3. 3. Permissions required for Digital Investment Management
This section of the Guidance outlines the permissions that may be required to conduct digital investment management in or from ADGM. It also describes the relief available to Digital Investment Managers whose business models meet conditions that serve to reduce the risks they pose.
Financial Services Permissions requirements
Digital Investment Managers operating in ADGM will require an FSP to undertake any Regulated Activity as part of their business model. The FSRA has observed that the core services provided by a Digital Investment Manager typically involve the provision of one or more of the following Regulated Activities.a. Advising on Investments or Credit: for example, recommending that a client invest in a portfolio of Financial Instruments, or recommending that a client buy or sell particular Financial Instruments in order to rebalance the client’s portfolio.b. Arranging Deals in Investments: for example, after recommending that a client invest in a portfolio of Financial Instruments and, with the consent of the client, passing instructions to a broker to buy those Financial Instruments on the client’s behalf.c. Managing Assets: for example, exercising discretion to rebalance a client’s portfolio by passing instructions to a broker to either buy or sell particular Financial Instruments on the client’s behalf.
In order to facilitate the investment process, a Digital Investment Manager may choose to hold Client Assets directly (i.e. in a Client Account in the Digital Investment Manager’s name that is held with a Third Party Agent as banker or custodian), or may instead arrange for its clients to establish a direct relationship with a regulated Custodian to hold Client Assets. In the latter case, the Digital Investment Manager may require an FSP to carry on the Regulated Activity of Arranging Custody, unless it meets the exclusion criteria2 set out in Paragraph 47 of Schedule 1 of FSMR.
2 The exclusion criteria sets out that a person (the “introducer”) does not Arrange Custody by introducing a person to another person ("the custodian") who is authorised by the FSRA or a Non-Abu Dhabi Global Market Regulator to carry on the activity of Providing Custody, if the introducer is not connected with the custodian. An introducer is considered to be connected to a custodian if (a) the custodian is a member of the same Group as the introducer or (b) the introducer is remunerated by the custodian or a member of the custodian's Group for making the introduction.
A Digital Investment Manager holding an FSP to carry on the Regulated Activity of Managing Assets will not require separate permissions for Advising on Investments or Credit and/or Arranging Deals in Investments if it only undertakes those Regulated Activities incidentally, as part of its investment management activities.3
3 If the Digital Investment Manager operates advisory accounts or arranges deals in investments that are separate from, or not incidental to, its discretionary investment management activities, it will have to apply for permission to carry on one or both of the Regulated Activities of Arranging Deals in Investments and/or Advising on Investments or Credit as applicable.
Prudential capital requirements
Each of the Regulated Activities mentioned in paragraphs 3.2 and 3.3 has associated regulatory obligations, including in respect of prudential capital requirements.Table 1: Prudential capital requirements4
Prudential Category Maximum of: Base Capital Expenditure Based Capital Minimum Requirement Managing Assets 3C $250,000 •Holding Client Assets: 18/52nds of Annual Audited Expenditure •Otherwise: 13/52nds of Annual Audited Expenditure Advising on Investments or Credit Arranging Deals in Investments Arranging Custody 4 $10,000 •6/52nds of Annual Audited Expenditure
4 Note that the applicable Capital Requirement is the higher of the Base Capital Requirement and Expenditure Based Capital Minimum. Where a Digital Investment Manager undertakes a combination of activities, the highest prudential category will apply.
Relief For Digital Investment Managers Utilising Regulatory Technology
Relief for Digital Investment Managers engaged in Managing Assets
Paragraphs 3.7 to 3.13 of this Guidance outline the prudential capital relief available to Digital Investment Managers that undertake the Regulated Activity of Managing Assets, subject to meeting all of the conditions detailed below.
Where any Digital Investment Manager makes use of technology that enables the FSRA to better supervise the Manager’s activities, manage business risks or achieve better regulatory outcomes, the FSRA may also consider modifying or waiving prudential and other regulatory requirements. Applications for modifications or waivers will be assessed on a case-by-case basis and granted at the FSRA’s discretion.
3.7The higher prudential capital requirement for Digital Investment Managers engaged in Managing Assets, compared with those that are only engaged in Advising on Investments or Credit and/or Arranging Deals in Investments, is primarily a function of:a. the risks inherent in an investment process whereby an investment manager has discretion to make investment decisions for the client without first obtaining the client’s approval; andb. the increased operational complexity involved in holding Client Assets as part of the discretionary asset management process.
The FSRA recognises that many Digital Investment Managers engaged in Managing Assets only exercise discretion in the investment management process when ‘rebalancing’ a client’s portfolio, in order to ensure that the asset allocation remains suitable in light of the client’s investment objectives and parameters.5 This approach is typical of Digital Investment Managers that apply passive investment strategies that track the performance of an index or benchmark by investing in products such as exchange traded funds (“ETFs”) and index trackers.
5 Typically, the initial decision to invest in a portfolio of Financial Instruments is taken with the client’s consent. Thereafter, the decision to rebalance a client’s portfolio by buying or selling Financial Instruments is taken by the Digital Investment Manager without first obtaining the client’s consent for the specific transaction to go ahead.
These products are generally well-diversified, causing them to be less volatile relative to Financial Instruments that are commonly traded in active investment strategies (such as shares in a particular company, for example). A consequence of lower volatility is that the Digital Investment Manager has less cause for trading, including to adjust for market movements that would cause the portfolio to become unbalanced relative to the allocation agreed with the client.6 Digital Investment Managers that operate in this way present less risk than traditional investment managers who may have greater discretion to buy and sell a broader set of Financial Instruments for their clients on a more frequent basis as part of an active investment strategy.
6 That is, the initial decision to invest in a portfolio of Financial Instruments is not discretionary but subject to the client’s agreement.
Similarly, some Digital Investment Managers engaged in Managing Assets do not hold Client Assets, arranging instead for Client Assets to be held by an independent third-party financial institution under an agreement between the financial institution and the client. Digital Investment Managers who adopt this approach are less complex from an operational perspective. They take less time to wind down in the event of insolvency because Client Assets are easily identifiable, being held by a business that remains a going concern, has a direct relationship with the investor-client, and are protected from the claims of the Digital Investment Manager’s creditors. As such, less capital needs to be set aside to ensure that an insolvency practitioner can effect an orderly wind down of the Digital Investment Manager’s business.
3.11In light of these considerations, the FSRA will lower the prudential capital requirements applicable to Digital Investment Managers that are engaged in Managing Assets with a business model that meets all of the following conditions.a. Financial Instruments: the product offering is limited to passive investment products such as ETFs and index trackers. The Digital Investment Manager must satisfy the FSRA that the passive investment products are sufficiently liquid, non-complex and diversified.b. Discretionary Management: the discretionary investment management activities are limited to portfolio rebalancing. Such rebalancing must not involve the purchase of new investment products that were not included in the portfolio agreed to by the client.c. Client Assets: the Digital Investment Manager does not hold Client Assets. Instead, clients have a direct contractual relationship with an independent third-party financial institution to hold Client Assets.
Details of the lowered prudential capital requirements for Digital Investment Managers who meet the criteria in Paragraph 3.11 are set out in the table below.
Prudential Category Base Capital Requirement Expenditure Based Capital Minimum Managing Assets
3C $10,000 •6/52 of Annual Audited Expenditure
The lowered prudential capital requirements will be made available via a class modification. Digital Investment Managers wishing to avail of the class modification are required to approach and satisfy the FSRA that each of the conditions in paragraph 3.11 are met.