The take-aways: exploring the macro-themes
Overall the DP touches on a number of cross-cutting themes for asset managers. The FCA makes clear that the improvements suggested in the DP are not intended to further complicate the regulatory perimeter, and, in flagging the areas flagged for discussion, the FCA has kept in mind the overarching aim to protect investors from harm, increase consumer choice, and encourage competition in the market. We have identified some key themes arising from the DP which firms may find helpful when deciding how to respond:
The DP builds on the FCA’s agenda to simplify the existing regulatory framework for asset managers. It covers a number of areas in this respect including by introducing the possibility of a common rulebook for asset managers to follow (without consolidating the existing requirements in COLL and FUND). This could set common standards for UK asset managers and reduce duplication which has arisen through implementing various EU-derived rules, including core conduct obligations such as conflicts of interest rules across the different fund regimes (see below). Whilst such a simplified regime would be welcomed by market participants and inherently make the Handbook easier to follow, this should be balanced against the costs and disruption to existing business models that may result from a significant change in the UK regulatory perimeter as it applies to asset management.
Whilst the DP focuses on simplifying the UK regulatory regime for the asset management industry and addressing gaps in current legislation, which would have clear benefits, clients should be aware that they could also face additional burdens in relation to their current business models as a result. For example, asset managers would need to adhere to new regulations which may include (if pursued) requirements to carry out regular stress testing to ensure effective liquidity management. If the reporting obligations for the fund industry are enhanced as proposed in the DP, firms may also face the cost of improving their systems and controls to meet these new requirements and ensuring they have adequate resources to implement any large scale changes.
Further, portfolio managers (PMs) may be subject to new requirements, such as stringent rules on contracting with host AFMs (which we envisage might include prescribed contractual term requirements similar to those for appointed representatives). This may deter new non-traditional asset management participants from offering products under the regulatory regime and create additional burdens for compliance teams, who will need to ensure that governance frameworks within a firm remain compliant with new regulatory requirements in the sector.
Market participants should have regard to the possibility of further complexity arising from any divergence from EU law in the UK’s post-Brexit framework. Many asset managers work on a cross border basis, and their products are offered to market participants globally. Whilst the DP highlights the theme of simplification and conformity with other jurisdictional rules, there may be further complexities if the UK diverges substantially from the EU framework where there are no corresponding changes in the EU to match the UK’s plans. The DP acknowledges that the regulatory framework for asset managers and funds derive from key EU legislation, but does not delve deeper into the specific implications that global firms may face if the UK moves away from key aspects of that legislation.
Focusing on consumer outcomes
The DP discusses the UK retail funds regime and highlights current complexities that inadvertently restrict consumer choice. As we have seen through the Consumer Duty, the FCA is focused on firms providing better outcomes for retail consumers, and the proposals outlined in the DP go hand in hand with that agenda by simplifying the regulatory regime for complex retail funds which are intended for the mainstream retail market to make it a more attractive framework to use (and increase consumer choice by doing so). However, whilst the FCA sets out ways in which the regime can be simplified on first look, in some areas the DP in fact proposes increasing regulation where the current framework does not achieve the results the FCA expects in the market. Firms should be mindful that simplification of the regime does not necessarily mean reduced obligations, but may in fact lead to asset managers being required to comply with more regulation in the sector to achieve the good outcomes for consumers that the FCA hopes for.
While the DP sets out a wide range of policy ideas for improving the UK asset management regime, it is clear that the FCA does not intend to implement all of them. Instead, the FCA is asking the industry to help it decide which of these ideas should be prioritised for further development and consultation. Some of the proposals are relatively limited in scope whilst others are more material, and their impact may vary for different market participants. For example, although the proposed changes to the threshold for full-scope alternative investment fund managers (AIFMs) are unlikely to significantly affect well-established AIFMs that already operate as full-scope under the current rules, they may increase investor choice by encouraging new AIFMs into the market that would otherwise have been deterred from operating under the current regime due to the compliance and cost burden involved in operating as a full-scope AIFM.
A step forward
Whist this DP is likely to be one of many parts of the government’s FRF review to determine which elements of EU law should be retained and which areas should be reshaped, it is a step forward in affirming the UK’s place as a ‘world leading centre for asset management’. We set out below a summary of the key areas mentioned in the DP which have the potential to reshape the UK asset management industry.
Structure of the regulatory regime for asset management
The DP notes that the current regulatory framework for the asset management sector is based on three predominant pieces of European legislation - the Undertakings for Collective Investment in Transferable Securities (UCITS) Directive, the Alternative Investment Fund Managers Directive (AIFMD), and the Markets in Financial Instruments Directive (MiFID) (collectively, the AM Regulations).
