Speech by Dan Waters, Asset Management Sector Leader, FSA
IMA Conference
16 June

The global pre-eminence of the UK industry

Good morning ladies and gentlemen. I am delighted to be here with you today at this important annual gathering of the leaders of the asset management industry. The UK is recognised globally as a pre-eminent centre of asset management. This year's IMA survey results show that at June 2004 its members managed a staggering £2.16 trillion of assets in the UK, up from £1.99 trillion the prior year . Adding in assets managed that are overseas the total is more than £2.8 trillion. That puts us third in the world after the US and Japan in terms of assets under management with about 8% of global assets under management here in UK. We are all aware of the importance of the sector to UK consumers and to the UK economy as a whole. It is also encouraging that weighted average profitability across the groups surveyed by IMA this year rose to 23% from 21% the previous year. The averages as ever tend to conceal the variability of results at individual firm level: in general larger institutions seem to have faired better than others. As was the case last year, 70% of respondents fell below the average profitability level, with the median being 17%.

Overall a picture that is pretty positive. But developments in the retail funds side of the market are gloomy. One indicator is the disappointing ISA season this year. IMA figures show that sales in the "ISA season" (Q1) were down 5% over the 2004 figures. To add insult to injury, redemptions were up 30%, so the net effect was a reduction of net inflows to ISAs of 36% for Q1 2005 when compared with Q1 2004. This appears not simply to relate to uncertainty about the future tax treatment of ISAs -- net sales of authorized retail collective investment schemes (UCITS) were down a eye-popping 51% for Q1 2005 when compared with Q1 2004. The mild recovery in UCITS sales that followed the equity bear market of 2000-2003 has faltered, despite the rally in equity markets. This may reflect a lack of confidence contagion: although UCITS products have not thankfully featured in any recent mis-selling episodes, there seems to be a continued fragility of consumer confidence in investment products generally (no doubt abetted by the allure of other asset classes -- in particular property). This lack of consumer confidence is a more serious concern against the backdrop of the ‘savings gap’ and the increasing individual responsibility for financial provision that is fundamental to public policy thinking. We think that consumer confidence will only recover fully in a world in which customers are treated fairly. That is a topic that I will turn to in a moment.

Before I do, I thought I would take the opportunity of being the first speaker to front run those who are following me. We have studied with interest the recent report undertaken by OXERA (commissioned by the IMA and the Corporation of London) which will be covered in the next session. Without pre-empting that discussion, I do want to take the opportunity to respond to a few points raised in the report. The report makes it very clear that core asset management activities are very firmly rooted in the UK and are likely, in the view of the survey respondents, to remain here. Marketing and distribution look firmly linked here as well. Scores in respect of back and middle office however were slightly lower. But overall a very positive message which the FSA welcomes, mindful as we must be in our regulation of the competitive position of the United Kingdom.

There were some important messages about regulation in the report as well. The report states that "For the most part the UK regulatory regime is regarded as favourable". For a regulator, this is about as good as it gets. But a series of issues were raised, including concerns about how regulation may develop. Those concerns are consonant with a growing chorus of concern about the cost and burden of regulation. Although it is not a uniquely asset management issue, it is sufficiently important that I want to take a few minutes to touch on some of the things the FSA is doing to respond to concerns about the costs of regulation.

I hope I won’t come across as defensive if I say that when the financial services industry has been asked to rate UK financial services regulation as against that in the US and Europe, we have consistently come out at the top of the pile. CBI rated the regulatory environment in the UK ahead of that in the US and materially ahead of France and Germany. On 25 October the CBI published a report on 'Financial Services; promoting a global champion', about the importance of the financial services sector to UK plc and the risk to the sector's continuing success from various sources. The report compares the regulatory environment in the UK, the US, France and Germany. Overall, the UK and the US score 4 out of 5 (5 = 'very good'), with France and Germany both on 3. Most of their recommendations for action are directed to the Government, including that 'all government departments should match the recent commitment made by the FSA on goldplating'. On FSA staff the report notes 'Industry speaks highly of the quality of people that it deals with within the FSA'. Anxieties are expressed, however, on issues which we know are of concern to the industry - in particular, the cumulative effect on the market of EU regulation.

