UK/EU Investment Management Update (June 2022)
FCA powers to vary and cancel permissions
The FCA has updated Chapter 8 of its Enforcement Guide to clarify how it intends to apply its new powers to more swiftly vary and cancel permissions. This follows our September 2021 Update on the FCA’s consultation regarding these powers.
The FCA will provide a firm with two warnings if it believes it is not using a regulatory permission it holds. The FCA will be able to cancel or vary a permission 28 days after the first warning if the firm has not taken appropriate action.
The FCA has indicated that it will apply its powers in a range of instances, including where:
- Firms are misusing their permissions, that is to market products outside the scope of their permissions;
- Firms may be implying to consumers that unregulated activity they undertake is covered by regulatory permissions; and
- Firms have not paid their regulatory fees or submitted required filings.
These actions will support the FCA’s existing “use it or lose it” initiative, which has seen the FCA carry out 1,090 assessments since May 2021 to see whether firms are undertaking the financial activity for which they have permission.
FCA refuses application to provide regulatory hosting services
Alexander Jon Compliance Consulting Limited (AJCC) sought FCA authorisation to provide regulatory hosting services to investment businesses. This service would have granted AJCC to take responsibility for firms carrying out regulated activities without being approved by the FCA, known as appointed representatives (AR).
On 13 May 2022, the FCA published a final notice explaining its refusal to authorise AJCC to deliver the services applied for, putting the hosting model under further scrutiny in line with the FCA’s ongoing consultation on such services.
Upon investigation, AJCC was found to have one director and no employees. It was unable to be specific about its business model, adequately identify prospective ARs, or explain how ARs would assess that products or services were appropriate for consumers. The FCA concluded that AJCC did not present the appropriate skills, experience, or staff to manage and oversee an investment business as principal.
This decision comes as a reminder to firms engaging in regulatory hosting services that they must demonstrate adequate ability for proper supervision of ARs.
New FCA charges for senior managers and controlled persons
The FCA has confirmed that it will begin to apply a new charge for the processing of:
- Standalone Form A applications for the approval of Senior Manager Functions under the Senior Managers Regime; and
- Applications for the approval of Controlled Functions for Appointed Representatives.
The charge is £250 and is in effect as of 27 May 2022.
FCA publishes newsletter on market conduct and transaction reporting issues
On 17 May 2022, the FCA published its Market Watch 69 on market conduct and transaction reporting issues.
In this edition, the FCA discussed firms’ arrangements for market abuse surveillance, drawing on their observations from engaging with small and medium-sized firms. The key observations discussed are as follows:
- Market abuse risk assessments. The FCA is of the view that the most effective assessments involve consideration of the different types of market abuse and how they apply across different areas of the business and asset classes.
- Order and trade surveillance. Discussions with firms have highlighted that surveillance arrangements are improving across industry; however, there continue to be inconsistencies in (i) applying generic calibration across asset classes and instruments; (ii) alerting for insider dealing; (iii) monitoring all orders and trades, including cancelled and amended orders; (iv) review of surveillance exception alerts; and (v) using an in-house solution, a vendor-supplied solution, or a combination for trade surveillance.
- Policies and procedures. While firms may be wary of being over-prescriptive and may want to encourage initiative in their staff, they may want to consider whether there are benefits in creating policies and procedures that provide a level of guidance in how their work should be undertaken.
- Outsourcing. The FCA reminds firms that where there is delegation to a separate organisation, the person delegating should have sufficient expertise and resources to oversee the services provided.
- Front office. Viewing the front office as a mitigator for a limited or absence of surveillance in the compliance team can lead to risks such as suspicious activity not being consistently identified and escalated or staff knowing when trading activity might be escalated and instead sharing their knowledge with clients. The FCA advises firms to consider whether their market abuse training is effective and tailored to the risks associated with the desk, asset classes traded, client types, and other relevant factors.
- Countering the risk of market abuse-related Financial Crime (SYSC 6.1.1R). Following the release of the Financial Crime Guide, the FCA found that firms that had created a formal framework to manage relevant risks were generally able to take appropriate decisions in managing those risks in a consistent manner. Those firms yet to create a framework sometimes struggled to demonstrate that their approach was consistent or effective.
