UK/EU Investment Management Update (July 2024)

1. UK — FCA

2. UK — ESG

3. EU — ESG

4. EU — Prudential Framework

5. EU — NBFI

6. EU — Trade Settlement

7. EU – Artificial Intelligence

8. International — Market Outages

1. UK — FCA

FCA speech on key areas of focus in the asset management industry

On 5 June 2024, Nikhil Rathi, Chief Executive of the FCA, delivered a speech on the FCA’s key areas of focus to asset management at the Investment Association Annual Conference. Rathi’s speech provided insight into the FCA’s activities in the following key areas of focus:

• Liquidity risk management. The FCA has been focused on liquidity risk management, particularly in relation to open-ended funds, in light of what Rathi noted as the “dash for cash” liquidity crunch of Covid 19 in March 2020. The FCA has been working with the UK Financial Policy Committee on developing a systemwide stress testing exercise, including NBFI.
• Leverage and NBFI. The joint FCA–European Central Bank working group on leverage in NBFI is in the final stages of collating data and policy tools currently available to authorities enabling them to monitor and address build-up of systemic risk.
• Margin preparedness. The FCA is also focused on margin preparedness alongside the Financial Stability Board’s open consultation on liquidity preparedness for margin and collateral calls. The FCA comments that enhancing the liquidity preparedness of participants and the monitoring ability of authorities will curb market stress and improve financial stability.
• AI and innovation. Whilst it aims to be a “technology neutral” regulator, the FCA is concerned with making sure that the use of AI does not pose risks such as entrenching biases in data or enabling market manipulation. Rathi’s speech emphasised that the FCA does not want to put the “brakes on innovation” and that for now, the FCA considers that the existing governance frameworks are sufficient, including the senior manager regime and the Consumer Duty.
• Operational effectiveness. The FCA is cognisant of its regulatory authorisation times as a top concern. The FCA noted its achievements with speeding up this process, including that the introduction of automated forms should help make the process more efficient. The speech highlighted that 98.1% of authorisation applications were determined within the statutory deadline in Q1 2024.

FCA enforcement action — SVS Securities

On 24 June 2024, the FCA banned and fined three senior management individuals from SVS Securities Plc (SVS) for failure to manage conflicts of interest and reckless conduct with customer pension funds.

SVS managed investments held on behalf of its customers and was obliged to act in the best interests of its customers and to avoid conflicts of interests from interfering in SVS’ obligations to such customers.

However, the FCA found the following failures:

• The CEO was found to have caused SVS to transact into high-risk illiquid bonds operated by SVS directors via a complex business model that prioritised income to SVS (including unauthorised introducers with undisclosed commissions of up to 12% of invested funds). This led to SVS keeping 10% of customer funds and generating £359,800 in income for SVS at the expense of its customers.
• The head of compliance failed to fulfil its responsibilities to ensure that SVS was following the rules.
• The finance director failed to fulfil his responsibilities to manage conflicts of interest and ensure proper due diligence was carried out.

In the FCA’s view, SVS’ business model created “systematic conflicts of interests” and “inappropriately prioritised income to SVS over the best interests of their customers.”

As a result, the FCA has fined the individuals sums ranging from £52,100 to £215,500. In addition, the CEO has been banned from working in financial services, whilst the other two individuals have been banned form holding senior management roles.

FCA enforcement action against Instagram influencers — unauthorised investment schemes and financial promotions

On 13 June 2024, the FCA provided an update on the charges it has brought against nine individuals in relation to an unauthorised investment scheme. The FCA has alleged that two central figures used an Instagram account to advise its audience on buying and selling contracts for difference when they were not authorised by the FCA to do so. In addition, the FCA also alleges that seven other individuals, including reality TV stars, promoted this Instagram account to their own Instagram followers.

On account of the actions above, the FCA is charging one individual with running an unauthorised investment scheme in breach of the general prohibition under Section 19 of the UK Financial Services and Markets Act 2000 (FSMA) from carrying on regulated activities. In addition, all nine individuals are also being charged with issuing unauthorised communications of financial promotions in breach of Section 21 of FSMA, which is punishable upon conviction by a fine and/or up to two years’ imprisonment. The FCA’s enforcement action in this area is another recent example of the FCA’s efforts to address consumer harm in financial promotions.

