The FCA has, this week, published a discussion paper proposing ways it may change the regulation of UK asset management in the post-Brexit era.
The discussion paper is likely to be one of many in the context of the Future Regulatory Framework as the Financial Conduct Authority (FCA) assesses whether it is appropriate to copy out existing EU retained law or whether a fundamental rethink of the rules is required.
In this briefing note we summarise the key areas of potential change for the UK asset management sector.
The regime for fund manager and portfolio managers
The FCA recognises that the regulatory regime for UK asset management has become overly complex. The rules, which are derived from UCITS, AIFMD and MiFID, involve considerable duplication but also different rules for different types of firms. Often the differences are in the technical detail (for example, conflict of interest rules). However, the FCA identifies other areas where the differences are more material (for example, different conduct rules apply depending on whether a firm is a fund operator or a portfolio manager).
Portfolio management is also part of this review, including model portfolio services. The FCA notes that given developments in technology it may be as efficient for an asset manager to manage multiple individual portfolios as to manage a fund. However, unlike managing a fund, the asset manager does not need to comply with specific rules that apply to fund managers. The FCA is asking whether it is appropriate to apply a consistent set of rules to the management of funds and individual portfolios. If such proposals go ahead, this will result in an extra layer of regulation for portfolio managers.
The FCA asks whether the UK retail funds regime needs to be updated, noting the other initiatives it is pursuing in the retail market with the Consumer Duty and the proposed new core investment advice regime. The current regime of UK UCITS and NURS funds was previously driven by the UCITS directive. The FCA highlights certain issues with the UCITS regime, including that quite complex funds can be established as UCITS (even though these funds were originally designed for the mainstream retail market) and that restrictions in the UCITS framework can mean it is unattractive to use, particularly if a master feeder structure is envisaged. The FCA notes that there are differences between the treatment of UCITS and NURS funds under the current rules.
The FCA suggests a number of possible changes to the regime, such as:
Removing the boundary between UCITS and NURS funds so all authorised retail funds would be subject to a single set of rules.
Rebranding NURS funds as “UCITS plus” so that mainstream retail products would fall under the UCITS label and more complex products would fall under the UCITS plus label.
Creating a new category of “basic” retail funds which would be limited in the types of investments they could make.
Simplifying certain specific requirements, for example, having more flexible rules for master-feeder fund structures.
A simplification and rationalisation of the UK retail funds regime that erases the somewhat arbitrary regulatory differences between the rules that apply to different types of retail funds is likely to be welcomed by AFMs. Maintaining product choice is essential, however, and it is good to see the FCA seeking industry views as to whether the boundary between the UCITS and NURS regimes should be kept.
The discussion paper gives particular consideration to professional funds. The FCA queries whether the regulations applicable to AIFMs of professional funds are, in fact, overkill, given the sophistication of their investor base. Here, the FCA will have its eye on the regulatory burden in the UK versus other fund jurisdictions, and will want to ensure that any proposals reflect the Government’s commitment to ensuring that the UK is attractive in the international market.
The FCA is considering a range of approaches to change the current regime:
Changing the size threshold at which firms must apply for the full-scope UK AIFM regime.
Allowing firms that meet criteria other than their size to use the small authorised UK AIFM exemption.
Making the FCA’s expectations of small authorised AIFMs clearer, including minimum standards in areas such as fund valuation, liquidity management and investor disclosure.
In addition, small-registered AIFMs should take note. The FCA is consulting with the Treasury on this regime and queries whether it remains appropriate. There is a concern that the regime may mislead consumers into thinking that a firm is FCA authorised. The FCA suggests it could require some types of small registered AIFMs to become authorised and remove the registration requirement for others.
Responsibilities of host AFMs
Host AFMs have been in the regulatory spotlight over the last few years, following the FCA’s host AFM review in 2021. The FCA indicates that misunderstandings by some portfolio managers about the role of the host AFM could be causing gaps in oversight. The regulator asks whether it should clarify its expectations of portfolio managers of funds and set specific contractual requirements as between the AFM and the portfolio manager, so as to reduce the risk of the portfolio misunderstanding the obligations of the AFM.
Liquidity management and asset due diligence for authorised funds
The FCA also addresses investor protection and asset due diligence. Unsurprisingly, following the failure of the LF Woodford Equity Income Fund, the FCA is focussing on the requirements for liquidity and stress-testing within authorised funds. The FCA proposes to enshrine ESMA’s liquidity stress testing guidelines in the rules and states that it is also considering whether it is appropriate to set out regulatory expectations around investment due diligence for all types of asset management activity. The FCA is also considering whether to impose more rules governing the use of anti-dilution mechanisms.
Clarifying rules for depositaries
The FCA points out that depositaries have not always challenged fund managers in the way that the FCA would expect. This has also been a recent area of focus for the FCA, which published a Dear CEO Letter to custody and fund services providers in March 2022. The FCA sees benefit in updating and clarifying their rules for fund depositaries.
Fund investments: Eligible assets and spread rules
The FCA is concerned that the rule which permits UCITS to invest up to 10 per cent of their portfolio into assets that do not meet the eligible markets criteria may be perceived by some asset managers as a general permission to invest part of the fund into a wider range of assets without considering suitability or risk management factors. It is therefore proposing to give guidance on its expectations around the use of the 10 per cent rule.
When operating authorised funds for retail investors, AFMs are required to achieve a “prudent spread of risk”. The fund portfolios themselves are also subject to strict quantitative “spread” rules. The rationale of these spread rules is to prevent a fund being overly exposed to a particular issuer or counterparty. (An example of which is the so-called “5/10/40 rule”). Some stakeholders in the industry have commented that it is possible to achieve a “prudent spread of risk” without such boundaries in place. The FCA indicates that it is currently minded to remove these quantitative boundaries and has asked for further stakeholder input.
Innovation: Direct2Fund and tokenisation in funds
The FCA is keen to identify opportunities for technological change in the fund industry and to think strategically about longer term trends. It recognises that technology can be a driver of better consumer outcomes and it has asked for stakeholders to respond with any rule changes which would be helpful to enable fund managers make wider use of technology.
In particular, the FCA is considering whether it should work towards implementing the “Direct2Fund” model – a proposition put forward by the Investment Association to make it possible for investors to transact directly with the fund when buying and selling units.
Tokenisation is also on the agenda. The FCA wishes to understand whether there is an appetite to allow the tokenisation of fund units (ie to give fund managers the ability to issue a fund’s units to investors as digital tokens.) In addition, the regulator is seeking views as to whether authorised funds should be able to invest in tokenised assets and whether this should be expanded to allow investment in unregulated tokens such a stablecoins and other forms of cryptocurrency.
Investor information and engagement
The FCA is also consulting on changes to the rules designed to improve investor engagement.
We can expect further rules to ensure that intermediate unitholders, such as platforms, adequately consult their underlying investors where an asset manager wishes to undertake large changes, such as merging a fund or making fundamental changes to a fund’s investment objective.
Some of the areas of discussion clearly complement the forthcoming Consumer Duty. The FCA has recognised that retail fund prospectuses and periodic reports can be difficult for retail clients to access and engage with. The FCA clearly expects fund prospectuses to be easily accessible online and has said that retail investors may find the term “prospectus” to be opaque and unhelpful. We think that AFMs will welcome a discussion as to how the prospectus and reports can be streamlined and made more manageable for retail clients, as this will help with their push towards a better consumer understanding of their products.
The new discussion paper will certainly give asset managers a lot to think about. The FCA encourages all stakeholders to provide their feedback here before the consultation period closes on 22 May 2023.
This publication is a general summary of the law as at the date of publication. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, February 2023