FCA’s Post-Brexit Review of the UK Asset Management Regime

On 20 February 2023, the Financial Conduct Authority (FCA) published its Discussion Paper (DP23/2) on updating and improving the UK regulatory regime for asset management (the DP).

The DP invites feedback on a number of proposals for modernising and improving the FCA rules applicable to asset managers. This includes both fund managers (that is, alternative investment funds managers, or AIFMs, and Undertakings for Collective Investment in Transferable Securities, or UCITS, management companies) and portfolio managers (that is, Markets in Financial Instruments Directive, or MiFID investment management firms), as discussed below.

The context for the DP is the proposed transfer of post-Brexit retained EU financial services law from the statute books into the regulatory rulebooks under the Financial Services and Markets Bill (FSMB), which currently sits before the UK Parliament. The FCA is seeking to review the effectiveness of the asset management regulatory framework prior to the transfer of a number of parts of the regime that are currently implemented via legislation into the FCA rulebook. See our separate August 2022 Sidley Update for further information on the FSMB that may be of relevance to investment managers.

The DP discusses the following areas:

• simplifying the structure of the regulatory framework for asset managers;
• accommodating technological changes; and
• specific changes in relation to retail funds and their depositaries.

While the DP covers the asset management sector as a whole, the primary focus of the FCA appears to be in respect of the retail funds sector. However, the DP also raises important issues for the institutional asset management sector; this Update focuses on those issues in particular.
Responses to the DP must be submitted by 22 May 2023. The FCA intends to publish a related feedback statement later in 2023, possibly as part of a consultation paper on certain topics discussed in the DP.

DISCUSSION TOPICS FOR INSTITUTIONAL ASSET MANAGERS

1. Simplifying the regulatory framework for asset managers

The FCA notes in the DP that current UK regulation of the asset management sector largely derives from three pieces of EU legislation: (i) the UCITS Directive, (ii) AIFMD, and (iii) MiFID.

The FCA refers in the DP to managers of funds that are subject to rules derived from the UCITS Directive and AIFMD as “fund managers” and firms subject to rules derived from MiFID as “portfolio managers.” The latter term includes both UK firms managing segregated portfolios, as well as those that perform discretionary management services as a delegate of a fund manager.

As the law-making process for each of these Directives was independent, and due to differences in the Directives themselves, the FCA notes that this has resulted in considerable duplication of, and minor inconsistencies between, the rules applicable to managers of UCITS funds, AIFMs, and portfolio managers, respectively. This is observed particularly in the case of the core conduct rules that address organisational requirements, conflicts of interest management, and outsourcing. Accordingly, the FCA notes that the current regulatory regime is not as clear or coherent as it could be.

Rules for fund managers and portfolio managers

The FCA distinguishes between differences of technical detail and differences of substance.

As an example of a technical difference, the FCA cites the conflict of interest rules that apply to different types of asset managers. These are spread across various parts of the Senior Management Arrangements, Systems and Controls sourcebook of the FCA rules as well as various pieces of “onshored” EU legislation under the above Directives.

While these rules all seek to achieve the same objective, the FCA considers that the differences in the expression of the requirements gives rise to unnecessary complexity and uncertainty as to the standard required for different types of asset managers.

However, the FCA considers other differences between the rules for fund managers and portfolio managers to be more substantive. For example, fund managers must consider the risks their management activities could pose to financial stability. In contrast, portfolio managers are not subject to any specific requirement in this regard. The FCA notes that in certain cases, portfolio managers may be responsible for designing services that could create financial stability risk, citing recent difficulties in the market for liability-driven investment services. Therefore, it may consider whether any gaps in the regulatory framework for portfolio managers need to be addressed.

One way to address the differences between the current regimes would involve creating a single rulebook for all asset managers. However, the FCA notes that its rules apply to a wide range of different types of firms, including asset managers, and as such it is unlikely to consolidate all asset management rules into a single sourcebook.

The FCA is exploring the potential benefits in making the common rules that apply to all types of asset management more consistent and coherent. As such, it will consider introducing a common framework that would set standards applicable to all asset managers.

While a simplified and more intuitively navigable set of rules applicable to asset managers would be welcome, as the FCA observes, this needs to be balanced against the likely high costs and disruption that could result from any significant overhaul of UK asset management regulation as it has applied to date. Regard should also be had to the complexity that may arise from further divergence from the EU framework, noting there is no corresponding proposal in the EU to consolidate rules applicable to different types of asset managers.

Further, while the key message of this part of the DP is one of simplification, the FCA also indicates that it perceives gaps in the regulation of portfolio managers and that it may address these by aligning the MiFID-derived framework with the AIFMD and UCITS Directive-derived framework for fund managers. Such alignment could result in the imposition of new requirements on portfolio managers (such as the above example of the requirement to consider financial stability risks).