Changes to Firm Details Attestation forms

The FCA has flagged that the regulator is reviewing the Firm Details Attestation form to improve data quality and guidance. As part of these changes, the FCA plans to implement data matching for firms’ registered name, registered address, and financial year end.

The new form is expected to be published later this year. Accordingly, any firms that are registered with Companies House are strongly encouraged to review and update their data held by Companies House before completing their next attestation under the new form.

2. UK — ESG

FCA publishes guidance on sustainability investment labelling regime

As a reminder, the FCA’s labelling and disclosure regime for products with sustainability objectives, part of the FCA’s framework for its SDR and investment labels (SDR Framework), will come into force on 31 July 2024. For more information on the FCA’s SDR Framework, please see our Sidley Update Final Rules on UK Sustainability Disclosure Requirements and Investment Labels — Key Takeaways for Asset Managers.

On 1 July 2024, the FCA published guidance on how managers should notify the FCA if they wish to use labels for investment funds that have a specific environmental or social goal. As a reminder, the FCA investment labelling regime for products with sustainability objectives will come into force on 31 July 2024. Investment managers that opt into the regime will be using the following labels if their funds meet the relevant criteria: Sustainability Impact, Sustainability Mixed Goals, Sustainability Focus, and Sustainability Improvers.

In summary, the FCA’s guidance states that whilst FCA approval is not needed for using investment labels, notifications should be provided to the regulator using the relevant form on the FCA Connect platform. The FCA has provided guidance on the relevant steps for four different scenarios:

1. an authorised fund that the fund manager considers meets the criteria for a label without the need for changes to the pre-contractual disclosures;
2. an authorised fund that the fund manager considers requires changes to the pre-contractual disclosures to meet the label criteria;
3. a new fund that the fund manager considers will meet the label criteria; and
4. in-scope unauthorised alternative investment funds looking to use investment labels.

3. EU — ESG

ESMA publishes its Final Report on Greenwashing

On 4 June 2024, the European Securities and Markets Authority (ESMA) published its Final Report on Greenwashing (Greenwashing Report) in response to the Commission’s request for input on greenwashing risks and the supervision of sustainable finance policies.

ESMA’s Final Report was published in conjunction with the other European Supervisory Authorities (ESAs) – the European Banking Authority (EBA) and the European Insurance and Occupational Pensions Authority – which also published respective final reports.

Common understanding of “greenwashing”

Collectively, the ESAs agreed that greenwashing is:

“a practice where sustainability-related statements, actions and communications do not clearly or fairly reflect the underlying sustainability profile of an entity, financial product or a financial service. This practice may be misleading to consumers, investors, or other market participants.”

The ESAs also agree that sustainability claims and sustainability information should be “fair, clear and not misleading.”

Observations on supervisory practices

ESMA’s Greenwashing Report details ESMA’s approach to tackling greenwashing under its remit and the steps that National Competent Authorities (NCAs) have taken to supervise sustainability claims in EU Member States.

Key observations:

• Progress needed in compliance with sustainability disclosures. Generally, NCAs have found that there is still scope for improvement for entities to comply with relevant sustainability-related requirements under EU legislation, such as the Sustainable Finance Disclosure Regulation (SFDR), and the need to access high-quality and comparable data.
• Shortcomings in SFDR disclosures. NCAs noted examples of bad practice, which included inconsistencies between marketing materials and disclosures. In addition, NCAs found that the following areas generally lacked sufficient disclosures: governance (procedures and controls), binding elements of investment strategy, and data and methodologies limitations.
• Challenges with assessing use of ESG data. Availability, accessibility, and comparability of data have been challenging for both investment managers and NCAs. NCAs have noted difficulties in the quality of data and methodologies used by investment managers. Multiple NCAs noted differing practices across managers in terms of disclosing and controlling use of ESG data.
• Challenges with identifying greenwashing. Some NCAs found that the unclear definition of “sustainable investment” under Article 2(17) SFDR made it difficult to identify instances of greenwashing.
• Supervisory action on greenwashing. Where greenwashing occurred, NCAs have taken a variety of approaches. These include requesting investment managers to improve/change website and precontractual disclosures under SFDR (such as fund names, methodologies or investment processes) and to amend offering documents to have a clearer representation of ESG profiles (in the context of marketing authorisation).

