Asset Managers: Conduct Risk 2020

Asset managers based in the UK continue to face unprecedented levels of regulatory and market pressure.

On 20 January 2020 the FCA published its supervisory priorities for asset managers and the alternatives sector in the form of “Dear CEO” letters. 

We look beyond those broad areas of FCA supervisory focus and predict the top ten areas where conduct risk is likely to crystallise within the asset management sector in 2020. We recommend that firms keep all of these areas under active review.

Culture and governance

The UK regulators consider that poor culture presents the biggest source of conduct risk for any financial services business and poor culture is the biggest indicator that conduct risk may crystallise. 

From some well publicised recent failings, it is clear that this is equally true in the asset management sector. The FCA expects all firms to drive cultural change as a key way of mitigating conduct risk.  

Challenge on culture and governance, and a firm’s cultural direction of travel, will be core to the FCA’s supervision of asset management firms.  This includes a focus on non-financial misconduct (including sexual harassment, bullying and discrimination) as being a regulatory concern, which can call into question the fit and proper status of senior managers who fail to ensure known problems in their firms are addressed.  It also encompasses the broader themes of “purpose” and sustainability of business models.

The FCA highlights the harm that can arise from a failure to recognise and manage conflicts on interests between affiliates, such as between an Authorised Fund Manager (AFM) and a delegate manager. 

Firms that have not yet commenced a culture self-assessment and change programme should do so now.

Value assessments and statements

For AFMs and UCITs management companies authorised in the UK, the new rules on fund governance, stemming from the findings of the Asset Management Market Study (AMMS), have applied from 30 September 2019.  Of these, the change that is likely to have the greatest market impact is the requirement for AFMs to perform a detailed assessment of whether a fund is providing value to investors and to publish the results of this assessment, including what corrective action is being taken where the AFM has concluded that good value has not been provided. 

2020 will see the first round of value statements being published.  This first cohort of statements will see close scrutiny from the financial press, investors and the FCA.  The value assessment process is a brand new one that will evolve over time with experience, not least because AFMs have been encouraged to work out their own bespoke solutions.  There are bound, therefore, to be mistakes and differences of opinion along the way, which means that there will be some AFMs and funds where conduct risks crystallise around the value assessment and statement process.  It is easy to see the pressure towards presenting favourable information, the risks of innocently providing inaccurate information and the high level of subjectivity in determining how the prescribed assessment criteria can be satisfied, notwithstanding the structured internal scrutiny by INEDs and the Chair of the AFM’s governing body.

Liquidity management and illiquid assets

Liquidity risk management will remain an intense area of focus for the FCA in 2020, following recent high profile failures and fund suspensions where arguably the letter but not the spirit of EU UCITS rules was followed.  FCA interventions are already in process. 

Funds and asset managers should continue proactively to review and amend portfolios and closely monitor redemptions in light of this risk. 

The investment process and risk management are relevant to the quality of service criterion in an AFM’s value assessment. 

Managers of alternative funds and UCITS funds that in practice are marketed only to professional investors, should remember that the problem of illiquid assets and liquidity risk is not confined to retail funds.

Product governance

The FCA is conducting a supervisory review of firms’ implementation of the MiFID II product governance rules and we expect to see the output of that work during 2020.  Asset managers should take this opportunity to be on the front foot by conducting an end to end review of their product governance framework. The FCA’s review includes a focus upon whether products are designed with the best interests of the target market in mind, the information flow with distributors and the extent to which there is effective ongoing monitoring that the product is being sold only to the target market. 

In the regulated funds space we have already seen piecemeal interventions by the FCA in its outputs following the AMMS, including strengthening fund governance, the requirement for value for money assessments and the FCA’s guidance (PS 19/4) on the clarity of description of fund objectives and investment policies. This leaves much that could still be done to mitigate conduct risk by instituting a review of a fund’s entire proposition, as described throughout the prospectus and other promotional and customer communication literature.  This would ensure that the proposition is clear to investors and is complied with by managers and would test that the fund can deliver what it was designed to do and promised.  Improvement of the quality of customer communications throughout the proposition will enable investor expectations to be better managed.

The FCA has a particular concern that host AFMs, not within the group structure of the manager, may not be discharging their product governance responsibilities effectively, given their reliance on revenue from the investment manager. 

One immediate and critical challenge of your product governance systems and controls will be LIBOR transition – see below.

LIBOR transition

LIBOR will cease to be available by the end of 2021.  The UK regulators are pushing the banking sector to move as early as possible to replacement rates and you may well already have received preliminary communications from some of your bank counterparties about their plans. 

During 2020 your investors are likely to begin raising questions and including LIBOR transition in due diligence exercises. The FCA is gathering data on buy side exposure and this will feature in supervisory interactions. 

The transition presents asset managers with significant conduct risk, if the transition is not handled well and value is lost for underlying investors.  There are three main ways in which asset managers will be impacted:

  • LIBOR based products in portfolios (and products referencing other IBOR rates that are also being replaced) including hedging derivatives, Floating Rate Notes, securitisations and private debt;
  • Use of LIBOR as a performance target or benchmark for funds or mandates;
  • Critical models and systems underpinning operations and administration use LIBOR as an input including pricing, valuation and risk models.

You will need to develop a communication strategy for investors, which is a particular challenge at a stage when market solutions are still in development.

Market conduct and anti-market abuse controls

The FCA remains alert to identify weaknesses across firms’ market abuse control frameworks.   A particular focus of the FCA continues to be improving surveillance, detection and Suspicious Transaction and Order Reporting for non-equity investments and for market manipulation, which remain significantly under reported as against equities and suspected insider trading incidents. However, even for equities and insider trading the battle continues.

