The FCA’s Dear CEO letter to alternatives managers

On 22 January 2020 (though dated 20 January 2020), the FCA published a Dear CEO letter (the Letter) which sets out the regulator’s “Alternatives Supervision Strategy” and outlines its view of the key risks that alternative investment firms pose to their customers or the markets in which they operate.

The Letter was addressed to CEOs in the FCA’s alternatives portfolio – this comprises FCA authorised firms that predominately directly manage or advise on alternative investment vehicles (for example, hedge funds or private equity funds) or assets.

The letter should be seen in the context of the Dear CEO letter sent on the same day to the FCA’s asset management portfolio (ie, FCA authorised firms that predominantly manage or advise on mainstream investment vehicles other than wealth managers and financial advisers), although it is interesting to note the different topics that the FCA identifies in the two letters.

A summary of the asset management letter can be found here.

A third Dear CEO letter was also sent out on 21 January to financial advisers – a summary of that letter can be found here.

Overview

The Letter flags up three general points which it expects the alternatives sector to bear in mind in order to protect its customers and oversee their investments effectively over the long term. These are

• standards of governance fall below the FCA’s expectations – this is particularly the case at the level of the regulated entity
• the appropriateness of investment products for investors is ‘far too often’ not adequately considered, which presents a significant risk of harm where high-risk alternative investments are made available to less-sophisticated investors
• client asset (CASS) oversight and controls are not always robust, leading to the risk of client money and assets being lost.

FCA’s six supervisory priorities for alternatives

The Letter also highlights six issues which the regulator regards as the key risks of harm that alternative investment firms pose to investors or the markets.

Under each of the first five priorities, the FCA sets out actions that it is either intending to take or which it warns it might take, to ensure that firms are taking adequate notice of the Letter’s shot across their bow.

1. Investor exposure to inappropriate products or levels of investment risk

Given the “significant levels of investment risk” which the FCA believes alternative investments can carry, the Letter emphasises that it is important for firms to consider the appropriateness or suitability of investments for their target investors.

This should include

• recognising that alternative products may only be appropriate for a niche market
• observing the relevant restrictions on marketing to retail investors when communicating or approving financial promotions for alternative products
• assessing whether an alternative investment is appropriate or suitable for retail investors
• robustly assessing a client’s knowledge and experience of the relevant market where a firm allows investors to opt up to elective professional status.

The Letter notes that the FCA will be reviewing retail investor exposure to alternative investment products and that this “will cover a broad spectrum of alternative investment products and strategies”. Firms will be tested both on whether they are aware of who their customers are and whether they are clearly focussed on acting in the best interests of their clients and funds.

In addition, the FCA will be checking that firms have taken reasonable steps to ensure that investors adequately understand the risks they are exposed to through their investments and are not inappropriately exposed to products that carry risk beyond their risk profiles.

2. Client money and custody asset controls

Firms must follow the rules in the Client Assets Sourcebook (CASS) when holding or controlling client money or safeguarding custody assets.

As part of its review of retail investor exposure to alternative investment products, the FCA intends to test whether firms with permission to hold client money and safeguard custody assets are exercising those permissions under robust control frameworks.

3. Market abuse

Firms must make sure that their that market abuse controls are sufficiently comprehensive and tailored to their individual business models.

The FCA’s view is that such controls have “significant scope for improvement” across the alternatives sector.

A recent FCA assessment on the adequacy of market abuse controls in the sector entailed visits to a number of firms as well as a questionnaire to a large sample of firms across the buy side. Similar exercises may be carried out in the future and where the FCA finds that a firm is not complying with MAR, it will consider the need for enforcement action.

4. Market integrity and disruption

Since the FCA considers that alternative firms have scope to take “significant investment risk”, it expects to see them operating robust risk management controls which avoid excessive risk-taking and which mitigate the potential for harming or disrupting financial markets (such as through the use of leverage or illiquid investments). Where very high-risk investment strategies are adopted (particularly where significant leverage is employed), risk management controls should be of commensurately high quality.

The Letter warns firms that the FCA may “choose to undertake in-depth assessments of firms’ controls” in the future.

5. Anti-money laundering and anti-bribery and corruption

All authorised firms must have appropriate and proportionate systems and controls in place to mitigate the risk they might be used to commit financial crime, such as fraud, money laundering, terrorist financing, bribery and corruption. Third party due diligence and Know Your Client (KYC) checks are particularly important.

The FCA intends to review firms’ systems and controls in this area, paying particular attention to the risks of money laundering and terrorist financing.

6. EU withdrawal

Following the UK’s likely departure from the EU on 31 January 2020, an implementation period is due to operate until 31 December 2020, during which EU law would continue to apply in the UK and passporting would continue.

Firms are expected to consider how the end of the implementation period will affect them and their customers, and what action they may need to take to be ready for 1 January 2021.