The Bank of England’s consultation on Fundamental Rules for financial market infrastructures – a new basis of supervision?

The Bank of England (the “Bank”) has published a Consultation Paper under which it proposes to introduce a set of Fundamental Rules for financial market infrastructures (“FMIs”) incorporated in the UK – such as central counterparties (“CCPs”) and central securities depositories (“CSDs”).  Similar requirements are also being proposed for recognised payment service operators (“RPSOs”) and specified service providers (“SSPs”).

Background

The Prudential Regulation Authority (“PRA”), which is part of the Bank, currently applies a set of fundamental rules to the authorised firms that it regulates – specifically banks, insurance companies and systemically-important investment firms. 

These fundamental rules act as a foundation for the regulation of such firms, and apply in addition to the detailed rules that the PRA makes under its statutory rule-making powers or that have been assimilated from EU law.  The PRA has the power to take enforcement action against PRA-authorised firms for breaches of those rules, even where the firm in question has not breached any of the more detailed requirements of the PRA rulebook.  The FCA similarly requires the firms it authorises to comply with similar “Principles for Business”.

The current position in relation to FMIs is more complicated.  FMIs are regulated by the Bank rather than the PRA, but this is done under a patchwork of legislation which includes the Banking Act 2009, the Bank of England Act 1998, the Financial Services and Markets Act 2000, binding Codes of Practice for payments systems and specified service providers, and EU law that was onshored into UK law as part of Brexit.  Under the FMI arrangements, there is currently no single Rulebook or set of fundamental rules like those that apply to PRA-authorised firms.

The proposal

The Bank is proposing that FMIs will become subject to their own set of fundamental rules (referred to below as the “Fundamental Rules”).

For CCPs and CSDs, the Fundamental Rules will take the form of rules made under Financial Services and Markets Act 2000.  For RPSOs and SSPs, they will take the form of a binding Code of Practice, pursuant to the powers given to the Bank under Part 5 of Banking Act 2009.  

The Bank says that it also intends to apply the Fundamental Rules to systemic stablecoins, alongside the existing payments Codes of Practice, in due course.

In its Consultation Paper, the Bank noted the critical role that FMIs play in managing risk and allowing payments to be made safely.  The Fundamental Rules are intended to:

• clearly set the outcomes that the Bank expects from FMIs, including in relation to their financial and operational resilience, and the actions they should take to understand and manage the risks they may pose to the broader financial system; and
• increase the transparency and effectiveness of the Bank’s role in supervising FMIs, supporting UK financial stability and the UK economy more broadly.

The Bank is also consulting on a draft Supervisory Statement on the Fundamental Rules, which is set out in the Appendix to the Consultation Paper.

The Fundamental Rules

The Fundamental Rules that are proposed are as follows:

The Bank’s draft Supervisory Statement contains further information about the Bank’s approach towards each of the Fundamental Rules.

Most of the Fundamental Rules for FMIs have a direct equivalent in the fundamental rules that the PRA applies to the firms it regulates.^[1]  There may be learnings for FMIs in how the PRA approaches the same principles when supervising banks and insurers – but FMIs should bear in mind that the principles behind those rules might apply differently in the case of an FMI, given the nature of its business and its potential to have an impact on the wider financial system. 

Two of the Fundamental Rules for FMIS are new and are not included in the PRA equivalent – namely:

• Fundamental Rule 9 (FR9): An FMI must maintain sufficient operational resilience

  The Bank and the PRA already place a high level of emphasis on the need for the firms they regulate to be operationally resilient.^[2] By placing operational resilience within the Fundamental Rules, the Bank is emphasising the importance it places on FMIs ensuring their own operational resilience, in order to maintain the financial stability of the system. 

  The Bank notes that the increased complexity and interconnectedness within the financial system makes it even more critical that FMIs understand, test and address possible risks to their operations which may have an impact on financial stability. 

  The draft Supervisory Statement says that “sufficiency” of resilience should be interpreted to mean that FMIs are able to deal with an extreme but plausible event, where firms not only can withstand such a scenario but can get back up and running in line with impact tolerances agreed in advance with their supervisors.

