” in cases where not doing so could lead to conflicts of law (except where supervisory responsibility is normally reserved for a host state regulator). This means that a firm operating under the TPR will not be deemed in breach of UK MiFID rules if it is demonstrated that it complies with corresponding EU MiFID rules; 
  • amends the Data Reporting Services Regulations 2017 to put in place a transitional arrangement in which EU-authorised data reporting services providers that meet the required conditions will be granted temporary authorisations to continue to provide data reporting services in the UK for a period of up to one year;
  • provides that the EU is treated as a third-country, with certain exceptions – for example, UK firms will be able to treat Undertakings for Collective Investment in Transferable Securities (UCITS) in the EU as automatically non-complex instruments, so that they can, in general, continue to be sold to retail clients in the UK without a client undertaking an appropriateness test;
  • grants the FCA temporary powers which will allow the FCA some flexibility over how the MiFID II transparency regime is operated during a transitional period of up to four years. Among other things, the temporary powers include the ability, in certain circumstances, to direct the application of the Double Volume Cap Mechanism; and
  • amends the MiFID II transaction reporting regime so that UK branches of EU firms will be required to report to the FCA, as opposed to their home regulators, in the same way as UK branches of non-EEA firms are required to do. A draft SI addressing Market Abuse Regulation will be published in due course.

The draft SI is still in its developmental stages and may change before the final SI is laid before Parliament. The Treasury notes that the SI is not intended to make policy changes, other than to reflect UK's new position post-Brexit and to smooth the transition of this position. The Treasury plans to lay the MiFID II SI before Parliament in the autumn of 2018.

MiFID II and MiFIR third-country regimes: ESMA’s letter to the European Commission

In a recent letter to the European Commission (the Commission), the European Securities and Markets Authority (ESMA) suggests changes to the MiFID II Directive (MiFID II) / MiFIR, including further restrictions on MiFID II reverse solicitation and using AIFMD letterbox provisions for outsourcing of critical and important functions under MiFID II. While the concerns ESMA raise are identified in the context of the UK's withdrawal from the EU, ESMA states that the issues "seem more general and apply beyond the Brexit debate, thereby making it important to address them".

ESMA's communication follows a November 2017 letter it sent to the Commission in which ESMA forewarned the Commission that it may propose further actions regarding the MiFID II / MiFIR third country (TC) regimes. In its latest communication, ESMA makes suggestions relating to:

  • TC firms providing investment services and activities at the exclusive initiative of clients (reverse solicitation): ESMA recommends the Commission reviews the MiFID II framework which permits reverse solicitation, to mitigate the effects of reverse solicitation which are "a source of legal uncertainty and potential detriment" to clients. ESMA suggests limiting the services that may be provided by reverse solicitation and imposing additional obligations on TC firms relying on reverse solicitation, such as an explicit obligation on them to demonstrate on request to EU authorities the client's initiative and submitting to EU dispute resolution at the client's request.
  • The requirements on firms for the outsourcing to TC providers of critical or important functions other than those related to portfolio management: ESMA suggests that the regime should be made stricter to facilitate supervision and ensure a higher level of investor protection. In particular, ESMA is concerned about the risk of the establishment of letterbox entities. ESMA puts forward the AIFMD anti-avoidance framework as a starting point for further development under MiFID II.
  • The MiFIR regime for TC firms providing investment services and performing investment activities to eligible counterparties and per se professional clients: ESMA supports the Commission in further harmonisation and, in addition to the existing requirement for equivalency decisions, suggests such TC firms directly comply with MiFID II / MiFIR provisions relevant to the service or activity being performed and are brought under direct supervision of national competent authorities in the EU.
  • TC firms providing investment services and activities to retail and professional clients on request: While this is permitted where a member state chooses to permit branches of TC firms, ESMA suggests the Commission considers harmonisation. ESMA states that the lack of harmonisation risks legal uncertainty and regulatory and supervisory arbitrage between jurisdictions with potential detriment for investors (including eligible counterparties and per se professional clients until the TC regime is active for the relevant TC).

Firms currently making or implementing contingency plans for a no deal Brexit should pay heed to the tightening direction of travel in Europe regarding TC access.

Prudential requirements

Revised EU prudential framework for investment firms: ECON votes to adopt draft reports

The European Parliament has published a press release announcing that its Committee on Economic and Monetary Affairs (ECON) has voted to adopt its draft reports on the EU Commission’s proposal for a Regulation on the prudential framework for investment firms (Investment Firms Regulation (IFR)) and a Directive on the prudential supervision of investment firms, which amends the CRD IV Directive and the MiFID II Directive (Investment Firms Directive (IFD)).

ECON suggests amendments to the Commission proposals on the following aspects highlighted in the press release:

  • enabling competent authorities to subject an investment firm below the more stringent CRD IV requirements when its activities are carried out at such a scale that the failure may pose a systemic risk;
  • extending the period during which thresholds must be exceeded before moving to the higher, more burdensome category;
  • increasing the number of investments that are subject to the lowest requirements;
  • tightening the equivalence rules for the third country investment companies. On top of fulfilling additional prudential organisational, internal control and business conduct requirements, these firms would be able to provide services of systemic importance to the EU only after a detailed assessment by the Commission paired with a regulatory monitoring by ESMA. They would also need to set up a proper subsidiary in the EU if they want to provide typical bank-like services;
  • requiring same or similar type of jobs to be equally remunerated regardless of gender, and adding a new disclosure requirement on investment policy; and
  • MEPs also agreed to take special account of exposures to environmental, social and governance (ESG) risks when setting out prudential requirements.

