Background to the review

This DP is part of the FCA’s work towards the Government’s Future Regulatory Framework (“FRF”). The Government’s FRF review was set up to decide how the regulatory framework for financial services should adapt to the UK’s new position outside the EU. The Government has published a policy statement outlining an ambitious plan for enacting the repeal of retained EU law in financial services and building a “smarter” financial services regulatory framework specifically tailored to the UK. The Financial Services and Markets Bill currently before Parliament starts this process. Once the Bill becomes law, the regulatory framework will change. The Treasury and the financial services regulators will then start to move firm-facing requirements from legislation into regulatory rulebooks. In practice, this means the Treasury repealing retained EU law and replacing it with an appropriate UK framework. The financial services regulators will then make detailed, firm-facing requirements in their rulebooks.

Much UK regulation of the asset management sector comes from three pieces of EU legislation that the UK helped to develop: the Undertakings for Collective Investment in Transferable Securities (UCITS) Directive, the Alternative Investment Fund Managers Directive (AIFMD), and the Markets in Financial Instruments Directive (MiFID). There are also several pieces of retained EU law setting technical standards and regulating particular fund types. Through DP 23/2 the FCA commences a review of the wider regime for asset management. The FCA will use the feedback it receives on this DP to help shape its approach to rule-making under the new regulatory framework. Importantly the DP considers not just the regulation of fund managers but also of individual portfolio managers. Where we refer in this article to the UCITS Directive, AIFMD and MiFID, we mean the “onshored” UK versions of these.

A common framework of regulation for all asset managers?

One key question raised by the DP is whether the FCA should create a common framework of rules covering all asset managers of funds and individual portfolios. If so, views are sought on the timescale needed to implement such a change. In this article “fund manager” refers to firms that are Authorised Fund Managers (“AFMs”) under FCA rules derived from the UCITS Directive or Alternative Investment Fund Managers (“AIFMs”) under FCA rules derived from the AIFMD. We use the term “portfolio manager” to refer to discretionary investment managers subject to FCA rules derived from MiFID. We refer to these firms collectively as “asset managers”. For portfolio managers, the FCA’s proposals potentially involve a significant uplift in regulatory requirements.

Chapter 3 of the DP discusses the differing rules that apply to authorised funds and their fund managers and depositories as compared with funds that are not authorised and portfolio managers. These rules mainly come from the various requirements of the UCITS Directive, AIFMD and MiFID. All three include measures that apply to asset managers but each directive was legislated independently and each of them has been amended at different times. This has led to much duplication, especially for the core conduct rules (such as general organisational requirements, conflicts of interest management and outsourcing) but with similar activities being regulated to a slightly different standard. Different rules apply depending on whether a firm is managing a segregated portfolio for an individual client, an alternative investment fund (“AIF”), or a UCITS fund. Sometimes the differences in the rules are mainly technical detail (for example, conflicts of interest rules) but in other cases are more substantial. Examples of the latter highlighted by the FCA include:

• different rules applying to UCITS and Non UCITS Retail Scheme (“NURS”) UK regulated funds, such as the restrictions on UCITS funds investing in other funds;
• differences in best execution standards between UCITS funds and AIFs;
• no specific rules for portfolio managers on investment due diligence and managing liquidity (though the FCA accepts that these may be implicit in other rules and may also be dealt with in the contract between the client and the portfolio manager);
• no regulatory requirements on financial stability apply to portfolio managers (a gap highlighted by the recent difficulties with liability-driven investment management mandates);
• management of multiple individual retail client portfolios on a standardised service (such as model portfolio services) with similar economic effect for the manager as managing a fund but without the need to apply rules applying to fund managers.                               

