The FSM Bill therefore establishes a revised blueprint for financial services regulation, revamping the existing model under the Financial Services and Markets Act 2000 (FSMA) and providing the framework for the revocation of retained EU law (REUL) in financial services. The financial services regulators will be delegated powers for detailed rulemaking, while being subject to enhanced oversight by Parliament. To maintain the U.K.’s position as a leading financial services centre, the FSM Bill empowers HM Treasury to change legislation to ensure that mutual recognition agreements (MRAs) can be properly implemented, including bestowing powers on the relevant regulators to give effect to the MRAs.
Other post-Brexit initiatives are prioritized. Using a transitional regime to avoid further delay, there will be welcome relief to those acting in the wholesale markets, with the reduction of some of the more burdensome requirements across a raft of areas regulated under the U.K.’s Markets in Financial Instruments package (as inherited from the EU), as prefaced by the Wholesale Markets Review, which we discussed in our client note, “U.K. Wholesale Markets Review.”
The path is also laid for other initiatives to come to fruition, such as enabling the regulation of stablecoins for payment, key to encouraging innovation in payments and establishing the framework for financial market infrastructure (FMI) firms to explore new technologies in temporary pilot schemes.
There are also significant consumer protection measures in the FSM Bill, which will facilitate and protect access to cash (such as via ATMs), improve the financial promotions regime and provide for greater protection of victims of authorized push payment scams.
The FSM Bill is an important step forward for the U.K. in adjusting its regulatory framework. The implementation of the comprehensive FSMA model will involve immense effort by the government, the regulators, industry and other stakeholders. Other post-Brexit initiatives remain to be addressed: the government intends to implement more measures for the crypto market, with detailed consideration being given to alternatives over the next few months. And a consultation on the U.K.’s overseas persons regime is expected before the end of the year. In this client note, we summarize the main changes proposed in the FSM Bill.
New UK Regulatory Architecture
The system by which financial services laws and regulations were made while the U.K. was part of the EU needs to be adjusted to reflect that the U.K. has now left the EU. The EU framework involves many requirements for firms that are written into statute because of the need to harmonize the position across all EU member states. The U.K.’s current system is designed to facilitate the EU law-making process. Prior to the EU’s financial services action plan and the 2008 financial crisis, EU financial services directives were high level, mostly only addressing passporting with principle-based requirements. Then, the U.K. had extensive rules in the Financial Services Authority’s Handbook, as did other EU national regulators. Those rules were subsequently harmonized across the EU in regulations, directives and technical standards, and upon Brexit, were grandfathered into U.K. law as statute, becoming REUL. However, with MiFID II alone comprising 1.7 million provisions, it is not reasonable for Parliament to keep all this up to date. It is therefore necessary to reinstate the status quo ante, with this detail in the FCA and PRA rules. It is widely accepted that many of the detailed requirements for financial services firms should be transferred to the U.K. regulator’s rulebooks to allow for a more nimble approach by expert regulators.
The FSM Bill implements the government’s policy of establishing a comprehensive FSMA model for financial services regulation. This will be accomplished by bringing some areas currently covered by REUL into FSMA, transferring the responsibility for making detailed rules to the regulators and strengthening Parliament’s oversight of the regulators.
Implementing this policy will involve several steps: first, the creation in FSMA of a Designated Activities Regime (DAR) for the regulation of activities related to the financial markets; secondly, the granting of rulemaking powers to the regulators for those areas where they do not yet have such powers to allow them to introduce rules covering the requirements in the (to-be-revoked) REUL. For example, a general rule-making power will be provided to the Bank of England (BoE) in respect of central counterparties (CCPs) and central securities depositories (CSDs), and the Financial Conduct Authority (FCA) will have the power to make rules for Data Reporting Service Providers (DRSPs) and Recognized Investment Exchanges (RIEs). Finally, the revocation of most REUL for financial services (set out in Schedule 1 to the Bill).
The Designated Activities Regime
The Designated Activities Regime – or DAR – will operate in a similar way to the regime established for regulated activities under the Regulated Activities Order (RAO). HM Treasury will be empowered to designate in secondary legislation activities relating to financial markets, exchanges, instruments, products or investments. However, unlike the RAO model, HM Treasury will be able to set certain requirements directly and then provide for certain areas to be covered by the FCA’s rules. The FCA will only be able to make rules relating to a specific designated activity; its remit will not extend to the wider unrelated activities of those carrying out a designated activity, making it a narrower power than the regulator has over authorized firms. The carrying on of a designated activity must comply with the requirements or rules unless there is an exemption.