The European Parliament will now consider in plenary the motion for a resolution as set out in the draft reports. Last month, the European Central Bank published an opinion commenting on the Commission’s proposals. See our Investment Management Update of 12 September 2018 for more information on the issues flagged in the opinion.


NURS investing in illiquid assets: FCA consultation

The FCA has published a consultation paper on illiquid assets and open-ended funds (CP18/27). Illiquid assets are those which are illiquid under normal market conditions, such as property or infrastructure investments. The FCA states that its proposals aim to reduce the risk of poor outcomes to retail investors in open ended funds, specifically non UCITS retail schemes (NURSs) that invest in illiquid assets.

The proposals in the CP require: 

  • a NURS that holds immovables to temporarily suspend dealing if the standing independent valuer expresses "material uncertainty" about the value of immovables that account for at least 20% of the value of the scheme property;
  • NURS managers to have contingency plans for dealing with liquidity crises;
  • depositaries to exercise a specific duty to oversee the processes used to manage the liquidity of the fund; and
  • a NURS that invests mainly in illiquid assets to disclose information about liquidity risks, the liquidity management tools available to the manager, the circumstances in which they may be used, and the potential impact on investors. This will include identifying the nature of the fund in its name, risk warnings in financial promotions to retail investors and details of the risk management strategy in the fund prospectus.

In addition, the FCA proposes guidance to clarify that managers of NURSs and UCITS should not hold large cash buffers for a long period for the purpose of dealing with the possibility of unanticipated high levels of investor redemption requests in the future.

Stakeholders should feedback to the FCA, including on whether these measures will have the desired effect of reducing the rush of investors seeking to redeem their investments during stressed market conditions. The consultation ends on 29 January 2019.

Proposed Directive on cross-border distribution of collective investment funds: ECON’s revised draft report

ECON has published a revised draft rapporteur report on the European Commission’s proposals for a Directive on facilitating cross-border distribution of collective investment funds. The revised report includes amendments by Parliament to the draft legislation. See our Investment Management Update of 12 September 2018 for more information on the key areas identified by the rapporteur as warranting action.

Stress testing rules for money market funds under MMF Regulation: ESMA consultation paper

ESMA has published a consultation paper on draft guidelines on stress test scenarios under the Regulation on money market funds (MMF Regulation).

Under Article 28 of the MMF Regulation, each MMF is required to have robust stress testing mechanisms in place which enables identification of possible events or future changes in economic conditions which could adversely affect the fund. The stress tests must be based on objective criteria and consider the effects of severe plausible scenarios.

ESMA is responsible for developing guidelines on the stress test scenarios under the MMF Regulation. Official translations of ESMA’s 2017 guidelines on stress test scenarios for MMFs were published in March 2018, but these guidelines are to be updated once a year to account for the latest market developments. The consultation paper represents the first step in the development of the updated guidelines and sets out proposals on which ESMA is consulting. Stakeholders' views are sought on the methodology, risks factors, data and the calculation of the impact. Comments can be provided up until 1 December 2018. Finalised guidelines are expected in the first quarter of 2019.

Mutual recognition of funds: FCA and SFC sign MoU

The FCA and the Securities and Futures Commission (SFC) have entered into a Memorandum of Understanding (MoU) on mutual recognition of funds, enabling eligible Hong Kong public funds and UK retail funds to be distributed in each other's market through a streamlined process. The MoU establishes the following in relation to the cross-border offering:

  • a framework for exchange of information;
  • regular dialogue; and
  • regulatory cooperation.

Further information on the scheme can be found in the SFC circular and the FCA circular


Updated MiFID II ESMA Q&As

ESMA has published updated Q&As made under the MiFID II Directive and MiFIR on the topics listed below.

Topic Updates
Investor protection and intermediaries
  • New Q&A: 19 (Best execution)
  • New Q&A: 2 (Investment advice on an independent basis)
Temporary product intervention measures on the marketing, distribution or sale of contracts for differences (CFDs) and binary options to retail clients under Article 40 MiFIR
  • Q&A 5.12 updated (Rolling spot forex)
Commodity derivatives under MiFID II / MiFIR
  • On the ancillary activity test, Q&As 3 and 10 are updated and Q&A 13 is deleted
  • On positon limits, new Q&A 18 clarifies the treatment of legacy positions on OTFs
  • On position reporting, new Q&A 22 specifies further the types of firms that have to submit weekly position reports
Data reporting under MiFIR Questions in the following sections are updated:
  • Section 11 (Field 14 and Field 17: Total issues nominal amount)
  • Section 15 (FX swaps reporting)
  • Section 16 (Interest rate swaps reporting)
  • Section 18 (FIRDS fields 8 to 11)
Market structures under MiFID II / MiFIR New Q&As are added to the following sections:
  • Section 3: Direct Electronic Access and algorithmic trading – Q&As 26, 27, 28
  • Section 5: Multilateral and bilateral systems – Q&As 7, 8 and 9
Transparency under MiFID II / MiFIR
  • Q&A 10 (Default liquidity status of bonds) is modified
  • New Q&A 13 (Classification of derivatives on derivatives)
  • New Q&A 14 (Scope of Article 9(1)(c) of MiFIR)