Change: buy-side asset managers – regulatory developments May 2017

Gerard Dique MCSI, senior compliance officer at AXA Investment Managers Real Assets (UK Compliance), with the help of his intern Alexis Vanchieri, outline some important topical points

1. MiFID II conflicts of interest that asset managers can’t ignore The updated Markets in Financial Instruments Directive (MiFID II) is a monstrous piece of regulation that has been postponed but becomes all too real on 3 January 2018. One of the issues that looks like it should be straightforward is ‘Conflicts of interest’, but is not. Let’s consider ten principle areas of focus, as outlined at a MiFID II briefing by Norton Rose Fullbright on 5 April 2017:

  1. Considerably more onus on firms to prevent conflicts (ie, identify, source, manage).
  2. Reliance on disclosure as a risk mitigant is no longer acceptable – disclosure is a last resort, as outlined in Hogan Lovell’s MiFID II Conflicts of interest report, December 2016 (ie, disclosure has always been a staple for dealing with conflicts but disclosure under MiFID II can only be used when the firm’s administrative arrangements to manage conflicts are inadequate).
  3. Need to think about all conflict risks, not just material risks (ie, this is a game changer requiring considerable thought on reviewing conflict risks across the business).
  4. Onus on firms to take ‘appropriate’ rather than reasonable steps – requiring positive determination from organisations (ie, again a big change from the traditional reasonable approach that has dominated the UK regulatory landscape for 20 years, requiring a measured, audit trail forensic approach).
  5. Expectation that firms focus systems and controls on the identification and resolution of conflicts.
  6. Larger firms with multiple parts need to consider their entire organisation’s conflicts and impacts.
  7. Significant focus on inducements (note that asset managers don’t need much reminding of the FCA’s gifts and entertainment guidelines – approvals can’t be excessive and need to be justified and benefit or enhance the service to clients, according to the FCA inducements and conflicts of interest thematic review: key findings).
  8. Internal staff remuneration is key.
  9. Focus on conflicts disclosures.
  10. Reports to management on conflicts annually.  
Most buy-side firms should be deep into their MiFID II projects, but for those who are still considering their positions, some practical considerations include:
  • Conflicts clearance – With increased focus on prevention of conflicts, there is a high importance placed on early detection and assessment to show a reduced reliance on disclosure, such as how to identify potential conflicts, however material and to ensure the issues are properly dealt with prior to undertaking the business.
  • Mindset change and education – Such as changing from a detection to prevention approach, focusing on all potential conflicts and not just material ones, and moving away from the ‘conflicts happen’ acceptance mentality so that the number of conflicts that are not prevented at source are reduced. 

2. FCA Business Plan 2017/18 and FCA asset management market study interim report – what buy side asset managers need to know

The FCA highlighted six long-term cross-sector priorities in its 2017/18 Business Plan:

All these subjects deserve their own summary, but space dictates we select only a few. The FCA continues to focus on poor culture and the asset management industry. The November 2016 Asset management market study – interim report for example notes fund governance bodies (either in-house or outsourced) lack independence from fund managers and do not appear to effectively challenge value for money. Examples of planned activities in 2017 include extension of the Senior Managers and Certification Regime for asset managers and the continuing review and oversight of remuneration (both for senior management and at the fund fee level). Culture and governance will no doubt continue to be important factors for any FCA on-site review and firms need to evidence what culture and governance activities they have carried out proving they are embedded in the business.

Promoting competition and innovation has become a much bigger part of the FCA’s focus in recent times (this became an objective in 2015 with a new FCA competition team of around 90 staff) to review poor competition and how it impacts on effective customer outcomes. It is seen as a mechanism to improve service levels, and lower prices in a regulatory environment that enables competition to thrive. That’s the theory. In its interim report the FCA notes it will consult on asset allocation advice given by consultants and quality of advice, with the Competition Market Authority (CMA), on whether to make a market investigation reference to the CMA for in-depth investigations. The FCA is aware innovation can help competition thrive, and has outlined areas in the Business Plan including:

  • exploring ways to strengthen Project Innovate and improve impact
  • supporting firms, offering one-to-one support to manoeuvre through the regulatory landscape
  • building on the work of the FCA Advice Unit and Regulatory Sandbox (initiative kicked off in 2014 to provide innovators with support to navigate the regulatory system and promote competition in the interest of consumers)
  • continuing to communicate with firms and regulators regionally and internationally
  • introducing a new bank start-up unit to help support new entrants into the market.

The FCA appears to be taking its competition objective responsibilities seriously, so asset managers must be mindful that their activities will increasingly include how they fit into the competition and innovation good and bad practice. Expect FCA guidance on competition and innovation in a year or so.

3. Cyber crime/cyber security

The dangers of cyber are no longer restricted to the imaginary world of Dr Who, but are firmly based in everyday risk for asset managers. Employees should complete ‘phishing’ training so as to be aware of email and text attacks on their firm’s business (attempting to access systems and data, disrupt, compromise or corrupt systems and data). Cyber crime now forms a real and present risk for asset management and many businesses. Technological change and resilience is one of the FCA Business Plan themes for 2017/18 and focuses on how well firms are managing the risks associated with new technologies, and ever-growing cyber risks. In a recent Citywire Asset Management Compliance & Risk Conference on 30 March 2017, the panel had a number of questions to consider:

  • What are the latest cyber security developments asset managers should be aware of?
  • How to know that you have done everything you can to prevent attacks?
  • How are you protected?
  • What are the costs involved in ensuring you are adequately protected?

