The FCA is proposing amendments to the appointed representative (AR) regime, including seeking input on how to manage regulatory hosting. Alex Ellerton and David Morrey discuss how new definitions and requirements will impact their operations.
The consultation focuses on three areas of change: notification and reporting, due diligence and on-going oversight including annual reporting, and a discussion on regulatory hosting.
Regulatory hosting was not foreseen when the AR regime was initially established. Some firms are solely carrying out regularity activity through the appointment of AR. This has led to poor outcomes as some firms have insufficient resources and weak management of conflicts of interest controls relating to their dependency on the remuneration paid by ARs to support their business model.
Therefore, the regulator is proposing new rules and is opening a discussion on additional steps it's considering to protect customer and markets integrity. This discussion will be followed by another consultation paper. Firms engaging in regulatory hosting must look at the proposed changes and assess the impact on their activities.
The FCA is proposing to re-define regulatory host as a firm that:
offers or provides a service by which unauthorised persons, whether or not closely linked to the firm, may become appointed representatives of it
markets or offers the service to unauthorised persons as an alternative to applying for authorisation
provides the service for remuneration with a view to profit
does not carry on any regulated activities in a principal capacity
regulated activities carried one or more appointed representatives of the firm that are not connected to any regulated activity undertaken by the firm in a principal capacity.
The proposed definition focuses on circumstances where a principal does not individually carry out out the regulated activity carried out by the AR. This definition covers business models observed in the general insurance and investment management sectors.
However, this does not systematically cover areas where regulated firms would use an AR to access different markets. For example, a regulated firm providing wholesale products and services using ARs to carry out the same regulated activity, but providing products and services to retail customers.
The FCA wants to implement a new notification requirement on the regulatory host. A regulated firms intending to act as a regulatory host will have to notify the FCA at least 30 days before it begins offering services. This notification is additional to any other AR notifications, such as the intent to appoint an AR. It should be noted that the intention to appoint an AR notification must be completed at least 60 days prior to the arrangement taking effect.
Discussion to tighten rules
Following of the review of the Greensill Capital collapse, the FCA and HMT were requested to consider reforms to the regime with a view to limiting its scope and reducing opportunities for abuse of the system. This discussion is issued in this context as poor AR management practices by principals and customer harm is greater where regulatory hosting is taking place. The FCA is discussing a broad spectrum of remedial actions going from prohibiting regulatory hosting to using the new requirements under the AR regime laid out in this consultation paper.
The AR regime encourages innovation and competition by enabling organisations to carry out regulatory activity without having to be authorised on their own rights. The regime is often used as a springboard for small firms that become fully authorised when they have become large enough to bear the cost of being fully authorised.
However, these benefits are subject to the reliance on strong principals that can ensure that the ARs understand and comply with the applicable regulations. Where AR activity is disconnected from the principal business model and expertise, or the AR is disproportionally bigger and/or more complex than the principal, the risk of customer harm and market integrity is greater – this is because appropriate supervision by the AR is unlikely.
The FCA is considering the following options.
Banning the use of regulatory hosting services
While banning regulatory hosting might remediate the risk associated to an appropriate supervision of AR and conflicts of interest, it would create a greater risk of customer harm. Firms may exit the market leading to a reduction of product offering and potentially the interruption of the provision of services mid-contracts. This option is also highly likely to reduce the level of innovation and competition. The FCA also acknowledges that a transition period will be required if this was to be implemented.
However, it is unlikely that this option will be considered further by the regulator.
Limiting the size of appointed representatives
Limiting the size of ARs could encourage them to become fully regulated once reaching a certain size. This gives the FCA full supervisory power over the ARs activity and reduces the risk of having principals that do not adapt their supervision approach to match the size and complexity of their ARs. However, the nature of financial services is so varied that setting quantifiable and proportionate limits would be very complex.
Such limitation might reduce the use of the AR regime to support innovation, as it's leveraged by incubators in financial services. Existing ARs of size exceeding the thresholds may decide to exit the market owing to the cost of being fully authorised, reducing the product offering and potentially causing customer harm. The establishment of thresholds will have to carefully consider costs associated of full authorisation for each type of ARs. Implementing this option would require a long transition period.
The risk associated with this option and the complexity of it makes it relatively unlikely.
Require specific consent
The FCA is already proposing in this consultation paper to request prior notification for regulated firms intending to provide regulatory hosting services. The option of obtain consent/approval is only one step further than the current consultation and will be easier to implement for the FCA.
The provision of the new data by principal to the FCA will allow the regulator to identify when principal-host regulated activity is carried out and when the AR would fall within the definition of ‘large’. Therefore, it will be important for firms to appropriately monitor their activity and the growth of their AR business to ensure that consent is requested in a timely manner.
This option presents the least risk in compromising the FCA’s competition objective and would give sufficient tools to the regulator to effectively supervise principal and ARs’ activities.
We would consider that this option is the most likely to be considered further.
Limit the range or scope of regulated activities
The FCA is discussing the possibility of limiting the regulatory activity that would be open for regulatory hosting. This option is likely to reduce the risk of customer harm for some regulatory activities.
However, the definition of regulated activity is often broad and covers a variety of services and products that have very different customer harm risk profiles. This may restrict the provision of services and products that have been appropriately provided by the AR, overseen by principals and have a low risk profile. This may lead to a reduction of product offering owing to providers exiting the market rather than seeking full authorisation.
This is an area that the FCA might consider further. If this is the case, the FCA could maybe consider which product category should be subject to restrictions under each regulated activity.
Additional requirements applicable to regulatory host and firms with larger ARs
The FCA is already increasing the level of controls that principals should have in place by including a customer harm impact assessment for each AR relationship, providing further guidance on its expectation on due diligence and ongoing oversight.
The FCA is also proposing to include new compliance and self-assessments. The examples suggested by the FCA would be challenging to implement - owing to the diversity of ARs and the business models of firms within the regulated sector, and might not lead to reducing the risk associated with regulatory hosts.
All regulated firms are subject to the other sections of the handbook, which requires firms to have sufficient resources (financial and non-financial) and have appropriate risk management systems. These, in combination with the new requirement proposed in the consultation should be sufficient to enable the FCA to appropriately supervise regulatory host and firms with larger ARs.
The above assessment will not influence the FCA’s decision making. The regulator will consider the input it receives and subsequently propose more developed rules or guidance.
What can firms do now?
Firms acting as regulatory hosts should consider the options mentioned above and assess their impact on their business model and how the principal and ARs could mitigate customer harm for each option.
Considering the level of additional guidance provided by the FCA, firms should undertake gap analysis of their current due diligence and ongoing oversight to ensure that they meet regulatory expectations and include new requirements. The review of your AR framework should include all obligations.
You should act sooner rather than later as the final rules will be delivered quickly.
If you want access to leading advice, consultancy and support, we offer a range of services across regulatory compliance for financial services. Contact Alex Ellerton or David Morrey for more information on our services.