Investment Management Update

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

This issue includes:


Investment funds


Role of artificial intelligence in the future of regulation: FCA speech

The Financial Conduct Authority (FCA) has published a speech by Christopher Woolard, Executive Director of Strategy and Competition at the FCA, in relation to the role of artificial intelligence (AI) in the future of regulation. Key points from the speech include:

  • the FCA and the Bank of England found that AI in regulated firms was best described as nascent. The technology is employed mainly for back office functions, with customer-facing technology largely in the exploration stage;
  • for risks presented by AI, there is no one universal approach to harm across financial services and the assessment of harm has to be dealt with on a case by case basis;
  • the FCA has partnered with The Alan Turing Institute to explore the transparency and "explainability" of AI in the financial sector. Through the collaboration, the FCA wants to move the debate from the high level discussion of principles towards a better understanding of the practical challenges on the ground that machine learning presents. A joint publication around these themes is planned for early next year; and
  • AI encourages the development of new business models offering innovative services, which in turn stimulates competition. The FCA gives an example of Open Banking where customers have access to their information and they can better compare offerings from different providers.

MiFID II compliance functions draft guidelines: ESMA consultation

The European Securities and Markets Authority (ESMA) has published a consultation paper on guidelines of the MiFID II compliance function requirements. The purpose of the guidelines is to enhance clarity and to ensure a consistent and harmonised application of the new MiFID II compliance function requirements. The guidelines address the following areas:

  • responsibility of the compliance function: compliance risk assessment; monitoring obligations of the compliance function; reporting obligations of the compliance function; and advisory and assistance obligations of the compliance function;
  • organisational requirements of the compliance function: effectiveness of the compliance function; skills, knowledge, expertise and authority of the compliance function (this is a new guideline); permanence of the compliance function; independence of the compliance function; proportionality with regard to the effectiveness of the compliance function; combining the compliance functions with other internal control functions; and outsourcing the compliance function; and
  • competent authorities’ review of the compliance function.

The deadline to submit responses to the questions in the consultation is 15 October 2019. ESMA will consider the responses it receives in Q4 2019/Q1 2020 and expects to publish a final report, and final guidelines, in Q2 2020.

Principles and guidance for board risk committees and risk functions: The Risk Coalition’s consultation

The Risk Coalition has published a consultation paper on principles and guidance for (i) board risk committees and (ii) risk functions in the UK financial services sector. The Risk Coalition is a network of not-for-profit professional bodies and membership organisations committed to raising standards of risk governance and risk management in the UK.

The guidance sets to raise expectations and promote good practice of risk oversight in UK financial services and to provide a benchmark against which board risk committees and risk functions can be objectively assessed.

The consultation provides detailed practical guidance for firms operating a three lines of defence model" based on the following principles.

  • Board risk committee principles: chief risk officer and risk function independence; board accountability; composition & membership; risk strategy & risk appetite; principle risks & continued viability; risk culture & remuneration; risk information & reporting; and risk management and internal control systems; and
  • Risk function principles: group risk functions; independent risk oversight; independent perspective; risk governance; risk reporting; corporate strategy and objectives; risk function independence & effectiveness; risk culture; and innovation & change.

The deadline for submitting responses to the consultation is 20 September 2019. The Risk Coalition intends to publish the final guidance in December 2019.

Fair pricing discussion paper: FCA feedback statement

The FCA has published a feedback statement on fair pricing in financial services outlining the summary of responses and next steps. The FCA published a discussion paper on this topic last year which set out a six question framework for assessing concerns about fairness of a given form of price discrimination.

Key themes and clarifications include:

  • that the framework should be applied on a case-by-case basis and should be considered holistically and retain a significant element of judgment when applied in practice;
  • the FCA’s concern about consumers affected by price consideration goes wider than vulnerable customers and includes all consumers, though the FCA is more likely to intervene if harm is caused to vulnerable customers;
  • the FCA would not automatically be concluding that a pricing practice is unfair if it finds that only a small minority of consumers are harmed. The FCA will consider the proportion of customers and the actual level of harm, alongside its framework questions; and
  • the FCA clarifies that stakeholders should not conclude that if a service to a customer is not essential then the practice cannot be unfair.

The FCA recognises that assessing whether a particular pricing practice is unfair and the effect of a pricing practice is complex and context-dependent. The FCA notes that the first application of its fair pricing framework will be in the general insurance pricing practices market study and that the findings from this will help inform how the FCA will use the framework in subsequent pieces of market work. The FCA intends to publish a review of its principles in Q4 2019/20.

FCA provides update on evaluation of RDR and FAMR

The FCA has published an update of the evaluation of its Retail Distribution Review (RDR) and Financial Advice Market Review (FAMR).