But even if we score well against our counterparts, that does not mean we could not and should not do better still. We recognise concerns about the impact of regulation on business and are far from complacent in responding to them. As you will be aware, we have commissioned with the FSA Practitioner Panel a review of the costs of compliance. Deloittes has been appointed to conduct that work, which will focus on three areas: the retail advice market, corporate finance and institutional fund management. We will augment that work with further work on the benefits of regulation. We await with interest the outputs of this project.

But let’s be honest with each other. The pace and content of policy making and regulation is to a large extent now driven by Brussels, not by the UK government or the FSA. We have in the past two years cut back drastically on the number of CPs we issue – nearly halving the number last year and keeping to that much reduced level this year. But the Financial Services Action Plan is only midway in its implementation. The wave of change that we are riding this year recedes a bit next year but gathers force again in 2007 with the implementation of the Markets in Financial Instruments Directive, a far reaching directive that will impact the wholesale and the retail markets in very significant ways.

We have listened hard to the complaints about superequivalence and gold-plating in our implementation of directives. As a policy director in the FSA, I can tell you from personal experience that any proposed superequivalence in the implementation of a directive is now examined very closely indeed by senior management and required to clear a very high hurdle to be included. Our modus operandi these days is copy out of the directive text. That is the starting position – any deviation from it must be justified and pass the rigorous cost benefit analysis and market failure analysis that we undertake for all policy proposals.

Before leaving our general efforts on reducing the cost of compliance and turning to asset management issues, let me just mention one other major initiative that I want you to be aware of. My division is hard at work at the moment on putting together proposals to simplify the retail provisions of the FSA’s Conduct of Business Sourcebook. As many of you will remember, when the FSA was formed we took a decision, which government and the industry supported, not to undertake a drains-up review of the substance of the retail conduct of business requirements of the old regulators. Basically we eliminated duplication, did a few tweaks at the margin and brought the lot into the FSA Handbook. That was all the FSA and indeed the industry was able to cope with at the time.

But times have changed. The implementation of MiFID, which will directly impact huge swathes of the conduct of business sourcebook, presents us with a perfect opportunity to take a fundamental look at the retail rulebook that we have inherited. We think that we can do better. We think that in its current form it does not sufficiently reflect the kind of regulation that FiSMA contemplates and that the FSA espouses – namely, risk based, focused on senior management responsibilities, easy for firms to interact with and understand, and sensitive to the needs in particular of small financial services businesses. On 30th June, as part of a consultation paper looking at removing a number of regulatory requirements in different areas, we will be setting out the philosophy and framework that we propose to adopt in rewriting the retail Conduct of Business requirements. We will be very interested to hear your views on our proposed approach.

The OXERA report focuses on the attractiveness of the UK for asset management businesses. Specific regulatory concerns were raised in connection with the UK as a domicile for funds. The report pointed out that some European member states – Luxembourg and Ireland in particular - have taken a more flexible approach to implementing the UCITS directive -- for example in relation to money market funds. We are in fact in discussion with IMA and the Institutional Money Market Funds Association (IMMFA).on this very issue. As many of you will know better than I, there are a whole raft of difficult issues about the consistency of treatment of UCITS across Europe, to which I will turn to later in my remarks.

The measured liberalisation of the CIS regime

But in the meantime we have not been deaf to the pleas of industry to liberalise aspects of the existing regime. The IMA obviously has always taken a keen interest in the authorised CIS regime, so a few words by way of update about what we are doing here. As you know, the new Collective Investment Schemes Sourcebook (COLL) came into force in 2004. Under its transitional provisions, all schemes operating under the old Collective Investment Schemes Sourcebook (CIS) must be converted to COLL by 12 February 2007 at the latest. Those that are currently passporting or intending to passport have, consistent with the agreement reached in CESR, only until the end of this calendar year. I know that those of you for whom this is relevant are well advanced in your work, for which thanks. I note however that only 6% of all funds have yet converted to COLL, so forgive me if I remind you of the need to do so in the next 18 months.

One issue to highlight, (as your outgoing Chairman noted in his farewell speech at the recent IMA dinner), is that we have dispensed with the specific requirement to publish unit prices in a UK national newspaper. This is a practical deregulatory measure which could save the fund management industry millions of pounds a year. It should be noted that we will still require firms to publish unit prices in an appropriate manner which could include on a Website or other online medium. Recent developments such as the new "Daily Fund Price Section" on the IMA Website are making such alternative means of price provision more accessible to investors and we thank the IMA for their constructive input in getting this proposal right.

