Financial Conduct Authority

The Race to Brexit Has Just Started

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Theresa May has now triggered the UK’s article 50 notification to exit the European Union (“EU”), raising the very real risk of the loss of passporting rights. This could have severe implications for all sectors of the financial services industry, which have evolved around the use of the passport.

Looking to the asset management sector, the loss of passporting rights would prevent EU-domiciled UCITS funds from using UK fund managers. In addition to the operational disruption, the underlying service agreements may not be easily terminated without significant costs. UK-domiciled UCITS funds would be re-classified as alternative investment funds and lose their rights to be marketed to retail consumers across the EU. The affected fund management groups would now need to comply with the Alternative Investment Fund Management Directive, whose provisions are very different to the UCITS Directive. A shift to a new set of regulations is bound to be costly and time-consuming.

Another concern is that UCITS funds are only allowed to invest up to 30% of net asset values in non-UCITS funds. In light of the UK’s third-country status, fund mandates would need to be reviewed and investment strategies adjusted with the potential for further costs and crystallised losses for retail investors.

The potential restructuring driven by a cliff-edge Brexit will fragment the pan-European business model, reduce profits, lead to sub-optimal capital allocation and trapped liquidity. It will also introduce a wider range of potential consumer protection, legal, operational, financial stability and market integrity risks.

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Regulatory Equivalence

Regulatory equivalence has been mooted as a panacea to these problems. Equivalence is an assessment of a third-country’s legal, regulatory and supervisory framework to determine that it is broadly equivalent to the EU’s.

The European Commission is responsible for decisions on equivalence, supported by technical advice from the European Supervisory Authorities. In theory, this should not present any problems for the UK as its currently regulatory framework is derived from the EU’s.

However, equivalence provisions are set out in individual European Directives rather than any overarching provisions. Thus, they are tailored to the specific scope, needs and objectives of a particular Directive. Each Directive sets out a range of conditions and criteria for a jurisdiction to be deemed equivalent. Some of these conditions may concern issues broader than the subject matter of the Directive, such as tax regimes or professional secrecy.

Crucially, a number of Directives contain no equivalence provisions, such as the UCITs Directive. Others limit the scope, such as the Capital Requirements Directive, which offers prudential benefits but would not permit provision of banking services.

Reliance on equivalence provisions is, therefore, sub-optimal because they were developed in a fragmented and piecemeal way. They do not offer the same level of access currently enjoyed and could be revoked at any time. Thus equivalence is the swapping of an enshrined legal right for a privilege that is granted subject to certain conditions with an uncertain tenure.

Despite the scope of provisions being set out in each Directive, the EU may attach additional conditions or requirements to its decision. These could range from:

  • Placing specific conditions or requirements on the third-country;
  • Limiting its scope to specific types of entities, products or services; or
  • Permitting it for a fixed period of time only.

The assessment should theoretically be a technical assessment but political imperatives may intervene. The equivalence provisions were never drafted with the UK in mind. Withdrawal will result in a significant concentration of EU financial activity occurring outside of its jurisdiction that could be a potential threat to its financial stability. The EU would certainly respond by adapting its regulatory framework to ensure that it can control and react to systemic events if this was the case.

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Transitional Arrangements

A new framework will need to be agreed and, in the interim, transitional arrangements will be required. Transitional arrangements provide a bridging period to enable firms to understand future rights and obligations and to plan appropriately. They are normally agreed towards the end of the process when there is clarity about the framework. This would, however, be too late for firms as it takes time to recalibrate business models, novate client contracts or shift operations to new locations.

Assuming a new framework could not be agreed within two years, Brexit-related transitional provisions would serve the twin purpose of maintaining the status quo and facilitating a smooth transition to a new regime. To reduce the uncertainty, the UK government could seek early on in the negotiations some form of pre-emptive or provisional equivalence with the EU. However, any transitional arrangement would need to overcome the political paradox that the purpose of Brexit is to put an end to EU regulation, restrict freedom of movement and extinguish the jurisdiction of the European Court of Justice.