Common framework for asset managers
Although the AM Regulations were developed independently from one another, the FCA acknowledges that some of the rules overlap considerably, which has led to the Handbook being duplicative in some areas (such as core conduct obligations like conflicts of interest rules).
The FCA notes that whilst it is unlikely that it will consolidate all of the rules applicable to asset managers into a single sourcebook (such as FUND or COLL), it is seeking stakeholder views on whether there is a benefit in creating a common framework for asset managers to follow in respect to the rules that are common to all types of asset managers. The FCA’s rationale against consolidating all of the rules applicable to asset managers is that some of the rules are applicable to a wide range of firms and not just asset managers. A common framework for firms to follow in the sector could lead to greater operating efficiencies alongside simplifying the compliance obligations on new firms entering the market. However, the one-off costs of implementing large rule changes could be significant for asset managers and something to consider when submitting a response to the DP.
The DP notes that the authorised retail funds regime currently consists of UCITS funds and non-UCITS retail funds (NURS). The FCA emphasises that regulatory changes are in progress in the retail market (such as the new Consumer Duty and the proposed new core investment advice regime) and there are potential changes that could be made to the retail fund space to simplify the treatment of UCITS and NURS funds. The FCA mentions that currently, there are restrictions for UCITS funds and complex rules in respect of master feeder funds, and, as a result, asset managers prefer to set up NURS which are ‘simpler and more widely used’. The FCA sees some benefits in potentially reducing the complexity of the rules for UCITS funds and suggests a number of possible changes to the regime, which include, amongst other things, removing the boundary between NURS and UCITS to create a single set of rules for all authorised retail funds, rebranding NURS funds as ‘UCITS plus’ to identify when more complex products are used, creating a new category of basic retail funds (which are limited to certain investments) and simplifying the master feeder fund structures to allow more choice in the market.
The DP also explores professional funds. The FCA notes that many alternative investment funds (AIFs) are operated exclusively for professional investors, but governed by rules created under the AIFMD framework. The FCA queries whether these rules are too prescriptive given the sophisticated target market for these funds. In particular, the FCA highlights that firms below a certain size threshold are subject to less prescriptive requirements than a full-scope AIFM (e.g., a small UK AIFM) and is seeking views as to whether stakeholders would see benefit in increasing the size threshold at which firms must apply the full-scope UK AIFM rules, to reflect any growth in the market since the initial threshold was set. Additional suggestions in the DP include allowing more firms to use the small UK AIFM exemption (by widening the eligibility criteria) and making expectations of small UK AIFMs clearer, including by creating minimum standards in areas such as fund valuations, investment disclosures and liquidity management.
Improvements to the current regime
The DP asks for views on certain aspects of the current regulatory framework for the asset management sector. This includes requests for views on clarifying the relationship between host AFMs and PMs, enhancing the liquidity management requirements for funds, setting clear expectations as to the role of depositaries and providing clearer standards that are expected when conducting investment due diligence.
The FCA notes that in some fund arrangements, a host AFM is appointed as the AFM of the fund to allow PMs to carry out services for the fund (such as discretionary portfolio management) without the fund having to seek authorisation itself. The FCA acknowledges that having the option to use such a model promotes competition and provides investors with greater choice in the market; however, there is still the potential for such a model to bring harm to investors.
In particular, the DP mentions that there are circumstances in which the FCA have found that some host AFMs have fallen below the requisite standards expected of an AFM. An AFM is expected to have in-depth knowledge of the investment portfolio of the fund for which it acts as manager and comply with the relevant regulatory framework. Moreover, the FCA expects PMs who use such hosting arrangements to understand the role of the AFM and what is required for the host AFM to comply with its obligations, such as the obligation to conduct suitability assessments for investors in the fund.
The FCA states that in most cases where a host AFM fell below the required standards, it was as a result of misunderstandings arising from PMs on the role played by the host AFM. The DP seeks views from stakeholders on whether it would be beneficial to mandate contractual requirements between PMs of a fund and the host AFM to ensure that all regulatory responsibilities and obligations are clearly set out in a contract. Moreover, the FCA mentions that a trade association could assist in developing industry guidance for host AFMs to further clarify the obligations of PMs and host AFMs when a host AFM is appointed for a fund.
The FCA has acknowledged that improvements could be made to the current liquidity management rules in the asset management sector. It notes that many of the rules concerning liquidity management in funds are designed to protect investors to ensure that the fund passes on appropriately the costs of dealing in investments and treats all unitholders fairly. The FCA emphasises that liquidity management is essential for the markets to function properly.
