FSA meets fund managers to discuss market timing concerns

United Kingdom

Last Wednesday, the FSA met with senior managers of 25 major OEIC and Unit Trust mangers and expressed concerns that UK fund managers may have been managing funds in a manner that has enabled market professionals to profit at the expense of buy and hold retail customers, thus resulting in detriment to consumers. The FSA cited late trading and market timing as examples of activities which might be included. It has asked fund managers to provide it with specific information on these types of activities by 24 December 2003.

The issue

Market timing is more generally referred to in the UK as arbitrage and is not a precisely defined term, but generally refers to a trading strategy involving frequent purchases and sales of units or shares in open-ended funds with the intention of anticipating changes in market prices. Such frequent trading, whilst not in itself illegal, is viewed as poor practice, as it causes dilution in the fund, by compelling the fund manager to retain a higher level of liquidity than is desirable, or to buy and sell holdings more frequently than may be desirable, thereby incurring costs, such as broker commissions and market spreads.

Market timing or arbitrage can occur where an investor is aware that the security prices upon which a fund's dealing price is calculated do not take account of the most recently available market information. An example would be when a fund is priced using closing prices from a market which closed for trading materially prior to the fund valuation point (for example, a UK unit trust which is invested into US stocks, valuing at 9 a.m. UK time and using US market closing prices, from 9.30 p.m. the previous day), during which time, a significant event has occurred that arbitrageurs believe will impact prices when the market reopens.

Fund managers would be in breach of the FSA's rules and principles if they actively encourage market timing activity, or if they knowingly or negligently allow the funds they manage to be used in this way. The FSA has stated that it would be very concerned indeed if it were to find that fund managers were providing market professionals with advantageous pricing to facilitate market timing, or with information that has enabled them to assess how price movements have affected the securities in fund portfolios.

Late Trading involves collusion between fund managers and market professionals to circumvent the fund's internal procedures on the timing of trades and would be viewed by the FSA as a clear breach of its Collective Investment Schemes rules. There are safeguards against late trading in the UK, but the FSA has indicated that it wishes to investigate whether late trading is a feature of the UK market.

Systems and controls are a subsidiary concern of the FSA in its investigation of these issues. The FSA has said that even where fund managers do not actively facilitate market timing activity, they could nevertheless still be in breach of the FSA's principles if such activity is being carried on elsewhere in their firm, but their systems and controls are not adequate to alert them to it. The FSA will follow up any case where it finds a firm's arrangements to be deficient.

What the FSA requires

The FSA has asked fund managers to provide it with specific information on these issues. It is expecting CEOs to be personally involved in, and to take direct responsibility for, ensuring that there is a proper review of past trading practices in their firm. CEOs are to be required to explain to the FSA precisely what reviews have been carried out in their firms, what was found and what remedial action was taken. Non-executive directors must be kept fully informed of the progress of the review and asked to participate in ensuring its adequacy and the firm's response.

What should firms do?

  • The FSA expects to be informed if there is any reason to believe that anyone in the firm has been involved in market timing activity or late trading.
  • Firms should also inform the FSA if reviews showed up any weaknesses in systems and controls.
  • The FSA further requires to be informed if a firm has been approached by market professionals, suggesting that the firm assist them in market timing activities. In this case, the FSA would also like the name(s) of the counterparties involved.
  • The FSA requires the industry as a whole to come up with systems and alternative revaluation arrangements that reduce - or eliminate – the scope for these types of activity.

Is there any risk of enforcement action being taken?

The simple answer is yes. The FSA has said that any evidence of late trading, market timing or shortcomings in systems and controls could result in enforcement action being taken.

If you believe that your firm has been involved in late trading or market timing activity, or there have been deficiencies in your systems and controls, how you present the information to the FSA will be determinative. Information should be presented in the proper context, with full details of all steps taken to mitigate any risks. Where problems have been discovered as part of the review required by the FSA, full details should be given of any remedial action taken, including any steps taken to avoid financial loss to customers.

For further information, or to discuss how we could help you, please contact Charlotte Hill at [email protected]