Recommended remediation actions

The Greenwashing Report sets out a recommended actions for NCAs, ESMA, and the Commission to take to further mitigate greenwashing risks in relation to investment managers:

• NCAs. Take account of examples of “good practices” within the Greenwashing Report; consider the use of supervisory technology (SupTech) tools to support supervision of the funds industry; participate in the Technical Support Instrument project; maintain internal databases to aid/conduct supervision; and where relevant, use the databases to support portfolio analysis.
• ESMA. Develop indicators/SupTech tools for monitoring greenwashing in the funds industry (and help NCAs develop SupTech tools); explore information exchanges and improving flow of data on portfolio composition; and consider follow-up actions to the ESMA Common Supervisory Action on sustainability risks.
• Commission. Adopt regulatory technical standards to improve access to machine-readable SFDR disclosures for end users and NCAs to help foster use of SupTech tools.

ESAs publish joint opinion on SFDR changes

On 18 June 2024, the ESAs published a joint opinion (Opinion) on the assessment of SFDR. The Opinion does not respond to a mandate from the Commission and is not legally binding; however, it will likely hold weight in the Commission’s comprehensive review of SFDR at both Level 1 and Level 2 regulations (known as SFDR 2.0).

The ESAs’ main policy recommendations include the following:

• Development of a product categorisation system. The ESAs recommend introducing a product classification system, based on regulatory categories and/or sustainability indicators, to help consumers navigate the wide selection of sustainable products. The categories should be simple with clear objectives or thresholds in order to identify which category the product falls into. The ESAs suggest the categories of “sustainability” and “transition,” at the least.
• Disclosures. The ESAs propose specific disclosure, product naming, and marketing requirements depending on the categorisation of the product. Additionally, they suggest that the Commission ensures that sustainability disclosures meet the broad needs of investors, with very simple disclosures provided to retail investors and more complex information provided to more sophisticated investors. The format of the information should be adapted to enable investors to digest the information digitally.
• Sustainability indicators. Either in addition to, or instead of, introducing a product categorisation system, the ESAs suggest that sustainability indicators could refer to environmental sustainability, social sustainability, or both. This would help provide investors with a scaled representation of the product’s sustainability features.
• Sustainable investment definition. The ESAs recommend that the Commission provides clearer parameters for definition of “sustainable investment” under Article 2(17) of SFDR. A prescriptive definition would allow for more uniformity in the application of “sustainable investments” across the market and enable more comparability between products.
  
  In addition, the ESAs suggest clarifying the relationship between “sustainable investment” as defined under the SFDR and as defined under the EU Taxonomy Regulation. In this regard, the ESAs note that the Commission should prioritise completing the EU Taxonomy and extending it to cover social sustainability.
• Scope. The ESAs recommend that the Commission carefully reflects on whether to include other products within the scope of SFDR to ensure harmonised disclosures (both for products currently within the scope of SFDR and other products that could be brought into scope).
• Principal adverse impacts (PAIs). The ESAs see merit in clarifying the disclosure requirements for PAIs. They suggest that the Commission could consider making “consideration” of PAIs investment decisions on sustainability factors mandatory for products qualifying for the new “sustainability product” category; “information” on all PAIs mandatory for the “transition category;” and some minimal disclosures such as “information” about select key PAIs, selecting a list of priority indicators, mandatory for all financial products that should always be disclosed.
• Government bonds. The ESAs suggest that the Commission considers evaluating the introduction of a framework to assess the sustainability features of government bonds, taking into account the specific characteristics of that asset class.

In addition to the above recommendations, the ESAs suggest a number of technical amendments the Commission could consider in its assessment of SFDR.

EFRAG and TNFD publish report of ESRS' alignment with nature-related disclosures

On 20 June 2024, the European Financial Reporting Advisory Group (EFRAG) and the Taskforce on Nature-Related Financial Disclosures (TNFD) published a joint correspondence mapping report (Report), which assesses the alignment of the European Sustainability Reporting Standards (ESRS) with the TNFD’s recommended nature-related disclosures.

