The risk of monetary loss that can arise from many types of financial transactions has highlighted the need for financial markets to be subject to rules and codes of conduct to protect investors and the general public. The development of such rules and the extent to which they are enforced has varied from country to country.
Typically, as financial markets develop and wealth increases, the sale of financial products increases too. Agreeing standards of behaviour and providing mechanisms for dispute resolution is a key part of this development. These standards, rules and codes of conduct may be established through self-regulation under, for example, stock exchange membership or by means of a statutory approach where governments provide enabling legislation and establish statutory-based regulatory authorities. How self-regulation is applied is analysed in greater detail later on; integrity and ethical behaviour are always a key part of codes of conduct but have also gained increasing prominence by governments, regulatory bodies and professional bodies.
As financial markets have become increasingly global in nature and interdependence has grown, countries have generally seen a move from self-regulation to a statutory approach. This has facilitated international cooperation and the development of improved and common standards.
Another key area is where regulation has been used to restrict the ability of criminals and terrorists to use the financial system and to aid enforcement and intelligence agencies to identify criminal activity. Again, this has developed from purely domestic initiatives to major international efforts to reduce crime related to financial services. These crimes include money laundering, fraud and tax evasion.
For the population of any country to benefit from the development of financial markets, systems and the investment opportunities that follow, they need to be aware of and understand what the markets offer, the risks they may face and the rewards available.
To summarise, the objectives and benefits of regulation can be viewed as the following:
- To strengthen confidence and trust in financial markets, systems and products
- To help establish the environment to encourage economic development and wealth creation
- To reduce the risk of market and system failures (along with the economic consequences of such failures)
- To better protect the consumers, giving them the reassurance they need to save and invest
- To reduce financial crime through a financial system that is not an ‘easy target’ for criminals to exploit crime
In most countries the objectives noted above are achieved through a combination of law and regulation.
Law refers to legislation, which has the potential to result in criminal sanctions. In financial services, legislation often provides the structural framework for the industry itself or the products it offers.
International laws also cover areas such as the prevention of money laundering and terrorist financing, and may extend to international tax laws that are relevant to the structuring of banking or other financial products or customer advice.
In addition, consists of rules and standards generally covering matters such as:
- observing proper standards of market conduct
- managing conflicts of interest
- treating customers fairly
- ensuring the suitability of customer advice.
The regulatory framework, therefore, has various sources including:
- primary legislation
- rules and standards issued by legislators and supervisors
- market conventions
- codes of practice promoted by industry associations or professional bodies
- internal codes of conduct applicable to the staff members of financial institutions. Industry and internal codes are likely to go beyond what is legally binding and embrace broader standards of integrity and ethical conduct.
When drafting regulation, a regulator needs to decide on whether its rules will stipulate the minutiae of how a firm must act (eg, prescribing what checks should be established, and how frequently they should be performed) or instead focus on the outcomes that the firm’s behaviour and activity should deliver. A high degree of prescription produces a rules-based approach based on very detailed statements of what firms and individuals should do in order to comply.
Rules-based regulation can, therefore, be inflexible as it demands strict adherence to precise rules. Each topic must either be right or wrong, with little grey area accommodated.
As a result, a rules-based approach must be sufficiently detailed to always provide a reliable distinction between right and wrong. As markets have evolved – particularly with the increase in technology and the range of products and assets that can be created for use by customers – the ability of a regulator to maintain and communicate a comprehensive rules-based model comes under significant strain. The wider and more complicated the market becomes, the more rules the regulator must write to take into account evolving business activities.
In contrast to a rules-based system, a principles-based approach draws out the types of behaviours that a firm and its management should display, and the types of outcomes that should be achieved. Rather than prescribing a particular process, a principles-based approach to financial regulation is one that is designed to act as a fundamental source of guidance on how firms and individuals must act. Principles will be set at a high level, setting expectations of behaviour and leaving it to the firm or individual to decide how, and to what extent, they must meet these principles. The difficulty of such an approach for regulators is ensuring that firms apply consistent interpretations to their implementation of the principles.