• Fundamental Rule 10 (FR10):An FMI must identify, assess, and manage the risks that its operations could pose to the stability of the financial system.

  The inclusion of this requirement in the Fundamental Rules is likely to reflect the Bank’s concern that, by their nature, FMIs are particularly likely to pose risks to the stability of the broader financial system if they themselves fail.  As a result, they will be subject to an additional requirement under which they will have to know and understand their place with the financial system and be able to identify and deal with the risks that their operations could pose to the stability of that system.

  FR10 may require FMIs to undertake additional actions.  In particular, FMIs (and their Boards) may need to examine their position within a chain of relationships and understand how risks that affect them can affect the wider chain.  They will also need to understand and explain how those risks are to be managed and mitigated. 

  The draft Supervisory Statement notes that, in recognition of the international importance of the services that UK CCPs and UK CSDs provide, the Financial Services and Markets Act 2023 also requires the Bank also to have regard to financial stability in countries where UK CCPs and UK CSDs provide services.  As such, FMIs should consider the nature of their business as it relates to cross-border activities when interpreting this rule and engaging with their supervisors.

(Please note that, even though the PRA does not include these two specific principles in its own fundamental rules, PRA-authorised firms may be subject to similar requirements under the PRA rules or other regulatory requirements.)

[1] Fundamental Rules 1 to 7 are word-for-word the same as the equivalent wording in the PRA’s fundamental rules, except that:

• Fundamental Rule 4 refers to an FMI having to have “sufficient” resources, whereas the PRA equivalent refers to a PRA-authorised person having to have “adequate” resources.  The Consultation Paper says that the term “sufficient” was chosen because it aligns with the Principles for Financial Market Infrastructures (PFMI) developed by the Committee on Payments and Market Infrastructures (CPMI).
• Fundamental Rule 8 is very similar to its PRA equivalent, except that the FMI version refers not only to the resolution of the entity but also to it possibly going into administration.  This is likely to reflect the fact that the regime for payments and settlement systems is a special administration regime that focusses on facilitating the continuity of critical services.

[2] The Bank notes that Fundamental Rule 9 rule is consistent with and complements the PFMI in respect of operational risk, relevant articles of UK EMIR and UK CSDR, and also the Bank’s supervisory statements on Operational Resilience for CCPs and CSDs, and Code of Practice for Payments Systems and Specified Service Providers

Territorial scope

The Fundamental Rules will only apply to FMIs that are incorporated in the UK.  However, where the Fundamental Rules do apply, they apply extraterritorially to all the FMI’s activities – whether in the UK or elsewhere.

The Fundamental Rules do not apply to third-country CSDs and “systemic third-country CCPs”, because the Bank does not currently have power to impose rules on non UK FMIs.  However, the Bank says that if HM Treasury makes regulations in future allowing for the application of rules to third-country CSDs, or sets criteria of general application in respect of a “systemic third-country CCP”, the Bank may look to apply the Fundamental Rules to these entities as well.

Although non-UK RPSOs and SSPs currently fall outside of the scope of these proposals, the Bank says that it may also look to extend the Fundamental Rules to these types of entity in due course.

Application to groups containing in-scope CCPs and CSDs*

Fundamental Rules 3, 4, 5, 6, 8, 9, 10 and (in so far as it relates to disclosing to the Bank) 7 will apply to activities within a CCP/CSD’s broader group activities, insofar as the activities of a group company affect the ability of the CCP/CSD to comply with the Fundamental Rules.  An example of this is Fundamental Rule 4 (financial resources):  the activities of an FMI’s broader group could have a material impact on the FMI’s ability to ensure that it has sufficient financial resources.

Fundamental Rules 1 and 2 do not apply to the wider group of a CCP/CSD, as the ability for a CCP/CSD to behave with integrity, due skill care and diligence is internal to the CCP or CSD itself.

