How well do you know who are your underlying investors?

The FCA has published three Dear CEO letters earlier this week (w/c 20 January 2020); serving notice to large chunks of the UK Financial Services industry that the regulator has shortcomings in those sectors firmly in their sights. In this piece, we look at the FCA's letter to alternative investment firms (which include hedge fund and private equity fund mangers). 

The FCA flags a number of key issues it will be prioritising, including: investor exposure to inappropriate products or levels of investment risk; client money and custody asset controls; market abuse; market integrity and disruption; financial crime; and Brexit. None of these are surprising in of themselves.

Participants in the alternatives space would do well to read the letter as a whole, but two items jumped out immediately from the letter to me.

One is that the FCA will be focusing on retail investor exposure to alternative investment products. I think everyone who has been involved in the sector has been expecting this, so it shouldn't come as a surprise. And it segues with the FCA's accountability and responsibility expectations of firms under SMCR.

The other is that the FCA expects risk management controls adopted by firms to be commensurate to the level of risk their strategies pursue. By "risk", the FCA is talking about leverage and illiquidity (expressly) and it is reasonable to add derivatives in to the pot too. But the take away here is, I think, that size of a market participant shouldn't matter in this equation. In other words, even if the high risk strategy is small, the FCA expects the firm to have in place high quality and robust risk management controls. The FCA hints that it will be carrying out spot checks and firm visits to test this area.

Finally, and an interesting point to note is that, the FCA does not give the alternative investment sector a time frame for this focus. (This is in distinction to the FCA's letter to financial advisers which mentions that the FCA will focus on supervision in specific areas over the next two years.)