RE-IMAGINING THE UK APPROACH TO REGULATION

The Report of the Taskforce on Innovation, Growth and Regulatory Reform and What It Means for Financial Services Regulation in the UK

The Report^[1] of the Taskforce on Innovation, Growth and Regulatory Reform makes bold and aspirational recommendations for reforming the U.K.’s approach to regulation as well as practical suggestions for implementing the reforms. The main recommendation tasks the government with building a U.K. regulatory framework that has proportionality at its core and that is based on the principles of U.K. common law. The report also provides specific proposals for regulatory reforms across several sectors, identified as high growth sectors, including the financial services sector.

The TIGRR recommendations will be progressed by the newly established Brexit Opportunities Unit, which is being led by Lord Frost, Minister of State at the Cabinet Office. Consultations on proposals to implement these ambitious recommendations are expected later this year. This note discusses these key recommendations, including those specific to the financial services sector. Shearman and Sterling are proud to have been a contributor to this important report.

A Proportionate, Common Law Approach to Regulation

Noting that the U.K.’s regulatory framework impacts its competitiveness, the TIGRR report recommends that it be reformed along traditional common law lines, moving away from the EU codified system. The report suggests that the government reconsiders the approach to regulation with the aim of enhancing productivity, encouraging competition, and invigorating innovation. To do this, the Taskforce proposes, among other things:

• Re-imposing the ‘one-in, two-out’ target on all government departments to ensure that regulation is only introduced when necessary;
• Ensuring agile and adaptive regulation, with regulators that are proportionate in their approach, forward-thinking, collaborative and responsive;
• Mandating a proportionality principle so that regulation is proportionate to the risks involved and focuses on the desired outcomes;
• Introducing mandatory statutory objectives for regulators to promote competitiveness and innovation;
• Delegating rulemaking to the regulators, allowing them to adopt flexible and responsive rules, guidance and decisions;
• Appointing a lead cabinet minister and establishing a cabinet committee to be responsible for regulatory reform;
• Establishing an accountability and scrutiny framework, including requiring:
  • the Regulatory Reform Committee to scrutinize all regulators and assess all regulatory reform proposals;
  • regulators to report publicly on their actions to promote competition and innovation;
  • Regulatory Impact Assessments that discuss the wider effects of proposed policies, where possible; and
  • An innovation scorecard to annually assess the performance of regulators;
• Creating regulatory sandboxes, such as the Financial Conduct Authority’s sandbox, across all regulated sectors to more quickly test innovations and to ensure regulation is based on demonstrated impact; and
• Establishing regulatory scaleboxes to support companies in their early growth phases (which the FCA is aiming to launch in the Autumn for the financial services sector).

Specific Recommendations for Financial Services

The TIGRR report makes three main recommendations for financial services. These are:

• Return to a common law principles-based approach to financial services regulation

The Taskforce advocates that the U.K. returns to a common law principles-based approach to financial services regulation, freeing the U.K. of the rigid and too prescriptive EU approach. This is based on recommendations by Shearman & Sterling partner Barnabas Reynolds in his book “Restoring UK Law: Freeing the UK’s Global Financial Market,” which provides detailed analysis of the topic. Notably, the Taskforce goes further and recommends this approach is adopted for all regulated sectors, not only the financial services sector.

The report provides two examples where this can be put into action. The first example concerns the MiFID II position limits regime, which sets limits on the largest position a firm may have to a particular contract that is traded on an exchange. The TIGRR report states that the EU rules, while aiming to address the risk of a market squeeze, are too rigid and add unnecessary cost and complexity without enhancing protections. It is argued that a more discretionary approach, such as is adopted under the U.S. system, would achieve the same protections for critical contracts. This could be achieved by reviewing the scope of the contracts subject to the regime and weighing up appropriate exemptions.

The second example suggests introducing a more discretionary approach to calculating CCP margins. CCPs are required to run a model for the calculation of margin and obtain regulatory consent for any significant change to the model before adopting the revised model. This prescriptive approach is not suited for all situations, such as the recent negative oil prices in Texas. It also constrains innovation. Furthermore, the EU’s strict rules on holding of margin, such as the margin period of risk (known as MPOR) requirements could be better framed taking into account the approach of other jurisdictions.