 

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Mar 29, 2017
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The Retirement Planning Landscape

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I was recently interviewed by Nucleus Illuminate’s Jun Merret on the retirement planning landscape. Here were her top questions.

Nucleus Illuminate: Why is everyone talking about pensions?

The pensions freedoms have transformed the pension landscape. According to HMRC figures, more than 770,000 over-55s have taken on average £11,000 out of their pension pots. Between April and June this year, 159,000 people withdrew £1.8 billion, accelerating the trend since their introduction and bringing the total withdrawals to £6.1 billion. We are now in a situation where people are drawing out more from their pensions then being put in to pensions.

From an industry perspective, this creates increased commercial opportunities to widen product range, deliver innovative advisory solutions, deepen relationships with clients and enhance revenue streams.

With the recent Brexit vote, cash equivalent transfer values are at an all time high and we can expect further discussions between advisers and clients on the merits of transfer.

Nucleus Illuminate: Concerns have been raised by a number of people. What are they?

The so-called pension freedoms turn retirement planning on its head. Advice will change from decisions about managing income requirements, preservation of capital and the optimal time to annuitise, to whether a pension should even be used to provide a retirement income. These are legitimate discussions with clients who have a right to an evaluation of and advice on their options.

My view, however, is that this will conflict with the FCA’s stance on pensions. I think they will see pensions primarily as a vehicle to provide retirement income and that people should not put their retirement income at risk if this could lead to hardship when they are no longer working.

There is also the ‘Lamborghini effect’ – where people will choose to access their pension pot to make one-off purchases such as cruises or cars to the detriment of their future retirement income and welfare. This is an example of a person focusing on their immediate cash needs without considering the longer-term implications.

These risks are further amplified by demographic changes. Retirement is no longer a one-off event, with phased retirement becoming increasingly common. The retirement life cycle is changing as we live longer and so it is becoming much more uncertain and unpredictable. Our income requirements are likely to be higher in the earlier, active years but diminish in the later years with lump sum capital required to pay for long-term care or infirmary costs.

So there are a confluence of factors that create complexity and trade-offs when providing advice because of:

Changing income requirements;
Undefined capital needs; and
Uncertain longevity.

Additionally, we are seeing so-called ‘third way’ products designed to manage these uncertainties. The paradox is that, with the proliferation of products, this leads to greater complexity, especially if it is difficult to compare product features, such as charges and guarantees.

As an industry, we need to be very careful that we do not sow the seeds of the next mis-selling scandal.

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Nucleus Illuminate: What do you think the FCA will be concerned about?

The FCA will be primarily concerned with consumer protection and, in particular:

The welfare impact of consumers running out of money in retirement; and
Consumers failing to maximise their retirement income due to poor advice and retirement solutions.
If you speak to most investment professionals, they favour an income drawdown or investment solution as a retirement solution. This is because they believe annuities offer poor value for money. However, in a paper titled “The value for money of annuities and other retirement income strategies in the UK”, the FCA concluded that:

‘For people with average-sized pension pots and low risk appetite, the right annuity purchased on the open market offers good value for money relative to alternative drawdown strategies’

This is based on a measure called ‘money’s worth’. This metric analyses the return of capital from an annuity, taking into account a particular discount rate and certain assumptions on mortality.

Whether or not the FCA’s analysis is correct, we can see that its view is that a pension is primarily to provide retirement income, and annuities should not be overlooked.

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Nucleus Illuminate: You talk about the ‘Lamborghini effect’. Why would consumers take decisions that are not in their longer-term interests?

Consumers suffer from behavioural biases that inhibit rational decision making. Most consumers would strongly object to making a one-off decision to secure a pension through an annuity, especially at the earlier phase of retirement. There is a lot of emotion attached to working for a lifetime to accumulate a fund, only to potentially lose the money on death or not be able to leave it to loved ones.