- Investigations into potential market abuse by firms’ employees. The FCA reminds firms subject to Article 16 of the UK Market Abuse Regulation that they should also consider the requirement to submit a suspicious transaction and order report (STOR) without delay once they have a reasonable suspicion that employee conduct could constitute market abuse.
UK Financial Services and Markets Bill
As part of the Queen’s Speech delivered on 10 May 2022, the Prince of Wales announced that the UK government will be proposing a new Financial Services and Markets Bill (the Bill). The details of the Bill will be unknown until it is formally introduced before Parliament but will include the following elements:
- Revoking retained EU law on financial services and replacing it with an approach to regulation that is “designed for the UK”;
- Updating the objectives of the financial services regulators to ensure a greater focus on growth and international competitiveness; and
- Reforming the rules that regulate the UK’s capital markets to promote investment.
One of the stated benefits of the Bill is to support the “safe adoption of cryptocurrencies and resilient outsourcing to technology providers.”
A separate Brexit Freedoms Bill will also be introduced to enable inherited EU laws to be more easily amended or repealed.
More details will be available when the Bill is formally introduced.
On 31 May 2022, HM Treasury released a consultation on managing the failure of systemic digital settlement asset (including stablecoin) firms (the Consultation). The Consultation follows HM Treasury’s earlier consultation on a proposal to regulate fiat-linked stablecoins as covered in our Update UK to Regulate Fiat-Linked Stablecoins (April 2022).
The Consultation concerns potential risks to financial stability arising from the use of “digital settlement assets” (DSAs) including stablecoins. The UK government has expressed concern about the potential harm that could result from the collapse of an issuer or service provider for a stablecoin that has reached “systemic scale.” Although the Consultation does not mention TerraUSD (the value of which recently collapsed, thereby breaking its peg with the U.S. dollar) by name, it does make reference to “events in crypto-asset markets [that] have further highlighted the need for appropriate regulation to help mitigate consumer, market integrity and financial stability risks.”
HM Treasury seeks feedback on extending the scope of existing legislation to “systemic DSA firms,” which the Consultation states “refers to systemic DSA payment systems [e.g., a payment system based on the use of stablecoin rather than fiat money] and/or an operator of such a system or a DSA service provider of systemic importance.” The Consultation further notes that this may include “the issuer of a stablecoin, a wallet, or a third-party service provider.” It also proposes to extend the Financial Market Infrastructure Special Administration Regime (FMI SAR) — a bespoke insolvency regime that applies to systemically important payment systems — to systemic DSA firms. This would make the Bank of England the lead regulator of systemic DSA firms in administration.
According to the Consultation, the UK government also intends to add an additional objective to the FMI SAR “covering the return or transfer of funds and custody assets” that would apply when the FMI SAR has been applied to a systemic DSA firm. The Bank of England would be empowered to direct administrators to pursue this objective over the objective of ensuring continuity of service where it deems this appropriate.
FCA hosts two-day CryptoSprint event on the evolution of cryptoassets
On 10 and 11 May 2022, the FCA hosted a two-day CryptoSprint event to explore how the evolving world of cryptoassets could be regulated in the UK.
Building off the FCA’s established Techsprint approach, CryptoSprint allowed various participants from the crypto industry to come together and share their views on how the FCA can tailor future policies in a way that makes them innovative and protective for consumers and markets.
This is the first of many planned industry engagements that will inform what a future regulatory regime for cryptoassets could look like.
The FCA will share results from CryptoSprint later in the summer.
ESMA public statement: actions to manage the impact of the Russian invasion of Ukraine on investment fund portfolios
On 16 May 2022, ESMA released a public statement on actions to manage the impact of the Russian invasion of Ukraine on investment fund portfolios exposed to Russian, Belarusian, and Ukrainian assets. The intention behind the statement is to promote convergence in relation to such actions. The obligations of EU alternative investment fund managers (AIFMs) and internally managed alternative investment fund (AIFs) as well as Undertakings for Collective Investment in Transferable Securities (UCITS) and other types of funds are addressed.
- Material liquidity issues and valuation uncertainties. As a general principle, fund managers need to follow a consistent approach to the valuation of assets in line with the applicable policies and procedures and EU and national law. Where a fair value can no longer be determined, or the subscription or redemption of shares or units at the current market price is not in the best interest of investors, consideration should be given to suspending subscriptions and redemptions temporarily. Managers may also consider other measures, such as (i) the total writeoff of the relevant assets, (ii) liquidation of the fund, or (iii) segregation of the assets that have become illiquid or non-tradeable.
