Investment management update

In this edition we cover the FCA's policy statement on illiquid assets and open-ended funds, provide a summary of editions 61 and 62 of the FCA's Market Watch newsletter and outline the key points in the FCA's improving suitability of financial advice speech, amongst other topics.

This issue includes:



FCA policy statement on illiquid assets and open-ended funds: liquidity implications for all open-ended funds

The Financial Conduct Authority (FCA) has published a policy statement (PS19/24) in relation to illiquid assets and open-ended funds. Although the policy statement is focused on non-UCITS retail schemes (NURS) rather than UCITS, the policy statement was delayed following the suspension of the LF Woodford Equity Income Fund so that the FCA could consider any potential read across to the proposed remedies for NURS.  

Most of the proposals in the FCA’s consultation paper in October 2018 on this topic have been adopted including:

  • introducing a new category of "funds investing in inherently illiquid assets" (FIIA) within the FCA Handbook which will be subject to additional requirements, including enhanced depositary oversight, standard risk warnings on financial promotions, increased disclosure of liquidity management tools and liquidity risk contingency plans. Where authorised fund managers (AFMs) managing NURSs choose not to manage the liquidity mismatch directly, the fund must be classified as a FIAA or comply with the new requirements; and
  • a requirement that NURSs must suspend dealing in fund units where the standing independent valuer expresses material uncertainty regarding the value of 20% of the scheme property. However, following feedback to the FCA consultation, an AFM may now continue to deal where they have agreed with the fund’s depositary that this is in the fund investors’ best interests.

The FCA has not implemented the following proposals from the consultation paper:

  • the requirement for a manager of a FIIA to add an “identifier” to the name of the fund; and
  • the requirement to limit the accumulation of large cash buffers within NURS and UCITS funds.

The new rules will apply from 30 September 2020.

The  FCA has also made clear that it is concerned that similar issues can arise with a UCITS fund if it invests in less liquid assets and that it is considering whether these measures should be applied more widely than NURS. The FCA are considering (amongst others):

  • the potential for the use of notice periods and reduced dealing frequency as liquidity management tools for open-ended funds investing in illiquid or less liquid assets, particularly if these funds are offered to retail investors;
  • liquidity risk stress testing, potentially including quantitative stress limits and the appropriate regulatory implications for those funds that fail these tests (taking into account the recent ESMA liquidity stress testing guidelines);
  • the definition of liquid and illiquid assets held in open-ended funds; and
  • how funds manage liquidity risk arising from large individual holdings, and whether separate redemption conditions should apply to such investors.

The FCA will consult on any new rule changes for UCITS.

Market conduct and transaction reporting issues: FCA Market Watch 61

The FCA has published issue no.61 of its market conduct and transaction reporting issues newsletter. In this edition, the FCA helps firms prepare for a possible no-deal Brexit on 31 October 2019. Points of interest include:

  • the FCA is continuing to update its Brexit material and encourages firms to consider the issues raised by Andrew Bailey in his recent speech - Preparing for Brexit in financial services: the state of play - as part of their contingency planning. See our update of 25 September 2019 for a discussion on the speech;
  • transaction reporting rules under MiFID II: in the event of a no-deal on exit day, firms that are unable to comply fully with the transaction reporting regime at the time of the UK’s withdrawal from the EU will need to be able to back-report missing, incomplete or inaccurate transaction reports as soon as possible;
  • the FCA provided an update to explain how the MiFID transparency regime will work in a no-deal scenario. The updated statement covers the Financial Instruments Transparency Reference system (FITRS), the double cap volume (DVC), equity and non-equity transparency, systemic internalisers, and tick sizes; and
  • as part of the development of the post-exit MiFID regime, industry testing for FCA FITRS opened on 10 October 2019.

Market conduct and transaction reporting issues: FCA Market Watch 62

The FCA has published issue no.62 of its market conduct and transaction reporting issues newsletter. In this edition, the FCA expresses concerns in relation to person account dealing (PAD) where employees of an authorised firm trade for themselves rather than for clients. The FCA considers that a number of firms in the wholesale broking sector have not identified or managed the PAD risks or conflicts of interest specific to their business model adequately. The FCA considered that this may stem from a culture which has not sufficiently identified the potential for harm to clients or market integrity caused by inappropriate PAD practices.

