IDBs Put on Alert: Greater FCA scrutiny coming

The FCA has published a portfolio letter in respect of  wholesale brokers, setting out details of FCA engagement with firms to date in respect of addressing identified harms. The letter demonstrates that the FCA plans to act on the interdealer broker sector, with a special focus on remuneration and conduct. The FCA will be taking a granular look at broker behaviour, pay and actions and how these influence internal and external business dynamics. Key concerns are how firms are complying/not complying with key remuneration requirements (like maintaining a suitable remuneration policy, observing the Remuneration Code) and dealing with problematic behaviour from high performers. The FCA has also indicated that it will not shy away from imposing additional measures such as additional capital requirements where weaknesses are found in contingency funding plans and liquidity frameworks. Firms should note key messages and gap key findings against current practices.

Previous cycle

• Prudential risk management.  To date, the FCA's main focus in this area has been in relation to clearing brokers and addressing deficiencies in relation to liquidity risk management and stress testing. Progress has been made by firms particularly in relation to liquidity risk management frameworks (LRMFs), with the FCA planning to publish an observation paper in the near future. The FCA plans to continue to carry out work in this area.
• Financial crime. The letter refers to an inherent risk of wholesale brokers being used to facilitate financial crime. Firms are warned against underestimating money laundering risks and are expected to review the FCA's recent publication "Assessing and reducing the risk of money laundering through the markets (MLTM)" , as well as adopt the good practices outlined in relation to enhancing systems, controls and training. The MLTM review found examples of incomplete business-wide risk assessments, inadequate methodologies for risk-rating clients and activities appropriately, and overreliance on other parties within the transaction chain for due diligence. The FCA also states that weaknesses in AML are often linked to those in relation to market abuse.
• Remuneration and broker misconduct. The letter cites the benefits of appropriate and SMCR-compliant remuneration arrangements but warns that the FCA is still seeing inconsistent application of the Remuneration Code, with some firms failing to have an appropriate remuneration policy in place. Other firms are not properly observing rules on deferrals and non-cash variable remuneration. The FCA has been engaging with firms to take necessary action in response to these weaknesses and any failure by firms to take remedial action may be met with FCA regulatory tools (e.g. imposing additional capital requirements). Boards are reminded that firms are expected to adhere to the Remuneration Code at all times. 

Strategy for the next two years

• Broker conduct. The letter refers to risks arising from "an inherent conflict of interest" that may prevent a client from achieving best outcomes, as well as firms ignoring misconduct of star performers (whether financial or non-financial). These risks include: insider trading; market abuse; overcharging clients for order execution (particularly in more niche markets);  and abuse of gifts and entertainment resulting in trade flow being directed towards specific brokers/desks. The FCA will be carrying out targeted work looking at how firms manage their brokers and expects firms to have suitable controls in place to detect misconduct and take appropriate action. Instances found of material weaknesses in frameworks for broker conduct may lead to restrictions imposed on individual firms/enforcement action against firms or individuals.
• Culture.  The letter reiterates merits of board diversity and confirms that the FCA will use the results of its survey on non-financial misconduct for further engagement with firms, focusing on so-called "outlier firms".  This will look at: policies and procedures; management of NFM cases by firms; and processes for making sure fair outcomes are reached.
• Business oversight. The FCA will be testing firms' frameworks via its work on broker conduct. This will look at firms' use of remuneration tools (e.g. deferrals, clawback or malus in cases of proven misconduct), in addition to usual work on detective and monitoring controls (e.g. client onboarding, monitoring of unsettled and/or failed trades and escalation processes). The FCA is keen to find out whether firms are using remuneration tools consistently across the sector.
• Financial resilience. Points made here in relation to the importance of adequate levels of capital and liquidity for orderly wind down, with the FCA confirming that it will be checking on firms subject to its liquidity review to see if they have acted on feedback and have implemented good practices. The FCA confirms that it will also be testing contingency funding plans and frameworks for wholesale brokers to see whether plans are adequate for potential liquidity challenges. Firms are expected to observe relevant liquidity requirements, with additional capital and liquidity requirements to be imposed by the FCA where it finds material weaknesses.