Another jigsaw piece FCA Policy Statement

On 26 July 2021, the FCA issued a Policy Statement  (PS21/9) containing feedback to its April 2021 consultation paper on the implementation of the IFPR (CP21/7). This follows on from the June 2021 FCA Policy Statement (PS21/6) published in respect of the FCA's first consultation paper on the IFPR (CP20/24).

Appendix 1 to PS21/9 contains a draft version of the Handbook instruments containing near-final rules. The FCA confirms that the rules will be made final once the relevant Financial Services Act 2021 statutory instruments are in place and that it does not plan to make any changes to these rules before they are made final.

The FCA confirms that it is planning to issue a third consultation paper and a third Policy Statement later in 2021. IFPR comes into force in January 2022.

We summarise the important points raised in the Policy Statement below.

Changes to the definition of an SNI firm

The FCA confirms that it has amended the definition of an SNI firm to reflect that daily trading flow (DTF) now also applies to firms that trade in their own name on an agency basis (in addition to firms that trade in their own name as principal). It states that these are firms that might not have permission to deal as principal. It confirms that there is no change to the application of DTF to firms that deal in their own name, for themselves as well as clients. It confirms that any firm that has a non-zero value of average DTF cannot be an SNI firm, and a firm that has permission to deal as principal is automatically a non-SNI firm.

In relation to FCA investment firms that are clearing members and indirect clearing members, the FCA confirms that: these firms should automatically be non-SNI firms as they are interconnected with other financial institutions; K-DTF would apply to them; and they should include pre-funded contributions to a CCP default fund as part of the trading counterparty default (K-TCD) requirements.

Risk management

The FCA's proposals in this area included: introducing an Overall Financial Adequacy Rule; establishing the ICARA process as the basis for investment firms’ risk management; setting expectations and standards around the assessment of the adequacy of own funds and liquid assets; introducing notification and intervention points to clarify expectations of firms facing challenges to their financial resilience; aligning oversight of the ICARA to responsibilities under the Senior Managers & Certification Regime (SM&CR); and introducing the ICARA questionnaire. In the Policy Statement, the FCA clarifies the types of firms that should conduct more in-depth stress testing and reverse stress testing. It also sets out an example on how a firm might determine the potential harm caused by a cyber incident.

Firms have expressed concerns regarding the timing of the first round of ICARA reporting, as they will be required to familiarise themselves with the new ICARA process, gather data, and conduct a review in 2022. Firms with accounting reference dates of 31 December in particular have questioned when they should set their reference date for a 2022 review. In response, the FCA stated that firms will be required to review their ICARA process at least once every 12 months and that it expects firms to review their ICARA process during 2022 and to submit their MIF007 report on their review of the ICARA process within a reasonable period after the review date (which may be in 2023). Significantly, the FCA also stated that it understands that firms will be familiarising themselves with the new process, and it asks firms to compete their ICARA reports on a "best efforts" basis in 2022, and firms may choose to complete their first ICARA in early 2022, with the report covering only part of that year.

The FCA confirms that it is planning to send a questionnaire to all FCA investment firms in the autumn, and it will provide aggregated feedback on first ICARA report submissions.

Own funds requirements: Fixed Overheads Requirement

The FCA has amended its rules and issued guidance to clarify aspects of the calculation of the fixed overheads requirements (FOR) in response to queries raised by firms. Points of clarification include: relevant expenditure for FOR should be calculated before the distribution of profits; LLP members' shares in profits will receive the same treatment of deduction from total expenditure as those of ordinary and limited partnerships; guidance is given on the meaning of "non-recurring expenses" and 'payments into a fund for general banking risk'; and the relevant expenditure of the entire firm should be included in the calculation (and not just the expenditure related to its regulated activities).

Own funds requirements: K-COH and K-DTF

The FCA refers to queries raised in relation to K-COH, notably that the FCA Glossary definition of "client orders handled" covers: (i) reception and transmission of client orders; and (ii) execution of orders on behalf of clients. The FCA notes that under MIFIDPRU 4.10.4R, a firm is not required to include in COH orders it executes in its own name, including where it does so on behalf of a client. The FCA refers to suggestions made by respondents that it is possible for an investment firm to execute in its own name without dealing on own account and as drafted, the FCA's proposed rules would not capture this under either COH or DTF. The FCA confirms that generally, the decision of whether a transaction that a firm has executed would fall under either COH or DTF is to be regarded as a binary decision. COH if in the name of the client, and DTF if in the name of the firm even if on behalf of a client. It confirms it is not making a change to rules for COH in respect of this but has amended the general provision in MIFIDPRU 4.11.4R and added a new provision underneath it to ensure that K-DTF is not limited to an FCA investment firm that deals on own account, but would also apply to a firm that executes orders on behalf of clients in its own name (i.e. there will be firms to which K-DTF may apply even if those firms do not hold, or otherwise need to hold, dealing on account permission).

