Striking a balance

Practices in the global securities industry are “opaque”, Adam Szubin told delegates at Sibos 2014 in Boston. Szubin, then director of the US Office of Foreign Assets Control (OFAC) and now under-secretary for terrorism and financial crimes at the US Department of the Treasury, went on to call for “transparency as the fundamental starting point of any meaningful compliance programme”.

“Transparency must be improved,” says Stephen Lomas, head of market policy for global transaction banking at Deutsche Bank. “The question is how best to accomplish this.

The international system under which securities and mutual funds are held, settled and distributed is highly complex and involves many different institutions.” In March, however, Szubin reiterated the intention of policy-makers and regulators to cut through complexity. “We continue to focus on increasing the transparency of legal entities by proposing to require the collection of beneficial ownership information.”

Opacity is never the objective of a legitimate securities transaction, of course, but operational efficiency is not necessarily enhanced by its exclusion; after all, it can be a long way to the far end of a complex, cross-border custody chain. It is also true that, not least for pragmatic operational reasons, absolute end-to-end transparency has never been part of the securities industry’s approach to due diligence. Marco Zwick, head of compliance (Europe) and global head of anti-money laundering (AML), RBC Investor & Treasury Services, says: “Cross-distribution models currently pursue transparency at the end of the value chain. This is generally achieved by appointing distributors in local markets which are subject to equivalent international AML standards.” The compliance obligation thus “cascades” through regulated professionals.

Zwick, also president of the Luxembourg Association for Risk Management, says: “The global securities industry has tried to strike the balance between transparency and operational efficiency by introducing the concept of ‘know your intermediary’ in addition to the regulatory concept of ‘know your customer’.” Upsetting the balance may also upset the customer, Zwick suggests: “The currently pursued objective of transparency, also motivated by factors other than AML, will impact the efficiency of international distribution models and the associated costs.” Lomas acknowledges the need for further flexibility. “The balance that must be struck is to implement a new control framework that satisfies regulatory authorities worldwide while minimising disruption to the current system,” he says.

Stretched to the limit

On the question of transparency of beneficial ownership – Szubin has previously singled out omnibus accounts as potentially problematic – Olivier Goffard, head of group compliance and ethics at Euroclear, makes a seemingly practical point. “If we have to provide the ultimate beneficial owner information within transaction messaging fields, we are limited because at the moment we don’t have a standard that might be used for this purpose across the different stakeholders within the custody chain in an automated way,” he says.

But this is more than a discussion about messaging technology. “Messaging complexity leads to wider complexity within a given financial institution. If we, Euroclear, have to deal with all the names of beneficial owners, we have to be able to record them in a uniform way, to process them. The more names, the more we have to control. And furthermore, it is not always clear precisely who within an organisation you are dealing with, particularly if it operates across many times zones and different business lines. Ultimately, it is a question of efficiency; does the same due diligence have to be performed at every point on the chain?” Goffard asks. Transparency is a virtue, but so is efficiency. To emphasise the former to the exclusion of all else, could make it mutually exclusive with the latter. It would also send the IT budget through the roof.

Transparency may have practical limits in other respects too. Stuart Weinstein, head of Coventry Law School and author of a SWIFT Institute-funded study, ‘Regulatory Compliance – The Extraterritorial Challenge’ (due for completion in Q3 2015), says: “If people are smart enough to engage in terrorism or money-laundering, they are fairly sophisticated players and they do know how to game the system. You can only be one step ahead of the criminals and that’s the hard part. You only discover the newest criminal techniques too late.” There will be a criminal ‘solution’ to transparency one day, if regulators come to rely on it.

There are also non-criminal but fallible individuals in sensitive positions in the securities industry. Weinstein says: “If you’re working in the front office of a bank, you have a tremendous amount of volume coming into your operation. You do your best to keep track, but the reality is that it’s an imperfect world.” You make mistakes. Crucial details slip through the cracks. Your bank gets hit for a vast fine and withdraws from, say, countries where compliance is difficult, or not cost-effective. The sanction and the reaction to it are disproportionate, perhaps, but for Weinstein, the more important impact will only be felt later: “If there was no intent in the bank to engage in criminality, you really have to question whether the strict liability that is imposed works against finding the right solution.”

No one’s perfect

The risk of vast fines and reputational damage dampens the enthusiasm for business in distant, less familiar markets. More importantly for the long term, such experiences potentially discourage banks from engaging in constructive dialogue with regulators. But that’s what needs to happen, and the signs are that it’s not only happening, but also starting to work. In his March speech, Szubin said: “I want to make clear that we do not expect perfection from the private sector. We understand that financial institutions are not infallible, and that it is not possible or practical for them to prevent every single potentially illicit transaction flowing through them.”

There is a fine but crucial distinction between stopping criminals at all costs, and defending a vital, pivotal industry against crime. Lomas says: “Transferring or transforming ownership interests multiple times brings enormous benefits to the global economy by achieving significant scale benefits that result in low transactional costs and a high degree of securities mobility.”

Efforts are afoot to come to terms with the regulators’ requirements. In May 2014, the International Securities Services Association (ISSA) launched an initiative to address compliance with recent interpretations of financial crime regulation in the securities and funds space. The principle objectives are: to provide a meaningful framework to guide custodians and funds distributors in the application of IOSCO principles on client identification and beneficial ownership; to minimise gaps between market practice and regulatory expectations, with particular reference to issues raised by enforcement actions and regulatory comment; and to create a set of principles for the securities services space, similar to the Wolfsberg Questionnaire for correspondent banking. Lomas, who also chairs ISSA, asserts that collaborative work of this nature will bring about effective change. “The principles are being discussed with the wider securities industry and key regulators across the global landscape to ensure that these deliver in line with expectations,” he explains.

Arguably the most effective approach to striking the balance between transparency and efficiency is to do it before the regulator does. Weinstein says: “We have to be self-policing. There’s no tolerance for people using settlement systems for illicit activity. If we develop the standards ourselves, we can suggest to the regulator the right approach. I think that’s the key.”