With the year fast drawing to a close, Herbert Smith Freehills' Financial Services Regulatory (FSR) team reflects on the year that was in FSR and what to expect in 2018 both on the global stage and closer to home.
As we forecast in last year's outlook:
- Enforcement action from global regulators in relation to market misconduct continued, focussing particularly on the manipulation of markets, especially benchmark rates.
- Regulators have sought to support innovation that benefits consumers, whilst ensuring appropriate supervision and protection, by establishing "hubs" and "sandboxes" or issuing specific FinTech related no-action letters and licences where new products can be tested, all under the watchful eye of the regulator.
- Accountability continued to spread around the world, with Hong Kong's Managers in Charge regime, Australia's Banking Executive Accountability Regime, and Singapore poised to follow suit. Following a similar approach adopted for anti-money laundering compliance earlier this year, the New York State Department of Financial Services (NYDFS) also requires annual compliance certification by senior management of the regulated entity in relation to cybersecurity risk management.
- The first year of the Trump presidency, with its "America first" mandate and the Republican Party's willingness to repeal or weaken the Dodd-Frank Act, epitomised our predicted divergence in the approach of global regulators on key issues. The inward focus of the Trump administration contrasts with efforts from other jurisdictions, particularly those in the European Union (EU) and Asia Pacific, to reach international consensus on the regulation of key issues.
- Technology and innovation in the financial services industry (FinTech and RegTech) has continued to revolutionise the way firms engage with consumers and regulators engage with firms.
So what can we expect to see in the FSR space in 2018?
The Global Outlook
Diverging or Converging? Is regulatory cooperation still in vogue?
At the end of 2017, we are ten years on from the financial crisis that ushered in an unprecedented period of international cooperation in the area of financial regulation. In 2018, we expect the dichotomy of approach to co-operation in different areas of regulation to continue.
The September 2009 G20 Summit saw world leaders set out the regulatory reform agenda which would preoccupy national and regional policymakers for close to a decade. Four critical areas for reform were cited in the Leaders' Statement: building high quality capital and mitigating pro-cyclicality; reforming compensation practices to support financial stability; improving the over-the-counter (OTC) derivatives markets; and addressing cross-border resolutions and systemically important financial institutions by end-2010.
Arguably, much progress has been made across these four areas. For example, wide-ranging reforms were introduced in the United States in the wrapper of the 2010 Dodd-Frank Act. In the EU, a number of legislative initiatives spoke to the aims of the G20, including the EU Markets Infrastructure Regulation (EMIR), a fourth iteration of capital legislation in the package of the Capital Requirements Directive and Regulation (CRD4/CRR), and the revised Markets in Financial Instruments Directive (MiFID II). And across the globe, regulators continue to build on the original reforms, notably in the area of senior executive and manager accountability.
However, there are warning signs that a decade on, the impetus that the financial crisis provided for international cooperation is starting to wane. A number of developments seem to indicate a trend towards a more national focus. For example, the current tone of the US Presidency is to move away from global collaboration; withdrawals from key Obama-era initiatives like the Trans-Pacific Partnership and the EU-US Trans-Atlantic Trade and Investment Partnership can be cited as evidence of this re-focus.
Wavering US support for international cooperation is illustrated by a November opinion piece in the Wall Street Journal by the Chairman J Christopher Giancarlo of the US Commodity and Futures Trading Commission (CFTC). In a piece titled: "An EU Plan to Invade US Markets", the Chairman sets out how European Commission proposals for financial markets regulation post the United Kingdom's (UK) exit from the EU threaten "the availability of food in American grocery stores, the cost of home heating, and mortgage interest rates."
And then there is the new FinTech gold rush which has the potential to be the biggest driver pulling countries away from global cooperation. Political aspirations to be the "hub of FinTech" are evident in many jurisdictions, where there are clearly assumptions that the economic and social rewards will be substantial.
At a local level, this presents regulators with the challenge of balancing their regulatory regimes to encourage innovation while also maintaining financial stability. A number of regulators have established so-called regulatory sandboxes alongside advice services for financial and technology firms; these enable testing of propositions (sandboxes) and/or direct engagement with FinTech developers to understand how propositions fit within the regulatory framework. The current position presents opportunities for regulatory arbitrage.
