The U.K. financial regulator said it will pay close attention to how transition management (TM) providers manage and mitigate conflicts of interest and urged improvements in the performance and monitoring to ensure that best execution is achieved.
The Financial Conduct Authority’s (FCA) long awaited thematic review of the sector was published today, with the regulator concluding that its existing rules and guidance establish a high standard and are fit to govern TM practices. The regulator said it will continue carry out normal supervisory activities, while keeping the conduct of providers under review.
The regulator began its review to look at standards in the TM industry in 2012, prompted to do so by failures to manage conflicts of interest, poor governance and insufficient oversight. It said incidences since 2011 raised questions about the role of TM providers. It said poor conduct in TM—where over £165 billion of assets invested in pensions and other large funds were transitioned between 2010-13—could potentially impact those underlying clients. It said it would take action against firms that fail to meet its requirements. It recently fined State Street £23 million after it found that the custodian bank had overcharged six clients, including Royal Mail pension, the Kuwait Investment Authority (KIA) and the National Pension Reserve Fund (NPRF) in Ireland, a total of $20,169,603 between 2010 and 2011.
In total the FCA reviewed 13 transition management firms, who at the start of 2013 were conducting such business on a regular basis in the U.K. It found broadly appropriate controls and an understanding of the risks among providers but the quality and effectiveness of controls varied.
In its findings, the regulator alluded to complexities in TM, where clients may not be aware of the potential conflicts of interest in the TM relationship and how it might impact the service provided. It highlighted circumstances where the provider would be dealing as agent and principle, executing orders of behalf of clients and arranging deals in investments. The FCA said TM providers are required to comply with the provisions set out in the existing rules, notably rule SYSC 10, requiring that a firm must take all reasonable steps to identify conflicts of interest between: the firm, including its managers, employees and appointed representatives, or any person directly or indirectly linked to them by control, and a client of the firm; and one client of the firm and another client.
The FCA set out several of the inherent conflicts of interest that may arise in the provision of TM services. It said it remains the responsibility of firms to identify, record, manage and (where the arrangements made to manage conflicts are not sufficient to ensure that the risks of damage to the interests of clients will be prevented). It highlighted several areas of risks, including in:
– Pre-trade information—such as an assessment of the complexity of the trade and the TM provider’s desire to win business through an “unrealistically low estimate” or, to ensure a good performance relative to the chosen benchmark.
– Mis-use of information—controls should be in place to manage the risk of client information of trades being used in front running or market abuse.
– Principal trading—client and TM providers may have a direct conflict over the provider’s choice of how (and with whom) it executes client orders.
– Internal crossing—for example, trading is delayed to allow the buy and sell orders in the same securities to be matched (crossed) with another client, or where crosses occur internally at a worse price than could have been obtained in the open market.
– Execution venues—TM providers may direct the transactional flow from TM mandates towards particular execution venues (e.g. multi-lateral trading facilities or dark pools) in which they have a commercial interest.
The best execution rule is of particular relevance to TM performance, said the FCA. Among its key findings, the regulator said this rule also places obligations on firms to regularly monitor and review their execution policies and procedures, and to take action required to correct any deficiencies. “Monitoring performance, and being able to demonstrate to clients that reasonable steps to achieve best execution have been taken, is a crucial component of the regulatory regime because it empowers clients to hold firms to account for the quality of their TM service. Clients have a continuing role to play in ensuring that they receive an adequate service from TM providers and that regulatory tools are available to facilitate scrutiny of performance.”
The FCA noted that monitoring and reviewing of their best execution policy is still an area where TM providers can improve. “We found instances of poorly worded and potentially misleading marketing materials. Several firms were also found to be issuing materials to clients stating that they would act as a ‘fiduciary’ during the transition process, even though the standard legal agreement governing transition arrangements at those firms had expressly excluded the existence of a fiduciary relationship. We have made clear our concerns to the firms involved.”
On oversight and governance, the FCA found that the relatively small scale of TM at many firms is such that it is easy for senior managers and control functions to underplay oversight of TM in the belief that it is low-risk, quasi-project management business. “Before our review, some TM desks appeared to have had limited contact with their control functions or senior management. When problems have occurred these have often been compounded by basic failures in oversight.”
The FCA said it expects TM providers to be vigilant in monitoring the application of their controls to meet their obligations. “A full appreciation of the complexity of TM will be required to establish appropriate first, second and third line of defense controls. In the normal course of our supervisory work we will focus on management of conflicts of interest, oversight, governance and controls at TM firms, transparency and communication and client understanding.”
Commenting on the FCA’s findings, Andrew Williams, head of TM at Mercer said there would be more onus on the industry to provide better reporting, adding there would be an opportunity for providers to improve transparency and demonstrate how they monitor risk. “On the reporting side, where and how a transaction was executed will be important, there will be a greater emphasis on the analysis and monitoring of those deals,” said Williams.
U.K. Regulator Says Existing Rules Are “Fit to Govern” Transition Management
The Financial Conduct Authority’s (FCA) long awaited thematic review of transition management was published today, with the regulator concluding that its existing rules and guidance establish a high standard and are fit to govern TM practices.
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