On 20 February 2023, the FCA published a discussion paper on ‘Updating and improving the UK regime for asset management’ (DP23/2). The FCA’s aim is to obtain a broad range of views about the current UK regime for regulating funds and the asset management industry. DP23/2 sets out ideas for how UK asset management regulation might be reformed to support the UK’s position as a world-leading centre for asset management, better meeting the needs of UK markets and consumers and taking into account the developments of technology and supporting innovation.
The paper covers a wide range of ideas in a generally broad-brush approach, including how the FCA can support firms’ use of technology to improve customer experience and efficiency in the asset management sector. It also discusses how the FCA’s rules could be streamlined and improved to help firms deliver better support to investors, both retail and wholesale, UK-based and international.
The paper notes the complexity of the existing regime and the differences that currently exist between the regulation of the managers of funds (referred to in the paper as fund managers) and the managers of individual portfolios (referred to in the paper as portfolio managers) and in the regulation of UK authorised funds compared to non-authorised funds and suggests that a more unified and consistent overall regulatory approach to asset management and different fund products may have benefits.
At the same time, the paper addresses some fairly specific issues regarding authorised funds (which it characterises, not necessarily entirely accurately, as "retail" products) while appearing to conclude that the regime applicable to non-authorised funds (characterised, again not necessarily entirely accurately, as "professional" products) ought to remain broadly unchanged.
The approach underpinning the paper appears to be one of focussing on how the current regulatory mosaic could be made more consistent or, in some cases, augmented, rather than identifying opportunities to reconsider, rationalise or reduce the regulatory burden.
The feedback that the FCA receives to DP23/2 will help prioritise which specific changes the FCA will take forward as part of the Future Regulatory Framework (FRF) review and the future UK rules for asset management. DP23/2 is the first stage in the process and views are requested by 22 May 2023. DP23/2 will be followed by a consultation and appropriate cost benefit analysis at a future date.
The FCA states that it will only make reforms where there are clear benefits to doing so and that any changes, if made:
better meet the needs of investors, both domestic and international, and retail and professional;
enable technological development, innovation and better use of data;
be consistent with international standards and take account of rules in other jurisdictions, so that firms can continue to operate efficiently on a global basis; and
achieve rules that are effective and proportionate, simplifying and standardising requirements where possible.
Background to DP23/2
DP23/2 summarises the background to the review of UK asset management rules in the context of the FRF review, which was set up to decide how the regulatory framework for financial services should adapt to the UK’s new position outside of the EU. The FRF review and the Financial Services and Markets Bill (FSM Bill) is currently progressing through Parliament (and, according to City Minister Andrew Griffith, likely to be on the statute book by Easter 2023) and will start the process of repealing retained EU law and moving financial services regulation into regulatory rulebooks. This is intended to establish a consolidated comprehensive rulebook (rather than the current patchwork of legislation) modelled on other forms of regulation set out in the Financial Services and Markets Act 2000 (FSMA) (FSMA model).
The detailed requirements of retained EU law relating to funds and asset management are currently contained in the following:
the onshored Undertakings for Collective Investment in Transferable Securities (UCITS) Directive;
the onshored Alternative Investment Fund Managers Directive (AIFMD);
the onshored Markets in Financial Instruments Directive II (MiFID II);
several pieces of retained EU law setting technical standards and regulating particular fund types such as the Money Market Funds Regulation.
Retained EU law relating to funds and asset management will need to be moved to detailed, firm-facing requirements in the regulatory rulebooks pursuant to the finalised requirements of the FSM Bill. The government’s approach to creating the comprehensive FSMA model and the prioritisation of repealing retained EU law in financial services is set out in HM Treasury’s Policy Statement ‘Building a smarter financial services framework for the UK’ published on 9 December 2022. In publishing DP23/2, the FCA is reviewing the wider regime for the asset management industry ahead of this repeal of retained EU law to help inform what the asset management regulatory requirements will cover.
The structure of the asset management regulatory regime
DP23/2 contains a description of the current asset management rules and whether they could be simplified or restructured. As set out above, the rules for UK asset managers come from several different EU directives and regulations. The FCA notes that this means that the UK rules take their structure from the areas covered by EU legislation rather than the activities of firms which can result in a lack of clarity or coherence in some areas and has led to technical and substantive differences in the application of the rules.
