Will Morrell is a regulatory consultant at Cordium. He recently joined from the FCA where he was the lead associate of the thematic team in the asset management department. He led the Dealing Commission Thematic Review that was published in the summer, and co-wrote the content in chapter three in which the supervisory findings are to be found. This article discusses what FCA supervision looks like and how firms have experienced that supervision.
The FCA are very interested in wholesale markets at the moment, and I think that is reflected in both the thematic reviews of dealing commission and best execution. It’s no longer sufficient to be able to say that that’s market practice: they are going to be expecting you to be able to explain why what you’re doing is in the best interests of your clients, and indeed the best interests of the market as a whole.
The FCA’s supervision strategy is based on three pillars; here we look at what those pillars are and examples of them. Pillar one is called the firm systematic framework. This is simply firm supervision – where you either have a named supervisor, or you contact the contact centre. Pillar two is event-driven work, dealing with problems and fixing them. I think this stemmed from the problems that the FSA had dealing with issues such as PPI, where firm supervisors were getting tied up dealing with problems. Splitting these issues out from firm supervision allows supervisors to be more forward-looking. The third pillar is issues and products; this is thematic reviews.
All firms would have been given a conduct classification at the legal cut over to the FCA in April of last year. Hopefully you know your conduct classification. If you don’t, you can call the contact centre and find out. Most hedge fund managers are in either the C3 or the C4 bucket, and these are typically what would have been previously small firms and dealt with a contact centre. C1 firms are an elite section of 11 of the largest banking and insurance firms – note that this is banking and insurance groups, so there may be some asset managers in there as part of groups, but there are no independent asset managers. There are also only a small number of C2 firms within the asset management industry. Most hedge funds fall within the C3 and the C4 buckets.
The other classification that should have been given is your prudential classification. Both of these should have been sent out in a letter in April last year, but you can contact the contact centre if you don’t know. P1 firms (as in “Prudential 1”) are deemed to be potentially critical to a market or consumers as a whole. These firms are almost looked at ona going concern basis, as it is deemed that a failure of one of these firms would be incredibly disruptive. Therefore the FCA have quite close interaction with the firm from a prudential standpoint. P2 firms are normally where “wind down can be achieved”, so it may have a large impact, but it can be done. P3 firms (provided they have the appropriate regulatory capital and provided that CASS arrangements are in place) are firms that the FCA believes should be able to fail, and they could fail without there being a major impact on the market. Most hedge funds will be in this P3 category. P4 firms are firms which are already in administration or insolvency. So you don’t want to be a P4 firm; most hedge funds will be C4 and P3.
C3 & C4 Supervision
We have a number of C3 firms at Cordium: medium-sized hedge funds that are subject to an annual peer group business model strategy analysis. This will take the form of an information request similar to the hedge fund survey the FSA used to issue. This is very much trying to get on the forward-looking agenda, looking at what it is the firms are doing. You will know if you are a C3 firm as you will likely have had some interaction with the FCA already, but you still deal with the contact centre on a day-to-day basis – you won’t have a point of contact or a named team or individual at the FCA. C3 firms will also be subject to periodic assessments – essentially a deep dive on one particular topic area. Market abuse has been popular.
As I mentioned earlier, most hedge fund managers will be classified as C4 and will be subject to sectorial analysis and thematic reviews, but this will be based on the information the FCA already has, either publicly available or potentially via the Annex IV reporting, once they get their heads around that. I think the biggest thing to focus on for C4 firms (and I think it has been missed since being published in March last year) is a four-yearly assessment via phone, a face-to-face interview, online assessment or a combination of these. The FCA wants to have a touch point with every firm at least once every four years irrespective of size, and then to follow up with a random sample of this.
Moving on to our experiences of what this actually means for firms, we’ve seen no sign of an online assessment, but we have seen firms being invited to the FCA for a three-hour interview. The letter comes in saying that they want to discuss various topics – typically it’s all the topics you can imagine from management, governance and culture, right through to your products and the instrument types that you trade in. They aren’t as scary as they sound. We’re aware of quite a few firms that have gone in for these now and generally firms have found them useful, with the feedback from the FCA being proportionate and relevant to their business.
Pillars of supervision
The fact that the online assessment hasn’t materialised would suggest that the FCA are moving straight ahead with face-to-face interactions. We have heard rumours that this may be for as much as 10% of the C4 population, which means there’s quite a strong likelihood of being called in to the FCA for a C4 assessment. They are examples of pillar one supervision, so the firm-specific supervision.
