First published on Thomson Reuters Regulatory Intelligence on 5th January 2023
It has been a year of calamity and upheaval. Number 10 became, in effect, a revolving door, turfing out Liz Truss after only 45 days in office, but not before a mini-budget chaos that induced stress in liability-driven funds and once again brought the spotlight on market-based finance.
The last-ever "Queen's Speech", delivered by the then Prince of Wales, was published in April 2022. This was followed by the Financial Services and Markets Bill 2022-23, which set out the government's vision for UK financial services regulation post-Brexit. The Edinburgh Reforms announced in December 2022 set out measures covering: competitive marketplace promoting effective use of capital; sustainable finance; technology and innovation; and consumers and business. For consumer credit lawyers, the good news was the confirmation of the reform of the unwieldy leviathan that is the UK consumer credit framework. Time will tell whether this amounts to a Big Bang or a damp squib.
In July 2022, the Financial Conduct Authority's (FCA) Consumer Duty also landed. It represents the biggest change to the retail market in a generation and signals material changes to the way in which firms think about conducting their business with retail customers. This was against the backdrop of a continuing cost-of-living crisis that has seen the FCA issue several communications to firms, and the European Securities and Markets Authority (ESMA) issue a statement to investment firms about the impact of inflation in the context of providing investment services to retail clients.
The Russia-Ukraine crisis intensified in February 2022, prompting fears about energy security and adding strain to an already vulnerable commodities sector. UK, EU and international regulators reacted swiftly with a number of statements to financial services firms on everything from the use of the crypto-assets sector to circumvent sanctions, to statements on effective cyber security, as well as liquidity management tools for asset managers. As the turmoil in the markets threatened to become a full-blown financial crisis, the EU and UK responded with energy packages addressing liquidity stress and volatility in markets.
As was the case last year, environmental, social and governance (ESG) remained on the regulatory radar, with the FCA finally publishing its consultation paper on sustainability disclosure requirements (SDR) and investment labels and the EU introducing the Corporate Sustainability Due Diligence Directive. Regulators also stepped up efforts against so-called greenwashing, with the UK Advertising Standards Authority (ASA) clamping down on the practice, and the FCA and the EU inviting discussion on greenwashing.
The expanding reach of Big Tech in financial services also came into sharper focus, with both UK and international regulators indicating that they would take action.
A review of 2022 would be incomplete without mentioning the turmoil in the crypto-assets sector. It was a tricky year, to say the least, but the underlying technology will undoubtedly continue to transform financial services.
What next for the financial services sector? Predictions certainly get no easier as the years go by, but the authors will gaze into the regulatory crystal ball and offer their two cents.
The first Big Tech company will obtain a banking or credit licence, or announce that it is applying for one.
Regulators have noted the increasing digitalisation of financial services and the expanding footprint of Big Tech. Big Tech is defined by the FCA and the Financial Stability Board (FSB) alike as large digital companies with established technology platforms and extensive established customer networks. In November 2022, the FCA issued a discussion paper on Big Techs' forays into financial services. It noted that Big Tech firms have some FCA permissions to carry out business in retail financial services (with some obtaining payments permissions and e#money permissions, as well as consumer credit and insurance permissions). It said that no Big Tech firm yet has permissions to provide products and services in deposits or mortgages, but that there were commercial relationships between Big Tech firms and deposit-taking incumbents.
Big Tech activity in financial services outside of the areas of payments and e-money may therefore increase.
Yet more action on the regulatory hosting model
In December 2021, the FCA and the UK government issued a consultation paper and a call for evidence respectively in relation to the appointed representatives regime. This was in response to concerns that principals were failing to perform adequate due diligence in respect of their appointed representatives, as well a number of scandals involving appointed representatives (most notably the Greensill saga).
Both papers noted the evolution of the regime, from one originally used by self-employed representatives to carry out regulated activities without being authorised, to the present arrangement involving a wider range of models, such as regulatory hosting and a broader range of products and services.
Broadly, the "regulatory hosting" model is one where, rather than undertaking any substantive proportion of the regulated activity itself, the principal oversees the use of its permissions by appointed representatives. It has been observed that in this framework, the principal's appointed representatives are generally all independent, unconnected businesses, in some cases operating in different markets. This is in contrast to more traditional models, where the appointed representative and the principal typically operate in a particular sector.
