Compliance Management: from afterthought to mission critical strategy

Hazem Elmalla joined Advent Software in 2000 as an application developer and systems integration specialist. He now works as a senior implementation and business consultant. He was involved in the implementation, support and solution delivery for some of the largest firms in the asset management industry.

While many of the world's financial markets were being squeezed of life by the bear hug of the credit crunch, there was a period in 2008 when many argued the Gulf region, with its energy-based reserves and revenues, might escape the turmoil. It hasn't quite turned out that way though. Instead the region has struggled in the face of lower export earnings from plummeting crude oil prices, reduced investment flows, crashing property prices, an expat exodus and tourism slowdown. And while the IMF's Regional Economic Outlook prediction of 2.6 percent growth for the MENA region in 2009 is rosy compared to the world economy as a whole, which is expected to see GDP shrink 1.25 percent, it marks a slump relative to recent rates.

Countries across the world, including those in the Gulf, therefore continue to wrestle with what went wrong, and are striving to implement measures to prevent such a crisis from happening again. And notable among these efforts are a series of legislative and regulatory proposals from governments, supervisory authorities and international bodies aimed at controlling risk, tackling fraud, protecting end clients, and creating a more robust and sustainable financial system.

As chief executive of the Dubai Financial Services Authority (DFSA) Paul Koster noted in a letter to authorised firms in June setting out changes to the DFSA's supervisory programme: "Regulators around the world, in response to the recent financial crisis, are increasing the level of supervisory scrutiny of corporate governance structures, senior management capability, capital, risk management and remuneration policies. The aim is to enhance regulation and organisational standards within Firms to address the risks posed by a more complex and interconnected global financial market."

Many jurisdictions' initiatives are still being thrashed out. What is clear however is that regulation, and supervision, are on the rise. As a result, compliance will more than ever be an enterprise-wide, business critical function that must feature higher up the boardroom agenda.

Regulatory Changes

Depending on a firm's structure, product offering and geographic target area, it will likely have to comply with a medley of rules and regulations. What is more, in markets across the Gulf a number of significant changes have been made over the past year affecting firms' compliance requirements. For as Phillip Thorpe, chairman and CEO of the Qatar Financial Centre Regulatory Authority (QFCRA), commented when signing a memorandum of understanding on insurance supervision with the Capital Markets Authority of The Sultanate of Oman in January, the Gulf Cooperation Council (GCC) members "understand that strong economic performance must be matched by clear improvements in financial regulation in the region."

Qatar

The QFCRA, for instance, published its Financial Services Regulations (Financial penalties-late returns or reports) Policy 2009 in March, allowing for financial penalties to be imposed on firms that are late in submitting returns or reports. The policy, the QFCRA said in its announcement, is expected to promote and encourage a compliance culture among QFC firms to make timely filings, and help towards maintaining a well-regulated financial environment.

Alongside such explicit measures, the regulatory authority is also conducting a series of educational seminars to assist firms in meeting their obligations. In April it kicked off a series, which will run throughout the year, to bolster the effective implementation of Anti Money Laundering and Combating the Financing of Terrorism (AML/CFT) policies and procedures by firms operating within the Qatar Financial Centre. Another seminar series, this time on its Conduct of Business Rulebook, began in June. The seminars, which also run throughout the year, aim to help firms understand what the Rulebook entails and ensure their practices, policies and procedures fully comply with it.

Dubai

For its part, the DFSA - which regulates all financial and ancillary services conducted through the Dubai International Financial Centre - is changing its supervisory approach "to ensure that Firms regulated by the DFSA can address the upgrade in management and controls now required, worldwide, of financial market participants," according to Koster's June letter. "In doing so, the DFSA aims to maintain a regulatory environment that is robust and commensurate with international standards, but is also an enabling environment for prudent growth."

To this end it is introducing an annual questionnaire concerning issues of management and control that is to be completed by all Category 4 firms i.e. those that provide advising and arranging services. Other initiatives include the introduction of an enhanced risk assessment of firms to assist in risk profiling, and transaction testing visits for higher risk players to assess their business operations and controls in various areas. As of August 1, Enhancements to Client Asset Protection Provisions Rules Instrument (No. 66) 2008 will also come into effect. The rule changes aim to enhance the protection of client assets held or handled by authorised firms or their agents.

The DFSA then announced in July the creation of a Market Practitioners Panel of industry experts to review the DIFC's Collective Investment Funds regime. The panel's remit is to identify any potential changes that would make the regime more attractive to the funds industry and potential investors.

Bahrain

Meanwhile, the Central Bank of Bahrain (CBB), the sole regulator and supervisor for the kingdom's financial sector, is in the process of developing Volume 6 of its Rulebook, the section that pertains to capital markets-related activities. The project is due to be completed this year, and aims to update and consolidate the existing capital markets regulations to create a single, comprehensive and structured publication.

