Download - IMC notes (1)
Financial markets and Institutions Types of Investments
Debt – i.e. tradable bond, issued by a company or govt or non-‐tradable bank loan, bank deposit
Equity/share – tradable securities giving an ownership stake in a company
Other include commodities, property, derivatives, foreign exchange
Savers can invest in the above directly or indirectly (through an intermediary) – through insurance companies, pooled investment vehicles, or pensions schemes. The indirect method gives:
• Diversification • Reduction in transaction costs • Access to expertise • Access to assets that would otherwise not be available
UK banking system uses the universal bank model involves providing financial services of various kinds, including advisory services, in addition to deposit and lending services.
Types of Assets
Tangible assets such as land and buildings (property, or real estate), machinery, oil, sugar and gold, are all real assets. The utility of such an asset gives it an intrinsic value.
In a monetary economy, there are claims that may represent the right to a return, such as interest and the eventual repayment of principal (on a loan), or dividends payable out of a company’s profits (for shares in a company). Such claims are financial assets.
Shares
The ordinary shareholders of a company are the owners of the company. However, it is normal for ordinary shares to possess a vote.
Companies legally do not have to declare a dividend on ordinary shares, many of them do in order to maintain shareholder loyalty.
For public companies, this will not be paid until the shareholders have agreed it at the AGM.
Companies may only pay dividends out of post-‐tax profits – that is, from their distributable reserves.
In any single year, the dividend paid could exceed the profit for that year, because there may be distributable reserves brought forward from earlier years.
Bonds (fixed income securities)
A bond may be defined as a negotiable debt instrument for a fixed principal amount issued by a borrower for a specific period of time, making a regular payment of interest/coupon to the holder until it is redeemed at maturity, when the principal amount is repaid. Derivatives Derivative contracts is a term encompassing contracts such as futures, options and swaps which derive their value from the movement, up or down, in the price of an underlying asset. Derivatives contract enable investors to take a position in the price of an asset without actually taking delivery of the underlying asset. For example, a position can be taken on the price of oil, without participants in the related derivative contract taking physical delivery of oil at any point
Derivatives can be divided into exchange-‐traded and over-‐the-‐counter (OTC) types. • Exchange-‐traded derivatives are more standardised and offer greater liquidity • OTC contracts are tailor-‐made to meet the needs of buyers and sellers.
Currency transaction
Currency or foreign exchange trading (or FOREX as it is commonly known) is the dealing of the currencies of various countries. No formal market place for FOREX trades: in London, trading is over-‐the-‐counter (OTC). Prices are advertised on screens and deals are conducted over telephones. The major players are investment banks and specialist currency brokers FOREX transactions are described either as spot or forward.
• Spot means the trade is to meet immediate currency needs and will settle in two business days after the trade day (known as T + 2).
• Forward is when an exchange rate is agreed today for settlement at some future date
Pooled Funds
In order to minimise the risk involved in investment, it is often a good idea for the investor to spread invested money over a range of instruments, thereby diversifying risk. Individual investors’ investments to be grouped together and form a collective investment vehicle. Here they pool their money in a large fund, which is managed and invested for them by a fund manager. There are different types of ‘pooled’/collective investment vehicle:
• Unit trusts • Open-‐ended investment companies (OEICs) • Investment trusts.
There are also exchange traded funds (ETFs), which are typically designed to track an index. Authorised unit trusts and OEICs are Authorised Investment Funds (AIFs) and are often referred to simply as funds. Differences A unit trust differs from investment trusts and OEICs in the way it is set up, as a unit trust is not a company with shares. Pricing For unit trusts and OEICs, there is a direct relationship between the value of the underlying investments and the value of units. Units are priced according to Net Asset Value (NAV). Investment trust shares and also ETFs, however, are priced according to supply and demand in the stock market. Unit trusts are, like OEICs, called open-‐ended funds as there is no limit to the amount of money which can be invested. If no ‘second-‐hand’ units are available, the fund is permitted to create more units and expand the fund. Investment trusts, on the other hand, are closed-‐ended: except when new shares are issued – eg, on launch of the trust – the buyer of investment trust shares is buying them from existing holders of the shares. The function of securities market
• Raising of capital • Transfer of risk • Price discovery • Creation of liquidity
By short-‐term capital, we mean capital that is lent or borrowed for a period which might range from as short as overnight up to about one year, and sometimes longer.
By long-‐term capital, we mean capital invested or lent and borrowed for a period of about five years or more, but sometimes shorter.
Price transparency, liquidity, transaction costs
Price discovery
The process through which an equilibrium price for a financial instrument is revealed continuously through bid and offer prices, and trading
• Market establish equilibrium price • Markets disseminate the price to investors/the public
Price Transparency
Important that the investor knows the price before, during and after a deal in order to be satisfied that he has a good deal
• Pre-‐trade transparent (data on quotes and orders) vs post trade transparency (publication of sizes and prices of trades)
• Organised markets are transparent than OTC
Liquidity
• Liquidity measured by bid ask spread in quote driven market or by difference between the best sell and buy prices in order driven markets
• Liquid markets are those where large quantities are traded or where order need to be very large to have an impact on price
Factors contributing to liquidity are: • Effective and efficient IT • Settlement systems • Stock availability • Stock lending facilities • Diverse membership
Must calculate round trip transaction costs incorporating bid-‐ask spreads, dealing commission and transaction taxes, both in percentages and in absolute amounts
Transaction costs
Broker commissions (pay fee to broker because investor can’t invest directly), bid ask spreads and market impact
Costs of a share transaction for a UK investor can be broken down as follows:
Purchase cost. • The purchase cost includes a spread which is the difference between the bid and
offer price of the share. Broker's commission
• Brokers incur various costs for the resources they employ to fill orders, including costs for market data and order routing systems, exchange memberships and fees, regulatory fees, clearing fees, accounting systems, office space, and staff to manage the trading process.
• A typical charge could be, say, 1.5% on a deal up to £7,000 and 1.0% above that, with a minimum charge of £25
Stamp Duty and SDRT • Stamp Duty Reserve Tax (SDRT) is payable at 0.5% on the value of purchases of UK
equities settled through CREST (ie most transactions), rounded up to the nearest 1p and on equities not settled through CREST, at 0.5%, rounded up to the nearest £5. (There is no Stamp Duty if the charge so calculated would be £5 or less.)
Panel on Takeovers and Mergers Levy
• The PTM levy is a flat £1 on transactions (sales and purchases) that are in excess of £10,000
Market Impact
• Buyers putting through large buy orders may need to push up the price of the security up in order to make the trade.
• Sellers who want to put through a large sell order quickly may need to accept a lower price than is immediately available to a seller with a small order.
• The cost effect of this tendency for fluctuating order sizes to move prices is called the market impact or price impact, and is a significant component of transaction costs for large financial institutions.
Limit orders, which will be filled only if the price is better than the stated limit, provide a way of limiting transaction costs, Market orders are filled at whatever prices are available when the order is placed.
LSE trading platforms
Three domestic trading platforms at the LSE
Characteristics of these platforms can be summarized as whether or not they are:
• Order driven v quote driven
This is decided by:
• Depends on liquidity of share
The trading platforms for domestic securities are:
• SETS • SETSqx • SEAQ
LSE Settlement period T +2-‐ when all paper work and legal details are in place/money also moved between relevant bank accounts
Stock Exchange Electronic Trading Service (SETS)
• Automatic matching for trades in most liquid listed shares • Only LSE members can place orders • Only standard settlement permitted
o T+2 • Orders ranked by price then time of input • Change in order -‐> new input time • All trades anonymous due to LCH Clearnet acting as central counterparty service
(CCP) – process known as novation
SETS – Quote and crosses (SETSqx)
• Hybrid System – for less liquid stocks • Combines quote driven platform with periodic (orders) electronic auctions
(uncrossings) • Auctions at opening (8:00am), 11:00am, 3:00pm and closing (4:35pm) • If want to trade at other times of the day, Market makers must quote bid and offer
prices for transactions of at least 1* NMS (Normal market size) – per person or on a whole basis?
NMS is a minimum volume set by LSE
Stock Exchange Automated Quotation System
Price dissemination system
Pure quote driven
System used by the LSE to display market maker prices on AIM stocks (not traded through SETS or SETSqx)
• Minimum of two market makers input bid-‐ask spread into SEAQ • SEAQ displays two way prices to Public (brokers/dealers/investors) • Brokers Dealers deal by phone with market makers
Only market makers are able to quote prices on SEAQ
Gilt Market
The gilt-‐edged market is a further major capital market in the UK. The government borrows over the medium and longer term by issuing government stocks (called 'gilt-‐edged stock' or ‘gilts’).
Trade in second-‐hand gilts will continue until the debt eventually matures and the government redeems the stock.
Gilts settle T+1 via Euroclear UK & Ireland (using the CREST system)
Less liquid than shares, so will need quote driven system with market makers (investment banks)
Gilt Edged Market Makers (GEMMs):
• Required to make 2 way prices to customers • Must provide information on closing prices, market conditions and their turnover
and positions • Are expected to participate in Debt Management Office’s gilt issuance program • Must always participate when DMO issues further debt
Main holders: UK pension funds, insurance companies overseas investor + less extent wealthy private individuals
Quoted excluding interest (clean pricing), however settlement price includes accrued interest (dirty pricing)
Actual bond transaction prices reflect accrued interest based on actual/actual basis
Holders of gilts can now receive coupon payments gross
New Issues of gilts
Issued by Debt Management Office (DMO) to fund the public debt/Public Sector Net Cash requirement (PSNCR) or to refinance maturing debt
DMO typically issues gilts by auction (preferred method)
All bidder in market bid what prepared to pay for certain volume of gilts
Alternative arrangement is ‘tap’ method –issue announced, investors invited to tender. Smaller volume of gilts.
• If a part not take up at the required price – that part is withdrawn and released into the market later
Alternative trading venues
Set up outside of LSE
Dark Pools
• Price transparency does not need to be as high • Electronic trading platforms where neither price nor identity of trading firm is
revealed • Don’t know prices someone else is willing to buy or sell at • Post trade transparency is possible but not pre-‐trade
Multilateral trading facility
• Electronic trading platforms arranged in a similar manner to SETs but designed to be cheaper than SETs trading
• Lots of investment banks, get together cause LSE charges hefty fee to trade: BATS, CHIX, less than half blue-‐chip now trade on LSE
Systematic internalises
• Investment banks who execute client orders by trading for their own account rather than with an exchange or MTF
• Trade their own stock
Should know description to match to right platform for exam
Algorithmic trading
Algorithmic trading
A broad term describing all scenarios where electronic platforms:
• initiate orders or • decide on/ recommend aspects of orders (timing, price, quantity) generated by
humans
High frequency trading
• A subset of algorithmic trading where computers make decisions or initiate orders based on electronically received information before (human) traders get change to process what they observe.
Role of LSE member firms
Main market is London Stock Exchange whose members are:
Broker/Dealers
May act in dual capacity (Big bang in the 1980s made this possible)
• Broke a customer’s business (agent) • Deal directly or buy securities for own business (principal)
Equity market makers/Gilt Edged market makers
• Must quote two way prices • Make market
Interdealer brokers (IDB)
• Arrange matched anonymous principal to principal trades between market makers • Safety valve, esp. for gilt edg3d market makers who are obliged to follow through on
deal up to certain size, could find themselves loaded up with securities. If large stock cant shift on market directly as other members will lower price. To help them unwind large positions the IDB act as brokers to market makers to allow them to trade large positions anonymously.
The Stock Borrowing and Lending Intermediaries
• If market makers wish to take a short position in a stock, ie sell more than they currently have on their books, they will need to have stock in order to settle the trade.
• The Stock Borrowing and Lending Intermediaries (SBLIs) provide access to large pools of unused stock.
• The institutional investors in the UK buy large blocks of securities and often hold these blocks for a number of years. The SBLIs borrow stock on behalf of market makers from these
dormant positions. The stock is passed to the market maker who uses it to settle the trade, and in effect, to go short.
Central counterparty (Novation)
Clearing house (LCH:Clearnet)
Central counterparty stands between buyers and sellers
• Short seller to every buyer • Log buyer to every seller
Purpose: eliminates counter party-‐risk
When dealing directly with someone else there is risk that they won’t deliver on their promise (won’t pay before delivering security)
LCH.Clearnet Margining
Initial Margin
• Returnable good faith deposit paid on opening positions • Based on maximum probable one –day loss (amount security can fall in value in one
day)
Variation Margin
• Cash Settlement of daily profits or losses based on closing price each day • Paid to or received from LCH Clearnet the following morning. • If one side decides to default whole contract is void
UKLA and LSE
Companies have limited liability and can be private (cannot offer shares to public) or public
Public PLC can offer shares to public (majority do not)
If offer shares to public:
May choose to trade shares on exchange as will struggle to sell shares without secondary market for buyer to sell shares and realise profit.
To trade on exchange most commonly you have shares listed on full list of LSE, must satisfy req of UKLA (FCA) referred to as competent authority
• Listing: must satisfy UKLA listing requirements
Onerous requirement led to junior markets
• AIM: not regulated directly by FCA, is reg by LSE requirements • ISDX: UKLA requirements
UKLA listing Rules
Main conditions for full listing:
There are two tiers of listing:
• Premium listing (required for FTSE UK Index membership), involving the UKLA’s ‘super-‐equivalent’ requirements, which go beyond EU standards
• Standard listing, with less stringent requirements that are broadly similar to AIM requirements
Requirements:
• Minimum market capitalisation: o ≥£700,000 shares o ≥200,000 debt – if want debt to be traded
• Freely transferable -‐ cant restrict • 25% in public hands – free float/in public hands (excludes shares held by founders,
or huge blocks of shares)
Premium listing extras:
• Must have 3 years continuous trading record/ • 3 years of audited accounts (waived for innovative high growth companies and
investment companies. • Company must show that it has sufficient working capital to cover the next 12
months at least, • Must be a sponsor for the admission
Prospectus (prospects of company before they offer shares to public) has to be published unless the offer is made to:
• Qualified investor • Fewer than 150 persons (private placement) • Minimum amount you can invest per investor is high -‐ €100,000 • Total consideration of the offer less than €100,000 • Shares representing less than 10% of the shares already admitted for trading
UKLA Continuing obligations
Must allow market to have full understanding of company’s position
Disclose
• Price sensitive information • Significant transactions – plans to sell large chunk of buswiness • Changes in directors • Changes in registers – key shareholders • Dividend distributions – when they decide to distribute
Listed company discloses to -‐>
Primary Information providers (PIP)/Regulatory Information Service (RIS – part of LSE) (these entities are signed off by the FCA) tells -‐>
Quote vendors (Bloomberg and reuters etc.)
