UK/EU Investment Management Update (May 2020)

Delays to FCA activities and regulatory change

On 1 May 2020, the FCA announced that in response to COVID-19, it was reviewing its work plans to delay or postpone activity that is not critical to protecting consumers and market integrity in the short term.

A number of consultation and discussion papers will be delayed. Of interest to investment managers will be delays to the following areas, which were originally scheduled to be consulted on by June 2020:

• Consultation Paper: the FCA’s approach to market integrity and wholesale markets
• Discussion Paper: Prudential requirements for MiFID Investment Firms (see this Sidley Update for an analysis of these new requirements)
• Directory of certified persons (due to be published on the Financial Services Register)

The FCA simply says that it will “provide updates at an appropriate point.”

Temporary changes to regulatory reporting

On 22 April 2020, the FCA published temporary measures for firms submitting regulatory returns, in light of the impact of the COVID-19 pandemic.

In particular, the FCA has permitted:

• a one-month delay in submission for a set list of SUP 16 handbook returns
• a two-month delay for FIN-A (annual report and accounts)
• firms not to submit the Employers’ Liability Register compliance return for 2020 

Expectations for funds

On 6 April 2020, the FCA published a new webpage setting out its expectations for funds in light of the COVID-19 pandemic.

The key takeaways for alternative fund managers are as follows:

• The FCA has agreed to extend deadlines for publishing funds’ annual and half-yearly reports and accounts. The FCA’s temporary relief will permit an additional two months to publish annual reports and an additional month for half-yearly reports.

Sidley Comment: Please note that this relief applies only to UK authorised fund managers; it is not relevant for non-UK managers (e.g., U.S. managers) who market their funds into the UK under the Article 42 AIFMD national private placement regime.

• The FCA expects firms to already put in place plans to deal with issues concerning their risk controls, including compliance with limits on value at risk, and to take appropriate remediation action, considering market conditions and what is in the best interest of their customers.
• The FCA will accept electronic signatures on applications to authorise funds or approve changes to funds. Applicants may validate accompanying documentation electronically where it is possible to do so. In all cases where an electronic signature is used, the FCA needs to be assured that the signatory has seen and agreed with all the information in the form.

On the topic of electronic signatures, note that on 20 April 2020, the FCA issued a statement with respect to its expectations for wet-ink signatures in light of COVID-19 restrictions. The FCA clarifies that its rules do not explicitly require wet-ink signatures in agreements nor prevent the use of electronic signatures in agreements.

SMCR

On 6 May 2020, the FCA announced that it was extending the maximum period firms can arrange cover for a Senior Manager without being approved, from 12 weeks to 36 weeks, in a consecutive 12-month period. Firms can use the modification by consent if, for example, a Senior Manager is absent because of coronavirus, or recruitment to replace a Senior Manager is delayed due to the coronavirus pandemic. Firms can apply for the modification by consent as a precautionary measure, in advance of actually needing it.

On 3 April 2020, the FCA published its expectations of solo-regulated firms in relation to their obligations under the Senior Managers and Certification Regime (SMCR) in light of the COVID-19 pandemic.

The FCA has stated that it does not require firms to have a single Senior Manager responsible for their coronavirus response. Firms are expected to allocate these responsibilities in the way best enabling them to manage their risks.

The FCA also sets out its expectations for furloughing Senior Managers, noting that individuals performing required functions (e.g., compliance oversight, money-laundering reporting) should be furloughed only as a last resort.

The National Bans were originally announced by those five EU member states on 17 and 18 March 2020 and were due to expire mid-April 2020. Italy also has a ban in place, which is stated to expire on 18 June 2020.

For an analysis of the National Bans, please refer to an updated version of our Update EU Bans on Short Positions – Implications for Market Participants and to our Update European Union Net Short Position Reporting Threshold Reduced to 0.1 percent, as previously referred to in our UK/EU Investment Management Update of April 2020.

