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Acing the 2020 U.S. compliance exams: Advice from a veteran top regulator

Richard Satran  Financial Journalist, Thomson Reuters Regulatory Intelligence

Richard Satran  Financial Journalist, Thomson Reuters Regulatory Intelligence

New examination priorities and rules from U.S. financial regulators put the onus on firms this year to carefully review their business models, products and contracts, and to ensure that their technological capabilities can match the oversight agencies come exam time, a former top U.S. regulatory official said in an interview.

Carlo di Florio, who headed the Securities and Exchange Commission’s (SEC’s) exam office and served as chief risk and strategy officer for the Financial Industry Regulatory Authority (FINRA), identified topics of significant new emphasis in this year’s regulatory exams during an interview with Thomson Reuters Regulatory Intelligence (TRRI).

The topics di Florio identified included: i) how investment firms are implementing Regulation Best Interest and other new customer-care rules; ii) how firms are preparing for the end of the LIBOR (the London Interbank Offered Rate) interest rate benchmark; iii) how they carrying out any environmental, social, and governance (ESG) investment strategies; and iv) how they are adapting to technology developments including the rise of “alternative data” trading information.

You can read the full article from TRRI’s interview with Carlo di Florio here, and you can see a video of the interview here.

“We always tell firms … do a health check against your own business, and then fix those issues,” said di Florio, now chief services officer for ACA Compliance Group. “When regulators come in, they are going to assume that you had the opportunity — and if you haven’t addressed the issues yourself… then that can result in deficiency letters, enforcement actions, and other problematic issues.”

Areas of regulators’ focus

In his interview, di Florio noted several areas where regulators are likely to focus during their examinations, including:

Regulation Best Interest

One of the biggest regulatory changes for Wall Street is the SEC’s rules governing sales practices and customer relationships. The package includes Regulation Best Interest for broker-dealers, Form CRS Relationship Summary for brokers and investment advisers, and investment adviser standard-of-conduct guidance.

The underlying principle — aligning the firms with their customers’ best interests — will require firms to review all their operations, products and communications to consider whether they are fair and transparent.

FINRA and the SEC say they will work with firms on how to implement the rules. Regulators understand there will be “unanticipated or unintended consequences,” di Florio said.

Carlo di Florio
Carlo di Florio

The compliance date for Regulation Best Interest is June 30. Examiners will spend the first half of the year looking at firm preparations. Later they will scrutinize compliance. The entire year, however, will be a learning experience for the industry and its regulators.

“In this early period, they want to be helpful,” di Florio explained. “They’re trying to promote compliance, and they want to get out there and understand what firms are doing, how they’re doing it, what are the challenges firms are facing.”

ESG investing

The SEC’s addition of environment, social and governance investing to its examination priorities reflects a boom in ESG investment products and strategies.

The SEC will examine firms to ensure that ESG investment practices match their declared  strategies, di Florio said. The agency will be less concerned with measuring the real-world impact. Rather, it will focus on the accuracy of ESG disclosures and how clients’ ESG preferences are being carried out.

“This is a fast-growing asset class and strategy, and regulators want to sure that there’s some rigor and discipline about how firms and individuals market their services in this area,” di Forio said.

Transition from LIBOR

The transition from the LIBOR interest rate benchmark, scheduled for end-2021, is one of the SEC’s top priorities. Di Florio cited the need for firms to begin the process “with a sense of urgency — because it’s not a light lift.”

Millions of contracts across the financial industry will need to be reviewed and amended. Regulators around the globe are stridently warning that firms risk being unprepared. “You have to be able to identify all the places where that (LIBOR) is referenced,” di Florio said.

Alternative data

Examiners will consider technology advances in several ways. The SEC has targeted the growing industry use of “alternative data” in making investment decisions. Firms using such data from sources including web sites, satellite imagery, and consumer credit card information will need to make sure that the data does not violate insider-trading prohibitions or other protections.

Firms must understand that some alternative data could give them “an unfair advantage in using material non-public information,” Di Florio said. They will be held accountable, even if the data comes from vendors who may lack experience in the regulated securities industry.

“Whether you’re a large asset manager or whether you’re hedge fund, private equity firm, or small investment adviser,” any firm buying data needs to be able to show regulators that it has an effective compliance program to control its use, he said.

Needle in haystack

Firms need to keep pace with the regulators’ growing ability to accumulate and analyze vast amounts of data.

Examiners no longer must hope that spot checks of trade information will uncover problems. Now, they can analyze comprehensive data on a firm’s policies and practices, transactions, and communications — and firms need to use similar processes to pinpoint and fix problems before examiners arrive.

“So, rather than looking for a needle in a haystack you’re actually ingesting the whole haystack and identifying the specifics spots where there are likely to be needles,” di Florio said.

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