Issues of mutual interest to the FSA and the Asset Management Community
Speech by Thomas Huertas, Director, Wholesale & Institutional Markets, FSA
PIMA Annual Conference
25 November 2005
Good afternoon and thank you to PIMA for inviting me to address you today. [I am standing in for Hector Sants who sends his apologies for not being able to attend.]
My theme today revolves around matters of mutual interest to the FSA and the asset management community. In particular, I want to update you on some key issues and initiatives in this area where there have been recent developments. Before I comment on any specifics, however, I would just like to emphasise the importance that the FSA attaches to the funds management community. At the end of 2004, the UK fund management industry had nearly £3 trillion of funds under management, a figure which has doubled over the past ten years. Further, it is estimated that the industry as a whole (including stockbrokers) employs more than 50,000 people, and contributes around 0.5% of GDP. As you can see, asset management is clearly a very important component within the scope of our engagement with the financial services industry.
I should also pause here to put what I am about to say into perspective by briefly outlining the FSA's regulatory philosophy. At the FSA, our aim is to promote the effective working of markets to deliver benefits for firms and consumers. We therefore operate a risk-based approach, which enables us to focus our resources and activities on the most significant risks. This approach accepts that some failure neither can nor should be avoided.
We aim to work with the grain of the market, introducing new rules, where we have discretion, only where this is justified by market failure and cost-benefit analysis – in other words, where we judge that market forces will not rectify the problem, and where it is likely that the benefits of that intervention would outweigh the costs.
While enforcement is an important part of our regulatory apparatus, our day-to-day supervision of firms and thematic work (where we seek to identify risks arising across different types of firms and market sectors) play a vital role in enabling us to achieve our statutory objectives. When we identify emerging risks, we set standards and work with the industry to mitigate them.
Finally, we aim to be principles-based. By this, we mean relying on general principles, rather than detailed and prescriptive rules. This is an approach to regulation in which the emphasis is on the objective sought and does not specify how compliance is to be achieved. Along with an emphasis on senior management responsibility and a preference for market-based solutions, this is reflective of our belief that firms have both the knowledge and responsibility to manage their firms.
Let me turn now to matters of mutual interest to both the FSA and the asset management community. In order to provide something of interest to all areas of PIMA's diverse membership of asset managers I would like to cover 5 key areas. These are:
- EU issues;
- Treating customers fairly;
- Financial capability;
- Current developments in authorised collective investment schemes, and
- SIPPs.
European issues
I will start in Brussels, as the pace and content of our policy making and regulation continues to a large extent to be driven from there. I would like to say a few words about the Markets in Financial Instruments Directive (or MiFID), the Capital Requirements Directive (or CRD), and the European Commission's green paper on Asset Management.
MIFID
To begin with, some words about MiFID. The first general point to make on MIFID is that thanks to diligent engagement by Member States and their industries, we are beginning to see some shifts in the Commission's thinking. For example, the requirements on client agreements now seem unlikely to trigger the need for a comprehensive – and costly – repapering of clients.
There are however, I think, two chief areas of concern from MiFID for asset managers – particularly where retail customers are concerned. First of all, the implications of a MiFID "appropriateness" requirement for execution-only business models. MiFID restricts pure execution-only business to "non-complex instruments". Where the boundary will fall between "complex" and "non-complex" instruments is at present uncertain, but it is likely to be more restrictive than is currently the case in the UK. Where firms provide execution-only dealing facilities for retail clients in more complex instruments, they will in future need to take steps to determine whether that trading is, in the terms of the Directive, appropriate for the client. However, that does not mean, in our view, that firms are compelled to provide advice. And it doesn't mean firms have to determine whether the investment is suitable for the personal circumstances of a particular client. But it is likely to mean some revision of the firm's procedures for client management and information handling. And it could mean some firms have to rethink their financial promotion strategies. In my view there's scope here to meet MiFID standards by adapting current approaches, in a way that does not fatally undermine existing business models.
Secondly, there's the question of best execution, where the outcome in prospect is looking more manageable than seemed likely at one stage. Perhaps the most significant element for this audience would be the obligation to produce a written policy on execution and to monitor the effectiveness of that policy. The policy will need to explain the steps that you are taking to achieve best execution, including information about the execution counterparties you are using. We recognise that these requirements pose important questions about the nature of the trading information available to you and about retention and comparability of data. We will address those with you in our implementation work.
