MiFID2: FCA consultation paper - key developments for UK asset managers

The FCA’s Consultation Paper CP16/29 (CP3), its third consultation paper on the implementation of MiFID2 in the UK, is a very significant development for UK firms caught by MiFID2, as it sets out the FCA’s proposed approach to the core conduct of business requirements under MiFID2. This includes proposals for how the FCA will implement in the UK the MiFID2 rules on inducements, investment research, best execution, telephone taping, product governance, client classification, disclosures, suitability and appropriateness, and many other conduct rules.

In particular, the FCA is implementing conduct requirements set out in the MiFID2 Level 1 Directive, the Level 2 Implementing Directive, and the Level 2 Implementing Regulation. You can find more information on these three EU provisions in our briefing notes for asset managers on MiFID2, the L2 Implementing Directive, and the L2 Implementing Regulation.

While CP3 will be relevant to firms across the financial services industry, the commentary in this note focuses on its application to UK asset managers. This includes asset managers authorised as a MiFID investment firm, and the note will also be relevant to an authorised UK AIFM or UCITS management company (ManCo), in respect of certain proposed gold-plating by the FCA. This note assumes that the relevant firm deals only with professional clients, and so we do not in this note discuss in detail the FCA’s proposals around retail clients.

Headline points

CP3 is a weighty tome, clocking in at 568 pages, but we consider that the five key takeaway points for asset managers are:

• For MiFID investment firms, the FCA has largely approached CP3 as an “intelligent copyout” exercise, to use the FSA’s old term for this type of approach. By this, we mean that the FCA is predominantly proposing to copy relevant sections of MiFID2 and the L2 provisions directly into the FCA Handbook, with minimal changes. In many cases, this is by way of new chapters of the Handbook which will sit alongside the existing pre-MiFID2 regime, which is being retained for certain types of non-MiFID business. Much of the discussion in CP3 is around the application of MiFID2 on the “edges” (Article 3 exempt firms such as corporate finance boutiques, and retail investment advisers) which will not be relevant for many asset managers.
• If the FCA follows through with these proposals, the UK will end up with a (partially) parallel rulebook, with generally one set of legacy pre-MiFID2 rules and, alongside it, a parallel set of new MiFID2 rules. As an incidental side-effect, this may prove to be a useful starting point for lobbying efforts around a post-Brexit regulatory regime.
• Many of the directly applicable provisions of the MiFID2 regime, which are set out in the L2 Implementing Regulation, will be copied into the FCA Handbook, even though those provisions otherwise directly apply to MiFID firms as a matter of EU law.
• There is not much significant gold-plating proposed for MiFID firms. Where the FCA does propose certain gold-plating, this principally relates to (i) investment research, (ii) inducements and the interaction with RDR/adviser charging rules, and (iii) product governance and retention of RPPD. This is largely just retaining existing UK retail-focussed regimes which were front-running MiFID2, such as RDR and RPPD.
• Probably the biggest surprise in CP3 is a higher degree of gold-plating than expected for AIFMs and UCITS ManCos. The FCA proposes to gold-plate the following rules to all fund managers, which would not otherwise be applicable to AIFMs and UCITS ManCos: (i) inducements and research rules, (ii) best execution transparency rules (ie annual publication of top five execution venues), and (iii) telephone taping and electronic document retention. Gold-plating the research rules was flagged in advance, but the other two are more surprising.

More in depth comments on key areas follows below.

Investment research

The FCA’s proposals around investment research are arguably the most important section of CP3, at least for asset managers.

