Regulation Tomorrow: Asset Management series - Macro-themes from FCA discussion paper DP23/2

Hello and welcome to the first in a series of Regulation Tomorrow podcasts that focus on the future of asset management regulation in the UK. My name is Anita Edwards and I’m a Senior Knowledge Lawyer here at Norton Rose Fulbright in London. Today I am joined by Hannah Meakin, a partner in our Financial Services team, and Associate Taher Ahmed – and we’re going to be discussing some of the macro-themes that we saw coming out of the FCA’s recent discussion paper, DP23/2, on the future of the UK’s asset management regime.

So, the FCA published the DP in February, asking for views on the current UK regulatory regime for funds and asset managers and setting out various ideas to improve it. Now I should just note that the FCA isn’t suggesting that it will implement all of the ideas included in the DP – this is sort of a menu of ideas that it is seeking views on from the industry, until the 22^nd of May. Our recent briefing note goes into the detail of some of those ideas, so if you haven’t seen that yet, it is worth a read.

The first cross-cutting theme from the DP that I wanted to touch on is the FCA’s stated overall aim of simplifying the asset management regime, and the broader impact that might have on asset managers in practice.

Hannah, perhaps we could come to you for this first theme. How is the FCA proposing to simplify the regime, and what could the broader costs or implications be for the industry? 

Thanks Anita and hello everyone. The current rules for UK asset managers come from various pieces of EU legislation, rather than being structured in a more coherent way. Several of the ideas in the DP are aimed at simplifying or restructuring the rules to address this, and a good example is the FCA’s proposal to introduce a common rulebook for asset managers.

At the moment, managers have to look at the COLL and FUND sourcebooks, plus various other rules elsewhere in the FCA Handbook including SYSC and COBS, and where applicable the onshored AIFMD or MiFID level 2 regulations. Different rules apply to different types of funds and asset managers, but there is also duplication, for example in core conduct rules around conflicts of interest management and outsourcing.

The FCA isn’t proposing to consolidate all of the rules that apply to asset managers into a single sourcebook, like COLL or FUND, but it is considering whether to create a common framework for asset managers, so that the rules that are common to all types of asset management are more coherent and consistent. The FCA hasn’t given any detail around exactly what that would look like and we are unlikely to see any details around that until after 22 May, as it is still in the early stages of its thinking on this.

In terms of implications for the industry, there are some obvious potential benefits of simplifying the regime. It would reduce the compliance burden for new asset managers entering the market, which might in turn improve competition in the market. A simplified regime might also make it easier for the FCA to supervise firms efficiently.

On the other hand, changing large parts of the FCA rules will cause disruption and extra costs for many existing firms, in the short term at least. How severe that impact is will depend on the extent of the change in the rules – for example, if a new rule seeks to achieve similar outcomes to the current rules, the impact on individual firms should be less. The FCA suggests in the DP that it could allow longer for firms to implement the changes where the impact would be greater. Another key consideration in creating a common rulebook is the fact that despite the FCA’s best intentions, asset managers may end up having to comply with more regulation as opposed to less. Whilst it may be easier to navigate the UK rules if the FCA introduces a common rulebook, there would still be cross over areas where other parts of the Handbook would apply to multi-purpose firms who are not only conducting asset management activities but also things like brokerage and research services. 

The overriding message from the FCA is that it wants asset managers, and others in the industry more broadly, to give their views on these simplification ideas and help the FCA decide whether on balance they are worth pursuing. 

Thanks Hannah. Many asset managers, and others in the industry, will be thinking about their response to the DP in the run-up to the 22^nd of May deadline. While they are putting together their feedback on the FCA’s ideas, what are the potential additional burdens they should be taking into account? Taher maybe we can come to you for this. 

Thanks Anita. As  Hannah mentioned earlier, existing firms are likely to be hit by the proposed changes more than new entrants, as their systems and controls are already geared towards the current regulatory regime.

Asset managers are likely to have a set of new rules to comply with, which could include enhanced reporting requirements – if these are introduced there would be a cost implication for firms as they will probably need to improve their systems and controls to meet those requirements. Proposed changes around liquidity management would also see managers having to carry out regular stress tests, which would give rise to additional cost burdens.    