Throughout the MiFID process we at the FSA have been very much alert to the practical and cost implications of the detail of the Directive, the so-called Level 2 issues, which are still under negotiation. When that negotiation concludes [hopefully next month], attention will shift to UK implementation, and we are already talking to several trade associations as we plan our approach to the transposition into UK regulation.
I know that a common accusation levelled against the FSA is that we gold plate Directives. So let me make clear that wherever possible we will be 'copying out' the text of the Directive in our rules; and if we do add new requirements on top of MiFID it will only be where there is a manifest market failure and our cost-benefit analysis stacks up. We will not be looking to recast the MiFID wording into UK-speak. Rather, we will be recasting our conduct of business requirements around the MiFID approach. That means firms, and for that matter FSA staff, will need to get to grips with a new format.
There are significant issues in implementation because MiFID does not apply to insurance investment products or to banking deposits. As we have seen, these are increasingly in head-to-head competition with investment products, and we are conscious of the need to keep the competitive playing field level. We will be using the new benchmark set by MiFID as a reference point for a wider review and simplification of the CoB sourcebook for non MiFID business. However, until we know for certain what the detail of the Directive looks like, it is difficult to speculate on how much unjustified complication will be stripped-out.
We are expecting the Commission to publish its final level 2 advice in December; accordingly we will not be able to issue a CP on this until next spring. We have, however, just published a document called "Planning for MiFID" to help firms plan for the implementation of MiFID, and to make sure that they are aware of the steps they need to consider. Whether you already have a plan in place for implementing MiFID or not, I recommend this document to you
We expect CESR’s level 3 advice by April 2006, and we will also need to consult on this. We have a goal of making final rules by early 2007 so we can give firms as much time as possible to implement these rules by the end of October 2007. We appreciate the burden this will put on firms and in commiseration I would say that we too have to review our systems to meet the same deadlines.
CRD
Let me now briefly touch on the CRD. We have sought to engage firms at an early stage, both during the negotiation of this Directive, and as we progress with domestic implementation, in an effort to better understand your key concerns. This engagement has already paid dividends. As a result of successful lobbying, the CRD will provide a more proportionate capital treatment in respect of operational risk for so-called 'limited licence' and 'limited activity' firms. It is expected that 'pure' asset managers and brokers – i.e. those who do not deal on their own account – will fall within the limited licence category. They would then simply be required to hold minimum capital related to a fixed overheads formula or, if higher, the sum of their market risk and credit risk requirements.
Earlier this month, we sent a Dear CEO letter to all small investment firms to explain the scope of the CRD and identify some areas firms should be considering. Firms will need to map from their post-MiFID list of permissions to the CRD categories and we acknowledge this will not be straightforward in some cases. Once we have consulted on MiFID, we intend to provide a chart which will show how a firm's permissions map across to the categories for firms contained in the CRD.
European Commission's Green Paper on Asset Management
Whilst CRD and MiFID are at our doorsteps, the Commission is shaping the agenda for the future with their recent Green Paper on Asset Management. This paper offers policy options, as well as an indication of the priority with which the Commission views these options. In the near term, the Commission sees no case for major legislative change, and has listened to industry calls for a slowdown in the pace of regulatory change. The Commission has, however, begun a program of work to make the UCITS directive work better – which we strongly support - and I will return to the detail of this later.
The green paper starts the 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. In this context the Commission has examined the viability of a true management company passport, and has considered whether procedures to facilitate cross border fund mergers and allow fund pooling will deliver worthwhile benefits such as economies of scale. It also considers an EU framework for private placement for non-UCITS funds.
The consultation period for the paper closed on 18 November and the Commission will publish a feed-back report summarising comments in 2006. The FSA and HM Treasury submitted a joint response to the Green Paper, agreeing with the Commission's analysis and supporting its high priority proposals of detailed work on the areas just mentioned.
Treating customers fairly
Moving back to the domestic space, I'd like to now talk about a key element of the FSA's non-European agenda, Treating Customers Fairly (or TCF for short). TCF is rooted in our statutory objectives and strategic aims. It is also embedded in Principle 6 which states that "a firm must pay due regard to the interests of its customers and treat them fairly."
There are two dimensions in our current TCF work that mark a departure from our approach to this subject in the past. Firstly our approach has not been to define precisely what constitutes "treating customers fairly", but rather to challenge the senior management of firms to work this out for themselves, taking into account the particular types of business that they undertake. Most senior management when asked will say all the right things about putting the customer first and delivering what the customer needs, and many recognise the importance of TCF as a key component of building a successful brand. But we are looking for more than just words: we expect senior management to build TCF into the operating model and culture of all aspects of their business. We are asking firms these questions as part of our current supervisory work and we will include points on their Risk Mitigation Programmes if we do not receive satisfactory answers.