One outstanding issue that is of concern to some of you is the dual pricing of CIS. We are well aware that if we do not make rules to extend the ability to dual price funds, that ability will disappear in 2007 when the CIS sourcebook comes to an end. We will consult in good time on whether to allow the continuation of dual pricing. Given the beneficial impact of dual pricing on threats like market timing, but without prejudging the outcome of our review, I would be surprised if the outcome were to prevent its continuation.

Treating customers fairly - Background

Let me turn now to the topic I touched upon earlier, that is, treating customers fairly. We believe that the fair treatment of consumers by firms (and its perception as such) can contribute a great deal to the rebuilding and maintaining of consumer confidence in long term savings and investments products generally. Treating customers fairly or TCF as it has inevitably been branded, is an important initiative which has sparked a great deal of interest and indeed some concern in the industry.

Our starting point is that the market in retail investments and savings products in the UK, like those in many other countries, is characterised by some serious market failures. By that I mean features or characteristics of the market that mean it does not operate in an optimally competitive manner to deliver good value outcomes. What are the key failures? At a high level they are well known. Consumers, or many of them suffer from inadequate understanding of their own financial needs and of the products in the market capable of meeting those needs. Many of them indeed struggle with basic literacy and numeracy skills, which make engaging successfully in financial investments extremely difficult. Moreover the products they buy necessarily have a built in uncertainty in terms of the return they are likely to yield, and that return may not be known for many years in the future, depending upon the product, again, a situation that does not obtain in many other consumer goods markets.

Given these deficits and difficulties, it is unsurprising that consumers of UK retail investment products do not behave like consumers in other UK retail markets. They do not, for example, shop around for better value products. I am not saying that cheapest is necessarily best. But the market is characterised by a sometimes startling price dispersion – products whose risks and return characteristics are virtually interchangeable sometimes attract wildly different commission and charging structures, something that would be unthinkable in a market where consumers understood what was good value for money.

And there are failures on the supply side too. The remuneration incentives for advisers and distributors of financial services products often run counter to the interests of consumers with whom they deal. The chances for less than optimal outcomes are increased. In addition to the potential misalignment of incentives, providers and sellers of financial services enjoy very significant information advantages over the consumers who purchase them. This imbalance is often exacerbated by the flood of incomprehensible financial literature that may accompany even the simplest financial services offering.

The FSA and many other regulators around the world have intervened in markets to try to redress the failures that exist. Rules requiring simple and clear disclosure, requirements to provide suitable advice, education and awareness initiatives directed at the long-term improvement of consumer financial capability are some examples. Our treating customers fairly initiative falls squarely in this territory. It is worth recalling that treating customers fairly has always been one of the core principles of FSA regulation. The phrase itself in fact comes from principle 6 of our central 11 principles for businesses. But to be fair, our recent approach is somewhat different and I think I ought to explain how and why.

The first important difference is our focus on the senior management of firms. We are having grown up conversations with major firms about their strategy for making money in the retail market. We want to ensure that strategy includes and addresses the regulatory risks of getting it wrong. Most senior management when asked will say all the right things about putting the customer first and delivering what the customer needs. And they mean them. But we are looking for more than words: we expect senior management to build TCF into the operating model and culture of all aspects of their business. Many firms do this now; many more are working hard to raise their games.

The second refinement to our approach is our increased emphasis on principles-based regulation rather than detailed rules. We have lots of rules relating to TCF. And we could deal with the shortfalls we have experienced in recent years by adding yet more detailed rules. But we do not see that as the best outcome for firms or for consumers. The limitation of a detailed rules-based approach is that it will deliver a solution that does not provide the flexibility that firms need to deliver fair treatment in ways that fit their particular circumstances and business models. A principles-based solution, which makes clear the requirement to treat customers fairly, but allows firms the flexibility they need to deliver it, can be a better approach. But its success depends on firms taking the action needed to ensure that the principle of fair treatment of customers is a reality.

