As regulatory rules are increasingly made in Europe, within the UK, the new Financial Conduct Authority (FCA) will move to becoming – as Hector Sants put it – a “supervisory arm” of Europe in relation to conduct issues.  But has the UK really given enough thought to compatibility with European legislation, and to the need for coordination and cooperation with the ESAs and other competent authorities, or are we enshrining potential problems for ourselves in the proposed legislation and policy approach?

In considering the proposals in the UK’s Financial Services Bill (the FS Bill) to give FCA product intervention powers, the interaction with European requirements and the role of the European Supervisory Authorities (the ESAs) assume heightened importance.  Concerns about this interaction were a continuing theme emerging from responses to the FSA’s discussion paper on product intervention. 

The FCA has confirmed that its Product Intervention Committee and the Board will have due regard to how the national approach fits within the wider EU legislative framework and that they will, where appropriate, recommend consideration of the same  issues at EU level.  There is also an acknowledgment that there may be a need to change national rules with the advent of new European rules.  These are welcome assurances, but may not go far enough to address some of the issues to which the interaction of UK and EU product intervention powers may give rise.

How the FCA will cooperate and coordinate with the ESAs and other competent authorities in this context – and vice versa?

Generally, permanent bans on a specific product or activity will remain within the remit of the national authorities, although the ESAs are expected to advise the Commission where they see a need for a permanent ban or restriction on a particular kind of financial activity. 

The founding regulations of each of the ESAs require them to take a leading role in promoting transparency, simplicity and fairness in the market for consumer financial products or services across the internal market.  In that context, they must each establish a Committee on financial innovation involving all relevant competent national supervisory authorities, and develop a coordinated approach to the regulatory and supervisory treatment of new or innovative financial activities, and advise the Commission, the Council and the Parliament accordingly. 

The ESAs are given a range of powers.  These powers include adopting guidelines and recommendations, and issuing warnings about financial activities posing a serious threat to the ESA’s objective (note for example ESMA’s warning in November 2011 about trading in foreign exchange).   They also extend to temporarily prohibiting or restricting certain financial activities that threaten the orderly functioning and integrity of financial markets or the stability of the EU financial system, either where permitted by specific EU legislative acts such as the Commission’s proposed Markets in Financial Instruments Regulation (MiFIR), or in an emergency situation.

It’s important to remember that the FCA’s engagement with the ESAs will be complicated by the fact that the ESA’s responsibilities are divided by sector, whereas regulatory responsibility in the UK will be divided functionally, with responsibility for financial stability vested in the Bank of England and the Financial Policy Committee (FPC) directly, and in the Prudential Regulation Authority (PRA) indirectly.  The FCA, on the other hand, will for these purposes be concerned with consumer protection in its broadest sense, and with ensuring that markets function well.  The ESA interventions may be stability based, whilst, somewhat sub-optimally, the FCA does not count financial stability amongst its objectives and is not the UK regulator that will regularly engage with the ESAs and other competent authorities on financial stability issues.

MiFIR will expressly confer a temporary intervention power on ESMA, in certain specified conditions.  Under the Commission’s original proposals, ESMA could intervene to address a threat to investor protection, to the orderly functioning of the market or to the stability of the EU financial system, provided that:

  • applicable requirements do not address the threat;
  • no regulator has intervened or if they have, that the action taken had not adequately addressed the threat;
  • the effect to the efficiency of the market or investors would not be disproportionately detrimental; and
  • no risk of regulatory arbitrage is being created. 

This is a temporary power, reviewable at intervals of no more than 3 months – but, the regulation says, such action will prevail over action taken by the competent authority. 

So even though the Commission’s impact assessment describes the power as complementary to the powers granted to national authorities, the regulation clearly envisages the possibility that there could be a conflict of interventions.  ESMA’s obligation is to notify the competent authorities (but not, apparently, to consult them – an interesting mismatch with the obligations being imposed on the competent authorities – see further below). 

The FCA’s draft statement of policy on temporary product intervention envisage that its rules may be revoked or changed for various reasons, including the introduction of new EU rules.  However, a ‘prevailing’ ESA intervention should be the trigger for revocation of any previous action taken by the FCA in respect of the product or activity targeted by that ESA intervention.  Otherwise there is some risk that financial institutions, which are already subject to an existing FCA intervention, might find themselves subject to doubly onerous, or even conflicting, requirements.  Where compliance with both is impossible, should the burden of taking legal steps to judicially review or otherwise challenge the pre-existing action fall on the financial institutions affected?

