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Dear CEO | Release Date: 10th December 2021

To read a shorter summary of this Dear CEO letter, click here.

To access the original FCA document, click here.

Long Summary

The Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA) have conducted a thorough review of equity finance businesses, particularly in response to the default of Archegos Capital Management in March 2021, which resulted in substantial losses across the financial sector. This letter outlines significant deficiencies identified in the risk management practices of firms and sets forth expectations for future compliance and oversight.

Key Findings from Regulatory Review

Business Strategy and Organisation

Firms exhibited disjointed business strategies lacking in coherence and rigour, driven by opportunistic growth rather than sustainable planning.

Fragmented organisational structures led to inconsistent risk management practices across business units, resulting in varying standards in client onboarding, margining, and documentation.

Onboarding and Reputational Risk Management

There was a failure to uniformly apply rigorous due diligence processes, particularly regarding the reputational risks associated with new and existing client relationships.

Existing KYC and financial crime controls were found to be robust; however, they did not adequately address the ongoing assessment of reputational risks.

Financial Risk Management Controls and Governance

Many firms had weak documentation standards and inadequate contractual rights, hindering their ability to respond flexibly and promptly to changes in counterparty risk.

Margining practices varied significantly across firms, with many relying on outdated static models that did not adequately reflect current market dynamics or the actual risk profile of clients.

Liquidation and Close-Out Procedures

There was a lack of preparedness for handling rapid liquidations and close-outs, with many firms not having actionable and clear default playbooks.

Firms often failed to consider their capabilities in liquidating large positions, exacerbating risk during periods of market stress.

Regulatory Expectations and Required Actions

Review and Remediation

Firms are expected to conduct a comprehensive review of their equity finance operations, assessing their practices against the deficiencies highlighted.

This review should extend across all sales and trading activities, not limited to equity finance but inclusive of all forms of secured and synthetic financing activities.

Remediation plans should be detailed and submitted to the PRA and FCA by the end of Q1 2022, demonstrating how firms intend to address the identified issues.

Enhancing Risk Management Frameworks

Firms must invest in strengthening their risk management frameworks to ensure they are robust and capable of managing current and future risks effectively.

There is a need for a more integrated approach to risk management that aligns strategies, governance, and controls across all business units involved in equity financing.

Promoting a Culture of Risk Accountability

Senior management must take a proactive role in fostering a culture where risk management is seen as a core aspect of business operations, not just a compliance requirement.

Compensation and incentives should be aligned with risk management outcomes to reinforce accountability at all levels of the organisation.

Strengthening Governance and Oversight

Firms should enhance governance frameworks to ensure that risk management processes are subject to rigorous oversight and continuous improvement.

This includes establishing clear criteria for escalation, improving the quality of management information, and ensuring that senior management is engaged in the risk oversight process.

Conclusion and Future Direction

The default of Archegos Capital Management has highlighted significant vulnerabilities within the global equity finance sector, necessitating a reassessment of risk management practices. The FCA and PRA expect all firms to take immediate and decisive action to address the shortcomings identified. This involves not only remedial measures in direct response to the Archegos incident but also broader enhancements to risk management practices that will strengthen the resilience of the financial system as a whole.

Key Takeaways and Actions

Systematic Review Implementation: Firms must undertake a thorough review of their equity finance business, aligning practices with regulatory expectations and rectifying any deviations.

Risk Management Overhaul: Enhance risk management strategies and governance frameworks to robustly address both identified and potential future risks.

Culture and Incentives Alignment: Cultivate a risk-aware culture within all levels of the organisation, ensuring that incentives promote risk-conscious behaviours.

Continuous Improvement: Maintain an ongoing focus on improving risk management capabilities, adapting to new challenges and regulatory expectations as they evolve.

The FCA and PRA will continue to monitor the sector closely and will not hesitate to intervene further if necessary to ensure the stability and integrity of the financial system.

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