Schedule 6B to the Bill sets out the activities that will become designated activities (HM Treasury will be able to designate further activities.), which are:
- Activities related to entering derivatives contracts and holding positions in commodity derivatives.
- Short selling.
- On a securitization, acting as an originator, sponsor, original lender or a securitization special purpose entity and selling a securitization position to a U.K. retail client.
- Offering securities to the market and admission of securities to trading on a securities market.
- Using a benchmark and contributing to a benchmark.
Revocation of REUL
Creating the concept of “EU-derived legislation”, the FSM Bill will revoke most REUL for financial services, including the statutory instruments that amended REUL in the “onshoring” process. However, the Bill will generally not revoke REUL incorporated into U.K. primary legislation or that is already part of a regulator’s rulebook. To enable a smooth transition, where appropriate, the revocation of legislation will only begin once the regulators have drafted and consulted on rules that are to replace the corresponding REUL provisions.
To illustrate how the new regime will work, the DAR activity of offering securities to the market and admission of securities to trading on a securities market falls within the prospectus regime, changes to which were announced in March this year. These will be implemented into the regime as follows:
- HM Treasury will restate in regulations parts of the existing legislation on prospectus requirements, with amendments. For example, the regulations will introduce a general prohibition on public offerings of securities, then set out the exemptions, which will comprise those from the Prospectus Regulation (some in amended form) and the new exemptions. The regulations will also restate the scope of new public offerings of securities regime: the existing scope of transferrable securities will be retained, but the scope will be expanded to include non-transferrable securities. Finally, the regulations will set out those areas which will be subject to the FCA’s rules.
- The FCA will consult on its proposed rules in those areas set out in the regulations. Those rules will comprise the existing detailed requirements, potentially in amended form, such as, for admission to trading, if and when a prospectus will be required, whether it needs to be approved and its content. The FCA will have to follow the new process in making these rules, such as notifying the Select Committee when consulting on rules. Under the Bill, the FCA may forego consultation if the existing legislation is being restated in its rules without any material change.
- The Prospectus Regulation and related legislation (see Schedule 1 of the Bill) will be revoked, HM Treasury’s regulations will come into effect and the FCA’s rules will apply, at the same time.
Regulatory Accountability
The additional rulemaking responsibility for the regulators will significantly increase their powers. How and whether those powers should be constrained or overseen has already been subject to much debate. The FSM Bill makes provision to strengthen the regulatory accountability framework. HM Treasury will be empowered to require either the Prudential Regulation Authority (PRA) or FCA to make rules but may not specify the content or outcomes that such rules should seek to accomplish. The regulators will be required to keep their rules under review and to publish a statement of policy on how they conduct such reviews. HM Treasury will be able to require a regulator to review its rules (or appoint an independent reviewer) where HM Treasury considers it is in the public interest, for example, in response to market developments or if the rules do not appear to realize their purpose.
The FSM Bill will also require the PRA and FCA to notify relevant Select Committees when they launch a consultation on proposed rules, publish proposals on how they exercise their general regulatory functions or consult on proposals under a duty imposed by legislation. In June, the Treasury Select Committee (TSC) announced the creation of a new sub-committee – called the Sub-Committee on Financial Services Regulations – that will scrutinize financial services regulatory proposals, either ex-ante or ex-post. Ex-ante work will usually start at the consultation stage, with a decision on whether a proposal warrants detailed examination. The FSM Bill will require the regulators to respond in writing to any formal response to a consultation by a Parliamentary Committee.
In his new book, entitled Rules for the Regulators – Regulating Financial Services After Brexit (published with Politeia), Shearman & Sterling partner Barnabas Reynolds makes recommendations to promote a manageable, clear and simple system, including the below with regard to regulatory accountability:
- The regulators should be obliged by statute to make clear and predictable rules under Parliamentary oversight – proposed rules should be laid before Parliament, in the manner of the U.S. Congressional Review Act, allowing for veto within 60 Parliamentary days.
- The regulators should be required by statute to supervise and enforce predictably in accordance with their rules, ensuring their decisions are consistent between firms which operate businesses of a similar size and scope.
- Formal decisions by the regulators should include published reasons, with sufficient analysis to operate as precedents, illuminating the application of the relevant regulator rules. There should also be a greater use of guidance offered by the regulators, with examples.
- An appeal process should be available, for a short (defined) time period after the regulators have made supervisory or enforcement decisions, and well-defined thresholds have been reached, such as the size of the fine or the nature of the alleged breach and/or the size of the firm or status of the individual.