The FCA had already identified key areas of focus including access and affordability, consumer needs, market trends and achieving effective regulation. This update adds to these key areas by highlighting the following themes:

  • lack of consumer access to appropriate services, particularly in relation to consumers with smaller amounts of money to invest;
  • lack of clarity on the point where helpful guidance becomes investment advice;
  • need for better education of consumers to encourage engagement with guidance and investment advice services; and
  • conflicting views on innovative ways of providing advice, with some respondents saying that online services are still less popular, and others saying that they are becoming more useful but technological and streamlining improvements are needed.

There has been a sustained regulatory focus on the provision of investment advice over the last decade which, as evidenced by the call for input and ongoing regulatory scrutiny of this area, is not showing any sign of abating. It is hoped that the FCA report will provide clear and practical feedback for the various firms working in the retail financial services space. In the meantime, this update re-states the FCA's emphasis on consumer engagement and access, and the use of technology in the regulatory sphere.

In terms of next steps, the FCA will conduct a further information-gathering exercise and intends to publish a final report in 2020.

FCA "Dear CEO" letter to wealth managers

The FCA has published its latest "Dear CEO" letter to wealth managers setting out its priorities and the key risks posed by the industry. Unsurprisingly, top of the FCA’s list of priorities and issues were:

  • suitability/high risk investments and investment scams;
  • MiFID: best execution;
  • MiFID: costs and charges disclosures;
  • Brexit & SM&CR; and
  • platforms & switching. 

Singled out by the FCA for particular consideration are firms which:

  • use a single market maker for the execution of orders;
  • do not share their costs and charges with other firms in the distribution chain;
  • do not disclose third party costs and charges to their clients especially transaction and incidental costs; and
  • offer platform services with inefficient switching processes.

In relation to Brexit, the FCA also warns that it expects UK wealth managers to take "steps available to them" to continue to service EEA customers in accordance with local regulators' expectations and to act in clients’ best interests. It is recommended that firms re-visit each of the areas covered by the letter in their compliance, and management and oversight, committees to satisfy themselves that they are compliant, and that work is progressing appropriately in relation to regulatory change projects such as the Senior Managers and Certification Regime (SM&CR).

CEOs may also decide to require updates in each area covered in the letter in their next board meetings, and should scrutinise and challenge the management information provided to support any conclusions drawn. This will be especially important for firms offering platform services given the FCA’s stated intention to review switching processes later this year and again in 2020 and to "take further action if efficiency does not improve".

SM&CR: FCA policy statement on final rules

The FCA has published its final rules on the extension of the SM&CR to the majority of FCA solo-regulated firms. In general, the FCA has implemented the proposed changes to the SM&CR as consulted on. The main changes to the FCA's existing rules include:

  • confirming that the Head of Legal function is not required in the Senior Managers Regime;
  • amending the intermediary revenue criterion for the Enhanced regime;
  • clarifying the requirements and scope of the Certification Regime (in particular, the scope of the Client Dealing Function and the application of the Systems and Controls roles); and
  • extending Senior Manager Conduct Rule 4 (SC4) to non-approved Executive Directors at Limited Scope firms.

Firms now have until 9 December 2019 to implement the final rules, although certain rules will be phased-in over time, and ensure that they are compliant with the new regime.

Fair treatment of vulnerable customers: FCA guidance consultation 

The FCA has published a guidance consultation on what firms should do to ensure that vulnerable consumers are treated fairly and consistently across the financial services sectors. According to the FCA’s Financial Lives Survey, 50% of UK adults are shown as being potentially vulnerable and are therefore more likely to experience harm. The guidance consultation gives the FCA’s view of what its Principles for Businesses require of firms to treat vulnerable customers fairly. 

The guidance sets out a definition of vulnerable consumers, the four key drivers of vulnerability (health, life events, resilience and capability) and the scale of the issues and the potential impact on consumers being vulnerable. 

The FCA explains how it will hold firms to account if they breach the Principles and how it will monitor the effectiveness of the guidance. The FCA also explores how the guidance fits with other requirements on firms included within its regulatory framework, and wider legislation outside of its perimeter.

The FCA has adopted a two-stage approach to this consultation. The first stage involved the publication of the guidance consultation and seeking feedback. Responses need to be submitted by 4 October 2019. The second stage involves consulting on a revised draft guidance and publishing a cost-benefit analysis taking into account the feedback received.

Cryptoassets: FCA policy statement on final guidance 

The FCA has published a policy statement (PS19/22) on the final guidance for the regulation of cryptoassets. The final guidance aims to give market participants and interested stakeholders clarity on the types of cryptoassets that fall within the FCA’s regulatory remit and the resulting obligations on firms and the regulatory protections for consumers. 

