The future of financial services regulation: Financial Services Bill

Executive summary

In summary, the Financial Services Bill:

• LIBOR and Benchmarks - sets out the UK's legislative regime for tough legacy contracts on the discontinuation of LIBOR and makes other amendments to the Benchmarks Regulation;

• Prudential Regulation - confers new powers on HM Treasury, the PRA and FCA to give effect to UK prudential regulation after the end of the Brexit transition period, including the FCA's new Investment Firm Prudential Regime;

• PRIIPS Regulation - makes minor amendments to the PRIIPS regulation, most notably in relation to KIDs;

• MIFID - amends MIFIR in relation to third-country investment firms carrying out investment services or activities in the UK;

• EMIR - incorporates the FRANDT requirement into UK law;

• Market Abuse - makes minor amendments in relation to insider lists, notifications by senior management and increases criminal penalties;

• Financial Collateral - settles longstanding issue about vires of UK implementing legislation;

• Part 4A permission - makes it easier for the FCA to cancel permission in some cases;

• Overseas Funds Regime - gives effect to HM Treasury's March consultation proposals.

Introduction

Ever since the Brexit referendum in June 2016, the legislative focus of the Whitehall has been on maintaining the status quo on the UK's departure from the UK. This process is known as "onshoring", which neatly describes the task of transforming existing EU regulations into UK law and ensuring the UK statute book works effectively post-Brexit. To date, hundreds of onshoring statutory instruments have been made and the FCA and PRA are planning extensive amendments to their rulebooks.

The Financial Services Bill, which was introduced to Parliament on 21 October 2020, has a different focus. The Bill looks to the future, when the UK is no longer constrained by EU law, and begins to answer the difficult question of how the UK wishes to regulate financial services outside of the EU. There are tensions here. The UK needs to be competitive to maintain its pre-eminence in financial services. But undercutting regulatory standards will undermine confidence. There is also the thorny question as to whether the UK will seek equivalence decisions from the EU. Equivalence improves access to EU markets but at the cost of adhering to regulatory standards in which the UK no longer has any say.

The Bill covers a very wide range of areas. These include prudential regulation, benchmarks and LIBOR, PRIIPS, MIFID, market abuse, financial market infrastructure, financial collateral, Gibraltar, Part 4A permission and the overseas funds regime. The burden of all the regulatory change coming down the pipeline is unprecedented and raises serious questions as to how firms are expected to ensure compliance.

Timeline

The Bill was laid before Parliament on 21 October 2020 and it is currently at committee stage in the House of Commons. We cannot currently predict the extent to which it will be amended in Parliament or when it might receive Royal Assent. However, given the timing of some of the reforms set out in the Bill, the government and the regulators must hope that it receives Royal Assent by about Spring 2021 in order to enable some of the reforms to take effect in the summer.

Abbreviations

In this note, we use the following abbreviations:

• BRRD: Directive 2014/59/EC establishing a framework for the recovery and resolution of credit institutions and investment firms

• BRRD2: Directive (EU) 2019/879 amending Directive 2014/59/EU as regards the loss-absorbing and recapitalisation capacity of credit institutions and investment firms.

• CRR: Regulation (EU) No 575/2013 on prudential requirements for credit institutions and investment firms

• CRR2: Regulation (EU) No 2019/876 amending Regulation (EU) No 575/2013 as regards the leverage ratio, the net stable funding ratio, requirements for own funds and eligible liabilities, counterparty credit risk, market risk, exposures for central counterparties, exposures to collective investment undertakings, large exposures, reporting and disclosure requirements

• CRD4: Directive 2013/36/EU on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms

• CRD5: Directive (EU) 2019/878 amending Directive 2013/36/EU as regards exempted entities, financial holding companies, mixed financial holding companies, remuneration, supervisory measures and powers and capital conservation measures

• EMIR: Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories (the European Market Infrastructure Regulation)

• EMIR REFIT: Regulation (EU) 2019/834 of the European Parliament and of the Council of 20 May 2019 amending Regulation (EU) No 648/2012 as regards the clearing obligation, the suspension of the clearing obligation, the reporting requirements, the risk-mitigation techniques for OTC derivative contracts not cleared by a central counterparty, the registration and supervision of trade repositories and the requirements for trade repositories