French AMF statement pushing for EU-wide ban

On 5 May 2020, to mark the publication of the annual report of the Autorité des Marchés Financiers (AMF), AMF Chairman Robert Ophèle explained, during a virtual press conference, the various measures taken in recent weeks to ensure the orderly operation of the markets. In relation to the AMF’s short selling ban, Mr Ophèle said:

In a consistently bearish market with considerable uncertainty about the extent of the decline, short sellers contribute little to price formation, and an increase in short selling can have unwelcome pro-cyclical influence…. The question is why this measure has not been taken at European level.

The AMF press release notes that Mr Ophèle is in favour of a coordinated response agreed by the European Securities and Markets Authority (ESMA).

WFE academic review of short selling bans

Remaining on the topic of short selling, on 29 April 2020, the World Federation of Exchanges (WFE), the global industry group for exchanges and central clearing counterparties (CCPs), published an academic review of short selling and short selling bans. The paper compares arguments against and in favour of banning short selling. It concludes that academic evidence points to such bans being disruptive to the orderly functioning of markets by reducing liquidity, increasing price inefficiency and hampering price discovery, thus, in effect, exacerbating rather than containing market volatility.

Given the delays to Brexit negotiations that have resulted from the COVID-19 crisis, it is beginning to look challenging for the assessment to be completed by end-June 2020.

On 6 May 2020, the FCA’s Nausicaa Delfas (Executive Director of International) gave a speech, where she commented on that end-June deadline:

We are continuing to work closely with the Treasury on this issue, and will continue to provide technical advice as requested. Our work on this remains on track.

If that timing is not met, then UK firms — including investment management firms that would benefit from MiFID equivalence — need to plan for the real possibility of a “no-deal” Brexit from that perspective. Indeed, Ms Delfas notes in the same speech:

[F]irms should continue to consider what actions they need to take to be ready for the end of the transition period, and what this will mean for their customers.

We also expect that over the next few months, EU regulators will put out statements reminding UK firms of their obligation to put in place plans for doing business in each EU member state. For example, on 29 April 2020 the Bank of Italy published Instructions to UK intermediaries operating in Italy after the Withdrawal Agreement.

FCA statement on temporary transitional powers

On 30 April 2020, the FCA (along with the Bank of England (BoE) and the Prudential Regulation Authority (PRA)) updated its webpage on the Brexit Temporary Transitional Power (TTP).

The FCA confirms that after the Brexit transition period, it intends to apply the TTP on a broad basis and to the same areas as previously communicated. It also intends to grant transitional relief from the end of the transition period until 31 March 2022.

This means that regulatory obligations on firms will generally remain the same as they were before the end of the transition period (31 December 2020) until 31 March 2022. Generally, UK-regulated firms will not need to complete preparations to implement changes in UK law arising from the end of the transition period by December 2020.

The FCA will not, however, grant transitional relief in certain specific areas, including the MiFID II transaction reporting regime and European Market Infrastructure Regulation (EMIR) reporting regime.

AIFM Transition Period — AIMA letter to the FCA

On 30 March 2020, the Alternative Investment Management Association (AIMA) sent a letter to the head of the FCA Asset Management Department, Nick Miller, with a request for clarification on practical implications of the UK’s withdrawal from the EU for alternative investment fund managers (AIFMs).

The key issues raised in AIMA’s letter concerned the impact on European Economic Area (EEA) AIFMs marketing to UK investors under the current passporting regime and under the National Private Placement Regime (NPPR). Existing UK legislation lacks provisions on the process of how existing EEA AIFMs can convert to become Third Country AIFMs, begging the question of whether their status under passporting or the NPPR can be converted to the new Third Country AIFM status or if this will require deregistration and reregistration.

Earlier in March 2020, AIMA sent similar letters to certain national competent authorities (NCAs) in the EU27 with respect to the status of UK AIFMs following the transition period.