Rules for managers of professional funds

UK fund managers that manage assets above a specified size threshold are subject to UK rules derived from AIFMD and required to be authorised as “full scope AIFMs.”.

However, firms below the size threshold, referred to as “small UK AIFMs”, are subject to less prescriptive requirements.

There are two regimes that apply to small UK AIFMS: (i) an authorisation regime for firms carrying out regulated activities (“small-authorised AIFMs”); and (ii) a registration regime for other firms that do not require authorisation and also satisfy certain criteria (“small registered AIFMs”). Unlike small-authorised AIFMs, small registered AIFMs are neither (i) considered authorised persons by the FCA nor (ii) subject to FCA rules in relation to any alternative investment funds (AIFs) they manage. As such, investors in an AIF that is managed by a small registered AIFM are unlikely to receive the same level of protection as if they invested in an AIF managed by an authorised AIFM (i.e., a small-authorised AIFM or a full scope AIFM). For example, investors in small registered AIFMs may not be able to complain to the Financial Ombudsman Service or make a claim on the Financial Services Compensation Scheme.

The FCA does not plan to significantly amend the rules that apply to full-scope AIFMs.

However, the FCA is considering ways of potentially addressing feedback it received, which suggests that in some areas, the full-scope AIFM standards go beyond what professional investors consider necessary to protect their interests.

As such, the FCA notes that it will contemplate changing the size threshold at which firms must apply the full-scope UK AIFM regime. Alternatively, the FCA could allow firms that meet criteria other than size (such as criteria relating to the types of strategy or clients of the firm) to be classified as small UK AIFMs.

In light of a possible expansion of the small AIFM exemption in the future, the FCA wants to ensure that the exemption would be used appropriately. As such, it is exploring the possibility of setting minimum standards for small authorised AIFMs on core fund areas such as valuation, liquidity management, and investor disclosure. Any new requirements would be less prescriptive than equivalent requirements under the full-scope AIFM regime.

The FCA is also engaging with HM Treasury on ways to potentially minimise the risk of consumers mistakenly confusing small authorised AIFMs and small registered AIFMs. The FCA is particularly concerned that the existence of a registration regime might mislead consumers into wrongly thinking that a registered small AIFM is authorised. Such confusion could be minimised by, for example, requiring some types of small registered AIFMs to be authorised and removing the registration requirements for others.

Sidley commentary

The proposals for reforming regulation of UK AIFMs are on the whole relatively limited in scope. For example, a more ambitious post-Brexit regime would involve establishing a new asset management framework that does away with historical EU labels (UCITS Directive vs AIFMD vs MiFID), and sets common “base” prudential requirements (e.g., regulatory capital, remuneration) and conduct requirements (e.g., conflicts of interest, liquidity and risk management, reporting). Managers with retail investors/customers might then be subject to certain higher standards of disclosure and investment restrictions. However, that kind of regime would need to be led by HM Treasury rather than just by the FCA, and it is presumably the case that the UK government does not wish to take such an ambitious step at this point.

2. Accommodating technological changes

The DP sets out the FCA’s thinking on the role of technology in the asset management sector and invites views on how regulation should respond to this.

In particular, the FCA makes the following observations and invites views on how it should consider reshaping regulation to address these issues.

• Fund operations: Long-standing processes, such as the way units in funds are bought and sold, could be modernised using technology that could enable investors to transact directly with funds. Current regulation does not dictate exactly how technology might be used. However, where the regulation is prescriptive about certain processes, the FCA notes that this could deter firms from finding better technological solutions.
• Fund tokenisation: Funds could issue their units to investors as digital tokens, such as by means of distributed ledger technology, to eliminate administrative inefficiencies. Current regulation may not be flexible enough to allow for developing technologies in this regard. As such, the FCA invites views on what regulatory changes would be needed to enable the tokenisation of fund units.
• Tokenised portfolio assets: Existing assets could be held in a fund’s underlying portfolio and traded on a secondary market in tokenised form with fully digitised clearing and settlement. The FCA invites views on how regulation should respond to such developments.

DISCUSSION TOPICS FOR MANAGERS OF AUTHORISED FUNDS (RETAIL)

The DP also discusses other topics relating to the authorised funds in the retail asset management sector. Though not generally of relevance to institutional fund and portfolio managers, these are summarised below.

Rules for retail funds

The UK authorised retail funds regime divides funds into two main categories: UCITS funds (those within scope of UK rules that implemented the UCITS Directive) and non-UCITS retail schemes (NURS). NURS are a form of retail AIF, subject to rules implementing AIFMD as well as more stringent standards under FCA rules.

