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FCA Fires Warning Shot to Brokers in Wholesale Markets

Latham & Watkins LLP

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European Union, United Kingdom April 30 2019

Latham & Watkins operates worldwide as a limited liability partnership organized under the laws of the State of Delaware (USA) with affiliated limited liability partnerships conducting the practice in France, Hong Kong, Italy, Singapore, and the United Kingdom and as an affiliated partnership conducting the practice in Japan. Latham & Watkins operates in South Korea as a Foreign Legal Consultant Office. Latham & Watkins works in cooperation with the Law Office of Salman M. Al-Sudairi in the Kingdom of Saudi Arabia. Under New York’s Code of Professional Responsibility, portions of this communication contain attorney advertising. Prior results do not guarantee a similar outcome. Results depend upon a variety of factors unique to each representation. Please direct all inquiries regarding our conduct under New York’s Disciplinary Rules to Latham & Watkins LLP, 885 Third Avenue, New York, NY 10022-4834, Phone: +1.212.906.1200. © Copyright 2019 Latham & Watkins. All Rights Reserved.

Latham & Watkins Financial Regulatory Practice 30 April 2019 | Number 2494

FCA Fires Warning Shot to Brokers in Wholesale Markets Latest Dear CEO letter from the regulator includes strong criticism and warns that firms need to improve to meet regulatory expectations.

Key Points: • FCA supervisory work during the next two years will focus on four key areas that the FCA

considers require urgent attention. • Firms should review the FCA’s concerns carefully and take action now to address any areas in

which they may not be meeting regulatory expectations.

The FCA has sent a Dear CEO letter to wholesale market broking firms, which strongly criticises relevant firms and their practices. The letter is not entirely clear as to whether it applies to wholesale brokers only, or all brokers operating in wholesale markets, but the issues are relevant to both and so should be taken into account by all firms in the sector. Although Dear CEO letters typically are critical in nature, in this instance the FCA uses particularly strong language to convey its dissatisfaction with firms in the sector, and therefore brokers operating in wholesale markets should ensure that they respond accordingly.

The FCA observes that it continues to see a “complacent attitudeâ€, and a failure to meet expectations across all areas of regulation the FCA has examined recently. In the FCA’s view, brokers in wholesale markets have made less progress than other sectors in embedding a culture of good conduct, and so action to raise standards across the sector has become “urgentâ€. The FCA considers that brokers have not kept pace with, and have under-invested in, the new requirements under MiFID II and MAR. In particular, the FCA notes that supervisory intervention, rather than firms’ own initiative, has more often been the driver for recent improvements in compliance resourcing and systems and controls.

The letter was swiftly followed by a further publication on payment for order flow (PFOF), reporting on the FCA’s recent supervisory work in this area. The report’s findings are relevant to some of the concerns expressed in the letter, as discussed below.

What Issues Did the FCA Find? The FCA explains that it has found four key drivers of harm, and that its supervisory strategy over the next two years will focus on these four areas.

Compensation and incentives The FCA pinpoints poor and outdated remuneration models as a root cause of misconduct risk in this sector. In particular, the common “eat what you kill†remuneration model allows little or no room for firms to adjust compensation for non-financial performance measures, or to assess those measures in a fair and objective way.

The FCA is currently reviewing market practices in a survey of around 50 firms in the sector. According to the FCA, findings so far show a worrying lack of awareness of obligations around the awarding of remuneration and, in some cases, material non-compliance. The FCA plans to publish its findings later in 2019, and states that it will take a tough stance with firms in future.

Governance and culture Due to the brokerage business model and the power of individual brokers within broking firms, the FCA considers that wholesale brokers should have strong governance frameworks and should be headed by effective boards. The FCA believes that the SMCR will form a key driver for change, and the regulator will work with firms to ensure that they implement the regime effectively.

Capacity and conflicts of interest The FCA considers that firms generally are weak in identifying the particular capacity they are acting in for a given transaction. As a result, firms often do not ensure the necessary arrangements are in place to identify and address conflicts of interest. This issue is explored further in the FCA’s report on PFOF, which explains how firms have applied the rules inconsistently and sets out the FCA’s expectations.

The FCA stresses that it expects firms to implement the necessary systems and controls to enable themselves to identify, and apply the appropriate safeguards to, the particular service they are providing at a given time. The FCA highlights that, following the publication of its report on PFOF, it expects firms to be fully compliant in this area and will consider appropriate interventions if it identifies individual cases of continuing non-compliance.

Market abuse and financial crime controls The FCA describes firms as being “complacent†about their responsibilities to monitor and mitigate market abuse and financial crime risk. Firms have demonstrated both a lack of understanding of these responsibilities and underinvestment in systems and controls, including surveillance systems and training. The FCA stresses the heightened risk of market abuse within wholesale broking, and expects firms to improve surveillance arrangements and senior management engagement.

The FCA has recently examined personal account dealing at a number of broking firms, noting poorly designed policies that do not meet FCA requirements, and worryingly low levels of personal account trades being reported. The FCA will be publishing findings of this work later in the year, and will be following up with individual firms at which the FCA has identified shortcomings.

Other considerations The FCA also highlights the importance of technology, and states that it will continue to encourage firms to test their IT controls and pursue necessary improvements. In particular, the FCA has identified serious deficiencies in firms’ operational resilience and in their preparedness to combat cybercrime.