As part of the potential reforms in this area, the FCA is keen to see fund managers carrying out effective liquidity management which includes carrying out liquidity stress tests in accordance with the European Securities and Markets Authority (ESMA) guidelines. The FCA plans to transpose the ESMA guidelines into its Handbook and is looking at placing further restrictions in COLL to prevent fund managers avoiding carrying out liquidity stress testing for the funds which they manage.
Further, the DP seeks views on whether dilution and anti-dilution mechanisms (also known as ’swing pricing’) should be made clearer, with a particular focus on improving the current guidance in place when calculating a dilution adjustment in a fund.
From a reporting perspective, the FCA notes that it currently receives reports from firms for certain liquidity categories for AIFs (which could also be extended to UCITS funds) in accordance with existing regulatory requirements. Building on such requirements, the FCA is seeking comments from stakeholders on whether there are benefits in requiring funds to make public disclosures on the liquidity of their investments and any costs which could arise as a result of such an obligation.
Rules for depositaries
The DP mentions that depositaries for funds have, in some cases, not intervened or challenged fund managers appropriately as part of their oversight duties. The FCA is therefore of the view that depositaries do not always achieve good outcomes for fund investors. The FCA sees benefits in making the rules clearer for depositaries (especially as some rules in the Handbook are prescriptive but have limited benefit) and welcomes further discussion on whether there are existing rules which can be removed, or areas that would benefit from greater clarification taking into account the interests of investors in funds.
Further, the FCA notes that it is considering clarifying expectations for the role of depositaries in several areas, including but not limited to: systems and controls; resources, knowledge, skills and experience; actions expected when a breach is identified; escalating breaches where managers do not take action; and oversight obligations in respect of liquidity management and pricing and dealing in fund units.
Investment due diligence
The FCA acknowledges that the current rules regarding suitability of investors in funds are high level. Similarly, the rules for fund managers on conducting investment due diligence are not overly prescriptive as to what fund managers need to know about the investments that are made by the fund they manage. The FCA has found, in some cases, that asset managers conduct investment due diligence, such as performing credit assessments, which is inconsistent and could contribute to harm in the markets. In particular, the FCA mentioned that it has seen investments being made in liquid or complex securities without adequate due diligence being conducted, which has resulted in investors suffering losses as a result of managers overlooking material risks that would have been apparent had they done so.
The FCA reiterates that all authorised firms are expected to apply due skill, care and diligence, which extends to adequate due diligence being conducted on investments within a fund. The FCA welcomes comments from stakeholders on the FCA’s proposal to make its expectations clearer for all asset managers that conduct due diligence on the funds they manage. It notes that any reform in this area would be limited to setting clearer standards as opposed to creating onerous or complicated restrictions.
Technology and innovation
The FCA flags that the pace of change in technology may mean developments break new ground not previously considered by regulation. To address this, the DP discusses areas where fund regulation could be improved so that firms can take advantage of technological advances in the best interests of their customers. It also considers how technology-led innovation could be used to support better outcomes for consumers.
One idea highlighted for discussion is the ‘Direct2Fund’ (D2F) model proposed by the Investment Association (IA). This optional model would enable investors to deal directly with a fund when buying and selling units, as an alternative to the traditional UK business model where the AFM acts as a counterparty to the transaction. The FCA and IA have been working together to identify and analyse regulatory issues arising from the D2F model, such as how to maintain the existing protections for investors under the COLL and CASS rules. If ‘satisfactory progress’ can be made in dealing with these issues, the FCA may consult on rule changes to implement the D2F model – it is asking for industry feedback on this approach.
Views are also sought on fund tokenisation, which allows a fund to issue units or shares to investors as digital tokens. Noting that existing rules on how units are created, transferred, registered and cancelled might not be sufficiently flexible to allow firms to operate a ‘digital register’, the FCA is exploring what would need to be done to enable this. The DP asks for help in understanding what interest there would be, in the short to medium term, from investors able to use this technology, and how fund regulation should respond to the implications of a growing market in tokenised financial instruments.
On cryptoassets, the FCA states that it does not intend at this stage to explore the possibility of bringing unregulated tokens (such as stablecoins and other cryptocurrency) into the scope of the authorised funds regime by classifying them as permitted investments. Any work on this will be postponed until the government has advanced its thinking on bringing portfolio management of cryptoassets into the regulatory perimeter.
Improvements to investor engagement
The FCA is seeking views in a number of areas in order to improve investor engagement. Specifically, the FCA is looking at how it can modernise prospectuses, improve managers’ reports and accounts to better meet investors’ information needs, and improve investor engagement at meetings.
