Our thoughts on the FCA's recent Discussion Paper on updating and improving the UK regulatory regime for asset management

The current UK retail funds regime contains two concepts, Undertakings for the Collective Investment in Transferable Securities (UCITS) and Non-UCITS Retail Schemes (NURS), that the FCA considers could benefit from a change “that helps retail investors navigate it more effectively”. We do not go into detail on the two regimes but the crux is that UCITS and NURS can both be low or higher risk, simple or more complex. The FCA has considered three approaches:

• Removing the boundary between UCITS and NURS entirely;
• Rebrand the NURS regime as ‘UCITS plus’, with mainstream retail products falling under the UCITS banner and more complex retail products under the ‘UCITS plus’ banner; and/or
• Create a category of basic funds, which would be limited in the types of investments that they could make (for example, they could be required to have a level of diversification or limited to only the largest and most liquid investments).

“Although some may criticise changing the existing internationally recognised and trusted framework (and the costs and time associated with this), retail clients’ understanding of the current framework is lower than it should be, so we would welcome the attempts to simplify the boundary, which we believe will lead to greater customer understanding and trust, which should benefit regulated firms in the long-term.” – Adam Edwards | Head of Financial Services Regulation

Most alternative investment funds (AIFs) are operated exclusively for professional investors and are are not FCA authorised funds. If the alternative investment fund manager (AIFM) of the fund manages assets above a certain threshold (known as full scope AIFMs), the AIFM is subject to detailed and prescriptive rules derived from AIFMD. Small AIFMs (sub-threshold) are subject to less prescriptive requirements. They can choose to operate in line with the full-scope AIFMD rules but are not required to do so. There are two regimes for small UK AIFMs: an authorisation regime and a registration regime.

It is interesting to note that the FCA does not plan to significantly change the rules derived from AIFMD. However, the FCA is considering the following options:

• Increasing the threshold at which AIFMs become full-scope (reflecting the growth in the markets since it was introduced); or
• Change the criteria from size to other factors, such as the strategies or types of clients AIFMs have.

Whether or not the above changes are made, the FCA is considering making the expectations of small authorised AIFMs clearer. The FCA is also considering changing how the small authorised and small registered AIFM regime works, given that customer understanding of the difference between the two is low. Finally, if the exemption for small AIFMs is broadened significantly, the FCA acknowledges it may need to introduce a set of high-level rules setting minimum standards on core fund areas such as valuation, liquidity management and investor disclosure. This would be less prescriptive than the full-scope AIFM regime.

“If increasing competition in the fund management space is desirable, then reducing regulatory complexity is one of the ways to achieve that.  Compliance burden can operate as a significant barrier to entry for new market entrants.  Investor protection is important, of course, but where products are available only to professional investors who are well equipped to assess (and bear) risk for themselves, the need for regulatory oversight is reduced.  Moreover, many would argue such investors would benefit from a broader choice of managers and products to invest in, as well as lower operational costs which a leaner regulatory regime may bring.” – George Metcalfe | Private Funds Partner

The FCA states in the DP that most AFMs do not manage the assets of their funds but another firm acts as a portfolio manager. Some of the functions that a fund manager must or should do can be easily carried out by a firm that is independent of the portfolio manager, but other functions may be more integral to the day-to-day management of the portfolio. These activities may need in-depth knowledge of the assets in which the fund invests to be able to carry them out to a good enough standard to ensure an appropriate degree of consumer protection. Some of the FCA’s concerns arise from a misunderstanding by some portfolio managers about the role of the AFM. The FCA suggests that they could clarify their expectations in rules by creating specific contractual requirements between the AFM and the portfolio manager. The FCA is querying whether it should change its rules to make its expectations of portfolio managers clearer or to set minimum contractual terms between portfolio managers and AFMs.