• FCA: Financial Conduct Authority

• Financial Collateral Arrangements Directive: Directive 2002/47/EC of the European Parliament and of the Council of 6 June 2002 on financial collateral arrangements 

• FRANDT: fair, reasonable, non-discriminatory and transparent

• FSMA: Financial Services and Markets Act 2000

• IFPR: Investment Firm Prudential Regime (UK's proposed implementation of the EU's IFD/IFR)

• KIDs: Key Information Documents

• MAR: Regulation (EU) No 596/2014 of the European Parliament and of the Council of 16 April 2014 on market abuse

• MIFIR: Regulation (EU) No 600/2014 of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments

• PRA: Prudential Regulation Authority

• PRIIPS Regulation: Regulation (EU) No 1286/2014 of the European Parliament and of the Council of 26 November 2014 on key information documents for packaged retail investment and insurance- based investment products

Development of the Bill

In July 2019, HM Treasury published the Future Regulatory Framework Review Call for Evidence, which was concerned with how the UK's regulatory framework needed to adapt to the future and in particular to the UK's position outside of the EU. This was followed by a closer examination of how financial services policy and regulation are made in the UK, including the role of Parliament, the Treasury and the financial services regulators, and how stakeholders are involved in the process.

Prudential regulation has played a key part of the analysis. The PRA has launched two consultations on the implementation of CRD5 (CP12/20 and CP17/20) and the FCA published a discussion paper on the new proposed Investment Firm Prudential Regime, summarised in this Insights article. HM Treasury has also consulted on its implementation of BRRD2 and issued a call for evidence on Solvency 2.

Benchmarks have also occupied an important place in the government's thinking. On 21 October 2020, at the same time as the Financial Bill was laid, HM Treasury published a consultation on amendments to the Benchmarks Regulation to support LIBOR transition.

Other reforms were trailed in previous policy statements, including the UK's approach to settlement discipline, securities financing transactions, market abuse, PRIIPs and financial market infrastructure.

LIBOR and Benchmarks

One of the most significant set of provisions in the Financial Services Bill relates to LIBOR and benchmarks. As is well known, the FCA has reached a voluntary agreement with the LIBOR panel banks to continue contributions to LIBOR until the end of 2021. After that date, the panel banks may cease contributing and LIBOR may become unrepresentative. Accordingly, the government and the regulators have been urging market participants to transition to alternatives rates. The difficulty is that there exist a range of contracts which face substantial barriers to transition, for example contracts with retail clients who may not be engaged with LIBOR transition. These "tough legacy contracts" may be frustrated if LIBOR were to cease.

The Financial Services Bill confers powers on the FCA to address this issue. It amends the UK's onshored version of the EU Benchmarks Regulation to enable the FCA to manage the orderly winddown of a critical benchmark such a LIBOR.  The FCA can require the administrator of a critical benchmark to assess whether the benchmark is representative. The FCA may then make its own assessment, taking its account the administrator's assessment. If the FCA considers that the benchmark is no longer representative, and that it cannot be made representative or there is no good reason for doing so, the FCA may "designate" the benchmark. Once a benchmark has been designated, the FCA may direct changes to its methodology, rules or code of conduct, and supervised entities may not use the benchmark. However, the FCA has powers enabling it to permit some or all legacy contracts to continue using the benchmark. The FCA's powers to compel administrators of a critical benchmark has been increased from five to ten years. Although the FCA has not committed to doing so, it could for example designate LIBOR, direct changes to its methodology so that it is no longer reliant on panel bank submissions (a "synthetic LIBOR") and enable tough legacy contracts to continue referring to it. The FCA must publish a statement of policy on its approach to designating critical benchmarks, prohibiting their use and exceptions for legacy contracts, so more detail should emerge in due course.

