The FCA and alternative fund managers in 2020: regulatory priorities
The letter is useful in identifying the areas of focus for managers in 2020 but is not the final word on regulatory priorities with some omissions which we also deal with in this briefing.
The headline point: governance
In the letter, the FCA identifies low overall standards of governance as a “key cause of harm” in the asset management sector. It is clear that the way in which a manager approaches governance will determine its effectiveness at addressing all the issues highlighted in the letter and managers will need to remind themselves that governance is not a buzzword.
Managers will need to continue asking questions such as: are people in place who understand not just the business but the regulatory environment? Is there sufficient challenge within the management body on decisions taken or not taken, either by non-executives or the executives themselves? Is the management information clear, manageable and therefore useful? Are reasons for decisions properly recorded? Could collective and individual decisions be defended to the FCA years after they were made?
Priorities identified in the letter
Investor exposure to inappropriate products or levels of investment risk
The FCA points out that, by their nature, alternative investments can carry significant levels of investment risk. It is important that, where relevant, managers offering products and managing investments with exposure to alternative assets and strategies consider the appropriateness or suitability of those investments for their target investors. Where managers allow investors to “opt up” to elective professional status, the FCA expects managers to robustly assess a client’s knowledge and experience of the relevant market, alongside meeting the relevant quantitative tests, and refrain from re-categorising a retail client if they do not meet the threshold.
Although the letter does not refer to liquidity management (unlike the “Dear CEO” asset management letter), where there is retail exposure, the FCA’s expectations of managers to take appropriate action to ensure that liquidity risk is effectively managed is relevant.
Managers will need to ask whether their funds will be distributed to retail investors and more specifically: when manufacturing or distributing products, has the client type and investment need been properly identified, recognising that alternative products may only be appropriate for a niche market? Have the relevant restrictions on marketing to retail investors when communicating or approving financial promotions for alternative products been compiled with? Has the appropriateness or suitability of alternative investments for retail investors been adequately assessed? Are managers aware of who their customers are and that they are placing a clear focus on acting in the best interests of their clients and funds? Have they taken reasonable steps to ensure that investors adequately understand the risks they are exposed to through their investments and are not inappropriately exposed to products that carry risk beyond their risk profiles?
Client money and custody asset controls
The FCA reminds managers that they must follow rules set out in the Client Assets Sourcebook (CASS) whenever you hold or control client money or safeguard custody assets. This is crucial in helping to ensure that client money and custody assets remain safe and can be returned to customers if firms fail and exit the market.
The FCA states that, as part of its review of retail investor exposure to alternative investment products, it will also test whether firms that have permission to hold client money and safeguard custody assets are exercising those permissions under robust control frameworks.
Managers will need to ask again whether their funds will be distributed to retail investors, as this is where the FCA has a particular concern, and ask more specifically: is there a risk of receiving money belonging to clients into company accounts, e.g. through an overpayment of management fees? If so, what is being done to address the risk (either through client documentation or getting permission from the FCA to hold client money)? To the extent that client money permission exists, what support is being given to the oversight of CASS operations, are adequate books and records being maintained and is the business operating in a CASS-compliant manner?
The FCA’s comments on market abuse in the letter are also relevant to managers. It points out that robust systems and controls are critical to mitigating the risk of market abuse. A manager’s market abuse controls will need to enable them to discharge obligations under the Market Abuse Regulation (MAR).
Managers will need to ask: are market abuse controls sufficiently comprehensive and tailored to individual business models? Has preparation begun for the changes resulting from the review of MAR, for example considering the impact of extending MAR to spot FX contracts traded within the business and the definition and delayed disclosure of inside information in different cases?
Market integrity and disruption
The FCA points out that alternatives managers often have scope to take significant investment risk in managing their products. This can include market risk, credit risk and liquidity risk, as well as more idiosyncratic risks in certain strategies, such as legal risk. Use of leverage and illiquid investments presents risk to their own portfolios and can also create risk for other market participants and the wider markets. Where managers adopt very high-risk investment strategies, particularly where significant leverage is employed, the FCA expect commensurately high quality risk management controls and may choose to undertake in-depth assessments of firms’ controls.
Managers will need to ask: is the firm operating robust risk management controls to avoid excessive risk-taking and to ensure that the potential for harm or disruption to financial markets is appropriately mitigated? In responding to the first question, what is being done to specifically identify and tailor systems and controls to mitigate properly market risk, credit risk, liquidity risk and legal risk?