- Permissibility of side pockets. ESMA states that side pockets may be preferable from an investor protection perspective compared to temporary suspension, especially where assets are valued at significantly lower prices. ESMA notes, however, that potential risks of side pockets include (i) moral hazard problems, (ii) illiquid assets transferred to side pockets necessarily becoming liquid or gaining value again, and (iii) operational problems that fund distribution platforms with their creation.
Side pockets are recognised and explicitly referenced in the current AIFMD framework, allowing authorised AIFs to consider their use where it is in the best interests of investors. However this is under discussion in the context of the current overarching review of the AIFMD (that is, AIFMD II).
European Commission publishes New Q&A on the SFDR
On 25 May 2022, the European Commission (the Commission) published its answers to questions raised by the European Supervisory Authorities (ESAs) relating to the interpretation of the SFDR and the Taxonomy Regulation (TR).
Please see our Update European Commission Q&A on SFDR - Five Key Takeaways for Investment Managers (June 2022) for a detailed analysis of the Commission’s responses.
ESMA supervisory briefing for investment funds with sustainability features
On 31 May 2022, ESMA published a briefing for supervisors setting out guidance on the integration of sustainability risks and disclosures in the area of investment management (the Briefing). The Briefing is applicable primarily in respect of EU-based managers, but national competent authorities (NCAs) could potentially take the same approach for non-EU managers that apply for marketing approval under the AIFMD national private placement regimes.
The following may be of interest, noting the comments regarding presentation of disclosures, fund names, and enforcement:
- Verification of compliance. NCAs should create a checklist based on the information to be provided in pre-contractual templates to assess compliance of disclosures of new and existing funds disclosing under Article 8 or 9 SFDR. On the basis of this checklist, NCAs should verify that (a) the prospectus includes a prominent statement referring to the sustainability information to be found at the annex; (b) pre-contractual templates have been properly completed; (c) there is a description of the manner in which sustainability risks are integrated into investment decisions; (d) the environmental and/or social characteristics promoted by funds are clearly stated and explained; and (e) the strategy to attain such characteristics is clearly identified and part of the investment policy.
- Verification of consistency of information. NCAs should be satisfied that the sustainability-related disclosures made are consistent across the fund documentation and marketing material.
- Presentation of disclosures. The following criteria should be applied in ensuring information disclosed is presented in a clear, fair, non-misleading, and succinct way: (a) Sustainability-related disclosures should not include boilerplate language, and supervisors should treat the repeated use of the same or similar standard text across different funds as a warning sign; (b) there is limited usage of cross-referencing; (c) the disclosures should not require investors to search further for relevant information; and (d) there should be mention of which article of SFDR the AIFM/UCITS discloses against.
- Fund names. Terms such as “ESG” “green,” “sustainable,” “social,” “ethical,” and “impact” should be used only when supported in a material way by evidence of sustainability characteristics, themes or objectives that are reflected fairly and consistently in the fund’s investment objectives and policy and its strategy as described in the relevant fund documentation. Additionally, to avoid confusion, it is advised that the use of the term “sustainable” or “sustainability” should be used only by (a) funds disclosing under Article 9 SFDR, (b) funds disclosing under Article 8 SFDR that in part invest in economic activities that contribute to environmental or social objectives, and (c) funds disclosing under Article 5 Taxonomy Regulation (TR).
- Sustainable investment policy and objectives. A sustainable investment policy and/or objectives should be included in the fund documentation, and the fund should be managed according to it. In addition, the sustainable objectives or characteristics should be clearly identified, and expressions such as “the fund pursues ESG objectives in general” without any further specification should be avoided. In case of environmental objectives, a way to clearly identify those objectives is if they are referred to in Article 9 TR.
- Investment strategy. For a strategy to be clearly identified, at least some of the following non-exhaustive key elements should be disclosed: (a) investment universe (including limits and thresholds), (b) screening criteria applied, (c) specific ESG characteristics/themes or non-financial impacts pursued, (d) use of benchmark/indices and relative expected tracking error (if applicable), or (e) stewardship approach.