The reforms don’t go this far. They also fall short of requiring the regulators to follow decisions of the Financial Regulators Complaints Commissioner, despite the FCA’s recent and high-profile decisions to ignore its own Commissioner in the London Capital & Finance case.[1]
New Objectives and Principles for Regulators
New Growth and International Competitiveness Secondary Objectives
New secondary statutory objectives will be introduced obliging the FCA and PRA in carrying out their functions to support long-term growth and international competitiveness. For the PRA, the new growth and international competitiveness objective will operate in conjunction with its existing secondary objective to facilitate effective competition in the markets for services provided by PRA-authorized firms (banks, large investment firms, insurers and credit unions). For the FCA, the new objective will go together with the FCA’s three existing operational objectives of consumer protection, market integrity and competition.
It is hoped that this will provide motivation for the FCA in particular to improve on its woeful turn-around times for new business for authorizations and other regulatory processes.
New Net Zero Regulatory Principle
The FSM Bill will also introduce a new regulatory principle which the FCA and the PRA will be required to observe. They will be told to have regard to the need to achieve the U.K.’s statutory climate target. To avoid duplication, the Bill will remove the existing sustainable growth principle for both regulators. The Payment Systems Regulator’s (PSR’s) objectives are not changing and therefore its sustainable growth principle will remain; however, the net zero regulatory principle will be integrated into that principle.
Wholesale Markets
The policy was adopted following HM Treasury’s Wholesale Markets Review, in which wide-scale changes were proposed across a raft of areas formerly regulated under the EU’s MiFID II regime. The U.K. originally “on-shored” the Markets in Financial Instruments Regulation into U.K. law as REUL with only minor amendments following its exit from the EU. The FSM Bill includes the new set of amendments that aim to tailor this unwieldy package of European measures for the U.K. market. Changes are to be made in particular where the rules are considered to have had unintended outcomes, are duplicative or excessive or have curbed innovation in the market.
Relevant parts of the U.K.’s MiFID II legislation is due to be revoked under the FSM Bill. However, the amendments discussed here are subject to a transitional period, allowing the changes to be made before revocation, giving priority to these significant measures.
Commodities Derivatives Markets and Position Limits
The MiFID II requirement for commodities position limits to be applied to all exchange-traded contracts will be revoked. Over-the-counter, or non-venue traded (OTC), contracts that are economically equivalent to exchange-traded commodity derivatives will also be removed from the position limits regime. The powers for setting position controls will be transferred from the FCA to the operators of trading venues, reflecting the status quo ante under MiFID I. The government will, however, give the FCA discretion to determine the contracts in respect of which trading venues will be required to set position limits. The FCA will continue to set limits directly for OTC contracts, if needed, and will have new powers to establish a framework to support trading venues in setting position limits.
Fixed Income and Derivatives Markets
MiFID II imposes a “trading obligation,” requiring mandatory on-venue trading of some derivatives. However, changes made by the EU in 2019 to the scope of the related clearing obligation in EMIR were not reflected in the MiFID II trading obligation. This led to a mismatch in the scope of parties captured by the trading and clearing obligations. To eliminate this, the FSM Bill aligns the scope of parties subject to the trading obligation and clearing obligation and explicitly makes counterparties that fall within the scope of the clearing obligation subject to the trading obligation.
The FCA is also being granted a new power to make changes to the trading obligation, where necessary, to prevent or mitigate disruption to markets, subject to HM Treasury’s approval.
Firms that use the risk reduction measure of portfolio compression are currently exempt from certain obligations, including the trading obligation, best execution requirement and transparency obligations. To further encourage the use of risk reduction measures, the Bill grants the FCA powers to specify other risk reduction services that can benefit from these exemptions. The BoE is also being granted powers to exempt such services from the clearing obligation. The power will only be available where the BoE considers it necessary or expedient for financial stability purposes. Risk reduction services are post-trade services that aim to reduce non-market risks in derivatives portfolios, such as portfolio compression. Transactions that contribute to the price discovery process are excluded.
The MiFID II pre- and post-trade transparency regime, previously set out in primary legislation, will be delegated to the FCA. The regulator will make rules to provide for a qualitative and quantitative assessment of instruments that should fall within the regime, determine when and how pre-trade transparency requirements should apply and establish a post-trade transparency regime.
