Securing The Future For Principal Firms In The UK’s Financial Industry
13th March 2022 by Brielle Hewitt
Looking ahead, we explore the moves Principal firms will need to make to ensure they are part of the UK’s Financial industry for many years to come.
Principal firms have been back in the FCA spotlight recently, with FCA Consultation Paper CP21/34 suggesting reform for principal firms and standardisation of compliance practices across the industry. This has been driven by ongoing FCA reviews as well as concerns raised by the House of Commons over Greensill. For some, this is a welcome review that will help to strengthen governance across the industry, but the implications for those firms operating a low-cost, light-touch model are significantly less positive.
Regulatory hosting enables businesses to navigate the alternative investment landscape without direct FCA approval, providing an effective route to market, particularly when testing a new concept as a start-up. One commonly used solution is a regime not originally unintended for use in investment services, where a client’s business becomes an Appointed Representative (AR) of a Principal firm. This is a type of “Regulatory Hosting” and the AR’s regulated activities become the responsibility of the principal. While it covers retail and wholesale financial products, we look at wholesale specifically in this article.
The Appointed Representative Regime overall has clearly been a net positive for the industry. It has helped London to maintain its status as an attractive place to operate despite Brexit, and it has increased competition offering a more cost-effective opportunity for start-up firms looking to launch quickly, and cost-effectively. But, as the use of principal firms has increased, gaps have grown both in the understanding of their responsibilities and in the controls expected for proper oversight.
We held another SHIFT – thought leaders panel earlier this month with Andrew Shrimpton, Chairman of IQ-EQ’s RegCom and Joe Vittoria, CEO of GRSS and driving force behind what is now ACA Mirabella. Both are pioneers of the Regulatory Hosting model and are well-respected voices of reason for principal firms. Alongside Fingerprint’s CEO, James Hogbin, the discussion focused on the outcomes of the review and what the future might hold for the hosting industry. We expect the upcoming shakeup to challenge principal firms in meeting higher standards while trying to scale profitably. The consensus from the panellists – a change in approach is needed.
Why are principal firms under scrutiny by the FCA?
The FCA consultation suggested that many principal firms generally did not understand their responsibilities as outlined by the regulator. The FCA has so far also only required high-level detail for reporting on AR activity, creating a blind spot as the true activity being carried out remained unchecked.
In 2017 they (the FCA) finally started looking at the AR regime, the teeth came out and they started shutting firms down and asking questions. When they met with us bigger principal firms, they told us “We can’t understand how anybody can operate and do this properly for less than £2000 a month”. This realisation and push for viable, well-governed principals is moving across the industry.
Joe Vittoria, CEO | GRSS
Some Principal firms have operated on a low-cost model, pricing their regulatory services much lower than others in the market. Over the last few years, this has led to more questions raised around the level of regulatory supervision they have provided over their Appointed Representatives and the wider knock-on effect this may have over the wider financial industry.
How is the role of Principal firms changing?
Practically speaking, for some this could result in little more than a change in implementing more robust monitoring and reporting standards. For many, this will mean a wider review of current operating practices as they respond to stricter requirements laid out by the FCA. What is clear for all principal firms is that they will be held to a higher level of accountability. Evidencing proper controls rather than just attesting to them will be the key point to address. This will not only impact what responsibilities they carry out but also how they do it.
The fundamental problem is that the industry was founded by entrepreneurs who were in it for commercial reasons…they were targeting revenue growth, but they were also responsible for creating the standards and the systems of controls. What is happening now, and what we’re doing at IQ-EQ, is having a separate CEO and a separate Compliance Officer, creating stronger governance and better business models
Andrew Shrimpton, Chairman | IQ-EQ RegCom
Principal firms saw an opportunity to provide compliance as a service, often scaling fast in creating a profitable business model. But where the title of CEO and Head of Compliance could be held by the same person, the consequences of this conflict of interest between revenue growth and high governance standards has now come to light. Short-sighted financial gains prioritised over creating a solid compliance framework has caught the attention of the FCA. Their recommendations hope to increase the minimum governance standards across the industry.
