front office controls – what are the fca’s expectations?

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Eversheds LLP – Front office controls – what are the FCA’s expectations?

Navigating ComplianceFront office controls – what are the FCA’sexpectations?

AIMA Hedge Fund Manager Training, 13th April 2016

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Todays speakers

Mike Booth

Regulatory Director Eversheds Consulting

Andrew Henderson

Partner Eversheds

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1. The FCA rules applicable to front office controls

2. The respective roles of compliance and front office teams

3. What firms are doing in practice (not included in slide share)

4. The lessons that can be learned from the recent front office controls fines

5. A brief overview of the new MAD II / MiFID II rules in the context of front office controls (not included in slide share)

The session will cover

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Todays session will cover

Timeline

Order Execution Allocation Post Trade

A. Application of investment

strategyD. Recordkeeping

L. Fair allocation

M. Dealing with errors

B. Allocation of investment

opportunities

I. Aggregation

G. Segregation of duties

C. Market abuse

N. Breaches

O. Performance review

Pre-order

Middle / back office

H. Telephone recording

J. Best execution

E. Risk management

F. Pre-trade compliance

K. Broking commissions

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1. What are the rules?

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Investment management inline with investor expectations and the prospectus

“Closet trackers” & the FCA Market Study

Competency: New types of mandate or more complex investment strategies

Process for investment decision making FCA TR 16/3 “Meeting Investor Expectations”

A. Application of investment strategy

COLL SYSC 5.1 TC 2 SYSC 3 FUND 3.2

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Overlapping investment universes or unclear mandates It is important that all clients have access to the investment

opportunities identified by the investment manager.

Cherry picking You shouldn’t be treating the fund with the highest performance fee

or the one close to its high water mark differently to the rest.

Conflicts of interest Are these conflicts on your conflicts of interest register?

B. Allocation of investment opportunities

SYSC 10 FUND 3.2 COLL 3.2 COBS 4 FUND 3.2

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C. Market Abuse

Can the teams spot inside information?

Do they know who to report to? How is it recorded? Are trading decisions consistent

with the process of investment decision making?

Is there peer review of orders?

Is there a pattern? Who reviews trading activity?

Inside information Manipulation

MAR

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D. Recordkeeping

The name of client of or other designation of any relevant person acting on behalf of the client

Buy/sell Instrument Price Quantity

The name of client Name of the broker

to whom the order was transmitted

The terms of the order

The date and exact time of transmission

Name of the client Day Time Buy/sell Instrument Price Quantity Counterparty Venue

Decision to deal Transmittal to broker Order executed

COBS 11.5

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D. Recordkeeping

But not forgetting CASS 8…CASS 8.3.1 “A firm that has mandates must establish and maintain adequate records and internal controls in respect of its use of the mandates”

• An up-to-date list of each mandate

• A record of any conditions placed by the client or the firm's management on the use of the mandate

• A record of each transaction

• Transactions must be in accordance with the mandate given

• Controls around the giving of instructions under the mandates

Records must include

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D. Recordkeeping

• Order based on up-to-date and accurate portfolio information

!!

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E. Risk Management

Order review

• Are there any errors?• Does it align with the analysis?• Does it make sense?• Consistent with investment thesis?• What was the due diligence?

Portfolio review

• Is it suitable for this portfolio?• What would be the impact on the portfolio as a whole?• How would it impact VaR and other risk metrics?• What level of modelling is sufficient?

Restrictions• What is the impact on leverage (AIFMD/UCITS or IMA)• Eligible asset (UCITS or IMA)• Weighting and concentration restrictions?• Eligible for PM to trade (competence)

Operations• Is the asset setup in the system?• Can we value it accurately?• Are we fudging it in the system? What is the impact of this?

Prev

enta

tive

FUND 3.7 SYSC 3 COLL 5

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No regulatory obligation to use an order management systemSet-upWho codes the restrictions?

Access restrictionsWhat individuals have access to which mandates? Should PMs be able to see trading activity on other funds?

Soft blocks Important to record rationale for overrides Are the reasons being reviewed Should some soft blocks be hard blocks?

Hard blocks Cleared by independent individual Rationale for clearing documented

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There is no obligation to have a separate dealing desk… ..However, when there isn’t a separate desk there needs to be a

process to ensure that any conflicts of interest or risk of errors are mitigated. Designated individual for dealing Second pair of eyes review Recording the review

IT ControlsWhat access rights to individuals have in the system?

Amending rights audit trail? Do they need all these rights?What is the process for changing user rights?