Key findings from the FCA’s recent study into PAD activity, policies and systems and controls in a sample of wholesale broking firms include:

  • employees in front-office roles not appearing to understand their firm’s PAD policy despite having signed attestations that they have read, understand and will comply with those policies;
  • employees – including front office, compliance and surveillance - deliberately not declaring external accounts to their employer and/or circumventing requirements. This includes operating undeclared accounts in the names of relatives where trades are executed without any input from the named account holders;
  • an absence of pre-approval for PAD trades, a low number of identified breaches and an absence of STORs submission within the sample of firms may indicate a lack of effective monitoring and management of risks; and
  • the number of PAD breaches proactively identified by firms sampled was generally low and none had submitted a STOR relating to PAD in the past year. The FCA said this was surprising (and likely indicative of weaknesses in culture and controls) as other types of firms regularly do submit STORs about PAD.

The FCA sets out considerations for firms when designing their PAD policy including:

  • where PAD creates conflict of interest or market abuse risk within its business model;
  • how such risks can be adequately mitigated. This should include identifying if PAD of any sort, by front office and compliance staff in particular, presents risks that it cannot adequately mitigate within its business model;
  • given the easy access that employees have to a range of markets for PAD, including CFD and spread betting markets which are open round-the-clock, what effective monitoring and control of PAD it could do;
  • how it ensures that employees are aware of their obligations;
  • the appropriate degree to which it should rely on employees acting with integrity and following internal procedures and what level of post-trade monitoring of PAD activity is necessary to ensure employees comply with policies;
  • what appropriate processes should be in place for assessing PAD requests and/or notifications submitted by employees so the firm can operate appropriate control;
  • how such post-trade monitoring feeds into identification of potential suspicious activity which the firm can review and, if necessary, report to the FCA; and
  • whether senior managers are leading by example when engaging in PAD and act as advocates of strict compliance with the firm’s PAD rules.

In addition, the newsletter sets out the FCA’s observations on transaction reporting. Its ongoing monitoring of transaction reports and engagement with firms has led it to identify further data quality issues. These relate to issues including reporting transaction prices, inaccurate reporting of national identifiers, misuse of the aggregate client account and misreporting of certain indicator fields. Firms should review transaction reports to ensure the information is complete and accurate.

Improving suitability of financial advice: FCA speech

The FCA has published a speech by Debbie Gupta, Director of Life Insurance and Financial Advice Supervision, in relation to improving the suitability of financial advice. Ms Gupta states that there are four areas of work the FCA is focusing on regarding suitability: improving standards; targeting firms that cause the most harm; supporting consumers; and helping advisers. Ms Gupta notes that the rate of suitable advice is lower for more complex issues. The area of greatest concern for the FCA is unsuitable advice in relation to defined benefit (DB) pension transfers. Findings from the FCA’s DB work shows that only around 50% of the advice given on DB transfers was sensible.

In particular, Ms Gupta focuses on two areas where the FCA has observed, in its supervisory work, shortcomings in suitable advice: (a) fact-finding and recording clients’ needs and objectives; and (b) evidencing the correlation between a firm’s recommendation and the client’s attitude to risk. Firms should take note of the detailed and practical dos and don’ts that are set out in the speech.

MiFID II research unbundling rules: FCA findings from review

The FCA has published the findings from its multi-firm review regarding MiFID II and research unbundling reforms. Prior to MiFID II, research costs were often bundled into overall transaction fees paid by investors to managers. Since 3 January 2018, asset managers have been required to charge for research separately from execution services. This meant that firms have had to decide between paying for the research themselves or recovering the cost from the client through a research payment account meeting specific criteria.

Approaching two years into MiFID II, the FCA has found in its review that most asset managers have chosen to pay for research from their own revenues. In a sample of firms, the FCA considers that this has saved investors in UK-managed equity portfolios around £70m in the first six months of 2018.

However, the review also found that research budgets have fallen by 20–30%. According to the review, most asset managers responded that they are still getting the research they need in spite of this and that research coverage of small and medium enterprises listed in the UK has not seen a material reduction thus far. Nonetheless, it is difficult to see how such a large budget cut could fail to impact on the coverage and quality of research. The measures will need to be monitored over a period of time to see the real impact on the breadth and quality of research provided.

The FCA acknowledges that the implementation of the MiFID II research unbundling rules is still at a relatively early stage and that it will conduct further work to assess the impact of these reforms in 2020/21.