The second change in this TCF initiative is our increased emphasis on principles-based regulation, rather than detailed rules. We have lots of rules relating to TCF, and indeed we could deal with the shortfalls we have experienced in recent years by adding more. 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 much better approach. But of course its success depends on firms taking the action needed to ensure that the principle of fair treatment of customers is a reality.
We want senior management – and we recognise that many of you have already done this or are in the process of doing so – to begin by carrying out a "gap analysis", to identify areas of their business – throughout the product life cycle - where they are not meeting the obligation to treat customers fairly. Senior management will then need to embark on a programme to address any shortcomings, and to set clear priorities and targets to determine how progress will be tracked. Treating customers fairly needs to be embedded into the culture of a firm at all levels, so that over time it becomes business as usual.
To help you with this we have produced a number of statements of good practice (and, indeed, some indications of less good practice) and case studies to illustrate some of the considerations that senior management should take into account. We published many of these in a paper in July, and further case studies are on our web site.
Financial Capability
TCF is about ensuring confidence in the financial services industry – i.e. the sell side. We must also not neglect the abilities of the buy-side - the consumers, whose needs you as an industry, are trying to meet. Turning away from the strict asset management agenda for a moment I would like to say a few words about our Financial Capability work. This work complements our TCF work, and flows from our statutory objectives and our retail agenda which is built on having capable and confident consumers. Financial capability is important - the ability to understand one's personal finances is central to well being in any society. Individuals are now are expected to take personal and financial responsibility in new areas, such as pensions and education. This in turn this requires a more financially aware population who are able to make informed decisions about the many choices available to them. As tax advantaged products are likely to be among the first savings and investment products that consumers purchase, this is an area of importance to you as PIMA members. A possible example of the size of the FC problem facing the industry is that Child Trust Fund voucher uptake has been low currently, running at 49.5% - and this is free money!
The FSA's resources in the FC area are limited – we have a budget this year of £8m against a central government education budget of £32bn, so our challenge is to identify the areas where our efforts can have most effect and where our expenditure has the most leverage.
We have a Financial Capability Steering Group that along with representatives of the seven working groups, met recently to consider options for the future. They agreed to focus on the effective and sustained implementation of seven initiatives. These include:
In schools - to develop a comprehensive service providing teachers with support, training and resources for personal financial education.
In higher education – to promote personal finance education guidance in universities, providing "drop in" and telephone help and promotion through youth friendly media.
In the workplace – rolling out a programme of support and encouragement for personal finance guidance. Pilot schemes have included large firms such as Stagecoach and Centrica, and also public sector and medium and small employers.
Resources for maternity/paternity leavers to highlight the financial impacts of new parenthood – which, as any of you with children will know, are many and long lasting.
Next year we aim to launch an online tool for consumers which can help them to assess how close their debts are to becoming unmanageable. We have already, in conjunction with the BBC (and sitting on the BBC's website), developed a Financial Healthcheck, which provides a general guide to help people identify their financial needs.
FC priorities also include the development of a Quality Assurance Scheme for generic advice in partnership with the Financial Services Skills Council. This will look to define the competencies required for the provision of generic financial advice, and I was pleased to see the draft standards published for consultation earlier this month.
Finally, we have set aside £100,000 to establish a Financial Capability Innovation Fund. This is designed to provide the financing for experiments by those in the voluntary sector aimed at tackling financial capability issues. The application period for this has now closed and we hope to make the awards by the end of the year. However these experiments can only be limited and our bigger challenge is to how to engage the resources of industry and government in meeting the larger costs of expanding any initiative, and this was raised recently by the Treasury Select Committee.
Collective Investment Schemes (CIS) Agenda
A topic more specific to asset management and an area that is very relevant to PIMA – is that of regulated CIS (which account for about 44% of PEPs and ISAs or, according to the IMA, a considerable £80bn), I will mention three areas: measures aimed at achieving a measure of controlled deregulation; conversions to our new Collective Investment Schemes sourcebook (COLL); and EU.