• Deliver a regulatory framework that supports U.K. global leadership in FinTech and digitalization of financial services infrastructure

The Taskforce report sets out four ways in which the government can meet this recommendation, some of which echo the Kalifa Review^[2] recommendations.

1. The Taskforce suggests that the government should mandate the advancement from Open Banking to Open Finance quickly for the benefit of consumers and increasing the U.K.’s GDP. The Taskforce advocates a return to principles-based regulation to secure the competitive advantage of moving to Open Finance within two years, keeping pace with or exceeding the steps taken by other jurisdictions, such as Australia.
   
   
2. Adopting a graduated regulatory approach for challenger banks will, the Taskforce suggests, increase competition, particularly in retail banking. The report calls for the smallest banks to be subject to the simplest rules and for different levels of regulation to apply as a bank grows, with the largest banks remaining subject to the existing rules. The Prudential Regulation Authority is currently consulting on proposals to introduce a “strong and simple” prudential framework for non-systemic banks and building societies that are not internationally active.^[3]
   
   
3. Reducing the anti-money laundering burden on certain Open Banking service providers and other FinTech firms. According to the report, the firms providing Account Information Services and Payment Initiation Services should not fall within the definition of a “financial institution,” which brings them into scope of the AML regime. This (likely unintended) result means that these firms must perform due diligence on customers, duplicating the work of a payment service provider or bank, which is an unnecessary burden because of the low money laundering risks involved.


4. Launching a U.K. Central Bank Digital Currency pilot within 12 to 18 months. The report urges the government to step up its work on a U.K. CBDC because by moving quickly, the U.K. can seize the opportunity to lead the global pathway for digital currency implementation on U.K. terms, ensuring efficiency and safety. Welcoming the creation of the U.K. Digital Currency Taskforce^[4], the Taskforce argues that the U.K. should consider a hybrid model such as that proposed in the “CityUnited Projects proposal,” under which the CBDC is a claim on the central bank and intermediaries manage retail payments.

• Amend disclosure and transparency requirements for financial services products to make them more proportionate and less burdensome

The Taskforce believes that many of the disclosure requirements inherited from the EU regime are not appropriate for the U.K. in its position outside of the EU. It recommends implementing a more proportionate regime that encourages the bespoke provision of information to clients instead of requiring prescriptive reporting that does not result in useful transparency for customers. Some of the examples highlighted in the report are:

1. The costs and charges transparency obligation when investment services are provided to eligible counterparties and professional clients and the best execution reporting obligation,^[5] required under the Markets in Financial Instruments rules. In the Taskforce’s view, these can be significantly reduced or removed.


2. The “investment recommendation” disclosure requirements under the U.K. Market Abuse Regulation. This obliges firms that prepare or distribute investment to take reasonable care to ensure that the information is objectively presented, and to disclose their interests or indicate conflicts of interest concerning the financial instruments to which that information relates. The TIGRR report states that these could be removed where trading and sale information needs to be provided to wholesale clients.


3. The scope of the U.K. Packaged Retail and Insurance-based Investment Products Regulation (onshored from the EU). The scope of the U.K. PRIIPs Regulation would benefit from clarification and should be limited to those products that are truly complex and that require specific disclosure for retail investors to understand and compare the key features, risks, rewards and costs of the products. The FCA has been granted powers under the Financial Services Act 2021 to clarify the scope of the rules. The products that are within scope of the PRIIPs Regulation has been a concern since it was first proposed. The uncertainties of the application of the PRIIPs Regulation to capital markets instruments, including vanilla corporate bonds and standard exchange-traded futures, resulted in many capital markets industry participants conservatively including PRIIPs-specific selling restrictions in addition to Prospectus Directive selling restrictions, thus significantly reducing direct access for retail investors to these products.^[6] The European Supervisory Authorities sought to alleviate the issue by releasing guidance on the scope of PRIIPs in October 2019, after the European Commission declined to do so.^[7] The EU is expected complete its holistic review of the Regulation by the end of Q1 2022. The extent of divergence, if any, between the approach of the U.K. FCA and the EU remains to be seen.