On 24 April 2017 Nausicaa Delfas (executive director, FCA) gave a speech to the Financial Information Security Network (‘Expect the unexpected – cyber security – 2017 and beyond). She said: “The threat from cyber crime continues to rise, and with the asymmetric nature of this battle favouring the criminal. Even those mature organisations that have recognised the threat, are well funded and have mature security capability, cannot fully counter the threat in isolation. As a sector we need better collaboration amongst ourselves and with government to share intelligence and grow the necessary talent to keep us safe and secure in the future.”

The key points from the speech include:

  • The threat landscape is ever-evolving, including the ‘internet of things’ being exploited to conduct distributed denial-of-service attacks through SMART TVs and fridges.
  • Rather than treading over old ground, it’s time to step forward to address the ever-widening gap between criminal capability and intent, and our capability to defend ourselves.
  • To manage these threats we need to move the dialogue on:
    • getting the basics right could prevent 85% of breaches
    • moving to a secure culture – take staff on a journey to change their mindsets
    • measuring that culture
    • using other drivers beyond the boardroom, such as institutional investors
    • sharing information
    • building capability.

4. UK gold plating: key buy-side topics – beyond MiFID II

The FCA is currently proposing to extend three MiFID II conduct standards to collective portfolio management firms that do not carry out MiFID business (ie, Undertakings for Collective Investment in Transferable Securities (UCITS) and Alternative Investment Fund Managers (AIFMs)), so firms need to be aware of this impact.

Inducements and research

In the FCA’s CP 16/29 it confirms: “We recognise that firms may find it more practical to take a single approach to compliance for closely connected lines of business notwithstanding the differing regulatory standards”. In other words, firms may wish to consider applying the higher standards across the entire business.

Under MiFID II, research is allowed not to be treated as an inducement provided that it is paid for:

The FCA intends to extend these requirements to UCITS management companies and AIFMs (non-MiFID businesses).

Best execution

The FCA is proposing that AIFMs and UCITS management companies (ManCos) will be subject to the annual disclosure of top five execution venues for each instrument class.

Osborne Clarke states firms must determine the top five execution venues in terms of trading volumes based on executed client orders, and publish details of the percentage of orders which were passive or aggressive. The summary of outcomes should include a number of points, for example the importance given to factors such as price and speed, a description of any conflicts of interest, and how order execution differs according to client categorisation.

If a firm only uses one execution venue, it will be required to show, using execution quality data or internal analysis, that this consistently delivers the best possible results which are as good as the results which could reasonably be expected if alternative venues had also been used.

The deadline for each report is 30 April following the end of the period to which the report relates, with the first report to be provided by 30 April 2018. This ongoing requirement will prove a challenge both in time and resources for firms generally.

Recording of telephones and electronic communications

  1. Removal of investment manager exemption (COBS 11.8) and replacing it with new SYSC chapter: The FCA is removing the current COBS 11.8 exemption for investment managers from telephone taping. Investment managers will therefore be directly within scope of the telephone taping rules.
  2. Gold-plating to AIFMs and UCITS ManCos: The FCA proposes to gold-plate all of the MiFID II telephone taping and electronic communication retention rules onto AIFMs and UCITS ManCos. Complying with these rules will bring significant cost and operational burden for such firms. The FCA has acknowledged that the full taping obligation may not always be appropriate for retail financial advisers.
5. The FCA sets sights on fund ratings and assesses impact of Brexit

In an FT Adviser article in January 2017, Rory Maguire (managing director of the only FCA-authorised ratings agency, Fundhouse) confirms it is a “matter of time” before the FCA turns its attention to fund ratings. Fund ratings are one of the favourite tools for investors (retail and institutional), to promote their funds and influence investors. Another article by the Financial Times also confirms a “good rating will often draw investors in droves, and research has shown that money is concentrated in funds with higher ratings”. The FCA highlights in its Asset management market study interim report in November 2016 that “funds with the best ratings do not significantly outperform their benchmark net of charges; net of fees excess returns are statistically indistinguishable from zero over various different holding periods”. Given the FCA’s focus on treating customers fairly and customer protection it is not surprising ratings is a risk it is focusing on, especially as the average retail client will not understand the rating agency model approach.

Rating providers have (unless provided free, for example the Morningstar gold, silver and bronze rating) had to manage the conflict of interest of being paid to provide a rating. The FCA’s interim report mentions that some asset managers who do not pay for a licence fee will then not be rated.

To complicate matters, Brexit is now front and centre in regards to question marks over regulatory responsibility post-Brexit, and casts doubt over ratings agencies’ future in London (Standard & Poors’, Fitch and Moody’s are authorised by the European Securities and Markets Authority (ESMA), so if the UK leaves the EU these ratings agencies become unregulated). Discussions with the FCA and the Bank of England (the two institutions who potentially may take responsibility post-Brexit) need to take place. The ESMA will need to assess if UK regulation is equivalent to the EU ratings regulation, which is on the to do list under Brexit financial services, along with loss of passporting rights and freedom of movement of EU nationals into and out of the UK. Given the big three London ratings agencies employ 1,400 people and generate £600m, this is another part of the UK financial services which could be damaged by the Brexit juggernaut. If no transitional agreement is in place, March 2019 is looming fast.

Views expressed in this article are those of the authors alone and do not necessarily represent the views of the CISI.

Published: 11 May 2017
  • Change
  • Wealth Management
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  • Compliance, Regulation & Risk
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  • Change May 2017

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