The absence of an internationally-agreed regulatory approach or framework for FinTech is a significant gap. In 2017, the Financial Stability Board (FSB) published papers outlining the financial stability risk associated with FinTech generally and artificial intelligence (AI) specifically, and the Basel Committee on Banking Supervision has published a consultation paper on FinTech principles. But the regulatory approach, at a global level, is lagging behind the FinTech industry.
Efforts to cooperate on investigations and enforcement are nothing new. Regulators continue to work together on the contentious front. However, a failed prosecution due to fumbled concurrent Financial Conduct Authority (FCA) and Department of Justice (DOJ) investigations this year highlighted the challenges of cross border, multi-agency investigations. This is particularly so where the targets include individuals, as important rights and protections come into play, that may not be available or relied upon where the only targets are corporate, which can significantly complicate cooperative efforts. With individual accountability an increasing focus in many jurisdictions, the coordination between regulators will become more difficult. However, firms subject to investigation by multiple regulators will also need to be conscious of the potential for individual due process rights and protections to vary, and must be careful not to compromise those rights and protections. Inadvertently foiling the prospects of a successful conviction is unlikely to earn cooperation credit.
"The buck stops with you!"
… is the message that governments and global regulators will be sending to financial services directors and executives as the focus on individual accountability continues throughout 2018. While regulators generally agree that good culture drives good conduct (and vice-versa), the debate continues as to whether it is possible to measure, influence and even regulate such a nebulous concept.
In Australia all eyes will be on the "BEAR", officially the "Banking Executive Accountability Regime", designed to enhance the individual accountability of senior executives in Australian banks. Central to the BEAR is a new power for the Australian Prudential Regulation Authority (APRA) to disqualify a senior executive where they have failed to comply with their accountability obligations in a sufficiently serious way. The Australian Securities and Investments Commission (ASIC) will also make increasing use of a requirement for attestations from senior managers as part of regulatory settlements. The recently announced Royal Commission into the Australian banking, superannuation and financial services sector will inevitably result in further scrutiny of senior executives, particularly their role influencing organisational culture.
In the UK, the Senior Managers and Certification Regime (SMCR), which currently applies to all banks, building societies, credit unions and large investment firms, will be extended to apply to all financial services firms, increasing the number of SMCR-regulated firms to close to 50,000. In Hong Kong, the Manager-In-Charge regime will enter its second year of operation and will continue the Securities and Futures Commission’s (SFC) regulatory focus on individual accountability for senior executives in licensed corporations, likely leading to the first enforcement action under the regime. The Hong Kong Monetary Authority (HKMA) will also introduce its own management accountability regime, applicable to dual regulated firms from April 2018.
The shift in regulatory priorities under the Trump administration in the US is unlikely to dampen the DOJ's resolve to pursue enforcement action against individual executives to combat the root causes of corporate fraud and other misconduct. The interplay with the administration's regulatory reforms will be interesting to observe, with US Attorney-General Jeff Sessions and Deputy Attorney-General Rod J. Rosenstein hinting recently that the 2015 Yates Memorandum, which set out the DOJ’s approach to prosecuting individuals for corporate wrongdoing, is currently under review, yet the DOJ recognises the importance of individual accountability and wants to promote the investigation and prosecution of individual wrongdoers.
We anticipate a similar focus on individual accountability from the US Securities and Exchange Commission (SEC). The SEC's former Chair, Mary Jo White, commented in November 2016 that "if we are to hold more senior executives responsible for misconduct that occurs at their companies, we have to think outside the box of our current laws", endorsing the UK's SMCR as a way of doing this but emphasising the SEC, would for the moment, just wait and see. Chair White's replacement, Jay Clayton, has indicated that enforcement priorities remain the same following his appointment.
In Singapore, we anticipate the Monetary Authority will announce its own formal management accountability regime in the first half of 2018.
Other key areas of regulatory focus, designed to enhance a culture of accountability within organisations, will likely include ensuring a positive "tone from the top", sound customer complaints handling, a robust whistleblowing framework, incentive structures aligned with corporate values and a transparent and cooperative engagement with regulators, including in relation to breach reporting.
