The Financial Conduct Authority (FCA) has written a Dear CEO letter outlining some of the risks of harm that alternative investment firms pose to their customers and the markets in which they operate. In doing so, the FCA has set out its regulatory expectations against six supervisory priorities.
Alternative investment firms should consider whether they present the risks the FCA has identified and develop strategies for mitigating them. Firms should also be aware that they may be the subject of an FCA review and/or be asked to take part in one or more pieces of work related to these priorities in the future.
Why has the FCA done this?
The FCA believes that more needs to be done by the asset management sector to ensure that firms deliver on their objectives to protect and grow the capital of their customers and to oversee their investments effectively over the long term. To do this, alternatives firms need to act in their customers’ best interests.
According to the FCA, overall standards of governance, particularly at the level of the regulated entity, generally fall below expectations. Firms that fail to adequately consider the appropriateness of investment products for investors, or do not have robust systems and controls in place, risk harming their investors and open up the market to financial abuse.
Which firms fall within the FCA’s alternatives portfolio?
According to the letter, this comprises FCA-authorised firms that predominately manage alternative investment vehicles (for example, hedge funds or private equity funds) or alternative assets directly, or that advise on these types of investments or investment vehicles.
The FCA recognises that many of the issues are common to the alternatives and traditional asset management sectors, and has therefore published a corresponding Dear CEO letter for asset managers.
What should alternatives firms do?
The FCA has identified the following supervisory priorities, along with the actions firms are expected to take and how the FCA intend to assess their compliance on an ongoing basis:
1. Investor exposure to inappropriate products or levels of investment risk
Firms offering products and managing investments with exposure to alternative assets and strategies should consider the appropriateness or suitability of those investments for their target investors. They can do this, for example, by identifying the client type and investment need; complying with relevant restrictions on marketing to retail investors; and adequately assessing the appropriateness and suitability of the product.
The FCA will review retail investor exposure to alternative investment products offered by alternatives firms. In particular, the FCA will be testing that 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. The FCA want to know whether firms have taken reasonable steps to ensure that investors adequately understand the risks they are exposed to through their investments and are not inappropriately exposed to products that carry risk beyond their risk profiles.
2. Client money and custody asset controls
Firms must follow the rules set out in the Client Assets Sourcebook (CASS) whenever they hold or control client money or safeguard custody assets.
The FCA will test whether firms that have permission to hold client money and safeguard custody assets are exercising those permissions under robust control frameworks to: (i) support the oversight of CASS operations; (ii) maintain adequate books and records; and (iii) operate in a CASS-compliant manner.
3. Market abuse
Firms are expected to ensure their market abuse controls enable them to discharge obligations under the Market Abuse Regulation. Firms must also make sure their controls are sufficiently comprehensive and tailored to their individual business models to effectively mitigate the risks of facilitating market abuse or an occurrence of this within their firm.
The FCA recently assessed the adequacy of market abuse controls in the sector. It visited a number of firms and provided individual feedback. It also sent a questionnaire to a large sample of buy-side firms. The FCA warns that it may conduct similar exercises in the future with other firms.
4. Market integrity and disruption
The FCA expects alternatives firms to 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. Where firms adopt very high-risk investment strategies, particularly where significant leverage is employed, there should be commensurately high-quality risk management controls.
The FCA has reminded firms that it may choose to undertake in-depth assessments of firms’ controls.
5. Financial crime
Alternatives firms should be alert to the risk they could be used to facilitate financial crime and must operate appropriate and proportionate systems and controls to mitigate this risk.
The FCA intends to review firms’ systems and controls to mitigate this risk, paying particular attention to the risks of money laundering and terrorist financing.
During the transition period, the UK and the EU will negotiate the terms of their future relationship. During this time, EU law will continue to apply in the UK and passporting will continue.
The FCA expects firms to consider how the end of the implementation period (which is due to operate until 31 December 2020, but may be extended) will affect them and their customers, and what action they may need to take to be ready for 1 January 2021.