14 Nov 2022
Side pockets: delivering at pace
One of the most important policy developments of 2022 is the FCA’s guidance on side pockets, aimed to address the fund suspensions seen earlier in the year.
One of the most important policy developments of 2022 has been the introduction of the FCA’s guidance on side pockets. These proposals aimed to address the significant number of fund suspensions seen earlier in the year: geopolitical events led to a sharp rise in sanctions and resulting exposure meant that many funds had little choice but to suspend. Over twenty funds found themselves in this position, creating a challenge for the FCA in terms of how best to enable funds to eventually re-open in a safe and appropriate manner.
What was remarkable about the consultation and implementation process was the speed at which it was delivered: an example of the FCA delivering on its commitment to become a more ‘innovative and adaptive’ regulator. The consultation period closed after only two weeks (16 May) and the policy statement was issued on 08 July, with implementation occurring a mere three days later. The circumstances were exceptional and the focus on side pockets, suspensions and sanctions required a significant refocus. This meant that timelines for other initiatives such as ESG related activities had to be pushed back somewhat. However, this is a striking example of the regulator moving at pace to deliver consequential changes.
The side pocket proposals
The features of the side pocket proposals only apply in relation to the current geopolitical situation – they will not become a standing option to be used in other scenarios, although this is something which may be considered further down the line. The proposals are essentially for a one-for-one unit match whereby an ‘internal side pocket’ is created for non-sanctioned assets which can then be reopened. Existing investors will also retain units in the sanctioned part of the fund which can be redeemed as and when sanctions are lifted.
Another option – the so-called ‘external side pocket’ which would have set up an entirely separate fund for non-sanctioned assets - was also floated in the consultation and had some supporters, but was ultimately rejected, due to perceived additional complexity. Interestingly, European regulators such as the CSSF and CBI appear to have favoured the external option over the internal option so there is a divergence in terms of UK and EU approaches to addressing the glut of fund suspensions.
There are a number of technical details for firms to chew over. The requirement for AFMs to treat the introduction of side pocket classes as a fundamental or significant change has been waived, but the AFM must provide justification in its notice to unitholders. If the AFM determines that implementing side pocket unit classes should be treated as a significant change, the requirement to give prior notice will be removed (although unitholders must still be given some form of timely notification). The policy statement also provides guidance on how voting rights for side pockets may be exercised at a unitholder meeting and provides guidance that AFMs should consider the operational needs of distributors before deciding to set up a side pocket.
Not 'one size fits all'
It appears that the proposals will not be adopted by all funds currently suspended: perhaps around half will take up the FCA’s offer to introduce a side pocket. This means that a sizeable proportion will either remain in suspension or will be seeking their own bespoke remedy. The reason that uptake is relatively muted is that suspended funds are not ‘one size fits all’. Some have far more exposure than others, and such a sizeable exposure, that the side pocket fund would be too small to be viable.
While the proposals may not have suited all suspended funds, and the rush to address the issue of suspensions has meant that some other regulatory milestones have been pushed back, the experience of side pockets now stands as a case study in how the FCA is able to move fast and deliver sizeable regulatory change in an agile fashion. It may act as a template for similar challenges in future.
Welcome to the latest edition of Depositary Insights which offers the latest thinking on regulatory and industry developments from NatWest Trustee and Depositary Services.
The economic downturn, war in Ukraine and the aftermath of the UK government’s mini-budget have coalesced to ramp up the regulatory focus on fund liquidity.
Brexit caused many UK fund managers to head to Europe, but with the UK government now taking active steps to support domestic financial services, a two-way trend of relocations looks set to continue.
Regulators’ efforts to combat greenwashing, bolster operational resilience and oversee the move to Direct2Fund will shape the investment industry this year.
The UK’s proposed new approach to regulating digital assets should start to unlock their potential to transform the investment industry.
In November, NatWest Trustee and Depositary Services (NWTDS) held an in-person event on the topic of embracing change and preparing for a digital future.