Latham & Watkins 30 April 2019 | Number 2494 | Page 3

Further, the FCA expects senior managers to take responsibility for ensuring the firm’s Brexit planning will allow it to act in the best interests of clients, and in line with regulatory requirements, in all possible Brexit scenarios. Firms need to keep the FCA closely informed of their plans.

What Next? The FCA asks CEOs to consider and discuss the letter with their management board, in particular, how the issues the FCA has identified apply to their business. Firms should take steps to mitigate any issues that apply. The FCA will be engaging with firms in the sector during the next two years and implementing its supervisory strategy to effect change. The FCA plans to write to wholesale brokers again after March 2021 to communicate its updated views and to provide an updated supervisory strategy.

The FCA has also indicated in its Business Plan for 2019/20 that it will focus on the control of inside information within corporate broking functions, and that its MiFID supervisory work will continue to concentrate on conflicts of interest in wholesale markets. These workstreams tie in with issues highlighted in the FCA’s letter.

Although the FCA’s supervisory strategy spans two years, firms need to be thinking about the issues raised and promptly correcting any areas that do not meet regulatory expectations. Firms should also reflect on the fact that the FCA uses the word “urgent†more than once in the Dear CEO letter.

The checklist overleaf outlines key topics and actions that firms could consider and address in order to meet FCA expectations.

Latham & Watkins 30 April 2019 | Number 2494 | Page 4

Topic Action Complete?

Compensation and incentives

Review remuneration practices against the rules, and consider whether awards adequately take non-financial performance elements into account

Look out for the FCA’s findings from its review of remuneration, and ensure any issues that apply to the firm are addressed promptly

Governance and culture

Evaluate any conduct and culture initiatives within the firm, and consider whether these initiatives are having the right impact

Consider how misconduct is addressed within the firm (including non- financial misconduct)

Review board composition and effectiveness

Consider SMCR implementation planning and ensure this is on track

Capacity and conflicts of interest

Ensure appropriate arrangements are in place to identify the capacity in which the firm is acting, and address conflicts of interest accordingly

Review the FCA’s report on PFOF and ensure the firm is meeting the FCA’s expectations

Market abuse and financial crime controls

Review surveillance arrangements and consider whether these are fit for purpose, and how they could be improved

Review procedures for handling and controlling access to confidential and inside information

Ensure staff are appropriately trained and understand the risks and their obligations in relation to financial crime

Look out for the FCA’s findings from its review of personal account dealing, and ensure any issues that apply to the firm are addressed promptly

IT Review recent investment in IT systems and consider whether improvements are needed

Test IT controls to check resilience and ability to deal with potential cyber-related incidents

Brexit Consider how Brexit planning will ensure fair treatment of customers and compliance with relevant regulatory obligations

Ensure that the FCA has been informed of the firm’s Brexit plans

Latham & Watkins 30 April 2019 | Number 2494 | Page 5

If you have questions about this Client Alert, please contact one of the authors listed below or the Latham lawyer with whom you normally consult:

David Berman [email protected] +44.20.7710.3080 London

Stuart Davis [email protected] +44.20.7710.1821 London

Sam Maxson [email protected] +44.20.7710.1823 London

Kishore Bhindi [email protected] +44.20.7710.4785 London

Carl Fernandes [email protected] +44.20.7710.4777 London

Ella McGinn [email protected] +44.20.7710.4649 London

Brett Carr [email protected] +44.020.7710.4695 London

Nicola Higgs [email protected] +44.20.7710.1154 London

Rob Moulton [email protected] +44.20.7710.4523 London

Charlotte Collins [email protected] +44.20.7710.1804 London

Gabriel Lakeman [email protected] +44.020.7710.4645 London

Denisa Odendaal [email protected] +44.20.7710.1845 London

Becky Critchley [email protected] +44.20.7710.4519 London

Anne Mainwaring [email protected] +44.20.7710.1018 London

Jonathan Ritson-Candler [email protected] +44.20.7710.1815 London

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Client Alert is published by Latham & Watkins as a news reporting service to clients and other friends. The information contained in this publication should not be construed as legal advice. Should further analysis or explanation of the subject matter be required, please contact the lawyer with whom you normally consult. The invitation to contact is not a solicitation for legal work under the laws of any jurisdiction in which Latham lawyers are not authorized to practice. A complete list of Latham’s Client Alerts can be found at www.lw.com. If you wish to update your contact details or customize the information you receive from Latham & Watkins, visit https://www.sites.lwcommunicate.com/5/178/forms- english/subscribe.asp to subscribe to the firm’s global client mailings program.

This article is made available by Latham & Watkins for educational purposes only as well as to give you general information and a general understanding of the law, not to provide specific legal advice. Your receipt of this communication alone creates no attorney client relationship between you and Latham & Watkins. Any content of this article should not be used as a substitute for competent legal advice from a licensed professional attorney in your jurisdiction.

Latham & Watkins LLP - David Berman, Stuart Davis, Sam Maxson, Kishore Bhindi, Carl Fernandes, Ella McGinn, Brett Carr, Nicola Higgs, Rob Moulton, Charlotte Collins, Gabriel Lakeman, Denisa Odendaal, Becky Critchley, Anne Mainwaring and Jonathan Ritson-Candler

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