Potential changes in regulation on which the FCA seeks views include:

• apply the same regulatory rules to portfolio managers as apply to fund managers, insofar as relevant;
• apply a single set of rules to all authorised funds;
• alternatively rebrand the NURS regime as “UCITS plus” and perhaps establish a new category of “basic funds” restricted in their investment activities (for example to the most liquid investments and with a high level of diversification);
• change the size threshold at which firms must apply the full-scope UK AIFM regime, alternatively allow firms that meet criteria other than their size to use the small authorised UK AIFM exemption (for example related to strategies or types of client);
• amend the regime for small registered AIFMs so as to remove the risk of customers misunderstanding their distinction from small authorised AIFMs, for example by requiring some types of small registered AIFMs to become authorised.

Incremental improvement of the existing regime?

Instead of (or perhaps in addition to) changes to the structure of asset management regulation discussed above, Chapter 4 of the DP discusses areas where the existing rules could be modified to improve outcomes for investors.  The specific areas of FCA focus are set out below.

Responsibilities of “host” Authorised Fund Managers

Some firms operate a business model where they act as a host AFM and hire out their services to portfolio managers, allowing the portfolio manager to utilise a fund structure without having to set up its own AFM.  The AFM is responsible for ensuring the fund complies with the FCA’s rules. It also has a range of responsibilities in operating the fund.  However in the FCA’s view host AFMs sometimes fall below appropriate standards. Some functions of the AFM are readily carried out by a firm that is independent of the portfolio manager. However, other functions are more integral to the day-to-day management of the portfolio, requiring an in-depth knowledge of the fund’s investments to be able to carry them out effectively.

Sometimes issues arise because of misunderstandings by a portfolio manager about the role of the AFM. The FCA asks whether it should clarify its expectations regarding the role of the AFM in rules by creating specific contractual requirements between the AFM and the portfolio manager articulating the scope of their respective responsibilities.  An alternative could be the development of guidance in this area, perhaps led by a trade body.

Liquidity management

The regulatory framework for funds contains rules requiring liquidity management, designed for consumer protection by ensuring that funds pass on appropriately the costs of dealing in investments and that all unit holders are treated fairly.  The FCA believes the size of the UK fund management industry is such that liquidity management in funds is also relevant to the good functioning of markets and so proposes rule changes aimed at reinforcing best practice. In particular the FCA proposes to convert the liquidity stress testing guidelines issued by the European Securities and Markets Authority (“ESMA”) into rules and guidance in the Handbook. The FCA also proposes clarifying its rules relating to dilution adjustments.  It is also considering what reporting may be necessary to ensure it has appropriate regulatory oversight, for example extending to UCITS funds the reports it receives from AIFs on liquidity categories and whether funds should be required to make public disclosures of the liquidity of their investments.

Investment due diligence

The FCA has found inconsistent approaches to investment due diligence that can contribute to harm, for example investments made in illiquid or complex securities without significant due diligence.  All UK financial services professionals are expected to apply due skill care and diligence, and so are required to perform adequate due diligence on investments.  In addition, specific rules on due diligence apply to fund managers, which set out knowledge requirements about fund investments.  Though portfolio managers must follow rules about suitability of investments, the explicit rules concentrate on information that the portfolio manager needs to know about the client.  The FCA ask for views whether it should set out its expectations for investment due diligence for all types of asset management activity.

Depositaries

The depositary oversees how the manager manages the fund in line with the rules and the fund prospectus. This includes monitoring what the fund can invest in and the pricing and dealing in units.  The FCA’s view is that depositaries do not always conduct their oversight duties effectively and the FCA’s expectations of depositaries sometimes differ from depositaries’ own interpretations of the FCA’s rules.  The FCA seeks views on whether it should clarify its rules for depositaries, given their important investor protection role. It also seeks views whether there are any rules for depositaries that are of limited benefit and so which the FCA could remove.

Areas where the FCA considers enhancing the clarity of its rules include:

• the systems and controls that a depositary must have in place to identify breaches of the rules and constituting documents of a scheme;
• the resources, knowledge, skills and experience that a depositary should have;
• actions to be taken when a breach is identified;
• what the depositary should do if the manager does not take action to deal with a breach;
• the depositary’s oversight of the AFM’s liquidity management, including liquidity stress testing;
• the depositary’s oversight of the AFM’s pricing and dealing in units of the fund.

