Change Q2 2017: Top regulatory developments

Christopher Bond, Chartered MCSI, Change editor, outlines key regulatory changes in the finance industry in the past quarter. The regulatory updates outlined below were originally published in the Q2 print edition of The Review


2017 has started like a lion. Firms must focus on preparing for the updated Markets in Financial Instruments Directive (MiFID II) in January 2018, but are distracted by making contingency plans for Brexit and the extension of the Senior Managers and Certification Regime next year. The UK regulators are also actively reviewing many sectors from an investor protection and markets perspective, and there are the ongoing priorities of cyber crime and money laundering. A substantial amount of time at board meetings has been spent on regulation over the past few years, but there are signs that the flow of big regulatory changes is slowing at source internationally.

I have selected below some points for firms’ management which affect all firms, and some points for specific financial sectors. These points are addressed to senior managers, although compliance officers may also be interested to know what is happening in other sectors.

1. Preparing for MiFID IIThe European Securities and Markets Authority (ESMA) has published more information (questions and answers) on price transparency and markets, including on  pre-trade price waivers and the Systematic Internaliser (SI), multilateral trading facilities (MTFs) and Organised Trading Facilities’ (OTFs) regimes, which all sell-side firms should study to see if they come into one of these categories, and if so, gain an understanding of the consequences. Although published earlier, the corporate governance management requirements can be easily overlooked.

The FCA has issued another (fourth) consultation on specialist areas not covered in its previous mainstream ones, such as corporate finance, stock lending and oil market participants. Note also the PRA Policy Statement of October 2016 on algorithmic trading, including client direct electronic access.

The financial services sector is waiting for the FCA’s policy statements on these and hoping that there will be enough time  to make the IT, organisational and regulatory changes before the start of MiFID II in January 2018. The deadline for this is 2 July 2017, although the sector would like this earlier. Most of MiFID II  is planned to start on 3 January 2018; some parts are later, eg, the SI regime and the double volume cap on non-regulated market transactions in August and September 2018.

The attitude of the FCA on late compliance may depend on the area – it has emphasised the importance of transaction reporting. The tight timetable has made developing IT programmes for collecting newly required data difficult – to the great benefit of IT service providers.

2. The slow death of the investment analystThe combination of the unbundling requirements for research and transaction costs of MiFID II (with strong incentives on  fund managers to absorb research costs) and the Market Abuse Directive’s restrictions on investment research, has already reduced the number of analysts – particularly in investment banks – and resulted in some moving from sell-side firms to buy-side ones or to independent firms. One consequence of this change has been to further disadvantage smaller fund houses already subject to disproportionately high compliance costs. It is reported that some banks are asking for substantial annual payments from fund companies for access to their research platform.

3. Qualifications for wholesale advisersOne lesser-known change introduced by MiFID II is its increased ‘knowledge and competence’ requirements for wholesale investment advisers. The ESMA guidelines under MiFID II require anyone making personal recommendations to professional or retail clients to have a qualification – a requirement that was dropped in the UK in 2006. There is no grandfathering relief. This means that all sell-side advisers (but not discretionary managers) such as corporate analysts, corporate brokers, salesmen to professional clients and corporate finance advisers; and buy-side advisers, such as to funds and portfolios, will need qualifications. However, ‘qualifications’ are defined to extend to training and testing as well as exams. In its consultation paper the FCA proposes to give firms the choice over these so long as they could satisfactorily explain them. The policy statement is due in June. The start date is 3 January 2018 so there is little time. The CISI is to offer compliant exams for employers. The extension of the Senior Managers Regime (see article 6 below) to non-banks in 2018 will mean that the firm’s annual ‘fitness and competence’ assessments will need to take this separate requirement into account.

