In this regulatory update we look at some important recent communications from the UK's Financial Conduct Authority about changes that it proposes to make to allow retail investors to invest in patient capital and its assessment of Britain's withdrawal from the European Union.

The FCA’s Brexit-related 'impact assessment' tries to predict the prospects for the UK's financial sector in the event of the UK leaving the EU without an agreement on 29th March or at the end of a putative transitionary period, known to the Government as 'the implementation period.' It also analyses the Prime Minister's tentative withdrawal agreement with the EU. Meanwhile, the Competition and Markets Authority has published some findings from its investigations in the investment consultancy and fiduciary management sectors.

The FCA's response to the CMA’s investigation

The Competition and Markets Authority has published a report about the UK's investment consultancy and fiduciary management sectors. It embarked on its investigation last year when the FCA 'made a reference' (jargon for asking it to investigate) as part of its own study of the asset management market. The FCA had uncovered some disturbing facts about competition in both markets.

The CMA's investigation, which began in September 2017, found that fiduciary management providers had an incumbent advantage over their competitors because pension scheme trustees often chose the same providers that they used for investment consultancy. Prospective customers also lacked access to clear information about fees, historic performance or any way of assessing the quality of providers. The investigation also found that the cost of switching between providers was (and remains) relatively high.

Pension scheme trustees care little about the investment consultancy market. This makes it difficult for the regulator to promote competition and discourages participants from competing. To deal with the problem, the CMA is proposing the following.

• The introduction of mandatory tendering for pension trustees who want to purchase fiduciary management services for the first time, along with a requirement for trustees to run competitive tenders sometime in the next five years in cases where they have obtained services without tenders.
• A rule that forces investment consultants to separate the marketing of their fiduciary management services from the promotion of their investment advice.
• To ask the Pensions Regulator to lend more support to pension trustees who run tenders and to evolve guidelines to promote the other remedies that it is proposing.
• A rule that requires fiduciary managers to provide clearer information about fees and performance.
• A requirement for pension trustees to assess the quality of the advice that they receive about investments and to set clear objectives for investment.
• Basic standards for reports about performance in both investment consultancy and fiduciary management.
• To ask the Government to extend the FCA’s regulatory reach to cover all of the main investment consultancy activities and to enable the Pensions Regulator to "oversee the implementation of its remedies aimed at pension scheme trustees."

Responding to the CMA’s report, Christopher Woolard, the FCA’s Executive Director of Strategy and Competition, said: “We welcome the CMA’s in-depth analysis of both investment consultancy and fiduciary management services and support the package of remedies proposed. It is essential that competition works well as these services have a significant impact on the retirement outcomes of millions of pension savers. We will continue to work closely with the CMA, HM Treasury and the Pensions Regulator to implement the CMA’s remedy package and take forward the recommendations in its report.”

The FCA's plans to help consumers invest in patient capital

In last year's Budget Speech the Chancellor, Philip Hammond, said that he was taking steps to boost investment in 'patient capital,' a broad term that he used to describe a range of alternative investment assets, including infrastructure, venture capital and private equity. To help him, the FCA is proposing to remove any unjustified barriers that lie in the path of retail investors who want to invest in such assets through unit-linked funds, as long as this does not interfere with its aim of protecting investors from sharp practice. It wants to do four things:

• provide additional information to do with the 'permitted links' rule to be found in COBS 21.3;
• broaden the range of "permitted link categories;"
• restrict the overall investment in illiquid assets held in a linked fund to no more than 50% of the total fund; and
• promulgate 'risk warnings' that educate consumers about the liquidity-related risks that they run when investing in funds of this type.

To accompany the consultative paper in which it makes these proposals, the regulator has also published a discussion paper in which it explores the effect that its rules are having on investments in "patient capital assets," as it calls them, through authorised funds. The paper asks practitioners whether the current limits on investments in patient capital are appropriate, whether there is much demand in the market for a new type of fund that can invest all its capital in patient capital assets and whether it should change its rules to make it easier for people to invest directly in infrastructural projects.
 