- Verification of compliance with website’s disclosure obligations and period disclosure obligations. NCAs should verify such compliance, ensuring that information published, maintenance requirements, and annual reporting obligations are met.
- Additional supervisory actions. NCAs should verify the compliance of UCITS management companies and AIFMs with the disclosure of sustainability risk integration on websites referred to in Article 3 SFDR by performing sample checks based on surveys and questionnaires relating to the integration of sustainability risks.
- Regulatory intervention. Administrative measures, including enforcement, may be appropriate in the following examples: (a) Legally required SFDR disclosures have not been made at all after the application of the new rules; (b) SFDR disclosures are viewed as severely misleading. This is particularly the case when consistency checks would highlight a situation where there is a significant discrepancy between what the fund actually invests in and what has been disclosed to investors in pre-contractual disclosure documentation; (c) sustainability risks have not been integrated throughout the organisation despite an appropriate period of time after entry into force of the AIFMD and UCITS amendments in this respect; (d) the periodic disclosure of a financial product disclosing under Article 8 or 9 SFDR does not match (or fulfill) the characteristics or objectives shown in the fund documentation; and (e) financial product disclosing under Article 9 SFDR with a sustainable investment objective shows in periodic disclosure that significant proportions of investments do not comply with the sustainable investment criteria of Article 2(17) SFDR.
ESA publishes further clarification on the draft regulatory technical standards (RTS) for the SFDR
On 2 June 2022, the ESAs published further clarification on the draft RTSs for the SFDR (these were adopted by the Commission on 6 April 2022). Some of the key insights from the ESA’s statement are set out below.
- Use of sustainability indicators. The SFDR’s reference to “sustainability indicators” (under Articles 10(1)(b), 11(1)(a), and 11(1)(b)) is distinct from the reference to principal adverse impact (PAI) indicators (under Article 4 SFDR and Annex I); in other words, they relate to different sets of disclosures. However, they are not mutually exclusive concepts: It is possible also to use PAI indicators to measure the environmental or social characteristics or the overall sustainable impact of the financial product.
- Product-level PAI disclosures — PAI calculation methodology. With regard to the calculation of indicators on greenhouse gas emissions, it is worth noting that in some cases an investee company’s emissions may change throughout a reference period, and the size of the investment in that company may evolve, too. As such, the assessment of impact for PAI disclosures should be based on the average of four calculations made on 31 March, 30 June, 30 September, and 31 December of a calendar-year reference period. A worked-out example is provided for reference.
- Product-level PAI disclosures — “look through” approach. The ESAs consider that all investments, both direct and indirect (e.g., investments in funds, funds of funds, or derivatives) should be included in the calculations made for PAI reporting.
Where the investee company is a holding company, collective investment undertaking, or special purpose vehicle, managers should “look through” to the individual underlying investments of those companies and consider the total adverse effects arising from them. If such information is not available, the manager should disclose details of the best efforts used to obtain the information either “directly from investee companies, or by carrying out additional research, cooperating with third party data providers or external experts or making reasonable assumptions.”
In the case of investment decisions where an investment exclusively finances a project, for example, an investment in a green bond, the assessment of the adverse effects of the investment decisions could be limited to the adverse effects of the project or type of project funded by the instrument.
In addition, the ESA provided further guidance on adverse impact indicators, pre-contractual and periodic product-level disclosures, taxonomy-related product disclosures, and “do no significant harm” disclosures.
ESMA publishes consultation paper in respect of the notifications for cross-border marketing and management of AIFs and UCITS
On 17 May 2022, ESMA published a consultation paper containing draft technical standards on the notifications for cross-border marketing and cross-border management of AIFs and UCITS.
The consultation applies only in relation to the marketing activities of EU AIFMs and UCITS.
ESMA is undertaking the development of technical standards to specify the content and format of notification letters that EU AIFMs (and management companies/UCITS) are to provide to the NCAs of the host Member States where they undertake cross-border marketing or cross-border management activities. The purpose is to streamline the notification procedure by harmonising the information to be notified to NCAs and developing common templates to be used by management companies, UCITS, and AIFMs.
As such, ESMA has published a draft template notification letter that EU AIFMs are to submit to their home NCA to notify their intention to market AIFs that they manage in their home, or any other, Member State. ESMA has published similar template letters for UCITS and management companies.