Other biases include bounded rationality, which is the inability to make decisions if there is too much complexity. The ‘Lamborghini effect’ is an example of present bias, where a disproportionate focus is placed on higher levels of consumption today without considering the impact on future welfare. These all have implications for how you engage and transact with consumers.

So consumer biases need to be taken into account when designing the proposition and advice processes.

Nucleus Illuminate: What sort of discussions are you having with clients?

On a commercial level, the new legislation potentially makes a pension fund an ultra-long term asset with a possible duration of sixty or seventy years – possibly longer if bequeathed to the next generation. This raises three critical issues.

The first is ensuring that firms create a brand that is universally appealing across generations. There are clear differences in how baby boomers and millennials perceive brands and their respective buying behaviour. This requires ambidexterity; firms that are not embracing digital modes of delivery, for example, will struggle to remain relevant.

The second issue is particularly important for owner-managed firms. With the potential for an ultra-long inter-generational relationship, these firms need to convince clients that they will still be in business in fifty or sixty years time. After all, if you were a client, would you want to instruct a firm that may disappear with the principal? The key is a coherent investment philosophy, underpinned by consistent and repeatable investment processes but also ensuring there is a pipeline of future talent and succession planning.

The third issue is that an ultra-long investment horizon requires a re-assessment of the asset allocation and investment portfolio planning process. It may now be entirely appropriate to operate across a wider range of asset classes, including those that are more illiquid and esoteric. With wider asset class coverage, I would suggest a re-think on how to structure existing research capabilities and processes to ensure sufficient depth of expertise and asset class coverage.

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From an advisory perspective, when assessing the right retirement strategy for each client, there really needs to be a clear rationale for discounting the annuity. Even if annuities are poor value for money, they offer a guarantee of income for the client. This should be used as a reference point to assess all potential options available for the client.

A pragmatic approach might be to use the annuity as a risk-free rate of return and a reference point for any deviation from its use. Although not perfect, this will allow all potential benefits, limitations and trade-offs to be identified as part of the assessment of the right solution.

If the retirement strategy is geared towards preservation of the pension, it may make sense for clients to run down directly held assets. A critical factor will, therefore, be the optimisation of tax-efficiency in how non-pension assets are realised. This will necessitate greater integration of financial planning skills and investment management, creating even more opportunities to deepen client relationships. My prediction is that we will move from the all encompassing one adviser-servicing model to teams of specialists surrounding the client to deliver these solutions.

A real concern across the industry is the suitability risk. One of the ways to manage this complexity is client segmentation. Segmentation can help identify associated client segments and solutions. For example, clients with substantial defined benefit pensions or buy-to-let properties will have different attitudes and needs from those who are more reliant on money-purchase scheme pots. So the advisory model and potential range of solutions are different. Proper client segmentation allows the design of effective and scalable propositions to suit particular segments.

With all this in mind, one consumer bias to be aware of is ‘framing’. This is influencing a client’s choices through the way information is presented. Studies have shown that framing the retirement decision as a decision about securing current and future consumption rather than accumulating or preserving wealth results in a preference for annuities. Understanding this concept is particularly important where a firm’s business model revolves around growing assets under supervision.

Originally published on 13th September 2016 at https://illuminate.nucleusfinancial.com

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Oct 02, 2016
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As the Brexit Dust Begins to Settle…

 

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The EU referendum was a historic moment for the United Kingdom (“UK”), heralding a new relationship with the European Union (“EU”). Questions remain as to what the mantra ‘Brexit means Brexit’ actually means. Ultimately, it will boil down to a question of trade-offs between control on immigration and access to the single market.

Whilst this plays out at the political level, what are the implications and potential impacts for UK financial services firms in the event of a Brexit entailing no access to the single market?

Cross-border matters

The loss of the passport has received the most media attention. In my own experience, the passporting system is far from perfect but its removal will impair cross-border business. With Brexit, the UK will become a third member state and firms wishing to undertake cross-border business will need to establish separately capitalised and authorised legal entities within another EU State. This will introduce further costs and create additional complexity.

