On 11 January 2023, the FCA published a portfolio letter setting out its new strategy for supervising wholesale brokers. The letter details what the FCA believes are the most important risks arising from wholesale brokers, what it thinks drives those risks and the supervisory focus for the next two years.
Given the current economic climate, the FCA has drawn on recent supervisory work to identify the following four key areas of focus for wholesale broking firms:
- Financial resilience – Where firms have adequate capital and liquidity, they are far less likely to cause market disruption if they fail, and in the event they do, a prudent approach will mean that the risk of clients suffering losses is greatly reduced. However, the FCA is concerned by weaknesses in clearing brokers’ liquidity risk management, observing that firms fail either to develop their own competence on liquidity risk management sufficiently, or to recruit expertise externally to intraday liquidity risks from their own business as well as from key clients and counterparties. In order to improve financial resilience, firms should review the level of liquidity that they hold under the new Investment Firm Prudential Regime (IFPR) and ensure that their assessment is commensurate with the risks they face. Furthermore, firms should look beyond recent historical precedent when modelling stresses, noting that the past twelve months have produced a series of events that were previously considered implausible based on historic modelling. Henceforth, firms should seek to model stress events in more extreme, or reverse stress scenarios, and consider what they might need, or need to provide in these circumstances, and test what can be done to reduce vulnerability in those events.
- Remuneration structures – The FCA continues to see brokers receiving lower salaries with large cash bonuses based on the value and volume of trades they conclude for clients, which may lead them to focus on achieving short-term financial targets at the expense of client interests. Firms need to ensure that their remuneration structures match the risks associated with their business model and higher risk firms must identify Material Risk Takers (MRTs) whose professional activities have a material impact on the risk profile of the firm or the assets it manages. The FCA expects wholesale brokers and CEOs to ensure that their remuneration structures comply with the new IFPR remuneration requirements. In 2023 the FCA will focus on ensuring that firms are appropriately applying deferrals, malus and clawback when remunerating relevant staff. Where firms have failed to evidence that they have taken appropriate steps to implement the required IFPR remuneration requirements, the FCA will consider using a range of regulatory tools, including routinely imposing additional capital requirements to account for the increased risk that weak incentives can drive.
- Governance and culture – Wholesale broker firms that are governed by boards with a suitable mix of skills and experience for the firm to draw on and that provide effective challenge to management are more likely to make better decisions, manage risks and succeed. The FCA has observed that, poor decision making and failures in oversight played a key role in exacerbating the extent of any underlying issues or preventing them from being resolved earlier. Therefore, firms should continue to embrace the Senior Mangers and Certification Regime (SMCR) to promote good decision making and individual accountability, and with an understanding that the nature of their business means that relatively junior employees (in terms of traditional hierarchy) can expose broking firms to significant risk of harm to the firm, their clients and the market broadly. Firms can also help themselves to avoid conduct risk by properly taking into account regulatory references when hiring new certified staff and considering appropriate risk mitigations with any individuals where adverse information comes to light in the hiring process.
- Control functions – To achieve effective compliance, firms should stay abreast of the risks posed by their business models, design clear policies and processes around those risks and promote a culture where adherence to their rules is actively encouraged. Financial crime and market abuse mitigation are areas where the FCA commonly find brokers have weak systems and controls, and firms should continue to develop safeguards to mitigate these risks. The FCA’s recent work highlighted widespread deficiencies in wholesale brokers’ client onboarding processes to control financial crime and money laundering.
By the end of February 2023, the FCA expects all CEOs to have discussed this letter with their fellow directors and/or board and to have agreed actions and/or next steps.