The FCA has outlined some key risks of harm in the asset management and alternative investments sector and the steps that firms should take to address these risks. Firms may therefore need to make changes to their current practices and procedures.
The FCA has written to Chief Executives of both asset managers and also alternative investment firms setting out its view on the key risks of harm that such firms pose to their customers and the markets more generally. The FCA defines "alternative investment firms" as firms managing or advising on alternative assets and/or alternative investment vehicles (such as hedge, credit or private equity funds). Asset managers include FCA authorised firms which directly manage or advise on mainstream investments, particularly retail investments.
In the two letters, the FCA has also set out some priorities on which it expects asset managers and alternative investment firms to focus in order to address such risks. While none of these measures is new, firms should consider their current practices and procedures in light of the FCA's comments and assess whether any improvements should be made.
The FCA states that the overall standards of governance of alternative investment firms and asset managers (especially at regulated entity level) generally fall below its expectations.
The FCA warns that it may carry out visits to such firms to assess their compliance with the FCA's rules and other legislation and that firms may also be required to take part in related work by the FCA. The FCA has specifically identified some areas where it will be contacting or visiting firms. Summary of FCA's key comments below.
1. Alternatives Supervision Strategy
Suitability, appropriateness and client money
Firms which offer products or manage investments with exposures to alternative assets and strategies should consider the appropriateness or suitability of those investments for their target investors. In particular, firms should make sure that they identify the client type and investment need when manufacturing or distributing products (bearing in mind that certain products may only be suitable for a niche market). We assume that this refers to the product governance rules and so, in relation to distributors, would apply only to target investors which are the firm's clients.
Firms should also ensure that any decision to opt-up investors to elective professional status is done on the basis of a robust assessment (for both clients and non-client investors).
The FCA intends to review retail exposure to alternative investments. It will test whether firms are aware of who their customers are and that they are placing a clear focus on acting in the best interests of their clients and funds. In addition, the FCA will be looking to assess whether firms have taken reasonable steps to ensure that investors adequately understand the risks of their investments and are not exposed to products outside the scope of their risk profiles. As part of the retail investor review, FCA will also look at client money and asset controls within firms.
The FCA observed that market abuse controls across the sector "have significant scope for improvement". Firms are required to make sure that their market abuse controls are sufficient to enable them to discharge their obligations under the Market Abuse Regulation and that they are sufficiently comprehensive and tailored to the firms' business models. The FCA sent a market abuse questionnaire to asset managers in 2018, followed by a number of firm visits. The FCA may include alternatives firms in future questionnaires.
Market integrity and disruption
Firms must operate robust risk management controls to avoid excessive risk taking and to ensure that the potential for harm or disruption to financial markets is appropriately mitigated. In particular, firms adopting very high-risk investment strategies, particularly those employing significant leverage, should have appropriately high-quality risk management controls and may be subject to FCA review.
Firms should be alert to the risk that they may be used to facilitate financial crime and have appropriate and proportionate systems and controls. Of particular importance are due diligence on third parties and know your client (KYC) checks. The FCA intends to review firms' systems and controls in this area, paying particular attention to money laundering and terrorist financing.
2. Asset Management Supervision Strategy
The FCA confirms that effective liquidity management in funds is a central responsibility for authorised fund managers, even where investment management is delegated to a third party.
The FCA also expects firms to take any necessary or appropriate action in light of PS19/24 on illiquid assets and open-ended funds, its letter of 4 November 2019 to the boards of AFMs outlining its expectations regarding liquidity management and the FCA and the Bank of England’s joint review of liquidity risks in open-ended investment funds.
Firms should ensure that firms' boards engage in robust discussion and challenge around important business decisions, without undue reliance on group structures. In addition, firms should recognise and take steps to mitigate harm arising from any conflicts of interest between affiliates, notably between an authorised fund manager and any delegate investment manager.
Firms should have refreshed and improved their approach to governance in line with the Senior Managers & Certification Regime (SMCR) including through clear lines of accountability and responsibility for senior management functions (SMFs). The FCA will review firms' governance and SMCR implementation in the first half of 2020.
Asset management market study
Following the Asset Management Market Study, fund managers should carry out value assessments on their authorised funds. The FCA will review firms' work in this area in the first half of 2020. Funds’ objectives should also be clear, fair, not misleading and comply with new rules around objectives disclosure.
Governing bodies of managers of authorised funds should also ensure that they have at least one quarter (and no fewer than two) independent members. The FCA will look to see evidence of meaningful challenge by the independent members including on costs, fees and product design.
Firms subject to product governance requirements should ensure that products are designed with the best interests of a specified target market in mind and do not include features that are manifestly not in the interests of customers (e.g. funds tracking an undisclosed index or where fees exceed target returns). The FCA is currently reviewing firms' compliance.
Where authorised funds are managed by fund managers which are not in the same group as the investment manager (including host ACDs), the FCA has concerns that such fund managers may not be carrying out their responsibilities properly, particularly in respect of conflicts. The FCA is undertaking a further review of these types of arrangements.
Firms should also be aware of their responsibility to ensure an effective transition away from the London Interbank Offered Rate (LIBOR) and should be planning on the basis that LIBOR will cease from the start of 2022.
The FCA has previously indicated in a separate communication that, where appropriate, firms subject to SMCR that are affected by the LIBOR transition should identify the senior manager responsible for overseeing transition away from LIBOR and detail those responsibilities in that senior manager’s Statement of Responsibilities.
Firms should manage their technology and cyber risk appropriately, including through appropriate oversight of third party firms and intra-group service providers, taking into account the FCA's review of technology resilience for asset managers. The FCA may also carry out proactive technology reviews on firms which have a greater risk of causing harm.
For both asset managers and alternative investment firms, the FCA expects firms to consider how the end of the implementation period following the UK's withdrawal from the EU will affect firms and their customers. The implementation period is currently expected to last until 31 December 2020 and firms are required to consider what action they will need to take to be ready for 1 January 2021.
4. How we can help
Our Financial Services and Markets Department has extensive experience in advising asset managers and alternative investment firms on all the areas covered by the FCA's letters. To find out how we can help, please speak to your usual Travers Smith contact or any of the partners below.
This article is provided as a general informational service and it should not be construed as imparting legal advice on any specific matter.
Tim Lewis is Head of the Financial Services & Markets department at Travers Smith LLP. Specialising in financial services law and regulation, his clients include trading venues, payment system operators, investment managers, alternative asset managers, pension fund trustees, banks and brokers.
Jane Tuckley is a Partner in the Financial Services & Markets Department at Travers Smith LLP. Her clients include portfolio managers, investment banks and corporate finance firms. She advises on the law, practice and regulatory requirements relating to the financial services industry and the securities markets, with particular emphasis on complex regulatory change projects.
Philip Bartram is a Partner in the Financial Services & Markets Department at Travers Smith LLP. Advising financial market participants on law and regulation affecting their business, he is counsel to hedge, private equity and real estate fund managers, as well as banks, brokers, corporate financiers, exchange-traded product providers and payment institutions.
Stephanie Biggs is a Partner in the Financial Services & Markets Department at Travers Smith LLP. Her clients include some of the world's largest alternative investment firms, which she advises on a range of complex domestic and cross-border regulatory matters.
Michael Raymond is a Partner in the Financial Services & Markets Department at Travers Smith LLP. He has a broad financial services regulatory practice, advising financial markets participants, including some of the world's largest multi-strategy investment managers, on all aspects of law and regulation.
For more information, please visit www.traverssmith.com.