The FCA is also proposing new requirements that would impact portfolio managers, notably in relation to host AFMs. The DP suggests creating specific contractual requirements between the AFM and the portfolio manager, to reduce the risk of misunderstandings about their respective obligations – the FCA hasn’t gone into detail at this stage but it seems likely these could include prescribed contractual requirements similar to those for appointed representatives. This would clearly increase the compliance burden for PMs and might even deter some potential new entrants from entering the UK market. We will go into these implications in more detail in a separate podcast soon as the focus on host AFMs by the FCA has been significant from an oversight perspective. 

As you and Hannah mentioned earlier though, these are just ideas at the moment. For example, the FCA does suggest in the DP that, as an alternative to creating the host AFM contractual requirements, a trade body or similar could help develop industry guidance to set appropriate standards and act as a guide for host AFMs, and that kind of approach might reduce the amount of increase in the compliance burden for PMs. It will be interesting to see what trade associations think of this and their views on how this may affect their members. 

Thanks Taher – lots for firms to mull over there while putting together their responses.

As well as seeking to make the regulatory regime simpler for asset managers and funds, the FCA’s proposals also aim to help firms provide better outcomes for consumers. This goes hand in hand with the FCA’s general focus on improving consumer outcomes, as demonstrated through the Consumer Duty.

Taher, how does this focus on consumer outcomes affect the extent to which the FCA can simplify the regime? 

Well as you say, the Consumer Duty, which starts to apply for open products and services from 31 July this year, does reflect a change in approach to regulation by the FCA, with a greater emphasis on consumer protection and improving consumer outcomes.

The FCA notes in the DP that it wants to see the asset management sector work in the best interests of the consumers and businesses it serves – and in some areas this will mean setting more extensive requirements for firms, particularly in areas where the FCA feels consumer needs are not being met because some firms are not operating to a high enough standard. One example discussed in the DP is around the public disclosure of fund liquidity – the FCA is considering whether to require funds to publicly disclose information on the liquidity of their investments, and also whether to extend the types of funds in scope of its existing liquidity reporting requirements, to ensure it has appropriate regulatory oversight. It also discusses the possibility of making its expectations on investment due diligence clearer for all types of asset managers, as it found that practice in this area has been inconsistent and has in some cases led to consumers suffering losses.

So firms should be aware that the FCA’s desire to see good consumer outcomes across the industry could mean increased obligations in some areas, rather than making life easier for asset managers as the idea of ‘simplifying’ the regime might suggest.

Conversely, though, there are other areas where the FCA suggests reducing current regulation to improve consumer outcomes, for example where it might be imposing excessive costs on firms or consumers or creating unnecessary barriers to innovation. The UK retail funds regime, for example, is an area where the DP highlights complexities in the current rules which it says inadvertently restrict consumer choice. The FCA proposes simplifying the regulatory regime for complex retail funds that are intended for the mainstream retail market, to make it a more attractive framework to use and so increase consumer choice. 

Thanks Taher. We’ve been talking a lot about potential changes the FCA might make to the UK’s regulation of asset managers, as part of its post-Brexit ‘tailoring’ of the regulatory framework for financial services. Hannah, what might this mean in practice for firms that operate cross-border? 

Well there certainly seems to be the potential for divergence here from EU law, and that could cause extra complexities for UK asset managers. A lot of asset managers work on a cross-border basis, offering their products to investors in the EU and elsewhere. And if the UK regime ends up diverging significantly from the EU rules, this could make that cross-border model more difficult. Whereas the UK’s asset management regime currently derives from EU legislation such as AIFMD and the UCITS Directive, moving away from key aspects of that legislation could leave UK managers with two different sets of rules to comply with when doing business in the EU – but this may just be an inevitability of the new era we find ourselves in.

Thanks Hannah. Another area that the FCA has been quite vocal on recently is the use of technology in general in the financial services markets. The DP mentions the Investment Association’s proposal of a Direct2Fund model, where investors would be able to deal directly with a fund when buying and selling units or shares rather than having to transact via the AFM. Taher, can we go into a bit more detail on what this proposal is, and how it could reform the industry? 

Thanks Anita, of course. The D2F model proposed by the IA is an alternative investor-fund dealing model for UK funds. The way it works is that D2F allows investors to transact directly with the investment fund of their choosing, bypassing the AFM. By removing the AFM from the chain, investors are given more freedom to choose who to transact with, and the risk of loss is minimised if not eliminated because there is no possibility of investors bearing the consequences of a failing AFM.