AIM/ICAP – ISDX markets rules
AIM
• Appoint NOMAD (nominated advisor) – expert financial services firm that ensure they fulfil obligation to aim rules
• Produce admission document • Securities must be freely transferable • Should have broker to support trading of the company shares • On-‐going obligations to publish price sensitive information immediately and
disclose significant transactions. • Lock in – companies with less than 2 years track record must agree to lock-‐in where
directors, significant shareholders and employees with 0.5% or more of the capital agree not to sell their shares for 1 year following admission.
• No minimum market capitalisation • NO minimum proportion of shares held by public
ICAP Securities and derivatives exchange (ISDX)
Applicants must:
• Appoint ISDX corporate advisor – specialists financial services firm • Demonstrate appropriate corp governance – how comp managed and directed • Have published audited accounts no more than 9months prior to date of admission
to trading • Adequate working capital – short term finance for business to run for next 12
months • Free transferability of shares – cant restrict ownership • No minimum market capitalization
Dual listed companies
Structure where two corporations function as single operating entity (e.g. Royal Dutch shell (UK & Netherlands))
• Separate legal entities and stock exchange listings – with supervisory board • Equalisation agreement – legal contract – describes how ownership is shared • Single board of directors, single management structure • May have tax advantaged • Arbitrage opportunities may arise-‐ risk free profit where two things should be the
same but are priced differently
Cross-‐Listing
A company may list its shares on more than one exchange – for example, a UK company may list in on the LSE in London while also making its shares available through American Depository Receipts (ADRs) (discussed further later in this Chapter) in New York. This is termed a cross listing.
Note characteristics for exam
Disclosure and Transparency Rules -‐ UK
Companies keep registers for all shareholders but sometimes shareholders could be hidden
Nominee broker deals on behalf.
Holders (including connected parties) of 3% and go up or down through a % point
• If holdings reach (3%), • falls below 3% • or moves through any percentage point above 3% • Notify company by T+2
Persons discharging managerial responsibilities (PDMR) (and their connected persons (family)) must inform company of any transactions in own company shares/derivatives
• Notify company by T+4 • Company tells market via regulatory information service (RIS)/Primary information
provider (PIP) by next business day. T+1
Not just shares but also any derivatives
Legal owner is anyone connected whether directly or indirectly
Settlement period
• From 6 October 2014, standard settlement in the UK is T + 2 for equities. • The ex-‐dividend date will always be a Thursday • These changes comes ahead of a proposed January 2015 start date for T + 2
settlement across the European Union. • Settlement of UK Government stocks (gilts) is normally T + 1, or on the same day
• Settlement in sterling or euros is made on a Delivery versus Payment (DVP) basis,
where both parties are ready to settle with each other at the same time, known as real time gross settlement.
Connected parties
Includes:
• Family stockholding • If you own a third or more of any company, that companies stockholdings are
included • Concert party = two or more persons who agree (formally to informally) to act in
agreement(e.g. investment club)
Each persons must notify that they are party to the agreement
Meetings
Annual general meetings (AGM)
• Must be held every calendar year (max gap 15 months) • Must be within 6 months of financial year end • ≥21 days notice required
• Members attend/send proxy • Standard tasks undertaken
o Approve accounts o Approve dividends o Approve (annual) reports of the directors and auditors o (Re)appoint directed o (Re)appoint auditors
All of these will be voted on.
Can be done via show of hands
• If more than 10% or at least 5 shareholders present request paper vote, company must do so
Proxy
Proxy power normally lasts for given meeting and any adjournments that may be created
• General proxy – flexibility in decision making, vote as they feel is appropriate • Special (two way proxy) – told how to vote
General Meetings
General meeting (any meeting other than AGM)
Can be requested by holders of > 5% in private company or 10% in public of paid up capital share.
If this happens:
• Directors must call general meeting within 21 days • Notice Period (≥ 14 days) -‐ notice to allow shareholders to come • Meeting must be held within 28 days of the notice calling to a meeting being sent
out.
Ordinary resolutions require > 50% votes cast
Special resolutions require >75% of votes cast
Corporate governance regulations (1)
UK Code on Corporate Governance
Main principles of the Code:
• Leadership -‐ Board is collectively responsible, lead by chairman • Effectiveness – board to have balance of skill, experience, knowledge • Accountability – board should present a balance assessment of firm position • Remuneration -‐ remuneration levels to be able to attract retain and motivate (NB
All Medium and late companies, irrespective of listed status are require to public remuneration report)
• Relations with stakeholders – dialogue and mutual understanding
Code applies to listed firms only, compliance non-‐mandatory, disclosure required or if they don’t they must explain in AGM why they did not
Stewardship Code
Financial reporting council also crated the stewardship code (2010) directed at (big shareholders) institutional investors, consisting of 7 principles:
1. Publicly disclose their policy on how discharge stewardship responsibilities 2. Have a robust policy on managing conflicts of interest 3. Monitor investee companies 4. Guidelines on when and how activities escalate to protect or enhance shareholder
value 5. Be wiling to act collectively with other investors 6. Clear policy on voting (and periodic disclosure of voting activity) 7. Report periodically on stewardship activities – to underlying clients using them as
investment manager
The Principal – agent problem
Small firms
• Owners = managers
Large firms
• Owners (principal) • Managers (agents)
This is Separation of ownership and control
The agency problem arises when large firms often owned by many shareholders appoint managers to run the firm.
The interests of the shareholders may be significantly different to the interests of the managers.
Possible solutions:
• Align the incentives – shares and stock options • Board of directors monitoring managers • External pressure (on managers) – if not being run well, it becomes a takeover target • Shareholder activism – turning up at AGM, grouping with other shareholders to
remove poor directors by voting them out
Functions of financial services industry
4 Function of financial services industry
Financial intermediation
• Linking those with capital to lend with those who need capital
Pooling and managing risk
• Pooled investment funds insurance or derivative products
Payment and settlement services
• Mechanisms for the transfer of money or assets
Portfolio management
• Allows investors to manage their wealth through advice and management services
The role of the government
• Production of services that the private sector is unwilling or unable to deliver • Regulation of firms (to ensure consumer protection) • Intervene in the distribution of income and wealth • Stabilization of the economy (reduce fluctuations of income employment and prices)
EU and UK
The European Union is an example of an international economic association.
It has a common market combining different aspects, including a free trade area and a customs union.
• A free trade area exists when there is no restriction on the movement of goods and services between countries.
• This may be extended into a customs union when there is a free trade area between all member countries of the union, and in addition, there are common external tariffs applying to imports from non-‐member countries into any part of the union.
A common market encompasses the idea of a customs union but has a number of additional features.
• Free markets in each of the factors of production. o E.g. A British citizen has the freedom to work in any other country of the
European Union. • Also aims to achieve stronger links between member countries
o e.g. by harmonising government economic policies and by establishing a closer political confederation
UK membership of the EU has restricted the previously unfettered power of Parliament. There is an obligation, imposed by the Treaty of Rome on which the EU is founded, to bring UK law into line with the Treaty itself and with EU Directives. Regulations, having the force of law in every member state, may be made under provisions of the Treaty of Rome Monetary Policy
The Monetary Policy Committee (MPC) of the Bank of England was charged with the responsibility of setting interest rates with the aim of meeting the government’s current inflation target
-‐ 2% measured by CPI, plus or minus 1% The MPC decides the short-‐term benchmark ‘repo’ rate at which the Bank of England deals in the money markets.
International securities markets
Why would investors want to invest in overseas securities?
Maybe Diversification, more return.
European Equity
• Typically done on electronic order matching systems (like SETS) • Operate under European directives from EU to make sure rules are broadly similar
US equities
• NYSE uses floor based specialist system – trading floor, individual trading directly on floor
• Presence of designated market makers – each stock that trades is run from central trading post-‐ more than one stock attached to trading post. Each trading post will have designated MMs assigned
• A lot trade by universal trading system (like SETS)
Emerging markets equity
Unique challenges due to often poor:
• corporate governance • Transparency • Regulation • Liquidity • Political risk=>volatility
Eurobonds
Eurobonds markets (international bond issue use by governments, corporations and banks)
Debt instrument issued by borrower normally outside of the country in whose currency it is denominated.
Companies issuing debt in the Eurobond market have their securities traded all around the world.
Since its Unsecured debt, the market only accepts highly rated companies.
• Pay coupons gross and annually/issued in bullet form • Bearer (form) instruments – issuer does not retain a formal register of ownership,
however to make sure settlement go through CCP will hold register (not open to government or tax authorities)
• Does not attract withholding tax for this reason (bearer form) • There is no formal market place • Market is telephone driven • Market Regulated by ICMA (international capital market association) • Gilts settle T +1 • Corporate bonds: confirm T+1, settle T+2 – requirement of ICMA
• 2 independent clearing houses do settlement: Euroclear or clearstream • These clearing houses immobilise the stocks in their vaults and then operate
electronic registers of ownership
Eurobond Process
• The most common form of issue used in the Eurobond market is a placing. • Issuer appoints a lead manager and award them the mandate. • Mandate gives lead manager power and responsibility to issue the bond on the
issuer's behalf. • Lead manager then creates management group of other Eurobond houses. • Each house then receives a portion of the deal and places it with its client base. • The lead manager may elect to run the entire book alone, and miss out the other
members of the management group.
Fixed price re-‐offer
• Lead manager can amend the terms of the issue as market conditions dictate. • Under fixed price reoffer, members of management group are prohibited from
selling bonds in secondary market at below the issue price until the syndicate is broken
• Syndicate breaks when lead manager believes the bulk of issue has been placed
Central Securities Depositories
Central Securities Depositories (CSD) hold securities. The fundamental objectives for the establishment of a CSD are for gains in efficiencies and for reduction in risk. Efficiency gained through:
• the elimination of manual errors
• lower costs • increased speed of processing through automation
Which all translate into lower risks. Almost all countries have some form of central depository where the securities are either immobilised or dematerialised
• In a 'dematerialised' system, there is no document, which physically embodies the claim.
o The system relies on a collection of securities accounts o instructions to financial institutions which maintain those accounts, and o confirmations of account entries
• Immobilisation is common in markets that previously relied on physical share certificates, but the certificates are now immobilised in a depository, which is the holder of record in the register. Access by investors to the depository is typically through financial institutions which are members of the depository
ICSD and CSD
International centrals securities Depositories (ICSDs) have established linkages with several domestic CSDs and have created a sub-‐network.
E.gs. Euroclear & Clearstream
ICSD CSD International Client Base Domestic client base Cross-‐border activities Domestic activity only All securities Local securities only Settlement Settlement Custody Custody Collateral management Securities lending Other Services
Regulatory Environment Eu Directives is an obligation for member states to ring their law in line with the directive.
Member states (UK)
• UK government – writes the laws in UK • HM Treasure
Acts
• Public interest disclosure act • Trustee Act 2000 • Data Protection Act 98 • Pensions Act 2004 • Financial Services & Markets Act (2000) -‐ most relevant for exam • Financial Services ACT -‐1021
Regulatory bodies
• FCA • Bank of England
o FPC o PRA
• Take Over Panel • Competition Markets Authority
Legislative Structure
Financial Services & Markets Act
Primary law – tend to deal with top level stuff, guidelines and principles
Enables secondary legislation
• (Regulated activities order, financial promotions order)
Enables the power of regulator to write detailed rules for industry and enforce those rules
Historically there was single regulator –FSA
Disbanded in 2000 and his power was handed to two regulators (FCA and PRA)
Prior to 2013
Single regulator FSA – covered botha spwcts of regulation which has two starnds
Conduct -‐ dsy day operations of company
Prudential – financial safety and soundness of cpmany – make sure company isn’t ging bust ensuring that if nees to payback debt can do without falling into default.
Problem with this was that it ws hard to keep eye on both aspects at once.
• Analysts felt UK felt credit crunch so badly because regulator took eye of the whole. Northern rock was looked into and made sure customers were being treated fairly, but didn’t see that it was about to go bust
Financial Services Act split FSA into:
• Conduct was taken on by FCA • Prudential take on by PRA
FCA -‐ accountable to government (Her majesty treasury)
• Regulates provision of financial services to consumers • Will aim to protect and enhance confidence in UK financial system • Deal with conduct of around >26,000 firms/every firm across the industry
PRA – division of the bank of England (Micro picture, individual firms and spotting if issues at the individual firm level)
• Objective to promote safety and soundness of regulated firms • Designed to minimise the adverse effects of firms failure • Only do checks on 3000 firms, those that are systemically important (firms that
would be too damaging to fail:
Includes:
• all banks • Insurers • And large firms
Leaves prudential bit for other 23,000 to FCA.
FPC – division of bank of England, looks at Macro across industry as a whole
• Responsible for macro prudential regulation • Aim to ensure the stability of financial system as a whole
FCA
FCA took legal structure of FSA in April 2013
Responsible for conduct supervision of all firms and for prudential supervision of non-‐pra firms
Supervises trading and market infrastructure
Competent authority for listing and prospectuses and is referred o as the UK listing Authority. UKLA and FCA – two separate roles, but conducted by same body.
UKLA responsible for approving companies seeking a listing and for writing and enforcing the listing rules (part of FCA handbook)
Responsibility for client assets oversight and countering financial crime
FCA has: 1 strategic, 3 operational objectives
Legal high level strategic objective to ensure relevant markets are functioning well
Operational objectives: PIC, protection, integrity, competition
• Secure and appropriate degree of protection for consumers o Keeping bad companies and products out of the industry o Compensation and redress in event of things going wrong
• Protect and enhance the integrity of the financial system • Promotion of effective competition in the interests of consumers
PRA
General objective: promotion the safety and soundness of regulated firms
• Uses resolution planning (companies version of living will – preparation for in case they go bust) to ensure that firms that fail do so in an orderly way
• The PRAs approach to supervision emphasises the importance of judgements made by supervisors. – is company at risk of going bust in the future, judging the firms to find at risk firms
FPC
• Responsible for identifying monitoring systematic risks, and taking action to address them
• Makes recommendations and gives directions to PRA and FCA
• FPC is required to take economic growth into account • FPC will publish two financial stability reports every 6 months.