Funds - eligible assets and prudent spread of risk

The eligible assets regime for UCITS sets requirements on what a UCITS fund can invest in, including rules on eligible markets.

UCITS funds are permitted to invest up to 10% of their portfolio into assets that do not meet the eligible markets criteria.  However, these assets must still meet the other eligible asset criteria, for example requirements regarding reliable valuation and liquidity characteristics. The FCA is concerned that some UCITS managers 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.  The FCA asks for views whether it should give additional guidance on its expectations for when the “10% rule” may be used, such as not undermining fund liquidity.

Authorised funds (other than Qualified Investor Schemes) must have a prudent spread of risk. The COLL rulebook sets out the maximum amount which a fund may hold in specific assets.  The detailed rules on spread aim to limit the risk that a fund can take, with specific limits that AFMs and depositaries can monitor. Some stakeholders have suggested that the FCA should remove these prescriptive quantitative requirements in favour of a more principles-based regime to allow greater investment flexibility, underpinned by the rules on risk management. Arguably quantitative limits can prevent managers from investing in ways that would be reasonable and in line with sound risk management, and also present the risk of  inadvertent breaches, which take time to deal with.  The FCA does not seem persuaded by these arguments. It specifically states that it is not currently minded to remove quantitative restrictions.  Nevertheless the FCA seeks views on whether it should consider removing or loosening any specific restrictions.

Harnessing technology and innovation

The final two chapters of the DP (chapters 5 and 6) explore potential improvements in fund regulation to enable firms to deploy technological developments in their customers’ best interests.  The main areas discussed are set out below.

Fund structure and operations and digital assets

Discussions have already begun in the fund management industry about modernising the way units are bought and sold, such as the Investment Association’s ‘Direct2Fund’ proposition which would make it possible for investors to transact directly with a fund when buying and selling units. The FCA has been engaging with the Investment Association’s working group to identify regulatory issues in introducing this new dealing model, in particular how current  investor protections in the COLL and CASS rules can be maintained. If these issues can be overcome the FCA may consult in due course on rule changes to establish this new model.

The DP also seeks views about the potential introduction of tokenised units in authorised funds, by which the FCA means issuing a fund’s rights of participation (units or shares) to investors as digital tokens by means of a distributed ledger. Tokenisation at this level would not affect the choice of investments by the fund or the way they are held and dealt in.  This could simplify dealing in fund units by removing some of the participants in the process and increasing the efficiency of remaining interactions. If units are issued via a distributed ledger, this ledger should be the sole incorruptible record of the number of units held by each participant which could eliminate administrative errors. Existing rules that govern how units are created, transferred, registered and cancelled may need to be changed to allow firms to operate a ‘digital register’. Specific new risks associated with using the technology, such as in relation to operational resilience, would also need to be considered.

The discussion then turns to the implications of a growing market in tokenised financial instruments, for example the potential to hold tokens representing fractional interests in real estate or an infrastructure project which could be more easily transferable than traditional forms of title and so assist liquidity management.  Portfolio assets generally could be traded in a secondary market in tokenised form, with fully digitised clearing and settlement. Further, potentially an authorised fund could hold securities tokens where the instrument represented by the token is itself eligible for investment

Since cryptoassets are not currently permitted investments, meaning that authorised funds cannot hold them. The Government has recently consulted on the next phase of its plans for regulating cryptoassets in the UK - click here to read our recent article. The FCA cannot do further work regarding cryptoassets and authorised funds until the Government has completed its consideration of whether the activity of portfolio management of cryptoassets should be brought into the regulatory perimeter.