Efforts to address "rolling bad apples", or individual employees with poor conduct records moving between firms and potentially engaging in further wrongdoing, will also continue. In the UK, the FCA and Prudential Regulation Authority (PRA) introduced measures in 2017 to require banks and other financial services firms hiring a person to a regulated role to seek references from that person’s prior employers (who must disclose any instances of prior misconduct or matters that go to the individual's fitness and propriety). The proposed expansion of the SMCR will significantly increase the number of individuals subject to these requirements – notably including non-executive directors of regulated firms. This bilateral approach contrasts with the centralised approach of the industry operated BrokerCheck Program in the US, administered by Financial Industry Regulatory Authority (FINRA), which has now been operating for several years. Other jurisdictions will likely consider similar regulatory referencing measures throughout 2018, designed to ensure that a person cannot distance themselves from their past wrongdoings simply by jumping ship.
No end in sight for the technology revolution
In 2018, global regulators will continue their efforts to keep pace with rapid developments in FinTech, RegTech, and cryptocurrencies. Developments and innovations that once seemed like science fiction are becoming recognised features of global financial markets.
Regulators will continue to face the challenge of supervising a wave of new entrants to the financial services sector, stimulating competition, innovation and disruption. One species of new entrant to watch is "TechFins" – existing technology, e-commerce and telecommunications companies, such as Amazon, Google, Facebook and Uber, who seek to leverage their technology and access to consumer data to compete with traditional financial services firms.
With the European Payment Services Directive II (PSD2) and the Open Banking rules coming into force in 2018, we also expect major banks to increasingly embrace the brave new world of Open Banking to give consumers control over their banking data and empower them to seek access to a broader range of innovative products and services.
Technology will continue to transform the way banks run their businesses and engage with consumers in 2018. AI-based technologies will drive increasing activity in banking services and financial markets. The "bots" will be the heart of this movement, featuring in e-payments and banking services. We predict an increased use of distributed ledger technologies by financial intermediaries in the areas of clearing, settlement and international payments.
2018 will also see further efforts to move towards globally agreed standards, which have yet to emerge. Inevitably, and by necessity, analogue regulation will catch-up with the increasingly digital way of life. In the interim, national and regional regulators face the headwinds of economic circumstances and political aspirations to both facilitate innovation while meeting the objectives of facilitating competition, maintaining safety and soundness across financial systems, and protecting consumers.
Regulators will also benefit from the "fruits" of technological development and we expect to see increasing use of RegTech in areas such as market surveillance and digital forensics in the context of investigations and enforcement actions.
In 2017, we saw a global boom in cryptocurrency markets, with the price of a single Bitcoin reaching an all-time high of over US$12,000. While Bitcoin is currently the dominant and best known cryptocurrency, it is only one of several hundred cryptocurrencies which together have a combined global market capitalisation of more than US$375 billion. The "initial coin offering" (ICO) has also emerged as a lucrative form of crowdfunding using cryptocurrencies. ICOs involve the sale and distribution of "coins" or "tokens" based on blockchain or other distributed ledger technologies.
However, cryptocurrencies and ICOs continue to raise significant regulatory risks and uncertainty, including:
- uncertainty as to the application of existing securities laws due to the unclear legal character of coins and tokens;
- difficulties in regulatory oversight due to the decentralised nature of cryptocurrencies, which generally have no central authority, are easily transferable online between jurisdictions, do not use large financial institutions as intermediaries, and cannot be "frozen" by local law enforcement officials; and
- the risk of criminal activity, including fraud, scams and money laundering/terrorism financing, due to the lack of transparency around the identity and operations of ICO promoters and cryptocurrency exchanges and the limited legal protections available to consumers.
