The Financial Services and Markets Bill (FSM Bill), which was laid in front of Parliament in July 2022 and is expected to be finalised in the coming months, includes the introduction of a new designated activities regime (DAR). The DAR was originally proposed as part of the Future Regulatory Framework (FRF) review in November 2021 and has the initial aim of bringing activities that are currently regulated under retained EU law into the Financial Services and Markets Act 2000 (FSMA) model in a proportionate way, with the potential to add further activities in future. The FSM Bill will establish a framework for repealing all retained EU law relating to financial services and moving to new requirements under the FSMA regime. The government’s long term goal in creating the DAR is for the regulators’ rulebooks to become the single source of regulatory requirements for UK firms.
The Edinburgh Reforms, announced by the Chancellor in December 2022, gave some further detail on the intended use of the DAR, including plans to use the new regime to replace the UK Prospectus Regulation and elements of the UK Securitisation Regulation – both of which were onshored post-Brexit as part of retained EU law.
As we will explore further below, the move from retained EU law to the DAR will mean that as well as firms that are authorised and therefore already regulated by the Financial Conduct Authority (FCA), unauthorised firms that have until now fallen outside the scope of the FSMA model will be subject to regulation (albeit to a limited extent) by the FCA.
The new regime
The DAR will exist in parallel with the framework for regulated activities requiring authorisation under FSMA. It will enable designated activities that were previously regulated under retained EU law, or such other activities as HM Treasury decides, to be regulated by the FCA outside the context of authorisation (i.e. without requiring the entity performing them to be authorised). The carrying on of a designated activity must comply with the requirements set out by HM Treasury in secondary legislation or in FCA rules, unless there is an exemption.
HM Treasury can, by way of regulations, ‘designate’ activities related to the UK financial markets under new part 5A of FSMA. Activities under the DAR will not be subject to authorisation or the threshold conditions, but instead HM Treasury and/or the regulators will be able to impose direct requirements (i.e. rules regarding how the activity must be carried out) or bans on them. There will not be a single approach to all designated activities or universal consequences for their breach under FSMA. Each designated activity will be governed by its own FCA requirements and any applicable rules directly imposed by HM Treasury in its regulations.
When designating an activity, HM Treasury will be able to make regulations relating to the performance of that activity, including prohibiting it in its entirety, or setting direct requirements and stipulating where the FCA may make rules relating to the performance of the activity. The FCA’s powers to make rules for each designated activity must be expressly granted by HM Treasury and will only extend to the designated activities of a firm (i.e. not the firm’s wider unrelated activities). In this respect the FCA’s powers are more limited under the DAR, as its general rule-making powers in relation to authorised persons under FSMA do not apply.
However, if provided for in HM Treasury regulations, the FCA can issue directions imposing requirements specific to a firm or a group of firms relating to the carrying out of designated activities (e.g. to take or refrain from taking a specified action). Such directions may extend to activities which are not designated activities (new section 71O(4) FSMA).
The consequences of a breach of designated activity requirements are not set out in the new FSMA provisions on the DAR. In contrast to a breach of the regulated activities framework, a contravention of a designated activity rule or regulation does not automatically make a person guilty of an offence, or make transactions void or unenforceable or give rise to action for breach of statutory duty, unless the relevant designated activity regulations explicitly state otherwise. HM Treasury has the power, however, to make provision for liability and penalties and to create enforcement frameworks, in particular by applying existing FSMA provisions (with or without amendments) to designated activities, including criminal offences created by FSMA. It is worth noting that FSMA, as amended by the FSM Bill, will explicitly state that no action for damages can be brought under section 138D FSMA for a breach of designated activity requirements (new section 71S(6) FSMA).
Under the planned regime, HM Treasury can specify an activity as a designated activity if it is related or connected to either:
a) the financial markets or exchanges of the United Kingdom, or
b) financial instruments, financial products or financial investments that are (or are proposed to be) issued or sold to, or by, persons in the United Kingdom.
There are no definitions of financial instruments, financial products and financial investments, but new section 71K(7) of FSMA clarifies that these may include cryptoassets (as defined in section 417 FSMA, as amended by the FSM Bill). It was confirmed by the Economic Secretary to the Treasury, Andew Griffith, during the Bill’s committee stage in the House of Commons that this was necessary to allow the government to regulate cryptoassets beyond the regulation of stablecoins.