Authorisation Requirement
Firms are required to be authorised – licensing program imposed by regulators on companies
Section 19 of FSMA 2000 – The general prohibition
• Company cannot conduct a regulated activity in the UK by way of a business (financial service main part of business) unless they are authorised or exempt.
If breached, then company taken to court
Civil court or criminal court – difference relies on evidence of guilt
Dual regulation
Banks and Insurers
• Systematically important so they are monitored by PRA for financial safety and soundness • They are also supervised by FCA who will be monitoring their day to day conduct.
All other firms – FCA is responsible for financial safe and soundness as well as conduct.
FCA/PRA Permission
Dual regulated firms will apply to the PRA for authorisation. However, the FCA will be consulted and will give or refuse consent to the PRA based on conduct implications. PRA will be bound by the decision.
What are regulators looking at when looking to authorise a firm:
Authorization is given by obtaining part 4a permission and fulfilling the relevant threshold conditions which depend on whether dual or FCA only regulated.
Threshold conditions depend on whether regulated by FCA or FCA and PRA
Threshold Conditions Application Location of Office (head office needs to be in UK so you can be sued by UK law if problems)
FCA & dual reg
Effective supervision (is business transparent enough for regulators to check your meeting requirements, FCA – business activities, (how/what selling) PRA – finances)
FCA and Dual Reg
Suitability (fitness and properness, are you going to be run well y good directors who will benefit customers)
FCA and Dual Reg
Business Model (what you have planned/is it sustainable)
FCA and Dual Reg
Appropriate resources (financial and non-‐fin) Need to see whether your human resources are good, people of right calibre. Financials are needed as FCA will be looking at soundness of these companies
FCA firms only
Business conducted in prudent manner (Reason for being of PRA, company must be prudent in how dealing are handled/ensure not about to go bust)
Dual regulated firms only
Appropriate non-‐financial resources (PRA interested in whether you have right people around to run the business)
Dual regulated firms only
Claims reps (insurers only) – claims reps
Dual regulated firms only
Legal status (insurers only) Dual regulated firms only
Need to know all 9 of these
Legislative structure
Does the firm need authorisation? – very examinable
1. Is it doing a regulated activity? If Yes, 2. Is it regarding a specified Investment? If Yes, 3. Is it an exempt person? If No
You would need Authorisation!
Regulated Activities
Regulated activities or (specified activities under the Regulated Activities Order) – there are 16
Can be divided into:
Wholesale financial services activities – big financial (investment banks -‐buyside) service firms (7)
• Dealing in investments (buying and selling assets)
• Dealing as an agent (executing orders/trading/broker for others (3td parties)) • Operating a MTF Multilateral trading Facility (alternative trading platform outside of
conventional stock exchange – institutions trade between themselves and allow some others to trade on their exchange too)
(Investment Management Community (sell side))
• Managing investments (managing money for clients) • Advising clients
(Back Office functions)
• Safeguarding of investments -‐ (custody, making sure legal title has ben correctly transferred, making assets have been bought legally and are safely kept and all legal title in clear)
• Sending de materialised instructions -‐ (Clearing houses perform this -‐ no longer have bits of paper floating about, information sent electronically via various dedicated systems (SWIFT) to make sure custodians know what has been dealt)
Insurance
• Offering/effecting insurance – selling or running insurance contracts to clients • Assisting in insurance – certain activities that may be carried out by legal 3rd party for
insurer (underwriting risk, claims handler – may not offer or handle insurance but are vital if you want to claim on insurance)
• Lloyds (of London) – specialised insurance market (original home of insurance) – specific insurance market for insuring big ticket risks ships sinking or office being attacked) on Lloyds trading floor these big things are insured then the risk is traded between the various Lloyd companies or members
Retail
• Deposits takers • Offering electronic money services (paypal) • Regulated Mortgage (on primary residence) mortgages on second homes or buy to let are
not necessarily regulated • collective investment schemes (CIS) – a fund
o Authorised unit trust o Open ended investment company (investment company with variable capital)
• Funeral plans -‐ really a form of collective investment scheme
Agreeing to provide regulated activities – process of becoming regulated is quite long, what firms do is while going through service they start legally committing to provide services by agreeing contracts with parties for the future.
MADAM LEASES ACAFE
• Multilateral trading ability • Advising on investments regulated mortgage/home finance contracts/stakeholder products
• Dealing in investments as principal or agent • Arranging regulated mortgages/deals in investments • Managing investments
• Lloyds insurance market related activities • Entering into/administering a regulated mortgage or home finance contract • Accepting deposits • Safeguarding/administering investments • Establishing/operating winding up a CIS or pensions scheme • Sending dematerialised instructions
• Agreeing to provide regulated activities • Carrying out or effecting contracts of insurance • Assisting in the administration and performance of a contract of insurance • Funeral plan contracts • Electronic money
What’s an Investment?
Specified investment:
Securities:
• Shares -‐ in any company • All tradable debt
o gilts o bonds o treasury bills (short term tradable debt issued by British government) o commercial papers (short term tradable debt issued by companies), o certificate of deposits (bank account that’s tradable), o FRNs (floating rate note-‐ bond with variable rate of interest. o Private loans are not tradable unless they are securitised. o Premium bonds are not tradable – they are like private loans between individual
and companies • Hybrids
• Depositor Receipts – don’t actually take ownership of share, share remains in hand of depositary investment banks, but you get any benefits of share like price appreciation or dividend s and votes – allows people who don’t want to trade directly to trade • Global depositary receipt • American depository receipt
• Warrant o Options right to buy shares are specified price
• Rights to or interest in investments
o Repos – sale and repossession agreement – investment bank sells bond cause it needs some short term money and when it sells bond it includes agreements to repurchase bond.
Derivatives – very examinable
• Options on investments (anything in securities) and on currencies, gold, silver, platinum and palladium (precious metals)
o Options on commodities are not specified investments (neither are commodities themselves)
• Futures for investment purposes -‐ obligation to buy or sell some underlying asset in the future (regardless of underlying asset, it is a specified investment)
• Contracts for difference, e.g. swaps, forward rate agreements, spread betting in general
Insurance
• Contracts of insurance – life and general • Lloyds investments
Retail
• Deposits • Rights under a regulated mortgage (primary residence) • Rights under a funeral plan • Units in CIS – unit trusts & OEICs • Personal and stakeholder pensions (private – personally made decision to take out which
differs form occupational investment) -‐ subset of above
Exempt persons – from formal regulation process
Reason recognised institutions are exempt is because they are recognised, recognition process is far more demanding
5 different classes of exempt people -‐ APRIL
Appointed representatives (Tied agent)
• Independent legal entity e.g. self-‐employed insurance salesman • If tied agent breaks any rule, the parent company will be punished
Professional People (regulated by designated professional body)
• Lawyers, accountants and actuaries
Recognised Institutions
• Recognised investment exchanges (LSE) • Recognised overseas investment exchanges (NASDAQ)
o Overseas exchange that can trade on form the UK with approporate terminal • Recognised Clearinghouses
o e.g. Euroclear (crest)
Intuitions (that are specifically exempt)
• e.g. IMF or Bank of England,
Lloyds members
• Made up for firms or syndicates/members that trade insurance on Lloyds of London trading floor.
• To do this trade you must be a formal Lloyds member • Lloyds itself is regulated but its member firms are not • If any firms breach FCA rules, Lloyds will punish (like appointed representatives)
Principles for Businesses (firms)
1. Integrity – acting without dishonesty, or intentionally misleading customer (1=I) 2. Skill care and diligence – you don’t mislead customer through lack of research (2=Due-‐
diligence) 3. Managements and control – CEO has sub managers and they have team managers reporting
to them, a clear tree of management control (3=tree) 4. Financial prudence – businesses does not overstretch itself (4=door=often see chancellor
standing outside door who should be most prudent person) 5. Market conduct – standards of conduct differ across markets (5=hive –full of honey and
money sells on market) 6. Customer interests – TCF-‐ always act in customers best interest (6-‐fixed (rate of
return/interest) 7. Communications with clients – clear fair and not misleading – (7=heaven, clients are gods) 8. Conflicts of interest – recognises and manage these conflicts (8=hate of conflict) 9. Customer relationships of trust -‐ (9-‐ wine, trusting relationship have a dinner and rink with
customers) 10. Clients assets – keep client assets safe and warm until mature into cash (10-‐hen (nurtures
eggs) 11. Relations with regulators (Open and honest with regulators (11-‐RR)
Individuals can sue firm if they are hurt because firms breached a rule
Hurt Individual cannot sue firm for breach of principle
Regulation of investment exchanged
FCA has recognised number of investment exchanges such as:
• LSE • NYSE Liffe • London metals exchange
Recognised exchanged are required to deliver a high standard of investor protection and market integrity
• Exchanges have to undergo higher level of checking out to become recognised
Recognised clearing houses that used to be recongised yb the FCAs predecessor the FSA, but are now regulated by the Bank of England
Off exchange derivatives (OTC)
• largely unregulated • but settlement and clearing now subject to new requirements* such as clearing through
central counterparty risk management procedures and reporting.
Regulation of derivatives
MiFID applies to firms carrying out activities in relation to any derivative instrument
UK market regulated by the FCA (only in relation to those derivatives covered under specified investments)
International accounting standards states that (non-‐hedge) derivatives must be rescored in the balance sheet at fair value.
• If fair value changes over companies accounting year, then that should be recognised as a gain or loss in income statement
• Except derivatives used a hedge where gains and losses are recognised in reserves
Approved Persons (individual)
Within an authorised firm, people carrying out ‘controlled functions’ must be approved
Must satisfy the FCA as to fitness and propriety
1. Honest, integrity and reputation (going to jail may exclude someone from this) 2. Competency and capability (including the need to pass approved exams and an internal
assessment) 3. Financial soundness (if ever been declared personally bankrupt you probably cannot look
after other peoples money)
Key issue is disclosure, of when apply you do not disclose any relevant details, this immediately makes you dishonest.
• Approved persons must comply with FCAs “Statements of Principle”
Controlled functions
(SIF)
Significant influence functions -‐ run whole departments, have influence on companies direction, policies and how the business is run
Governing functions
• Directors, partners if partnership
Required Functions
• Compliance oversight (head of compliance) officer • Money laundering officer
Systems and controls -‐ To have necessary control in business that regulator says you must have
• Finance officer (head of finance) • Head of audit • Head of risk
Significant management
• Trading company -‐ Heads of settlement • Bonds-‐ Head of bond trading
Majority of people performing controlled function:
Customer function -‐ Anyone who has influence on customer’s wealth
• Investment advisor • Trader – indirectly by trading with market
Who undertakes approval:
If only FCA regulated (majority of firms) not considered systematic risk – FCA signs of any individuals
If working for dual regulated firms, PRA approves however PRA needs consent from FCA before grants approval
• PRA checks individuals will handle businesses finance in right way • FCA will check persons follows correct conduct rules on day to day basis
Statements of principle (approved persons) – distinguish from principle of business
Apply to all approved persons – first 4
1. Integrity 2. Skill, care, diligence 3. Proper standard of market conduct 4. Deal with regulator in open way
Apply only to significant influence functions -‐
5. Proper organisation of business – must run area of business responsible, clear organisational structure, clear job descriptions communicated clearly
6. Skill care diligence in management -‐ delegating is not abdication of responsibility, must understand what you are delegating to understand if person delegating to is doing good job and not rogue trading
7. Comply with regulatory requirements – must be proactive, ensure that areas of business you are responsible for respond to changes in regulatory environment,
The code of practice for approved persons sets out descriptions of conduct that does not comply with the above principles.
FCA Handbook
5 Main books
High level standards
• Principle for business • Statements of principles • Threshold conditions • Fit and proper test • Training and competence • Senior manage arrangements • System and controls
Business standards
• Conduct of business • Client assets • Market conduct
Regulatory processes
• Supervision • Decision procedure and penalties manual
Redress
• Complaints handling • Compensation – not very examinable
Regulatory guides
• Enforcement guides
Knowledge of other books not required – just know they exist should be enough
(prudential standards, specialist sourcebooks and listing, prospectus and disclosure)
Senior manage arrangements system and controls (SYSC)
Purpose:
• System and controls are appropriate to the nature, scale and complexity of the firm o Outcomes based so different companies require different types of systems
• Effective compliance systems (especially countering financial crime) • Create common platform of requirements for firms subject to CRD and/or MiFID
o To achieve consistency across Europe – Common platform
Apportionment of senior management responsibilities
• CEO responsible for apportionment • Knowing and recording who does what (recorded kept for at least 5 years from
organisational structure changes – MiFID)
Training competence and professionalism
All staff (everyone) employed in authorised firms must be competent
If dealing with retail clients:
• Employee must be assessed as competent • Employee must be supervised
Retail distribution review – new requirements from Jan 2013 when giving retail investment sector:
• Retail investment advisor must hold statement of Professional standing –issued by an accredited body such as the CISI
• The SPS confirms that the advisors hold an appropriate level 4 qualification and has completed a minimum of 35 hours CPD per year / 21hours must be structured
In addition to the above advisors must subscribe to a code of ethics
Takeover Code
Regulated by the Takeover Panel
Takeover panel Funded by a £1 levy on LSE share transactions (buyer and sellers) above £10k
Regulates offers for shares in all UK public limited companies (plcs) that are listed on exchanges
Key points
• Promote fairness (note: the code does not consider competition issues or public interest) o Equal treatment for all shareholders of a particular class o Allow a reasonable period for the bid to be considered
• Reduce occurrence of defensive measures take by target co. Discourage financial structure that make it difficult for someone to launch a takeover bid, so they can be launched so the investors can then decide whether or not they wish to go forward
• Mandatory bid is required if shareholder acquires > 30% of the voting rights of a company. They must make a cash offer to all other shareholders at the highest price paid in 12 months before the offer was announced.
o Below 30% considered minority shareholder. • Offer must remain open for >21 days • If achieve >90% acceptance – can compulsorily purchase remaining 10% • Directors of target company should not deny shareholders the opportunity to consider the
bid.
