High risk not enough rewards

On 19 January 2022, the FCA published its consultation paper on "Strengthening our financial promotion rules for high risk investments, including cryptoassets" (CP 22/2).

Key points

• FCA will classify invests as Readily Realisable Securities (RRS), Restricted Mass Market Investments (RMMI) and Non-Mass Market Investments (NMMI). The financial promotion rules will be stricter the more risky/complex the product (i.e. NMMIs).
• Firms will have to display new risk warnings to consumers
• There will be a ban on inducing customers to trade RMMIs and NMMIs, similar to the CFD ban already in place.
• Firms will have to use positive frictions – or circuit breakers – in the sign up flow so consumers have a cooling off period before being able to trade. Something the UX/CX designers from the business will hate!
• Removing the self-certification exemptions for certain classes of investor and requiring firms to ensure consumers meet the relevant exemptions.
• Increased use of the appropriateness test and new guidance around what it should and should not do.

The FCA's ongoing concern with high risk investments and consumer protection

It is no secret the FCA is concerned with the popularity of high risk retail investment products. In the regulator's view, these are not well understood by consumers nor aligned with consumer needs. These concerns have only been exacerbated by the COVID-19 pandemic, which has seen a rapid rise in consumers holding these investments.

The consultation paper is hot on the heels of the Treasury's consultation on cryptoasset promotions and contains a number of proposals to mitigate the marketing of high risk investments, some of which extend and others which compliment proposals previously published:

Proposal 1: Classifying High Risk Investments

The FCA is introducing its new risk classification to make it easier for consumers to accurately match products with their level of risk and to make the rules clearer and simpler for investment firms to apply to their products and services in practice.

The consultation paper proposes to introduce a new tripartite classification of investments, based on their level of risk. Restrictions on who can receive financial promotions relating to these investments are set out for each of the three categories, with fewer marketing restrictions for low risk investments, and greater marketing restrictions for high risk investments.

We summarise the FCA's proposals below:

Proposal 2: Strengthening the consumer journey

The FCA has proposed making the following changes to the consumer journey when the client wishes to begin trading higher risk investments:

• Risk Warnings: The FCA proposes to introduce new risk warnings (and accompanying prominence requirements) for all RMMI and NMMI investments, based on behavioural testing, which (a) describe the investment as high risk, (b) warn the customer that they could lose all they invest, and (c) direct them to further information on the risks of the investment.
• Ban on Inducements: Extending its current ban on inducements for CFDs, the FCA is proposing to ban any financial promotion for RMMI and NMMI investments which contain "any monetary and non monetary benefits that incentivise investment activity, including such incentives paid in cryptoassets".
• Positive Frictions: Positive frictions are designed to prevent consumers from quickly clicking through risk warnings and accessing high-risk investments immediately. The positive frictions would be applied to consumers the first time they use a platform to trade an RMMI that has been directly offered and/or NMMI. The positive frictions are:
  
  • Personalised risk warnings: The consumer must be shown a personalised risk warning that uses their name and addresses them directly. The FCA's current proposed wording warns the client, "This is a high risk investment. How would you feel if you lost the money you’re about to invest?"
  • Cooling Period: After being presented with a risk warning, the client must wait 24 hours before they are able to trade.

• Client Categorisation: The FCA is concerned the current rules on client classification allow consumers to self-certify themselves as high net worth or sophisticated without fully understanding the impact of this classification or meeting the characteristics of these classifications to the FCA's satisfaction. The FCA proposes to move away from the self-certification approach. It also shares the view of the Treasury that firms should be responsible for classifying consumers as sophisticated or high net worth, and only where they have a reasonable belief the customer meets the characteristics of the relevant classification. This would likely require clients to provide evidence that they satisfy relevant classification requirements.

