Comment: Preparing for regulatory changes in 2023

By Ros Clark, regulatory risk assistant director, NatWest Trustee & Depositary Services.

After a tumultuous few years, the regulatory agenda has, for many financial service providers, been pushed back – but there are still important rule changes coming down the track that firms need to be ready for.

Some of the biggest regulatory shifts happening this year will centre around regulators’ efforts to combat greenwashing, as well as to bolster operational resilience and oversee the move to Direct2Fund. These three changes will shape the investment industry in 2023, so firms should prioritise preparation, in order to remain one step ahead.

Greenwashing

There was an uptick in applications to launch ‘sustainable’ or ‘ESG’ funds in 2022, a direct reflection of the growing consumer appetite for these types of funds and their more thematic offshoots. For example, by the end of the third quarter of 2022, the number of funds globally with a climate-related mandate had increased by 32% during the year, according to Morningstar.

As a result, regulation is beginning to catch up. The European Securities and Markets Authority has recently held a consultation around ESG fund names, while the three European supervisory authorities are calling for greater evidence to substantiate green claims.

Stamping out greenwashing in fund marketing will also be a key focus for the Financial Conduct Authority (FCA) this year. Back in July 2021, the regulator said it was concerned about the “poor quality” of many ESG fund launch applications, pointing to misleading fund names, limited exclusions from indices and unreasonable goals.

In October 2022, the FCA unveiled a proposed package of measures in CP22/20, which it hopes will protect consumers and build trust in sustainable investment products by eliminating the potential for “exaggerated claims” and mislabelling. CP22/20 also includes plans to create a new category of funds that are improving their sustainability over time. This could be good news for asset managers, as it has the potential to give them scope to buy and hold firms that don’t have a perfect ESG record but can be pushed to do better through fund manager engagement.

Regulators will also be putting ESG data under the microscope this year. In November 2022, the FCA announced plans to develop a code of conduct for ESG data and ratings providers. Data quality can vary by provider and firms will need to validate this with due diligence.

Operational resilience

As a result of the many global business disruptions this decade – including Covid-19, the war in Ukraine and a spree of cyberattacks – operational resilience is firmly on the regulatory agenda. As a result, the FCA is expected to go beyond its Operational Resilience Framework to assess firms’ compliance.

Safeguarding operational resilience can be an onerous process, so firms will need to plan ahead. By 31 March 2025, larger firms with identified important business services that could “cause tolerable harm to customers, the firm or the market if disrupted”, must be managed within risk tolerance.

The process involves mapping and testing to identify potential vulnerabilities, followed by interventions and investment where required. This will ensure firms can consistently operate without risking market integrity or harming customers, whatever challenges arise in the wider environment.

Due to the UK fund industry having various third-party entities performing different functions, we can also expect to see regulators give more attention to these critical third parties. This could include those that may not be regulated but could cause material impacts if they fail, such as cloud providers. The FCA has made public its concern about the risk posed by the operational resilience of third-party businesses if they were to fail.

Firms will be expected to look through the value chain to make sure the services they are outsourcing have appropriate preventative measures and business continuity plans in place. Tools used for such investigations include scenario testing, cyber resilience testing and skilled persons’ reviews of critical third parties.

Direct2Fund

Direct2Fund is a proposed investor-fund dealing model that could offer an alternative to the traditional and rather cumbersome UK model.

The UK model, in which investors interact with funds through an authorised fund manager’s dealing account, is an outlier among EU financial centres. Replicating the Direct2Fund process used in these markets would allow UK investors to transact with funds directly.

The hope is that this will make the UK investment management industry more competitive, while enabling operational efficiencies. However, there are many questions that need to be addressed. For instance, how much direct engagement would depositaries have with investors? And what are the implications for Know Your Customer guidelines and Anti-Money Laundering regulations?

There are also data protection considerations as Direct2Fund may place customers’ personal information in the hands of firms that are not used to handling it, and they will need to ensure the data is given the required protections under GDPR rules.

A crucial question is whether investors’ monies will still be classified as client money and protected accordingly – it’s unlikely that the FCA will be comfortable removing consumer protections that apply to clients’ money. Previously, the FCA has handed out fines for failures to oversee client money held by third-party providers, so we know that this is an issue it takes very seriously.

Tokenisation using blockchain technology may offer a way around this. By representing the ownership of an asset as digital tokens, rather than a share or fund unit, fund providers could offer tokenised collective investments and distribute them directly to the market. This could break down the barriers between fund managers and investors, and help create a more direct connection – perhaps tokenisation could even herald a transformational approach to dealing.

The FCA, in Discussion Paper 23/2: Updating and Improving the UK Regime for Asset Management sets out its views on the utilisation of technology to collectively shape market standards. It specifically questions whether firms agree if the FCA should consult on the implementation of Direct2Fund, requiring responses to the benefits of tokenisation and the priorities of these technology initiatives.

Greenwashing, operational resilience and Direct2Fund will all present firms with new hurdles to overcome in 2023, while working within the unique parameters of the UK financial services model. As the regulatory agenda kicks into high gear once more, firms will need to stay one step ahead of the changes to ensure they remain both resilient and compliant.