Money Laundering: the FSA's new role

In CP46 the FSA has published its proposals to combat money laundering thereby working towards one of its objectives, the reduction of financial crime.

Objectives

Three key themes run through the FSA's approach to its new role.

First the FSA emphasises that it is a regulator who promotes co-operation with criminal authorities but is not anything like a criminal authority itself. Secondly the FSA proposes to concentrate on the system and controls already in place inside regulated businesses in order to prevent money laundering and enhance the effectiveness of money laundering being reported to the criminal authorities.

Thirdly, the FSA proposes to promote and actively pursue the co-operation between them, the criminal authorities, and the financial services industry.

Controls

The FSA proposes to implement controls in and set standards for FSA regulated-businesses so that vigilance is raised and an effective protection against money laundering is achieved. These controls are:

• whenever business with a new customer is commenced care must be taken
• to give alert and informed consideration to the possibility of money laundering by a prospective customer or customer at that stage or subsequently
• to communicate these to the criminal authorities, if suspicions of money laundering arise
• to keep records which may prove significant for subsequent criminal investigations and prosecutions

Exclusions

Professional firms such as solicitors and accountants who are covered by Designated Professional Bodies will not be governed by these money laundering rules as they are not FSA-regulated but instead carry on "exempt regulated activities". It must be noted however that the primary statutes and the 1993 Regulations are unaffected by this exemption.

The key rules

The FSA proposes to disapply its money laundering rules in the case of general insurance business as the extra costs of imposing the requirements set out would not be justified. It must be noted, however, that the underlying statutory position (for example, not to assist in, and to report knowledge or suspicions of, money laundering) applies to all business, including general insurance. Also the FSA has proposed to apply the rules to incoming firms that have set up a branch in the UK.

The rule on compliance as proposed by the FSA states that a firm must take reasonable care in ensuring that proper control systems for compliance with the regulatory obligations are implemented and maintained.

The proposed rule on records says that a firm must make sure that adequate records which are appropriate to the scale, nature, and complexity of its business are kept.

The proposed rules permit a firm, provided it is not on actual notice or suspicion of money laundering, to commence business with or for a new customer before completing identification checks. This is because, in relation to that rule, views differed so much that the FSA has chosen not to change the requirements set out in the 1993 Regulations.

These proposed rules are not a guidance on the 1993 Regulations and, despite its links to the FSA's regulatory objectives, they should be considered separately - an example of the "parallel, but separate" approach.

Training

On training the FSA proposes that a firm should:

• train its employees to reach sufficient level of competency for the functions they are carrying out
• provide for adequate and appropriate supervision in relation to the attainment and maintenance of competence and for a regular review of the training and competence of its employees
• when considering the above points, have regard of the level of competence required in relation to the nature of its business and the role of its employees.

Money laundering compliance officer

Finally, in order to report suspicions of money laundering effectively as required by the proposed rules, a money laundering reporting officer (MLRO) who must be an "Approved Person" and whose function must be a "Controlled Function" should be appointed.

Following responsibilities for the MLRO are proposed:

• he must receive reports of suspected money laundering from others within the firm and must submit reports of suspected money laundering to the National Criminal Intelligence Service
• he must ensure that the firm has adequate arrangements for money laundering awareness and training
• he must make annual reports to management about the firm's money laundering compliance

A firm is required to make sure that its MLRO has sufficient seniority and resources to carry out the role.

Conclusion

These proposals represent a further development to the current money laundering regulations. Firms should be alert to two particular shifts in emphasis:

• the requirement for alterations to money laundering not only on client take-on, but also for ongoing transactions with an established client;
• the need for a firm's MLRO to take a clear and proactive lead in achieving compliance with both these and the existing regulations.

FSA consults on fee-raising

The FSA is considering changing the way it determines its fees. At the initial stage of setting its fees, the FSA has published a consultation paper and is asking for responses to this consultation by the 25th of September 2000 with a response paper issued in November.

The consultation contains a number of proposals

Periodic fees

Periodic fees will usually be charged on an annual basis. All of the fee-payers will be grouped into fee-blocks with similar fee-payers based on the products and services that they offer (eg, business categories for authorised persons, a separate group for professional bodies). A major factor for determining the fees will be the risk that the fee-payer poses to the FSA's statutory objectives calculated in the manner explained in FSA's "A new regulator for the new Millennium" (see FS Brief 35).