The FCA would need to consider how this might play out, particularly since such a model could result in the majority of CASS rules no longer needing to be applied – as traditionally and currently, the investor’s credit risk to the AFM is mitigated through the operation of the CASS rules. So, if such a proposal goes forward there would be no need to operate a client money account or a dealing account as the investor will transact directly with the fund and the cash would go directly to the fund, where it is received into the Issue and Cancellations bank account. This has significant advantages but the most important is that credit risk could be eliminated as the AFMs role is removed (as opposed to merely being mitigated by the CASS protections). It is important to note, however, that although the CASS risks may be removed, there will be other risks such as investment risk that the regulator will need to work through carefully before deciding whether to go ahead with such a proposal.

Thanks Taher. Hannah, whilst on the topic of technology, the DP also seeks views on fund tokenisation. Given the recent interest in tokenised assets by the FCA, what are some of the things firms should have regard to when considering whether to deal with tokenised assets in funds? 

Thanks Anita. The DP limits the tokenisation discussion to that of fund tokenisation as opposed to more widely on crypto-assets (and as we have seen recently, there are a number of regulatory reforms proposed and underway in the crypto space). Fund tokenisation would allow funds to issue units or shares to investors via digital tokens. This is a new area and careful consideration needs to go into whether this aligns with the regulatory landscape and what needs to be done by the regulator to ensure transactions of this kind do not cause harm to investors. 

Clearly, the market needs to be reactive to the fact there are a growing number of tokenised financial instruments. The FCA is mindful of the fact that the current rules in place on how units are created, transferred, registered and cancelled may not be flexible enough to allow firms to operate ‘digital registers’. Before progressing with the use of tokenised assets in funds, existing funds regulation would need to be uplifted to ensure that investors remain protected and their assets are secure. I suspect the FCA is monitoring this closely and it is possible that the responses from the DP will feed into a much wider discussion about tokenisation across the financial services landscape and not just for the asset management industry. We look forward to seeing what the FCA concludes once the responses are gathered.

Tokenisation does have significant potential benefits. For example, many market participants see digital assets as part of their future. Firms that seek to tokenize securities or other financial instruments, or even other assets, tend to use technology like blockchain to create a digital version of that security. This comes with the advantages of enabling firms to streamline processes and expand their client base. It creates new opportunities, can save on costs (by lowering the cost of bringing offerings to the market) and there is the potential for payment processes to be streamlined by removing third parties and back office service providers.

Thanks Hannah, that is certainly food for thought. So looking ahead, what can funds and asset managers expect to see coming down the line after the DP closes on the 22^nd of May? What is the FCA’s planned approach? 

The FCA seems to be still in the fairly early stages of its thinking on the future of the UK’s asset management regime. When it published the DP, it made clear[1] that it hadn’t ‘cemented’ any new proposals at this stage but instead wanted to promote further discussion and listen to stakeholders’ views about what it should prioritise. It sees this as an opportunity for the UK, in the post-Brexit era, to update and improve its regulation of asset management with a more modern and tailored regime, that better meets the needs of UK markets and consumers.

There is quite a wide range of policy ideas set out in the DP and the FCA certainly doesn’t seem to be planning to implement all of them, or at least not all at once. This is a chance for the industry to get involved and help the FCA decide which ideas to prioritise over others. The ideas that it does take forward will take account of the feedback from industry and will be subject to public consultation. 

Thanks Hannah. Taher, any concluding thoughts? 

Thanks Anita, I think as Hannah says we are in early stages right now. There are lots of interesting proposals that have come from the FCA and we have only touched the surface. Over the next few weeks we will open dialogue with our clients in this space and get their insights too. I can imagine some clients are excited for change and others may be worried or overwhelmed at the thought of such changes.

We are on hand to advise clients and offer our insights on these exciting, proposals. We look forward to seeing the responses when the FCA publishes them, and also the FCA’s proposed next steps. We will also host more podcasts exploring some of the more technical areas in the DP and possibly some in person events to get clients together across different industries to share some more insights on what the market is seeing right now. 

Thanks Taher, and Hannah, for your insights today.

Please look out for further updates on this and other topics on our Regulation Tomorrow blog, including further podcasts on the future of the asset management regime. If you want to discuss anything we have covered today, please do get in touch with Hannah or Taher or me and we would be happy to assist.

Thank you for listening.