Pillar two supervision: up until very recently, I don’t think we had really seen anything that had crystallized enough for there to be the need for a team to go in and take ownership of that issue in the asset management sector. But when the FX fines were released, there was also a section at the bottom of that press release talking about an FX remediation plan, which went largely unnoticed and unreported because of the size of the fines.
We’re now aware of a number of hedge funds that have been called in to this FX remediation programme. It is being run by the specialist supervision department, which is the team that deal with these problems and is challenged with fixing them. From reading the letter, it looks as if they are going to be looking for the firm to review its processes and then attest that its controls are sufficient. They won’t be wanting to do the work themselves, but they do want comfort that the firm has looked at its controls and attested that the controls are sufficient.
Examples of pillar three supervision: as part of the FCA’s transparency agenda these are typically announced in the business plan that’s published around March time. We have seen dealing commission and best execution published, and I will talk about those in a moment. We have not seen the results of the market abuse thematic review, but we had a few clients that were involved in that, so it definitely happened, and I would imagine has concluded.
Turning to the dealing commission thematic review, only 12% of those sampled met the regulator’s expectations, but that does mean it’s possible. We can safely assume it did cover the full range of firms. Although there were not many that were actually meeting the FCA’s expectations, it is possible. The FCA is not just looking for compliance with rules: they are looking for compliance with best practice or the findings of best practice that they publish in these thematic reviews. There’s no official guidance – there’s just the thematic review and what they found, and you have to work out what they want.
In some instances it’s very clear what good practice and poor practice is. Sometimes they even spell it out, but at other times it is hidden in some of the wording that they use. So what we’re going to do now is look through some of the paper, pull out some of the quotes that are in there, and look at what that means for firms and what the FCA expect of you.
There are still too few firms applying sufficient rigour in assessing the value of the research services they use. This really talks to the fundamental problem with the use of the dealing commission regime: that the value of research is not really assessed. Nobody is deciding whether to purchase research at a certain price or not. That’s perhaps a blanket comment, but too many firms are not assessing the value. So there should be that kind of assessment, where a firm is looking at what it’s receiving, what its fund managers actually value, and then paying an appropriate amount. Some of the better examples in investment managers seeking to assess the value of research involved independent assessment by people not working in the investment process, or the use of proxies such as other price services.
One of the common concerns when talking about how you value research is that it’s very difficult to value, or nobody puts a price on it, so how am I supposed to value it? Quite simply, you need to look at what you’re receiving and decide how much you would be willing to pay for it if you were paying for it out of your own money. Also, there are price services, independent research providers that charge either a subscription or will commission a piece of research for you if you ask them, and that has a price for a defined piece of work. So there are reference points and it is possible.
I think that investment managers should be involved in the process of assessing that value: they are best placed. There are some people who feel it should be a wholly independent assessment. Personally, I think that if you have got both involved, so there’s some kind of challenge to the investment manager as to what they want to pay to certain research providers, then that leads to a much healthier discussion and a much more robust assessment of the value.
One of the other fundamental problems with the current market for research is that quite often the amount paidis related to the amount traded, and there’s no reason why they should be.
Market data services (MDS)
This is very topical and I’m sure a lot of people won’t like it: “One firm was using dealing commission to pay for market data services in full, with no apparent mixed use assessments determining which parts of the service were eligible to be paid for out of dealing commission and which were not.”
If you are paying for a service that has elements of eligible and ineligible services, most typically this is talking about market data services, but it does also apply to other services. Market data services are either risk or analytic tools: Bloomberg, Reuters, those kind of tools where there is legitimate research available there that you may wish to pay for out of dealing commission, but there are also other services that the firm values and probably would pay for itself. You should assess the value both parts, considering the amount that you would be would be willing, in good faith, to pay for the ineligible elements and how much you’re willing to pay for the research element out of dealing commission.
To be honest with you, if I was a compliance officer at a firm, I would not be comfortable paying for any market data services out of dealing commission. It has been repeated time and time again by the regulator that this is not acceptable without a robust mixed use assessment.
But that being said, you can pay for MDS out of dealing commission, the rule is there, and as with all regulations they’re there for you to interpret, so it’s very much up to you to determine whether you are comfortable paying for it. My advice would be not to, and if you do to decide to then you should perform and document a robust mixed use assessment.