The fees will be calculated for individual authorised persons in the following manner:

• The FSA will determine its annual funding requirement (AFR).
• The AFR will be split amongst the fee-blocks pursuant to a cost allocation method.
• Tariff-bases will be determined on the size of the fee-payer's business and the perceived risk that the individual firm poses.
• A range of fee-tariffs will be set for the different fee-blocks, including minimum and maximum fees, the 'steepness' and form of variability of the fees.
• Discounts will be given for EEA authorised/recognised entities.

Application fees

Application fees will be charged from organisations applying for authorisation, recognition and from those seeking significant changes in their permission.

Flat rate fees will be charged varying depending on the authorisation or recognition sought.

Each fee-block will contain three bands of flat rate fees:

• for straightforward applications
• for applications with some degree of complexity
• for complex applications

Conclusion

FSA continues to focus its attention on risk, and its proposed fee structure is part of its attempt to reward firms which comply and focus on those which pose a risk. It will be difficult for firms to object to this approach, which will give firms a further incentive to analyse their own risk and take steps to address (perhaps even to window-dress) areas of weakness.

FSA's annual report 1999/2000

This reports on FSA's progress in designing the new regulatory system.

FSA's projects for the current year are stated to include work in relation to:

• E-commerce.
• Money laundering.
• Treatment of customers after point of sale.
• Regulation of mortgages.

In the meantime, FSA will continue working on:

• Construction of the rulebook regime.
• Grandfathering, whereby current firms and registered individuals will obtain uninterrupted authorisation under the new regime.
• Establishing procedures for authorisation, approval and discipline.

The Report also contains formal reports from the Chairman, managing directors, consumer and practitioner panels. Appendix 6 is concerned with costs. FSA points out that it is at present running within its budget, but principally because of cost savings owing to unfilled staff positions. The Report also takes the costs of regulation between the United Kingdom and nine other countries, but warns that comparisons are inappropriate and that the table cannot be used to determine whether regulation in one country is more cost effective than another. However, other figures contained in appendix 1 to the "New Regulator" document do tend to suggest that UK regulation is very cost effective.

Financial Services and Markets Act

Financial Services and Markets Bill receives royal assent

433 sections and 22 schedules long, the FSM Act ("FSMA") is a massive piece of legislation.

Royal Assent was obtained in June, and the Act will be brought into force in stages. As has recently been announced, the main impact date, when the Financial Services Authority will assume its full powers, is probably going to be in late Summer 2001.

But what difference will the FSMA all actually make? There are two ways of assessing the likely impact of the new FSA. First, to point out that there is a large degree of continuity, with the overall design of the regulatory system being little altered. However, much of detail is new, and we now review three areas which are likely to have the greatest impact on firms.

The Financial Services Authority

The new FSA, as an amalgam of the current financial services, banking and insurance regulators, will possess a formidable array of powers, many of which are derived from existing legislation. The most significant change, though, is conveyed by its website: www.fsa.gov.uk. The FSA is now part of the Government, and the journey from self regulation to state regulation has now been completed. In practice there are likely to be a number of consequences.

• Less potential for practitioner involvement. Despite the creation of a practitioner panel, industry experts may need to work hard to make their voices heard within FSA.
• A change of attitude. Sir Howard Davies' ambition to create a "world class regulator" will be to the discomfort of non-compliant firms who will see IMRO's "zero tolerant" approach carried forward into FSA's Enforcement Division.
• A "broad band" approach to regulation. Some firms who were previously only subject to conduct of business regulation under the FS Act have noted how the prudential regulators are working in closer co-operation with the conduct of business regulators, and how some features of conduct of business monitoring are being adopted by IFSD.

Senior management responsibility

Determined to prevent a repetition of Barings or Morgan Grenfell, FSA is under a statutory duty to have regard to the responsibilities of management when discharging its functions. In practical terms FSA is seeking to achieve this by:

• Requiring a wider range than at present of senior management to be individually registered.
• Laying down seven principles of individual application, three of which are directed at senior management.
• Planning to hold senior management responsible, in terms of individual discipline, for breach of those principles.