Non-structural Change: Enhancing liquidity management for AFMs

The regulatory framework contains rules around liquidity management, which are designed to protect consumers. The FCA wants to see fund managers carrying out effective liquidity risk management. The FCA also expects firms to comply with the liquidity stress testing guidelines issued by the European Securities and Markets Authority (ESMA). The FCA plans to convert these rules and guidance in the Handbook. The FCA is also considering removing or significantly restricting the limitation around liquidity stress testing in COLL 6.12.11R(2), so that the qualification ‘where appropriate’ does not give fund managers a reason not to carry out stress tests. The FCA is also considering making clearer the rules around dilution adjustments (sometimes referred to as ‘swing pricing’) and other anti-dilution mechanisms.

“The basis for these proposed changes makes good sense. We also welcome alignment with ESMA here, which will help firms operating in both the UK and EU.” – Adam Edwards | Head of Financial Services Regulation

The FCA has found that practice around investment due diligence (including credit assessment) appears inconsistent. Weaknesses in this area sometimes appear to contribute to harm. The FCA has seen investments made in illiquid or complex securities without significant due diligence. In some cases material risks appear to have been overlooked. Some consumers may have suffered harm as a result. So, the FCA is considering making its expectations clearer by setting regulatory minimums on investment due diligence for all types of asset management activity. In our view, these rules should ensure there is a level playing field with all firms conducting the same minimum level of due diligence, which we expect a lot of firms will welcome.

The FCA is also looking at the following changes to the rules for depositaries to encourage them to intervene or challenge fund managers and achieve effective outcomes:

• achieving the systems and controls that a depositary must have in place to identify breaches of the rules and constituting documents of a scheme;
• looking at actions the FCA expects to be taken when a breach is identified;
• making clear what the depositary should do if the manager does not take action to deal with the breach;
• clarifying the depositary’s oversight of the AFM’s liquidity management, including liquidity stress testing; and
• clarifying the depositary’s oversight of the AFM’s pricing and dealing in units of the fund.

“There have been a number of scandals across the financial services sector where the level of due diligence of investments was poor and this resulted in avoidable customer detriment, so it is not surprising to see the FCA focusing on this.” – Adam Edwards | Head of Financial Services Regulation

The FCA has concerns that some UCITS managers might perceive the 10% rule (that is where funds are permitted to invest up to 10% of their portfolio into assets that do not meet the eligible markets criteria) as 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. One option is for the FCA to provide guidance on the 10% rule, in particular the FCA has suggested that the 10% rule should not be used in a way that undermines the overall liquidity of the fund.

It has been suggested to the FCA, by certain stakeholders, that it removes hard quantitative spread limits in fund portfolios and that a more principles-based regime that allows for greater investment flexibility is substituted. These stakeholders argue that quantitative limits restrict portfolio managers from investing in ways that would be reasonable and in line with sound risk management. Specific limits also create the potential for inadvertent breaches, which take time to deal with. Interestingly, the FCA does say that it is currently contemplating this, although it is not “currently minded to remove quantitative restrictions” but instead asks respondents about loosening specific restrictions.

Technology: fund operations

Some fund managers are keen to modernise the way units are bought and sold,. The Investment Association’s ‘Direct2Fund’ proposition is a model which would make it possible for investors to transact directly with the fund when buying and selling units. This would offer an alternative to the current model where the AFM buys and sells units on behalf of the fund and its investors. The FCA hopes to be able to consult on implementing the model depending on clarifying a few regulatory issues such as how investor protections currently afforded by the COLL and CASS rules could be appropriately maintained.

“The Direct2Fund model is similar to some models operated in other jurisdictions such as Luxembourg and Ireland, but would be a significant shift in the UK.” – Adam Edwards | Head of Financial Services Regulation

‘Fund tokenisation’ means the ability to issue a fund’s rights of participation (units, shares or interests) to investors as digital tokens, usually by means of a distributed ledger. In this case, tokenisation is at the level of the interactions between the fund manager, the fund, and its investors. The FCA recognises that fund tokenisation could lead to “greater efficiency with resulting cost savings, and faster transactions, as well as eliminating potential administrative errors”, and that existing rules are not flexible enough to allow firms to operate a digital register. The FCA is already working on potential rule changes in this area, and asks for views on the benefits of fund tokenisation, what regulatory changes are required to make this happen and how much of a priority this is for market participants.