The following is a neat little one liner, and I don’t just say that because I wrote it: “Firms should be able to pay for research without trading with that broker and pay for execution without paying for research.” Basically you have to have the ability to trade execution only. If you don’t, you can’t be certain that you are not overpaying for research.
It does also suggest that the regulator approves of commission sharing agreements (CSAs) where it says that you should be able to pay for research without trading with that broker as well. This is the other very simple one liner: “Better practices generally involved CSAs”. It is possible to operate to the FCA’s expectation without using them, but operationally very difficult to implement. A lot of people still ask me whether the FCA is supportive of CSAs, and I think that’s why something like this is quite useful, just trying to draw out certain quotes from the paper. There it’s quite clear that best practice involved the use of CSAs.
This next section comes back to the link between the amount you are paying for research and the amount you are trading. “A vote did not typically represent a specific monetary amount; it represents a percentage of the CSA balance.” As soon as that’s happening, that means that you are linking the amount you trade to the amount you pay for research, and that would not meet the FCA’s expectations. It’s okay to have a broker voting system – in many instances it is the easiest way of operating CSAs – but that broker vote, or a more accurate description, investment managers voting on who they want to reward for research, commonly known as a broker vote, should be based on a monetary amount.
If nothing else this gets the individual investment managers thinking about what they are paying to individuals, as opposed to ranking them one above the other and not realizing that they’re paying a certain broker £100,000 in that period even though they didn’t value their research that highly.
“Ensure that the services you are paying for are eligible, and then pay an appropriate amount”. It looks very simple on paper, but I do appreciate that it is not quite that simple in practice, especially the second part. I think that’s where some of the conversations that the FCA has initiated on this do help. From the dealings I have had with firms, there has been more willingness from brokers to engage in these kind of conversations about what it is that people value. I would also add to that, that where possible you should establish CSAs with the brokers that you trade with most frequently as a bare minimum, to enable you to reward research providers that you may not be able to get best execution from and also to answer that question about being able to reward research providers for research, without paying for execution.
Best Execution Thematic Review
The Best Execution Thematic Review is a very technical paper and quite long but I think it was very good, and I didn’t write that one. But it is very technical, very long and very difficult to get to grips with, especially as it is such a technical and specific topic.
The report itself was quite damning. Here is a quote showing how damning it was: “Our review identifies significant risk that best execution is not being achieved to all clients on a consistent basis.”
This review was aimed at brokers, mainly. The FCA set out the types of firms included in the review – investment banks, contract for difference (‘CfD’) providers, wealth managers, brokers/interdealer brokers and retail banks. Note that that list doesn’t include asset managers, and that’s why I think it’s probably more relevant than any of the other thematic reviews. Because if the FCA want to look at something, they are going to look at topics in which they have expertise and experience, so that they can go in and challenge these practices in wholesale markets knowledgeably and with individuals that are familiar with the topic. They now have that with best execution and asset managers have not had a review so I would not be surprised if that does happen at some point.
It’s similar to my earlier comment about pillar one firm supervision, where some of the C3 firms had market abuse periodic assessments pillar 1 periodic assessments. It’s likely that was because they had the resources and the know-how to do those reviews, because of the thematic review that was ongoing. If you apply the same thing here, they have got people that know what they’re talking about, they can go in and have sensible conversations with the individuals doing the buy-side trading as well as sell-side, and actually assess that with knowledgeable individuals.
So I think this is a very important area for the industry at the moment. And it also talks to the wholesale agenda. The paper opens with a great statistic as well − this is clearly why they’re interested in both best execution and dealing commission: “Over a 30-year period, one basis point improvement in trading costs could represent an additional $37.5 billion in client returns.” Shortly after that quote they go on to say that this is a conservative estimate, and that many industry participants believe it could well be higher.
Demonstrating best execution
“Firms must establish and implement effective arrangements… Firms must monitor the effectiveness of their arrangements… Firms’ senior management also need to use the results of their robust monitoring.” This is what you should be doing with anything, really, any kind of process that you’ve got in place: establish and implement effective arrangements, monitor the effectiveness of those arrangements, and senior management also need to see the results of that monitoring to enable them to demonstrate that they, as a firm, are operating in their clients’ best interests. Senior management are going to have these conversations with the FCA; especially with larger firms where they will have interactions with some of the directors, and the directors will be interested in how they, living up to their SIF responsibilities, know that they are doing the best for their clients and the market as a whole. They’re going to want to know that they are seeing sufficient MI and information from the ground that their controls are effective, especially following the various attestations that have happened. The FCA have still got all of those “Dear CEO” letter attestations from November 2012 that the FSA collected, saying that firms were managing conflicts of interest effectively, if you were asked to submit one that is.