While the details of the new regime, contained in Consultative Papers 26 and 35 are not yet finalised, the message is clear. The main trust of the three senior management principles is to require each manager to run his or her division in a complaint way, supervising skilled delegates and ensuring issues are properly addressed as they arise. Every authorised firm should therefore review its regulated functions, identify key risk areas and ensure that they are properly monitored by management.

Particular changes

Out of a myriad of detailed alterations it is possible to select five areas to which all firms should be particularly alert. It is also important to remember that the FSM Act is framework legislation. Many key areas, including the definitions of the regulated activities and investments, and the new version of the old investment advertisement exemption orders, are left to as yet unpublished statutory instruments.

• Changes to the scope of regulation Mortgages, deposit taking and general insurance are now included within the list of regulated investments. With the exception of mortgages, none will for the present be subject to a detailed conduct of business regime, but firms operating in these areas should be aware that the required standard of compliance with the Banking Code, and the GISC Rules, will be high.
• Changes to detailed definitions The definitions of regulated activities and investments, formerly in schedule 1 FS Act, are contained in the Regulated Activities Order, of which the first - and last - draft was published over 18 months ago. While most definitions are unaltered, firms should carefully study the next draft as there are some detailed changes.
• New rules FSA is issuing its new rulebooks - termed Sourcebooks - for consultation. The conduct of business sourcebook represents a skillful amalgamation of the existing SRO rulebooks in a user friendly form, albeit biased towards packaged products. In particular, the distinction between "black letter" rules, rules of evidential value and guidance is made particularly clear in the new layout, although unfortunately guidance is not a safe harbour. Once again, there are few changes, but firms should study the sourcebook carefully to see how particular areas may have been altered.
• Financial promotion This is a new regime combining investment advertisements and cold calling, and is a source of considerable controversy. While the old rules were clearly aimed at advertisements, financial promotion catches a wider range of communications. Firms must revise their advertising procedures to include many inter-business communications which are not advertisements.
• Market abuse Market abuse is, in short, behaviour in relation to certain traded investments which falls below the appropriate standard, and is even more controversial than the financial promotion regime. Intended to provide a workable alternative to insider dealing prosecutions, market abuse is punishable as a civil offence (a new invention) without the need for FSA to prove intent. The definition, which was altered nearly half a dozen times during the passage of the Bill, is opaque and confusing. Any firm which deals on a specified exchange must have appropriate procedures in place to ensure that its dealers and managers avoid market abuse.

In summary, the FSM Act may in many ways be old wine in new bottles but - watch out - this wine has a bite to it!

Industry news

Polarisation and financial services intermediary regulation

London Economics was commissioned by FSA to produce a report on the economic effect of alternative polarisation requirements. Produced in the wake of the Office of Fair Trading's somewhat confusing Report on Polarisation (August 1999) this document (published in July 2000) is an economic analysis of the impact of polarisation and neither a regulatory analysis nor an FSA policy statement.

One of the report's first conclusions is that while polarisation has some anti-competitive effects, it operates to reduce customer detriment by clarifying the status of advisers. Against this background, the Report goes onto review four possible alternatives from an economic standpoint although it does not, interestingly, evaluate the current regime other than as a benchmark.

Three alterations are considered to be unsatisfactory. They are:

• Removing collective investment schemes from polarisation. This was suggested by the OFT Report but is considered to be potentially confusing to investors and of limited economic benefit.
• Removing ISAs/stakeholder pensions from polarisation on the grounds that they are sufficiently regulated as products. Again, this is not favoured as conferring limited economic benefits.
• Allowing product providers to add to their ranges by "badging" third party products. This, again, is felt to be of limited economic benefit.

The possibility which the report considers most economically attractive is allowing multi-ties because these would lower costs and increase competition - the economic benefits which the other proposals lack. It would also not adversely affect the size and independence of the IFA distribution channel.

Possible features of such an amended polarisation regime could include:

• Multi-tied agents could tie to a number of product providers, and thereby benefit customers by offering new products.
• Product providers could "add on" third party products, and this gap filling could lead to improved customer service.

The report goes on to consider two further proposals relevant to IFAs:

• only fee based advisers may call themselves "independent"
• IFAs should separate consideration of the "best advice" panel from commission arrangements but can see no economic case to making recommendations on either of these subjects.

