2013 may go down in history as the year of regulatory obfuscation. Regulation became ever more opaque and confusing. Regulators usurped many of the core roles of management in their battle to ensure that financial sector losses never again hit the public purse. Managers often appeared to focus less on managing their business but more on overseeing compliance and risk against a background of a Pandora’s Box of overpowering regulations and guidelines. Investors basked in a world of unlimited protection from the iniquities of the supply side, the complexity of their preferred products and the banishment of caveat emptor in any material sense.
The proverbial man from Mars looking down at the financial sector has to be confused. Are the intended consequences of this new environment the elimination of anything more complex than a time deposit? Can the supply side accept unlimited and extra judicial penalties resulting from the apparent new infallibility of regulatory opinion? At what height does the mountain of regulation become unstable? Surely it is already incomprehensible in its intentional ambiguity and accumulating detail.
The advantage of being “the voice of experience” is that I can remember the good old days! Those were the days when a quiet word from the Central Bank about obeying the spirit as well as the letter of their high level take on regulation sufficed to kill a delinquent idea. It was an era when “my word is my bond” had meaning and was not subject to a series of escape clauses. But most importantly, it was an era of light touch regulation, firm guidance and financial sector compliance. And nobody thought of going to a meeting with a lawyer, risk and compliance officer. But it was a totally different world from the one we live in today!
What has gone wrong with regulation? In reality there are three major problems we face in today’s world. There is the sheer quantum of rules, regulation and laws. There is the ambiguity of much of the wording that can make or break an organization. And there is the invasive aspect of the extraterritoriality of legislation in the global financial market place. This is not necessarily the fault of regulators. Part, or even much of the blame, has to be attributed to the material increase in product complexity and the globalization of the investment business over the last two decades.
The reality is that it is almost impossible, even for the best staffed firm with the most astute and dedicated legal and compliance divisions, to come to grips with the mountain of legislation in flow. I was recently involved in a review of the relevant regulations for an EU-based global custodian. They included AIFMD, AML (in many guises), Basel III, CAD, CSDR, Dodd-Frank, EMIR, FATCA, MiFID II, Securities Law regulations, Solvency II and UCITS V. We also had to struggle with the impacts of antipathy to dark pools, encouragement of Swap Execution Facilities, T2S, CCP memberships and Trade Repositories, shifting sands on short selling rules or FTT, and a raft of regulation inspired changes to client and supplier documentation. And we had to note that key regulations in both the U.S. and Europe still had to be enacted; in fact, under half of the detailed rules expected in the U.S. and Europe have been finalized! It is no wonder that J.P. Morgan announced recently that they had recruited an added 3,000 compliance staff worldwide. And their action is being replicated in banks all over the world. If only I had taken that law degree!
Compliance, audit and risk are not usually seen as the most business-friendly stakeholders in banking organizations. Their role is not to generate business but to protect the bank from loss. And the trouble with regulation and laws is that there is often no right or wrong. There is just a substantial area of uncertainty. I can remember taking a legal opinion on a matter, and for a substantial fee, learned counsel opined that “there was more to be said in favor of the bank’s opinion than against.” That was a great comfort!
The problems, though, are multiplying. Latent risks can be found in AIFMD for the poor manager, depository or administrator. After all, what constitutes the “high standard” that has to be applied by the manager in investment selection, or what are “reasonable steps” that should be taken to obtain the best results in respect of executing portfolio management decisions? What are the “reasonable steps” that need to be taken to avoid conflicts of interest? We know several as they are listed but, quite rightly, the list is stated to be non-exhaustive. That definitely allows for post-event attribution of blame irrespective of the impossibility or not to foresee the relevant event. The “rigorous and comprehensive due diligence” expected of a depository is unlikely to be much of a barrier to loss attribution as it is quite simple to deem the due diligence was not up to that standard, which is after all not defined. It appears clear that CSD risk would normally fall to a fund, although transfer agency risk (which is surely much greater in some of more exotic hedge fund domiciles) remains firmly with the depository. And we must not forget the role of the prime broker, for they are a sub-custodian in most cases enshrined in an amalgam of brokerage centric and banking activities. They, unless they are part of a major banking group, are surely as threatened a species as the independent administrator. And that is even during the helpful, but perhaps high risk, depository “lite” era, which is expected to run through to 2018, when the private placement regime is scheduled to be abandoned.
If a fund can get launched or a bank will agree to act as depository for that fund, the different participants will then be faced with struggling how to manage the inevitable conflicts of international law. Indeed in some areas, it is hard to manage the conflicts of interpretation between domestic regulators. On Dodd-Frank, the SEC and CFTC conflict in several areas. Even without that conflict, it is possible that U.S. firms could be barred from participating in some activities outside the U.S. to avoid contagion. We have already seen firms declining to deal with U.S. banks as counterparties to avoid the mere cost of process to comply with U.S. regulations. FATCA will inevitably lead to limitation of access to several investment funds by U.S. residents. EU regulation is likely to see several funds declining to accept EU investors. Vermont- and Delaware-based funds have found themselves downgraded to being domiciled in “bad tax” centers by some countries with requirements for more AML data as a result. The costs and complexity of ensuring compliance cross border by customer legal domicile is a nightmare and is happening.
So, we leave 2013 in a sorrier state than we started. Guilt appears assumed as a given unless there is a cast iron case against. Penalties include compensation, fines and class action as well as intense supervision in one guise or another. It must be wrong to make it so difficult to do business. It must be wrong for even the most ethical firm to find it so hard to establish fair and correct process. It must be wrong for regulators to write the rules, interpret the rules and apply the penalties with little apparent power for the regulated to fair and correct process.
It is true that there were market excesses. It is true that there have been aberrations. It is true that regulation needed to be improved. But the key improvement needed was in culture—at regulators and at regulated. And, unfortunately, this new regulatory nemesis will not lead us there. It has created an over-legalistic jungle of rules and regulation without ensuring that necessary culture of a willingness to obey the spirit and the letter of a clear and just regime.