The competition and Markets Authority (CMA)
The CMA was established under the Enterprise and Regulatory reform Act 2013.
Will investigate all mergers if :
• Proposed merger where turnover of company is at least >70 m in UK • Or when combined market share is at least 25% of total
If either of two tests are breached they will launch a Phase 1 Study (takes up to 40 days)
• To determine If the merger results in substantial lessening of competition
Phase 2 Investigations
Merger may be approved, prohibited or remedies/conditions imposed
• Statuary time of 12 weeks following phase 2 for remedies to be implemented.
Fines
CMA is empowered to impose fines up to 5% of the combined worldwide turnover of merging companies for breach of an order.
They can also impose fines for failure to provide requested information.
Data Protection Act 1998
Data protection act applies when processing personal data
Data controllers must register with the Information Commissions officer (ICO)
If in contravention of data protection, commissioner can serve enforcement notice. Failure to comply with enforcement notice could lead to a £500,000 fine
Eight principles to ensure personal information is:
• Fairly and lawfully processed • Processed for limited purposes • Adequate, relevant and not excessive
o Required to keep data on customers to satisfy rules (anti money laundering). Data protection act would say that if you asks for information that is not required for regulatory purposes then they are in breach
• Accurate and up to date • Not kept for longer than necessary • Processed in line with an individuals rights • Secure • Not transferred to other countries without adequate protection
o If data moved must be confident that data protection rules in that country are adequate enough
• Person whose data is held is entitled to ask for access to that information (subject access request) and has the right to correct where appropriate.
o They can be charged a maximum fee of £10 for access (max fee of £2 for credit reference agency records)
o The person entitles to be told the source, purpose and recipients of data. o DPA 1998 requires that subject access requests take place within 40 days of the
request (including fees) being received.
Breach is a criminal act resulting in fines but not jail
Whistleblowing procedure
• Whistle-‐blower interests stem from Public interest disclosure Act 1998 -‐ Law • Law is detailed in SYSC – part of FCA handbook -‐ regulation • Process whereby a worker seeks to make a disclosure to a regulator or law enforcement
agency relating to criminal offence or breach of rules (e.g. FCA rules) • No contractual restrictions for whistleblowing • Should be no discrimination for whistleblowing
Trustee Act 2000
When set up a trust, should be legal trust deed behind it which gives clear advice of how any money should be invested
If no trust deed, trust act 2000 would be default
Trustees are in power to invest in any appropriate asset and must review investments and obtain and consider advice.
Pension Act 2004
Introduced new regulatory authority – the pensions regulator
• For occupational pensions • Defined benefit Pensions only – promise certain % of your salary when you retire
New Pensions protection fund for where an employer who runs a scheme becomes insolvent and unable to pay liability
PPF provides compensation up to 100% of benefits to existing pensions and 90% to those not yet retired (funded by charges on companies that run these pensions on other defined benefit pension schemes)
Minimum funding requirement replaced by scheme specific objectives:
• Required trustees of defined benefit schemes to prepare a statement of funding principles which will clearly outline how necessary funding will be achieved – outlines what future liabilities will be and how much companies needs to put in to attain that target
• This must be reviewed every 3 years.
Conducts of Business Sourcebook (COBS)
Who?
Applies to Authorised firms
What?
Day to day activity rules in relation to:
• Client categorisation • Financial promotions • Investment research • Suitability and appropriateness • Dealing and managing • Client assets and client money
Rules on Client Assets are covered by a separate sourcebook (CASS)
Client Categorisation
Anyone you would be offering financial services to are potential clients
Look at the level of knowledge of financial services that clients have
High level
• Eligible counterparty (other authorised firms) • Level of protection will be low
Eligible Counterparty – must want following services:
• Receipt and transmission of orders • Execution of orders • Dealing on own account
Per se eligible counterparties
Authorised firms
National, central banks, international/supranational intuitions
Low level
• Retail client • Level of protection will be high
Retail
• Individuals and persons • Small businesses
Medium Level
• Professional Client • Medium level of protection
Professional
• Authorised firms when business they seek when business they is not in eligible counterparties risk
• Large undertakings in non finance
Per se Professional client
Authorised firms who are not eligible counter party
National, central banks, international/supranational institutors and regional government
Institutional investor whose main activity is to invest in financial instruments -‐ SPV
A large undertaking which meets two of the following :
If subject to MiFID • €20m balance sheet total • €40m net turnover • €2m own funds
Non-‐MiFID
• €12.5m balance sheet total • €25m turnover • 250 average employees in year
or (single test trumps all others:
• £5m share capital/net assets
Clients can elect to opt up, subject to certain criteria
• Protection costs money, so may end up with cheaper fees
• Retail clients may be deemed unable to handle risk of certain products so may have greater access to products
General notification
Firms must notify clients of their categorisation
Prior to the provision of services firms must inform the client
• Any right to request a different categorisation and • Any limitations to the level of client protection that such a different categorisation would
entail
Elective professional Clients
3 letters in this process
A firm can treat a retail client as an elective professional client if:
• Firm carries out a Qualitative test and for MiFID business also a and Quantitative tests • Clients requests this in writing and • Forms gives clear written warning of the protections and investor compensation rights lost • clients states in writing in a separate document that they are aware of the consequences.
Qualitative and Quantitative tests
Qualitative test
Firm undertakes adequate assessment of KNEES
• Knowledge and • Expertise • Experience of the clients
This assessment hives firms reasonable assurance that client is capable of making their own investment decision and understands the risks involved
Quantitative test – only if MiFID business (3 Rs: Regular, Rich, Resume)
At least two of three of following:
• Client has traded in significant size on the relevant market (that they are seeking business with you in) at an average frequency of 10 per quarter over previous 4 quarters
• Financial instrument portfolio > €500,000 • Client works/has worked in financial sector for at least 1 year in professional position which
requires knowledge of transactions/services
Financial Promotions
Must follow rules appropriate to type of client
Financial Promotions -‐ Invitation or inducement to engage in investment activity
Written promotions (non-‐real time)
• Adverts • Letter • Mailshots • Websites • Emails
Non-‐written (real time promotions) – potentially more aggressive
• Meetings • Telephone Calls
FSMA 2000
Financial promotion can only be issues by an authorised financial services firm, if not authorised would need approval by authorised financial firm
• e.g. Overseas financial firm not authorised would may seek to enter UK market
COBS Financial Promotion
Communication and financial promotions must be fair, clear and not misleading
Guidance:
A firm should ensure:
• It is clear if a clients capital is at risk • Any yield figure quotes gives a balanced impression of short/long term prospects
o If 1st year of investment gives bonus high rate, but drops in subsequent year must give balanced view of this
• Complex charging structures are explained • The FCA is named as regulator • A clear impression is given of any 3rd party packaged/stakeholders product provider
Exceptions
• Those communicated only to investment professionals (dragons den types) or eligible counterparties
• Excluded communications – if there are another set of rules that apply to communications. E.g. takeover rules take precedence over financial promotions rules
• A ‘one-‐off’ promotions (that is not a cold call) – communicated to a specific client or to one group of recipients -‐ could be a rich individual or family and promotion is tailored to their needs.
Communications with retail clients
Requirements for communications with retail clients
• Must be likely to be understood by an average member of the target group • Fair and prominent indication of relevant risks • Important items are not disguised, diminished or obscured • Must include the name of the firm
Comparisons of investments/businesses must be fair
• Specify information sources, key facts and assumptions o Comparisons must be fair – e.g. cant compare returns on bank deposit to equity
Past performance data
Past performance data should:
• Not be the most prominent feature of the communication • Contain a warning that pas performance is not a reliable indicator of future results • Cover at least 5 years immediately preceding consecutive 12 months • Include reference period and source • Contain a currency risk warning • Disclose the effect of charges if based on gross performance
Cold calls/unsolicited calls
Investment firms must not make a cold call unless:
• Existing relationship where recipient envisages the call • It relates to generally marketable packaged product
o We are allowed to sell to retail public, investment itself should be authorised and regulated by the FCA. Not just firms that are regulated, products must also be regulated
• It relates to a controlled activity/service carried out by an authorised firm/ or exempt person o involving readily realisable securities (other than warrants) o these are liquid and readily tradable
Definition of packaged product (CLIPS)
• Collective investment schemes (regulated) • Life policies
• Investment trust savings scheme – not collective investment because it is closed ended, finite number of shares. Like a company with shares trading on the market although all it does is own shares or stakes in other products.
o ITSS (savings scheme) You invest a regular sum of money with provider each month who n turn puts money into investment trust
o Investment directly into Investment trust is not a packaged product • Personal pensions • Stakeholder pensions
o Personal and stakeholder are private pensions. Stakeholder pensions have lower costs
Non-‐written financial promotions
A firm must not initiate a non-‐written financial promotion unless the persons communicating it:
• Does so at an appropriate time of day (for recipient) (must justify appropriate for specific person
• Identifies himself and the firm at the outset and makes the purpose of the communication clear
• Terminates the communication at any time if requested to do so • If signed up for communication; A contact point must be given, so that a future meeting if
arranged can be cancelled.
Investment adviser charging/remuneration
New rules since Jan. 2013 prevents firms making personal recommendations from earning commission set by product provider
Applies to retail investment products (broader than packaged product)
• Firms offering such service now charge for the advice they provide • Charges must be disclosed in writing in good time before advice given using clear and plain
language • Clients have the option of paying the charge upfront or may have it deducted from their
investment • Advisors can no longer receive commission from fund managers
Issues:
• Transparency • Conflict of Interest
Independent advice and restricted investment advice
Independent advice – you must cover all suitable retail investment products, relevant to the client base from relevant providers
• The RDR introduced a new definition of independent advice – which consider all suitable retail investment products
Restricted advice
• Advice which is not independent is described as restricted • Firms must disclose the nature of the restrictions (e.g. limited number of product providers
or specific types of product) to the client
Advising on packaged product
Advisers can choose to:
• Advise on the whole of the market (independent financial advisor) • Advise on limited product range (restricted) • Advise on a single providers products -‐ Appointed representative (exempt from
authorisation)
Key Feature Document must be given to a retail client when providing a recommendation on a packaged product including:
• Details on nature and complexity of the product • Complaints handling procedure • Compensations schemes (if provider goes bust) • Cancellation rights (if client invests but changes their mind)
Suitability and suitability reports
• For all Retail and professional clients: • Applies to personal recommendations and firms managing investments • Reasonable steps must be taken to ensure suitability • In order to do this firms must obtain necessary information regarding the clients:
o Relevant knowledge and experience o Financial situation o Investment objectives
• Retail clients must be sent a suitability report if recommendation related to an investment in a packaged product.
Appropriateness obligations
For all Retail and professional clients:
For investment services other than managing investments and personal recommendations (essentially execution only) – no advised service
• No need to assess appropriateness in relation to noncomplex financial instruments • Firms to assess appropriateness based on the clients relevant knowledge/experience
• If the product/service is not considered appropriate you must warn client • Where there is insufficient information to assess appropriateness the firm must notify the
client that we cannot do appropriateness check. It’s a firm’s discretion whether or not they execute order.
Best Execution
Applies to retail and professional clients
• When executing order a firm must take all reasonable steps to obtain the best possible results for its clients taking into account the execution factors
• A firm will satisfy this rule by executing a client order in accordance with the specific instructions of the client.
Churning and switching
Dealing with unjustified frequency/overtrading
Maybe due to racking up commissions
Firm should be acting in firms best interest
• Churning – relates to investments in general (switching between securities/assets) • Switching – if managing portfolio of packaged products (switching between funds)
Order Execution Policy
Clients must have prior consent to execution policy
For each class of financial instrument policy should include
• Information on different execution venues and • Factors affecting the choice of venue
For retail clients, the following information must be given in advance
• The relative importance of the execution factors • A list of execution venues • Warning that specific instructions may prevent firm form following its policy to obtain the
best possible results
Clients Order Handling
Retail and professional clients
• Firms must implement procedures and arrangement which provide for the prompt fair execution of client orders
• Comparable orders to be executed in accordance with the time of receipt by the firm
Aggregation and Allocation of Orders
• Could potentially aggregate orders as long as you believe it will not disadvantage either or clients and you disclose to clients that you will do this and that you have proper allocation policy (our systems and 3rd party systems clearly know about the allocations)
Inducements
A firm must act honestly, fairly and in best interest of their clients
Any fee commission or non monetary benefit paid to or provided by a 3rd party must be designed to enhance the quality of service to the client
A firm must disclose too the client any fees commissions or nonmonetary benefits in summary form.
Use of Dealing commission (Unbundling)
• Fund manager passes business to broker who they pay commission to execute the order • In return the broker executes and provides research + other goodies (subscription to
Bloomberg, invite analysts to training and education conference) • Problem is that fund managers customer is paying the commissions. Anything that
commission buys should give a benefit to the customer. • Rules now say that in return for payment of commission, no other goodies are acceptable.
Commission can only pay for execution of trades and research • Unbundle packages of returns form commission to make more transparent what customer is
paying for.
An investment manager must not execute customer orders through a broker and pass on charges to client unless the manage has reasonable ground to be satisfies that the goods services purchased with commission:
• Relate to the execution of trades • Comprise the provision of research • Will assist the manager in providing services to its customers • Do not impair compliance with the duty to act in clients best interest
Conflicts of Interest
Firms must identify conflicts of interest between
• The firms and its clients • One client and another
Maintain effective arrangements to manage conflicts
If the arrangements are not sufficient, and cannot manage conflict must disclose the nature of conflicts to firms and clients
Provide retail clients with a copy or summary of policy
Keep record of any conflicts
Conflicts of Interest Policy
The conflicts of interest’s policy must:
Set out the circumstances which gives rise to a conflict
State the procedure for managing conflicts, which could include:
• Information barriers such as ‘Chinese walls’ -‐ prevents information’s from following from the private (M+A advisory) to the public (advisors, analysts).
o Must prevent information from flowing between these two groups • Remuneration structures -‐ Avoid pay structures that create conflicts – if advisors paid by
commission they may not be working in best interest of clients • Independence -‐ analysts are independent to the private side. Stop one side from influencing
decision or research of the other (pressuring) • Segregation of duties – having a senior manager in charge of both public and private would
be bad. Need to segregate those duties
Investment research
Apply to investment research which is intended to be disseminated to clients/public
Covers written or oral material
Firms arrangements must manage conflicts of interest and cover
• No personal or firm transactions in unpublished research until clients have had reasonable opportunity to act.