Although the UCITS regime is recognised internationally as a de facto brand for retail funds, the DP identifies differences between the current UCITS and NURS regimes that could make it unattractive to structure a fund as a UCITS fund even where the product would be appropriate for a target market of mainstream retail investors. For example, the FCA notes that rules governing the formation of a feeder UCITS investing into a master UCITS are unnecessarily complex. The equivalent NURS rules are simpler and more widely used.

As such, the FCA will consider different approaches for potentially simplifying the UCITS regime, one of which would involve altogether removing the boundary between UCITS funds and NURS so that all authorised funds that can be distributed to retail investors would be subject to a single set of rules. Although changing the boundary between the UCITS and NURS regimes could produce benefits, the FCA is wary of inadvertently undermining the trusted framework for retail funds provided by the UCITS Directive.

Rules for authorised fund managers

The FCA acknowledges the benefits of existing rules that permit host authorised fund managers (AFMs) to use third-party portfolio managers.

However, the FCA also recognises that host AFMs must diligently ensure the adequate supervision of their portfolio managers. As such, the FCA will consider how it could clarify the responsibilities and expectations of both AFMs and portfolio managers without removing any responsibility from host AFMs. Such clarification could reduce the risk that either party misunderstands its obligations.

Separately, the FCA discusses ways that it could potentially improve the current rules on liquidity requirements for AFMs as well as possibly introducing regulatory expectations regarding investment due diligence that would apply to all types of asset management activity.

Rules for depositaries

The FCA is considering clarifying its expectations around several areas related to depositaries of AFMs, including the following:

• 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 expected of a depositary;
• Actions expected to be taken when a breach is identified;
• What the depositary should do if the manager does not take action to deal with the breach;
• The depositary’s oversight of the AFM’s liquidity management, including liquidity stress testing; and
• The depository’s oversight of the AFM’s pricing and dealing in units of the fund.

Rules for authorised funds

The FCA will consider clarifying the rules for fund managers to ensure they deliver appropriate outcomes in a way that is effective and proportional. For example, the FCA will consider issuing clarificatory guidance on the “10% rule,” which currently permits UCITS funds to invest up to 10% of their portfolio into assets that do not qualify as eligible assets under UCITS rules.

Accommodating technological innovation for retail funds

In relation to retail funds specifically, the DP invites views on ways of potentially accommodating technological innovation in the following areas:

• Investment in cryptoassets. The FCA notes stakeholder calls for unregulated tokens, such as stablecoins, to be classified as eligible assets for the purposes of the investment restrictions applicable to UK UCITS funds. The FCA stressed that it will not make any changes to the scope of the authorised funds regime to accommodate such tokens until HM Treasury has advanced its own thinking on the matter. (For further information on HM Treasury’s ongoing consultation regarding a potential future regulatory regime for cryptoassets, see our Sidley Update UK Proposes Regulatory Regime for Cryptoassets.)
• Consumer outcomes. Firms could implement consumer-friendly technology to encourage consumers to seek out and engage with a wider variety of products and services that meet their financial needs.
• Fund prospectus. In light of its concerns that the fund prospectus does not currently fulfil its primary function (i.e., provide in-depth information to fund investors), the FCA will consider modernising prospectus disclosures in a number of ways that could make a prospectus’ contents more easily comparable and available for public scrutiny.
• Managers’ reports and accounts. As it is now practical for firms to regularly publish digital content, the FCA will consider imposing more ambitious requirements related to the (i) more frequent publication of an actively managed fund’s portfolio holdings; (ii) publication of a fund’s prospectus, reports, and accounts in a prominent and easily accessible place on the fund manager’s website; and (iii) storage of a fund’s reports alongside company reports on a centralised and publicly accessible portal.
• Investor engagement and unitholder meetings: Some existing rules related to unitholder meetings assume that a fund’s investors are also the registered unitholders in whose name the fund’s units are registered. However, due to the growth in popularity of intermediary platforms, the unitholder is in practice often a nominee of whichever platform provider or other intermediary the end investor has chosen. As such, the FCA is considering ways that technology could be used to ensure that all interested parties may participate in a fund’s governance decisions (e.g., permanently allowing virtual or hybrid unitholder meetings).

CONCLUSION

The UK’s asset management regulatory regime is the product of decades of EU policy and legislation under AIFMD, the UCITS Directive, and MiFID.

While there is clear benefit in having a consolidated regulatory framework that is more intuitive for asset managers to follow and ensures greater consistency of standards across manager types, this must be balanced against the high costs and disruption that could result from a major overhaul of the requirements, as well as complexity arising from further divergence from EU standards.

For institutional fund managers operating as UK AIFMs, the reforms discussed are relatively limited in scope. While the proposed expansion of the UK small AIFM regime will be welcome to certain firms such as start-up managers, it is unlikely to be of significance to the more established managers in the sector.