De-regulation
De-regulation has become a political imperative to keep UK businesses internationally competitive. Within the constraints imposed by EU legislation and in the light of our obligation to regulate in a way which satisfies our FSMA objectives, we are pursuing an agenda of deregulation. Let me give three examples which relate to CIS, which as you know are subject to the heaviest product regulation. Firstly, the substantial overhaul of the CIS sourcebook led to major liberalisations, with which I am sure you are familiar. Secondly, we dispensed with the specific requirement to publish unit prices in a UK national newspaper, and dramatically reduced the amount of information to be sent periodically to investors, thus reducing industry costs. Thirdly, we know that asset managers have been awaiting an indication from us on how CIS are to be priced in future. At the moment our COLL sourcebook only allows for single pricing. There is a choice for the manager in the pricing of authorised unit trusts - they can be either single or dual priced. Open Ended Investment Companies (or OEICS) have, of course, always been single priced. We have however previously said that we would look again at this pricing question before the COLL sourcebook becomes mandatory. We realise that we need to do so early enough to enable managers to prepare for the position that will apply after February 2007, and so we plan to consult in Q2 next year.
We have decided that our starting point for consultation will be that dual pricing should be available for both authorised unit trusts as well as OEICs. This is on the basis that the industry has for some time operated single and dual priced funds alongside each other without apparent consumer detriment. In practice, our policy would therefore mean that dual priced unit trusts would be able to continue as before. It also implies that OEICs would be able to dual price for the first time.
It is of course possible that consultation could cause us to change our mind on this policy. But if that happens, we will ensure that managers have sufficient time to adapt their systems to single pricing, even if that means the continuation of dual pricing beyond 2007. My message to dual pricing managers is therefore that there is no regulatory need at this time to change over to single pricing.
Conversions to COLL
Authorised CIS have to convert to COLL by February 2007. Only 24% of funds have converted so far and we are keen that funds convert as soon as is convenient to them – not least so that the FSA’s CIS Authorisations team avoids a log-jam of conversions at the end of the transitional period. Although February 2007 seems a long way away, I would remind you that we have one month to consider any application and you will also need to consult your depositary and legal advisers and maybe your investors if you intend making fundamental changes to a scheme. Also firms may need to extend their FSA permissions and develop formal risk management processes if they intend to invest in derivatives.
We recognise there are reasons why some funds will be waiting to convert:
I have outlined our plans on single and dual pricing, and I would add that it is possible, through a waiver, to dual price under COLL at present, so please do not see this as a valid reason for not migrating from the CIS sourcebook to COLL.
Also, we do understand that one of the barriers to converting to COLL, particularly for fund of funds, is the absence of a pronouncement on the PEP and ISA eligibility of non-UCITS funds. As you will be aware, in this year's budget the Chancellor announced that regulations would be made to allow non-UCITS retail schemes to qualify for PEPs and ISAs, subject to meeting the 5% test and not restricting redemption. Although not under our control, we expect an announcement on this before the end of the year from HM Revenue and Customs, and this will remove another barrier to conversion to COLL.
Further we understand that schemes invested in by fund of funds may be delaying conversion as they don't wish to inadvertently exclude themselves from investment by fund of funds by taking extended investment powers. It is our presumption that most fund of funds will convert to non-UCITS schemes to take advantage of the wider range of funds available and in doing so will extend their own investment powers to allow investment in any UCITS scheme.
If there are other barriers to converting to COLL which you think we need to address, then please let us know.
EU
There is also an EU element to the CIS agenda at present in the form of developments relating to aspects of the UCITS directive. We have seen the implementation of the simplified prospectus, and thank those of you who were involved in meeting the challenging deadlines to introduce the new documents. Further the FSA is actively engaged with CESR on its work to define eligible assets for UCITS and to streamline the procedures for the notification of funds that are looking to exercise their passport rights to be sold in other Member States. Many states take a very bureaucratic approach to registering foreign funds. This delays marketing and incurs real costs for firms and investors. CESR has issued consultation papers on both subjects and I would encourage you to respond if you are likely to be affected.
While on the subject of UCITS, the changes brought about by the amendments in the so-called UCITS III Directive have opened UCITS up to some of the main investment techniques that have typified hedge funds, with surprisingly little fanfare. UCITS III funds can for the first time use derivatives as their core investment strategy in the fund, and they can leverage the portfolio up to 100% of NAV through the use of derivatives. Construction of synthetic short positions through the use of derivatives is also now possible.