According to the statement, the central assumption remains that firms cannot rely on LIBOR being published after the end of 2021. However, the FCA, BoE and RFRWG recognize the challenges presented by the current operating environment and take positive note of the continued progress on LIBOR transition. The bodies note that transition to Sterling overnight interbank average rate (SONIA) in the bond market for sterling cash markets has been largely completed. With respect to loan markets, the RFRWG, FCA and BoE recognize that a complete transition away from LIBOR across all new Sterling LIBOR-linked loans by the original end-Q3 2020 target will not be feasible, which will likely mean continued use of LIBOR-referencing loan products into Q4 2020.

The RFRWG recommends that

(i) by the end of Q3 2020, lenders should be in a position to offer non-LIBOR-linked products to customers

(ii) after the end of Q3-2020, lenders, working with borrowers, should include clear contractual arrangements in all new and refinanced LIBOR-referencing loan products to facilitate conversion ahead of end-2021, through preagreed conversion terms or an agreed process for renegotiation, to SONIA or other alternatives, and all new issuance of sterling LIBOR-referencing loan products that expire after the end of 2021 should cease by the end of Q1 2021.

The RFRWG, together with the FCA and BoE, will provide further updates as the impact of COVID-19 on LIBOR transition efforts evolves.

No-action letters have typically been used as a regulatory tool in the United States by the U.S. Securities and Exchange Commission (SEC) for recommendations by SEC staff for the SEC to abstain from enforcement action on the basis of a request from an individual or entity.

The European Securities Authorities (ESAs), including ESMA, were only recently empowered to issue such letters by way of Regulation (EU) 2019/2175 of the European Parliament and of the Council of 18 December 2019, which, among others, amended Regulation (EU) 1095/2010 applicable to ESMA. ESMA’s no-action letter regarding the ESG disclosure requirements under the BMR is the first time we are aware of that ESMA has used these new powers accorded to it. It will be interesting to see how this develops as a regulatory tool in the EU.

The guidelines apply only to UCITS and to EU-authorised AIFMs who market their funds to retail investors and is not relevant for the majority of alternative fund managers who receive this Update.

The guidelines provide comprehensive guidance to fund managers on the design of performance fee models for the funds they manage, including on assessing consistency between the performance fee model and the fund’s investment objective, policy and strategy, particularly where the fund is managed in reference to a benchmark. The guidelines are intended to harmonise how fund managers charge performance fees to retail investors and the circumstances in which performance fees can be paid. ESMA considers that the harmonised requirements will enable convergence in the supervision of performance fees models by NCAs and in disclosures across the EU.

The guidelines will become applicable two months after the publication on ESMA’s website of their translations into the official EU languages.

The flowchart provides indicators as to when FCA registration is likely to be required, depending on the type of activity carried out by the business and whether the activity is carried on by way of business in the UK. Where a business considers that registration is not required pursuant to the flowchart, the FCA may still ask for an explanation as to why the business considers its activities to be outside of scope.

For more information on the AML/CTF regime in relation to cryptoassets and the FCAs registration timelines, see this webpage published by the FCA. Existing cryptoasset businesses that were carrying on cryptoasset activity immediately before 10 January 2020 may continue with that business but must still comply with the MLRs. They will need to be registered before 10 January 2021 or cease all cryptoasset activity. New cryptoasset businesses that intend to carry on cryptoasset activity after 10 January 2020 must be registered before carrying out any activity.

As a general comment, it is worth mentioning the FCA’s statement, in light of the impact of COVID-19, that it has delayed certain planned activity where it has deemed it as not being urgent and as distracting firms from the immediate priority. The FCA also stated that it would review its plans set out in the Business Plan as the position on the pandemic becomes clearer, which may result in a change in its remit.

The following points are worth noting for investment managers.

Coronavirus (COVID-19)

• The FCA intends to focus on “ensur[ing] that financial services businesses give people the support they need, that people don’t fall for scams, and that financial services businesses and markets know what [the FCA] expect of them.”
• The FCA refers to its dedicated webpage on COVID-19, on which it provides consumers and firms with information on a regular and updated basis.