Unsurprisingly, ICOs have increasingly attracted the attention and scrutiny of global securities regulators. In Australia, ASIC has issued guidance indicating that corporations legislation could apply to an ICO depending on the nature of the ICO and the rights attaching to any coins or tokens issued. Similarly, in July this year, the SEC issued guidance on ICOs, noting that coins or tokens may be securities and therefore subject to federal securities laws. In September, the SEC brought charges under the anti-fraud and registration provisions against the promoters of two ICOs marketed as backed by investments in real estate and diamonds, describing the coins as unregistered securities. Other regulators have also expressed concerns about ICOs, with the FCA labelling ICOs "high-risk speculative investments" and various Chinese regulators announcing the prohibition of all ICOs in Q3 2017.
In 2018, we expect to see global regulators continue to grapple with the risks and uncertainties associated with the as yet unregulated cryptocurrency markets and for this to be fertile ground for new regulation. It is also expected that the new market entrants will be in a position to propose transaction structures and regulatory exemptions that will streamline these innovative products with proper protection for investors.
LIBOR-ate the benchmarks
2018 will see the continuing trend away from traditional benchmark rates in the aftermath of the manipulation scandals which surfaced in 2012. The regulatory response to those scandals has been more detailed and stringent regulation together with a move away from previously popular benchmarks towards benchmarks grounded in actual transactions.
Recent reforms of the London Interbank Offered Rate (LIBOR) brought the rate closer to actual transactions and assuaged concerns about its integrity, but it was too little too late – the FCA has agreed with LIBOR panel banks that LIBOR will be used until the end of 2021, after which market participants will transition to an as yet unknown alternative. This appears to be, in part, a recognition of LIBOR's shortcomings. While the LIBOR definition seeks to tie the submitted rate more closely to transactions, a degree of "expert judgment" is still used by submitters at participating banks as there are often not enough transactions available in the unsecured wholesale lending market that LIBOR seeks to measure – indeed, some forms of LIBOR appear to show a rate without a liquid market underlying it. In one example given by the FCA, a currency/tenor combination had only 15 transactions of potentially qualifying size in the whole of 2016.
The operational challenges presented by the proposed transition should not be underestimated: trillions of financial contracts depend on these rates, and the expected value of what are currently LIBOR based contracts could change significantly. Regulators, firms and a range of industry bodies are giving careful consideration to the fall-back position for legacy contracts that still exist in 2021 referencing LIBOR, the alternative rates that might be adopted for new transactions, and the likely effect on lenders, pension funds and corporates.
The preference for LIBOR replacements seems to be rates linked to actual transactions – such as the Sterling Overnight Index Average, selected as the UK's Risk Free Rate Working Group preferred rate, although this would not currently provide a forward looking term rate which provides certainty of cash flow for borrowers. In the US, the Alternative Reference Rates Committee determined in June 2017 that it would use a Treasuries repo rate, reflecting the cost of borrowing cash secured against US government debt.
The EU will kick off the New Year with the entry into force of the EU Benchmark Regulation, on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds. This will replace the existing UK regulation for benchmarks, and will include:
- a requirement that authorised firms use only benchmarks provided by an authorised administrator in the EU or a third country administrator/benchmark that has been recognised/endorsed by the EU;
- a requirement that benchmark administrators be authorised firms;
- categorisation of benchmarks into critical, significant and non-significant benchmarks with increased governance and control requirements for critical benchmarks (the Euro OverNight Index Average (EONIA) and the Euro Interbank Offered Rate (EURIBOR) have been designated as critical benchmarks, and the FCA expects LIBOR to be designated in the same way in due course); and
- increased governance and control requirements for benchmark contributors.
In Hong Kong, the Financial Industry Regulatory Authority has reviewed the need for reform for major interest and foreign exchange benchmarks in light of international recommendations. Reforms of foreign exchange benchmarks have been completed and further work is ongoing, together with the industry, on interest rate benchmarks.
In Australia, a proposed government regulatory regime is expected to commence in 2018 and is to be consistent with the International Organisation of Securities Commission (IOSCO) principles. Under this regime, which is currently before parliament, ASIC would have power to designate significant financial benchmarks and administer a licensing regime (including the power to impose conditions on, cancel or suspend a licence).
In the US, while the CFTC has been at the forefront of investigating and imposing significant penalties on benchmark manipulation in recent years, it has not proposed a similar government-sponsored supervisory regime.