As a reminder, the TNFD aims to provide a global voluntary disclosure framework for nature, similar to how the Task Force on Climate-Related Financial Disclosures (TCFD) provided a disclosure framework for climate. The ESRS is a disclosure framework for companies that are subject to the EU Corporate Sustainability Reporting Directive.

The Report states that there is strong congruence between the ESRS and all 14 TNFD recommended disclosures, and commonality is achieved through the following:

• Concepts and definitions. Both the ESRS and TNFD recommend the disclosure of nature-related impacts, risks, and opportunities.
• Materiality. The ESRS prescribe the double materiality principle towards disclosures, and the TNFD permits the double materiality principle as well as other approaches.
• LEAP approach. The TNFD prescribe the LEAP (Locate, Evaluate, Assess and Prepare) approach for the identification and assessment of nature-related issues, while the ESRS permits use of the LEAP approach in assessing sustainability of pollution, water, biodiversity, and circular economy.
• Reporting pillars. Both the ESRS and TNFD are shaped around the four disclosure pillars of the TCFD: governance, strategy, risk management, and metrics and targets.
• Recommended metrics. All 14 recommended disclosures in the TCFD framework are reflected in the ESRS.

The detailed mapping table produced by the EFRAG and TNFD in the Report will also aid consideration by EU undertakings of reporting requirements under the Corporate Sustainability Reporting Directive. 

4. EU — Prudential Framework

EBA and ESMA publish discussion paper on review of investment firms' prudential framework

On 3 June 2024, EBA and ESMA published a discussion paper on the potential review of the investment firms prudential framework (Discussion Paper).

The Discussion Paper follows the Commission’s call for advice on 1 February 2023 to the EBA and ESMA for a joint report from both bodies on the Investment Firms Regulation (IFR) and the Investment Firms Directive (IFD) for Markets in Financial Instruments Directive (MiFID) investment firms (together, the Prudential Framework), which have been fully applicable since 26 June 2021.

The Discussion Paper requests stakeholder feedback on the below topics:

• the adequacy of the current requirements of the Prudential Framework;
• an analysis of the existing methodology;
• risks not covered by the Prudential Framework;
• implications of the new EU banking package (the third Capital Requirements Regulations and the sixth Capital Requirements Directive) for the Prudential Framework;
• prudential consolidation and the resulting interaction of the Prudential Framework with requirements applicable to undertakings for collective investment in transferable securities (UCITS) management companies and alternative investment fund managers (AIFMs) providing MiFID services on an ancillary basis;
• an extension of the Prudential Framework to crowdfunding and cryptoasset service providers and the resulting interaction of the Prudential Framework with requirements applicable to investment firms providing cryptoasset services; and
• remuneration of investment firms, UCITS management companies, and AIFMs, including on policies, requirements on variable remuneration, and transparency.

The EBA has also launched a voluntary data collection initiative in parallel to the Discussion Paper in order to assess the impact of any changes made to the Prudential Framework.

Responses to the Discussion Paper are due by 3 September 2024, following which the EBA and ESMA intend to publish a joint report in response to the European Commission’s call for advice.

5. EU — NBFI

ESBR publishes annual NBFI risk monitor

On 13 June 2024, the ESRB published its annual EU NBFI Risk Monitor (Monitor).

Key issues raised in the Monitor are summarised below:

• Cyclical risks and structural vulnerabilities. The Monitor notes that the current economic climate of high interest rates and tighter financial conditions could amplify credit risk, exacerbating loss and/or strains in certain market segments. The Monitor further notes that NBFIs engaged in liquidity transformation, particularly those directly exposed to interest-rate-sensitive sectors such as real estate, will be at greatest risk.
• Leverage and interconnectedness. The Monitor emphasises that excessive leverage is a key vulnerability for NBFIs, increasing systematic risk from counterparty exposures and interconnectedness. Although typically associated with alternative investment funds, high leverage can also build up in UCITS funds; thus risk is capable of materialising in all NBFI segments.
• Ownership structure. The Monitor highlights that the majority of EU fund managers belong to banking groups as opposed to being independent asset managers as more typically seen in the U.S., creating the potential for reputational or step in risks.
• Money market funds (MMFs). With EU-domiciled MMFs being viewed to have a less formidable regulatory framework than UK and U.S. MMFs, the Monitor calls for a comprehensive assessment of EU MMFs to enhance their resilience.
• Private finance growth. Although private finance does not pose a current concern from a systemic risk perspective, this position may change if rapid growth continues.
• Entity- and activity-based monitoring. The Monitor states that the complementary use of both entity- and activity-based monitoring would ensure that all systemic risks are captured, providing a broader understanding of financial stability risks.