Sidley Comment: The FCA has made it clear that dealing with the effects of the pandemic on the financial market is its utmost priority, and it appears clearly to be taking an outcomes-based approach in this respect. The Business Plan, alongside measures already taken and communicated by the FCA, indicates that the FCA will be focussing on the investor/consumer protection actually obtained by investors/consumers in these circumstances.

Transformation of the FCA

•  The FCA plans to undertake a number of improvements to itself, including operating in a more integrated way as “One FCA.” The FCA intends to fundamentally change the way it works as a regulator and thereby enhance the speed and effectiveness of its decision-making. 

Transition from rules and process to principles and outcomes

• The introduction to the Business Plan states that “the current [regulatory] framework is too focused on rules and process, and not enough on principles and outcomes. The [FCA sees] far too many resources devoted to redress and remediation, and not enough to empowering consumers to take good decisions and regulatory action to prevent harm and safeguarding consumers’ financial wellbeing.”
• The FCA submits that it “want[s] all firms to take the end outcomes for consumers and markets into greater account when they design and delivery services”, in support of which it will be clearer on the outcomes it expects firms to achieve and how the FCA is targeting its own work to achieve them.
  
  Sidley Comment: Some may recall that prior to the financial crisis, the FCA had been lauded for taking a principles-based, rather than rules-based, approach. While that would have been a slightly simplistic view to take, it is certainly true that with the tsunami of postcrisis financial services regulation, the FCA became a much more rules-based regulator, not least because it was required to implement all the EU financial services directives and regulations. The FCA now appears to be setting itself up for a post-Brexit world, where it feels it has the freedom to return to a more principles-based approach.

Use of intelligence and information

• The FCA is focussing on making changes on how it identifies, prioritises and acts on information it receives, alongside streamlining data and regulatory returns through digital regulatory reporting and streamlining operational impact on firms through better coordination among regulators.

Enabling effective consumer investment decisions

• The FCA intends to focus on ensuring that investment products are appropriate for consumers’ needs, deliver value for money and are marketed in a fair, clear and not misleading way.
• As in previous years, the FCA continues to focus on corporate governance in firms and ensuring that the regulatory system can tackle the cost of misconduct it sees in networks of individuals in distribution chains.

Sidley Comment: The FCA considers that harm in the investment management sector is caused by several factors, including cases of poor governance, insufficient focus on delivering good value and lack of investment in technology and operational resilience.

EU withdrawal and international influence

• The FCA is committed to maintaining its influence as a leading global regulator and intends to continue working with European and global stakeholders on developing robust global financial standards and effective supervision.
• The FCA will provide the UK government with technical support as it negotiates the future relationship of the UK with the EU and other jurisdictions. The FCA will prepare transitional measures, including the temporary permissions regime for EEA-based firms and funds passporting into the UK.

Sidley Comment: The FCA is clearly having to devote much of its resources to COVID-19 issues and has not devoted much of the Business Plan to the topic of the EU/UK negotiations for the UK’s withdrawal from the EU. The Brexit equivalence assessments are also carried out by the European Commission, with the FCA having less work to do as the UK, unlike the EU, is generally permissive in terms of non-UK providers of investment services to professional clients in the UK. Equivalence on the UK side is therefore to a large extent political in terms of the UK government/HM Treasury seeking for the European Commission to grant UK equivalence, albeit the FCA having a supportive role to play.

Climate change

• The FCA notes that its regulatory approach needs to, and will, support the physical and transitional risk posed to the financial sector by climate change.

Sidley Comment: In March 2020, the FCA published a consultation paper on new climate-related disclosure requirements for premium listed issuers. The consultation period is open until 1 October 2020. For more information, please refer to our Investment Management Update of April 2020.

Innovation and technology

• The FCA is continuing with the focus mentioned in its Business Plan 2019/20 on investing in new technologies and skills, engaging with industry and society on artificial intelligence and working with stakeholders to support a joined-up approach to cryptoassets.
• The FCA intends to use technology to reduce the burden of regulatory reporting on firms, including by replacing its Gabriel system with a new platform for collecting firms’ data. It also plans to take forward its work on digital regulatory reporting.