These changes may seem tame relative say to some hedge fund strategies, but they significantly widen the range of potential investment outcomes, both on the up and the downside, and introduce performance characteristics that traditional unit holders and indeed some traditional fund managers will be less familiar with. If such funds are to be made available to retail investors then, consistent with our messages on TCF, we would expect full and clear disclosure of the risks involved to be made.
V Self Invested Personal Pensions
Finally SIPPs. From April 2007, operating a personal pension scheme looks likely to become a regulated activity. This also means that the FSA will apply its conduct of business rules to all advised SIPPs investments and to the financial promotion of all SIPPs. And a year before that – A-Day in April 2006 – the range of assets that can be held in a SIPP expands hugely to include residential property, fine wines, works of art, racehorses and a plethora of other exotic assets.
This means that there will be a year during which wider range assets can be placed in SIPPs, but that wider investment range will be unregulated. Our chairman recently voiced concerns about this gap to the Treasury Select Committee, albeit that many providers will already be registered and the concept of treating customers fairly will still apply to those involved.
We see a number of additional risks arising in relation to SIPPs that I would like to highlight today:
Risk 1 – Retail consumers and advisors may not understand the risks that attend more exotic investments in SIPPs. This may be exacerbated by the media hyping of non-traditional investments in SIPPs, particularly investments in residential property, which may encourage people to invest without understanding the nature of the risks of new investments or the temporary lack of regulatory coverage of them. Unfortunately this risk will continue after full regulation, as some of the most problematic ads are from entities that will not be regulated in 2007 because they are only giving generic advice.
Risk 2 – Churning - unjustified switching of retail consumers from existing personal pensions into SIPPs, causing them to suffer detriment especially if there are financial incentives for advisors to recommend SIPPs over other pension products or to recommend switching and the wrappers are not transparent in terms of costs. We are presently considering how the Menu should apply to SIPPs. It would be very difficult to present them in the existing PP category and there are a number of issues that make it problematic to include them in the same way the other products are covered. The Initial Disclosure Document will apply as normal i.e. we can extend it to cover SIPPs without any problem. We are currently working on a disclosure regime for charges. It looks problematic to achieve comparability using the Reduction in Yield method because of the diversity of charges. It may simply require text description based on TCF principles.
Risk 3 - Risk that retail consumers make unsuitable purchase or transfer of Residential property (Home or Holiday Home). This risk is really a subset of the first one, but I thought it worth highlighting. For better off consumers, there may be a strong demand for residential property purchases in SIPPs. But few consumers will have a sufficient fund size to purchase residential property through a SIPP post A-Day, and the transfer of a property has its own implications which must be thought through.
Risk 4 - Risk that retail consumers make unsuitable purchase of a buy to let property. There is growing evidence of property investments through SIPPs being heavily promoted by unregulated property seminar companies and brokers as a tax efficient method of purchasing property. There is often no mention of the increased risk of purchasing property through a SIPP within the promotions.
Mitigation of these Risks
Given these risks, the important question is to ask, what should be about them done and by whom? You would expect the FSA first to look to firms and their senior management, and we suggest that it makes sense for firms to treat the business as regulated now, given that the regulation is coming. Advisers who recommend unsuitable but unregulated SIPP investments during the gap year are well advised to consider what treating customers fairly after the point of sale means from April 2007. It would be wise to consider now the investment standards that will soon apply to these long-term products. Acting now in an inappropriate way could compromise a firm's application for authorisation in April 2007. Moreover, particularly egregious cases could suggest breach of our threshold conditions.
But we would also challenge the industry, individual providers, advisers and their trade associations to work together to ensure that the introduction of SIPPs brings the benefits of wider pension provision that are intended, without the unwanted taint of consumer confusion and detriment.
We also welcome the actions of responsible trade organisations to caution their members about the risks involved in these more exotic investments and exposure of the general retail public to them. We have been encouraged by the prudent approach being taken to this issue by some provider firms whom we have already contacted.
For our part, we are considering a range of options that could include expanding our consumer information to include explanation about SIPPs in a Consumer Fact Sheet, further information on our pension web pages, and online top tips on our consumer website. We are already monitoring adverts for SIPPs and will continue to do so. We may also include industry messages in our sector newsletters and in management speeches and trade press articles leading up to A-Day.
I have sought today to update you on those key initiatives which I believe to be of mutual interest. I hope you have found this informative. I think you will agree that a number of the issues are quite tricky and pose some significant implementation challenges. If we are collectively focused on these initiatives, however, I think we can effectively progress them to a satisfactory resolution. We look forward to working with you to do so.
I am now happy to take any questions you may have.