The explanatory note to the FSM Bill states that, “Initially, the government expects most designated activities to be activities which are currently regulated through retained EU law.” It is further indicated, however, that not all retained EU law will be covered by the DAR. For example, as discussed below only certain elements of the new securitisation regime will make use of the DAR. HM Treasury also noted in its November 2021 consultation on the FRF that it did not intend the DAR to be applied to certain financial market infrastructures that are systemic to the financial system but currently sit outside the core FSMA authorisation regime.
Schedule 6B to FSMA contains an illustrative, but non-exhaustive list of examples of the types of activity which HM Treasury intends to specify as designated activities. They include:
- Derivatives: activities relating to entering into derivative contracts (including those not cleared by a central counterparty) or holding positions in commodity derivatives.
- Short selling: engaging in short selling in relation to specified financial instruments.
• Securitisation: acting as originator, sponsor, original lender or securitisation special purpose entity in a securitisation or selling a securitisation position to a retail client located in the UK.
- Financial markets: offering securities to the public or applying for, securing or maintaining the admission of securities to trading on a securities market.
- Using or contributing to a benchmark: issuing an instrument which references a benchmark, measuring the performance of an investment fund through a benchmark, acting as a benchmark contributor or otherwise contributing data for the purposes of determining a benchmark.
HM Treasury’s power to decide which activities to designate is not limited by this illustrative list. HM Treasury indicated in its November 2021 consultation paper on the FRF that it intended the regime to be capable of applying to other activities in the future to adapt to developments, for example to new types of activity or where an existing activity becomes more risky. This approach was confirmed in the government’s policy statement on the Edinburgh Reforms.
The first pieces of draft secondary legislation relating to designated activities were published in December 2022, alongside the Edinburgh Reforms policy statement.
Edinburgh Reforms – new prospectus and securitisation regimes
While the FSM Bill sets out in general terms the types of activities that can be ‘designated’ by HM Treasury, the draft statutory instruments (SIs) relating to prospectus requirements and securitisation that were published as part of the Edinburgh Reforms provide the first illustrations of how designated activities might look in practice.
The draft prospectus SI sets out the government’s proposals for replacing the existing UK Prospectus Regulation (to be repealed as part of the wider cull of retained EU law) with a new ‘public offer and admissions to trading’ regime, which will rely on the DAR. Part 2 of the SI sets out eleven designated activities, which relate to public offers of relevant securities, admissions to trading on a regulated market and admissions to trading on primary multilateral trading facilities. Part 3 delegates authority to the FCA to make detailed rules in relation to those designated activities, including when a prospectus is required.
The government also plans to repeal the UK Securitisation Regulation, but the DAR will be used to replace only certain elements of the existing regime. This is due to the current split of regulatory responsibilities between the FCA and the Prudential Regulation Authority (PRA), which will be maintained under the proposed new securitisation regime. As a result, the list of designated activities relating to securitisation is much shorter than the one for the prospectus regime and there is a specific carve-out for PRA-authorised persons from certain FCA rules to be made under the DAR.
Who will be impacted by the new regime?
Under the current proposals, the DAR is likely to initially impact firms or companies that carry out any of the types of activities listed in the planned new Schedule 6B to FSMA. This means it will apply to a broader range of entities than authorised persons under FSMA, including unregulated corporates.
This means that entities that engage in short selling, enter into over-the-counter (OTC) derivative contracts, hold positions in commodity derivatives, are involved in securitisations, offer securities to the public, list their shares on an exchange, or use or contribute to a benchmark, may be subject to the regime.
The exact scope of activities covered, and therefore entities caught, will become clearer in time, once the FSM Bill has been passed and HM Treasury begins to exercise its powers under the Bill to designate activities. The areas with the most clarity at present around activities caught are those discussed in more detail above, i.e. activities relevant to the prospectus and securitisation regimes.
As discussed above, as well as the types of activity mentioned in new Schedule 6B, the DAR’s reach could be expanded in future to cover other areas. One clear example for further expansion is in the crypto space. HM Treasury’s proposals for regulating cryptoassets, the latest details of which were set out in a February 2023 consultation, will require persons carrying on certain crypto-related activities to be authorised to do so. Other activities, which relate to cryptoassets but do not require authorisation under the proposals, could instead be covered by the DAR.
How will firms be impacted?
The DAR is intended to be proportionate, ensuring non-financial services entities that carry on certain financial activities continue to be subject to rules after retained EU law is revoked, but without requiring them to be authorised. This approach should mean that the impact of the changes on these businesses is not overly burdensome. However, any firms falling within scope of the DAR will have a new set of rules to navigate, and dealing with the regulator (the FCA) will be a new experience involving new processes for unauthorised firms to adapt to.