Sidley Comment: See also the FCA’s webpage on digital regulatory reporting.

Operational resilience

• The FCA intends to set new requirements to strengthen operational resilience.

Sidley Comment: In December 2019, the FCA, PRA and BoE published a joint consultation paper on building operational resilience. The consultation period is open until 1 October 2020.

Financial crime

• Financial crime continues to be a high priority for the FCA (as in previous years). In line with its commitments in the UK’s Economic Crime Plan 2019 to 2022, the FCA plans to implement changes on how it reduces financial crime in 2020, including through greater use of data to identify potentially vulnerable areas and firms.
• The FCA intends to consult on extending the Financial Crime Data Return to more firms to aid in strengthening its risk-based supervision as part of its wider anti-money-laundering strategy.
• The FCA has implemented a new registration and supervision regime for cryptoasset activities.

Culture

• The FCA is beginning to shift its focus toward the culture of small firms, following the rollout of the SMCR regime to UK investment firms from 9 December 2019.

Transition from LIBOR

• The FCA is continuing its support for the transition from LIBOR to alternative “risk-free” rates.
• The FCA continues to assess the exposure of asset managers to LIBOR risk. The regulator seeks to ensure that managers have strategies to manage the risks and will monitor how firms implement their strategies.

Sidley Comment: For more information on the LIBOR transition and next steps, see this factsheet published by the RFRWG. In March 2020, the FCA and BoE also published a joint “Dear CEO” letter, to which we refer in our Investment Management Update of April 2020.

Budget and fees

• The FCA budget for 2020/21 is £587.6 million, indicating a 5.2% increase in its annual funding requirement to the previous year.
• Given the impact of COVID-19, the FCA is freezing the fees to be paid by the smallest 71% of financial services firms and providing small and medium firms with an extension until the end of 2020 to pay their fees.

Sidley Comment: The FCA has published a consultation on its proposed regulatory fees and levies for the financial year of 1 April 2020 to 31 March 2021. The consultation period closes on 19 May 2020. Under the proposals, contributions by advisers are set to rise by 1.6 percent, bringing the total amount funded by advisers, dealers and brokers to £80.7 million in comparison to the £79.4 million for the previous year.

Data for the fifth IOSCO survey informing the report was collected as at 30 September 2018 and, in comparison to the previous, 2016 survey, Switzerland was included among the nine participating jurisdictions (the remaining eight comprising France, Germany, Hong Kong, Ireland, Luxembourg, Singapore, the United Kingdom and the United States). The survey collected data relating to, among others, fund liquidity, collateral, margin, exposures and further data on measuring leverage in hedge funds. The report also provides, for the first time, a jurisdiction-level breakdown of information on long and short exposure on an asset-class basis and a number of specific leverage metrics, including gross notional exposure (GNE) and GNE adjusted. The key takeaways are as follows.

• The survey captured data from 2,139 qualifying hedge funds, an 8.5 percent increase compared to the 2016 survey.
• Assets under management increased by 19.5 percent to USD 3.85 trillion from 2016 to 2018.
• Multistrategy and equity long/short are the most common investment strategies of qualifying hedge funds.
• The largest exposures held by qualifying hedge funds (long and short), for both cash securities and derivatives, are in equities.
• On a gross notional basis, interest rate and foreign exchange derivatives positions are the largest in terms of fund exposures.
• Leverage, as measured on a gross notional basis, stands at 8.2x net asset value and net leverage stands at 1x net asset value.
• On average, qualifying hedge funds appear to have sufficient portfolio liquidity to meet investor liquidity demands in normal times.

Note that ESMA is currently consulting on draft guidance to address leverage risks in the alternative investment fund (AIF) sector. The consultation is part of the ESMA response to the recommendations of the European Systemic Risk Board (ESRB) in April 2018 to address liquidity and leverage risk in investment funds. The deadline for responses to the consultation is 1 September 2020.