The consultation is open until 9 September 2022, and ESMA expects to publish a final report by the beginning of 2023.
8. EU — MiFID II
ESMA report on best execution requirements
The “MiFID Quick Fix” Directive temporarily suspended the application of the RTS 27 and 28 reporting requirements for EU trading venues and EU investment firms for two years and requires the Commission comprehensively to review the adequacy of the best execution requirements. Under RTS 28, firms must publish annual reports to enable the public and investors to evaluate the quality of the firm’s execution practices.
In the context of the Commission review and as reported in our October 2021 Update, ESMA decided to consult on improvements that could be made to the RTS 28 regime for best execution reporting by investment firms and, on 16 May 2022, published its views, opinions, and proposals in a Final Report. As the Commission has proposed abolishing the RTS 27 reporting requirements for trading venues, the Final Report does not include proposals with regard to RTS 27.
ESMA is proposing that best execution reporting requirements are maintained under RTS 28 but that they can be improved in a number of ways, most notably:
- by amending MiFID II to clarify that reporting requirements apply to firms providing the service of reception and transmission of orders and to portfolio managers that transmit their decisions to deal to other firms for execution;
- by removing the requirement to report the percentage of orders that were passive and aggressive be removed; and
- by prescribing aspects of the modes of reporting. In particular, firms would be required to produce the quantitative information of RTS 28 reports in CSV file format and to maintain the reports on their websites for two years.
ESMA also notes that proposals under the review of the EU Markets in Financial Instruments Regulation (MiFIR) to bring forward the establishment of a consolidated tape provider (CTP) will mean that end users become reliant on best execution reports to assess how the CTP data is informing and affecting best execution.
The aim of the Final Report is stated to provide initial support to the Commission in its ongoing review of MiFID II. ESMA does not anticipate making changes to RTS 28 immediately.
Commission publishes Delegated Regulation amending EMIR in relation to Regulatory Technical Standards (RTS) for the transition to new benchmarks referenced in certain OTC derivative contracts
On 17 May 2022, the Commission published Commission Delegated Regulation (EU) 2022/750 (the Regulation) in the Official Journal of the European Union. The Regulation amends Commission Delegated Regulation (EU) 2015/2205, which set out RTS on the clearing obligation set out under EMIR for interest rate over-the-counter (OTC) derivatives classes. The amendments reflect the transition away from the use of all EONIA or LIBOR settings as a reference rate in new contracts and moving to Risk-Free Rates such as €STR, SONIA and SOFR. The date on which the clearing obligation takes effect for the new Risk-Free Rates is staggered depending on which Risk-Free Rate is relevant, as well as whether one counterparty is established outside of the EU (and whether an equivalence decision has been adopted for the relevant non-EU country) or whether a contract has been novated for the purpose of replacing a UK established counterparty with an EU Member State established counterparty.
Although this transition was intended to take place by 31 December 2021, ESMA had acknowledged in a public statement published on 16 December 2021 that the Regulation would not enter into force in time for the transition and encouraged NCAs not to prioritise supervisory actions in relation to the clearing obligation for the relevant interest rate OTC derivative classes. The Regulation came into force on 18 May 2022.
ESMA proposes increase of EMIR clearing thresholds for commodity derivatives
On 3 June 2022, ESMA published a final report containing draft RTS that would increase the current clearing thresholds for commodity derivatives transactions under EMIR.
The RTS would raise the threshold from €3 billion to €4 billion for both non-financial counterparties and financial counterparties. Following Brexit, commodity derivatives traded on UK venues must be counted towards the clearing thresholds, and ESMA cites this factor, as well as volatility in commodity prices, as necessitating an urgent change. The Commission will now review the RTS prior to adoption and scrutiny.
ESMA formally proposes three-year suspension of CSDR buy-in regime
As reported in our January 2022 Update, ESMA had stated that it does not expect NCAs to apply their supervisory powers in relation to the application of the mandatory buy-in (MBI) regime under the CSDR pending ESMA’s formal proposal to suspend the regime.
On 2 June 2022 ESMA published its final report containing draft RTS, which would delay the MBI regime for three years following adoption of those RTS. The Commission will now review the,RTS prior to adoption and scrutiny.
The Commission’s review of the CSDR is ongoing in the meantime and includes consideration of the scope of the MBI longer term.
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