“Many of the range of uses of distributed ledger technology are still in their infancy, but with huge consumer interest in the technology, we expect some retail investors will be keen to be able to hold units in this way.” – Daniel Seely | Associate Financial Services Regulation

Technology: Tokenised portfolio assets

In addition, the FCA also considers the possibility of tokenised portfolio assets, whereby funds could hold tokens representing underlying assets rather than holding such assets directly. These tokens can then be traded in a secondary market in tokenised form, with fully digitised clearing and settlement. An authorised fund may be able to hold securities tokens where the instrument represented by the token is itself eligible for investment.

“The FCA clearly recognises the improved liquidity and efficiencies which may result from the tokenisation of real estate and other real assets, such as infrastructure projects, and so it will be interesting to watch how the use of tokenisation in portfolio management develops.” – Daniel Seely | Associate

Improving investor engagement through technology

The FCA focusses in the DP on the fund prospectus and periodic reporting contained in managers’ reports and accounts.

Fund prospectuses for authorised funds

In relation to fund prospectuses, the FCA is concerned that these 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 documents.

The FCA is considering:

• making the prospectus more modular so that its important elements could be more easily accessed;
• altering the content requirements to support clearer and easier segmentation and allowing incorporation by reference for standard text;
• renaming the prospectus so that it is easier for investors to understand its purpose
• 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 (NSM) 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 about.

“Across the financial services sector, the FCA has a real focus on making sure firms are providing customers with the right amount of information presented in a useable format, seen most clearly in its new Consumer Duty. Ultimately it makes sense for firms to have well-informed customers as this enables them to build a relationship of trust and develop a more loyal customer base.” – Daniel Meyer | Senior Associate Financial Services Regulation

Managers’ reports and accounts

The FCA has found that these reports are often unengaging and not given much prominence by managers. The FCA believes there is important information in a manager’s report that any reasonable investor would wish to know. The FCA would like feedback on how the rules in this area could be changed to make best use of technology to meet investors’ information needs – e.g. having a common template that is machine readable or requiring them to be stored on a central repository maintained by the FCA. The FCA has also suggested that actively managed funds could be more transparent about their portfolio holdings.

“In some areas the FCA is moving away from providing standard documents to more outcomes-based rules requiring firms to judge the right level of information to give to clients with technology neutral rules. Investments in technology would be a big up-front cost to firms, but could lead to long-term efficiencies.” – Adam Edwards | Head of Financial Services Regulation

Investor engagement

The FCA recognises that some existing regulatory requirements assume that investors are the registered unitholders in funds and interact directly with fund managers. These rules are therefore no longer fit for purpose as they do not recognise the crucial role played by intermediate unitholders such as platform service providers and wealth managers.

The FCA is considering making a number of changes, which it recognises may be better implemented as examples of best practice, including:

• allowing unitholder virtual or hybrid meetings as a permanent arrangement (rather than the temporary forbearance measure during the COVID pandemic);
• enabling the use of technology to improve attendance and participation at investor meetings;
• providing greater visibility to fund managers as to the profile of the underlying investors in their funds; and
• enabling investors to exercise greater influence over issues such as a fund’s strategy, its approach to ESG considerations, or its stewardship policy for engaging with the companies in which the fund invests.

“The FCA clearly wants investors to be more actively engaged, but this could increase costs with firms having to spend more time discussing strategies with clients. Some clients may also not want to become more engaged. On this basis, it may be better that this is incorporated as best practice guidance rather than prescriptive rules” – Daniel Seely | Associate Financial Services Regulation