FCA signals material reforms in relation to the marketing of risk investments

What?

On 29 April 2021, the FCA published a discussion paper titled 'Strengthening our financial promotion rules for high-risk investments and firms approving financial promotions' (DP21/1) ("Discussion Paper").

The FCA classifies high-risk investments as any investment which is subject to marketing restrictions under the FCA rules, including non readily realisable securities ("NRRSs"), peer to peer ("P2P") agreements, non mainstream pooled investments ("NMPIs") and speculative illiquid securities ("SISs").

The Discussion Paper outlines a number of specific recommendations for future policy changes (summarised below).

1. Expanding the current classification of high-risk investments, in particular:
2. (a) bringing some cryptoassets into the scope of the financial promotion rules; and
3. (b) including ordinary equity shares as a type of security that can be a SIS, the result of which could be that shares issued to raise capital for speculative purposes (such as shares in SPACs) would be subject to the mass marketing ban on SISs.
4. Enhancing the responsibilities of firms in categorising clients as high net worth, sophisticated or (in the case of NRRSs or P2P agreements) restricted investors, such as by requiring firms to take "reasonable steps" in all cases to independently verify that a retail investor meets the relevant requirements to be characterised as a high net worth or sophisticated.
5. Changing the way in which risk warnings are presented to clients to make them more effective than current "capital at risk" warnings (such as by presenting visual rather than text-based risk warnings and/or by requiring more strict warning language).
6. Introducing additional requirements for firms when onboarding clients, designed to add "friction" to the client trading journey, such as by introducing cool-off periods and requiring consumers to demonstrate sufficient knowledge about financial products (e.g. passing an online test) before they are permitted to trade certain instruments.

Its proposals, if adopted, could materially disrupt the way in which investment services are advertised and provided to retail consumers.

In addition, the Discussion Paper also explores a number of product governance changes to the retail regulatory landscape. The Discussion Paper does not propose any firm alternative to the current classifications of retail, elective professional, and professional clients. However, it does emphasise the need for classifications that better reflect the different types of investors that make up the retail client space, from novice investors with little ability to withstand loss to experienced traders with a more substantial appetite for risk. In particular, the FCA expresses concern that current assessments of appropriateness and suitability may not be able to distinguish effectively between these different classes of retail clients and may, therefore, expose more vulnerable and less experienced clients to products that are not suitable investments for them.

The Discussion Paper also proposes placing additional obligations on firms to establish and verify that client classifications are accurate, rather than allowing clients to self-verify, placing greater responsibility on firms to identify appropriate investments for clients and ensure that they do not have access to inappropriate investments. In particular, it proposes adopting a more granular approach to the risk classification of certain types of investment. For example, both shares in listed companies and shares in SPACs and other SPVs are currently both caught under the same classification of "equity shares" and assigned a single risk value. At present, equity shares are classified as non-complex investments. The Discussion Paper proposes that all equity shares should be treated as having the potential to be complex investments, therefore placing responsibility on firms offering trading in equity shares to retail clients to make fair and accurate determinations as to the complexity of the products that they are offering and requiring them to make appropriate product governance decisions on the basis of this determination. If the proposals in the Discussion Paper were adopted, it is likely that most SPACs would be classified as complex products and would therefore be subject to a higher level of product governance obligations than at present.

Why?

The Discussion Paper follows a number of recent FCA publications, including its insight piece titled “Learning from experience in financial services” (August 28, 2019), its Call for Input in September 2020 and its March 23, 2021 press release announcing the publication of new research (titled "Understanding self-directed investors"), which express concern about the access to and popularity of high risk investments among retail clients. A key theme in responses the FCA received to the Call for Input was the need to further segment high risk investments from the mainstream market, and to help prevent consumers from investing in inappropriate investments that do not meet their needs.

In the Discussion Paper, the FCA expresses concern specifically about the rise in high risk investing by retail clients who self-assess as having lower risk appetites. This trend, which it describes as the gamification of trading, has developed due to advances in mobile and internet technology, which has made trading more accessible to new and inexperienced individuals, exacerbated by heavy advertising by online trading platforms and the rise in non-traditional sources of investment information, in particular via social media.

The proposals in the Discussion Paper are intended to disrupt this trend and to empower consumers to make effective investment decisions. Specifically, they aim at discouraging high-risk investments and providing retail clients with the tools to accurately assess the risks and benefits of investments, the potential costs, and whether investments will meet their needs through creating positive friction and developing new risk warnings that more accurately communicate investment risks to clients.

Who?

The proposals in the Discussion Paper will affect all sell-side firms, but their impact would be felt most heavily by online trading platforms whose business models rely on attracting first time traders and/or offering risky trending financial products, such as SPACs, cryptoassets, and forex trading. Changes to the financial promotions regime could have a substantial impact on such firms' ability to attract new clients and distinguish themselves from competitors, while positive frictions may reduce clients' appetites for high risk products.

What now?

The Discussion Paper, as its name suggests, is an invitation for discussion between the FCA and stakeholders and does not have any legal effect. However, we do expect that many, if not all, of these proposals will be adopted at some point in the future. With this in mind, firms should begin to consider how they will adapt their business models and product governance processes to accommodate these future changes.

That being said, the Discussion Paper does not spell the end for the retail trading market as we know it. The FCA specifically acknowledges that "higher risk investments can have a place in a well functioning consumer investment market for those consumers who understand the risks and can absorb potential losses", and its reason for opening discussion on these issues before creating new regulation is to ensure that it can find a balance between appropriate consumer protection in a rapidly changing financial services marketplace and protecting clients' ability to make free investment decisions.

Authors: Emma Tran and Anna Burn