• No personal transactions contrary to their current recommendation • No promises of favourable research to firm subject of research or will always have a conflict • No editorial control for the subject of the research
If significant shareholder of company we wirte share on, then we cannot get around conflict. In such cases:
• Disclose all relationships and circumstances which may impair objectivity of recommendation
Personal Account Dealing – requirements
Firms must establish implement and maintain adequate arrangements to:
• Prevent employees engaging in market abuse (insider dealings and related offenses) • Ensure all relevant persons are aware of restrictions
• Ensure any deals are notified promptly to the firm: post trade notification • Ensure adequate transactions record are kept:
Exceptions: discretionary fund management and nits in collective investment schemes (one information in one security held in fund (which generally has minimum of 16 securities)
Cancellation Rights
Life policies and pensions (stakeholder or personal) – you have 30 days to cancel without being charged any fees or commissions
Other products -‐ 14 days
• Consumer must be informed of a right to cancel • Cancellation date is the date of dispatch
Record Keeping
General rule
• MiFID – 5 years • Non-‐MiFID-‐ 3 Years
Records relating to pensions and life policies must be kept for 5 years.
Those relating to pension transfers, pension opt-‐outs or a free standing AVC must be kept indefinitely.
Record keeping re. financial promotions relating to life policies and pension must be kept for 6 years.
Reporting requirements
Occasional -‐ If executing order for client we must provide (occasional) reporting
Retail and professional clients
Retail clients to be sent an order confirmation by T+1
• Except when managing investments
Periodic – applies to investment managers
• Must provide periodic statements that gives information on content, value and performance of fund at regular periodic individual
• Default is every 6 months for normal securities (shares, bonds) • 3 months on request • If provide clients with order confirmations, the you only need to send report eervy 12
months • If portfolio is leveraged (or through derivatives) can create a lot of volatility in value of fund.
Because of this extreme volatility must report back to client on monthly basis
Holding of Client assets and client money
Make adequate arrangement to safeguard client’s ownership rights in event of:
• Insolvency of a firm – make sure that clients assets and money is separate from firms assets and money
• Unauthorised use by the firm – i.e. client must give prior consent to their use in security transactions such as stock lending. – if hedge fund want to take short position (sell something they don’t won) they borrow. Clients may not like their stocks lent out to hedge funds
Have an adequate organisation arrangements to minimise risk of loss or reduction of financial instruments, misuse, fraud, poor administration, inadequate record keeping negligence.
Custody Reconciliations
A firm must reconcile internal records with those of 3rd parties (such as custodian – who would have definitive record of firms assets)
• As regularly as necessary • As soon as reasonably practicable after the reconciliation date
Correct any discrepancies’ promptly
Notify the FCA of any breaches without delay
Client money
• Money which firm is looking after which is not its own • Client money must be held on trust • Client bank account should be separately identifiable form the firms own account • Main purpose of rules is to ensure money is protected in the event of insolvency.
Pollution of trust – if moneys of firms and clients account become mixed. Client’s accounts are susceptible to be taken by creditors in event of insolvency.
A firm must reconcile its internal record with those of 3rd parties (banks)
As regularly as necessary
As soon as reasonable practical after the reconciliation date
Correct discrepancies promptly
• If shortfall in client account top up account – not pollution • If excess, remove immediately – this is pollution of account
Notify FCA of any breaches without delay
Offences under FSMA 2000
FSMA makes it an offence to do the following:
• Describe oneself as authorised or exempt if one is not authorised or exempt • Contravene section 21 – financial Promotion • Make false or misleading statements • Knowingly or recklessly creating a false impression (for the purpose of personal gain
or loss to another person) o Might conduct phantom transactions between themselves and another
counterparty (washing) to make market for a security look more liquid • Contravene section 91 (FSA 2012) in relation to benchmarks, specifically to make to
another person a false or misleading statement or to an act or engage in any course of conduct that creates false or misleading impression
o Offense to deliberately use bench mark that does not give fair comparison (picking one that’s easy to beat).
Approaches to supervision: FCA
The FCAs supervision model is based on three pillars:
• Firm systematic framework (FSF) o preventative work through regular structured assessment of firm conduct
• Event-‐driven work o dealing with emerging issues and those that arise outside of the regular cycle
of firm assessment • Issues and products
o fast intensive campaigns on particular products or market sectors
Discipline and enforcement
Discipline
For disciplining firms or approved individuals
• Private warning • Public censure – Published on website of regulator and picked up by financial press
(reputational damange) • Unlimited fines
• Varying or cancelling permission – cancel authority to conduct in one or all areas • Withdrawal of approval – individuals who are approved
A firm/individual can appeal to the Upper Tribunal (not part of the FCA)
• Part of Tax and Chancery chamber, witihin of justice system
FCA has power to invoke ‘temporary product intervention rules’ (TPIR) allowing a product to be restricted or banned without following the normal disciplinary process.
Complaints procedure
Complaint-‐ any expression of dissatisfaction in any form
• Appropriate and effective complaints handling procedures • Publish summary of procedures and refer eligible customers to it at point of sale • Within 8 weeks of receiving complaint firm must either have sent
o A final response; or • If unable to resolve issue in 8 weeks:
• A letter explaining why the complaint has not been resolved and notification that complaint can be referred to the financial ombudsman service
• Summary report to the FCA every 6 months.
Financial ombudsman service (FOS)
Independent archer between complaining client and firm
Easy cheap and quick route, low publicity to resolution rather talking complaint to court
FOS has two Jurisdiction
• Compulsory Jurisdiction – FCA regulated firms • Voluntary Jurisdiction – VJ participants
The firm must cooperate with the FOS investigation:
Must complain to FOS:
• Within 6 years of event happening or • 3 years of customers knowing of the problem or • If raised complaint with firm, then you have 6 months of the firms final response
Maximum award £150,000 + expenses
Financial Service Compensation Scheme
Final safety net for eligible claimants of failed UK authorised firm:
• Claim must be made within 6 years of the date when the loss occurred • Maximum pay-‐out is £50,000 for investment business – for funds or securities • Maximum pay-‐out is £85,000 – on any deposits
Insider dealing – Criminal Justice Act 1993
Inside Info
• Unpublished • Price sensitive • Specific/precise
Inside Source
• Director • Employee • Shareholder • Virtue of work or employment elsewhere (in investment bank) • Direct/indirect source is one of above
Insider
• Dealing – via market/professional intermediary o If done privately OTC, probably not subject to insider dealing
• Encouraging – others to deal • Disclosing -‐ Inside information (unless proper)
Note that Insider dealing covers shares, bonds, warrants, depositary receipts and derivatives (including contracts for differences)
Did not expect it to lead to a profit…
General Defences
Dealing
• Did not think it would lead to profit • Believed it to be already widely known • Would have done it anyway
Encouraging
• Did not think it would lead to profit • Believe it to be already widely known • Would have done it anyway
Disclosing
• Did not think it would lead to profit • Did not expect it to lead to dealing
Special Defences (for certain circumstances/actors)
• Market Maker or those complying with stabilisation rules
o Stabilisation rules carried out during IPOs, prices can be volatile so stabilisation broker can buy shares to stabilise prices
• Market information o Dawn raids – if company thinking about takeover and buys shares in the
target company to build up ownership prior to formal bid
Penalties and enforcement
Penalties
• Summary Conviction (Magistrates’ Court) o Max: 6 months prison and £5,000 fine
• (More serious) Indictment (crown court) o Max: 7 years prison and unlimited fines
Enforcement
Her Majesties Treasury legislation –write laws on insider trading
LSE investigate – as usually occurs on exchange
FCA prosecutes but cannot send to jail, can only take to court
Market abuse
• Covers all persons • Seven types of behaviour that can constitute market abuse • It is a civil offense (so no jail) • Sanctions
o Unlimited fines o Public censure
Overview of Market abuse
Behaviour occurring in relation to qualifying investments traded on prescribed market. – any European economic market or investment traded on such market.
Focused on effect not intent.
Insider Dealing:
• Insider dealing • Improper disclosure • Misuse of information – much more general
Market Manipulation – misleading people to try and make a profit
• Manipulating transactions • Manipulating devices • Dissemination of false or misleading information • Misleading behaviour and distortion
Money Laundering
Definition: Process by which criminals seek to hide the true origins of money derived from activities (whatever they may occur) considered by the UK to be criminal conducts e.g. drugs, terrorism, tax evasion, minor theft.
Legislation
• EU Money Laundering Directive • Proceeds of Crime Act 2002 –focuses on individual liability • UK Money laundering Regulations 2007 – focuses on company liability • Senior Management Arrangements Systems and Controls (SYSC)
The 3 stages
Placements -‐> laying -‐> Integration
• The placement stage will involve retail financial entities: banks and building societies as cash related.
• The layering and integration stages more likely to involve investment management business.
Proceeds of Crime Act 2002
Individual liability
• Assistance o 14 years in jail and/or unlimited fine
• Failure to report knowledge/suspicion or reasonable grounds o 5 years in jail and/or unlimited fine
• Tipping Off o 2 years in jail and/or unlimited fine
UK Money Laundering Regulations 2007
Institutional liability applying to financial institutions and other relevant business e.g. casinos and estate agents
Main requirements:
• Appoint Money Laundering Reporting Officers (must be a senior employee) • Identification and KYC-‐ (know normal pattern of transactions)
• Records of evidence of identity and all customer transactions (5 years from when customer ceases to do business with firm)
• Training on recognising suspicions • Internal procedures for reporting suspicions • Various levels of ‘due diligence’ – CDD, SDD, or EDD for PEPs) • Failure to comply penalty – 2 years in jail (senior directors) and/or unlimited fine
Financial Crime Systems and Control’s (SYSC)
Part of FCA Handbook – applies to authorised firms
• Requires firms to have systems and controls to manage money laundering risk • Firm should maintain effective and proportionate systems in order to manage the
money laundering risk • Allocate to a senior manager responsibility for the establishment and maintenance
of AML systems and controls • Appoint MLRO and ensure MLRO provides a report at least annually to the
governing body/senior management • Provide appropriate training for employees
‘JMLSG’ Guidance Note 2007
• The guidance notes interpret relevant money laundering/terrorist financing legislation and indicate good industry practice for implementing these requirements
• When considering whether an offence or breach has occurred the courts/FCA will take into account compliance with guidance notes
UK Bribery Act 2010
There are 4 offences under the UK Bribery Act 2010:
• Paying bribes • Receiving bribes • Bribery of foreign officials • Failure to prevent bribery (commercial organisations):
o The company must put in place controls to prevent bribery being committed by its employees, agents and external 3rd parties.
Penalties
Individuals: maximum jail sentence = 10 years
Institutions: Unlimited fines
Financial services action plan (FSAP)
EU Issues directives, regulations and decisions
FSAP was launched in 1999,
It consists of 42 measures, including 24 EU directives to be adapted into law of each member state. Main ones pertain to:
• Market abuse directive • Prospectus Directive • Transparency Directive • MiFID
The FSAP has 3 specific objectives
• To create a single EU wholesale market • To achieve open and secure retail markets – allow operators throughout Europe to
sell throughout Europe • To create state-‐of-‐the-‐art prudential rules and structures of supervision
Direct effect
Principle of direct effect (or immediate applicability) enables individuals or firms to immediately invoke a EU provision before a national or European court. E.g. if directive not fully implemented in home country
Vertical direct – Directive takes precedence over national law in matters between member state and firm/individual
Horizontal direct -‐ between firms and/or individuals this does not apply. However courts should interpret law so as to achieve the result required by the directive.
European Securities and Markets Authority (ESMA)
ESMA (much like FCA) aims to ensure integrity transparency efficiency proper functions of securities markets in Europe
Contributed to safeguarding the stability of the European Unions financial system by:
• Ensuring Integrity, Transparency, Efficiency, orderly function of securities markets, and
• Enhancing investor protection
Developed a single rule book in Europe with 2 purposes:
• Ensure consistent treatment of investors across the EU, enabling an adequate level of protection of investors through regulation and supervision
• Promote equal conditions of competition for financial service providers.
It has a range of powers to meet its objectives:
• consumer protections – can prohibit financial products that threaten stability • monitoring systematic risk of cross border financial institutions • emergency powers • on-‐site inspections • Enter into administrative arrangements with supervisory bodies, international
organisations.. • Resolution of disagreements between national authoirties,
MIFID MiFID was set up adopted by the European council in 2004 and is part of the Financial services action plan.
Passporting Passporting already existed under the old (investment services directive) but MiFid expanded the scope by including more activities.
• Allows European firms to open branches and cross border sell through out the EEA without the need for licensing in each separate jurisdictions
• Tied agents established in the EEA will be able to act on behalf of a firm instead of the firm needing to set up a branch (tied agent, similar to appointed representative and so does not require authorization)
MiFIDs all about how firms set up and operate across boarders.
(Undertaking for collective investments in transferable securities directives) UCITS -‐ All about funds and how they can be sold across borders.
MiFID investment services and activities
Investment Services and Activities (wholesale FCA activities)
• Operating an MTF • Dealing on own account • Execution on behalf of clients • Receipt and transmission of orders • Investment advice • Managing portfolios • Underwriting/placing financial instruments (process when shares issued for first
time) (not on UK wholesale list)
These are the activities you may passport throughout EEA using MiFID
Ancillary Services (non-‐core)
• Safekeeping and administration (custodianship; collateral and cash, management) • Granting credit/loans • Corporate finance advice • Foreign exchange services • Investment research and financial analysis
May not passport these under MiFID
Home and host state responsibilities
Home is the one that your authorised in.
Host is the non-‐home you are operating in.