4. Asset managers under the regulatory microscopeThe FCA’s reports into asset management are well known. It is now demanding large changes to business models flowing from its analysis that the market is uncompetitive on fees, unlike some other sectors. The FCA wants an ‘all-in’ fee that includes transaction costs. Those in favour argue that investors should be able to compare total costs before choosing and that this also addresses churning; opponents argue it will encourage stasis in portfolios and closet tracking. There is also pressure to adopt single pricing (without separate buying and selling prices) which will affect ‘box profits’. This is in addition to the MiFID requirement to provide full disclosure of costs and for managers to fund research costs as described in the previous article.

5. Brexit planningThe only clear fact is that the Prime Minister has now given formal notice to the EU of the UK’s withdrawal. The two-year notice period for negotiating the UK’s membership and the future relationship has started. There is a high-level description of what the UK wants in the Government’s White Paper, but so far the reaction of the other EU members and of the Commission is fragmentary, such as the Commission’s working paper on harmonising the ‘equivalence’ provisions of different EU directives, and making them tougher, eg, on ‘equivalent’ countries following the EU as it develops its rules. The UK Government wants a bespoke agreement based on mutual recognition for which there is no precedent and which will need time to agree.

So, firms must now decide whether (a) they are affected, and (b) if they are, whether to wait and see what agreement there is or (c) whether they cannot wait because there is no certainty in such an agreement and it may take a year or two to obtain the appropriate licences to set up inside the EU. Many EU states are welcoming UK-based firms but on terms that the firm has a real presence in the state, and the EU office is not ‘paper’ simply making back-to-back transactions with the UK firm. Third country banks in particular that have Europe, Middle East and Africa (EMEA) offices in London, may need to action their contingency plans this year before knowing the outcome of the negotiations. Others, such as in asset management, may have more time to act if they already have other EU subsidiaries and funds with suitable licences. The UK regulators have a potential conflict of interest – they want firms to be prepared but do not want to encourage them to leave.

6. Non-banks prepare for the Senior Managers and Certification Regime

The regime which currently applies to banks will cover all other types of firm at some time during 2018. This gives individuals responsibility to the regulators, and outsources to firms the role of approving less senior staff (currently Approved Persons) and of annually checking their knowledge and competence. The FCA plans to issue a consultation paper before the end of June. Banks spent many months preparing for the regime. Key documents include the overall Responsibilities Plan, the individual senior manager responsibility statements based upon it, the handover certificates from existing to new managers, the giving and obtaining of detailed references from previous employers, maintaining a breaches register and reporting on it to regulators. Fortunately a few of these later requirements will not apply to non-banks.

The FCA has said that it will apply the regime ‘proportionately’ to  the 50,000 plus non-banks. The planned consultation paper will show how it plans to do this. One possible approach is to divide firms between ‘complex’ and ‘non-complex’ categories, with the first having to carry out the full range, and the second a reduced number. Informal comments from the FCA indicate that it expects managers to accept personal responsibility but may not expect small firms to spend a lot of time mapping responsibilities. However, larger or even medium-sized ones are likely to need to do so, and all senior managers should start thinking about how it will affect them personally. Enforcement cases against bank managers for problems in their areas are currently absent, and practical enforcement PRA and FCA policies are unpublished.

7. Regulatory reform signals from the US

A mixed picture is emerging on President Trump’s ‘bonfire of regulations’. He has commissioned a review of Dodd-Frank reforms, announced his ‘two out’ for ‘one in’ policy, and appointed bank- friendly advisers, including the new chairman of the Securities and Exchange Commission (SEC). In contrast most of the Dodd- Frank reforms are well advanced, such as in central clearing and regulated trading (and some say irreversible). Rule change is the domain of the SEC and Commodity Futures Trading Commission (CFTC), not the President, and some firms (particularly in derivatives) and politicians – even Republicans – like the reforms. So, no big immediate changes, although the big banks are hopeful that some of the constraints on them (such as trading) will be reduced or even removed.

