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Regulation in 2014

Ashley Kovas, Head of Funds

Bovill Limited

Q1 2014

The changing regulatory regime

The regulatory regime for financial services firms has changed substantially over the last few years as governments worldwide have sought to make structural changes to mitigate the risk of future financial crises developing. In the UK, 2013 saw the splitting off from the Financial Services Authority of its prudential responsibilities for banking and insurance with the remainder of the old FSA forming the new Financial Conduct Authority (FCA).  The FCA has a single strategic objective – to ensure that the financial markets function well.  In addition, the FCA has operational objectives:

  • Consumer protection
  • Integrity
  • Competition

The FCA will be assessed and will assess itself on its success in meeting its objectives. The ‘Integrity’ objective implies greater emphasis on the behaviour of individuals as well as that of firms. The ‘Competition’ objective implies a focus on business models, price and profitability. The ‘Consumer protection’ objective is not new and was also an FSA objective. However, the objectives as a package could affect the way in which the FCA approaches consumer protection. For example, realisation that consumers do not necessarily behave in the self-serving manner expected by classical economic theory may affect the extent to which the FCA will be prepared to rely on disclosure as a regulatory tool – indeed we already know that this is how the FCA is thinking. In addition, the FCA is taking forward the FSA’s intrusive and interventionist approach, where supervisors will be making judgements on the judgements of firms’ senior management. Given this style of regulation, together with the regulatory changes expected to affect asset managers, hedge fund managers need to stay abreast of four key regulatory areas as 2014 develops.

  1. Focus on the individual

The FCA understands that the behaviour of firms is driven by the actions of individuals within the firm. This may seem obvious and indeed it is, but historically in the UK (and elsewhere) the approach of financial regulators has been directed at firm behaviour, with regulatory sanctions being aimed at the firm rather than the individual. The FSA was criticised significantly for not taking action against individuals in the wake of the financial crisis. The expectation of society is that individuals will be held to account and in the future we can expect that to happen. The new Financial Services (Banking Reform) Act 2013 makes it an offence for a senior manager to make decisions that lead to the failure of at least part of the firm’s business. Although these provisions are likely to be enforced most readily against banks and other substantial institutions, the wording of the provisions means they can, in theory, apply to any firm.

Notwithstanding the 2013 Act, the FCA has already begun asking firms to make “attestations” in certain circumstances. An attestation effectively requires an approved person of the institution to attest to the truth of a particular statement – in effect, to promise that his firm is in compliance with some aspect of the regulatory regime. Requiring such attestations must inevitably be linked to the possibility of future regulatory action if the firm is not compliant, so the personal risk for the person attesting is reasonably high. The difficulty for the person making the attestation is that, in large and complex institutions, it may not be possible for that person to be fully confident of the state of affairs, at least without relying on the work of others. This suggests that attention needs to be paid to the gathering of evidence within the firm to support any attestations made. It is also necessary to look at reporting lines to see whether the person making the attestation can rely on promises made by others in his firm.

Given the increasing focus on the individual, all approved persons in the firm should be made aware of the nature of their obligations as such, together with the consequences of failing to meet the required standard. It is particularly important that firms take appropriate steps to ensure that persons making attestations are fully aware of the liabilities that attach to them for doing so and that there is a proper system of support to ensure that attestations are truthful.

  1. Conduct risk

Traditionally, compliance monitoring has been about determining whether the firm has breached the regulatory rules. The financial crisis has shown that firms were not sufficiently forward-looking in assessing the risks that their businesses were facing in the markets. Merely reactive compliance monitoring is not enough because all it tells you is whether you breached the rules at some point in the past. Whilst this is important, what might happen in the future is equally so; the financial crisis might have been avoided or mitigated had firms been looking forward rather than backwards. Firms need to develop a methodology to assess the potential risks to their operations; where these relate to regulatory risks this amounts to conduct risk. Conduct risk is similar to operational risk, but goes wider in that crystallisation of the risk may be damaging fundamentally to consumers or the market more generally rather than or in addition to the firm. Operational risks on the other hand tend to be risks to the firm itself. 

Larger firms are already being quizzed on the nature of the risks they face, including conduct risks.  Given the FCA’s intention to challenge firms’ business models and strategies, firms must be in a position to show that risks have been identified and considered. If they do not, they may find themselves in an uncomfortable position with regulatory challenge delaying the implementation of strategy whilst the risk implications are sorted out. A robust system for the identification, measurement, mitigation and monitoring of conduct risk is needed, particularly for larger firms. This is of course additional to the usual risk management disciplines: Operational Risk, Market Risk and the like.

  1. EMIR

The European Market Infrastructure Regulation (EMIR) came into force on 16 August 2012 and the first EMIR reporting date was 12 February 2014. EMIR represents the EU’s implementation of the G20’s efforts, in response to the financial crisis, to address systemic risk associated with the derivatives market.

EMIR requires any derivative contract that is concluded, modified or terminated to be reported to a trade repository.  Reporting must be done by the close of the business day following the transaction. Trades outstanding on 16 August 2012 and which were still outstanding on 12 February 2014 had to be reported within 90 days of the reporting start date.  There is a three-year period during which relevant trades that have matured since 16 August 2012 will need to be reported.  EMIR captures both OTC and exchange-traded derivatives (though OTC contracts are only caught for the clearing requirements).

  1. AIFMD

The Alternative Investment Fund Managers Directive (AIFMD) is now in force, although transitional provisions apply until July 2014. Just before Christmas 2013, the Treasury announced that it was to abolish the original January 2014 deadline by which time managers were required to submit their Variation of Permission to the FCA. Instead it will suffice for a manager to submit the application for Variation by 22 July 2014. Managers will need to comply with the AIFMD regime from that date but may carry on managing AIFs unless the FCA later decides not to grant the Variation.

The FCA is likely to do some form of thematic work in H2 2014 or possibly early 2015 to look at compliance with the Directive. AIF Managers will have put in place a series of policies and procedures and the regulator will want to see that they are working in practice.  The Risk Management Policy is likely to be tested, as are those on Liquidity Management and Conflicts of Interest.  Although many firms are currently working to ensure they will have the necessary permissions to continue to manage AIFs after July 2014, prospective AIFMs also need to consider how they will comply with the Directive’s ongoing requirements, particularly those involving reporting to regulators.


So the to-do list for 2014 might include some thought about the following:

  • Do you understand the obligations of “approved person” status?  The expected standard of behaviour has probably not changed significantly, but the regulators are increasingly looking to discipline individuals where things go wrong.  Are your systems and governance arrangements in the right place to support employees, particularly senior employees?
  • If you are asked for an attestation by the FCA, will you have in place the necessary controls to make such an attestation in a way that minimises the risk to the person(s) attesting?
  • Have you considered the risks affecting your business, particularly your Conduct risks?  Is risk identification a part of your business strategy development process?
  • Are you ready for EMIR?  If not, what urgent steps are you taking?
  • Have you considered your position under AIFMD?  Getting your Variation of Permission application into the FCA by 22 July 2014 is important, but it is also important to make sure that you can actually comply with the Directive from that date.

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