The Financial Services Bill makes further amendments to the UK's onshored version of the Benchmarks Regulation. These include:

1. conferring powers on the FCA to prohibit the use of a critical benchmark in new financial instruments or new financial contracts where the administrator intends to discontinue the benchmark;

2. extending the FCA's power to require contributors to a benchmark to continue making contributions to capture contributors based outside the UK, although enforcement might be an issue for the FCA;

3. clarifying how the Regulation applies to an "umbrella benchmark", which is a critical benchmark provided in different currencies, maturities or tenors. Various provisions of the Benchmarks Regulation (for example, designation) apply to the different versions of an umbrella benchmark as if they were different benchmarks; and

4. extending the transitional period for the use of third country benchmarks by three years from 31 December 2022 to 31 December 2025.

Prudential regulation: banks and investment firms

The Bill amends the UK's regulatory architecture for prudential regulation and needs to be read with the proposals made by the FCA and PRA.

Currently, banks and almost all investment firms are prudentially regulated in accordance with requirements which are derived from the Basel capital standards. However, these standards were designed for internationally active banks, and are poorly suited to a wide range of investment firms. As a result, the EU is in the process of implementing the new Investment Firm Regulation and Investment Firm Directive (IFD/IFR). The FCA played a pivotal role in creating this new regime when the UK was still a Member State of the EU, and it is no surprise that the FCA remains committed to implementing a variant of the IFD/IFR. Accordingly, it is proposed that all investment firms which are not regulated by the PRA will be moved off the CRR (or GENPRU/BIPRU for BIPRU firms) and onto the FCA's new proposed Investment Firm Prudential Regime (IFPR). A summary of the Investment Firm Prudential Regime can be found here.

Accordingly, the Financial Services Bill amends the UK's onshored version of the EU's CRR so that it applies only to credit institutions and PRA-designated investment firms. This bifurcates prudential regulation in the UK, with the PRA applying regulation derived from the Basel Capital Standards to banks and PRA-designated investment firms, and the FCA applying the Investment Firm Prudential Regime to almost all other investment firms.

(A) Banks and PRA-designated investment firms

Turning firstly to banks and PRA-designated firms, the CRR will be preserved as UK law at the end of the Brexit transition period. This includes some of the amendments made by CRR2, but most of CRR2 applies from June 2021 onwards and will not be preserved as UK law. Furthermore, the CRR has not yet been amended to reflect the December 2017 finalisation of Basel 3 (the EU is expected to make a "CRR3 and CRD6" proposal early next year). The task of updating the CRR will fall to the PRA and the Financial Services Bill creates the enabling legislative machinery. A power is conferred on HM Treasury to revoke provisions of the CRR, normally on the basis that they will be replaced by PRA rules.  Accordingly, a new Part 9D is inserted into FSMA to confer on the PRA the power to make rules for the prudential regulation of credit institutions and PRA-designated investment firms (the "CRR rules"). The PRA will be required to publish what is essentially a correlation table showing how the CRR rules relate to the revoked provisions of the CRR.

The Financial Services Bill provides (in a new section 144C of FSMA) that the PRA must, when making CRR rules, have regard to:

1. relevant Basel Capital Standards;

2. the likely effect of the proposed rules on the relative standing of the United Kingdom as a place for internationally active credit institutions and investment firms to be based or to carry on activities;

3. the likely effect of the proposed rules on the ability of credit institution and PRA-designated investment firms to continue to provide finance to businesses and consumers in the United Kingdom on a sustainable basis in the medium and long term; and

4. any other matter specified by the Treasury by regulations.

In addition, the PRA must consider, and consult the Treasury about, the likely effect of the proposed rules on relevant equivalence decisions.

There are several exceptions, for example rules made pursuant to a direction given by the Financial Policy Committee of the Bank of England.

"Have regard to" does not mean replicate exactly, and this gives the PRA some flexibility when making CRR rules. The range of matters which the PRA must consider demonstrates how the government is seeking to balance potentially conflicting policy objectives. However, the Explanatory Notes suggest that the PRA is committed to implementing the Basel Capital Standards, as least for the internationally active banks for which the Standards were designed.

What is interesting is that the PRA is not bound to respect existing equivalence decisions - it need only consider them. This means the PRA ultimately has the power to make rules undermining the UK's equivalence to the EU.