SYSC 10 SYSC 3

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Obligation Take reasonable steps to record relevant conversations made with or sent from or

received on equipment to enable an employee to carry out any of the activities referred to in COBS 11.8.1R

Relevant conversations Concluding an agreement With a view to concluding an agreement

COBS 11.8.1R includes Receiving/executing/arranging/placing orders Carrying out transactions on behalf of the firm, or another person in the firm's

group, and which are part of the firm's trading activities or the trading activities of another person in the firm's group

Investment management exemption Where the firm has a reasonable expectation that the sell side firm will be recording

conversations; or Provided that the relevant communications are infrequent and represent a small

proposition of the total telephone conversations


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There is technically no obligation to aggregate clients orders…

…However, for portfolio managers it may be a necessary to aggregate similar orders to ensure fair treatment of clients.

Where aggregating with a own account order the firm must consider:

−If it will work to the advantage of the client

−If there is adequate client disclosure

−An appropriate order aggregation policy

I. Aggregation

COBS 11.3

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A firm must take all reasonable steps to obtain, when executing orders, the best possible result for its clients taking into account the execution factors.

− Price

− Costs • implicit cost control, meaning minimising the market impact of order execution;• explicit external costs which include commissions, fees, taxes, exchange fees, clearing and settlement

costs, or any other costs passed on to the client by intermediaries participating in the transaction.• explicit internal costs, which represent the firm’s own remuneration through its commission or spread.

− Speed, Likelihood of execution and settlement

− Size

− Nature

− Any other consideration relevant to the execution of an order

J. Best execution

FCA“The rules on the application of best execution are not prescriptive in many areas. This

means that firms need to exercise their judgement in the best interests of their clients, given their differing needs and requirements”. TR 14/13

COBS 11.2

General

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Internal

The relative importance of the execution factors

A list of the execution venues for each type of financial instrument

The factors affecting the choice of execution venue

How much detail? CONSISTENCY

External

Non-retail “appropriate information”

PolicyJ. Best execution

COBS 11.2

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General prohibition for accepting goods or services unless: Reasonably assist in the provision of it services to clients Does not, and is not likely to, impair compliance of with acting in

the clients best interest And

Is directly related to the execution of trades; or

Amounts to the provision of substantive research

What if you accept but don’t pay for it?


COBS 11.6

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• Linked to the arranging and conclusion of a specific investment transaction (or series of related transactions); and

• Provided between the point at which the investment manager makes an investment or trading decision and the point at which the investment transaction (or series of related transactions) is concluded.

Directly related

• Be capable of adding value to the investment or trading decisions by providing new insights that inform the investment manager when making such decisions about its customers' portfolios;

• Whatever form its output takes, represent original thought, in the critical and careful consideration and assessment of new and existing facts, and must not merely repeat or repackage what has been presented before;

• Have intellectual rigour and must not merely state what is commonplace or self-evident; and

• Present the investment manager with meaningful conclusions based on analysis or manipulation of data.

Substantive research

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• Services relating to the valuation or performance measurement of portfolios

• Computer hardware

• Connectivity services such as electronic networks and dedicated telephone lines

• Seminar fees

• Corporate access services

• Subscriptions for publications

• Travel, accommodation or entertainment costs

• Order and execution management systems

Prohibited

• Office administrative computer software, such as word processing or accounting programmes

• Membership fees to professional associations

• Purchase or rental of standard office equipment or ancillary facilities

• Employees' salaries

• Direct money payments

• Publicly available information

• Custody services relating to designated investments belonging to, or managed for, customers other than those services that are incidental to the execution of trades.

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Passing on costs Full (no estimate needed)

Partial (consider the value of the research)Where not separately priced Where bundled with non-substantive research

Full / partial Negotiation of brokerage fees – acting in clients best interest

Is disclosure to clients sufficient?

Disclosures (keep records of these disclosures)−Prior

• Policy in relation to substantive research• Why the firm needs to use 3rd party research

−Periodic (at least once a year)• Details of the good or services


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−Allocate the price of orders fairly across the clients

−Have a process for dealing with roundings

L. Fair allocation

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What is an error?

Obligation Correct error ASAP, but also consider:

PRIN 7 – Communications with clients

Whatever is says in the IMA

Evidence of SYSC 3 (systems and control) deficiencies?

PRIN 11 – Relations with regulators?


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Identification Daily portfolio trading review by PM Independent post trade monitoring

Post trade rules Eligible assets Investment restrictions Leverage / borrowing restrictions Collateral eligibility

Root cause? What preventative control didn’t work? Was it a system or human failure? Is there a pattern? Is additional training required? Was it a service provider at fault?