Own funds requirements: K-AUM

The FCA responds to concerns about double-counting. In general, the FCA expects firms to calculate AUM at every level where the firm has obligations in respect of discretionary management (and non-discretionary arrangements constituting advice of an ongoing nature). To illustrate this, the FCA cites one example involving an entity managing funds that were delegated to it by a UK firm that is not subject to an AUM-based financial resources requirement, and where the recipient firm also manages investments on behalf of its own clients in those funds. The FCA addresses whether the AUM of the entity's own clients need to be added to the delegated AUM. The FCA states that in this case, the entity in question: (i) has been delegated the management of the entire portfolio by another firm and needs to decide where this should be invested; and (ii) manages assets on a delegated basis on behalf of its own clients. The FCA clarifies that there is no overlap and that the firm should consider the mandate it has been set by the delegating firm, as well as the mandate it has been set by its own clients. It does not consider this to be "double counting".

The FCA also provides some clarification in relation to queries received concerning calculation of AUM in the case of sub-delegation. It clarifies whether responsibility for calculating the AUM lies only the original delegating firm (the firm closest to the investor) where fund management had been sub-delegated. It states that the more removed the firm managing the funds is from the end client, the greater the operational complexity of the arrangements. The FCA is keen to avoid chain of sub-delegations where a large amount of AUM is covered by only one firm in the chain holding capital against the potential for harm from discretionary portfolio management. It is therefore proceeding with its proposal in relation K-AUM in the case of sub-delegation (that is, that the exclusion from "double counting" AUM can be used only where there is one level of delegation, and not where there are two or more levels).

Remuneration: Specific rules for carried interest

In the CP 21/7, the FCA set out: plans to create a single remuneration code for all FCA investment firms in SYSC 19G (replacing the IFPRU Remuneration Code (SYSC 19A) and the BIPRU Remuneration Code (SYSC 19C)); plans to apply different levels of remuneration requirements to different types of FCA investment firms (basic, standard and extended remuneration requirements); details on how remuneration rules would apply to CPMIs and in different group situations; information for how non-SNI firms should identify their material risk takers (MRTs) and which MRTs firms may exempt from certain rules. The FCA confirms it is proceeding with many of its proposals, including the thresholds for determining whether basic, standard or extended remuneration requirements will apply to firms.

The FCA has made specific comments on the approach to carried interest. It confirms that its Remuneration Code will apply to carried interest, but has added a new rule which means that the requirements on pay-out in instruments, deferral, retention and ex-post risk adjustment do not apply to carried interest arrangements where: the value of the carried interest is determined by the performance of the fund in which the carried interest is held; the period between award and payment of the carried interest is at least 4 years; and there are provisions for the forfeiture or cancellation of carried interest that include at least situations in which the MRT participated in or was responsible for conduct which resulted in significant losses to the firm, and situations in which the MRT failed to meet appropriate standards of fitness and propriety. This additional clarity will be welcomed by buy-side firms, although the FCA's conditions may still require some changes to vesting and clawback conditions for future funds. The FCA also confirmed that carried interest is valued at the date of award (rather than the date of vesting).

Governance

In its consultation paper, the FCA set out plans for to require the largest non-SNI firms to set up risk, remuneration and nomination committees. It confirms that it has now made amendments to: permit a non SNI firm to rely on a group level remuneration committee where the firm is part of an FCA investment firm consolidation group, and where the UK parent entity has a remuneration committee that: meets the composition requirements (where they apply); has the necessary powers to comply with the other obligations in MIFIDPRU 7.3 on behalf of the non-SNI firm; and has members with the appropriate knowledge, skills and expertise in relation to the non-SNI firm. Where these criteria are met, a firm may rely on the group level remuneration committee without needing to apply.

In response to queries about classifications under the SMCR (in particular, the Enhanced Firm designation), the FCA states that it is no longer using the term "significant IFPRU firm" to define which firms need to have risk, remuneration and nomination committees but is not making substantive changes in the other contexts in which it is used. It confirms that the thresholds behind "significant IFPRU firm" will continue to be used to define firms that are enhanced scope SM&CR firms.

Co-authors: Patrick Keenan and Bisola Williams