Rather helpfully, the Financial Services Bill gives the PRA an element of discretion not currently present in the existing system. The PRA has a power to waive or modify its own rules made under FSMA. However, it cannot waive or modify a provision of an EU regulation, such as the CRR. The Financial Services Bill gives the PRA a power to waive or modify CRR rules, which could potentially be helpful to firms.

The Financial Services Bill also amends the proposed Part 12B of FSMA. Part 12B is inserted into FSMA by the (still draft) Financial Holding Companies (Approval etc.) and Capital Requirements (Capital Buffers and Macro-prudential Measures) (Amendment) (EU Exit) Regulations 2020. It implements the provisions in CRD5 on the approval of certain holding companies and enables the PRA to exercise powers over unregulated holding companies heading up prudential consolidation groups. To the extent such rules are CRR rules, the PRA must have regard to the maters set out in paragraph 4.5 when making the rules.

Credit ratings are used as inputs into the assessment of credit risk in the CRR. The Financial Services Bill therefore confers a power on HM Treasury to amend the UK's onshored version of the EU Credit Rating Agencies Regulation to update it for changes to the Basel Capital Standards. As with the PRA's rules, the Treasury must have regard to the Basel Capital Standards - it is not required to replicate them in UK law.

(B) FCA authorised investment firms

The Financial Services Bill inserts a new Part 9C into FSMA in order to enable the FCA to implement its proposed Investment Firms Prudential Regime. The FCA is required to make prudential rules applying to FCA authorised investment firms. They must also make rules applying to their parent undertakings, unless they belong to a group which includes a credit institution or PRA-designated investment firm, in which case they have the power to make rules but not a duty.

The FCA's rules are called "Part 9C rules" and the FCA must have regard to the following matters when making them:

1. any relevant standards set by an international standard setting body;

2. the likely effect of the rules on the relative standing of the United Kingdom as a place for internationally active investment firms to be based or to carry on activities; and

3. any other matter specified by the Treasury by regulations.

The FCA must also consider, and consult HM Treasury about, the likely effect of the rules on relevant equivalence decisions.

There are a range of exceptions, for example rules made in compliance with a direction given by the Financial Policy Committee.

As with the PRA, the FCA can ultimately make rules undermining the UK's equivalence to the EU.

The FCA may also impose requirements on an individual basis on a non-authorised parent undertaking of FCA authorised investment firm. This is similar to the power under Part 4A of FSMA to impose requirements on authorised persons.

MIFIR: the regulation of third-country investment firms

The UK's onshoring of MIFIR preserves the regime for third-country firms. The regime enables third-country firms to provide investment services to, or perform investment activities for, eligible counterparties or professional counterparties in the UK without establishing a branch where:

1. HM Treasury has made an equivalence determination in respect of their country of establishment; and

2. the firm is registered in a third country register maintained by the FCA.

The Financial Services Bill amends this regime in order to confer:

1. a power on the FCA to specify reporting requirements for third-country firms; and

2. a power on HM Treasury to impose additional requirements on third-country firms to address issues relating to the firm's carrying on of business in the UK, which the FCA may operationalise in rules.

The Bill also amends the equivalence criteria to reflect the changes made to prudential regulation by the Bill (see paragraphs 4.1 to 4.10) and introduces additional powers for the FCA to impose temporary restrictions or prohibitions on, or withdraw the registration of, third-country firms.

The Financial Services Bill seeks to clarify the reverse solicitation exception in Article 46(5) of MIFIR. The exception permits third-country firms to provide investment services to, or perform investment activities for, an eligible counterparty or professional counterparty at their "own exclusive initiative". The Bill inserts a new paragraph 5A which provides that where a third-country firm or a person acting on their behalf solicits a person, the provision of an investment service or activity by the third-country firm to the person is not initiated at the person's own exclusive initiative.

The Financial Services Bill also amends MIFIR to apply the provisions in MIFIR on product monitoring and governance to third-country firms.