Home state (deal with big picture of overall parent organisation) = organisational matters including:
• Compliance arrangements • Internal systems and controls • Management of conflicts of interest • Certain conflict of business rules (personal account dealing and investment
research) • Client assets (clients protected by home state client assets rules)
Host state = operational matters including
• Most COBs rules
UCTITS Directives
Undertaking for collective investment in transferrable securities
Facilitate cross border sales of open-‐ended funds throughout the EEA
UCITS III Product Directive • Expanded the range of permitted investments that UCITS funds can invest in. • As a result UTICs schemes can now invest in:
o Transferable securities o Money Market instruments o Forward contracts and financial derivatives o Deposits o Units in other collective investment schemes o Commodity derivatives are excluded
• UCITS III ‘management Directives’ increased the range of services that can be passported under the UCITS including safekeeping and fund administrations UCITS IV Directive introduced:
o a passport for management companies o a procedure for fund mergers (cross border) o Key investor information document (replaced simplified prospectus) o Master feeder structure to permit asset pooling (different fund in different
EU countries that all feed into one overall fund)
European Market Infrastructure Regulation (EMIR)
EMIR comprises standards of regulation of OTC derivatives, central counterparties and trade repositories*
Implemented through FSMA 2000 in UK.
Aims for all standardised OTC derivatives to be cleared through a central counterparty.
Tries to clear up infrastructure behind derivatives when they are traded privately.
Structure around OTC derivatives (typically traded between big banks): when done privately there is no clearing house and all the settlement and paperwork is not pushed through formal process so some of the paperwork is not necessarily been processed correctly. This creates problems with risk management.
If derivative that is trade with bank, it may have been traded several times between other banks and so may not know who created the derivate. It might turn out to be a bank that went bust and no longer exists.
EMIR imposes the following 3 new requirements:
• To clear OTC derivatives through CCP • Put in place a risk management procedure for OTC derivative transactions that are
not cleared • Report derivatives to a trade repository.
o Trade repositories is an entity (an electronic platform) that centrally collects and maintains the records of OTC derivatives. So transparency of who owns what in OTC derivative market.
Legal Concepts Legal Persons 2 forms:
• Natural person = Individual human beings • Artificial persons = Corporations, cooperatives and countries
Corporation can be limited liability. An unincorporated association (for example, a partnership) is not a separate legal entity; it does not have a legal identity separate from that of its members. Legal Persons can:
• Pay Tax • Sue and be sued • Enter into contracts • Incur debt • Own property
Power of Attorney
• Power to make decisions on behalf of another • A power of attorney is a legal document made by a person (‘the donor’) which appoints
another person (‘the attorney’ or ‘the donee’) or persons, to act for the donor in legal matters
• The power of attorney may be a general power, to allow the donee to act for the donor in all matters, or restricted to a specific act
Enduring power of Attorney
• Pre 2007, It is not possible to make any changes to an existing EPA or make a new one (still valid if created prior to 2007)
• Does not need to be registered, can be a contract but no formal registration • Deals with looking after someone’s affairs usually the elderly • Not about personal health
Lasting power of Attorney • Post 2007 • Must be registered with the Office of the Public Guardian (OPG) • 2 types of LPA
o Property and Affairs LPA – right to make decisions about business affairs and property
o Personal Welfare LPA – decisions about care of an individual Contracts A contract is a legally binding agreement between mutually consenting two parties who intend to enter into a legal relationship
Can be written or verbal. Verbal contracts are valid in most situations except in relation to property and tenancy agreements. (First 3) Required elements of a contract
• Offer and Acceptance -‐ To determine whether or not an agreement has been reached, the courts will consider whether one party has made a firm offer which the other party has accepted
• Consideration – must be some form of payment in relation to service being done • Intention – the parties intend to create legal relations. What matters is not what the
parties have in their minds, but the inferences that reasonable people would draw from their words or conduct.
Other requirements • Legality • Capacity to contract is the legal ability to enter into a contract. Cannot enter contract if
insane or under 18 Contract discharge -‐ ways in which a contract could come to the end of its life
• Breach – 1 or more [parties has not fulfilled requirements set out in the contract] • Performance – If standard of service is not completed in accordance with
agreements, so obligations not met • Agreement – both parties happy to end contract • Frustration – events have made completion of contract impossible, whereby
obligations cannot be met (e.g. painter cannot paint house if house blows away) Utmost good faith
• Requirement to disclose all relevant information is fundamental to an insurance contract. If the rule is not observed the policy can be treated by the insurer as voidable. The requirement is termed ‘utmost good faith 'or uberrimae fidei.
Agency relationship
• Agents' are engaged by 'principals' generally in order to perform tasks which the principals cannot or do not wish to perform themselves,
• Agency is a relationship which exists between two legal persons (the principal and the agent) in which the function of the agent is to form a contract between his principal and a third party
Obligations of Agents
• Performance and obedience -‐ The agent must perform his obligations, following his principal's instructions with obedience, unless to do so would involve an illegal act
• Skill and accountability • No conflict of interest • Confidentiality • Any benefit must be handed over to the principal unless he agrees that the agent may retain
it. Forms of co-‐ownership of land If land (and the property built on it) is purchased or transferred to two or more persons, these persons become either joint tenants or tenants in common
• Joint tenancy is where two or more people acquire land but no words of 'severance' are used.
o This means that the transfer does not state what share in the land each person has. The land is merely 'held by X and Y'. e.g. husband and wife
o The importance of the distinction is that if a joint tenant dies his interest lapses and the land is owned wholly by the survivor(s). He may not pass his interest on by will.
o The advantage is that only a limited number of interests can exist. o The disadvantage is the fact that survival decides ownership.
• Tenants in common have shares in the land.
o A conveyance may state that the land should go to 'P, Q and R equally' – each then owns one-‐third part of the interest. It is equitable ownership. If P subsequently dies, his or her one-‐third share goes into P’s estate: Q and R still own a one-‐third share each
o Each tenant can bequeath his interest which means that a house owned by tenants in common (A, B and C equally) will, if C dies and leaves his interest to D, E, F and G, be owned by A, B, (one-‐third part each) D, E, F and G (one-‐twelfth part each).
o While perhaps being fairer, this can be cumbersome!
Other legal terminology Insolvency
• State of being • When ones liabilities and obligations/debt exceed ones assets + cash flow. • The company will need to take action to generate cash and/or re-‐negotiate terms with its
creditors • If prolonged the company declared insolvent and trading is suspended
The purpose of insolvency law is to govern what should happen to the property of a company that is insolvent. The basic aims of company insolvency law are to:
• Protect the creditors of the company • Balance the interests of competing groups • Control or punish directors responsible for the company's financial collapse • Encourage 'rescue' operations
There are three types of corporate insolvency 'officials', depending on whether a company goes into administration, receivership or liquidation Bankruptcy –legal matter Bankruptcy occurs when an individual's financial affairs are taken over by a court. The individual’s assets are transferred into a trust which is used to repay as much debt as possible.
• If insolvency persists leads to bankruptcy • Official Receiver takes control of the debtor's assets, as receiver and manager, selling
assets as appropriate • One is protected against further creditors, who can no longer chase you • Technically, if unable to pay £750 you can be taken to court and declared bankrupt • Lasts for period of 1 year
Will and intestacy
• A will appoints the persons who will have the responsibility for dealing with the estate (the executors, also called personal representatives) and gives instructions as to how the estate should be distributed.
Conditions for a will to be valid
• The will must be in writing • The will must be signed and witnessed by two people • The person making the will must be at least 18 years of age • The person must have the mental capacity to understand the effect of making a will • The will must not have been made as a result of pressure from another person.
A witness or the spouse of a witness cannot benefit from a will. If a witness or the spouse of a witness is named as a beneficiary, the will is not made invalid, but that person will not be able to inherit under the will. Probate
• Scenarios following death of individual • Executers of estate must establish financial position/ownership of deceased estate. • The workout what tax (inheritance is owed to government only after this can any
money be given to heirs. • The executors need to obtain a Grant of Probate from the Probate Registry to show they are
entitled to administer the estate. • Then they can collect the assets of the estate. The executors are responsible for settling all
liabilities of the estate before paying out the money to the beneficiaries. Intestate Testate
• Those with legal will determining where money goes after they die Intestate
• No will, no one person can determine where the money goes. • There is a strict hierarchy of where money goes determined by government
Types of Trust A trust is an equitable obligation in which certain persons (the trustees) are bound to deal with property over which they have control (the trust property) for the benefit of certain individuals (the beneficiaries)
• The trustees may also be beneficiaries of the trust. • An individual who transfers assets into a trust during his lifetime is known as a settlor and
such trusts are known as settlements. • A settlor may also be a trustee and/or a beneficiary. • A trust may also be set up in a will and is then usually called a will trust. Where the trust is
set down in writing, this document is called the 'trust instrument'. Settlor – persons who sets up trust and whose money goes into trust Trustees – manage the trust and take responsibility for entire trust Beneficiaries – receives money from the trust Life trust and Remainder man – associated with interest in possession trust
Bare Trust (simple trust)
• Assets of trust belong to named sole beneficiary before managed by trustees. Typical example is child trust
• The beneficiary of the trust can instruct the trustee how to manage the trust property, and has the right to take actual possession of the trust property at any time.
Interest in Possession Trust
• Beneficiary, known as an 'income beneficiary' or a 'life interest', has a legal right to the income or other benefit derived from the trust property as it arises.
o For example, the life interest may have the right to occupy a house during his or her lifetime, or an income beneficiary the right to receive income from the trust property for a specified period or until death.
• On the death of the life interest/income beneficiary, the assets of the trust will be held for the benefit of the second class of beneficiary, known as the remainder man or the reversionary interest.
• Stops trust from falling into hands of beneficiary named by original beneficiary of trust.
• Life tenant is primary beneficiary, Remainder man gets what’s left and can be given remainder in will by life tenant.
Discretionary Trust
• Setup when trustees hold assets for beneficiaries’. • Trustees exercise their discretion as to which beneficiaries will be entitled to receive income
or capital from the trust. • The exact rights of each beneficiary are not determined in advance. • Original settlors may not know who benefits are going to • E.g. university trust with old alum settlor, where university decides beneficiaries or
Grandpa for kids not yet born Inheritance tax (IHT)
• For inheritance tax (IHT) purposes, there is a chargeable lifetime transfer (CLT) when a discretionary trust or an interest in possession trust is set up.
• The trust suffers an IHT principal charge once every ten years and; • An exit charge when property leaves the trust
Charitable Trust
• Set up to provide for a charitable activities of charity in question. • Charity must be registered with charity commission and trust would provide making sure
that it carried out work as specified in the charitable trust. • Charitable trusts enable the settlor to give some degree of individuality to a gift, specifying
how it may be used and, as charities, are basically free from tax.
Client Advice Investors can broadly be categorised into two types:
• Individuals or retail investors o classified by firms according to their wealth
§ Retail § High net worth § Very high net worth
• institutional invest o Such as pension funds and mutual funds (a term used in the US for collective
investment funds), hedge funds, charitable and philanthropic trusts employ professional fund managers who manage funds on a large scale.
Explain the obligations of a firm towards retail clients. Authorised firms have an obligation to abide by the regulators’ Principles for Businesses and detailed rules, as set out in the relevant regulatory Handbook (FCA or PRA), in their dealings with consumers. Over-‐arching principles include:
• Requirement to treat customers fairly • Disclosures to be made to customers.
Fiduciary Responsibility An adviser's fiduciary responsibility implies that the adviser ought not to take advantage of a client's trust in him or her. The adviser (or firm) agrees to act in the sole interests of the client, to the exclusion of his or her own interests. The adviser's fiduciary duty implies:
• Avoidance of Conflict of interest • To always act in client's best interests • Full and fair disclosure of material facts, particularly where there may be a conflict of
interest.
Principle for Businesses 6 states that a firm must pay due regard to its customers and treat them fairly It is on the actual consequences of what firms do.
• By adopting a 'principles-‐based approach' to TCF through Principle 6, the regulator puts the onus on firms to determine what is fair in each particular set of circumstances.
• The emphasis of the Authority's philosophy is not so much on the principles themselves. It is on the actual consequences of what firms do. Increasingly, the term used for the regulators’ recent approach has been outcomes-‐focused regulation.
With regard to TCF, the FCA specifically expects firms to focus on delivering the following six consumer outcomes
• Corporate Culture o consumers can be confident that they are dealing with firms where the fair
treatments of customers is central to the corporate culture
• Marketing o products and services marketed and sold in the retail market are designed to meet
the needs of identified consumer groups and are targeted accordingly • Clear information:
o consumers are provided with clear information and are kept appropriately informed before, during and after the point of sale ability of advice
• Suitability of advice: o where consumers receive advice, the advice is suitable and takes account of their
circumstance product expectations • Fair product explanations:
o consumers are provided with products that perform as firms have led them to expect, and the associated service is both of an acceptable standard and also as they have been led to expect.
• Absence of post-‐sale barriers: o consumers do not face unreasonable post-‐sale barriers imposed by firms to change
product, switch provider, submit a claim or make a complaint
Investment management process 1) Plan
a. Identify and prioritise clients’ needs and objectives b. Establish the clients circumstances (via Data collection): suitability/needs c. Analyse different options to meet identified shortcoming/needs d. Meet with the client to agree strategic asset allocation
2) Implement a. Actually invest in funds and products
3) Review a. Check allocation is in line with objectives b. Circle around and go through plan stage again to make sure nothing has changed
and everything is in line Investor needs and objectives Identify 3 key factors
• Time horizon-‐ how long investing for • Return – to match expectations • Risk tolerance
Return Broadly speaking, the requirements of clients fall into one of two categories:
• To maximise returns, eg for positive net worth individuals looking for a portfolio to match their Risk/return preferences
• To match liabilities, eg in the case of pension funds, where the aim is to match assets and liabilities or minimise any mismatch.
Explain the importance of establishing and quantifying a client’s objectives. The first stage is to determine all of the objectives that the client is looking to meet and to prioritise those objectives and to quantify them in financial terms
From a quantification viewpoint, the requirements of a client portfolio may include such factors as school/college fees, loans, dependent pensions, and a primary consideration here will be whether those liabilities are nominal or real.
