A compact summary of the most recent regulatory developments relevant to the UK asset management industry. This issue includes details of an FCA report on algorithmic trading; the publication of the FSMA (Benchmarks) Regulations 2018; an update on compliance with the new data protection regulation; EMIR equivalence; recommendations on leverage and liquidity in investment funds; updated MiFID II transparency Q&As; a consultation on retail OTC leveraged products and the launch by ESMA of an interactive single rulebook.
ALGORITHMIC TRADING: FCA report
The Financial Conduct Authority (FCA) has published a report entitled “Algorithmic Trading Compliance in Wholesale Markets”.
Based on a number of cross-firm reviews, the report includes examples of good and poor practices.
The FCA has identified five key areas of focus:
- Defining algorithmic trading: firms must establish an appropriate process to identify algorithmic trading, manage ‘material changes’ and maintain a comprehensive inventory of algorithmic trading across the business.
- Development and testing: firms must maintain robust, consistent and well understood development and testing processes which identify potential issues across trading algorithms prior to full deployment.
- Risk controls: firms must develop suitable and robust pre- and post-trade controls to monitor, identify and reduce potential trading risks across algorithmic trading activity.
- Governance and oversight: firms must maintain an appropriate governance and oversight framework that demonstrates effective challenge from senior management, risk management and compliance.
- Market conduct: firms must consider the potential impact of their algorithmic trading on market integrity, and must monitor for potential conduct issues and reduce market abuse risks.
The FCA will continue to assess whether firms have taken sufficient steps to reduce risks arising from algorithmic trading. The Prudential Regulatory Authority (PRA) has also issued a consultation paper setting out expectations for the prudential aspects of risk management and governance of algorithmic trading at PRA regulated firms.
BENCHMARKS: FSMA (Benchmarks) Regulations 2018 published
HM Treasury has published the FSMA (Benchmarks) Regulations 2018 (UK Regulations) which relates to the UK implementation of the EU Benchmarks Regulation. They add a new regulated activity of administering a benchmark and insert a new article into the FSMA RAO making administering a benchmark a specified activity. This will be the only regulated activity relating to benchmarks as the existing transitional provisions concerning benchmarks in the RAO will be revoked.
The UK Regulations permit the FCA to exercise powers over persons who are involved in the provision of a benchmark but are not benchmark administrators as defined in the EU Benchmarks Regulation. They also give the FCA the power impose requirements on persons requiring them to administer or contribute to a benchmark and make provision for the FCA to regulate benchmark administrators, including the recognition of third country administrators. They amend other secondary legislation, including the FSMA (Exemption) Order 2001 to reflect the Benchmarks Regulation; and make a minor amendment to FSMA relating to the implementation of the Cyber-security Directive.
The UK Regulations have been laid before Parliament but are not yet in force.
DATA PROTECTION: FCA and ICO publish a joint update on GDPR
The EU General Data Protection Regulation (GDPR) comes into force in the UK from 25 May 2018. It will be regulated and enforced by the Information Commissioner’s Office (ICO). Complying with some of the FCA’s rules means that firms need to process personal data which brings them into scope of the GDPR. The FCA has published a statement to the effect that the GDPR does not impose requirements that are incompatible with the FCA’s rules as set out in the Handbook. The FCA says that compliance with the GDPR is now a board level responsibility and firms must be able to produce evidence to demonstrate the steps they have taken to comply. As part of their obligations under the Senior Management Arrangements, Systems and Controls module of the Handbook, firms should establish, maintain and improve appropriate technology and cyber resilience systems and controls.
The FCA and the ICO are working closely together to prepare for the GDPR and the ICO is providing tailored input to the FCA’s Innovation Hub.
EMIR: equivalence and intragroup exemptions
The FCA has updated its EMIR webpage with information about the October 2017 European Commission (Commission) equivalence decision for derivatives in the US. The decision means that technically the temporary intragroup exemptions granted by the FCA for trades between UK and US firms expire on 2 March 2018. However the positive equivalence determination allows firms to apply for exemptions with no expiry date. The FCA has decided that UK firms who currently benefit from the derogation under the Margin RTS with US group entities covered by the equivalence decision must notify it of the entity pairs to which the equivalence decision applies and confirm whether there have been any other changes to the conditions under which the original intragroup derogation was granted.
LIQUIDITY: ESRB recommendation on leverage and liquidity in investment funds
The European Systemic Risk Board (ESRB) has published a recommendation on liquidity and leverage risks in investment funds.
The ESRB raises concerns that increased financial intermediation by investment funds may result in the amplification of any future financial crisis. This is because mismatches between the liquidity of funds' assets and their redemption profiles may result in "fire sales" in times of market stress. Such sales could adversely affect other financial market participants that own the same or correlated assets.
The document is addressed to the European Securities and Markets Authority (ESMA) and the Commission and includes the following recommendations:
- The Commission should develop legislation that sets out a legal framework governing liquidity management tools in the design of investment funds.
- The Commission should develop legislation that includes measures to limit the extent to which the use of liquidity transformation in open-ended alternative investment funds (AIFs) can contribute to the build-up of systemic risks or the risk of disorderly markets.
- ESMA should develop guidance for managers of AIFs and UCITS for the stress testing of liquidity risk for individual funds.
- The Commission should develop legislation that requires reporting of UCITS liquidity risk and leverage data to national competent authorities.
- ESMA should provide guidance on Article 25 of the Alternative Investment Fund Managers Directive (AIFMD), including guidance on the framework to assess the extent to which use of leverage within the AIF sector contributes to systemic risk, and on macroprudential leverage limits.
Annex 1 to the recommendation contains compliance criteria for the recommendation, and annex 2 contains the economic assessment.
Section 2.3 of the recommendation contains a timeline, with suggested dates in 2019 and 2020.
MiFID II: ESMA updates Q&As on transparency
ESMA has updated its Q&A on transparency issues under the Market in Financial Instruments Directive (MIFID II) and the Markets in Financial Instruments Regulation (MiFIR). The updated Q&A outlines the scenarios in which, in ESMA’s view, an investment firm can pre-arrange or negotiate a trade that is subsequently executed on a trading venue. The Q&A specifically addresses the treatment of trades subject to the derivatives trading obligation.
OTC LEVERAGED PRODUCTS: IOSCO consultation
IOSCO has issued a consultation paper on retail OTC leveraged products following its December 2016 report which identified various risks to retail investors being offered and sold these products. The report highlights various regulatory approaches to enhance the protection of retail investors and covers the offer and sale by intermediaries of rolling spot forex contracts, contracts for differences and binary options.
IOSCO is proposing a series of measures including:
- A licensing requirement for all firms that sell the relevant products to retail investors either domestically or on a cross-border basis.
- Leverage limits and minimum margin requirements.
- Enhanced disclosure of costs and charges.
- Improved disclosure of risks, including profit and loss ratios.
- Restrictions on the sale, distribution and marketing of the products with a view to addressing miss-selling risk.
The deadline for responses to the consultation is 27 March 2018.
REGULATION: ESMA launches interactive single rulebook
ESMA has launched an interactive single rulebook. This is a new service for market participants and other interested stakeholders to facilitate the consistent application of the EU single rulebook for securities markets.
As it stands currently, the rulebook contains the level 1 text of the UCITS Directive with links to all relevant level 2 and level 3 measures.
ESMA plans to provide an interactive version for each key level 1 text under its remit. The next texts to be given this treatment will be the Credit Rating Agencies Regulation and MiFID II/MiFIR.