Why is the AR regime so important to maintain?
We’ve touched on why the AR regime has been crucial to the regulatory landscape. The wholesale market is significant to the UK financial services industry, and the AR regime has supported it for over 10 years. More recently this approach has even gone far to mitigate against Brexit by retaining ease of doing business versus alternative European hubs. The “regulatory incubator” model we see through principal firms such as Mirabella and IQ-EQ are also essential for driving innovation.
The role of principal firms is to keep the harmony between regulatory robustness and market competitiveness, allowing new entrants to leverage much needed expertise at a commercially viable cost. The ability to start operating in a matter of months as an AR versus a year or more as a fully-fledged regulated firm has attracted firms that might not have otherwise launched through London. It is therefore also the role of principal firms to upkeep standards to ensure this model of regulation can survive long-term. The responsibility is not solely on the regulator. Principals must do more to embed best practices and govern their ARs proactively.
Data & Technology will be key to support principal firm’s profitability & longevity.
A consistent theme throughout CP21/34 is that data collection, systems and controls at all levels will need to be improved. The FCA have noted that their own high-level reporting requirements on ARs is not sufficient for their own use in identifying risks and informing future policy. [Learn more on the regulatory requirements for adequate System and Controls in this short explainer video – insert link to James SYSC explainer)
Likewise, they highlight a clear lack of insight into AR activity by principal firms, due to the sheer operational undertaking of overseeing multiple disparate client, firms.
Most (regulatory hosts) rely on contracts with the clients to access data, access systems, and give (principals) permission to do monitoring…for the regulatory host it’s a massive technical challenge
James Hogbin, Founder & CEO | Fingerprint Supervision
Without collecting sufficient information, can principals really understand the activities that they are responsible for overseeing? The only way forward is harnessing technology to evidence proper controls and provide effective oversight from the bottom-up.
“The assets under management for each individual AR may only be small and therefore seemingly not require much oversight. It is however the sum of the multiple ARs’ combined assets that present the significant risk as they are all under one regulated firm. It is the sum of these parts that drives the need for greater controls.”
Andrew Shrimpton, Chairman | IQ-EQ RegCom
The failings identified also signal commercial pressure in two ways. Firstly, the levelling up of minimum standards will reduce the number of active principal firms through increasing compliance and operational costs, meaning an increase in the average number of ARs they manage. Secondly, the FCA will be publishing new guidance on what “adequate controls” mean, suggesting firms will be required to do more to manage ARs in keeping their licence to operate.
Evidently, a shift towards more holistic, technology-enabled data oversight and retention, and automated risk management is necessary to scale profitably. It seems there will also be an expectation of enhanced due diligence in appointing and monitoring ARs and their activity.
Regulatory hosts need to level up operations and oversight to ensure the future of the AR regime
It is in everyone’s interest to achieve greater compliance outcomes and embed better governance across the wholesale industry.
Regulatory hosts must prove they are robust enough in their activity to independently support ARs and are able to demonstrate robust governance and sufficient oversight of their ARs when the FCA comes calling.
However jarring this period has been for principals, there is opportunity in adversity, and those principals that are modelling best practice and creating a ‘regulatory incubator’ model for their ARs will rise to the top, ensuring the freedom for financial businesses to operate under the AR regime can be maintained, and the future of the hosting industry is secured.
How can Fingerprint support Principal Regulatory Hosts to ensure compliant AR client oversight?
Here at Fingerprint, we understand the specific operational requirements and pressures faced by Regulatory Hosts and those firms responsible for the oversight of multiple, disparate businesses. As a team and business, we are well suited to support Principal Host firms in implementing our supervision platform to improve client oversight, compliance processes and business outcomes all while ensuring regulatory compliance.
With 100+ clients using our supervision software, we are now one of the world’s largest providers of Unstructured Communications Supervision and compliance technology solutions to regulated firms. Our team boasts over 50+ years of industry experience, with skills ranging from regulatory IT and compliance to peer acclaimed technologists and developers. We are enthusiastic innovators continually seeking to improve and empower compliance operations and processes with technology.
Speak to our expert team today about how we can support your business.