The half-way point in the FCA’s two-year supervision strategy for wholesale market broking firms

In April 2019, the Financial Conduct Authority (FCA) sent a Dear CEO Letter to wholesale market broking firms. In that letter, the FCA committed to taking a “tough stance” with wholesale market brokers in pursuit of “necessary and urgent” changes.

The Dear CEO Letter set out the FCA’s supervision strategy in relation to four key concerns. That strategy covered the period between April 2019 and March 2021.  We have, therefore, just passed the half-way point. As such, it is time for firms to reflect on the progress that they have made so far – and to consider what steps they still need to take.

Firms should not expect the FCA to abandon its focus on these issues as a result of Covid-19. Just as firms are striving to maintain “business as usual” so the FCA is continuing to concentrate on its top priorities. 

One such priority is the question of culture at wholesale market broking firms.

Key “drivers of harm”

The Dear CEO Letter listed the following four key “drivers of harm”:

1. Compensation arrangements which link broker remuneration directly to business volume without giving sufficient recognition to long-term or non-financial indicators of performance;
2. Governance arrangements under which boards and senior managers lack the necessary tools with which to oversee their staff and business;
3. Workflows which fail to recognise that a broker may perform different regulated activities (and/or act in different capacities) at different times; and
4. A culture and mindset which underestimates the risk of brokers committing/facilitating market abuse and financial crime.

What progress will the FCA expect to see?

Compensation and incentives

The FCA was particularly concerned by the traditional remuneration model under which firms make cash payments to individual brokers based on the revenue which those brokers have generated. 

A year on, the FCA will not expect firms to be using a simple “eat what you kill” model without significant modification. The FCA expects firms to ensure that their remuneration models take a longer term view of performance and take account of non-financial performance. Relevant non-financial performance will include training, compliance and general contribution to a positive culture at the firm.

Given the level of concern expressed by the FCA at what might be called a fairly industry-standard approach to remuneration, firms should consider how they will be able to demonstrate that they can justify their particular approach to remuneration.

Governance and culture

The Dear CEO Letter also referred to that fact that brokers, who are often the principal revenue earners in their firms, have significant negotiating power. The FCA was concerned that boards may not always be able to stand up to brokers.

Given that firms have had a year to work on this and that the Senior Managers and Certification Regime has been rolled out to wholesale broking firms since the Dear CEO Letter, it is likely that the FCA will be expecting firms to have made significant improvements in this regard.

Importantly, many brokers will fall within in the Certification Regime. As such, it will be firms themselves which have responsibility for assessing brokers’ fitness and propriety. The FCA will want firms to be able to show that this assessment is a robust and evidence-based process rather than simply a “tick box” exercise. 

More generally, the FCA will want to see that directors have appropriate mandates and are operating effectively. 

Capacity and conflicts of interest

Firms will be well aware that this has been an area of particular focus. The Dear CEO Letter pulled no punches in this regard and said that the wholesale broking sector is “generally weak in identifying the particular capacity it is acting in for a given transaction”. This raises concerns regarding conflicts of interest.

More specifically, the Dear CEO Letter said that the FCA continued to be concerned about brokers “inappropriately charging commission to liquidity providers from whom they source liquidity” (known as “payment for order flow” or PFOF). 

Given the emphasis that the FCA has placed on PFOF over a number of years, firms should consider whether they still need to improve the quality of the practices, policies, systems and controls that they have in place to ensure compliance with PFOF obligations and conflicts of interest obligations more generally.

Market abuse and financial crime controls

The Dear CEO Letter said that “firms are generally complacent about their responsibilities to monitor for and mitigate market abuse and financial crime risk”. 

The FCA will want firms to have improved their surveillance arrangements (including the way in which they monitor communications) and to have increased the amount of resource devoted to this issue. Additionally the FCA will expect senior management to be more engaged in the process of identifying market abuse and financial crime risks.

The Dear CEO Letter specifically referred to “serious deficiencies in resilience and readiness to combat cyber-crime” and added “if firms fail to prioritise investment in IT this can cause serious harm to the firm, their clients and the market”.

The FCA will expect to see evidence that firms are testing their IT controls thoroughly and are making any necessary improvements. It is also likely that the FCA will expect firms to have increased the level of resource in this area.

Next steps

While firms are understandably diverting attention to coping with the impact of Covid-19, the FCA will still expect wholesale brokers to be addressing the issues set out in the Dear CEO Letter.

The half-way point in this two-year supervision strategy is a good time to take stock and to consider next steps. Firms would be well-advised to tackle these issues proactively rather than to wait for any follow up contact  by the FCA or, even worse, enforcement action.

---

For more information please contact William Garner, or Richard Ellis.