The government noted that the number of firms providing regulatory hosting services has grown significantly, adding that some principals employed the regulatory hosting model to provide a "regulatory incubator" service. Both the FCA and the government noted that there were harms in relation to the regulatory hosting model. They cited under-investment and a lack of expertise, knowledge and experience in the relevant markets, as well as inherent conflicts of interest in the model (arising from the fact that the regulatory host is reliant on fees paid by the appointed representatives as a main source of income) as reasons for the poor oversight they provided.
The FCA has since published a policy statement containing stricter requirements in relation to oversight provided by principals in respect of appointed representatives. Principals will be required to notify the FCA when they provide regulatory hosting services. At its recent annual public meeting, the FCA noted that the appointed representatives regulatory regime was established by legislation, and that the government had yet to publish a follow-up to its call for evidence.
The FCA commented that its changes to the appointed representatives regime took effect on December 8, 2022, and that it had sent principal firms as 165 request in December 2022. It announced that it would be reviewing data received and confirmed it was considering the regulatory hosting model. It also confirmed that it would take mitigating action where it found evidence of harm, including potential rules changes. It seems we have not heard the last word in this area.
More action from the FCA on consumer credit rating agencies
Credit information provides insight into an individual's financial standing, underpinning lending decisions made by retail lending firms. In 2019, the FCA launched a study on the credit information sector, owing to concerns about the quality of credit information and the extent of consumer engagement and understanding. The FCA has since noted that the cost-of-living crisis is likely to increase demand for credit, adding that this heightens the importance of having an effective credit information sector.
The FCA states that there are five main types of participants in the credit information sector: credit rating agencies; data contributors; credit information users (CIUs); credit information service providers (CISPs); and consumers. It notes that CRAs provide products and services designed to support: verifying identity and reducing fraud; lending and other risk#based decisions; customer account management; and providing information to CISPs.
The FCA noted high concentration in the sector, with almost all credit information supplied by three CRAs. It noted that aspects of the Consumer Credit Act 1974 apply to CRAs, including the statutory process for individuals to dispute credit information and to add a "notice of correction" to credit files. It also noted that CRAs and CISPs performing regulated activities of providing credit references and providing credit information services came within the remit of the FCA.
In November 2022, the FCA issued an interim report and a discussion paper, identifying significant differences in the underlying credit information that the three largest CRAs held on individuals. It argued that better market and consumer outcomes could be achieved through improvements in the reporting of data to CRAs. It called for an open debate on establishing a proportionate regulatory framework to improve the quality of credit information. The regulator also discussed possible measures to reform industry governance arrangements. A final report is due in 2023. There is seemingly more to come in this area, too.
More action from the EU and the UK in relation to open finance
Under open banking, customers consent to third parties accessing their payment account information or making payments on their behalf. Open finance refers to the extension of open banking-like data sharing to a wider range of financial products such as savings, investments, pensions and insurance. In 2021, the FCA published the feedback statement to its call for input on open finance ( FS21/7). It argued that open finance could offer benefits to consumers through improved advice and access to a wider range of financial products and services, but that the risks involved meant that a cautious expansion was needed (involving legislative changes from HM Treasury).
Action from UK regulators in relation to open finance was also urged by the 2021 report of the Kalifa Review into the UK fintech sector. There has been little action from the UK since then.
The EU appears to be moving at a quicker pace. Its Digital Finance Strategy contained details of the European Commission's intention to introduce legislation on a broader "open finance" framework. In May 2022, it issued a consultation on the revised payment services directive and on open finance. In November 2022, a report on open finance was published by a body that is providing expertise to the European Commission in preparation for EU legislative proposals and policy initiatives. These legislative proposals are likely to land in the first half of 2023. Although UK regulators have already got enough on their plate, it is unlikely that they will want to be left significantly behind their EU counterparts in this area.
More regulatory action in relation to investment consultants
Investment consultants offer a number of services to retail and institutional investors (including pension funds and large corporate employers). According to the FCA's interim and final reports on its asset management market study, defined benefit (DB) pension schemes represented the largest client base for investment consultants, receiving advice on investment strategy, asset allocation and choice of fund manager.
