Dear CEO…FCA’s quest to inspire a big change in culture and controls at wholesale brokers

The FCA wrote a “Dear CEO” letter to UK brokerage firms in April. Radar examines FCA’s proposals and the challenges it will face in overhauling a sector that it perceives to be behind the regulatory curve.

The UK’s Financial Conduct Authority (FCA) caught the attention of a select number of CEOs of brokerage firms in a new effort to tackle potential misconduct and what appears to be ingrained and generic practice across this group of firms. Unlike previous warnings, its focus is more on non-financial scenarios, and conduct and controls.

The letter, from FCA’s head of wholesale markets department Simon Walls, calls out a “complacent attitude” among brokerage firms who have “fail[ed] to meet expectations across all the areas of regulation [the FCA] has recently examined”.

Against a backdrop of major regulatory reform, with the implementation of MiFID II and MAR and the upcoming roll out of SMCR, the letter suggests that brokers have “not kept pace with, and have under-invested in,  the requirements of this new legislative and regulatory environment”. This is particularly true of culture and controls. As such, there is now an “urgent”need to raise standards and mitigate harms across the sector, for which FCA has a strategy.

Who received the letter?

It’s unclear to whom the letter, which was also published online, was addressed. However, a reliable industry source suggested that, on reading, the majority of their broker clients thought it was addressed directly to them as one or more of the issues raised in the letter will have been the subject of direct discussions with the FCA. Another source commented that a number of their broker clients had been in receipt of the letter.

What’s the FCA’s strategy?

In its bid to raise standards across the sector, the FCA proposes a supervision strategy. This is based around the principle that the current business model “places broker discretion at its centre”, which allows for significant harm to the market in the event that brokers fail to operate “within an appropriate culture and control environment”. The FCA identifies four drivers of harm on which its strategy will focus over the coming two years to March 2021: compensation and incentives; capacity and conflicts of interest; governance and culture; and market abuse and financial crime controls.

This strategy is not uncontentious and, without considered and methodical implementation, could cause more harm than good.

Compensation and incentives

Perhaps most contentious of the FCA’s proposed areas of change is compensation and how brokers remunerate their staff. Current models, it says, are “poor and outdated” and a “root cause of misconduct risk” within the sector. In particular, the FCA highlights models that see frequent and formulaic cash payments made to brokers dependent on the revenue they generate as it leaves “little or no room for firms to adjust compensation for non-financial performance measures”.

Vedder Price Partner, Sam Tyfield, suggested that altering the current approach, one that has long been the cornerstone of brokerage firms, will be no mean feat. The current model of remuneration is an “eat what you kill sales model”. Some firms will therefore be “much more focussed on the remuneration element…with the appropriate checks and balances they may well think ‘why can’t I remunerate my staff on an eat what you kill model’?” Sam Tyfield did note that he had observed, during a May 2019 FCA webinar on culture, the participants (including the FCA) had been enthusiastic in their support for the view that flexible working improves culture. That is not a contentious issue, but one of the main reasons that the participants on the webinar were so keen on flexible working was that an employer always got more hours out of a flexible worker than contracted (or paid). Frankly, says Sam, if the FCA is happy with that arrangement from a culture perspective, it should not have too much of an issue with eat what you kill remuneration models.

Commenting on changes, Vaughan Edwards, partner and specialist regulatory adviser at Elixirr, noted that “remuneration is the most pronounced issue here” and must not be dealt with “unilaterally” if it’s to work. If one firm is required to adopt a similar approach to the ones used in banking, a deferral and stock element of compensation, “that’s a huge first-mover disadvantage”. He continued, “it’s so big that it could actually be existential for them. If one firm suddenly goes ahead and adopts banking-style remuneration and the others don’t – if you’re a broker and one firm will pay you in cash every quarter, and another will pay you partly in cash and partly in stock and some of it’s going to be deferred – it’s a no brainer who you want to work for.”

The FCA is undertaking a review of market practice in this area with the findings to be published later in the year. Watch this space.

Capacity and conflicts of interest

Brokers are in a unique position as they often carry out myriad services; from broking to trading. The FCA acknowledges this and expresses concern that “the sector is generally weak in identifying the particular capacity it is acting in for a given transaction”. The point is moot as to whether firms are deliberately opaque in this regard.

Moreover, the FCA’s letter has repeated concerns that brokers continue to be “inappropriately charging commission to liquidity providers from whom they source liquidity”, also known as payment for order flow (PFOF). The weaknesses in the system present “substantial harm” to the market, and FCA wants to see a shift in how firms detect conflict of interest, and implementation of systems and controls that are going to identify this.