That is the high-level framework and approach to TCF. But I want to say something about what it means in the asset management sector specifically. In a nutshell, that means trying to understand what treating customers fairly means right through the value chain. OXERA in its report describes the asset management value chain as comprising core asset management /marketing and distribution and / middle and back office. I want to take a closer look today at the marketing and distribution links in that chain, from the perspective of treating customers fairly. As I hope you will see, we think that TCF has important implications for far more than just the adviser / consumer interface, territory which many of you do not directly occupy.

Treating customers fairly – Product Design

Let’s start at the beginning. That would be product design. The UK experience over recent years has not been without problems. Inherited problems from the old regimes – pensions mis-selling and mis-selling of endowment mortgages as well as more recent difficulties with so-called precipice bonds and split-capital investment trusts – have highlighted the downside risks of serious mis-matches between product characteristics and consumer needs. In our discussions with firms about how to avoid these disconnects, we have identified a number of good practice principles that can mitigate the risk of this mismatch.

For example, firms are using a range of techniques to test:
- whether the products they are designing meet the needs of the target customers;
- whether target customers would be likely to understand the product’s features;
- how the features of the product can best be made understandable to the target customers; and
- how the product would perform through a range of stress testing scenarios.

Such testing permits firms either to design problems out of products at the outset or to ensure that the right safeguards are built into the sales and after-sales processes. So there is quite a lot of groundwork to be done at the design stage if problems are to be averted further along down the chain. We are not expecting perfection; but it must be possible to achieve outcomes that avoid the systematic mismatches of consumer needs and product delivery that we have been witnessing and which have proved damaging to both consumers and firms.

Treating customers fairly: Financial promotions

Let’s turn now to marketing of financial services products. As you know, the FSA has from this year placed increasing emphasis on this aspect of the product value chain. Through our financial promotions team of some 30 staff, we are reviewing advertisements across all relevant media, looking for evidence of good and poor practice, with the aim of promoting the former and stamping out the latter. Focal points include plain English, and clear, concise and balanced communication of risks and rewards to consumers. A firm was recently issued a fine on the basis that promotions did not provide customers with sufficient information about how the product worked or the risks involved, choosing to focus on the benefits of the product, including free promotional gifts. Another firm issued an advert, which did not meet our standards as the promotion had completely bypassed the firm's internal approval procedures. In the course of cases like this, the team may choose to follow up their initial examination of specific adverts with focused visits to firms to review their processes for producing promotions. I would also highlight that the Fin Proms team have stepped up their direct contact with the advertising agencies designing promotional material as well as improving its contact with the Direct Market Association.

I would also refer you to the recently launched pages on our website for more updates on current issues in Financial Promotions as well as examples of good and bad practice in product marketing material. For instance, there are illustrations of the ways in which FSA would interpret information about past performance contained in advertising, expanding on the new COB rules of last year.

TCF at the consumer / advisor interface

We have talked about product design and marketing, what about TCF at the consumer / advisor interface? I know that many of you will have no direct involvement at the point of sale, as products you produce are being sold through distribution channels that are separate from you. But that does not mean that you have no interest in or exposure at the point of sale. There are multiple regulatory risks that arise at the interface which require careful management. Some of these risks fall upon the providers / manufacturers of financial services products, some on the adviser / distributor of them.

Consider product literature. Advisors will often be heavily reliant upon the product materials that are provided by the product provider or manufacturer. If you have created a product and / produced or caused to be produced the product literature, are you confident that your distribution network understands the product and its attendant risks? Do IFAs distributing your products, for example, have a clear understanding of the sort of consumer for whom a particular product might be suitable, and conversely for whom it would not be? What steps have you taken to satisfy yourself that this is the case?

You may be aware of a recent High Court case in which it was held that a marketing company must share liability to the end consumer with an adviser. While not an action under FiSMA, some of the principles underlying that case are not in substance different from the position that we consider applies now under our regulations. Cases always depend very much on their individual facts, but for example where a product provider creates the marketing literature that an IFA relies upon and distributes to its client base, the provider will itself be liable in the event that the marketing materials are not fair, clear and not misleading. Indeed both the IFA and the provider could be jointly liable in such a situation. So do not fall into the trap of thinking that all risk at the point of sale has been off loaded on to advisory firms. Thinking carefully about your distribution networks, about the quality of information provided and the level of the adviser's ability to deal with them will go a long way to mitigating the risk of the products ending up in the hands of consumers for whom they are not suitable.

