The Financial Conduct Authority (FCA) has promised to “take a tough stance” with wholesale market brokers in pursuit of “necessary and urgent” changes.
In its Dear CEO Letter of 18 April 2019 (Dear CEO Letter), the FCA has put wholesale market broking firms firmly under the regulatory spotlight. The letter explains the FCA’s view of the “key harms”that these firms pose to their clients and markets. The letter also sets out the FCA’s strategy to mitigate the drivers of those harms.
It is clear that brokers can expect to see a considerable increase both in regulatory activity and in enforcement action. Such firms would be well-advised to review their operations at an early stage and take steps to address the concerns raised by the Dear CEO Letter.
The four key “drivers of harm”
The FCA has identified the following four key drivers of harm in this sector:
- Compensation arrangements which link broker remuneration directly to business volume without giving sufficient recognition to long-term or non-financial indicators of performance;
- Governance arrangements under which boards and senior managers lack the necessary tools with which to oversee their staff and business;
- Workflows which fail to recognise that a broker may perform different regulated activities (and/or act in different capacities) at different times; and
- A culture and mindset which underestimates the risk of brokers committing/facilitating market abuse and financial crime.
Focus of supervisory activity
Compensation and incentives
The FCA is currently conducting a survey of around 50 firms regarding compensation and incentives in this sector. According to the Dear CEO Letter, the preliminary findings show “a worrying lack of awareness of obligations around the awarding of remuneration and, in some cases, material non-compliance”.
In particular, the FCA has taken aim at the traditional remuneration model whereby firms make cash payments to individual brokers based on the revenue which those brokers have generated. The FCA says that this model does not allow sufficient scope for firms to adjust remuneration in view of long-term and non-financial performance measures.
The FCA says that it will publish its findings later in the year and will thereafter take “a tough stance with all firms” in pursuit of “necessary and urgent” changes.
Governance and culture
The FCA is concerned that boards are not always able to stand up to brokers.
The FCA notes that individual brokers are often the principal revenue earners in their firms and, as such, have significant negotiating power. The FCA questions whether this undermines firms when dealing with misconduct.
The FCA notes that the Senior Managers and Certification Regime (SM&CR) will take effect in this sector in December 2019. The FCA says that SM&CR will form a key part of the FCA’s strategy for driving change. However, the FCA also says that, in addition to the work undertaken in the context of SM&CR, the FCA expects firms to demonstrate that they are headed by “effective boards operating under appropriate mandates”.
Capacity and conflicts of interest
In the FCA’s view, the sector is “generally weak in identifying the particular capacity it is acting in for a given transaction”. The FCA says that this raises concerns regarding conflicts of interest.
More specifically, the Dear CEO Letter says that the FCA continues to have concerns about brokers “inappropriately charging commission to liquidity providers from whom they source liquidity” (known as “payment for order flow” or PFOF). The FCA says that a review of PFOF will form part of its “ongoing supervisory work”. In this regard firms should note that, on 23 April 2019, the FCA published a report on its supervisory work regarding PFOF. This report says that the FCA expects firms “to consider the findings of this report and improve their practices, policies, systems and controls where necessary to comply with their obligations”. The report also says that the FCA “will continue to prioritise and monitor firms’ compliance on PFOF as part of [its] ongoing firm supervision” and that the FCA “will use all available tools, including potential enforcement action”where it identifies serious breaches of the relevant rules.
Market abuse and financial crime controls
The Dear CEO Letter says that “firms are generally complacent about their responsibilities to monitor for and mitigate market abuse and financial crime risk”. The FCA adds that there is a lack of understanding regarding these responsibilities and an underinvestment in systems and controls that are need to tackle them.
The FCA says that it “will be looking for improved surveillance arrangements (including communication monitoring), and increased resource allocated to this task”. It will also be looking for evidence of senior management engagement in the process of identifying market abuse and financial crime risks.
On the related issue of personal account dealing (PAD), the FCA says that it has found evidence that policies are “poorly designed” and that the volumes of PAD trades being reported are “concerningly low”.
The Dear CEO Letter says that it has previously found “serious deficiencies in resilience and readiness to combat cyber-crime” and adds that it continues to “encourage firms to properly test their IT controls and pursue necessary improvements in all parts of their businesses”.
The FCA expects the senior managers of firms to take responsibility both for ensuring proper Brexit planning and for keeping the FCA “closely informed” of those plans (including the way in which the details of those plans are communicated to clients).
The FCA’s supervision strategy regarding the points raised in the Dear CEO Letter is due to last until March 2021. The FCA says that it will continue to engage with brokerage firms during this period. Given that the FCA has already started much of the relevant work, it is likely that this engagement will start sooner rather than later.
Firms should consider taking defensive action before the FCA knocks on their door.