• Deleting the current rules in COBS 11.6: The FCA will entirely remove the current COBS 11.6 rules on use of dealing commission. Post-MiFID2, this will not be a regime relating to the generation and permitted use of dealing commission / soft dollars. Instead, the regime is entirely focussed on the receipt of research as an exemption to the otherwise applicable prohibition on the receipt of inducements. The research rules will be in a new section of the FCA Rules, COBS 2.3B.
• Hard dollars and RPAs only: The FCA preserves the L2 Implementing Directive approach which states that an asset manager is permitted to receive research only if that manager pays for the research via either hard dollars from its own balance sheet or a research payment account (RPA). As anticipated, this effectively outlaws “free” and bundled research.
• Research charges can be collected alongside trade execution: The FCA also confirms that the RPA can be funded by collecting a research charge alongside the execution of a transaction. There had been a degree of confusion in the industry about this position, although Simmons & Simmons had been clear in our view that the L2 Implementing Directive was intended to permit this approach. This allows the preservation of the existing CSA model adopted by some asset managers, albeit with some significant operational modifications.
• Research budgets for multiple clients: The FCA gives some very useful gold-plated guidance on research budgets. In particular, the FCA confirms that research budgets can be set across multiple funds or accounts where they share similar investment strategies and objectives, such that they can benefit from shared research. Effectively, this allows firms to set a research budget at a desk-level or strategy level. However, the grouping should not be so broad as to include clients with substantively different research needs under the same budget. If firms do include multiple clients in the same budget, they need a transparent methodology for how to allocate, which can be pro-rated.
• RPAs: There has been some uncertainty about whether the RPA model requires a separate RPA for each client (or each broker) or whether a single account is permitted. Helpfully, the FCA confirms that using a single RPA is permitted, and indeed the FCA goes a step further to comment that this would be the most effective way to meet the new requirements. The FCA indicates the operational changes needed under the CSA model to transition to RPAs. Amongst other things, research charges collected alongside execution of a trade must be “immediately” swept into the RPA (either during transaction settlement or by end of day). The RPA must be ring-fenced and held in name of the investment firm. A broker executing a trade and facilitating collection of a research charge cannot directly take the research charge; instead the money has to go into the RPA and then come out again to pay the broker.
• RPAs are not client money: Helpfully, the FCA confirms that RPAs are not client money for the purposes of CASS.
• Non-substantive research: The FCA states that the receiving firm will have to make its own assessment whether research falls into the “minor non-monetary benefits” exemption. An asset manager cannot rely on the sell-side’s assertions or how a document is labelled.
• Execution-related services: The FCA makes the (valid) point that the current COBS 11.6 regime permits a manager to use dealing commission to pay for certain execution-related services, but this will not be the case under MiFID2, as a consequence of the regime shifting to one based purely around receipt of research. A manager which receives execution-related services (over and above the execution of the relevant trade) will either need to cease accepting them, conclude they are a minor non-monetary benefit (of which the FCA expresses strong scepticism) or pay for them with hard dollars.
• COBS 11.6 “blacklist”: The FCA retains many of the legacy blacklisted examples from COBS 11.6 of non-permitted services which do not qualify as research. This includes, as before, corporate access services.
• Gold plating to AIFMs/UCITS ManCos: The MiFID2 rules, and the FCA’s supplemental commentary as summarised above, will be gold-plated onto AIFMs and UCITS ManCos. This is not just for firms with top-up permissions to do MiFID-style business; all fund managers will be caught in respect of their entire business. This is of course very significant for those firms, although had been largely expected by the industry.
• Impact on brokers: The FCA implements the rule from the L2 Implementing Directive that sell-side firms must separately price charges for execution and all other services (ie explicitly bringing an end to bundled services). The FCA gold-plates the MiFID2 rule by requiring sell-side firms to price services this way for all fund manager clients of the firm, not just for clients which are MiFID investment firms.

Order handling rules

• Gold-plating best execution transparency to AIFMs and UCITS ManCos: This is probably one of the biggest surprises in CP3. The FCA is proposing that AIFMs and UCITS ManCos will be subject to the annual disclosure of top five execution venues for each instrument class, under MiFID2 RTS 28. Again, this extension would apply to all AIFMs and UCITS ManCos, and not just those with top-up permissions. The FCA explains this on the basis that the business model of such firms is very similar to a MiFID portfolio manager (which is of course correct) but seems to overlook that the regimes contain a separate order execution standard. Indeed, for many of the other order handling rules, the FCA expressly does not gold-plate, on the basis that AIFMD and UCITS already contain adequate rules for firms authorised under those directives. It is not clear why disclosure of top 5 execution venues should be singled out, and nor that disclosure of this information by an AIFM would be of interest to a fund investor.
• Not gold-plating other MiFID2 best execution rules to AIFMs: The FCA is not gold-plating the other enhanced MiFID2 best execution rules onto AIFMs, but expressly states that it is going to review this in a future consultation. UCITS ManCos will, however, be within scope, as they currently are, subject to some modifications.
• Not gold-plating other order handling rules to AIFMs/UCITS ManCos: The FCA is expressly not gold-plating other order handling rules, such as aggregation / allocation, limit orders and (most significantly) transaction record keeping onto AIFMs / UCITS ManCos. However, in respect of transaction record keeping, the FCA expressly states that it is considering bringing AIFMs/UCITS ManCos within scope of these rules (although is not doing so yet)

Telephone taping

• Removal of investment manager exemption: As very widely expected, the FCA is removing the current COBS 11.8 exemption for investment managers from telephone taping. Investment managers will therefore be directly within scope of the telephone taping rules.
• Deleting COBS 11.8 and replacing with new chapter: The current phone taping rules in COBS 11.8 will be deleted, and replaced with a new chapter in SYSC.
• Gold-plating to AIFMs and UCITS ManCos: The FCA proposes to gold-plate all of the MiFID2 telephone taping and electronic communication retention rules onto AIFMs and UCITS ManCos. Again, this is whether or not the manager has top-up permissions. It goes without saying that the FCA requiring AIFMs and Manos to comply with these rules represents a significant cost and operational burden for such firms.
• FCA comments: In discussing the extension of phone taping to asset managers generally (and the removal of the exemption), the FCA provides somewhat tetchy general comments directed at the asset management industry. The FCA specifically states that it wants the phone taping rules to act as a deterrent to market abuse in buy-side firms, and that they have observed “shortcomings” and “difficulties” with the current regime (which requires FCA staff to go via sell-side firms when they want to get phone recordings of buy-side firms).

Brexit

• There are very few references to Brexit in CP3, other than the standard reminder that the UK remains an EU member for the moment, and the FCA will therefore continue to implement MiFID2 ahead of the deadline (and expects firms to be working to compliance).
• However, it is possible that the FCA is starting to anticipate a hard Brexit in its approach to CP3. Many in the industry have been clamouring for the UK to design a two-stream UK domestic regulatory system, with one stream being fully MiFID2/EU equivalent (for firms that want third country equivalence) and a second lighter-touch domestic regime for firms that don’t need this. It’s interesting that, for a lot of the MiFID2 conduct rules, that’s exactly what the FCA has done. It’s not stated anywhere in CP3, but query if this is the first step to the FCA designing that two-stream regulatory system?