As examples, the FCA highlights that the core conduct rules (including general organisational requirements), conflicts of interest management and outsourcing requirements that apply to certain funds, fund managers and portfolio managers come from various requirements of UCITS, AIFMD and MiFID. Each of these directives have been amended at different times, meaning that the current rule framework often leads to identical or broadly similar activities being regulated to a slightly different standard depending on the type of fund or manager. The FCA notes that this can lead to inconsistencies and therefore complexity and inefficiencies in applying the rules. For example, the AIFMD rules on best execution have not been updated to match the MiFID II best execution rules (by contrast, the UCITS rules have been updated). The FCA also gives the example of the rules relating to conflicts of interest which contain various differences in the technical detail depending on which firms they apply to despite the desired outcomes being the same. The FCA suggests a consolidation of the rules could simplify regulation of the sector.
Requirements for financial stability
The recent issues in relation to liability driven investments (LDI) provides context to the FCA’s consideration of whether portfolio managers like their fund manager and manufacturers of financial instruments counterparts should consider the risks they pose to financial stability. In contrast, portfolio managers do not have any specific regulatory requirement in relation to the risks that their investment activity may pose to financial stability. The FCA is requesting views on whether this is a gap in the regulatory framework and, if so, how it could be filled. It will be interesting to see what the feedback is in relation to this point given that individual portfolio managers are unlikely to create systemic risk on their own (absent possibly a small number of larger hedge fund managers).
Single rulebook for asset managers
The FCA notes that the UK Funds Regime Working Group set up by HM Treasury’s Asset Management Taskforce recommended creating a single rulebook for all asset managers . Whilst the FCA states that it is unlikely to try and consolidate all relevant rules into a single sourcebook, it does see benefits in making the rules that are common to all types of asset management more coherent and consistent by for example creating a common framework setting standards for all types of asset manager. The FCA acknowledges that this approach could have a significant impact on firms trying to operationalise new rules and is therefore requesting views from the market about the potential benefits but also costs in creating a common framework.
Rules applicable to managers of non-authorised funds
Managers of funds that are not authorised (i.e. non-UCITS funds) are primarily subject to rules derived from the AIFMD. The FCA states that it does not plan to significantly change these rules but highlights the following areas for consideration:
whether some aspects of the UK AIFM regime could be relaxed for funds aimed at professional investors;
whether the size or other thresholds for application for the full-scope UK AIFM regime should be modified;
whether the rules applicable to small authorised AIFMs should be augmented better to reflect the FCA's expectations; and
whether the small registered AIFM regime should be modified or possibly combined with the small authorised AIFM regime.
Possible combination of the UCITS and NURS regimes
The FCA requests views as to whether it should change the boundary of the UK UCITS and non-UCITS retail schemes (NURS) regimes and sets out three approaches as to how this could be done.
The first approach to reduce complexity would be to remove the boundary between the UCITS and NURS regimes so that all authorised funds that can be widely distributed to retail investors would be subject to a single set of rules. The FCA suggests simplifying specific requirements, for example by reducing the barriers to investing in units of other funds, or by creating a more flexible regime for master-feeder fund structures.
The second approach in line with a recommendation of the UK Funds Regime Working Group is to rebrand the NURS regime as ‘UCITS plus’. Mainstream retail products would fall under the UCITS banner and more complex retail products under the UCITS plus banner. This could create a clearer differentiation between the regulatory categories of product. The FCA says it would need to decide whether all funds that are currently NURS should be within the UCITS plus category, or if it would limit this only to more specialist categories of fund.
A third approach would be to create a category of basic funds. This could be done on its own or as well as one of the other approaches. A boundary could be set up to distinguish basic funds from other retail funds. Basic funds would be limited in the types of investments that they could make. They might be restricted, for example, to investing in only the largest and most liquid investments, or in their use of derivatives, or be required to have a high level of diversification. There might be benefits in categorising certain funds in a way that enables retail investors to identify them as a basic type of fund. But any such regime might be difficult to set up in a way that avoids distorting the market.
Against the potential benefits from changing the boundaries of the UCITS and NURS regimes are the cost implications, it may create significant complexities and it could take a long time to prepare for such a structural change. The FCA states that it recognises that UCITS is an internationally recognised and trusted (albeit EEA) framework for retail funds and it would not want to undermine this.