Application to unregulated activities*

The Fundamental Rules will apply to CCPs and CSDs across all regulated and unregulated activities.  If a CCP/CSD had an unregulated line of business that could impair the ability of the CCP/CSD to comply with the Fundamental Rules, those activities would be within the scope of the Bank’s powers.  In practice, however, CCPs and CSDs tend to engage in unregulated activities in a limited way and those activities are less likely to affect the ability of the CCP or CSD to comply with the Fundamental Rules.

(* There are no equivalents of either of these rules in the case of RPSOs and SSPs.  This is because, in relation to RPSOs and SSPs, the Bank supervises the payment system rather than the entity.  The Bank considers that there is less cope for unregulated activities and/or the activities of the wider group to have an adverse impact on the system itself.)

Practical implications for FMIs

The introduction of the Fundamental Rules could have a number of practical implications for FMIs, including the following:

• The Fundamental Rules will introduce a new lens through which the FMI will have to assess and comply with its regulatory obligations.  For example:
  • FMIs will need to be able to justify their decision making by reference to these broad principles, as well as the specific rule requirements that are relevant in the circumstances.  FMIs may therefore consider reviewing their governance arrangements through the lens of the Fundamental Rules, and documenting their decision-making processes accordingly.
  • If FMIs have in the past relied upon a technical interpretation of a rule rather than considering whether they are following the spirit of the Bank’s requirements, they may no longer be able to justify that position if their approach conflicts with one of the Fundamental Rules.
• The Fundamental Rules will be central to the FMI's supervisory relationship – and, as has been seen in the context of PRA authorised firms, breaches of Fundamental Rules can lead to enforcement action and significant fines.
• FMIs may need to review their firm governance and culture to ensure that the standards of expected behaviour are understood.
• FMIs will need to update their internal systems and procedures to ensure that respect for the Fundamental Rules forms a central part of the FMI’s decision making and governance.
• FMIs will need to be able to explain to the Bank how they are ensuring compliance with the Fundamental Rules across all of their operations.  It is likely that FMIs will need to undertake an exercise to analyse the new Fundamental Rules and determine what evidence they would need in order to be able to demonstrate compliance.  As an initial step this may, for example, take the form of a detailed mapping exercise, with a documented outcome tying together all of the key compliance arrangements and controls relating to each Fundamental Rule.  Supervisors will treat compliance with Fundamental Rules as relevant to every engagement and firms may want to seek clarifications from their supervisors if they are unclear about what will be expected of them.
• FMIs are likely to have to engage in a programme of training for senior management and other staff to ensure that they understand the Fundamental Rules and the implications of those rules for the FMI’s business.  For example, what exactly does acting with integrity mean in different contexts?  How does an FMI Board ensure that risk management is effectively scrutinised?  Whose responsibility is it to ensure and cultivate compliance with different Fundamental Rules?  Staff are also likely to need to understand how the Fundamental Rules apply to them at an individual level – for example, whether Fundamental Rule 7 results in an expectation that they personally notify the Bank of an issue that they considered notifiable, or whether that notification should be made by the FMI at an entity level.
• For UK FMIs who are part of a global group, the UK FMI will need to consider whether the activities of other members of the group could have any adverse impact on its ability to comply with the Fundamental Rules.  Where there is a risk that that could happen, the UK FMI will need to be able to show what steps it has taken to mitigate any such risk.
• FMIs who form part of a vertically integrated group may find that a contrast is created between the CCP/CSD part of their business, which will be subject to the Fundamental Rules, and the other parts of their business who would not.  FMIs may find it difficult in practice to apply the Fundamental Rules to only part of their group business without those Fundamental Rules affecting the non-CCP/CSD parts as well.
• UK FMIs who provide services to customers overseas will need to consider whether their activities in those other territories are in compliance with the Fundamental Rules, in addition to any regulatory requirements in the territory in question.
• The introduction of the Fundamental Rules could affect the scope of an external audit that the FMI commissions out in relation to its compliance with regulatory requirements.

Next steps

The deadline for responses to the Consultation is 19 February 2025.  After this, we expect that the Bank will issue a Policy Statement to set out its final rules.

The Bank has said that it expects there will be a six-month implementation period between the publication of the final rules and the Fundamental Rules actually applying to the FMIs.