• A nominal liability is one that is fixed in monetary terms irrespective of future inflation. • In contrast, a real liability is one which changes in monetary terms as we experience
inflation. Whatever the liability, assessment can involve a present value analysis of the anticipated future liabilities that the portfolio is aiming to meet.
• For example, to pay a pension of £20,000 pa for a period of 20 years when real returns (asset returns in excess of inflation) are 3% will require a fund value at retirement of almost £300,000, and so we would be looking to achieve this fund value at the retirement date.
Objectives
• Save for retirement • Provide financial protection • Repay mortgage • Insurance against disasters • Future liabilities to meet (school fees)
Other specific needs • Liquidity – time horizon may need funds in short term / which may cause short term losses if
SR depreciation in asset • Liabilities – • Tax considerations – different people, different tax needs • Regulatory requirements • Religious and ethical considerations – socially responsible investing
Risks
• Capital risk – chance of asset depreciating, but if focus solely on this may lead to bother risks
• Inflation risk-‐ risk that investment appreciation does not keep up with inflation • Interest rate risk – the risk of changes in bank base rates and the knock-‐on effect that this
may have on asset returns o To avoid capital risk may invest in low risk, low interest investments. But if IR
increase you may be locked into relatively low yielding asset. • Shortfall risk – failure to meet investment objectives. If don’t want to risk capital then you
may fail to meet objectives Diversification Consider an Investment in shares (equities). Two sorts of risk can be distinguished:
• The general market risk (or ‘systematic’ risk) of investing in shares or bonds • The specific risk (or ‘non-‐systematic’ risk) of any individual investment.
Through this process of diversification, investors are able to rid themselves of the specific risk of a stock. It is, however, impossible to remove the market risk. Different types of diversification
Diversification by asset class. • This is achieved by holding a combination of different kinds of asset within a portfolio,
possibly spread across: cash, fixed interest securities, equity investments, property-‐based investments, and other assets
Diversification within asset classes.
• An investor can diversify a portfolio by holding a variety of investments within the particular asset types that he holds. This may be achieved by holding various fixed interest securities, by holding equities in a number of different companies, by spreading investments across different industry sectors and geographical markets, and by holding a number of different properties or property-‐based investments.
Diversification by manager.
• Diversifying risk across different funds with different managers reduces the risks from a manager performing poorly. This is one of the attractions of 'manager of manager' and 'fund of fund' structures.
Timescales A client’s attitude to risk may be influenced by investment timescales.
• If the fund is a young scheme with 30 or 40 years to client retirement, then it can afford to take a reasonably aggressive attitude to capital risk and invest in what may be regarded as the riskier assets. May experience some poor years but we are also likely to experience some very good years. The effect is that risk averages out.
• If, on the other hand, the scheme is very mature and retirement is imminent, then there is insufficient time for this averaging effect to take place
Risk Tolerance Two approaches to gauging risk tolerance:
• The process will probably start with a review of the client’s current investments and risks, which will clearly illustrate the client’s historical attitude to risk. As we noted above, however, risk tolerance changes over time, so this historical information, whilst a very useful insight, is not of itself sufficient
• To augment this, the investment adviser will also undertake the fact-‐find soft facts review. They will ask the client to select a mix of, say, equities and bonds, to give an idea of the normal mix (and hence risk) that the client wishes to face. As part of the fact find process the investment adviser will illustrate various possible asset allocations and discuss in detail the potential returns and risks of each. Such targeted discussions should enable the manager to get an understanding of the clients general risk tolerance.
Investment and product selection Approach adopted depends on the investment management style adopted, ie active or passive Active investment manager An active investment manager is one who intervenes with the portfolio on a regular basis, attempting to use individual expertise in order to enhance the overall return of the fund.
• There are costs involved with all transactions, and hence limits on the number of active interventions taking place are likely to be to the advantage of the fund holder.
• AIMs do not believe that the securities markets are always efficient. They believe that securities can be misvalued. They attempt to time their purchase or sale on the basis of specific stock information, market information, economic factors etc.
• May obtain research from external sources such as investment banks, these are 'sell-‐side' analysts. They may establish an in-‐house research department, made up of ‘buy-‐side’ analysts. The benefit of generating unbiased internal research needs weighed against the costs of setting up the department.
Passive investment manager Passive investment management establishes a strategy which, once established, should guarantee the appropriate level of return for the fund.
• The simplest strategy is to 'buy and hold'. However, perhaps the most common form of passive management is indexation.
Indexation – Indexor tracker fund Fund manager selects an appropriate index quoted in the market place. Having established the index, the fund manager builds a portfolio which mimics the index, hoping that this portfolio will then perform in line with the index numbers. Likelihood is that the fund will underperform the index for a number of reasons.
• Firstly, there is the initial cost of creating the portfolio. • Secondly, and perhaps more importantly, all index funds tend to be based on a sampling
approach and consequently exhibit a degree of tracking error Hybrid Seeking to out-‐perform indexes requires a less than fully passive, and more interventionist, approach – possibly with an indexed core fund, and a Peripheral or satellite fund which is more actively managed and could involve the use of derivatives in order to establish larger trading positions than the fund itself can obtain Tilting -‐ Alternatively, the fund manager may combine both active and passive fund management methods by Tilting the fund. Tilting involves holding all (or a representative sample) of the constituents of an index (like a passive tracker fund), but with larger proportions in areas that the manager favours. Review Portfolio performance should be reviewed no less than once a year, or more regularly for short term funds, and will look to achieve a number of objectives.
• Client circumstances – we should look to determine whether any client circumstances have altered as this may result in an alteration of the client’s objectives. Any significant changes may require a modification to the investment strategy.
• Performance review– we need to monitor the performance of the portfolio against the selected benchmark to ensure that it is achieving its objectives
• Portfolio rebalancing– following on from the performance review we should consider whether there is any need to update the agreed asset allocations. Care needs to be taken here in respect of the tax liabilities that may arise from the effects of any rebalancing.
Establish client’s circumstances Data Collection/ Fact find Hard facts:
• Definite answer • Close ended questions
Soft facts: • Subjective • Open ended questions
Letter of Authority Should factor clients other investments into making investment decisions. This may require information on their other investments, so may need letter of Authority which would allow advisor to talk to other product provider to find relevant information. Advice and recommendations Having established client’s financial objectives and established their circumstances the advisor would:
• Analyse a range of options (of investments) • Prepare a report – explains options when giving recommendation • Implement the Plans
o Strategic Asset Allocation § Asset classes (shares/bonds) – based on objectives of the fund and client
• Important decision is asset class • 80-‐90% of differences in performance between investors
performance § Currencies – based on objectives of the fund and client § Asset allocation is the key driver of investment performance, not security
selection • Key to long term performance
• Review the plan, review changing circumstances and objectives and changed market conditions
Benchmarks When measuring performance of a portfolio, it is important to establish whether the performance was relatively good, or bad, and so a performance measure is required. Three main forms of comparable analysis of performance.
• Comparison to relevant stock/index, o eg a published market index
• Comparison to similar funds, o ie performance of other managers with similar objectives and constraints. PPM
consultants maintain extensive databases on statistical performance. • Comparison with a customised benchmark for funds
o that have a unique objective or constraint, eg ethical funds that cannot invest in arms/tobacco (although the standardised FTSE4Good indices meeting ethical criteria are available).
Benchmark indices To be useful in this context, however, the index must be comparable over the period being considered, and great efforts must be made to ensure that any index is both relevant and comparable. If an index is to be used as a performance yardstick against which the performance of a portfolio is to be assessed, it must provide a reasonable comparison.
Indices may be used for a variety of reasons. Historically, their main purpose was to give an indication of the mood of the market. More frequently now, they are used as a benchmark for performance assessment. To be appropriate for benchmarking purposes, an index must be indicative of the performance that could realistically have been achieved. The characteristics that are required to render an index suitable as a benchmark are therefore that it is:
• specified and unambiguous • Appropriate to the nature of the fund (eg, a UK blue chip fund may utilise the FTSE 100
Index) • Appropriate to the currency of the fund • Investable, ie composed of investments that could conceivably be held in the fund • Measurable, ie the return can be calculated on a frequent basis as required • Representative of achievable performance, ie it has an arithmetic weighted composition
(remember that the return of a portfolio is an arithmetic weighted average of the individual stock returns)
• Measures the relevant component of performance, ie total return indices for total return performance and capital value indices for capital growth
Source of wealth Investors may have acquired their wealth actively or passively. Passive wealth
• People who have acquired their wealth passively, for example, through inheritance, or those who have acquired savings gradually from their salaries
• These people are frequently less experienced with risk and do not believe that they could rebuild their wealth were they to lose it.
• They have a greater need for security and a lower tolerance for risk. Active wealth
• People who have earned their own wealth, often by risking their own capital in the process • These types of people are assumed to be more confident and familiar with risk. • They have a higher tolerance for risk. • They dislike losing control over anything, including their investments
Recommending funds Factors in fund selection process
• Past performance – no guide to the future • Charges
o Initial charges vs annual management charges • Financial stability of the provider • Stability, independence and standing of trustees, auditors and fund custodians
• Compare investment performance relative to the unbiased benchmark (ideally and unbiased benchmark such as market index comprising similar investment styles)
Where a portfolio is too small to be efficiently managed or the client’s objectives are too specialised to be handled in-‐house, the fund management may be outsourced. The decision to outsource will be determined when the overall strategy and policy are developed, towards the end of the initial investment management process.
Charges Fund charges tend to come in one of two forms
• Entry and exit charges – charges made when funds are invested or when funds are withdrawn
• Annual charges – generally charged as a percentage of the value of funds under management, though they may include a performance related element
Financial stability
• For many funds this is of little relevance, however it is key to 'with profits' funds run by life assurance companies whose performance accumulates over many years.
• 'With profits' funds aim to smooth the fund returns across the years through the application of bonuses.
• In very good years part of the fund return will be retained rather than being allocated as an annual bonus. In poorer years these retained funds can be called on to continue to provide the annual bonus.
• For this process to function requires a good degree of financial stability within the provider.
Stability, independence and standing of trustee, fund custodians and auditors One individual, the fund manager, has control of potentially quite substantial funds owned by others, the investors. As a result, there needs to be controls and checks in place to ensure that neither the fund manager nor anyone else involved in the process is either tempted or able to abuse their position. Typically, within a fund where a trustee is involved:
• The fund manager controls how and where the assets are invested but never personally has access to them
• Any trades are transacted by a broker • The funds are held in the name of the trustee who is charged with the task of ensuring that
the fund manager operates in accordance with his remit • Periodically, the fund accounts are checked by the fund auditor.
Any action taken by any one of these parties is immediately transparent to the others, so this segregation of duties should ensure the safety and security of the investor’s funds (except in the case of collusion between all of the parties involved) Written reports to clients Providing a written report to clients is an important part of the process of giving financial advice The parts of a financial planning report to a client are typically as follows
• A statement of the client's objectives • A summary of the client's income and assets and other relevant circumstances or problems
• Recommendations, including any proposals for immediate action as well as longer-‐term suggestions for the client to consider in the future
• Appendices, including any data that is best presented separately, if appropriate Asset and liability matching Young person’s
pension fund (40 years from retirement)
Mature pension fund (Close to retirement =close to pay-‐out)
Life assurance fund (pay out on death of policy holder)
General insurance fund (never know when may have to cash in)
Time Long term Short tem Long term Short tem Liability Real Real Nominal Nominal Liquidity Low High Low Very high Risk Tolerance High Low High Very Low Tax Gross fund
No tax (may include index linked gilts to protect against inflation)
Gross fund No tax (may include index linked gilts to protect against inflation)
Tax on income and gains
Tax on income and gains
Equity more bonds Equity Bond/cash/treasury bills Real = inflation linked. Liabilities goes up with inflation if real this means that investment must grow with inflation Pension funds A pension fund is an example of a liability matching fund or a return maximising fund. It represents a pool of money to be invested now, to achieve either:
• A specific return based on the employee's salary and number of years' service with the company – a defined benefit (DB)/final salary scheme,
o DB pension fund must ensure that the present value of liabilities equals the
present value of assets. Future pension liabilities is predictable by actuaries. This suggests that it is desirable to ensure the future cash flows from assets required to meet those pension payments are also reasonably predictable. This suggests that bonds should play a significant role in the portfolios of pension funds.
o DB pension funds need to consider longevity risk– the risk that liabilities to pay pensions will increase as pensioners live longer. It could be difficult to meet this risk through investment in bonds.
• A general increase in value of the contributions paid on behalf of the employee – a defined
contribution (DC)/money purchase scheme
o Personal pension plans, set up by an individual who is, perhaps, self-‐employed or is not a member of an occupational scheme, are DC pensions.
• Generally speaking, pension funds have fairly long-‐term horizons and, therefore, are
prepared to take on board a higher degree of risk, since any shortfall in the fund can be made up in future investment performance.
• This investment policy depends on the maturity of the fund. • If the fund beneficiaries are close to retirement, then it would be more appropriate to select
relatively short-‐term safe investments. Pensions -‐ Inflations Pension funds also have to keep control over the real rate of return that they earn since their liabilities, potential pension payments, expand with inflation. So, pension funds tend to invest in more speculative assets referred to as real assets (e.g. equities, property) as these offer protection against inflation. They keep small proportion of fund in fixed interest instruments, particularly index-‐linked stocks, partly because these guarantee real returns over a period of time, but also because the bonds tend to have fairly high durations and are therefore sensitive to movement in real interest rates. Equally, the pension fund will keep some assets in liquid form. Government bond markets are highly liquid market place in which to invest money gaining a moderate, risk-‐free return. Discretionary and non-‐discretionary portfolio management
• Discretionary portfolio management o the investment manager makes and implements decisions to buy and sell
investments in the portfolio without asking the client each time. • Non-‐discretionary portfolio manager
o provides advice to the client to assist the client in making their own investment decisions.
Execution-‐only customers
• Execution-‐only customers are those who are not given any advice by the firm when they make investment decisions. The only responsibility of the firm to such customers is one of 'best execution': to implement the customer's investment decisions at the best price available.
