The release earlier this year of an FCA Discussion Paper has raised the prospect of significant changes to the governance framework for UK asset managers in the years to come. Among the aims of these changes is to facilitate technological development, innovation, and the use of data within the sector. Discussion remains at an early stage, but affected firms should ensure they understand the changes and the potential implications for their risk exposure.
Keeping pace with technology
In February 2023, the Financial Conduct Authority (FCA) published its Discussion Paper 23/2 (opens a new window), focused on updating and improving the UK regime for asset management. The paper seeks to get a broad range of views about the current UK regime, and sets out some ideas about how it might be modernised in order to better meet the needs of investors.
Technological development has driven substantial changes across the asset management sector in recent years – yet, as the paper argues, product regulation has failed to keep up with innovation. The ongoing pace of change may also see further developments break new ground not previously considered.
Four potential reforms
In particular, the paper highlights the following areas where rules may be limiting the potential for innovation or efficient use of modern technology, and which the FCA intends to revisit:
Technology in fund operations – although regulation does not dictate exactly how technology might be used, it is sometimes prescriptive about processes, which could deter innovation. The FCA proposes developing rules which would implement the Investment Association’s “Direct2Fund” model, which allows investors to transact directly with a fund when buying and selling units rather than going through an intermediary.
Fund tokenisation – understood by the FCA as ‘the ability to issue a fund’s rights of participation (units or shares) to investors as digital tokens, usually by means of a distributed ledger’. Work is already underway on rule changes to accommodate this, and the consultation seeks to gauge interest to determine what priority that work should be given.
Tokenised portfolio assets – allowing assets to be held in the underlying portfolio and traded in a secondary market in tokenised form, with fully digitised clearing and settlement. The government’s Digitisation Taskforce (opens a new window) will be considering many of the issues relevant to this topic, and any change would be dependent on progress being made by market participants both in the UK and beyond.
Investment in crypto assets – the possibility of broadening the scope of eligible assets to include unregulated tokens, such as stablecoins and other forms of cryptocurrency. The FCA will not do any work on this until the government has advanced its thinking following the recent consultation (opens a new window) on bringing crypto assets into the regulatory perimeter.
The discussion paper also invites respondents to suggest any other regulatory changes that might enable fund managers to make wider use of advances in technology, without weakening investor protection.
New technology, new risks
Advances in technology will play a significant role in how investment managers operate, which in turn is likely to improve outcomes for UK markets and customers.
But the tech-driven changes are also set to change firms’ risk exposures, both positively and negatively from an insurer’s perspective. The introduction of regulation for crypto assets for instance may provide insurers with more comfort around providing cover for crypto-related risks. Features of tokenised funds, such as the embedding of token holder’s rights and obligations into a security token, may also serve to enhance transparency.
Conversely, the inclusion of crypto assets in the FCA’s regulatory scope may lead to a drive for asset managers to include them in investment strategies, exposing firms to the volatility of those markets and risking claims by disappointed investors should the particular cryptocurrency not perform or be stolen, lost, or destroyed. Any inclusion of them within funds and portfolios would require sufficient crypto-aligned practices and procedures being in place to meet anti-money-laundering (AML) requirements and guard against fraud.
Firms participating in tokenised funds and portfolios must carry out appropriate due diligence to account for the innovative and less established nature of the assets. This includes partnering with suppliers and advisors who have the right knowledge and experience, and ensuring assets held be appropriately traced and reviewed for their source and the transactions they have been involved in. For example, when looking at classic real estate funds, any auditor one would use would tend to be well known by insurers; but crypto auditors are not as well established by reputation so insurers will need comfort that the chosen auditor was selected on a process of good due diligence.
As ever, the growing adoption of technology is not without the heightened risk of data security breaches and cyber hacks. Overall, investment managers in the UK will need to take a proactive approach to implementing the latest technologies to remain competitive in the market, while remaining vigilant towards the potential exposures that such technologies may bring.
Responses to the discussion paper were requested by 22 May 2023. The FCA will now consider comments and publish a feedback statement later in 2023.
For further information, please visit our Global Financial Institutions (opens a new window) page, or contact:
Richard Ellis, Producer, Global Professional & Financial Risks
T: +44 778 048 5418
Laura Skaanild, Senior Vice President, Global Professional & Financial Risks
T: +44 207 933 1677