Trading Venues
The Wholesale Markets Review proposed a range of changes to the rules governing trading venues, but these have not been implemented in the Bill. The following actions are still expected from the U.K. government and regulators:
- FCA rules enabling OTFs to execute transactions in packages involving derivatives and equities;
- FCA rules allowing matched principal trading by an MTF, conducted under clear, transparent and nondiscretionary rules;
- publication of FCA guidance to clarify the scope of the regulatory perimeter, which will cater for new platforms emerging from technological developments;
- regulators using their existing tools to ensure market resilience during outages, with a consultation on future proposals later in 2022;
- legislative changes delegating the pre-trade equity waivers regime to the FCA.
The U.K. government is also considering the introduction of a new type of trading venue (or an additional segment of existing trading platforms) tailored to the requirements of smaller SMEs. Proposals to lift the restriction on operating Systematic Internalisers (SIs) within the same legal entity as OTFs are subject to further consideration.
Equity Markets
The following obligations will be removed from the rules for equity markets:
- Share Trading Obligation: shares that are admitted to trading will no longer have to be traded on a U.K. regulated market, MTF, SI or equivalent third-country venue by U.K. investment firms. It will be permitted to trade these shares OTC or on any U.K. or overseas trading venue of their choice.
- Double Volume Cap: the double volume cap, which limits the amount of trading that can occur without pre-trade transparency by restricting the use of certain waivers, will be removed. The FCA will have new powers to direct that those waivers should be suspended if, in its view, ongoing use of the waiver would impact market integrity. The FCA will have to consult with HM Treasury before directing such a suspension.
Systematic Internalisers
SIs are investment firms that execute client orders on their own account on an organized, frequent systematic and substantial basis. A quantitative threshold is currently used to determine whether an investment firm must be authorized as a SI (e.g., based on the number and size of trades it conducts). Under the FSM Bill’s proposed regime, the quantitative tests will be abandoned in favour of empowering the FCA to make rules on whether firms satisfy the conditions for SIs. Those rules may, at the FCA’s discretion, be entirely qualitative.
There will no longer be any restrictions on mid-point execution of client orders across an SI’s own book. This changes the position under MiFIR, which has since 2018 restricted SI’s execution of orders at the mid-point between best bid and offer for all transactions other than those which were “large in scale.”
The FCA has published a consultation on improving equity secondary markets, which includes proposals to amend the SI reporting regime. The FCA plans to replace the existing regime, which requires firms to report trades in financial instruments for which they are SIs in an SI register. The FCA will replace this obligation with a new designated reporter regime, where firms will voluntarily assume the obligation to report irrespective of the financial instrument in question.
Consolidated Tape
MiFID II introduced requirements for a “consolidated tape” for transactions in equity and non-equity instruments. It requires a consolidated tape provider (CTP) to collect post-trade information published by trading venues and approved publication arrangements and to consolidate this into a continuous live data stream made available to the public. No consolidated tape has yet been set up in either the U.K. or the EU. The U.K. intends to maintain these requirements to establish a consolidated tape.
DRSPs, (of which CTPs would be an example), are governed by the Data Reporting Services Regulations and currently fall outside the scope of the FCA’s authorization regime. The Bill will grant the FCA rule-making powers for DRSPs, which will (amongst other things) enable the FCA to set a framework for the development of a consolidated tape.
STS Securitizations
As confirmed in HM Treasury’s report on the review of the U.K. Securitization Regulation, the FSM Bill amends the U.K. Securitization Regulation to introduce an equivalence regime for recognizing non-U.K. securitizations as “simple, transparent and standardized” (STS) securitizations in the U.K. Currently, the U.K. Securitization Regulation provides that where originators and sponsors are established outside the U.K., the securitization cannot be designated as an STS securitization. This means that U.K. investors in such non-U.K. securitizations do not benefit from the preferential capital treatment accorded to U.K. STS securitizations.
As with the transitional changes for MiFID II, these changes to the U.K. Securitization Regulation are subject to a transitional regime.
Stablecoins
The Bill will give HM Treasury the power to bring the issuance or facilitation of the use of “digital settlement assets” (DSAs) used as a means of payment into the U.K. regulatory perimeter.
Scope
Initially, the regime is primarily intended to capture stablecoin activities. DSAs will be defined as “a digital representation of value or rights, whether or not cryptographically secured, that—
a. can be used for the settlement of payment obligations,
b. can be transferred, stored or traded electronically, and
c. uses technology supporting the recording or storage of data (which may include distributed ledger technology).”
The Bill introduces the above new definition of DSAs, which has a broad scope that will cover stablecoins and may also cover other digital or crypto assets that meet the terms of the definition. HM Treasury will be able to amend the definition to account for future technological developments. DSAs therefore differ from cryptocurrencies and other crypto assets that are primarily used for speculative investing, such as Bitcoin and Ether. The extension of the regulatory perimeter to stablecoins that are predominantly used to facilitate trading and investment activities in unbacked crypto assets will be re-considered by HM Treasury at a later stage (expected later in 2022).