Sam Tyfield suggests, however, that FCA’s proposal does not accurately reflect how business is done in all markets/instruments and ignores various changes to market structure forced on the sector by both MiFID II and the FCA itself. This will place an excessive burden on brokers, says Sam.

Governance and culture

The broking industry has a reputation for being “dog-eat-dog”, with brokers in it for themselves. The FCA alludes to this in its outline for supervisory work surrounding governance and culture: “Individual brokers in this market are often their firm’s principal revenue earners and relationship holders with their clients, and so have significant negotiating power.”

The FCA endorses the introduction of “strong governance frameworks that allow their culture and values to drive decision-making across the business.” Are these changes necessary? Apparently so, according to industry experts, with one commenting that there’s “a culture that definitely needs to change”.

The culture and governance within firms inevitably varies, often corresponding to the size of the brokerage. Where brokers are part of a bigger group, potentially including banks, it’s sometimes seen that culture is aligned to a higher standard. As Vaughan Edwards pointed out, “it’s difficult to see how a broking division of a large banking group could just operate in isolation and not operate to the same levels of compliance expected of banks and investment banks.”

Change is undoubtedly needed, but it might be too little too late. It might be suggested that FCA has uncovered issues that have been glaringly obvious for years, but they’ve failed to take action until now. However, a strategy whereby the FCA demands industry change in a short period of time may not be realistic. In an environment with individual competition running intrinsically through its culture, will steps by the FCA to reform culture be futile? How do you encourage and enforce transparency and compliance among brokers if they’re predominantly“in it for themselves”?

Market abuse and financial crime controls

The final area to receive the FCA’s supervisory scrutiny comes as no surprise, echoing its message across the wider market. Brokers have underinvested in systems and controls “including surveillance systems and training”, which has resulted in a lack of understanding about their obligations under core legislation.

One Radar contributor stated that the FCA’s concerns are warranted in some cases although its own inaction is partly to blame for the current landscape: “Many brokers have underinvested in compliance systems and surveillance relative to other parts of the industry. And the FCA has let them get away with that for a very long time.”

This is particularly concerning given that, by the FCA’s own admission, “the wholesale broking business model poses an inherently high risk of market abuse.” Brokers have access to significant non-public information, including trading intents and details about companies with publicly quoted securities. The FCA joins global regulators in its message that it wants to see “improved surveillance arrangements… communication monitoring…and increased resource allocated to this task.”

Culture change or competitive crisis? Consistency is key

It feels undisputed that a culture-shift within brokers is long overdue. However, there’s a real concern that a fragmented approach to implementing change could cause a competitive crisis among firms, and do little to inspire a new way of thinking.

The strength of tone and urgency in the Dear CEO letter is clear, but it remains to be seen how FCA will implement their strategy. As Vaughan Edwards noted, “if FCA is rolling this out consistently across the board, that’s fine. But if it goes after one firm and not the others that could cause serious problems.”

Of course, the FCA should be mindful that brokers, especially those within the IDB sector, have long been characterised by significant broker retention issues, with rival firms paying significant premiums to attract individuals and entire teams. An inconsistent application of FCA’s new approach could therefore have a significant impact on what is already a highly mobile workforce.

In order to effect meaningful change across the broking industry, FCA must be able to reassure firms, particularly senior executives and company boards, that they will not be put at a commercial disadvantage by implementing changes to their culture and controls. Perhaps the most logical method of doing this would be to effectively sit firms round a table, give them a timetable and make it clear what would be expected of them, by a realistic and achievable deadline.

Is culture the tool we’ve overlooked and underrated?

Culture has long been considered an ethereal topic and generally somewhat unessential to successful commerce. However, the tide is turning. If FCA considers their implementation strategy, one might speculate that culture is being utilised as an essential regulatory tool. Used correctly, regulators could harness cultural expectations as an all-encompassing means by which it can capture and sanction firms for activity that previously flew under the radar.

An example of this is the situation in which, when regulators turn up the heat, firms jump ship to a less regulated jurisdiction. As a reliable contributor speculated: “Moving people to Dubai is often mentioned. They’re not always subject to the same restrictions and are dealing with the same clients but they’re free to do what they want. Essentially you have people deliberately engaging in regulatory arbitrage.” This must frustrate the regulators, aware of this activity but largely unable to act.

If the FCA is methodical in its approach, culture might be the key to an effective, overarching regulatory regime.