Most recently we have seen a renewed focus on firms’ operation of Personal Account Dealing (PAD) Controls. This recurring interest in PAD controls is a perfect illustration of the wider truth that conduct risk mitigation measures, once implemented, should never be relaxed.  In Market Watch 62, following a review of PAD dealing controls at a sample of wholesale broking firms, the FCA expresses concern at how often it is seeing breaches by individuals of PAD controls. The FCA appears to conclude that firms may not be taking breaches by individuals of PAD controls sufficiently seriously and calls upon firms to develop a culture where adherence to the rules is the norm.  The FCA signals that firms should be considering such breaches as potential Conduct Rule breaches : “Approved persons and employees covered by SM&CR must act with integrity and observe proper standards of market conduct when performing their functions, including complying with their Firm’s PAD policies and procedures”.

Examples given by the FCA where firms did not seem to have taken PAD control breaches sufficiently seriously include:

  • Employees in front-office roles not appearing to understand their firm’s PAD policy despite having signed attestations that they have read, understood and will comply with those policies;
  • Firms and employees considering that ignorance of a firm’s PAD policy provides reasonable mitigation for PAD in breach of that policy;
  • Employees – including front office, compliance and surveillance - deliberately not declaring external accounts to their employer and/or circumventing requirements;
  • Employees trading in breach of the relevant policies, including fund managers buying a security they have advised their fund to sell.

The frequency of breaches raises questions whether the policies in place at firms are meeting the objectives of the PAD rules, including whether firms are appropriately managing conflicts of interest and the risk of market abuse being undertaken by staff and whether individuals with responsibility for overseeing PAD systems and controls are complying with their obligations.

Though Market Watch 62 concerns the FCA’s findings from a review of controls at wholesale broking firms, as ever the FCA will expect “read across” to other financial services sectors where the findings are relevant.  Asset managers should review their PAD dealing controls, including how staff dealing is monitored and ensure that appropriate disciplinary action and remediation steps are taken in response to breaches, including where appropriate identifying and reporting Conduct Rule breaches and assessing an individual’s fit and proper status in light of PAD dealing breaches.

Front office trading controls

Inevitably front office trading controls are a continuing source of conduct risk, not least because staff turnover means that corporate memory is short.  Trading outside investment guidelines, breach of trade allocation and best execution rules, whether innocent or deliberate, and poor responses to accidental trading errors are continuing “business as usual” sources of conduct risk that still crystallise relatively frequently. Now that asset managers are regulated under the Senior Manager and Certification regime, firms should ensure that their responses to such breaches and “lessons learned”/remediation exercises include an appropriate assessment of the culpability of involved individuals.

Technology and cyber risk

Obviously this is a “real and present” danger for all areas of the UK economy.  From a conduct risk perspective, we simply remind you that there are very few cases where firms are let down by technology alone.  Most operational outages, successful cyber-attacks and data loss incidents have as a root cause an error by a staff member, right through from poor judgment and short cuts in planning and implementing technology change projects, to IT staff failing to patch known vulnerabilities in software in timely way, through to an individual clicking the link in a phishing email that lets malware into a firm’s systems.

Stewardship and ESG

Calls to address Environmental, Social and Governance (ESG) issues in investment decisions and portfolio construction are gathering momentum, particularly in light of more widespread recognition (including by regulators) that climate change risk is real.  ESG focussed products and portfolios are being developed by asset managers to meet their own stewardship goals and to address investor demand.     However, ESG is a broad, ill-defined and subjective area.    Whenever asset managers agree investment guidelines and restrictions or make representations to investors about the objectives of a new product, there is a corresponding risk of misunderstanding and mismatch of expectations, which creates conduct risk.  Sceptics of ESG warn of the risk of “greenwashing” being used as a cynical marketing ploy to enable managers to gather in assets.  We consider that the risk of an “expectation” and “understanding” gap means that embracing ESG represents a significant area of conduct risk for well-intentioned managers, just as much as for “bad” actors.  Robust product governance controls will be particularly important here with well-developed and stress tested methodologies that can be clearly articulated to investors

Whistleblowing and speaking up

Whistleblowing is good for you. Willingness of staff to Speak Up, and robust procedures to enable them to do so, are signs of a healthy culture.

An uptick in the frequency of whistleblows by staff has been a continuing effect of the implementation of the SM&CR for banks and insurers.  We expect the same to be the case for asset managers and other solo regulated firms that have come into the SM&CR from 9 December 2019.  This stems from the heightened awareness of individual responsibility arising from the wide application of the Conduct Rules (to all staff apart from ancillary staff) and the training of staff on them.  However, to avoid the risk that a firm’s handling of the whistleblow itself gives rise to regulatory issues (as distinct from regulatory issues that may be raised by the contents of the protected disclosure) a firm must have well developed and tested procedures and decision making structures, to ensure that the whistleblower is protected and that the matters disclosed are appropriately investigated with necessary remedial action and notifications to relevant regulators.

Contact us

Assisting clients in mitigating conduct risk and in responding effectively to conduct risk incidents, forms a core part of our Financial Services Regulation and Investigations practice.  For further information on any of the issues raised in this note please contact Angela Hayes or Noline Matemera.

This publication is intended for general guidance and represents our understanding of the relevant law and practice as at January 2020. Specific advice should be sought for specific cases. For more information see our terms & conditions.

Date published

25 January 2020


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