UCIT funds will also be impacted. The UCITs Directive currently permits fund managers and fund administrators to be located in a different EEA state to where the fund is domiciled. If this arrangement ceased, UCITs funds with UK managers and administrators would need to be restructured and / or re-domiciled. This would reduce the scale economies from operating on a pan-European basis and will feed through into costs, profitability and fund charges.

EU-domiciled UCITs funds would also lose their right to be distributed in the UK and, therefore, be re-classified as unregulated or alternative funds. Current regulations prohibit sale and marketing of these funds unless an exemption applies. In reality, one would expect the FCA to introduce some form of recognition and / or grandfathering to ensure continuity for investment advisers and clients.

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Squaring the cross-border circle

Regulatory equivalence has been mooted as a potential solution for UK firms wishing to operate on a cross-border basis. Regulatory equivalence would permit the UK to access the single market if it can demonstrate equivalent regulatory standards with the EU. As the UK has been operating to these standards already, this should be entirely feasible.

However, in practice, this may be onerous because requests for equivalence require vetting by the relevant European Regulatory Authorities and subsequently by the European Commission.

One of the key problems is that there is no time-scale for this process to be completed. Equivalence also has an uncertain tenor because it could easily be revoked if, for example, the UK’s regulatory framework begins to diverge from the EU’s in the future. A decision to dilute the remuneration code, for example, could trigger such a move.

A corporate structure called a Societas Europae (“SE”) could be the solution. A SE is a company registered in accordance with the law and corporate governance standards of the EU. It enables the transfer of registered offices across member states. With the UK currently a member of the EU, conversion to a SE would allow transfer of the company to a new EU state. However, this is still not a simple task as full authorisation would be required in the new EU state. Additionally, sales and back-office staff will also need to migrate to avoid tripping the EU regulatory perimeter, adding a human capital dimension to the issue.

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Conduct of Business and Consumer Protection

With a full withdrawal from the single market, could this open up opportunities to reduce the regulatory burden and simplify the conduct of business rules?

The FCA’s conduct of business rules are predominantly derived from its consumer protection objective. The rules are designed to encourage good business practice, promote good governance and improve the ability of consumers to make buying decisions. It is difficult to envisage the FCA concluding that withdrawal from the EU means that consumers now need less protection. At the 2016 FCA annual public meeting, Andrew Bailey stated, “We don’t expect to be distracted from our regulatory obligations, our objectives will not change and, as such, no one should expect a bonfire of regulation”.

One of the factors hampering simplification is the interplay between EU law and regulation and our own. EU directives are transposed into UK law whereas EU regulations are implemented without transposition. With Brexit, EU directives will remain in place whilst EU regulations will fall away. Consequently, there will need to be substantive reviews of the existing regulatory framework to minimise disruption and ensure continuity as highlighted with the example of UCITs. This is a substantial undertaking unlikely to confer any net new benefits to either the FCA’s consumer protection objective or firms.

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What next?

Until we know what “Brexit means Brexit” actually means, it is still too early to predict the precise impact for firms and it is important to note that there will be a reciprocal impact on EU firms passporting into the UK.

For those operating on a cross-border basis, the uncertainty will be too great and they will re-locate or change existing business models. For other firms without this impetus, they should start evaluating different operating models and explore EU states to operate from – an analysis that will need to consider a much broader set of factors such as labour laws and tax regimes.

For domestically-focused firms, the regulatory framework remains the same. Current and future EU regulations must be adhered to and, in the event of Brexit-driven changes, one would expect a transitional period before the new framework comes into force.

Whatever the outcome of the negotiations and whoever are the winners and losers from Brexit, we can see the path ahead will be littered with both uncertainty and challenging decisions.

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Written by Esrar Moitra

 

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Sep 24, 2016
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Regulating Culture Through the Senior Managers’ Regime?

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Regulating Culture Through the Senior Managers’ Regime?