Permanent measures to restrict the sale of retail CFDs and binary options

The FCA has published a consultative paper in which it outlines its plans to stop consumers from coming to harm when purchasing certain complex derivative products. It wants to ban the sale, marketing and distribution of binary options to retail investors and restrict the sale, marketing and distribution of contracts for differences (CFDs). The European Securities and Markets Authority has already imposed two sets of temporary restrictions on these products, but the FCA wants to extend them to closely substitutable products as well. It wants to do the following.

• Limit borrowing to between 30:1 and 2:1 by insisting on the collection of a minimum margin as a percentage of the overall exposure.
• Close out a customer’s position when his funds fall to 50% of the margin required to maintain the open positions on his CFD accounts.
• Introduce rules to stop investors from losing more than the total amounts in their CFD accounts.
• Ban inducements (both monetary and non-monetary) that encourage trading.
• Introduce a standardised risk warning which discloses the percentage of retail client accounts that make losses.

The FCA estimates that these changes to CFDs could reduce retail investors’ losses by between £267.4 million and £450.7 million a year, with a permanent ban on binary options, saving them up to £17 million a year.

The FCA's research on effective current account prompts

The FCA has published its research on 'consumer prompts' (messages from banks that change customers' behaviour) in the current account market. Its recent behavioural tests have shown that clear prompts, which include all the information that a customer needs, alongside clear instructions about the steps that he should take, are the most effective prompts of all. The regulator has discovered that the following tactics are most likely to inspire a consumer to make the right decisions.

• The bank telling the customer why he is receiving this-or-that information.
• The dispelling of myths.
• Outlines of costs and the quality of service.
• The bank telling the customer that he may be missing out.
• Direct communication with the customer about his costs and charges.
• Action-orientated headlines.
• Clear steps to help the customer take action.
• Messages that interrupt the customer at relevant opportunities.
• Graphics, bullet points and the use of colour to attract the customer's attention.

The FCA also tested ‘teaser’ messages but found that these did not prompt customers to take action or find out more. Customers believe that it is not appropriate for firms to tell them to download apps or search online for further information.

What the future holds for crypto-assets

To mark the publication of HM Government's Crypto-assets Taskforce’s report about the regulatory regime that governs emerging financial technology, the FCA’s executive director of strategy and competition, Christopher Woolard, delivered a speech on the subject. He said that the year 2008 will go down in history as the year when Lehman Brothers collapsed, but it is also the year of another significant event - the publication of the Government’s first Bitcoin whitepaper. Since then, the crypto-asset market has changed significantly and HM Treasury, the FCA and the Bank of England have set up a a joint taskforce to deal with crypto-assets and distributed ledger technology (DLT).

The UK is not a major exchange market for crypto-assets at the moment and their use is not widespread, but the taskforce is still worried about these assets harming consumers. It is also worried that they may be of some use to financial criminals and others whose poor conduct could damage the integrity of Britain's markets.

To address these concerns, the taskforce outlined the Government's intentions for the New Year.

• The FCA will consult interested parties about "perimeter guidance" with the aim of drawing a clear line between the crypto-assets that it should regulate and the ones that it should not. Then, HM Treasury will ask the public whether it ought to extend the regulatory perimeter.
• The FCA will consult interested parties about the idea of prohibiting the sale of derivatives which refer certain types of crypto-asset to retail investors.
• The Treasury will develop - and consult the public about - rules that bring the European Union's fifth Anti-Money Laundering Directive (5AMLD) into force, also discussing methods by which it might broaden the reach of the UK's anti-money laundering legislation.
• The Treasury will try to find out how exchange tokens could be regulated effectively.

Is AI a 'silver bullet' that can kill the werewolf of financial crime?

Rob Gruppetta, the head of the FCA’s Financial Crime Department, recently spoke in public about the regulator’s use of 'innovation' (new IT) to combat financial crime and the findings from its first annual financial crime data return.