Rules for managers of authorised funds
Host authorised fund managers
The FCA notes that, in relation to host authorised fund managers (AFMs) models, although it sees benefits in allowing authorised funds to use third-party portfolio managers, the FCA's supervisory experience of host AMFs “is that they sometimes fall below appropriate standards”.
The FCA suggests that it may clarify its expectations by requiring specific contractual requirements between the AFM and the portfolio manager in order to reduce the risk that the portfolio manager misunderstands the obligations of the fund manager or, alternatively, that a trade body or other group could help develop industry guidance to set appropriate standards and act as a guide for host AFMs. The FCA also notes that new rules or guidance could make clearer the responsibilities of a portfolio manager of a fund, aligning their responsibilities more closely to the function they are carrying out.
Enhancing liquidity management
The FCA states that it wants to see fund managers of authorised funds carrying out effective liquidity risk management. The FCA expects firms to comply with the liquidity stress testing guidelines issued by the European Securities and Markets Authority (ESMA) which it plans to convert into rules and guidance in the FCA Handbook. It 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 its rules around dilution adjustments (sometimes referred to as ‘swing pricing’) and other anti-dilution mechanisms. The FCA is also considering what reporting may be necessary to ensure it has appropriate regulatory oversight. The FCA currently receives reporting of liquidity categories (or ‘buckets’) for alternative investment funds. It suggests that it could extend this to UCITS funds. The FCA is also considering whether there would be benefits in requiring funds to make any form of public disclosures of the liquidity of their investments.
Investment due diligence
The FCA states that in its supervisory work it 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. Consumers have suffered losses as a result. So, the FCA is considering making its regulatory expectations around investment due diligence for all types of asset management activity clearer for all asset managers.
Clarifying rules for depositories
The FCA states that depositaries play an important function in ensuring that the assets of a authorised fund are appropriately protected, and in overseeing the activities of the fund manager.
The FCA states that in its experience depositaries have not always intervened or challenged fund managers in the manner that the FCA would have expected and that the FCA’s supervisory expectations of depositaries sometimes differ from depositaries’ own interpretations of the FCA's rules.
The FCA considers that there is benefit in updating and making the rules applicable to depositaries clearer, including in respect of:
the systems and controls that a depositary must have in place to identify breaches of the rules and constituting documents of a scheme;
the resources and knowledge, skills and experience expect of a depositary;
actions the FCA expects to be taken when a breach is identified;
what the depositary should do if the manager does not take action to deal with the breach;
the depositary’s oversight of the AFM’s liquidity management, including liquidity stress testing; and
the depositary’s oversight of the AFM’s pricing and dealing in units of the fund.
The eligible assets regime for UCITS sets out the requirements for what a UCITS fund can invest in. There are two sets of rules, one relating to the individual assets, and one relating to the eligible markets on which those assets are traded. The rules on eligible markets limit which markets a UCITS fund can invest in. There have been significant changes in what constitutes a market since these rules were written. UCITS funds are permitted to invest up to 10% of their portfolio into assets that do not meet the eligible markets criteria (the 10% rule). But these assets must meet the other eligible asset criteria, for example around reliable valuation. The FCA has concerns that some UCITS managers might perceive the 10% rule 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. The FCA suggests that it could give guidance on its expectations around the 10% rule for example that managers should not use the 10% rule in a way that undermines the liquidity of the fund or its ability to deal with changes in the fund over time. The FCA requests views on what the potential impact of changing the eligible assets rules could have for managers of UCITS funds.
Prudent spread of risks
The detailed rules on spread of risk aim to limit the risk that an authorised fund can take. They set specific limits which AFMs and depositaries can monitor. But some stakeholders have suggested the FCA should remove the prescriptive quantitative requirements in favour of a more principles-based regime to allow greater investment flexibility. This would be underpinned by the rules on risk management. 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. The FCA is requesting views on whether changing the rules in this area could be of benefit and specifically whether it should consider removing or modifying detailed or prescriptive requirements on prudent spread of risk or other prescriptive requirements in the retail fund rules.
Technology and innovation
The FCA wants firms planning their response to technological changes to think about how those changes could drive competition in the interests of consumers, while also balancing consumer protection.