8. Change in the OTC derivatives markets

The media focus on preparing for MiFID II has covered big regulatory changes in trading and clearing over-the-counter (OTC) derivatives under both the European Market Infrastructure Regulation (EMIR) and MiFID II. Under EMIR, non-central counterparty (CCP) cleared transactions executed OTC between financial counterparties and larger non-financial ones have needed to pay variation margin since 1 March 2017, doing away with credit lines. Preparing for the change means changing documentation (particularly the Credit Support Annexe with numbers some estimate at 200,000) as well as making arrangements for providing variation margin (and initial margin, depending on group size) – sometimes daily. The logic is clear – if the new documentation is not in place, there should be no new trades. However, delays in new counterparty documentation (the International Swaps and Derivatives Association suggests that only 15% of counterparties have updated documents) have resulted in the US regulator delaying the start until 1 September 2017, and the International Organization of Securities Commissions (IOSCO)/ESMA issuing guidelines to regulators to focus on the biggest and riskiest market exposures. Other firms need to show good faith efforts to comply. There are also often difficulties in categorising counterparties (which depends upon group size and nature of activity), and some providers may be able to assist firms here.

9. Regulators face up to technical challenges

The speed of change in firms’ adoption of new technology is fast. Existing firms are facing multiple threats – both from new firms developing online services and existing ones adopting them first. In private wealth management, the ever-expanding roles of platform services, such as robo-advice and model portfolios, are disrupting business models. In retail banking, artificial intelligence and the use of mobile devices threaten firms with physical branches. In payment systems the entry of new types of business such as Amazon and Google could take away a key part of traditional banking, even extending to loans. In investment clearing and in insurance the use of blockchain could make central clearing counterparties obsolete just when the regulators are empowering them.

So how are regulators reacting to these developments? They welcome their ability to break down the barriers to entry to some services such as asset management and payments, reducing the cost to investors; they fear the systemic risk and lack of regulator control they produce. Above all the rule-making system from global bodies such as Basel (for banks) and IOSCO (for securities) which cascades down to individual regulators, is far too slow to do other than react a long time after the technology has changed the market and firms’ business models. After the 2008 crisis, markets  and firms will provide more transparency and ‘big data’ and artificial intelligence should help them understand it; but more forward- looking co-operation and information sharing is needed to control the new risks which could lead to a global crisis, such as the lack of time to deal with a failing market, clearer or bank in the full glare of social media. 

10. How should Financial Services Compensation Fund levies be calculated?

The fees and levies that the Financial Ombudsman Service (FOS) and FSCS impose are a high and increasing cost of doing business for all firms, particularly retail firms, for example, in life and pensions claims from self-invested personal pensions (SIPPs) and high risk non-standard assets. Which is why the possibility of the costs being risk weighted towards the riskiest business models is an important discussion. On the one hand, it may make some small advice firms uneconomic, and on the other, it addresses the argument that the good pays for the bad and brings it into line with insurance practice.

11. The Financial Ombudsman under pressure

The FOS is always controversial, trying to hold the balance between retail investors and firms. Recent questions include challenges on scope (should mini bond holders be covered?); persuading firms to accept its awards against them (the FCA has only taken action against five firms that ignored them although 195 were referred to it – we do not know how many firms paid up as a result of the reference alone). Latest figures show that the FOS upheld the adviser in 40% of complaints; and that the FOS commented on suitability: “One of the key things is to resist the temptation to include everything, and to make sure that it is as tailored as possible to the individual and their circumstances, as well as to keep an eye on their length, because this does risk people not reading them.” (Indeed, the FCA is proposing to change its Conduct Rules to  address “over disclosure”.)

This article was originally published in the Q2 25th anniversary print edition of The Review. The print edition is available to all members who opt in to receive it, except student members. All eligible members who would like to receive future editions in the post should log in to MyCISI, click on My Account/Communications and set their preference to 'Yes'.

Published: 31 May 2017
  • Compliance, Regulation & Risk
  • Change
  • SMCR
  • Brexit
  • ESMA
  • Mifid II

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