Anti-money laundering and anti-bribery and corruption
The FCA notes that, as part of its responsibility to ensure the integrity of the UK financial markets, it may require all authorised firms to have systems and controls in place to mitigate the risk they might be used to commit financial crime. Managers should be alert to the risk they could be used to facilitate financial crime and operate appropriate and proportionate systems and controls to mitigate this risk.
Managers will need to ask: does due diligence on third parties and Know Your Client checks continue to be sufficiently comprehensive and tailored to the firms individual business model? Is there a risk that the business (and the particular investments) could give rise to the risk of being used to facilitate fraud, money laundering, terrorist financing and bribery and corruption?
The FCA reminds managers that they must take action now to be prepared for when the implementation period ends on 1 January 2021. In addition to the points below, managers will need to monitor the negotiations and take the actions identified in our briefing on operating in the EU after Brexit.
Managers need to ask: will adequate licensing arrangements – in the UK via the Temporary Permission Regime and in the EU via member state authorisation – be in place by 31 December 2020? Are delegation arrangements properly documented and compliant with the applicable rules on substance and oversight? Has how to continue marketing EEA funds into the UK under the national private placement regime in the Alternative Investment Fund Managers Regulations 2013 been considered? Is the firm feeding into legislative reforms giving effect to or arising from Brexit?
Items not identified in the letter which managers will need to consider
Environmental, sustainability and governance (ESG)
Given the current market focus around ESG, it is surprising that ESG has not been mentioned. This should also prompt managers to ask whether they are placing ESG compliance in proper perspective, giving it neither too little nor too much importance but tailoring that compliance to their business. That said, there are specific pieces of regulation that fall within this broad category which managers need to consider, to the extent that they have not already done so.
A manager will need to ask the following: where it is marketing a fund as an ESG fund, has it got in place the governance systems and controls to ensure that its assets remain ESG compliant, howsoever described to investors? Even if the fund is not marketed as ESG compliant, has the manager identified, mitigated, including through the implementation of appropriate governance processes, and disclosed clearly any ESG risks? Has it considered the impact of EU Regulations, such as the EU Disclosure Regulation 2019 and the Low Carbon Benchmarks Regulation 2019 and taken any steps as necessary? Has it considered the impact the FCA’s proposals to implement the Shareholder Rights Directive II and the FCA Feedback Statement on Climate Change and Green Finance?
Governance structures and the Senior Managers and Certification Regime (SMCR)
As noted in the introduction, the FCA highlights the critical role of effective governance to the success of managers. Although the FCA does not go into more detail, as it does in the Dear CEO Asset Management Letter, the risks in group structures and conflicts of interest between affiliates, most notably between AFMs and delegated investment managers, are as relevant for alternatives managers as they are for authorised fund managers. The SMCR implementation to solo-regulated firms in December 2019 remains important and it should not be treated as a discrete compliance project.
The points noted on governance above are important when looking at governance structures and their effectiveness. Managers will also have to ask whether and how their own, or hosted AIFM’s, are exercising effective oversight of delegated managers? Does the sharing of members of the AIFM and management boards create conflicts of interest and how are these managed? Having refreshed their approach to governance to meet SMCR requirements, firms will need to ask themselves: how can we use the SMCR as an opportunity to deliver high standards of governance?
The FCA notes that managers are heavily reliant on robust and reliable technology, which underpins the smooth operation of their businesses and the protection of client assets. It expects managers to ensure technology and cyber risk is managed appropriately, including through appropriate oversight of third party firms and intra-group service providers.
Managers will need to ask: have the contents of the FCA Consultation on Operational Resilience been considered and responded to and, where appropriate, the proposed changes have been implemented? Is the firm in a position to respond to ad hoc FCA reviews of the effectiveness of systems and controls, for example in connection with cyber risk controls? Are processes in place to notify the FCA promptly should the firm suffer material technological failures or cyber-attacks?
The EU Investment Firms Directive (IFD) and Regulation (IFR) were published at the end of 2019. They will introduce more appropriate requirements for investment firms’ business models than those currently under the Capital Requirements Directive IV (CRD IV) regime. The FCA stated in its 2019/20 Business plan that it will consult on new rules and guidance. The Prudential Regulatory Authority (PRA) has also consulted on changes to its rules on common equity tier 1 capital (CET1) which is likely to have a knock-on effect for managers.
Managers will need to ask: are FCA consultations in connection with the IFD and IFR being monitored? Have any potential issues under the IFR and IFD, e.g., likely categorisation of Class 1, 2 or 3 firm, the changes in fixed overheads calculations which are potentially more onerous than those in BIPRU, the application of “K-Factors” and any impacts on consolidation issues been identified?