This is one of the other very damning statements: “All firms were unable to demonstrate to us that their front-office staff had a consistent understanding of the scope of best execution.” It is interestingly worded: it does not say that they “did not”; it just says that they were “unable to demonstrate to us”. I think that’s the job of compliance: to make sure that you can demonstrate to the FCA that you are abiding by the rules, and that your individuals are sufficiently knowledgeable to perform their functions.
It’s not in the rules to make sure that you can demonstrate that all your front-office staff are trained, just that they are, but they will be looking to see that you can demonstrate that as well. There were also a few things in there about dealing on quotes. There were a lot of firms that thought that the best execution obligations did not apply if they were dealing on quotes. The FCA doesn’t agree with that. It’s just too much of a blanket exclusion, and it says that in the paper. It ignores client classification, or the particular nature of the individual order.
Dealing on quotes itself doesn’t make it okay:
“Some firms maintained order execution policies which described their approach to clients dealing quotes so inconsistently that it was impossible to determine how the firm paid in practice.” You can apply this to all parts of your business: policies need to reflect what you do in practice. You need to make sure that the front line is involved in the creation and updating of policies and procedures. If you sit there in isolation and write a policy as a compliance officer or an operations individual, you’re not best placed to know how that market works, you’re not best placed to know how that particular dealer operates, and therefore you could end up writing something that not only isn’t being followed in practice, but couldn’t be.
This is my favourite quote: “Several firms sent in their execution policies, and one did not provide us with its execution policy at all in response to our information request.” It seems a little obvious that you have to have these policies. Not only do they need to say what you do, and how you control the risks, but you need to have them in the first place.
“Some firms said that the relative importance of each execution factor was ‘high’, leaving it impossible to understand how they weighted each factor in practice.” This is very similar to a board member answering the question “What is your risk appetite?” with the response, “low”. It is not particularly helpful, and it does not really help you articulate to the regulator actually what it is that would tolerate and what you would not.
There are different markets and different times when different execution factors are relevant. Price is not always the most relevant execution factor. As soon as you move into more illiquid stocks, fulfilling the order is going to be more important than the other execution factors. The next quote can be applied to lots of different areas and is similar to one of the other points that I made earlier: “One firm did not believe that compliance had any role to play, as they lacked relevant expertise and therefore no second line defence monitoring, challenge or validation was taking place.” This is the same as when we were talking about assessing the value of research: I think it should be that both parties are involved.
Front and back office in tandem
So you should have the front office, because they are the most knowledgeable on the topic, they know how execution works, how they go out to achieve best execution − and indeed are probably the best to judge whether best execution has been achieved at all. But then to exclude the second line from that, and say “we don’t need to be monitored because you wouldn’t understand”, probably isn’t going to cut it, if the FCA come in and talk to you. And that’s perhaps one way to encourage your front office to be a bit more engaged, if that’s their response: they’re going to be the one having to deliver that response. The FCA is going to want to talk to the people doing these tasks, not the compliance officers. It would be the same with any other thematic review that happens.
These are the kind of broad high-level questions that the FCA will ask you. Do you know if you are getting best execution, and how do you know? And they may be asking that of senior management. There has been a thematic review published. I don’t think they will necessarily expect the CEO to have read every thematic review that is published, but somebody in the organisation should have either read it or got a digest of it from somebody else, and then to have given the CEO or the senior management comfort that they are meeting the expectations set out in that paper. And this also talks to the FCA’s general approach to supervision. It will be a lot more about expectations of outcomes as opposed to meeting particular rules.
So what might happen next?
I think there will be more sectorial analysis. Similarly with thematic reviews, that was always seen as one of the key ways of identifying problems before they happen, or investigating market practices that may not be in the best interests of either consumers or the market.
There will also be a guaranteed interaction with the regulator at least once every four years. With a bit of luck that may be a phone call or attending a conference, but they have set themselves that challenge of having interaction with every firm once every four years. And challenge to accepting market practices: that very much is the theme of supervising wholesale markets off the back of LIBOR and FX. . As I said earlier, simply saying that that’s the way it’s done in the market or that’s what everyone does isn’t going to be sufficient. Finally, an AIFMD post-implementation review: there probably will be one. There normally is with any major piece of regulatory change, but I wouldn’t expect that to be for a few years yet.