• Appropriateness Testing: The FCA proposes to introduce appropriateness testing for all RMMIs and to publish new guidance on how to carry out this testing. The guidance will be similar to the current guidance that exists for P2P assessments, and will not list everything that should be covered by an appropriateness assessment, instead providing suggestions. In particular, the FCA has identified the following aims:
  
  • The number of test retakes (and the time between retakes) should be limited, so that a client cannot retake a test for the same product or investment within 24 hours.
  • Firms should not contact consumers to encourage them to retake a test where an investment has been considered inappropriate for them.
  • The questions that a consumer is asked should be different on each re-take.
  • The consumer should not be told in too much detail what questions they got wrong or what the correct answer is, in order to avoid coaching.
  • The consumer should not be provided with information throughout the process of the assessment, to prevent firms from using the appropriateness assessment as an educational or disclosure tool rather than an assessment. These materials may still be provided outside the assessment, including just before the assessment is taken place.

Proposal 3: Approving and Communicating Financial Promotions

The FCA has proposed additional requirements for firms that are able to approve financial promotions under "FSMA s21 approver" rules. In particular, if the proposals in the consultation paper are accepted, then:

• S21 approvers will be required to ensure all financial promotions state on their face (a) who approved them and (b) the date on which they were approved.
• S21 approvers will be required to self-certify that they have the necessary competence and expertise in an investment product or service before approving or communicating a relevant financial promotion.
• S21 approvers will be required to carry out ongoing monitoring of financial promotions that it has approved, taking into consideration factors such as whether there have been any changes to the product, whether funds raised are being used for the purposes described in the promotion, and if the promotion continues to comply with any new or updated regulatory requirements introduced by the FCA or other relevant parties.
• S21 approvers will be required to consider conflicts of interest when approving financial promotions for unauthorised firms and confirming compliance of financial promotions for authorised firms.
• S21 approvers will be required to apply appropriateness assessments, as required, on a periodic basis throughout the life of a promotion.

As the consultation paper makes clear, these requirements will be more onerous in the cryptoasset sector, which is currently outside the regulatory perimeter, meaning that most cryptoasset firms are unauthorised and will need to appoint a s21 approver to approve financial promotions of qualifying cryptoassets.

Proposal 4: Cryptoasset Promotions

The Treasury has announced that it intends to bring "qualifying cryptoassets" in scope of the UK's financial promotion regime. Qualifying cryptoassets are defined broadly as "any cryptographically secured digital representation of value or contractual rights which is fungible and transferable", but excludes electronic money, certain payment tokens, and central bank money. This definition would include most cryptoasset traded on retail exchanges, such as Bitcoin (BTC) and Ether (ETH).

As described above, qualifying cryptoassets will be classified as RMMIs, meaning that they will be subject to the restricted financial promotions regime, including prohibitions on inducements, new frictions in the customer trading journey and limits on the types of consumer that can be targeted by financial promotions.

The FCA, following the Treasury's approach, has proposed to exempt financial promotions to certified sophisticated investors from some of these restrictions. However, the FCA does not currently propose to extend this exemption to self-certified sophisticated investors and high net worth investors.

Our view

The contents of the consultation paper is likely to come as a profound surprise to those who have been monitoring the FCA's recent publications. However, it does demonstrate the seriousness of the FCA's intention to reduce the ability of consumers to access high risk investments, especially in the cryptoasset space as the definition of "qualifying cryptoasset" is so broad.

Of the FCA's suggestions, we are most surprised to see the strict ban on inducements, which would extend the FCA's current ban on CFD inducements far more broadly than might have been expected. We are least surprised by the proposed changes to the rules on appropriateness testing, with the FCA acknowledging in the consultation paper that its current rules have a number of weaknesses, and the new rules on s21 approvers, since the Treasury got in ahead of the FCA on that announcement.

As we said in relation to the Discussion Paper in 2021, the consultation paper is an invitation from the FCA to its stakeholders to consult on its proposals, and it does not have legal effect. However, it would be unwise not to expect the contents of the consultation paper to broadly reflect the rules that the FCA ultimately introduces. We would advise firms, especially those in the cryptoasset space, to begin thinking carefully about how they will adapt their business models, client onboarding and financial promotion approval processes to incorporate these new rules.

Co-Author: Anna Burn, Emma Tran