Some comfort is to be drawn from Stephen Maijoor’s assurance last November that this kind of intervention by ESMA, at least, would be limited to certain specific circumstances and that a condition for ESMA to step in would be that national authorities had not taken any action to address the threat.  Nevertheless, a greater degree of legal (and policy) certainty in this area would be welcome.

In relation to MiFIR, ESMA is also being given a facilitation and coordination role.  To review the action taken, and ensure that where necessary a consistent approach is taken by national regulators, ESMA is required to adopt an opinion stating whether it considers the action was justified and proportionate, and whether it believes that other competent authorities should take measures to address the same risk.  Competent authorities are not obliged to follow ESMA’s recommendation in that opinion but must publish an explanation of why they are not doing so (which could potentially open the way for ESMA to take its own action if it considers that the risks have not properly been addressed).

MiFIR requires national authorities to consult with ESMA and with competent authorities that might be affected by their proposed intervention action about the use of intervention powers in the context of MiFIR.  The practical impact of this is considered further below.

Compatibility of the UK’s approach with evolving product intervention powers and policy at the European level

The review of the Markets in Financial Instruments Directive (MiFID) is the EU legislative initiative which most obviously focuses on product intervention.  There seems to be broad alignment between proposed FCA and European policy in terms of product governance requirements:  for example, Rapporteur Ferber’s recent proposals that Member States should, in designing investment products or structured deposits for sale to professional or retail clients, seek to meet the needs of an identified target market and that firms should take reasonable steps to ensure that the relevant investment product is marketed and distributed to clients within the target group closely echo the FSA’s TCF initiative, including the RPPD and more recent guidance in relation to retail structured products. 

The Commission’s draft of MiFIR makes specific provision for product interventions by national competent authorities.  As a Regulation, it will have direct effect in the UK without national implementation measures, and it is being made under the Treaty’s approximation of laws powers [article 114(1) of the Treaty on the Functioning of the European Union] to ensure that product intervention powers are uniform – so subject to maximum harmonisation – across Europe.  Clearly MiFIR still has a way to go through the legislative process, so the proposals may change somewhat, but a fundamental shift in the legal basis for the Regulation seems unlikely.

So what does MiFIR propose?  The Commission draft would enable national regulators to prohibit or restrict the marketing, distribution or sale of certain financial instruments or financial instruments with certain features, or a type of financial activity or practice, in or from the Member State.  Our high-level comparative summary provides a brief overview of the conditions and thresholds for intervention under MiFIR.  It highlights some of the differences between the trigger/threshold, conditions and scope of proposed MiFIR power and the product intervention power in the FS Bill. 

The different threshold tests and conditions for use of the MiFIR and FS Bill powers would mean that in practice, in response to MiFIR-specified detriment or threats, the FCA would be confined to making interventions which met the MiFIR tests and conditions.

In this discussion, it is important to remember that the coverage of MiFIR is in some ways more limited than the scope for the FS Bill’s product intervention power – other European legislation does not presently constrain the FCA from exercising the full FS Bill product intervention powers in non-MiFIR interventions, such as, for example, in interventions in respect of the marketing and sale of non-MiFID investment products, insurance and (eventually) consumer credit. 

Generally MiFIR seems to envisage necessary interventions where there is evidence of serious detriment or adverse impact; the FS Bill permits expedient interventions, and (potentially) positive interventions – in the sense of promoting an outcome (e.g. advancing the objective of promoting competition) rather than dealing with a crystallised threat or concern.  In a MiFIR context, maximum harmonisation would not permit expedient or ‘positive’ interventions.

The purpose of moving to a twin peaks framework in the UK was to ensure that financial stability considerations were the focus of the prudential regulators, as embodied by the Bank of England, the Financial Policy Committee (FPC) and the PRA (indirectly through its focus on the safety and soundness of the firms it regulates). 

Unsurprisingly, therefore, the FS Bill does not propose to empower the FCA to intervene on financial stability grounds.  It does enable the FPC to make recommendations (or potentially give a direction if an appropriate power has been specified) to the FCA on those grounds.  A further complication is that the FPC’s remit is the financial stability of the UK, and not that of the whole of the EU (or indeed any part that is not the UK).  It is important that there should be some clarity around the way in which the FCA (as competent authority for MiFIR/MiFID) would meet MiFIR’s expectations of providing responses to serious threats to the stability of the whole or part of the EU financial system. 

A practical wrinkle is the MiFIR requirement for the FCA to consult with other competent authorities that might be affected by the intervention, and to give all European competent authorities at least one month’s notice of the intervention proposed. 

