Regulating the UK fund manager sector in the future – the FCA consults

At the moment, in addition to certain pieces of retained EU law which set out technical standards and regulating particular fund types (such as the Money Market Funds Regulation), the UK’s regulation of the AM sector is heavily underpinned by three pieces of EU legislation, namely the UCITS Directive, the AIFMD and MiFID.

The upshot of this, in the FCA’s view, is that the UK rules take their structure from the areas covered by EU legislation rather than the activities of firms and the regime isn’t always as clear or coherent as it might be. In particular, the current position has led to duplication – some technical, others more substantive - in the rules UK managers need to follow, especially in core conduct rules such as general organisational requirements, conflicts of interest management and outsourcing.

In this context, the DP invites comments on a range of questions, including

• the possible creation of a single rulebook for asset managers – while this could considerably simplify regulation, wholesale change could cause significant one-off costs and disruption for many firms
• where the boundary should be drawn between the current UCITS and NURS regimes (or whether it should be removed altogether)
• adjustments to the regime for managers of professional funds, including possible amendments to the size thresholds at which AIFMS must apply the full-scope rules under the UK’s AIFMD regime

This chapter looks at areas where the FCA either

• believes that current rules do not always lead to good investor outcomes or
• wants to explore where the rules could be modernised.

Responsibilities of host AFMs

Although the FCA sees benefits in the rules which allowing funds to use third-party portfolio managers, its supervisory experience of host AFMs is that “they sometimes fall below appropriate standards”. In some cases, this is a result of misunderstandings on the part of the portfolio manager about the role of the AFM.

Options available to the FCA, on which it seeks views, include

• clarifying its expectations in rules by creating specific contractual requirements between the AFM and the portfolio manager
• a trade body or other group could help develop industry guidance to set appropriate standards and act as a guide for host AFMs
• setting minimum contractual requirements between host AFMs and portfolio managers

Enhancing liquidity management

As liquidity management in funds has become relevant to the good functioning of markets, the FCA expectation is that firms comply with ESMA’s liquidity stress testing guidelines. The FCA is planning to convert these into rules and guidance in its Handbook. It is also considering removing - or significantly restricting - the limitation in COLL 6.12.11R(2), to prevent the qualification ‘where appropriate’ from giving fund managers a reason not to carry out stress tests.

The rules around dilution adjustments (‘swing pricing’) and other anti-dilution mechanisms are also within scope of the DP - firms use these rules in different ways and this could pose a risk to financial stability.

The DP invites views on whether the FCA could clarify the calculation of dilution adjustments through rules or guidance as well as on reporting obligations to ensure that it has appropriate regulatory oversight of the liquidity of funds.

Investment due diligence

The FCA sees practices around investment due diligence as inconsistent, with investments made in illiquid or complex securities without significant due diligence or material risks seemingly overlooked. As a result, it is considering making its expectations clearer.

MiFID portfolio managers are subject to suitability requirements, with the rules on what the portfolio manager needs to know about the investment set very high-level. For AIFMs, rules on due diligence set out at a high level what the manager needs to know about the investments its funds make.

In all cases, though, financial services professionals are expected to apply due skill care and diligence. The DP asks whether it would be better to set out regulatory expectations around investment due diligence for all types of asset management activity.

Clarifying rules for depositaries

The FCA’s experience has been that depositaries have not always intervened or challenged fund managers when it would have expected them to.

The FCA feels that there would be benefit in updating and making its rules clearer for depositaries, fund managers and investors – this could include a revision of the rules on (among other things) the systems and controls that a depositary must have in place to identify breaches of the rules; the resources, knowledge, skills and experience expected of a depositary; and/or the depositary’s oversight of the AFM’s liquidity management, including liquidity stress testing.

The DP also seeks views on areas where current rules could be removed as they require depositaries to carry out oversight functions that are of limited benefit.

Improving the fund rules

The DP accepts that fund rules may be unnecessarily complex or fail to envisage situations that occur in modern markets. The end goal though is for the rules to be smart and have an appropriate level of detail.

Areas where changes might be made to modernise or improve the fund rules include the following:
(a) Eligible assets
There are two sets of eligible assets rules for UCITS, which relate to (a) the individual assets and (b) the eligible markets on which these are traded.

Up to 10% of a UCITS’s portfolio can be invested in assets that do not meet the eligible markets criteria, though these must meet other eligible asset criteria, for example around reliable valuation.

These rules interact with the liquidity risk management requirements in COLL 6.12 and the FCA has concerns that some UCITS managers might see 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.

