21 Mar 2023
Regulatory outlook: What to expect in 2023
Regulators’ efforts to combat greenwashing, bolster operational resilience and oversee the move to Direct2Fund will shape the investment industry this year.
After a tumultuous few years, the regulatory agenda for financial services has been pushed back by six to nine months. But there are still important rule changes coming down the track, and firms need to be ready. Here are three of the biggest regulatory shifts we’ve identified, and what you should be thinking about to stay one step ahead.
Last year witnessed an uptick in applications to launch ‘sustainable’ or ‘ESG’ funds, reflecting growing consumer appetite for these funds and their more thematic offshoots. By the end of the third quarter of 2022, for example, the number of funds globally with a climate-related mandate had increased by 32% over the year, according to Morningstar.
Now, regulation is catching up. ESMA has recently held a consultation around ESG fund names, while the three European supervisory authorities are calling for evidence on greenwashing.
Stamping out greenwashing in fund marketing will also be a key focus for the FCA this year. Back in July 2021, the regulator said it was concerned about the “poor quality” of many ESG fund launch applications, pointing to misleading fund names, limited exclusions from indices and unreasonable goals.
In October 2022, the FCA unveiled a proposed package of measures in CP22/20, which it hopes will protect consumers and build trust in sustainable investment products by eliminating the potential for “exaggerated claims” and mislabelling.
This means that firms can expect restrictions on the use of terms such as ‘ESG’, ‘green’ and ‘sustainable’ in their marketing materials, as well as more detailed disclosure requirements to explain investments that consumers may be surprised to see within ‘sustainable’ funds.
CP22/20 also includes plans to create a new category of funds that are improving their sustainability over time. This could be good news for asset managers, as it could give them the scope to buy and hold firms that don’t have a perfect ESG record but can be pushed to do better through fund manager engagement.
The FCA’s new Consumer Duty rules, which come fully into force from July, may also affect how firms communicate their sustainability credentials.
The rules are designed to ensure that customers understand communications from firms, that products and services meet their needs and offer fair value, and that they get the support they need. Firms launching ESG funds should assess their plans through the lens of Consumer Duty to ensure they are correctly targeted and their objectives are achievable.
Regulators will also be putting ESG data under the microscope this year. In November 2022, the FCA announced plans to develop a code of conduct for ESG data and ratings providers. Data quality can vary by provider, and firms will need to validate this with due diligence while keeping an eye on costs.
2) Operational resilience
The many disruptions to global business so far this decade — Covid-19, the war in Ukraine and a spree of cyberattacks — have placed operational resilience firmly on the regulatory agenda. And this year, the FCA will go beyond its Operational Resilience Framework to assess firms’ compliance.
Safeguarding operational resilience can be an onerous process, so firms will need to prepare. By 31st March 2025, larger firms that have identified important business services, such as digital applications or core business processes, which could cause intolerable harm to customers, the firm or the market if disrupted, must be managed within risk tolerance.
This will involve a process of mapping and testing to identify vulnerabilities, followed by investment where required. The aim is to ensure that firms can consistently operate without risking market integrity or harming their customers, whatever challenges arise in the wider environment.
While large firms will have the most work to do here, we expect to see a trickle-down effect, which will have implications for small-and medium-sized firms too.
The UK fund industry has developed differently to others, resulting in a complex system with a lot of moving parts, with various third-party entities performing different functions.
Regulators will also shine the spotlight on critical third parties that may not be regulated but could also cause material impacts if they fail, such as cloud providers. Noting that the financial sector is increasingly reliant on third-party businesses, the FCA is concerned about the risk this poses to operational resilience.
Firms will be expected to look through the value chain to make sure the services they are outsourcing have appropriate preventative measures and business continuity plans in place. Tools that firms might use to do this include scenario testing, cyber-resilience testing and skilled persons’ reviews of critical third parties.
Direct2Fund (D2F) is a proposed investor-fund dealing model that could offer an alternative to the traditional and rather cumbersome UK model.
The UK model, in which investors interact with funds through an authorised fund manager’s dealing account, is an outlier among EU financial centres, and replicating the D2F process used in these markets would allow UK investors to transact with funds directly.
The hope is that this will make the UK investment management industry more competitive, while enabling operational efficiencies.
Findings from an Investment Association working group are expected to be published in shortly, paving the way for the FCA to consult on and implement any proposed changes.
There is much for the industry to thrash out: For instance, how much direct engagement would depositaries now have with investors? And what are the implications for Know Your Customer and Anti-Money Laundering?
There are also data protection considerations. D2F may place customers’ personal information in the hands of firms that are not used to handling it, and they will need to ensure that this data is given the required protections under GDPR rules.
A crucial question is whether investors’ monies will still be classified as client money and protected accordingly. We struggle to see how the FCA will ever be comfortable removing consumer protections that apply to clients’ money. We know from a past large fine that the FCA handed out for failures to oversee client money held by a third-party provider that this is an issue it takes very seriously.
Tokenisation using blockchain technology may offer a way around this. By representing the ownership of an asset as digital tokens, rather than a share or fund unit, fund providers could offer tokenised collective investments and distribute them directly to the market.
This could break down the barriers between fund managers and investors and help create a more direct connection. In fact, we believe tokenisation could herald a transformational approach to dealing.
Each of these regulatory trends will present firms with new hurdles to overcome while working within the unique parameters of the UK financial services model. As the regulatory agenda kicks into high gear once more, firms will need to stay one step ahead of the changes to ensure they remain both resilient and compliant.
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