Gruppetta said that the fight against financial crime and the aim of making the UK a hostile environment for criminals are high priorities for the FCA. Because the things that help financial criminals and money launderers are evolving constantly, the FCA is also changing the way it monitors the markets constantly.
 
AI is one innovation that the FCA favours in the fight against financial crime, but the technology is still in its infancy. Until someone has evolved sound principles for its further development, the FCA will continue to tread carefully. Machine learning is growing exponentially in use, with analysts able to apply it to a wide range of problems. It can analyse data to make systematic predictions about the direction in which financial crime is developing. Gruppetta believed that banks could only use it in this way if they had access to robust, industry-wide data that related to actual instances of financial crime and money laundering.

The FCA started to compel firms to send it annual financial crime data returns in 2016. The data helps it to set its supervisory priorities. By using machine learning to analyse this data, it has been able to detect suspicious activity in markets and venues. As a result, according to Gruppetta, its 'targeting' of AML risks has improved by more than 65%.

The effect of Britain's withdrawal from the EU

In response to a request from the Parliamentary Treasury Select Committee, the FCA has published an "impact assessment paper" that relates to the UK’s withdrawal from the EU. The paper examines three areas.

• The effect of the UK leaving the EU without an agreement on the 29th March 2019, or after the transitional period comes to an end in December 2020.
• The Prime Minister's tentative withdrawal agreement with the EU, which is awaiting a Parliamentary vote.
• Anglo-EU politics.

Leaving without an agreement

In the absence of a deal, the paper says, the UK will default to a ‘third country’ relationship with the EU, meaning that the 'passporting rights' that its businesses now enjoy will cease to exist and their access to markets in the EU will be determined by the rules of the World Trade Organisation, to which the UK and EU belong. EU financial rules will no longer apply and the UK will have to enshrine them in its law if the EU is to judge the jurisdiction to be 'equivalent' to it - a judgment on which the 'passporting rights' bestowed by many EU directives rely.

Firms are now in the process of putting contingency plans into operation. HM Government will take steps such as the "Temporary Permissions Regime" (which will allow every EEA firm that uses a passport to operate for a limited period while it seeks authorisation from the UK if the passporting regime falls away on 29 March) with help from the FCA but, ultimately, the long-term fate of passports lies in the EU’s hands. In the paper the FCA argues for "continued close co-operation."

The Prime Minister's withdrawal agreement

The paper looks at ways in which the Prime Minister's vision for a future deal with the EU might affect the FCA’s objectives, should Parliament vote for such a deal. In the paper the FCA makes the surprising revelation that the UK might go on providing the EU with data and expertise to help it develop future EU legislation during the implementation period, even though this is no longer in its interests. The UK therefore might, for some reason, go on contributing to the development of EU policies even though it can no longer benefit from them.

The UK and the EU still need to agree upon some regulations before the former leaves the latter. The FCA's paper continues: "While we have some knowledge of what is to come, there is a chance that further obligations will be pushed upon us."

Politics

EU regulations will continue to apply throughout the implementation period. Alongside the deal that the Prime Minister wishes to present to Parliament, the UK and the European Union have published a "political declaration" that outlines the terms of a new relationship between them. In it, they promise to maintain financial stability and market integrity, protect investors from sharp practice and promote fair competition and to start 'equivalence assessments' as soon as possible after the UK leaves the EU, aiming to conclude these assessments by June 2020.

The FCA's paper goes on to say: "The outline political agreement includes...an expectation of close and structured co-operation on regulatory and supervisory matters. This will be grounded in the economic partnership and based on the principles of regulatory autonomy, transparency and stability, recognising this is in the parties’ mutual interest."

The industry’s technological resilience

The FCA surveyed 296 firms in 2017 and 2018 to assess their cyber-related and technological capabilities, concentrating on governance, change management, third-party risks and cyber-defences. The regulator reported its findings under the following headings.