The FCA noted that the investment consultancy market was very concentrated. It stated that while larger institutional investors tended to be able to negotiate effectively with asset managers, this was less the case with smaller institutional investors, adding that investment consultants appeared to provide little assistance in this regard. The report argued that not all consultants offered bespoke advice for individual clients and that smaller pension schemes risked getting the same advice that was given to multiple clients and was not tailored to their needs.
The liabilities of DB schemes can be affected by changes in interest rates and inflation. The Bank of England's 2018 Financial Stability Report noted that many pension schemes have been in deficit. It set out how, through the use of liability-driven investment (LDI) strategies employing leverage, pension funds can hedge against interest rate and inflation risk while maintaining exposure to "growth assets". It stated that the most common LDI strategy was to use existing holdings of gilts as collateral to borrow cash, which was then invested in further conventional and inflation-linked gilts.
As the FCA explained in written evidence to the Work and Pensions Committee, larger DB schemes tend to buy into LDI strategies via segregated mandates (or a single client fund), where a portfolio manager executes the investment strategy on the scheme's behalf and to the scheme's instruction. Smaller DB pension schemes tended to invest via a pooled fund structure, where the fund is managed by an alternative investment fund manager approved by the regulator of the fund and managing to a specified investment policy set out in the fund documentation, it said.
The FCA also added that LDI funds and their alternative investment managers are typically based in the European Economic Area (EEA), and that generally only the portfolio manager is based in the UK.
In September 2022, the significant rise in government bond yields caused a significant fall in the net asset value of leveraged LDI funds, creating a need to deleverage either by selling gilts into an illiquid market, or by these funds asking their DB pension fund investors to provide more capital (with pooled LDI funds less able to do this and becoming forced sellers of gilts). The Bank of England was forced to intervene to calm markets.
The aftermath of the LDI crisis has involved UK parliamentary committees drawing evidence and contributions from representatives from the Bank of England, the FCA and the Pensions Regulator (as well as industry figures). Regulators have issued statements on the resilience of LDI portfolios and have advised managers of these funds to consider operational lessons and the importance of client and stakeholder engagement.
One consequence of the crisis may be to bring investment consultants within the regulatory perimeter. In evidence provided to the House of Lords Industry and Regulators Committee, the FCA referred to the recommendation arising out of its asset management study and its 2020/21 perimeter report that the government should consider bringing investment consultants into the FCA's regulation. The regulator noted that it had a "nagging concern about conflicts of interest within the investment consultancy model".
In its December 2022 Financial Stability Report, the FPC provided an overview of the LDI crisis and supported the recommendation to bring investment consultants within FCA regulation. The UK legislative agenda is quite full, but action in this area could take place.
That is what we think readers should look out for in 2023, but how did we fare with last year's predictions?
Prediction 1: The UK's ESG initiatives do not quite take off
We called this one correctly — sort of. The FCA's detail on its SDR proposals was delayed, and consequently it will be some time before these proposals enter into force, and the market. It is undoubtedly true that the EU Sustainable Finance Disclosure Regulation (SFDR) regime has become widely adopted in industry — article 8, article 9 and PAIs are all now standard vernacular — but there has been a backlash recently against the SFDR, with a number of high-profile asset managers "down-grading" their funds due to the legal uncertainty about fund classification.
The question will be whether, despite its failings, the EU SFDR maintains its first-mover advantage once the UK's SDR is launched. We like to think about this as the Betamax versus VHS battle of sustainable labelling regimes. While it is true that the FCA's initiative has not taken off quite as quickly as we thought it might, the EU SFDR is not as entrenched as it was this time last year. We give ourselves a half point for this one.
Prediction 2: Race to the "starting line" for new entrants in the cross-border payments sector
We will give ourselves half a mark on this one. Cross-border payments are currency transactions between people or businesses in different countries. We argued that that the prolonged "digital confinement" experienced by retail and wholesale markets alike, due to numerous lockdowns in 2020 and 2021 respectively, would result in an explosion of new entrants in the cross-border payments sector throughout 2022, as incumbent banks faced stiff competition from new disruptors.