The guidance specifies categories to distinguish the regulatory treatment that applies to all cryptoassets. The cryptoassets categories are: security tokens; e-money token and unregulated tokens. FCA authorised firms carrying out an unregulated activity in relation to cryptoassets should be mindful that it is possible some FCA rules may apply to that unregulated activity (even when a permission is not required to carry it out). The Principles for Business and the individual conduct rules under the SM&CR are examples of FCA rules that may apply in these circumstances.

Concerns on access to inside information: FCA Market Watch 60

The FCA has published the 60th edition of its Market Watch newsletter on market conduct and transaction reporting issues. The FCA has set out concerns it has in relation to the control of access to inside information, following the conviction of a former compliance officer at UBS London branch, and a recent review of the systems of controls in a sample of investment banks and other firms relating to the control of inside information (which follows on from the thematic report the FCA published on this topic in 2015 (TR15/13)). 

The concerns raised by the FCA include the following: 

  • instances of insider lists suggesting that on a small deal, only the deal team had access to inside information and omitted support staff who also had access to those documents (e.g. risk and compliance and other support functions);
  • the classification of "permanent insiders" without any obvious reason;
  • failure of the "need to know" principle due to failures to consider whether access rights are necessary for a particular individual's role;
  • absence of regular review of access rights;
  • inadequate IT segregation of files containing inside information;
  • absence of monitoring or lack of effective monitoring; and
  • inability to produce comprehensive audit trails of access to documents.

While there is nothing particularly new raised in the newsletter, it is a timely reminder of the issues raised in TR15/13 and a further reminder that the FCA is focussed on the "need to know" principle. Firms should therefore consider re-assessing their processes relating to control of inside information against TR15/13 and Market Watch 60.

FCA review of banking SM&CR 

The FCA has published findings from its review into the embedding of the SM&CR for deposit-taking firms and dual-regulated investment firms (the banking sector). The findings will also be of interest to solo-regulated firms that will be coming into the regime as they prepare for implementation.

Points to note include:

  • the FCA does not seek to redefine the roles of non-executives and that it does not expect non-executives to act like executive directors;
  • in respect of understanding the meaning of "reasonable steps" as relevant to a senior manager’s (SM) business, the FCA referred to the Decision Procedure and Penalties manual which sets out factors that SMs should take into account when assessing whether they have taken reasonable steps. The FCA notes that the list is not exhaustive and it’s the FCA’s expectation that SMs should be doing what they reasonably can to prevent misconduct. In particular, the FCA looks to SMs to think beyond controls and processes and to create an environment where the risk of misconduct is minimised, for example through nurturing healthy cultures;
  • firms need to do more to demonstrate the effectiveness of their certification assessment approach, use of subjective judgement or how they ensure consistency across the population of their certified staff; and
  • firms must ensure that conduct rules training is sufficiently tailored to staff’s job roles. The FCA noted that many firms were unable to explain what a conduct breach looked like in the context of their business.

The FCA states that this is not a full post-implementation review and it does not propose to make any policy changes based on it. However, it will increase its supervisory focus on the conduct rules.

Investment funds

Cross-border distribution of collective investment funds: Directive and Regulation published 

The Directive and Regulation in relation to the cross-border distribution of collective investment funds have been published in the Official Journal of the European Union. The legislation intends to make the cross-border distribution of investment funds simpler, quicker and more cost effective. The Directive amends the UCITS and the AIFM directives and the Regulation amends the EuVECA and EuSEF Regulations respectively. 

Among other things, the Regulation and Directive:

  • introduces rules on pre-marketing in the EuVECA and EuSEF Regulations – managers will be able to "test the appetite" of potential investors for new investment strategies by engaging in pre-marketing activities;
  • introduces new AIFMD pre-marketing rules (see our blog post of 17 July 2019 for more detail);
  • outlines additional requirements for UCITS managers to comply with. For example, marketing communications must, among other things: indicate that a prospectus and KIID is available and how this information can be obtained; and not contain information about a UCITS that contradicts information contained in its KIID/prospectus;
  • introduces a transparency framework for national provisions on marketing requirements – competent authorities will have to publish online information about applicable national laws, regulations and administrative provisions governing rules for AIFs and UCITS in "at least a language customary in the sphere of international finance";
  • requires competent authorities to publish and maintain up to date information on their websites on the fees or charges or relevant calculation methodologies;
  • introduces a requirement for ESMA to publish and maintain on its website a central database on all AIFs and UCITS marketed, their managers and the members states in which they are marketed; and
  • sets out new provisions on when an EU AIFM can discontinue marketing units or shares of an EU AIF that it manages in host member states; and
  • revises the existing "local facilities" requirements for UCITS managers, and introduces a requirement for AIFMs that market AIFs to retail investors. 

The Directive and Regulation entered into force on 1 August 2019, with the exception of certain provisions. The Directive needs to be transposed into national law by 2 August 2021.