We must now await FSA's response, but while regulatory policy will not necessarily follow economic analysis, it appears likely that there will be alterations to polarisation, possibly along the lines of multi-ties particularly if this benefits consumers and does not harm IFAs.

Conduct of business supplemental source book

CP57, published in July 2000, fills the gaps in the main Sourcebook (CP45 February 2000) and completes the first draft of the new Conduct of Business Rules.

The earlier Sourcebook has received a general welcome with the industry recognising FSA's achievement in combining the 14 SRO and other rulebooks into a single compact document, albeit one with a fairly clear bias towards packaged products.

Particularly notable is the fulfilment of the new Act's requirement to distinguish between:

• rules, identified by bold print
• guidance, in light print
• rules of evidential value (marked "E") which tend to establish compliance or non compliance with a rule together with a statement of purpose for each rule, and tables containing supplementary information printed adjacent to the rules to which they refer.

While a number of detailed observations can be made, the Sourcebooks mark a welcome break from the old style rulebooks without detracting from the requirements of authorativeness and legal enforceability.

CP57 addresses a number of areas of which the most important are as follows.

Customer classification

FSA consulted on customer classification in CP43 and, while a number of issues are still outstanding, FSA is reaching the following conclusions.

There will be three categories of customer - market counterparty, intermediate customers and private customers.

• UK and many overseas authorised firms will be classified as market counterparties when carrying on interprofessional business. Such a firm may "opt down" to intermediate customer status when dealing with a market counterparty in order to protect underlying clients. Market counterparties can also be governments and central banks. Carrying on inter-professional business with market counterparties would normally fall within FSA's Inter-professionals Code. Few conduct of business rules apply to market counterparties, with the principal exceptions of chinese walls and client classification.
• Intermediate customers which include substantial (as defined) companies, partnerships, trusts and certain special purpose vehicles. An intermediate customer may "opt up" to market counterparty status where it meets specified asset thresholds.
• Private customers, who may "opt up" to intermediate customer status (but not to market counterparty status) as experts, but not as rich individuals. All conduct of business rules apply for the protection of private customers.

A firm may now treat another firm as its customer even where it knows that the other firm is dealing as agent on behalf of others.

Chinese walls

Existing rules are carried forward, including:

• recognising that information may be properly withheld under an established chinese wall arrangement
• use of a chinese wall as a defence to an allegation of misleading the market together with the new addition of being able to use a chinese wall to protect against market abuse proceedings.

Comparative advertising

New rules have been introduced to implement the Comparative Advertising Directive, which will be of particular significance in retail financial services.

Best and timely execution

These rules reflect existing policy, although best execution will remain under review in light of current market developments such as competing exchanges and alternative trading mechanisms.

Personal account dealing

This also carries forward existing policy. However, the requirements of this rule will be rather more demanding for some firms than at present, and it would be appropriate for firms to check that their arrangements will remain in compliance after this rule is introduced.

Regulation of approved persons - Consultative Paper 53

Issued in June 2000, this Consultative Paper sets out FSA's proposals, together with draft rules, for controlled functions, which are the positions for which FSA's prior approval is required. Taken together with FSA's recent Response Paper "High Level Standards for firms and individuals, issues from CP26 and 35", the FSA is now setting forth its full proposals in this area.

Who will require individual approval?

Dealing with customers and their property

Falling in this category are the following:

• Customer adviser
• Customer trader
• Investment manager

However, introducers and execution only dealers not require individual approval.

Significant influence

This category takes in:

• Governing functions: Companies Act directors, Chief Executives and equivalent.
• Required functions, which are appointed actuary, money laundering reporting officer and the head of compliance, who will be at director or senior executive level. In addition, the executive responsible for the "apportionment and oversight function", in other words establishing the requisite system of control (see below).
• Management functions. If not already performed by individuals registered under "governing functions" this will include: Head of finance Head of risk Head of internal audit
• Significant managers. If not already registered under "governing functions" or "managing functions", the following significant managers will require individual authorisation. FSA expects that only firms of the largest size are likely to have individuals who have substantial autonomy of action, and who can exercise significant influence over the conduct of the firm's affairs and who will not fall into one of the other categories. These individuals are: Senior manager with responsibility for investment or business services, such as head of equities trading, head of back office, head of sales or head of retail banking. Senior manager in charge of non-life underwriting. Senior manager responsible for financial resources such as the group treasurer. Senior manager responsible for operations, such as head of settlements or head of claims.