There may not have been an explosion as such, but the Bank of England and international regulators have both opined on the importance of boosting cross-border payments, as well as the challenges. The Bank of England has noted that "growth and revenue expansion is also driving competitive interest in this market", and that "innovative new business models and participants are emerging in response". In October 2022, the FSB issued a report on the progress made in relation to the G20 Roadmap for Enhancing Cross-Border Payments, as well as a report on the FSB's prioritisation plan for promoting cross-border payments.
Prediction 3: We will hear more from the FCA on remuneration rules and overseas MRTs under the IFPR
We have not been right on this one — yet. Last year we noted how the FCA published final rules on disclosure and remuneration and, in particular, material risk-takers (MRTs) under the Investment Firms Prudential Regime (IFPR). We noted that, under the regime, remuneration requirements applied to categories of staff whose professional activities have a material impact on the risk profile of the investment firm or of the assets that it manages.
We noted that many UK firms that are part of international groups have senior overseas decision-makers on their boards or executive committees, to reflect group interests and strategy. We stated that the FCA stunned many in the industry by indicating that it wants such board members/executive committee members to be included as MRTs, and that their whole worldwide remuneration was included in scope of the rules.
We argued that the FCA's position was likely to be unpalatable for many, and predicted that either international groups would have their senior overseas people step down from UK boards and executive committees, or the FCA would need to rethink and review its position/ guidance. There has been little in the way of news concerning this issue, but that does not mean it will not happen. Given that the IFPR regime only came into force in January 2022, it is early days yet and we must continue to watch this space.
Prediction 4: More action from the FCA and the ASA to ban misleading advertising in relation to crypto-assets, high-risk leveraged retail products, and the use of social media and "celebrities" to promote investments
We called this one correctly. We noted the proliferation of advertisements enticing consumers to invest in various crypto-asset offerings. We noted that the marketing of crypto-assets was largely unregulated, meaning that advertisements usually only include the minimal disclosures. We said that crypto-assets, and the risks associated with them, continued to be a concern for the FCA.
In March 2022, the ASA issued an enforcement notice to more than 50 companies advertising cryptocurrencies, warning them to review their advertisements. The ASA had earlier issued online guidance and a statement on crypto-assets announcing that the advertising of crypto-assets was a "red alert" priority issue for the ASA.
In December 2022, the FCA issued a consultation paper on "Introducing a gateway for firms who approve financial promotions" (CP22/27), which confirmed, in effect, that unregulated firms like crypto-asset service providers and unregulated individuals like social media influencers and "finfluencers", etc., would be unable to advertise products and services in the UK unless they could find a firm that could approve their promotions.
This followed a January 2022 response from the government confirming that the promotion of crypto-assets would be brought within the scope of the financial promotion regime.
The FCA also issued its final rules restricting the promotion of high-risk investments to mass-market retail clients in an August 2022 policy statement (PS22/10).
Indeed, this issue is attracting attention from international regulators, with Kim Kardashian getting a slap on the wrists from the U.S. Securities and Exchange Commission (SEC) for failing to disclose compensation received for promoting crypto-assets. In the EU, ESMA issued a warning to consumers about the risks of crypto-assets in March 2022, advising them to be alert to the risks of misleading advertisements (including via social media and influencers).
Prediction 5: Flying close to the sun — greater FCA scrutiny of firms' [ICARUS] ICARA process under the IFPR
We called this one correctly. We noted how investment firms and their groups would be subject to a new prudential regime under the IFPR, and that firms would need to grapple with the longer-lasting impact of the internal capital adequacy and risk assessment process (ICARA).
The ICARA process refers to a firm's internal systems and controls to identify and manage potential material harms that may arise from the operation of its business, and to ensure that its operations can be wound down in an orderly manner. This is also the process for firms to assess whether additional own funds and/or liquid assets need to be held (similar to "Pillar 2" under the old regime).
Since our prediction, the FCA has published a statement regarding the MIF001 and MIF002 reports to remind firms that the requirements under MIFIDPRU 7 (including the ICARA process requirements) have been in force since January 1, 2022. Firms should therefore have been calculating and reporting their threshold requirements, rather than treating the ICARA process as an annual one that only needs to be undertaken when the MIF007 is due.
Overall score: 3/5
Not a bad result, and one we will be sure to aim for next year. On that note, a happy new year to you all. May 2023 bring you less chaos.