• Governance. Firms reported that they had mature 'governance capabilities' to make them resilient in the face of cyber-threats and technological problems. However, the regulator found that there was room for improvements, particularly when it came to the involvement of senior managers.
• The identification of key assets, services and third parties. Most of the firms that the FCA had surveyed had identified their information assets and critical business functions, but the FCA detected problems.
• The sharing of information. The FCA has found that larger firms are more willing to share data between themselves, but have not necessarily 'defined' the process of doing so. This makes them less able than they could be to seek help or share data in the event of a sector-wide cyber-attack.
• Security culture. 90% of the firms in the survey had internal 'cyber-awareness' plans. Many told the FCA that they found it hard to identify staff members in highly risky jobs, with only 47% providing these people with additional training when they did spot them.
• The detection of attacks. Only the largest firms had automated systems and process for detecting attacks and the FCA found them 'inconsistent.'
• Change management. There are inconsistencies between firms’ self-proclaimed strengths and the FCA’s own analysis of their technological capabilities, with poor change management accounting for 20% of all outages reported to the regulator between October 2017 and September 2018.

Pension transfer advice

Advice about pension transfers has been a significant area of interest for the FCA. The regulator has published some of the lessons that it has learnt from its most recent supervisory activity in this field. It has collected information on the subject from 45 firms and has also visited (and reviewed files at) 18 firms as part of an in-depth investigation. Those firms have given advice to 48,248 clients about their 'defined benefit' pensions, resulting in 24,919 transfers since April 2015.

Less than 50% of the advice reviewed by the FCA was suitable in its view. 23% of the files it inspected were unclear because they did not contain evidence of the suitability of the advice. The FCA also examined the firms’ disclosures to (and communications with) their clients, finding that 62% were non-compliant, mainly in the way they presented initial and continuing fees. Their failings included:

• the use of emotive language when outlining a scheme’s solvency or eligibility for the Pension Protection Fund.
• misrepresentations of the scope of the Pension Protection Fund.
• lengthy suitability reports with unclear recommendations.
• unclear and unfair information about the benefits and drawbacks of defined-benefit and defined-contribution schemes
• an over-emphasis in some 'suitability reports' on the benefits associated with a transfer.

Senior managers at several firms had failed to identify and offset the risks associated with defined-benefit pension transfers and there was evidence to suggest that firms had failed to spot and offset conflicts of interest associated with their charging structures. There was also evidence that risk and compliance budgets had not grown in line with the volume of transfer advice being given.

The FCA’s findings are based on 'targeted supervision' which focused on the most active firms in the market and on certain firms where informants had "blown the whistle" to the FCA. As a result, two firms have voluntarily ceased their pension transfer activity and a further two have changed their business models, surrendering their pension transfer advice licences, or 'permissions,' as the FCA calls them.

The Insurance Distribution Directive (IDD)
 
The FCA has outlined the things that it expects to see firms doing in relation to the IDD (which replaced the Insurance Mediation Directive on 1st October) in an 'update' paper. It expects firms to be doing the necessary things to comply already, but it also wants them to look at ways of improving results for customers continually. One of the core objectives of the IDD is to ensure that consumers receive the products that meet their needs. This does not prevent firms from carrying out non-advised sales and the regulator does not expect them to investigate every customer’s circumstances in detail. It does, however, expect them to identify his needs and to only recommend products that meet those needs. The update includes a range of examples of compliant and non-compliant scenarios to illustrate this point further.

There are new rules in the FCA's Product Governance Sourcebook (PROD). All firms involved in the creation of insurance products must meet the "product oversight and governance" (an EU phrase) requirements. When a firm makes significant changes to a product or creates a new one, it must put an appropriate process of 'approval' in place. Rule 3.2.3 says that each manufacturer must maintain, operate and review a process for the approval of each financial instrument before it markets or distributes it to clients. This springs from article 16(3) of the EU's second Markets in Financial Instruments Directive or MiFID II.