Taxation
• Income tax • Capital gains tax • Inheritance • Stamp duty • Corporation • VAT • Investor tax
Income Tax UK income Tax system PAYE
• Most of us are taxed by the (PAYE) pay as you earn system • Most tax deducted at source • Each month company deducts from salary the relevant amount of tax
If you have extra income you must fill out the Self Assessment form; to pay additional tax Payment on Account (if self employed or <80% of last years tax paid at source) National insurance is extra charge on earnings
• Payment contribute towards future benefits such as pensions Income tax fiscal years Fiscal years refers to personal income tax year – 2014/15 tax years runs from 6th April 2014 to 5th April 2015the following year. Resident and domicile Resident Statutory residence introduced in 2013 Status determined each year Residence is determined by where you live in tax year Possible to be resident in more than one place Automatically non-‐resident
• Resident in the UK for 1 or more of previous 3 years. Visit UK for fewer than 16 days • Non-‐resident in previous 3 tax years & spends fewer than 46 days during the year • Work fulltime overseas and visit UK fewer than 91 days during the tax year
• Non-‐residents liable to income tax only on income arising in the UK Automatically UK resident If non-‐residency does not apply:
• In UK for more than half the year (183 days) • Have their only home in the UK (don’t need to know conditions) • Carry out full time work in the UK
o There is a 365 day period when the taxpayer works an average of 35 hours a week in the UK.
o Within that 365 day period, no significant breaks of more than 30 days when he does not work in the UK (excluding annual leave and sick leave)
o Within that 365 day period, the taxpayer works in the UK on at least 75% of his working days.
o At least one day in the tax year when he does at least three hours work in the UK
• Residents liable to UK income tax on UK and overseas Sufficient ties test
• If you don’t pass either of the other two another series of tests related to circumstances
• Determining if you fall into residency or on residency • Don’t need to know this for exam
Domicile Domicile refers to the country you call home. A person can only have one domicile.
• Domicile: If UK domiciled you pay tax on UK and any income earned overseas • Non-‐domiciled: If non-‐dom you won’t be taxed on what earned overseas if you don’t
bring it back to UK If long term resident then may have to pay annual remittance basis charged to avoid income tax on overseas earnings not brought back to the UK:
• £30,000 if resident for at least 7 years of the last 9 years or • £50,000 if resident for at least 12 of last 14 years
Income tax computation Gross taxable income-‐ income from all sources Some income gets paid net of tax, so you must back out what actual gross amount is: May have to do this for exam using formula:
• Gross amount = net / 100-‐% tax rate Less: allowable deduction from gross income Deductions
• First £10,000 is deducted • Any money paid into pension up to £40,000 is deducted • Deeds of covenant to charity (not adhoc)
Charity Payroll giving scheme
• Under the payroll giving scheme, employees can authorise their employer to deduct charitable donations from their gross salary before calculating tax via the PAYE system.
Gift of certain shares and securities
• If an individual makes a gift of certain shares and securities to a charity, he can deduct the market value of the shares or securities at the date of the charitable gift, again giving the employee automatic tax relief at his marginal rate of tax.
Gift Aid
• All cash donations are treated as being paid net, ie after deduction of income tax at the basic rate (20%). So, a net donation of £800 is worth £1,000 (£800 × 100/80) as the charity can claim £200 (20% × £1,000) from Her Majesty’s Revenue & Customs (HMRC)
Income Tax computation Rate Taxable income Salary and interest Dividend Basic £0 to £31,865 20% 10% Higher £31,866 to £150,000 40% 32.5% Additional >£150,000 45% 37.5% Must work out in correct order:
• Earnings (Salary) and property (Non-‐savings) • Interest • Dividend
There is a starting rate of 10% for the first £2,880 of interest Income (2014/15). This only applies where savings income falls below the starting rate limit of £10,000
• Dividends falling in the basic rate tax band are taxed at 10%. As they come with a 10% deemed or ‘notional’ tax credit, no further tax is payable on dividends for basic rate taxpayers.
• Dividends falling into the higher rate tax band are taxed at 32.5%, and for additional rate taxpayers at 37.5%
If you earn over £100,000 for every 2 pounds you earn you lose 1 pound of your personal allowance. Up to 120,000 Allowances Certain loan interest payments can be deducted from total income. An individual who pays interest in a tax year is entitled to relief in that year if the loan is for one of the following purposes.
• Loan to buy plant or machinery for partnership use (interest allowed for three years)
• Loan to buy plant or machinery for employment use (interest allowed for three years)
• Loan to buy interest in unquoted employee controlled company • Loan to invest in a partnership • Loan to invest in a cooperative
Tax relief is given by deducting the interest from total income for the tax year in which the interest is paid. It is deducted from non-savings income first, then from savings income and lastly from dividend income National insurance contributions National insurance contributions (NICs)are payable by employees and their employers and also by self-employed individual Class Description 1 Payable by employees on their earnings
above the primary threshold. The amount payable depends on an individuals income
• Both employees and employers pay Class 1 NICs, in amounts that are related to the employee's earnings.
• Primary Class 1 NICs are paid by employees under the State Pension Age, on part of their earnings through a deduction from their pay.
• The employer adds their own contribution (secondary Class 1 NICs) and remits the total to HMRC
1A Payable by employers on certain types of non-‐monetary benefits (company cars, health benefit schemes)
1B Payable by employers on an employee’s earnings if they have entered into a PAYE settlement agreements (PSA)
2 Payable by self employed. If earnings are below small earnings exception then no NIC is payable
• Contributions are payable at a flat rate by self-‐employed persons, unless annual profits are below the small earnings exception limit
3 Voluntary – usually to fill gaps in contributions
4 Payable by self employed, if profits exceed a threshold (based on the level of their taxable business profits).
Taxation of trusts and beneficiaries Tax Band Non-‐dividend type income
(rent, savings, business income)
Dividend type
1st 1000 of income (standard rate band)
20% basic rate 10% dividend ordinary rate
Income over 1000 45% trust rate 37.5% (dividend trust rate) If settlor has more than one trust the standard band is split between them down to a minimum of £200 A beneficiary may be able to reclaim tax charged on income received from a trust Capital gains tax Capital gains tax (CGT) is payable by:
o UK - Domiciled residents o on the chargeable disposal o of a chargeable asset
• What you pay when you make a gain on selling asset • You must be chargeable person • A person resident or with sufficient ties to the UK
Overseas aspects
Individuals with UK domicile are liable to CGT on the disposal of assets situated anywhere in the world if, for any part of the tax year in which the disposal occurs, they are resident in the UK Chargeable disposal
• Sale of asset • Gift of asset • Received proceeds for asset
o e.g. insurance claim Chargeable asset Everything except:
• Gilts • Qualifying Corporate bonds • Principal private resident • Wasting assets (cars) • NISA • NS&I products • Gambling, lottery and premium bond pay-‐outs
Calculation of CGT Scenario A (‘000) Scenario B 1st: Total capital gains in fiscal year
37 8
Total capital losses in fiscal year
(16) (12)
=net gain or loss in current fiscal year
21 (4)
2nd: losses brought forward from previous years (net loss from previous year)
(5)
3rd: annual exceptions (11*) 4th: chargeable gain or loss 5 (4) – could bring forward to
offset subsequent gains in following year
Pay CGT at flat rate Salary and interest of 18% (28% for higher rate tax payers) Tax Planning Ways to mitigate the extent of CGT liabilities’:
• Spread ownership of assets amongst family members (although gifting you could trigger CGT)
• Phased encashment – only sell £11,000 each year to take advantage of allowance • Realise paper loss – offset against gain to reduce liability • Sell shares and repurchase similar different shares • Use ISA
IHT rates Chargeable estate
o On death value of all assets added together that’s what’s determined your charitable estate
o There’s no exception o The first 325,000 at 0% = nil banding o Everything above 325,000 taxed at 40%
Death bed bequeathal
• Potentially exempt (PET) o any gift made by individual in lifetime is potentially exempt IHT provided not
made in last 7 years. o any gifts in those 7 years will have inheritance tax imposed on them
• Gifts to trusts o Assets can be parked in a trust if trust isn’t legal property it isn’t charged to
your estate. o a transfer to a discretionary trust will attract an IHT rate of 20% immediately
• Gifts with reservation of benefit (GWR) o i.e. gift with strings attached. Still considered part of an individual estate for
IHT purposes o Can gift your house to children on condition that you get to live their rent
free, which means that it’s not a true gift. Must be paying rent for it to be seen as true gift.
Charity – reduction of 10% in IHT rate (to 36%) if deceased leaves more than 10% of their estate to charity Transfer of unused nil rate band
• An individual has a nil rate of £325,000 • If on death their chargeable estate is les than this nil rate band the excess can be
transferred t their spouse to be used on their death Property can move between spouses with no tax
• Nil rate bands can be transferred • Spouse can receive 100% of nil rate band at time of latter spouses’ death and add it
to her own nil rate band. Transfer is on percentage basis not a cash basis [This calculation will come up]
Stamp Duty Stamp Duty land tax – paid by acquirer of land and property in UK As property value rises, the stamp duty land tax increases. Should know bandings Non-‐residential property Residential Rate 0-‐150,000 0-‐ 125,000 0 150,001 – 250,000 125,001 – 250,000 1 250,001 – 500,000 250,001 – 500,000 3 Over 500,000 500,000 – 1,000,000 4 N/A 1,000,001 – 2,000,000 5 N/A Over 2,000,000 7 For non-‐residential property or land with a value up to 250,000 the SDLT rate is 1% rising to 3% for the 250,00-‐500,000 range and 4% for values grater than 500,000 Stamp duty reserve tax -‐ on purchase on assets, not property but on shares in the UK (LSE main market) ½% rate of tax ( of value of transaction) Payable in a paperless transaction by purchaser of : Shares in a UK company Shares in foreign co with a share register in the UK An option to buy shares Rights arising fro shares already owned An interest in shares Interest in shares -‐ interest in money made from selling shares Payments are made through crest (electronic settlement and registration system administered by Euroclear) For funds -‐ Unit Trusts and OEIC the fund manager pays SDRT when each individual investors units are sold Corporation tax Corporation tax is payable buy companies resident in the UK on their worldwide profits (overseas companies on their UK derived profits) -‐ don’t need to know how to calculate
• Main rate companies pay tax in 4 quarterly instalments based on an estimate of their corporate tax liability
• Other companies pay whole amount nine months and one day after end of accounting period (financial year end)
Applies to co’s with profits
of: From April 2014
Main rate >1.5m 21% Small companies <300k 20% Companies that lie between pay a sliding rate somewhere between 20% and 21% Losses can be offset against:
• This years income and gains • Last years income and gains • Future years profits from the same trade
VAT Chargeable on the supply of goods and services in the course of business Tax rates
• 0% Children books and clothes (not exempt) • 5% energy services and products • 20% most other goods
Investment services
• Commissions – exempt (not same as 0%) • Nominee services – exempt • Advisory services – standard rate, if invoiced separately (otherwise exempt) • Portfolio management – stand rate (20%)
Taxation of Investments Direct investments
• Taxed based on relevant income or capital gains tax rate • Examples include interest income form banks gilts corporate bonds, income part of
purchased life annuity, dividend income rental income • Most income is paid net of 20% (basic rate) tax. • Those paid gross include gilt interest (UK gov bonds) interest on NS&I accounts
interest paid to individual investors by listed UK comps Indirect investments
• Pension funds • ISA • REIT • CIS • VCT • EIC
• Life insurance funds Pensions Limit of how much can be contributed each year (£40,000) Tax relief at marginal rate : if under 75 Tax free lump sum (up to 25% of accumulate funds ) can be taken at retirement. Remainder used to produce an income subject to income tax Lifetime limit of £1.25m (2014/15) Amounts above this subject to tax at 25% if the excess take as income or 55% if excess taken as lump sum ISA
• Not an investment but rather a wrapper • Two types of ISA: Cash and Stocks and shares • Annual limit of how much can be invested in ISA (15000 for 14/15) can split as
desired between two types • Investments within ISA not subject to income or capital gains tax • Tax paid at source is not recoverable (10% on dividends and 20% on interest income
– on stocks and shares only (Basic rate)) Junior ISA Up to 4000 can be invested each year Can be split between stocks shares and cash REIT Real estate investment trust Company that primary business is to invest and rent out property If company turns itself into reit, rental income and capital against exempt within the fund, but requirement to distribute most rental income (90%) as dividend. ,which is taxed. Investors subject to income tax on distributions (20% basic rate tax withheld from dividend) Investors also subject to capital gains tax Taxation of investment vehicle Authorised UT/OEIC Investment Trst co Income (non-‐dividend) >Corporation tax of 20 Corporation tax (rate
depends on profitability of trust
Capital gains (gains within the fund)
NL NIL
Distributions form a collective investment fund treated as dividend distribution for income tax purposes
But, if fund holds >60 interest bearing securities, distribution is treated as interest income for income tax purposed (20%) On sale (including switching between sub-‐funds) investor subject to CGT Taxation of investment vehicle Offshore fund classification (no run in UK) Reporting status – how reports income to tax man , income taxed by income tax, gains taxed from CGT Non-‐reporting status ‘roll up funds’ retains most of its money to make more investments (buy more shares increase value of fund) -‐ gains in value isn’t about capital gains its about reinvestment – they pay income tax on any capital gains. – not great for investors as they miss out on large CG allowance Life assurance funds Fund insures lfie and promises investment return at end of period Process form qualifying life assurance policy free of income and capital gains tax so long as: Premium paid for at least 10 years Premiums paid at least annually 20% would be paid by higher rate taxpayers (25% for additional rate tax payers) on the surplus of process over premiums paid if the above is not satisfied One off or regular payments from a single premium UK life assurance policy usually leads to no income tax Max withdrawal of 5% of the original premium can be withdrawn without incurring additional income tax liability. Tax relief of venture capital trust Investor tax liability is rescued by 30% of the invested amount (max investment that attracts relief is 200,000) If shares not held for 5 years the relief is clawed back Dividend income is tax free No CGT (both within the VCT and for investor, irrespective of the holding period) Enterprise investment scheme-‐ tax reducer
• Offers tax incentives to individuals to invest in new and growing businesses • Certain unquoted shares and AIM shares • Income tax relief given at30% of investment (maximum investment is 1m) must hold
shares for 3 years • Gains on disposal are not taxed (so long as held for 3 years) • If shares sold at a loss the loss can be set against the investors income.