FCA warns of risks that alternative investment firms pose to their customers
The UK Financial Conduct Authority (FCA) has outlined its view of the main risks of harm that alternative investment firms, and the markets in which they operate, pose to their customers.
The regulator explains that, while its ban on the mass marketing of speculative investments to retail clients has led to a reduction in harm, inappropriate distribution and marketing practices by firms targeting mainstream investors remains a concern.
The FCA has seen examples of informal governance processes compounded by poor due diligence and inadequate investor categorisation leading to investors with a lower risk appetite accessing high risk products that may not match their objectives. Firms should consider the appropriateness or suitability of the investments they offer for their target customers, be they retail or elective professionals.
Firms can reduce the risk to consumers with limited investment knowledge or risk appetite being exposed to inappropriate investment strategies by conducting thorough investor assessments. In order to achieve this firms should:
- ensure that alternative investments are only offered to appropriate investor types, and that the investments meet client needs. Firms should recognise that not all alternative products are suitable for all investors.
- consider the application of relevant marketing restrictions to retail investors when communicating or approving financial promotions for alternative products.
- recognise that an adequate assessment of the suitability of alternative investments for retail investors is an essential mitigant in the reduction of potential harm.
- make sure that target markets are clearly outlined for distribution channels to ensure a clear understanding of in scope investors is in place.
Regarding crypto regulation, the FCA says it will publish final rules for the promotion of crypto assets once the Treasury formalises legislation to bring these into FCA remit. The regulator expects firms to monitor regulatory developments in this area and promptly review their business practices as new rules are introduced.
Firms should also consider their new obligations under the Consumer Duty which sets high standards of consumer protection across financial services by requiring firms to put their customers’ needs first. The rules and guidance being introduced for new and existing products or services open to sale or renewal come into force on 31 July 2023, and later on 31 July 2024 for closed products or services.
In the coming months, the FCA will be issuing a questionnaire asking all portfolio firms for information about their business model, products, investor categorisations and associated control framework. The regulator will follow up with those firms exhibiting characteristics that increase the potential of consumer harm. As part of this supervisory work, firms will need to evidence the reasonable steps taken to ensure their target market is both appropriately defined and not exposed to an unsuitable level of risk.
In addition, dirms are required to manage conflicts of interest fairly. Poor management of conflicted positions can encourage market manipulation or improper fund performance reporting, in turn producing poor consumer outcomes and loss of market integrity.
Where the FCA identifies harm to investors, it will assess to what extent inadequate management of conflicts played a role and will consider the need for Enforcement action as appropriate. Firm Boards should carefully review their procedures to ensure conflicts are avoided, managed, or disclosed in a way that minimises harm to investors and markets.
Firms should also consider the impact of their shareholder structure and the potential implications this has on the effective governance of their organisation.
Further, the FCA notes that market abuse undermines confidence in, and the integrity of financial markets. Established, robust systems and controls are crucial in mitigating this risk, with firms providing a vital first line of defence.
The regulator has previously observed that market abuse controls across the sector need to be improved. The FCA expects firms to have strong prevention cultures and effective systems and controls to enable them to discharge their obligations under the UK Market Abuse Regulation (UK MAR). Firms must ensure UK MAR controls are tailored to their individual business models. Where firms do not comply, the FCA will consider the need for criminal, civil or supervisory sanctions to provide effective deterrents.
Finally, the FCA says that a firm’s approach to remunerating and incentivising staff contributes to organisational culture. Remuneration policies can help ensure appropriate outcomes for customers and markets and reduce the likelihood of harm. Where employees are inappropriately incentivised, this can increase conflicts of interest and the potential for harm. Firms that are subject to the MIFIDPRU Remuneration Code are required to apply the relevant rules from the performance period on or after 1 January 2022.
During the forthcoming supervisory cycle, the FCA will look at how senior managers and firm policies influence an organisation’s culture. Evidence of staff being unable to speak up is an area of particular concern. Furthermore, the regulator is interested to understand how healthy cultures are embedded in firms where founders or other senior individuals occupy a dominant role.