Dear CEO - FCA Wholesale Broker Letter

Introduction

The FCA’s letter to CEOs of wholesale broker firms dated 11 January 2023 sets out the FCA’s strategy for supervising wholesale brokers for the next two years. Whilst acknowledging the important role that wholesale brokers play in markets, the FCA also note some areas of increased risk since it’s last supervisory letter nearly four years ago. The FCA are concerned about clearing brokers’ liquidity risk management and stress testing, noting that these firms have faced heightened liquidity risks as a result of having to post collateral to clearing houses at short notice to cover their positions before having been paid by their own customers. The FCA also detail concerns about governance and compliance controls and culture. This article looks at the themes coming out of the letter and what it means for wholesale brokers, with a focus on commodities, and how Cambitas can help.

Financial Resilience

A core focal point for the FCA over the forthcoming supervision period will be on financial resilience and firms having adequate capital to survive sudden and severe shocks. The Russia-Ukraine crisis had significant short- and longer-term impacts in commodities markets. During February and March 2022, and beyond, there was unprecedented volatility in multiple markets and a surge in prices. For example, in energy, by August 2022 the price of benchmark natural gas futures (Dutch TTF) climbed to 18 times the level observed at the beginning of 2021. In the nickel market on 8 March 2022, prices increased by over 250%, and some brokers faced severe liquidity issues. Margin requirements for exchange traded commodity derivatives can be very high: while the entire commodities segment represents roughly 2% of the gross notional value of positions in the euro area derivatives market, this segment accounts for a much higher share in terms of initial margins posted, exceeding 20%. Brokers’ counterparties came under pressure to meet large margin calls at short notice, but there was inevitably a delay in doing so, which created severe stress for the brokers.

Following the above, the FCA expects firms to develop their own competence in liquidity risk management and / or to buy-in competence externally. Given the risks highlighted above, this will be particularly important for commodities brokers. They will need to ensure the liquidity they hold can survive instantaneous shocks and extended periods of stress. Obviously this is made more difficult by some investment banks recently becoming less willing to lend to brokers in commodity markets. The models will also need to take account of more extreme events, noting that 2022 saw events that were previously considered implausible. The planning should also take into account systemic events (rather than idiosyncratic events), and be conducted in line with IFPR.

Importantly, the FCA expect the boards of wholesale brokers to give sufficient attention to the issues set out above. This will mean that the issues should be regularly discussed, in detail, at board level, and the discussion and challenge recorded appropriately.

Governance and culture

The FCA emphasise the importance of the board in setting the culture of the firm. Boards should have a suitable mix of skills and experience, which will provide effective challenge to the senior management. Getting the right personnel on boards - iNEDs who are prepared to challenge, and to spend time with senior management understanding the risks to the business - is increasingly important. The FCA is sometimes pursuing a tactic of refusing to approve individuals which it regards as unsuitable for boards, or where it believes there is an inappropriate balance of skills and experience, or where it believes there are issues at the firm which need to be addressed. The difficulty for firms is that the FCA may not outright refuse an individual proposed by the board, but will instead withhold its approval, putting the succession in a state of limbo.

It is worth noting that, in line with the increasing importance of the board, CEOs of wholesale brokers are expected to have discussed the contents of the letter with their respective boards by the end of February, and to have agreed actions or next steps.

The letter also focuses on the skills of the Senior Management Functions and ensuring that senior staff are receptive to challenge. The FCA are placing increased emphasis on culture - no longer can a hierarchical structure where the CEO or Executive Chair has excessive power be tolerated: functions like Compliance and Risk need to be appropriately staffed, and have a voice. Senior management must appropriately consider risks, and communicate the risk appetite to the board. Board minutes will need to show that risk matters are getting appropriate consideration and challenge. The FCA note that poor decision-making and failures in oversight have played a key role in exacerbating the extent of any underlying issues or preventing them from being resolved earlier. The FCA highlight the centrality of the Senior Managers 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 more broadly.

Firms must also take into account regulatory references when hiring new certified staff - the FCA have identified weaknesses in this area across a number of firms.

Other

As noted above, the FCA expects control functions (Risk, Compliance, Audit) to have a significant voice within the firm and at board level. The FCA note ongoing weaknesses in systems and controls at brokers (see the separate Cambitas note on “Market Abuse - the importance of a MARA”). Client onboarding processes to control financial crime and money laundering will be in the FCA’s spotlight.

The FCA continues to have concerns about remuneration structures at wholesale brokers. These include the balance of salary versus cash bonus, and bonuses being based on the value and volume of trades. This, in the FCA’s view, creates a risk of prioritising short term financial targets over client interests. The FCA highlight their MIFIDPRU Remuneration Code (SYSC19G) under IFPR, introduced in January last year, to which it expects all brokers to adhere.

The letter is clear that, as laid out in the SMCR, responsibility for compliance falls on the CEO. It also reminds firms that if they identify failures to meet relevant standards, they should notify the FCA immediately, setting out what they are doing to remedy any breaches. This is a point worth highlighting - it is always sensible to be open and transparent with the regulator, highlighting any shortfalls with a clear remediation plan.

How can Cambitas help?

Cambitas can help with any aspect of the above. By way of example, Cambitas could undertake a board effectiveness review to look at issues like (a) balance of skills and experience, (b) information flow to the board, (c) how effectively the board considers risk and liquidity issues, (d) channels of communication from control functions to the board, (e) board ownership of culture, (f) board relationship with, and oversight of, senior management, (g) board ownership of remuneration, (h) culture of challenge at board level, and (i) effectiveness of board minutes.

The review would be carried out by Tom Hine, who has extensive board experience, having been in charge of governance and company secretarial at a major regulated entity. Tom has deep understanding of regulators’ expectations and how to create a culture of effective governance.

The review would be an important step in demonstrating to the FCA that the firm is complying with the expectations set out in the Dear CEO letter.

If this is something which would benefit you, or you would like to discuss any aspect of this letter, please contact Tom at tom.hine@cambitas.com.

www.cambitas.com