Post-sale information and investor engagement

In December 2022 the FCA published discussion paper DP22/6 setting out its views on the future disclosure framework, focused on supporting retail investors to make informed investment decisions.  DP 23/2 instead focuses on ongoing information needs of investors after an investment has been made.  The new Consumer Duty will bring these post-sale communications more into focus for the asset management sector since most investments in funds are medium to long-term commitments.  The FCA’s discussion focuses on the fund prospectus and the periodic manager’s reports and accounts for authorised funds. These are documents that are required to be available upon request to investors (rather than routinely provided to investors) and are the subject of detailed rules in the FCA’s COLL sourcebook.  Views are sought whether these documents should be redesigned to better engage investors’ attention and interest, particularly if presented in a digital format.

The FCA is concerned that the prospectus is not fulfilling its primary function of providing in-depth information to fund investors who want to know more than is set out in the standard consumer disclosure documents that are provided at the point of sale. The FCA acknowledges that current rules about what must be included in the prospectus may not cover all the elements important to investors.  Further, prospectuses are generally written in legal, technical language and some of the most important pieces of information can be hard to find.

The DP points to several ways in which the prospectus could be modernised including:

• redefining and aligning to international best practice the important elements that all investors should understand, giving them sufficient prominence, for example information relating to environmental, social and governance (ESG) matters;
• making the prospectus more modular so that its important elements could be more easily accessed;
• altering the content requirements to support clearer and easier segmentation and allowing incorporation by reference for standard text;
• requiring firms to use machine-readable content, to enable more efficient search functions.

COLL requires AFMs to produce yearly and half yearly a long report containing specified information aligned with the fund’s financial statements.  The FCA considers that these fund reports contain information likely to be of interest to at least some investors, though they are also designed to provide wider market transparency. Though the reports can be provided electronically, typically they are conceived as paper-based documents and are created as flat files (such as PDFs) that are hard to review and search on screen. According to the FCA “Managers’ reports are often unengaging documents, given little prominence by fund managers, so it is unsurprising that few investors seek them out.” , though the FCA acknowledges that the monthly factsheets typically produced by fund managers may be meeting the information needs of many investors.  

Nevertheless the FCA states that the long reports are essential for consumer protection, containing important information that any reasonable investor would wish to know, such as lists of detailed portfolio holdings, precise past performance information, the findings of the AFM’s annual assessment of value review and sustainability disclosures.  The FCA seeks views on the digital presentation of the content of the reports with machine-readable formats, and also whether additional more comprehensive information could be provided digitally. Suitable presentation techniques such as layering could be used to make sure the essential elements are presented clearly and concisely, while allowing investors to look at other details if they wished. Machine-readable formats would also enable aggregators of information to extract data more readily and repackage it, to enable easier comparisons between funds.

Potentially more frequent updates about detailed portfolio composition could be provided, for example when there are significant portfolio changes or adjustments to investment strategy, especially after unexpected events such as the Russian invasion of Ukraine or the recent turbulence affecting the gilt market. 

Finally the DP acknowledges that the COLL rules regarding unitholder meetings and voting are out of date, as the rules still assume that the investors are also the registered unitholders when in most cases the unitholder is now a nominee of the investor’s service provider.  Rules that fail to recognise the presence of the intermediate unitholder may have the effect of disenfranchising investors.  Platforms and other intermediaries have a critical role to play.  The FCA intends to consult on rule changes that will make the COVID 19 forbearance of allowing virtual or hybrid meetings now a permanent arrangement.  Better use of technology could improve attendance and participation at unitholder meetings.  For example, customers of platforms could be enabled to attend and take part in virtual meetings through suitable online identity validation and platforms could enable their customers to vote electronically.

Next steps

DP 23/2 launches a wide ranging discussion.  Some of the proposals floated involve fundamental changes with significant implementation costs and timescales.  All firms affected would be wise to feed in their views whether by direct responses or through relevant industry bodies, such as the Investment Association.  Some firms in the context of the Consumer Duty are already examining some of the issues the FCA raises in the DP, in particular post-sale information.  Please contact us if you wish to discuss any of the matters covered in this article in further detail or to hear about the work we are doing with regulated firms on Consumer Duty implementation.