HM Treasury Powers in the FSM Bill
To bring stablecoins used as payment within the regulatory perimeter, the Bill empowers HM Treasury to establish a supervisory regime for stablecoin issuers, similar to the existing electronic money and payments regimes.
The FSM Bill also provides for the scope of Part 5 of the Banking Act 2009 to be extended to provide for the recognition of payment system using DSAs or a DSA service provider posing potentially systemic risks. DSA service providers will include the issuer of a DSA in a payment system, those providing services to safeguard and/or administer DSAs, DSA exchange providers, the firm setting the rules for access to the system and those involved in the transfer of money or DSAs using the payment system, including any infrastructure provider. HM Treasury would have the power to recognize the payment system using DSAs or a DSA service provider. Once recognized, the BoE would supervise the operators of a DSA recognized payment systems, with responsibility for issuing codes of practice, giving directions and taking enforcement action, among other things.
Under the Bill, DSA payment systems would also become subject to competition regulation by the PSR, and the scope of the Financial Services (Banking Reform) Act 2013 will be extended to provide for this. HM Treasury will also be responsible for designating firms for these purposes.
The Bill also gives HM Treasury power to amend, by secondary legislation, existing special administration regimes to cover recognized payment system using DSAs or a DSA service provider, to preserve financial stability in the event of any such firm’s failure.
Approach to Stablecoin Regulation
Details of proposed approach to the regulation of DSAs were previously published in HM Treasury’s response to the related consultation, which concluded that all stablecoins used for payment that reference fiat currencies, including a single currency stablecoin or stablecoin based on a basket of currencies, should be subject to U.K. financial regulation. Stablecoins that reference commodities will be excluded from the new rules, although such stablecoins may well already be regulated as futures.
In addition, the government intends the FCA to have the power to regulate issuers of stablecoins for payments as well as other entities providing related services, including wallet providers and firms providing custody services. The requirements will ensure convertibility into fiat currency, at par and on demand. As with other entities providing payment services and e-money issuance, stablecoin-based payment service entities will need to be established in the U.K. to provide these services in the U.K.
Notably, HM Treasury’s response highlighted that consumers would have a legal claim to redeem the value of the token against either the stablecoin issuer or, where appropriate, the third party facing the consumer. This is necessary since the government noted that often a stablecoin issuer may not offer holders a legal claim, leaving a customer with no redemption rights or with rights against a third party but that, for consumer protection, it will not permit no legal claim to be available.
Firms which engage in activities in relation to stablecoins for payment would become subject to numerous regulatory requirements, including FCA authorization, capital requirements, rules for ensuring the quality and safekeeping of reserve assets, orderly failure and insolvency requirements for issuers and service providers, systems and controls, risk management and governance, conduct requirements, anti-money laundering requirements, outsourcing, operational resilience and security requirements.
HM Treasury’s separate consultation on managing the failure of DSAs sets out its proposed approach, which entails adjusting the existing FMI special administration regime (FMI SAR). Proposed changes to the FMI SAR include an additional objective for the return or transfer of funds and custody of assets and empowering the BoE to introduce further rules to support the additional objective as well as to direct administrators. The regime would take precedence over the Payment and E-Money Special Administration Regime (PESAR) in cases where both the FMI SAR and the PESAR apply to a firm.
Investor Protection
Mitigating the Risks of Authorized Push Payment (APP) Scams
As announced, the FSM Bill will amend the Payment Services Regulations 2017 to enable the PSR to require mandatory reimbursement by payment service providers of victims of APP fraud. The PSR will have a duty to consult on a draft regulatory requirement, and to impose such regulatory requirement, within two and six months respectively of the legislation coming into force. This mandates regulatory action on APP scam compensation by participants in the Faster Payments Service where a payment is executed following fraud or dishonesty.
Enhancing the Financial Promotions Regime – the Regulatory Gateway
The FSM Bill will implement the regulatory gateway for the approval by authorized firms of financial promotions of unauthorized firms. Authorized firms will be banned from approving financial promotions of unauthorized firms and will need to apply to the FCA to have the prohibition removed in whole or part before they are able to approve financial promotions of unauthorized firms. Firms that apply for authorization in future will be able to apply for a permission to approve such financial promotions at that time. The FCA will be able to apply conditions to a permission, such as restricting the types of financial promotions a firm can approve.