Is it any surprise that, after a bailout of the banking sector in excess of £500 billion and banning only one bank director, the regulators have revamped its approach to accountability and responsibility through the Senior Managers’ Regime? The measures will be introduced in March 2016 with proposals to extend this to the rest of the industry by 2018.

Overview of the Regime

The regime has three parts. The first part, called the Senior Managers’ Regime, covers the Board and certain non-executive directors, the Executive Committee and other roles with particular responsibilities. These roles require regulatory pre-approval. Firms will have to allocate ‘prescribed responsibilities’ to named individuals. This will have an extra-territorial jurisdiction and each individual will have to sign a statement of responsibility detailing the scope and nature of those responsibilities.

Additionally, firms will need to map out those responsibilities to ensure that there are no gaps. These documents will also need to be updated with personnel and business model changes. The aim is to ensure that, whatever governance or committee structures are in place, there is a person accountable to the regulators who sit in positions exercising significant control and influence over the firm’s strategy, risk-profile, resources or control infrastructure.

The second aspect is the Certification Regime. This is for individuals performing ‘material risk-taking’ or ‘customer harm’ roles. Regulatory pre approval is not required but firms must undertake their own ‘fit and proper’ test. In effect, firms are stepping into the shoes of the regulator. These roles will be certified annually and certain roles that were not previously approved will now be subject to certification.

The third aspect is the conduct rules. These place conduct standards upon all other staff. Firms are also under an obligation to report any suspected breaches of rules to the regulator(s) within 7 days or 90 days dependent upon category of staff.

Challenges

The first challenge will be the allocation of prescribed responsibilities. With complex and internationally diverse organsiations, they are likely to sit across different job roles, different functions or different geographies. The aim is to trigger changes to organisational structure, reporting lines, governance and MI to enhance the integrity of individual legal entity governance. With the increased personal responsibility and accountability for senior managers, this will create a bullwhip effect further down the organisation as they seek to re-align recruitment, performance management and reward with these new responsibilities and accountabilities.

With the certification and conduct elements there will be increased evidential, monitoring and reporting burdens. With the requirement for annual certification, this raises some interesting dilemmas:

  • If deemed non-competent, should an individual still be allowed to continue in their role?
  • If not, would an individual line-manager be conflicted when making this assessment?
  • Should this trigger review and potential remediation of historical transactions?

The new conduct standards will need to be embedded into role descriptions, objectives and trained out. Each individual will need to understand their conduct-related obligations and what good conduct looks like for their specific role. Firms will need to define the appropriate role-specific behaviours and ensure the correct operational policies, processes and controls are in place to harness those behaviours.

Unpack this regulation and you can see that it is as much a cultural intervention as initiating structural change.

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Cultural Dimension

The cultural dimension is designed to make every employee a ‘conduct-leader’ who understands how to navigate the complex, sometimes conflicting decisions and judgements they will encounter. In our view, there are three overarching cultural elements that support successful implementation of this regime.

The first relates to the firm’s values and the extent to which they align with the FCA’s code of conduct. If the underlying values and beliefs are incongruent, irrespective of ‘robust’ systems and controls, this will drive the wrong judgements, decisions and behaviours.

The second is the ‘people’ lever; bringing in the right people and ensuring the right behaviours are driven, but crucially, ensuring there are consequences for poor conduct-leadership.

The third element is a strong change management capability. A strong conduct-culture is characterised as a learning organisation that learns from its mistakes and makes necessary changes to ensure they do not re-occur across the whole business.

In Summary

The introduction of the Senior Managers’ Regime is the regulators’ mea-culpa and squarely places accountability for managing, governing and controlling the business in the hands of senior management. Whilst much debate has centred on the tangible artefacts of the regime, such as governance, reporting lines, systems, process and controls, without the right cultural framework, conduct-risk will crystallise. Next time, however, it won’t be just shareholders and customers who will suffer as a result.

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Written by
Esrar Moitra

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Dec 17, 2015
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