COVID-19 | Compliance challenges for capital markets firms

Updated May 2020

Over the past weeks conduct supervisors have announced a number of measures to ease firms’ compliance efforts or alleviate their operational burdens, all in order to enable them to prioritise dealing with current challenges. However, the vast majority of regulatory requirements remain applicable – and some are even more important now than before.

With some firms reporting their onsite office staff being reduced to as little as one percent, large scale remote working, rapid adoption of new technologies and exceptional market volatility, we are seeing certain patterns emerging in the overall picture of compliance challenges that capital markets firms are now facing. In this blog we explore these issues as well as the potential solutions and possible workarounds.

New technologies 

As firms have moved to operating remotely at scale and with little preparation time, they are using new and often relatively untested forms of technology for communicating with clients, undertaking transactions, and operating as teams. The pace of this shift means that some firms could face challenges, and additional risks to the trading floor technology setup, if their standard systems and controls (such as communications recording or trade surveillance) have not captured these new technologies and ways of working.

Firms should, where possible, bring these technologies into the scope of the existing controls. If these are insufficient, they might need to be urgently revised. In any scenario, maintaining records of decisions and steps taken will be crucial from the supervisory perspective, as well as from many others.

New technologies may pose additional challenges, for example with MiFID/R rules requiring firms to make and keep recordings of all telephone conversations relating to transactions and provision of client services. ESMA and the FCA have signalled some flexibility in that respect, however firms are still expected to mitigate the risks. The ad hoc solutions suggested are to use written minutes or notes of telephone conversations, put in place enhanced monitoring, and conduct a retrospective review at a later stage. Firms should ensure that the alternative measures remain temporary. If firms are unable to record calls, the FCA expects to be notified. Record keeping is key here, and firms – and their Senior Managers - will be scrutinised on this in future.

Market surveillance 

Due to market volatility, many firms are experiencing a substantial increase in market abuse alerts generated by their automated surveillance systems. This is largely because their surveillance models are calibrated for “normal” market conditions and volumes, and have therefore not been responding well to recent events.

In such scenarios, urgent re-calibration of the models may be required. However, alerts that have been generated should not be “bulk” closed. If there are limitations on the firm’s abilities to deal with all alerts, it should seek to adopt a risk-based approach where higher risk events are prioritised. While doing so firms should ensure that all asset classes and activities are being reviewed. The backlog then could be processed over time, or reviewed using data analytics. It is imperative however that records of the prioritisation decisions are kept. For a more detailed analysis of market conduct risks please see here.

Lack of supervision

With remote working in place for a large majority of staff, some companies may be concerned with the risks arising from a lack of traditional, in person supervision.

This could be considered particularly true for Sales and Trading staff as traditionally they have rarely worked from home. The majority of supervisory controls rely on people being physically present (e.g. interaction with an individual’s manager) rather than being embedded in the IT and operational processes. This naturally becomes rather challenging when working from remote locations. Some firms, particularly those that have been investing in technology, navigated this challenge swiftly, but others have rapidly set up tactical controls to compensate for the lack of staff’s physical presence.

Some firms may consider increasing the use of existing metrics to detect conduct issues, such as unusual trading patterns, trading errors or limit breaches, or the volume of out of hours trading. Communications to front-line staff might need to be increased to remind them of the relevant policies and procedures, and senior management should clearly set out their key expectations. Firms may also want to assess and revise the extent to which they rely on supervisory controls, and implement IT and operational controls if need be.

Assurance and monitoring

As compliance and internal audit teams now have less direct, frequent and ready access to individuals and business lines, remote working is reducing firms’ ability to maintain existing assurance and ongoing monitoring by the second and third lines of defence. Access to data and information may also be slower or more challenging from a remote location.

To remedy this, senior management might want to assess the suitability of the firm’s existing arrangements in that respect. Firms should review the appropriateness of their current staffing levels, including any shortages caused by the outbreak. If internal audit and/or compliance reviews need to be cancelled or delayed, a risk-based and outcomes-focused methodology should be adopted for making these decisions.

Reliance on paper / post

Somewhat surprisingly, the outbreak has revealed that some key parts of the financial system’s processes continue to have a large degree of reliance on paper and the postal system. These include payments by cheque and receipt of payment instructions, among other things, and manual processes for tax purposes, such as stamping. The volumes, and the ensuing risks, increased further around the turn of the tax year. As all these activities require physical presence, remote working poses major problems in this respect.

Firms should identify or designate key persons to perform those processes and ensure appropriate coverage. The FCA provides some guidance on identifying key workers in financial services which might be helpful here but, above all, firms need to be mindful of potential health and wellbeing risks to their staff. In the longer term, firms should look into automating and digitalising these processes where possible.

Market volatility / Volume of business 

The high volatility in the market caused by the pandemic poses another set of potential issues. Extreme variations in market volumes, liquidity, and securities valuations can give rise to breaches of restrictions in the approved investment mandates, Value at Risk, and other portfolio tolerances. Solutions could include support around Root Cause Analysis and data cleansing.

Further, markets have experienced an upsurge in trading volumes, especially in debt capital markets, since the outbreak was announced. This additional volume of business may place extra pressure on firms’ reconciliation processes. As noted in our recent blog, the FCA has indicated it expects firms to continue to comply with the full provisions of the CASS handbook. Maintaining the firm’s ability to perform complete, accurate and timely CASS reconciliations and indeed complying with the wider CASS provisions therefore remains a high priority. Where firms fail to comply with the rules, the normal FCA CASS notifications requirements continue to apply.

As a temporary solution, firms could consider bringing in extra staff from other business areas. In the longer term, firms that are not yet doing so may want to look into automating reconciliations – for some, the lockdown may act as the catalyst they have needed to make the necessary investments.

Despite fast moving and volatile markets, firms are still expected to deliver best execution and obtain the best possible results for their clients when executing their orders. ESMA and the FCA have offered some supervisory flexibility in that area – extending the deadlines for publishing relevant reports from end-March and April to 30 June – however the principle itself still needs to be observed. The FCA’s guidance emphasises that firms should take into account current market conditions when determining the importance they place on the different execution factors, and consider their use of different types of orders to manage risk during market volatility.

Culture

Large-scale remote working is likely to affect culture within firms. The longer individuals perform business and other functions outside of the standard systems and controls (and out of sight of their managers), the higher is the risk of some degree of deterioration of culture. Those risks may be heightened by the current very challenging business conditions, and the proximity of the year-end and the results season.

To preserve and reinforce the firm’s culture, senior and middle management should consider increasing the frequency and means of communicating with their staff. This should not be limited to written correspondence but importantly include also face-to-face interactions. Emphasis should also be placed on engaging with whole teams, in addition to one-on-one communications. Management should also consider other additional activities, such as online training or virtual social/team events.

So what?

Following a tumultuous few weeks we are now seeing the first practical impacts of COVID-19 on financial services firms. Many risks have increased and new ones are emerging. While regulators are offering flexibility and forbearance in certain matters, being able to comply with regulatory requirements in this new and unfamiliar environment, and perhaps even more importantly being able to evidence this, is quickly moving to the forefront of firms’ and regulators’ interests. One conclusion is already clear – firms and their Senior Managers can expect to be scrutinised over how well they handled regulatory matters during this time. Firms need to consider now how regulatory measures can be leveraged to continue delivering positive outcomes for consumers, markets, and the economy as a whole, even during these extraordinary times.