20 February 2023 Raza Naeem Financial Regulation - Investment Funds

FCA discussion paper (DP 23/2) seeks views on updating and improving the UK asset management regime

Against the backdrop of the Government’s Future Regulatory Framework and with an eye to modernising and streamlining the current UK regime for regulating funds and asset managers, the FCA has published a discussion paper (DP23/2) seeking views on a wide range of its ideas for potential reforms.  The FCA has not cemented any new proposals at this stage and notes that it is unlikely to take all the specific ideas forward – the intention is only to reform where it can see clear benefits from doing so.  The feedback received will help it decide what areas it should prioritise.

Possible areas for change include the following:

Amending the structure of the asset management regulatory regime by:

  • Creating a common framework of rules for asset managers regardless of type of firm (e.g. AFM, AIFM, MiFID portfolio manager etc.):  The FCA is not proposing to create a single rulebook at this stage but suggests that a consolidation of the rules could significantly simplify regulation of the sector and improve competition by easing the compliance burden for new firms entering the market. However, the FCA acknowledges that changes to large areas of rules could cause significant costs and disruption, so a lengthy timetable for implementation would be allowed to reduce the impact. The examples provided by the FCA in the discussion paper suggest that most of the uplifts / impacts would be for MiFID portfolio managers who are not subject to (as the FCA noted) rules on due diligence, liquidity management or other rules that fund managers are subject to.
  • Changing the boundary of the UK authorised funds regime:  The FCA has previously identified that the market for authorised funds can be hard to navigate for consumers. The FCA suggests that there might be benefits in having a regime, or a sub-category of the retail funds regime, to help retail investors to navigate it more effectively. This could be approached in various ways: (i) by removing the boundary meaning that all authorised funds that can be widely distributed to retail investors would be subject to a single set of rules; (ii) by rebranding the NURS regime as ‘UCITS plus’, as recommended by the UK Funds Regime review; or (iii) creating a category of basic funds which would be limited in the types of investments that they could make, for example to investing in only the largest and most liquid investments. However, the FCA recognises the complexities and costs involved to prepare for a structural change like this and would like to hear from firms about what timeframe would be needed to change their existing product offerings or to develop new products.
  • Amending the threshold at which AIFMs must apply the full-scope rules: The FCA does not plan to significantly change the rules derived from AIFMD but if the current approach is not retained, one option would be to change the size threshold at which firms must apply the full-scope UK AIFM regime. An alternative option would be to allow firms that meet criteria other than their size to use the small authorised UK AIFMD exemption (e.g. firms that only have institutional clients).  Regardless of whether or not the threshold is changed, the FCA is considering making its expectations of small authorised AIFMs clearer by introducing a set of high-level rules setting minimum standards on core funds such as valuation, liquidity management and investor disclosure. This would be less prescriptive than the full-scope AIFM regime.

Improving the way the regime works by:

  • Amending the rules for authorised fund managers: The rules or additional guidance could be introduced to make clearer the requirements on portfolio managers of funds with a host authorised fund manager, or to set minimum contractual requirements between host AFMs and portfolio managers.
  • Amending the rules and guidance around liquidity stress testing: The FCA plans to convert the liquidity stress testing guidelines issued by ESMA into rules and guidance in its Handbook. It is also considering removing or significantly restricting the limitation around liquidity stress testing in COLL 6.12.11R(2), so that the qualification ‘where appropriate’ does not give fund managers a reason not to carry out stress tests. The FCA is also considering whether to extend the reporting of liquidity categories/buckets received for AIFs to UCITS funds and to see if there is any benefit in requiring funds to make any form of public disclosures on liquidity of investments.
  • Making regulatory expectations on investment due diligence clearer for all asset management activity. The FCA has seen investments made in illiquid or complex securities without significant due diligence. Whilst the FCA does not intend to create complicated or onerous restrictions in this area, it thinks there could be benefits from having clearer standards that apply to all asset managers – in their view the obvious gap being MiFID portfolio managers (notwithstanding the suitability rules they are currently subject to).
  • Clarifying rules for depositaries to make expectations clearer:  The FCA is aware that there may be areas where its rules require depositaries to carry out oversight functions that are of limited benefit and so would be interested to hear if there are any rules it could remove. It is also considering making clearer its rules and expectations around several areas, including among other things, the systems and controls that a depositary must have in place to identify breaches of the rules and constituting documents of a scheme.

Improving the fund rules by:

  • Updating or providing guidance on eligible assets: The FCA has concerns that some UCITS managers might perceive the 10% rule (that is where funds are permitted to invest up to 10% of their portfolio into assets that do not meet the eligible markets criteria) 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 suggested option is for the FCA to provide guidance around its expectations around the 10% rule- in particular the FCA has suggested providing guidance that the 10% rule should not be used in a way that undermines the liquidity of the fund.
  • Removing or modifying detailed or prescriptive requirements in the rules on prudent spread of risk in the COLL rules for UK authorised funds: Some stakeholders have suggested the FCA should remove the prescriptive quantitative requirements in favour of a more principles-based regime to allow greater investment flexibility.

Improving technology in fund operations by:

  • Implementing the ‘Direct2Fund’ model: This is the Investment Association’s proposition for an optional model which would make it possible for investors to transact directly with the fund when buying and selling units – an alternative to the current model where the AFM buys and sells units on behalf of the fund and its investors.
  • Exploring ‘Fund tokenisation’ of units in authorised funds:  Fund tokenisation is the ability to issue a fund’s rights of participation to investors as digital tokens, which could simplify the way units of funds are bought and sold. The FCA is keen to understand what interest there would be from investors to use this technology and areas where rules or guidance would be necessary or helpful.
  • Tokenised portfolio assets: The FCA is keen to hear views on how fund regulation should respond to the implications of a growing market in tokenised financial instruments. The FCA have indicated that this could be of particular interest to managers of QIS and LTAFs, for example in the context of holding tokens representing fractional interests in real estate or an infrastructure project.
  • Investment in cryptoassets: Until the Government has advanced its thinking on the regulation of cryptoassets, the FCA does not deem it to be appropriate to do further work on the scope of crptoasssets for the authorised funds regime. However, it is keen to hear about how fund managers could make wider use of advances in technology.

Improving investor engagement through technology 

  • Fund prospectuses: the FCA is concerned that fund prospectuses are not fulfilling their 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. The FCA is interested in feedback on how prospectus disclosures could be modernised – e.g. making prospectuses more modular, renaming prospectuses, mandating machine readability or requiring them to be stored on a central repository maintained by the FCA.
  • Managers’ reports and accounts: the FCA has found that these reports are often unengaging and not given much prominence by managers. The FCA believe there is important information in a manager’s report that any reasonable investor would wish to know. The FCA would like feedback on how the rules in this area could be changed to make best use of technology to meet investors’ information needs – e.g. having a common template that is machine readable or requiring them to be stored on a central repository maintained by the FCA. The FCA has also suggested that actively managed funds could be more transparent about their portfolio holdings.
  • Investor engagement: the FCA would like to understand if better use of technology could improve attendance and participation at unitholder meetings. The FCA have also asked for feedback on whether the FCA should do more to enable investors to engage with their fund manager – e.g. requiring managers to offer directed voting to investors in pooled funds.

What’s next? 

The FCA requests stakeholders to send comments by 22 May 2023 and aims to publish a feedback statement later in 2023, possibly as part of a consultation paper.

If any changes are made, the FCA says it wants them to be consistent with international standards and take account of rules in other jurisdictions, so that firms can continue to operate efficiently on a global basis.

The discussion paper published on 20 February 2023 is available here.

The FCA press release is available here.