FINANCIAL SERVICES & REGULATORY UPDATE - AFTER THE SUMMER
The post-summer season heralds a burst of activity or so everyone hopes. Within the world of financial services regulation, there has been a swelling body of water behind the dam, and both practitioners and market participants alike hope that when the sluice-gates open, the waters will irrigate and galvanise the financial markets. Therefore, this month we will briefly take a look at what might be in the offing both in the UAE and within the DIFC/DFSA.
Custodian clearance and ISIN numbers
The Emirates Securities & Commodities Authority (ESCA) has recently announced that equity markets (ie DFM and AFX) trade settlement will be conducted through market custodians. In 2010 it will remain optional, but in 2011 they indicate that settlement on this basis will be compulsory. This is important: it aligns the local markets with best practice in international markets and, whilst not strictly speaking an absolute guarantee against default, it goes along way in mitigating the effects of, say, broker failure.
Interestingly, ESCA made another announcement at the same time: the proposed implementation of the International Securities Identification Numbers system (ISIN) within the UAE financial markets. An ISIN number allows a security to be identified uniformly wherever in the world (to a very large degree) and on whatever market. An ISIN number contains twelve characters and so, in the case of Apple Inc for example, it would be: US0378331005. The “US” (unsurprisingly) is the country code. The remaining numbers, except the last, will be the code number assigned to it in its home market. In the US this will be another number and another acronym: the CUSIP code (in London it would be a variation of the SEDOL number). The last number is the product of a nifty, but mind-boggling (to lawyers, at any rate!) algorithm designed to check that there hasn’t been a mistake in the string itself.
Initiatives further to align local markets with their international counterparts are to be welcomed.
Another announcement - this time from the UAE Central Bank rather than from ESCA. They issued a notice requiring UAE regulated financial institutions to obtain Central Bank approval prior to the sale of any “structured product” to retail customers. In broad terms, a structured product is essentially a derivative security that packages or mimics underlying securities (bonds, equities, options etc) to represent and pursue a specific investment strategy. Such instruments are, of course, tainted by association with those dangerous classes of securities that brought the credit markets to their knees last year. There has also been a case in the UAE in which such products have come under adverse regulatory scrutiny.
The announcement is short on detail and we are seeking further clarification, particularly as to the scope of products to which it applies along with a clearer understanding of “retail customer” (technically there is no legislative distinction between retail and wholesale customers). Assuming that a product is caught within the restriction, what will be the criteria for allowing its sale? Or is there, for now, a de facto outright ban?
It is important that any financial institutional proposing to market structured products should take care to ensure there is no possibility there is not room for doubt as to its status and, in cases of doubt, seek advice.
The regulation of financial services: the Central Bank and ESCA
We still await the tangible manifestations of the Memorandum of Understanding entered into between the Central Bank and ESCA earlier this year. Will it alter the balance of oversight within the UAE as to the respective jurisdictions of the Central Bank and ESCA? We think it will. Might it alter the dynamic of regulatory supervision? We think it might. Will it provide welcome clarity (or at least less uncertainty) when it comes to guidance for financial institutions (particularly foreign or those based within the DIFC) in the marketing of foreign securities within the UAE? We certainly hope so.
DIFC – the funds regime
In July of this year a distinguished panel was appointed within DIFC to review the operation of the DIFC’s Collective Investment Law and Regulations, ie the framework by which funds can be marketed within the DIFC. The panel was charged with the job identifying “what if any changes are needed to make the regime more attractive to the funds industry and potential investors”.
Those familiar with the European framework for the promotion of funds will be aware of how fearfully complex the process can be in ways that often do not seem to be of the immediate benefit to investors. The DIFC framework does not suffer quite the same measure of regulatory overload and opacity as can be the case in Europe. Nevertheless there are areas that are susceptible to both relaxation (without endangering investors) and, of course, clarification.
We expect the panel to issue its findings shortly and will devote a specific article to the outcome in a future issue of Hadef Highlights.
DIFC/DFSA – Outsourcing compliance officers
For entities regulated by the DFSA, compliance with its rules can be complex and relatively expensive. Of course, there are numerous benefits derived from the robust regulatory structure in which a firm has to operate, and it is not my purpose to suggest otherwise. Many firms have turned to third party providers to perform certain licensed functions within their organisation particularly when it comes to the compliance and money laundering reporting, rather than taking on the burden of permanent headcount for these positions.
Given the central role performed by the compliance officer in ensuring that the firm avoids regulatory traffic accidents (or dealing with them, should they happen), the DFSA has conducted a “theme” review of outsourcing within regulated entities.
Its findings are not altogether surprising, and essentially focus on the need for initial and continued due diligence with respect to the service provider, and ensuring that there is frequent interaction between the SEO and the appointed compliance officer. Moreover, emphasis is laid on the regulatory reality that the ultimate responsibility lies with the firm and its governing body and licensed officers (including the compliance officer) and this responsibility cannot be laid off or delegated per se.
The “theme” review provides nine guiding principles for outsourcing by regulated entities which can be found on the DFSA website where the “theme” review is posted. The DFSA recognises that outsourcing the compliance function “poses important challenges”, there appeared to be no suggestion that the practice of outsourcing was about to be banned! However, one might expect that where serious regulatory issues arise and the compliance function has been outsourced, the DFSA will look carefully into the management of that relationship from both the perspective of the service provider and the firm.
DFSA – changes to the Markets Law regarding the Official List (ie listed securities)
We have seen from the above that change is wind for the regulation of UAE securities markets: from the Central Bank and ESCA, and with respect to the marketing of funds within the DIFC, the DIFC/DFSA.
There has also been talk of the extent to which the DFM and NASDAQ Dubai will converge. First the trading platform and then, who knows … full merger, maybe.
Unconnected perhaps with the potential macro picture (which has profound implications for the evolution of the UAE securities markets), the DFSA has recently issued Consultation Paper 62 which canvasses changes to the DIFC Markets Law of 2004 whereby the DFSA would have power to maintain an Official List of Securities when there was no Authorised Market Institution (ie a DIFC-located Stock Exchange) willing or able to do so.
A couple of observations:
First, it is often overlooked that an exchange like NASDAQ Dubai maintains the “Official List” for the securities it quotes because the DFSA has authorised it to do so pursuant to its powers in the Markets Law. And whilst for the most part, the listing rules and committees of NASDAQ Dubai determine whether the securities of a particular company are listed or not, the DFSA retains the power effectively to veto the listing or impose conditions or restrictions upon it. The company is required to notify the DFSA at least five business days prior to admission to the Official List of that fact and thereby give the DFSA an opportunity to object (the DFSA make it clear that this is a power that they would only use very sparingly).
Moreover, once as company’s securities are listed, it becomes a reporting entity for DFSA purposes and owes duties of disclosure to the DFSA as well as to the market, the Exchange and its shareholders. Lastly, the marketing of securities by the entity upon listing and thereafter are governed by the Offered Securities Law and Regulations which are administered by the DFSA.
This prompts a second observation or, rather, question. If there is a serious possibility of the merger between NASDAQ Dubai and DFM, how will the overall listing regime be governed? Will it be the joint effort of ESCA and DFSA? Will there be a new regulator? Will there be, in effect, two streams of listing? The dynamic of the DFM and NASDAQ Dubai regulatory frameworks bear similarities, but also marked differences.
As we get a clearer picture of how the situation might evolve, we will return to this question in Hadef Highlights and hopefully provide some answers or at least a commentary on the then current state of play.