With regard to prospectuses, the FCA is concerned that they are not fulfilling their primary function of providing in-depth information to fund investors who want to know more than is set out in the standard consumer disclosure document. In the FCA’s view, prospectuses are generally written in legal, technical language, often including generic elements such as a copy-out of FCA rules. Additionally, the FCA notes that while prospectuses are required to include any other material information which investors would reasonably require, in practice, some of the most important pieces of information could be hard to find. As such, the FCA is considering modernising prospectus disclosures in several ways, for example:
- redefining and aligning to international best practice what the FCA consider to be the important elements that all investors should understand, so those elements are given sufficient prominence, including for example information and labelling around environmental, social and governance (ESG) matters;
- making the prospectus more modular so that its important elements can be more easily accessed;
- altering the content requirements to support clearer and easier segmentation and allowing incorporation by reference for standard text;
- requiring firms to use tagging, data, or other forms of machine-readable content to enable more efficient search functions, making the documents more useful to advisers and other intermediaries carrying out comparisons of funds; and
- requiring the prospectus to be stored and published under a central repository, such as the FCA’s National Storage Mechanism which is used by issuers of listed securities, allowing it to be accessed by a wide range of online users to compare, test legitimacy, and comment on.
With regard to improving managers’ reports and accounts, the FCA is concerned that investors appear to have little interest in such reports even though they contain important information that any reasonable investor would wish to know. The FCA would like to improve investor engagement by improving the design, layout and accessibility of managers’ reports. Specifically, the FCA notes that managers’ reports are conceived as paper-based documents, which are typically created as PDF files that are hard to review or interrogate on a screen. However, the FCA notes that it is now practical for firms to produce and publish digital content relatively quickly, easily and in an accessible format. As such, in the FCA’s view, publishing reports in a machine-readable format could be beneficial as it might enable aggregators of information to extract data and repackage it in a user-friendly way. This in turn could allow easier comparisons to be made between competing products.
The FCA has also noted that that it is open to a more radical option, such as rethinking the purpose and structure of periodic reports and accounts. The DP references the Financial Reporting Council’s 2021 consultation paper on the future of corporate reporting, and notes that some of the proposals could be relevant to fund reports as well (e.g., breaking reports into a set of interlinked reports, each focused on a specific area).
Finally, with regard to improving investor engagement at meetings, the FCA has identified that, with the growth of platform service providers allowing investors to manage their relationships with multiple product providers through a single gateway, the ‘unitholder’ – that is, the natural or legal person in whose name units are registered – is now in most cases a nominee of whichever service provider the end investor has chosen. As such, the FCA is concerned that its rules may no longer achieve their aim of ensuring a fair balance between the interests of the investor and the fund manager. The FCA sees unitholder meetings as an important fund governance mechanism and would like to improve attendance and participation at these meetings by the end investors. In the FCA’s view, this could be achieved, for example, by enabling platform customers to attend and take part in virtual meetings through suitable online identity validation, and enabling customers to vote electronically on proposals and have the platform submit the consolidated votes to the meeting.
Reforming the prescriptive rules for funds
The DP covers a couple of areas for potential improvement to the prescriptive fund rules. Specifically, in relation to the eligible assets regime which permits UCITS funds to invest up to 10% of their portfolio into assets that do not meet the eligible markets criteria (the 10% rule), the FCA is concerned that some UCITS managers might perceive this a general permission to invest this part of the fund in a wider range of assets without considering the implications for suitability or risk management. To counter this, the FCA has suggested that it could give guidance on its expectations around the 10% rule, for example, clarifying that it expects managers not to use the 10% rule in a way that undermines the liquidity of the fund or the ability to deal with change in the fund over time.
Additionally, the FCA is considering changes to the detailed rules in COLL 5 on the spread of risk, which set out the maximum amount that a fund may hold in specific assets. The FCA notes that stakeholders have suggested that the prescriptive quantitative requirements be replaced with a more principles-based regime, underpinned by the rules on sound risk management, to allow for greater investment flexibility. The FCA notes that it is considering whether changing the rules in this area could be of benefit, but that it is not currently minded to remove quantitative restrictions.
The deadline for responding to the DP is 22 May 2023. The FCA also plans to engage with a wide range of stakeholders alongside the DP, through forums, roundtables and individual meetings.
Once the feedback period has ended, the ideas covered in the DP will be ranked in order of priority and, depending on the responses, the FCA plans to look at ways to develop some of those ideas using tools such as policy sprints. Any changes the FCA decides to make to incorporate elements of retained EU law for funds and asset managers into its Handbook will be subject to the FRF changes going ahead as proposed, and to HM Treasury’s timelines for repealing relevant areas of EU law. A feedback statement is expected later in 2023, possibly as part of an FCA consultation on some of the topics discussed in the DP.
We will also further explore some of these topics in the upcoming weeks as part of our Regulation Tomorrow podcast, with a new series focusing on the asset management sector.