Cancelling Part 4A permission

The Financial Services Bill creates a new, streamlined procedure for cancelling a firm's Part 4A permission where the FCA believes the firm is no longer carrying out any regulated activities. The circumstances in which the FCA may form such a view include (but are not limited to) a failure to pay a fee to the FCA or a failure to make regulatory returns.

Financial Market Instructure: EMIR

At the end of the Brexit transition period, EMIR as it is amended at that date will become part of EU law. This means that the FRANDT requirement of EMIR REFIT will not be onshored. The FRANDT requirement obliges clearing brokers to provide services on fair, reasonable, non-discriminatory and transparent commercial terms (FRANDT) to clients, and the Explanatory Notes to the Bill state that the government views the FRANDT requirement as desirable in order to reduce barriers to clearing. The Bill therefore introduces a FRANDT requirement into the UK's onshored version of EMIR and confers a power on the FCA to make detailed rules. Given the FCA's discretion, there is no guarantee that the EU and UK will end up with identical FRANDT requirements.

Similarly, there are requirements in EMIR REFIT on trade repositories which do not come into force until next year, and the Financial Services Bill amends the UK's onshored version of EMIR to implement them.

Financial Collateral

The Financial Services Bill introduces two technical amendments in relation to financial collateral.

In 2003, the government made the Financial Collateral Arrangements (No.2) Regulations 2003 in order to implement the EU's Financial Collateral Arrangements Directive. The scope of the Regulations is slightly broader than the Directive, in that they extend the protection conferred by the Directive to arrangements between two corporates and in relation to a slightly broader definition of collateral. This has led to concerns that the Regulation might be ultra vires. The Financial Services Bill contains provision retrospectively curing any lack of vires in the making of the Regulations.

The Financial Services Bill also amends the procedure which HM Treasury must follow if they wish to use powers in the Banking Act 2009 to make further provision about financial collateral arrangements in the future.

Market abuse and insider dealing

The EU Market Abuse Regulation will be onshored in UK law at the end of the Brexit transition period. The Regulation requires issuers or persons acting on their behalf or on their account (such as advisers and consultants) to maintain "insider lists" which contain the details of everyone who has had access to inside information. The FCA considers insider lists to be an essential tool in investigating the unlawful disclosure of inside information and insider dealing. At the moment, the obligation to maintain an insider list is imposed on the issuer or persons acting on their behalf or their account. The government considers that the use of the word "or" has led to some advisers not keeping lists. The Financial Services Bill therefore amends the obligation to keep insider lists so that the requirement is imposed on both issuers and persons acting on their behalf or on their account.

The Market Abuse Regulation also requires persons discharging managerial responsibilities, and those closely associated with them, to notify the issuer and the FCA of their transactions in financial instruments related to that issuer. Currently, the notifications should be made to the issuer no later than three business days after the date of the transaction. The issuer is then also required to notify the public of such transactions no later than three business days after the transaction. This creates a timing difficulty for the issuer if it receives notification close to the end of the three-day period, because it must make its own disclosure to the public almost immediately. The Financial Services Bill therefore makes a welcome amendment to the timetable to require issuer disclosures within two working days of receiving notification from the senior manager or person closely associated with them.

The Financial Services Bill also extends the maximum prison sentence for criminal market abuse from seven to ten years, putting it in line with comparable economic crimes.

PRIIPS

The proposed amendments to the PRIIPs Regulation mirror those suggested in the recent policy statement from HM Treasury. In summary, the PRIIPS Regulation would be amended as follows:

1. a power would be conferred on the FCA enabling it to make rules specifying whether a product, or category of product, falls within the definition of a PRIIP;

2. where KIDs must currently give a brief description of information on performance, the Bill would amend this to require a brief description of performance scenarios and the assumptions made to produce them; and

3. a power would be conferred on HM Treasury enabling it to specify a later date for the date in Article 32(1) (exemption of UCITS), but no later than 31 December 2026.

Overseas Funds Regime

The Bill gives effect to HM Treasury's proposals for a UK overseas funds regime set out in its consultation March this year. A summary of the March consultation paper can be found here and a separate Insights article on this aspect of the Bill can be found here.