Technology in fund operations
Some fund managers are keen to be able to modernise the way units are bought and sold, as an alternative to the traditional UK business model. The Investment Association’s ‘Direct2Fund’ proposition is an optional model which would make it possible for investors to transact directly with an authorised 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 is considering whether it should work towards consulting on rules to implement the Direct2Fund model.
Fund unit tokenisation
The FCA understands ‘Fund tokenisation’ to mean the ability to issue a fund’s rights of participation (units or shares) to investors as digital tokens, usually by means of a distributed ledger. The FCA notes that existing rules that govern how fund units are created, transferred, registered, and ultimately cancelled might not be flexible enough to allow firms to operate a ‘digital register’. The FCA is open to exploring what would need to be done to enable this within a risk framework ensuring controls around operational resilience.
Ability for funds to invest in tokenised portfolio assets
The FCA would welcome input from stakeholders about how regulation should respond to the implications for funds of a growing market in tokenised financial instruments. For some managers, fund tokenisation might be of interest as part of a wider programme in which existing assets could be held in the underlying portfolio of the fund and 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 refers specifically to the possibility of a fund holding tokens representing a fractional interest in real estate or an infrastructure project.
Investment in cryptoassets
Given government plans to regulate cryptoassets in the UK, the FCA acknowledges that some stakeholders might want it to explore the possibility of broadening the scope of eligible assets to include unregulated tokens, such as stablecoins and other forms of cryptocurrency and make it possible for authorised funds to hold them. The FCA requests views on whether fund managers should be able to make wider uses of advances in technology without weakening investor protection.
Improving investor engagement through technology
The FCA seeks views on the ways in which technological innovation could help improve the post-sale information that fund managers give investors and how retail investors can interact with the fund manager.
The fund prospectus
The FCA expresses concerns that the authorised fund prospectus is not fulfilling its 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. Current rules about what must be explicitly included in a prospectus for an authorised fund might not reflect all the elements important to investors. For example, there is no explicit requirement for the manager of a UCITS fund to set out the fund’s investment strategy (as opposed to its objective and investment policy), or to say how it intends to vote on proposals that relate to underlying holdings. It therefore suggests redefining and aligning to international best practice what the FCA considers to be the important elements that all investors should understand, to give those elements sufficient prominence, including for example information and labelling around environmental, social and governance (ESG) matters. It is therefore proposing to modernise the authorised fund prospectus rules for example to make the content more easily comparable and available for public scrutiny.
Managers' reports and accounts
The FCA suggests that authorised fund reporting could be updated to take account of technological developments, both in respect of the speed and format of reporting and the quantity and quality of information being made available. In addition, authorised fund prospectuses, reports and accounts of each authorised fund could be required to be published in a prominent and easily accessible place on the fund manager’s website. The FCA also suggests using a mechanism such as the FCA’s National Storage Mechanism to store authorised fund reports alongside company reports, allowing easier public access.
The FCA is considering whether better use of technology could address concerns caused by increased intermediation in the ownership chain for units in authorised funds, including to improve attendance and participation at unitholder meetings for authorised funds, which the FCA notes may be impacted by the use of intermediaries and nominee holdings, including through investment platforms. For example, customers of platforms could be enabled to attend and take part in virtual meetings through suitable online identity validation. Platforms, as the registered holders of the units, could enable their customers to vote electronically on proposals and then submit those consolidated votes to the meeting. Firms could also explore how to introduce straight-through processing of votes from the registered unitholder to the AFM and depositary. The FCA suggests that it could review the prescribed timelines for these processes, either extending or shortening them to take account of stakeholders’ needs.
The FCA also seeks views on how other aspects of investor engagement could be improved, including in light of the use of intermediate unitholders, and whether regulatory intervention may be desirable.
The FCA has requested views on the discussion paper by 22 May 2023 to promote further discussion and listen to stakeholders’ views about what it should prioritise. The FCA has not cemented any new proposals at this stage. The FCA will consider the responses to DP23/2 to look at amendments it could make to the UK regime for funds and assets managers as it incorporates elements of the retained EU law for funds and asset managers into the FCA Handbook. We will be following further developments in this area so please get in touch with your regular contact at Hogan Lovells to discuss any aspect of DP23/2 or wider matters.
Authored by Jonathan Baird and Melanie Johnson.