The proposed new Part 5A of FSMA gives the FCA powers to impose requirements on those carrying out designated activities, which ‘may extend to activities which are not designated activities’. This suggests there is the potential for a wider-ranging impact on firms’ activities. It also enables HM Treasury to use secondary legislation to set rules on liability, compensation and enforcement in relation to designated activities, and the draft SI for the prospectus regime, for example, includes provisions requiring the payment of compensation for failures to comply with the rules. Firms falling in scope of the DAR will need to familiarise themselves with the consequences of failure to comply with the rules relating to the designated activities they carry on, as well as the detail of the rules themselves.
The planned revocation of retained EU law and the transfer of regulation for these activities into the FSMA model seems likely to lead to further UK divergence from EU rules. The government has talked of a desire to ‘tailor’ the UK’s post-Brexit regulatory framework for financial services to best suit the UK market – this was an aim of the FRF review, which led to the reforms set out in the FSM Bill – and moving the rules for these activities into the FCA Handbook will arguably enable this tailoring to be done more easily, avoiding the need for future changes to go through the legislative process. Any further divergence from and inconsistency with EU rules may have an impact on firms that operate in both the EU and the UK.
The DAR is likely to affect, and to subject to various rules and a degree of supervision, a new category of firms that are currently unregulated with respect to the type of activities listed at Schedule 6B to FSMA. It is also clear that the DAR may affect firms engaging in activities in relation to cryptocurrencies. These firms and any authorised firms engaged in such activities will need to:
- Consider whether their activities will fall within scope of the DAR, either initially or in the foreseeable future.
- Keep track of any activities HM Treasury designates or proposes to designate and any relevant regulations and rules that are proposed and consulted upon, as well as any changes to the proposals.
- Prepare to comply with any new rules made in relation to relevant designated activities, including by amending relevant documentation with clients (such as terms of business) as well as internal documents and processes (e.g. compliance policies and procedures, and employee training to ensure staff are aware of and equipped to comply with the rules).
- Engage or, in the case of unauthorised firms, learn to engage with the FCA.
A number of practical matters relating to the proposed DAR are yet to be clarified, including:
We can expect further clarity on these points as HM Treasury publishes more draft SIs and/or the FCA launches regulatory consultations on its proposed approach and rules to implement the DAR.
- How unauthorised firms will be monitored. For example, it is not yet clear whether there will be a register or list of unauthorised firms undertaking designated activities.
- The consequences of breach of DAR requirements and enforcement methods, as discussed above.
- The extent to which the FCA rules on designated activities will diverge from EU and existing rules on such activities.
- How the FCA rules on designated activities will be implemented (for example, where they will sit in the FCA Handbook) and the extent of divergence and inconsistency with the existing rules in the FCA Handbook for authorised firms.
- For designated activities that are banned, it is not clear if there will be any permitted route to enable firms to conduct those activities. For example, firms can conduct regulated activities under the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (RAO) if they are authorised, but it appears that for designated activities that are banned, firms will not be able to engage with them at all, unless an exemption applies.
The FSM Bill is still being considered by Parliament and is currently at Committee stage in the House of Lords, with the latest sitting having taken place on 21 March 2023. Once it has passed through Committee stage, there will be a report and third reading in the House of Lords before the Bill reaches its final stages, where amendments will be considered and Royal Assent given. The government indicated in January that it hoped to have the Bill finalised by Easter 2023.
HM Treasury stated in its policy note for the prospectus SI that it did not plan to finalise that instrument until after the FSM Bill has received Royal Assent, as a lot of the detail of the new regime is still under development. We will therefore need to wait and see how the proposals develop and what will be included in the first substantive set of finalised designated activities. Until then, the focus will be on the progress of the FSM Bill through the Parliamentary process and how different it looks when it emerges.
It is also worth noting that the FCA published a document on the FRF review in December 2022, in which it flagged its work with HM Treasury on initial priorities for the transfer of firm-facing requirements from retained EU legislation into the FCA Handbook. As part of a ‘phased prioritisation approach’, the FCA said work had already begun on the first phase, which includes areas needing important changes in the short-term such as the UK Securitisation Regulation and the prospectus regime. It seems likely that we will hear more from the FCA on its plans for implementing the DAR once the FSM Bill has received Royal Assent.