Is it time to diverge as UK regulator mulls post-Brexit asset management?

The UK's Financial Conduct Authority (FCA) has published a discussion paper proposing ways it may change the regulation of UK asset management in the post-Brexit era, explain Jessica Reed, Grania Baird and Andy Peterkin, partners, Farrer & Co. 

This discussion paper is likely to be one of many as the FCA assesses whether it is appropriate to "copy-out" retained European laws, or whether a fundamental rethink of the rules is required. 

The FCA is looking to diverge from European regulation in a number of areas. We examine some of the key areas here:

Regulatory regime for fund managers and portfolio managers

The FCA recognises that the regulatory regime for UK asset management has become overly complex. The rules, which are derived from various EU regulations, such as UCITS, AIFMD and MiFID, involve considerable duplication. The FCA also identifies that different standards apply depending upon whether a firm is a fund operator or a portfolio manager. It asks whether it is appropriate to apply a consistent set of rules to the management of funds and individual portfolios.

Professional funds

The discussion paper gives particular consideration to professional funds. The FCA queries whether the regulations applicable to operators of professional funds are, in fact, overkill, given the sophistication of their investor base. Here the FCA will have its eye on the regulatory burden in the UK versus other fund jurisdictions and will want to ensure that any proposals reflect the Government's commitment to ensuring that the UK is attractive in the international market.

The FCA is considering a range of approaches to change the current regime, such as changing the size threshold at which firms must apply for regulation as a "full-scope UK AIFM" and allowing firms that meet criteria other than their size to use the small-authorised UK AIFM exemption. The FCA is also considering making its expectations of small authorised AIFMs clearer, including introducing minimum standards in areas such as fund valuation, liquidity management and investor disclosure. 

In addition, small-registered AIFMs should take note. The FCA is consulting with the Treasury on this regime and queries whether it remains appropriate. There is a concern that the regime may mislead consumers into thinking that a firm is FCA authorised. The FCA suggests it could require some types of small registered AIFMs to become authorised and remove the registration requirement for others.

Retail funds

The FCA asks whether the UK's retail funds regime needs to be updated. The FCA highlights certain issues with the rules deriving from the UCITS regime and also notes that there are differences between the treatment of UCITS and NURS funds under the current rules. 

The FCA suggests a number of possible changes to the regime, such as removing the boundary between UCITS and NURS funds so all authorised retail funds would be subject to a single set of rules, and rebranding NURS funds as "UCITS plus" so that mainstream retail products would fall under the UCITS label and more complex products would fall under the UCITS plus label. Additionally,

The FCA has recommended creating a new category of "basic" retail funds which would be limited in the types of investments they could make and simplifying certain specific requirements, for example, having more flexible rules for master-feeder fund structures.  

A simplification and rationalisation of the UK retail funds regime that erases the somewhat arbitrary regulatory differences between the rules that apply to different types of retail funds is likely to be welcomed by AFMs. Maintaining product choice is essential, however, and it is good to see the FCA seeking industry views as to whether the boundary between the UCITS and NURS regimes should be kept. 

Liquidity management and asset due diligence for authorised funds
 
The FCA also addresses investor protection and asset due diligence. Unsurprisingly, following the failure of the LF Woodford Equity Income Fund, the FCA is focussing on the requirements for liquidity and stress-testing within authorised funds. The FCA proposes to enshrine ESMA's liquidity stress testing guidelines in the rules and states that it is also considering whether it is appropriate to set out regulatory expectations around investment due diligence for all types of asset management activity. The FCA is also considering whether to impose more rules governing the use of anti-dilution mechanisms. 

Fund investments: Eligible assets and spread rules

The FCA is concerned that the rule which permits UCITS to invest up to 10% of their portfolio into assets that do not meet the eligible markets criteria may be perceived by some asset managers as a general permission to invest part of the fund into a wider range of assets without considering suitability or risk management factors. It is therefore proposing to give guidance on its expectations around the use of the 10% rule. 

When operating authorised funds for retail investors, AFMs are required to achieve a "prudent spread of risk". The fund portfolios themselves are also subject to strict quantitative "spread" rules. The rationale of these spread rules is to prevent a fund being overly exposed to a particular issuer or counterparty. (An example of which is the so-called "5/10/40 rule"). Some stakeholders in the industry have commented that it is possible to achieve a "prudent spread of risk" without such boundaries in place. The FCA indicates that it is currently minded to remove these quantitative boundaries.

Innovation

The FCA is keen to identify opportunities for technological change in the fund industry and to think strategically about longer term trends. It recognises that technology can be a driver of better consumer outcomes and it has asked for stakeholders to respond with any rule changes which would be helpful to enable fund managers to make wider use of technology. 

Tokenisation is also on the agenda. The FCA wishes to understand whether there is an appetite to allow the tokenisation of fund units (i.e. to give fund managers the ability to issue a fund's units to investors as digital tokens.)

The new discussion paper will certainly give UK asset managers a lot to think about. The FCA encourages all stakeholders to provide their feedback before the consultation period closes on 22 May 2023. 

Grania, Jessica and Andy are partners in the financial services practice at Farrer & Co. Grania and Jessica are retail funds specialists with experience in UK authorised funds structures. Andy focuses on the establishment of private funds.