Some firms and compliance officers prefer a rules-based approach because of the certainty of knowing exactly what is expected of them and take comfort from the fact that by following the rules strictly they cannot be challenged or criticised. Others prefer a principles-based approach because this can provide scope for innovation and freedom to develop services and business models, albeit their actions must still be consistent with the principles.
The success of a principles-based approach will depend upon firms and individuals making the right choices and doing the right thing.
Self-regulation exists where groups or industries mutually agree the rules that will govern their own collective behaviours, aside from any laws or regulations established by governments/instituted bodies. While self-regulation measures must operate within the parameters of national laws, strong self-regulation can reduce the need for, or extent of, state regulation. In the financial services industry self- regulation (typically involving a unique combination of private interests with government oversight) has delivered an effective and efficient form of regulation for the complex and dynamic environment.
As stated in a report by the International Organization of Securities Commissions (IOSCO) on Objectives and Principles of Securities Regulation: ‘Self-Regulatory Organisations (SROs) can be a valuable component to the regulator in achieving the objectives of securities regulation’.
The adoption of self-regulation differs from country to country, across market sectors and across the developed and emerging markets. Where its role is significant, it almost invariably derives from a long track record of responsible behaviour, under the oversight of statutory regulators. That relationship has permitted SROs to contribute to the quality of regulation and to the content of policy in the public interest.
The broad objectives of self-regulation in financial markets are the same as those identified for government regulation in the IOSCO Objectives and Principles of Securities Regulation:
- to preserve market integrity (fair, efficient and transparent markets)
- to preserve financial integrity (reduce systemic risk)
- to protect investors
Many different forms of self-regulation currently exist for financial markets to achieve these objectives. There are, for example:
- industry SROs
- exchange self-regulatory frameworks
- private associations
All of these define and encourage adherence to standards of best practice among their participants.
Self-regulation typically focuses on oversight of the market itself, qualification standards for market intermediation and oversight of the business conduct of intermediaries, including their relationship with their client market-users. A single SRO may be responsible for all of these tasks or they may be divided or shared among SROs within a given country or market sector.
Some approaches may be applied purely within the organisation. An example can be ethical-based finance. A firm may hold strong principles that guide its investment policies (eg, avoidance of sectors such as weaponry or tobacco). Those investing on behalf of churches or other religious institutions will often have ethics-based requirements. A firm might also choose to market itself according to ethical positions. While there may be no specific independent party overseeing such practices, a firm that takes a public moral position must ensure its reputation is secure.
The elements which contribute to an effective self-regulatory model include:
- Industry specialised knowledge – important given the increasing complexity of markets and products
- Industry motivation – business incentive to operate a fair, financially sound and competitive marketplace. Reputation and competition are powerful motivating forces for sustained proper behaviour
- Contractual relationship – this can go beyond national boundaries and require ethical standards that go beyond government regulations
- Transparency and accountability – an SRO’s compliance programme should be transparent and accountable to ensure that SROs follow professional standards of behaviour on matters including confidentiality and procedural fairness
- Flexible SRO compliance programmes – a product of the experience and expertise of self- regulatory bodies is their ability to modify their rules in response to changes taking place in the industry more readily than government agencies
- Coordination and sharing information – coordination and information sharing must be a priority among market in order to address cross-market issues. A coordinated approach is a necessity to address potential market abuse or systemic risk concerns that may impact more than one market
Finally, an integral component of many SRO compliance programmes is the development of guidebooks and other educational materials to help their members meet their regulatory responsibilities.
An example of self-regulation is the use of the ISDA Master Agreement. The International Swaps and Derivatives Association, Inc (ISDA) is a membership association established in 1985 with the aim to foster safe and efficient derivatives markets to facilitate effective risk management for all users of derivative products.
Members of ISDA agree to use the ISDA Master Agreement and associated documentation as a basis for derivative transactions. An example of how its members benefit from agreeing to use the ISDA Master Agreement is its netting provisions, which enable firms to net their exposures with each other. As a result the transactions are treated as a single legal whole with a single net value.