6. EU — Trade Settlement

Commission states need for one-day trade settlement

On 25 June 2024, Jennifer Robertson, the Commission’s leader of Financial Market Infrastructures, highlighted the need for the EU to move to a one-day trade settlement cycle to prevent fragmentation of European capital markets at the QED debate on Shortening the Settlement Cycle in Brussels.

In particular, Robertson noted that the recent move of certain jurisdictions, including the U.S., Canada, and Mexico, to a “T+1” regime whilst the EU remains on its two-day settlement cycle would create “very concrete practical issues” for the trading of EU-U.S. dual-listed shares and exchange-traded funds with underlying assets traded in both the EU and the U.S.

Robertson’s comments provide indication of the Commission’s potential direction with reforming the EU’s trade settlement system. ESMA is also expected to release a report on a potential move to T+1 in Q1 2025, which should provide further clarity on the EU’s intended approach.

7. EU – Artificial Intelligence

Commission requests input from finance industry on the use of AI in finance

On 18 June 2024, the Commission launched a targeted consultation to seek input on the use of AI in finance services. The goal of the consultation is to identify the key use cases and the benefits, barriers, and risks related to the development of AI applications in the financial sector and to provide guidance to the financial sector for the implementation of the AI Act.

The AI Act will govern the overall development and use of AI in the EU, which is expected to enter into force in July 2024 (for further information, see our Sidley Update Top 10 Questions on the EU AI Act). Notably, the AI Act will complement the existing financial services legal framework.

The Commission emphasises that the aim of the consultation is “not to lead to policy work that would generate new duplicative requirements in relation to the use of AI by the financial sector, or to new requirements that have the potential to stifle AI innovation.”

The consultation, which is targeted at all financial stakeholders, includes three main parts:

1. general questions on the development of AI;
2. questions related to specific use cases across different finance sectors (including market infrastructure, the securities markets, and asset management); and
3. questions on the AI Act related to use cases that have been identified as “high-risk” (they relate to AI systems used to assess natural persons for creditworthiness and risk assessments).

Stakeholders are invited to respond to the questionnaire by 13 September 2024. Depending on progress made, the Commission will then publish a report on findings and an analysis of the main trends and issues arising with the use of AI applications in financial services.

8. International — Market Outages

IOSCO publishes Market Outages Final Report

On 5 June 2024, IOSCO published its final report on market outages, which notes that market outages can be disruptive on any trading venue (TV) but can be particularly disruptive when they occur on a listing trading venue (LTV). Accordingly, it examines key findings from recent market outages on LTVs in IOSCO jurisdictions and builds upon past IOSCO work on operational resilience and business continuity planning to identify good practices for LTVs that may enhance marketwide resilience in the event of a market outage.

IOSCO has established five good practices aimed at assisting regulators, TVs, and market participants in preparing for/managing future market outages; these are designed to allow for sufficient flexibility for adoption across various trading venues, asset classes, and jurisdictions:

• Outage plans. Establish and publish outage plans — these could include the TV’s communication plan, reopening strategy, arrangements for operating a closing auction, and methodology for providing the market with alternative closing prices.
  
• Communication plans. Implement communication plans, which provide timely communication of the outage to market participants and the general public and regular updates to all market participants on the outage status and recovery pathway thereafter.
  
• Reopening of trading. Communicate reopening of trading information (in a timely and simultaneous manner to all market participants), providing clarity on the status of orders, and ensure an adequate period of notice before the resumption of trading.
  
• Closing auctions/closing prices. Processes and procedures for TVs to follow to operate a closing auction and/or establish alternative closing prices to be published in the outage plan and communicated to all market participants during an outage.
  
• Post-outage plans. Conduct and share with the relevant regulators a lesson-learnt exercise of the market outage and adopt a post-outage plan, with clearly defined timelines and allocation of responsibilities for remediation.

IOSCO notes that given the range of circumstances in which a market outage may occur, it is within the TV’s discretion whether and how to adopt these good practices.