N. Breaches

Error

Advertent

Market movement

Inadvertent

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O. Performance

Is the reason for poor performance identified?

How is consistent poor performance addressed?

Is disclosure of poor performance sufficient?

When does poor performance bring the skills and competence of staff into question?

Link to remuneration

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2. The respective roles of compliance and front office teams

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Overview

“taking into account the nature, scale and complexity of its business, and the nature and range of financial services and activities undertaken in the course of that business, establish, implement and maintain adequate policies and procedures designed to detect any risk of failure by the firm to comply with its obligations under the regulatory system, as well as associated risks, and put in place adequate measures and procedures designed to minimise such risks and to enable the appropriate regulator to exercise its powers effectively under the regulatory system and to enable any other competent authority to exercise its powers effectively under MiFID”

Business as a whole

• Monitor and, on a regular basis, to assess the adequacy and effectiveness of the measures and procedures put in place and the actions taken to address any deficiencies in the firm's compliance with its obligations; and

• Advise and assist the relevant persons responsible for carrying out regulated activities to comply with the firm's obligations under the regulatory system

Compliance

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Pre-trade compliance coding in order management system

Post trade monitoring

Lifting hard blocks

Risk management

Best execution monitoring

Areas of uncertaintyCompliance or front office?

SYSC 6

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4. What have firms been getting wrong?

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Aviva Investors Global Services Limited

Timeline




L. Fair allocation



opportunities

I. Aggregation


C. Market abuse

N. Breaches


Pre-order



J. Best execution

E. Risk management



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−“Aviva Investors had an incentive structure that created conflicts of interest whereby Side-by-Side traders had an incentive to favour funds paying higher performance fees”.

−“delayed booking and improper allocation of trades, including Cherry Picking”

−“On certain desks within Aviva Investors’ Fixed Income business there was no segregation of investment decision-making, order placement, trade execution, allocation and booking of trades during the Relevant Period. Instead, Traders on these desks were responsible for all of the above.”

−“Trades for the Long-Only Funds were processed through an order management system, while details of executed Hedge Fund trades were emailed to the middle office. Neither process required Traders to record the intended allocation of a trade on the system or with Aviva Investors’ middle office prior to booking the trade”

Aviva - selected highlights (emphasis ours)

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Threadneedle Asset Management Limited

Timeline




L. Fair allocation



opportunities

I. Aggregation


C. Market abuse

N. Breaches


Pre-order



J. Best execution

E. Risk management



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“TAML’s preventive controls were inadequate because they failed to:

(i) Restrict fund managers’ ability to initiate, execute and book trades on funds other than their own without obtaining express recorded consent;

(ii) properly calibrate pre-trade soft alerts on trades;

(iii) enforce a requirement for fund managers to provide a rationale for overriding a soft alert; and

(iv) code appropriate hard stops in its trading system which could prevent unauthorised trades in excess of those limits from proceeding to settlement.

TAML’s detective controls were inadequate because they failed to:

(a) test the evidence fund managers provided to prove that they had achieved best execution;

(b) put in place a written policy which formally required fund managers to review trades booked the previous day on the funds for which they were responsible and confirm in writing that they had done so; and

(c) require fund managers, in the absence of the segregation of trading duties, to obtain explicit approval to place trades with non-standard settlement terms.”

Threadneedle - selected highlights (emphasis ours)

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Invesco Asset Management & Invesco Fund Managers Limited

Timeline




L. Fair allocation



opportunities

I. Aggregation


C. Market abuse

N. Breaches


Pre-order



J. Best execution

E. Risk management



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−“failed to put in place adequate systems and controls to ensure that it recorded trades in all fixed income funds on a timely basis”−“This placed investors at a risk of loss, because:(a) fund managers may have made inappropriate investment decisions because they were based on an inaccurate valuation of the portfolio;(b) compliance checks would have been carried out on incomplete data; and(c) units in the funds may not have been correctly priced (although a subsequent review by Invesco Perpetual’s Internal Audit department did not identify any material compensatable errors).”−“used a manual paper based system in its fixed income business

which meant that it was more difficult to ensure that trades were captured in a timely fashion and Invesco Perpetual failed to put in place additional systems and controls to mitigate this risk“−“it failed to make or retain records of the initial decision to

deal and the intended allocation”

Invesco- selected highlights (emphasis ours)

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eversheds.com©2015 Eversheds LLPEversheds LLP is a limited liability partnership

Andrew HendersonPartner

D: +44(0) 20 7919 0898M: +44(0) 7747 795 049 [email protected]

Mike BoothRegulatory Director

D: +44 (0) 20 7919 0843M: +44 (0) 7464 906 [email protected]