Conflicts of interest: FMSB statement of good practice

The FICC Markets Standards Board (FMSB) has published a statement of good practice (SGP) in relation to conflicts of interest. The SGP aims to prevent or manage and mitigate conflicts of interest both specifically in connection with wholesale fixed income, currencies and commodities (FICC) markets business and more generally across a firm. Although the SGP is targeted at FICC businesses, the practice points are helpful for all firms when reviewing their conflicts of interest arrangements. Firms reviewing their governance arrangements as part of their implementation of the Senior Managers & Certification Regime (SMCR) should take note of these standards and use them to benchmark against their own conflicts of interest arrangements. The SGP sets out detailed helpful and practical examples of actions firms can implement to help them meet overarching principles designed to prevent and mitigate conflicts of interest.  

Amendments to PRIIPs Delegated Regulation: Joint Committee of ESAs consultation paper

The Joint Committee of the European Supervisory Authorities (ESAs) have published a consultation paper on the proposed amendments to Commission Delegated Regulation (EU) 2017/653 of 8 March 2017 on key information documents (KID) for packaged retail and insurance-based investment products (PRIIPs). The aim of the consultation is to address issues that have been raised by stakeholders and supervisors since the implementation of the KID in 2018. The consultation also aims to make specific changes to allow the rules applied to investment funds that are expected to prepare a KID from 1 January 2022 onwards.

Among other things, the consultation paper:

  • discusses changes to the presentation of performance information which are part of a parallel consumer testing exercise being conducted by the European Commission with the involvement of the ESAs (the results of which are expected in the first quarter of 2020);
  • presents proposals to change the methodology for performance scenarios, including some evidence to support the approach;
  • discusses a possible alternative to present illustrative performance scenarios;
  • sets out how past performance information could be included in the KID;
  • presents different options to change the methodologies to calculate costs and how these are presented in summary tables;
  • considers possible changes in view of the exemption in Article 32 of the PRIIPs Regulation being due to expire and the possible use of the PRIIPs KID by UCITS from 1 January 2022;
  • presents proposals to amend the rules related to PRIIPs offering a range of options for investment and includes an example KID relating to this; and
  • sets out the legislative amendments in the form of an amending regulatory technical standards (RTS) that would be needed for each of the proposals or options in turn.

The deadline for responding to the consultation is 13 January 2020.

AML update on high-risk jurisdictions: HM Treasury advisory note

HM Treasury has published an updated advisory note identifying higher risk jurisdictions for which enhanced due diligence (EDD) must be applied. The HM Treasury notice was issued following the publication last week by the Financial Action Task Force (FATF) of statements identifying jurisdictions with strategic deficiencies in their anti-money laundering (AML) and counter-terrorist financing (CTF) regimes.

In response to the FATF statements, HM Treasury advises firms that the Democratic People's Republic of Korea (DPRK) should be considered a high-risk country and firms should apply counter measures and EDD measures in accordance with the risks. Iran is to be considered as high-risk and firms should apply EDD measures in accordance with the risks, and any other measures as specified by the FATF that have a similar effect in mitigating risks.

Firms are also advised to take appropriate actions to minimise the associated risks, which may include EDD measures in high risk situations for the following countries: the Bahamas, Botswana, Cambodia, Ghana, Iceland, Mongolia, Pakistan, Panama, Syria, Trinidad and Tobago, Yemen and Zimbabwe.

The HM Treasury notice also reminds firms that they must apply enhanced customer due diligence measures and enhanced ongoing monitoring in any business relationship or transaction with a person established in a high-risk third country. High-risk third countries are identified by the European Commission (EC) in delegated acts adopted under the Fourth Money Laundering Directive. These delegated acts are set out in Delegated Regulation 2016/1675. Whilst there is some overlap in the FATF designated high risk jurisdictions and the EC identified high risk third countries (e.g. Iran and DPRK were already on the EC list), the lists are not the same and therefore firms must check both lists when implementing AML and CTF procedures.

New FCA webpages: SMCR Form K and change of control notifications

The FCA has published the following new webpages.

  1. SMCR conversion notification form (Form K) – Form K is the conversion notification form that enables firms to inform the FCA of the approved individuals that they wish to convert from the Approved Persons Regime to the corresponding senior management functions under the SMCR. The webpage sets out: which firms need to submit a Form K; how to submit the form (there are two new guides on this for core and enhanced firms); and further information on the different categories of firms. Form K must be submitted by 24 November 2019 to the FCA’s Connect portal.
  2. Preparing change of control notifications – The FCA explains how to prepare and submit a change of control notification and provides a contents template that firms can use assist them in drafting their business plans. Among other things, firms should consider in their business plans the governance requirements, how the firm will identify and manage conduct risks and whether any areas of the business is going to be outsourced and the oversight of this.