Workings of the new regime

There are four particular features of this regime, which are as follows:

• Recognising the requirement to cover for absences owing to illness or holidays, an individual may perform any of these functions for up to 8 weeks within any 52 week period without requiring to be individually approved.
• A firm may change the responsibilities of an approved person within a particular controlled function without requiring further approval.
• The requirement to obtain individual approval applies to arrangements for the performance of controlled functions both by the firm itself, and by another firm as its contractor.
• The individual approval regime applies to UK firms and (with some variations) to non EEA branches. For incoming EFTA and EEA firms, individual approval will only extend to functions subject to UK conduct of business regulation, which is likely to include certain senior and significant managers, together with dealing with customers and money laundering.

What are the rules?

FSA's "High Level Standards" Response Paper broadly confirms the previously published Statements of Principle, requirement of fitness and properness and draft rules for approved persons. They are as follows:

Fit and proper

Each approved person must satisfy the following criteria of:

• Honesty, which is defined to include compliance with FSA's requirements.
• Competence, which will most often be filled through a firm's training and competence scheme.
• Financial soundness.

Statements of principle

All approved persons will be subject to statements of principle which require:

• Integrity.
• Care, which is defined to include compliance with FSA's requirements.
• Market conduct.
• Co-operation with FSA.

In addition, the three Statements of Principle for senior management require that a senior manager:

• Controls the business for which he is responsible. This calls for clear apportionment of responsibilities, reporting lines and suitable delegates.
• Manages that business carefully. He must understand the business, receive sufficient information and carefully supervise delegates.
• Ensures that it is compliant. There should be adequate controls in place and an adequate compliance function. Apparent breaches should be investigated.

Rules for senior management

FSA's "High Level Standards" document has proposed a number of amendments to the draft rules, which are now as follows. Taken together, they call for the establishment of a control environment.

Apportionment of responsibilities among senior management

• The apportionment of individual responsibilities must be clear.
• The business must be adequately monitored and controlled.

Appropriate systems and controls.

• Reporting lines should be clear.
• Duties should only be delegated if appropriate safeguards are in place.
• Outsourced functions should be supervised.
• Adequate management information should be provided.
• Personnel should be suitable.

In addition, there must be an adequate compliance system.

Discipline for breach

Neither the Principles nor the Rules have substantively altered the circumstances when individual discipline may be brought, but some comfort can be taken from FSA's commentary:

• There will be no presumption that a rule breach is evidence of an individual having failed to take reasonable care.
• Individual disciplinary action will only be brought if the individual is personally culpable, and when his standard of behaviour falls below what is reasonable in the circumstances.
• In determining whether an individual's conduct was reasonable, FSA will take into account if he exercised reasonable care when considering information available, and reached a reasonable conclusion on it.

Conclusion

FSAs new regime for senior management responsibility is without doubt one of the most significant developments in financial services regulation. Firms would be well advised to treat it as a priority, and should already be taking steps towards achieving FSA's control environment.

We consider that one suitable approach to fulfiling FSA's requirements is as follows:

• For each of the firm's principal routines, such as new business processing, unit dealing or equity trading, each stage of the operation should be tracked, and the following identified: regulatory requirements key areas of vulnerability information needed to monitor these areas.
• Controls can then be established to ensure that the right information is promptly sent to the right level of management, such as (to continue these examples) data relating to rejected fact finds, aged reconciliations or failed trades. Management will be able to use the information derived from this control matrix to monitor the routine, and ensure that any necessary remedial action is implemented before problems get out of hand.
• Steps can then be taken to complete FSA's requisite control environment. These include ensuring that there are adequately documented procedures, clear reporting lines, properly trained and supervised staff and adequate compliance monitoring.

One advantage of this approach is that a firm can be satisfied that it has identified its principal areas of vulnerability, ensured that each of them is properly monitored and "owned" by a responsible senior manager, and thus created a key element in FSA's control environment.

The benefit from a senior manager's point of view is that his areas of responsibility have been defined, an appropriate reporting structure has been put in place, and he is thereby enabled to discharge his regulatory responsibility.