One option on which the DP invites comment is for the FCA to give guidance on its expectations around the 10% rule – for example, stating that managers are not expected to use the rule in a way that undermines the liquidity of the fund. We would like to understand the consequences for AFMs and investors of us doing this.

(b) Prudent spread of risk
Authorised funds (other than QIS) must have a prudent spread of risk.

Some feel, though, that the prescriptive quantitative requirements on spread should be removed in favour of a more principles-based regime to allow greater investment flexibility, underpinned by the rules on risk management.

By way of example, the 5/10/40 rule on spread for UCITS funds (which sets a limit of 5% of investments in any individual issuer, which can be raised to 10% in respect of 40% of the value of the fund) may not be the only appropriate way to achieve a prudent spread of risk.

Although the FCA notes that it is not “currently minded” to remove quantitative restrictions, it invites feedback on whether any specific restrictions could be loosened or removed.

Technology as a driver of better consumer outcomes

The pace of change in technology can mean that developments break new ground not previously considered by regulation. The DP looks to identify areas where improvements could be made to the regulation of funds so firms can take advantage of technological developments in the best interests of their customers.

In planning their response to technological changes, the FCA wants firms to think about how those changes could drive competition in the interests of consumers but, at the same time, providing consumer protection.

Technology in fund operations

Some fund managers are keen to be able to modernise the way units are bought and sold – the DP cites Investment Association’s ‘Direct2Fund’ proposition, as a possible alternative to the current model where the AFM buys and sells units on behalf of the fund and its investors.

The FCA has been engaging with the IA to identify and analyse several different regulatory issues in introducing this new dealing model and, provided satisfactory progress can be made, it hopes to consult on rule changes to establish the new model.

Fund tokenisation

The FCA accepts that existing rules around the creation, registration and cancellation of units may not be flexible enough to allow firms to operate a ‘digital register’ and work is underway on exploring what would need to be done to enable this.

The DP asks not only for input from stakeholders on areas where rules or guidance could help enable tokenisation of units in authorised funds but also a steer on what interest there would be, in the short to medium term, from investors able to use this technology.

Tokenised portfolio assets

In terms of fund tokenisation, the DP welcomes input on how regulation should respond to the implications of a growing market in tokenised financial instruments, for example, in the context of managers of QIS and LTAFs looking to hold tokens representing fractional interests in real estate or an infrastructure project.

Investment in cryptoassets

Unregulated tokens, such as stablecoins and other forms of cryptocurrency are not currently permitted investments. As such, it is not currently possible for authorised funds to hold them. The DP, though, notes HM Government’s recent consultation on regulating cryptoassets in the UK and that the question of bringing portfolio management of cryptoassets into the regulatory perimeter is still live.

The FCA will not be undertaking further work on the scope of the authorised funds regime until HM Government has advanced its thinking on this matter.

Finally, the DP considers how the fund prospectus, and the periodic manager’s reports and accounts could be redesigned, given technological developments, especially if presented in a digital format.

The fund prospectus

The FCA has concerns that the prospectus is not fulfilling its primary function of providing in-depth information to fund investors. It may modernise prospectus disclosures by, for example, redefining the important elements that investors should understand, so these are given sufficient prominence.

The DP invites ideas about how prospectuses could be improved, to give investors a better understanding of the fund and to help fund managers explain their products and services more clearly and consistently.

Managers’ reports and accounts

Although the contents of a manager’s periodic reports and accounts are prescribed, the rules say little about its design, layout, or accessibility. They are conceived as paper-based documents and typically created as files that are hard to review on screen.

The FCA believes that digitally accessed information could be more comprehensive than now, provided it is presented so as not to overwhelm readers, for example, by layering to make sure the essential elements are presented clearly and concisely, while investors can access other areas for the details if they wish.

The DP notes a number of changes the FCA could make, from explicitly requiring each fund’s prospectus and the reports and accounts to be published in a prominent and easily accessible place on the fund manager’s website to rethinking the whole purpose and structure of periodic reports and accounts.

Investor engagement

Better use of technology could improve both

• attendance and participation at unitholder meetings and
• interactions between the fund manager and fund investors in other ways where an intermediate unitholder is involved.

Some firms already offer an online service to customers that hold securities indirectly, so these can see which underlying companies in their portfolio have upcoming shareholder votes and can express a voting preference on the proposals. Others hold online forums to present and explain their strategies and take questions from investors.

While recognising there would be issues of costs and benefits, the DP seeks comments as to whether such initiatives should be considered best practice, for firms to do if they choose, and whether the FCA should do more to enable investors to engage with the manager of their fund.