Reporting and Governance

There is a grey area in the financial market that is largely unregulated. This area is populated by intermediary companies that do not outrightly sell speculative illiquid securities, but promote and market them to high-net-worth individuals and sophisticated investors. By Rachel Adamson, head of fraud and regulatory at Adkirk Law

The majority of companies operating in this space, nonetheless, make efforts to ensure their operations are legitimate and mirror the regulations that do not explicitly apply to them. They have a vested interest in carrying out due diligence on the products they market to protect both clients’ investments and themselves. However, there will always be a select few who are more concerned with the bottom line than protecting consumers.

Over the past couple of years, the UK’s Financial Conduct Authority (FCA) has been contemplating how to tackle this corner of the market and, following recent pressure from the Chancellor of the Exchequer, it would seem that it is now gearing up to take action. The watchdog must now undertake a crucial balancing act by clamping down on bad actors within the market, while avoiding regulation that unnecessarily pushes out well-behaved smaller operators.

FCA crosshairs

The FCA first laid down the law on speculative illiquid securities a couple of years ago, when it announced a ban on the promotion of high-risk speculative mini-bonds to retail consumers. This regulation did not prevent FPO exempt promotions to self-certified high-net-worth individuals, and self-certified sophisticated investors, but it did reduce a considerable corner of the market for a number of firms. Now, it is looking likely that the FCA will strengthen its financial promotion rules in the classification of high-risk investments, the segmentation of high-risk investments from other investments, and the approval of financial promotions. 

While action is necessary to stamp out bad actors, introducing new regulation into the market can often have unintended consequences, especially for small and medium-sized enterprises (SMEs). Take for example, the ban on the promotion of speculative mini-bonds to retail customers, which required companies to completely re-evaluate their entire framework of operations, strategy, policies and structure to ensure they were compliant with the new rules: a process that costs resources, time and money. For larger corporates this burden of cost tends to be a drop in the ocean, but for individual SMEs, this due diligence is a potentially fatal tidal wave of additional operating costs. Even before considering the expense of additional staff, this supplementary cost often means that SMEs simply cannot afford to stay afloat.

Moreover, the FCA guidance is often unclear and incomprehensible for smaller outfits. To navigate the overtly complex guidance, businesses are often required to outsource advice to compliance officers to ensure they are in line with any new regulations. While this poses no problem to larger firms that can afford this expensive exercise, it only increases the cost burden for SMEs. 

For those companies which endeavour to operate on the right side of regulation, and especially SMEs, increased regulation is an expensive headache. Larger or multinational organisations that have the resources to quickly adapt operations are therefore able to easily avoid the regulators’ crosshairs, and smaller businesses disproportionately suffer. 

Enforcement over regulation

To crack down on financial crime in the market, it is clear that action needs to be taken, but does enforcement not pose a more effective solution? After all, without proper enforcement, regulation fails to weed out or bring to order the larger companies that are regularly operating duplicitously in the grey area of the market.

Between 2019 and 2020, there were 1.7 million cases of intermediary companies connecting buyers of financial products to sellers, and over the past three years a total of 165 intermediary companies have exited the market due to financial crime. Clearly, then, existing regulation is able to catch perpetrators, and expanding on this regulation is surplus to requirements. The problem lies in under-investment in investigations and under-enforcement of existing regulation. 

Increased regulation is a blunt tool that will not solve the existing problem, a lack of enforcement. You can add another tool to the toolbox, but it is a useless toolbox if it is sitting in the shed collecting dust. The approach to financial crime needs to be properly targeted, and further regulation simply appeases political pressure to act and risks suffocating a large portion of businesses who do not have the resources to quickly adapt to, nor the desire to skirt around, new rules.

Moving forward

Regulation and enforcement are fundamental aspects of the crackdown on financial crime. However, the FCA’s current approach to regulation is flawed. It needs to work with the legitimate businesses in the unregulated sector; target fraudsters instead of the SMEs on the periphery; share knowledge with legitimate companies as to which financial products are potentially an issue; and fundamentally support SMEs in the market with costly due diligence. If not, many of the legitimately run businesses in the unregulated sector will simply be run into the ground, while the real targets of the change on regulation will continue to trade unhindered.

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