As you may know we are in the process of developing case studies that will illustrate good practice in various areas concerning TCF. Now I know some of you worry: isn’t TCF just the FSA making rules without the fuss and bother of rulemaking? If the FSA has a specific idea of what is right in its mind, why not just come out with it, write a rule that says what the answer is and be done with it.

We appreciate the desire for certainty. But we firmly believe that if we were to get into the business of trying to write down the answer for every scenario that comes up, our rulebook would sink Canary Wharf. As I explained a few minutes ago, we are moving in just the opposite direction. We already think we have too much prescription. This is a case of less is more – better delivery of our objectives with less regulatory intrusion. But the implications of that are also more reliance upon you to figure out what compliance means in your business circumstances. But we think that you must be best placed to work out what the major regulatory risks in your business are, and how you can best mitigate those risks.

I’ve covered the challenges of reducing compliance costs and treating customers fairly. Let me turn to the elephant in the room that has been mentioned from time to time. I mean of course the European Commission and its agenda for asset management.

CESR/EU Green paper

Last year the Commission established a team working specifically on asset management issues in its Internal Market division. Among other things. the team has been weighing up how the UCITS Directives are working. To give you the FSA perspective, I think it is fair to say that, though UCITS has its limitations, we think that at this stage there is no need to get rid of it and start again. You may have read the speeches of Commissioner McCreevy, which suggest that the Commission is coming to a conclusion similar to ours. Instead of large-scale revision, it sees the way forward as helping the Committee of European Securities Regulators (CESR) to make the best of the current legislative framework, for example by giving the Investment Management Expert Group appropriate mandates. I have personally been devoting a lot of time to forging agreement in CESR on some of these issues (for example on transitional arrangements, Eligible Assets and more recently notification procedures). Some of the negotiations have been very hard going. On the current consultation on eligible assets of UCITS we have received a huge number of very cogent comments. Rest assured that we are taking them very seriously indeed. We are attempting in the work of eligible assets to bridge two completely contradictory points of view in the EU about the treatment of close-end funds, among other things. We certainly have no intention of casting doubt on the ability of UCITS to invest in listed UK investment trusts – indeed they have done for years. I would expect a further round of consultation in the autumn. Hopefully that will clear up some of the problems seen in the current version. I urge you to keep an eye out for this draft and to make your contributions in a timely manner.

As you no doubt know the Commission intends to publish a Green Paper in July which will offer policy options and an indication of the priority with which the Commission views those options. In the near term, we believe that the Commission sees no case for legislative change. But it will begin a process of dialogue with stakeholders about whether (and if necessary, how) to modify the European framework for funds so that it better reflects the need to balance a varied range of investment strategies with the consumer protection imperative. I expect that in this context the Commission will examine the viability of a true management company passport. It will likely consider whether procedures to allow fund mergers and pooling will deliver worthwhile benefits such as economies of scale; and it may evaluate the merits of a passport for depositaries. It is absolutely essential that all those of you who are affected engage either directly or indirectly through the IMA with this work.

Hedge Funds

In closing let me just take a moment to say a couple of words about the much heralded discussion papers which we are issuing next week on hedge funds and retail investment products that share similar risk characteristics.

The first thing to do is to correct the impression given in more than one newspaper that the FSA has decided to open the door to retail consumers investing in hedge funds. These are discussion papers, not consultation documents. They analyse the range of risks presented by hedge funds and other products with some of the risk characteristics of hedge funds, and consider current and possible future mitigation. They do not propose definitive legislative or regulatory solutions.

One of the drivers of our review is the fact that the Commission's and indeed the European Parliament's interest in the regulatory arrangements for hedge funds is growing. The Green Paper is likely to include early thoughts about the treatment of non-harmonised funds (that is, funds that are not subject to the UCITS Directive).

As Commissioner McCreevy said at the start of his term, it is your internal market, not the Commission's. If we want to see the right kind of ideas coming out of Brussels, we need to contribute arguments, analysis, examples and raw data at the start of that process. At the FSA we believe that the UK asset management industry has much to contribute to, and much to gain from, a single market. We welcome and support the Commission's role in bringing this about. And I would strongly urge you to engage fully in the debate that the Commission is kicking off.

Thank you very much for your kind attention. I would be happy to take questions.

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