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Dear CEO | Release Date: 22nd January 2020

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) has organised its supervisory approach by grouping firms with similar business models into what are termed ‘portfolios’. This letter communicates the supervisory strategy for firms operating within the alternatives investment sector. These firms, which manage or advise on alternative investment vehicles like hedge funds or private equity funds, play a vital role in the financial market. The strategy outlined here reflects the FCA’s proactive approach to mitigate potential risks these firms may pose to their clients and the broader financial market.

Understanding the Context

The alternatives investment sector is characterised by its complexity and the significant levels of investment risk involved. It is imperative for firms within this portfolio to act in the best interests of their clients, safeguarding and enhancing capital through responsible management and oversight. Despite the critical role these firms play in the economy, there are inherent risks that require continuous and rigorous management to prevent harm to consumers and the markets.

Key Risks of Harm

The FCA has identified several key risks associated with alternative investment firms:

Inappropriate Product Offerings and Investment Risks: There is a significant risk that clients are exposed to inappropriate products or levels of investment risk, particularly where high-risk alternative investments are made available to less sophisticated investors.

Operational Failures and Weak Systems: Inadequate systems and controls can lead to operational failures, risking client money and custody assets, and can fail to mitigate the risks of market abuse and other financial crimes effectively.

Non-compliance with Governance Standards: Often, the level of governance and compliance with regulatory standards, including those related to the Client Assets Sourcebook (CASS), falls below what the FCA expects, creating potential risks of financial loss and exploitation.

Supervisory Priorities and Expectations

To address these risks, the FCA’s supervision strategy will focus on several priorities:

Governance and Culture: Firms must ensure that their governance structures support a culture that prioritises client interests and compliance with regulatory standards. Effective governance is crucial in managing the complex products and strategies typically seen in this sector.

Risk Management of Investment Products: Firms should rigorously assess the suitability and appropriateness of alternative investment products for their clients. This includes ensuring that products are designed considering the client’s knowledge, experience, and investment objectives.

Client Asset Protection: Strict adherence to CASS rules is mandatory to ensure the safety of client assets. The FCA will scrutinise firms’ compliance with these rules and their overall asset protection strategies.

Operational Resilience and Third-Party Risks: Firms must manage operational risks, particularly those related to technology and outsourcing. This includes ensuring robust business continuity and disaster recovery processes are in place and effectively overseen.

Market Integrity and Abuse Controls: Maintaining market integrity is paramount. Firms are expected to have effective systems in place to detect and prevent market abuse and other financial crimes.

Ongoing Review and Enforcement

The FCA will conduct ongoing assessments to ensure firms comply with established guidelines and regulations. This will include on-site visits, reviews of governance and operational controls, and evaluations of client asset management practices. The FCA will not hesitate to take enforcement action against firms that fail to meet regulatory standards.

Implications of EU Withdrawal

The upcoming changes due to Brexit require firms to prepare for new regulatory environments. Firms must stay informed and ready to adapt to ensure continued compliance with UK and international financial regulations post-Brexit.

Conclusion and Action Points

Firms are urged to:

Review and adjust their practices in line with FCA expectations.

Engage proactively with the FCA, especially in reporting potential issues.

Prepare for regulatory changes due to Brexit, ensuring readiness for new compliance landscapes.

Firms should also ensure they are prepared for the discontinuation of LIBOR and transition to alternative rates, understanding the implications for their operations and client communications.

Final Note

For further information or to discuss specific issues, firms are encouraged to contact the FCA directly. This proactive engagement is part of ensuring that the sector continues to operate with integrity and in the best interests of its clients and the broader financial market.

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