It would be simple for the FCA to comply with this requirement in respect of the ordinary product intervention procedures in the FS Bill as a matter of practice.  However, the need to consult and notify other competent authorities could impede rapid temporary product intervention in respect of financial instruments or activities within the scope of MiFIR, and reduce the value to the FCA of the FS Bill’s exemption from the need to consult on temporary interventions by building in delay to the process, which would create time for public consultation. 

This is definitely an area where the MiFIR text could change.  Rapporteur Ferber’s draft report proposes more precautionary, proactive interventions before detriment has crystallised, and would reduce the period for giving notice to competent authorities and ESMA to a 1 week minimum; he would, however, retain the requirement to consult other affected authorities. 

Solvency II

To illustrate the potential for other less obvious areas of interaction, it is worth turning very briefly to the insurance sector. 

Solvency II contains two articles – 181 and 182 – which rule out certain pre-approval and pre-notification requirements for non-life and life products.  This is consistent with the FCA’s proposed approach, and indeed with the Commission’s approach in MiFIR.  There are however two exceptions which permit competent authorities to require pre-approval of certain documents in relation to compulsory insurance and approval for premium increases as part of general price control systems. 

Could EIOPA to use its general product intervention power under article 9 paragraph 5 of its founding regulation to impose a restriction which would effectively require competent authorities to carry out pre-approval by imposing a restriction on marketing of non-pre-approved products? 

In theory, this seems feasible, although the context of these particular provisions, the prospect is perhaps remote.  Because Solvency II contains no express legislative provision enabling product intervention, EIOPA’s temporary product intervention powers (under article 9) could only be exercised in the event of an emergency situation as envisaged in article 18.  For this power to come into play, adverse developments which could seriously jeopardise the orderly functioning and integrity of financial markets or the stability of the whole or part of the financial system in the Union would need to have been identified (determined by the Council), and the restriction would need to be a justified and appropriate response to those developments.  At first blush, pre-approval requirements would not appear to be the most obvious tool to reach for in an emergency. 

Regulatory arbitrage

In the responses to the FSA’s product intervention Discussion Paper, particular concerns were expressed about the possibility of regulatory arbitrage if products designed elsewhere in the EU, without similar rules, could be passported into the UK, but if the UK regulator could not extend its intervention to include those products (so the risk of market detriment would remain).  In MiFIR, this has to some extent been dealt with in the text which refers to banning marketing or distribution in or from the Member State (which would accordingly cover the activities of firms passporting into that Member State), and in the requirement that ESMA should only exercise its temporary product intervention power where no risk of regulatory arbitrage is created.

However, the possibility of regulatory arbitrage arising from the UK’s approach to the use of the product intervention power remains in the context of non-MiFIR interventions, and, potentially acutely, if the FCA’s intervention were to involve the imposition of increased prudential requirements.  

The ESAs of course have their own temporary intervention powers which can be exercised in limited circumstances, and the power to recommend a more permanent form of intervention to the Commission.  These could be invoked to solve a broader problem.

The ESAs are also empowered to investigate an alleged breach or non-application of EU law at the instigation of another competent authority, and where appropriate, to make a recommendation to which the competent authority must respond by complying or explaining, and in the event of non-compliance, the Commission may then issue an opinion – effectively naming and shaming the authority concerned.  And in those circumstances the ESA could address a decision in respect of individual financial market participants direct (which again would “prevail” over any decision of the local regulator).

Conclusion

Both the current UK regulator and the European Commission recognise the risk that if used in an overly restrictive manner, product intervention could restrict financial innovation and withhold financial opportunities, and specifically investment and hedging opportunities, from market participants, and most critically from the real economy. 

The ESAs will be uniquely placed to deliver a safer environment for market participants and investors in a way that should eliminate the possibility of regulatory arbitrage.  They will be able to cut through the current ‘patchwork’ of the scope and nature of supervisory powers with regard to how products or practices involving financial instruments may be restricted.  They will, however, be heavily reliant on the national regulators for an understanding of how particular products and domestic markets work and may be impacted by proposed interventions, and it will be the national regulators who must supervise and enforce any restrictions or prohibitions that the ESAs issue.  It is critical that there should be no impediments to the FCA’s ability to liaise, coordinate and cooperate with the ESAs on proposed interventions, including those made on financial stability grounds. 

The European product intervention provisions aim to improve legal certainty, effectiveness, and ensure equal treatment of EU market participants and investors.  The detail of the European powers deserve close consideration in order to ensure that the UK’s new legislative and policy proposals for product intervention are optimally aligned to achieve these aims, and in particular, to deliver legal certainty for the UK markets.