Most recently the CBB issued the Prohibition of Market Abuse and Manipulation module in April, and is now finishing its consultation on the framework for Market Surveillance, Investigation & Enforcement, which lays out the process for detecting and investigating breaches of laws, rules and regulations, and the enforcement actions to be taken in response. Further modules will focus on anti-money laundering and financial crime, disclosure requirements, corporate governance, and investor protection, among others.

Saudi Arabia

And then there is Saudi Arabia, whose Tadawul Stock Exchange is by far the Gulf's largest by capitalisation. Past regulatory initiatives have fostered growth in its investment management market, with the granting of more banking licenses enabling the creation of investment houses to manage the wealth of its large pool of high net worth individuals. And with the Capital Markets Authority's (CMA) introduction last August of new rules allowing foreign investors to enter into swap agreements with authorised intermediaries, it has opened the door a little wider for non-residents to participate in the market, with the hope of further liberalising steps to come. Tadawul followed that in April this year with the announcement it is considering introducing derivatives and exchange-traded funds to its bourse, as part of efforts to encourage citizens to invest in the exchange.

Alongside such measures the CMA is tightening up some of its rules. Back in January it issued the Anti-Money Laundering and Counter-Terrorist Financing Rules, aimed at ensuring authorised and registered persons apply appropriate controls, procedures and principles to combat money laundering and the financing of terrorism, thereby bolstering the integrity of the country's capital market. Reportedly the Authority is also considering setting up an autonomous department to verify that listed companies comply with CMA corporate governance rules.

Islamic Finance

In addition to understanding and complying with country-specific rules and regulations, there are also the requirements of the Islamic financial marketplace to consider. According to Ernst & Young's 'Islamic Funds & Investments Report 2009,' Shariah-sensitive investable assets reached $736 billion in 2008 in the GCC and Asia. And despite the current difficulties in international financial markets, it said the fundamentals of the Shariah-compliant funds industry remain strong, and considerable opportunities exist for future growth.

But any local, regional, or international institutions wanting to operate in this arena must demonstrate their adherence to Shariah principles. To do so requires the appointment of a supervisory board of Shariah scholars, which will provide the institution with advice and issue rulings on their product and operational compliance. And obtaining such a certification means, inter alia, that Islamic funds are segregated from conventional ones, and transactions are backed by a tangible underlying asset. Such requirements then impact how a firm conducts its execution, performance analysis, client reporting and financial accounting, for example to meet the standards of the Accounting and Auditing Organization for Islamic Financial Institutions.

International Requirements

Organisations operating beyond the Middle East will likewise have a range of regulatory measures to contend with, which could include UCITS III, MiFID, the USA PATRIOT Act, Sarbanes-Oxley, and various jurisdictions' AML laws. Many are subject to periodic change too, as evidenced by the upcoming UCITS IV, and the potential extension of the MiFID regulations to other asset classes. New proposals are on the horizon as well, including the US administration's 'A New Foundation: Rebuilding Financial Supervision and Regulation' report and the European Union's alternative investments directive.

Client Considerations

End clients will be a key force shaping firms' compliance frameworks as well. Strong economic fundamentals, a range of attractive investment prospects, regulatory reforms and a maturing marketplace mean there are significant opportunities ahead in the MENA region for domestic, regional and international investors, and hence for the investment managers, brokerages, custodians and administrators they work with. But in the wake of the credit crunch institutional investors around the world are tightening the already rigorous terms and conditions they impose on the firms that service their mandates. Increasingly high net worth individuals are following suit too, moving towards mandates that call for considerable controls and rich reporting capabilities at a level previously only required by their institutional counterparts.

The Road to Effective Compliance Management

Given the changes and challenges facing market participants therefore, effective compliance management has become a business necessity.

The development process firms typically go through as their perception of the importance compliance holds shifts - and as they move towards a more effective management environment in response - is illustrated below:

TK - remove comma from end of second line in graphic above, and full stop from the end of the last line

Where a company is currently in the "red zone" it suggests a lack of understanding at boardroom level about the importance of compliance, an attitude that tends to permeate the rest of the organisation. Any firm still in those early stages though will be propelled forward by growing regulatory and client pressures.

However, the good news is that many improvements can be implemented relatively easily.

Keys to Successful Compliance Management

As with most challenges there is no silver bullet. Instead, the implementation of a successful compliance process requires a complementary approach that combines implementation of well-defined internal policies and procedures with sophisticated software tools that can automate normally laborious and error prone manual functions.

Effective compliance management therefore rests on five fundamental requirements:

1)      Take compliance seriously

Top management is routinely involved in approving or defining policies and procedures, and compliance is seen as an enterprise-wide activity. The firm will also have dedicated resources for the compliance function, and ensure a constant focus on education.

2)      Clear definition of control processes

This process will include the steps to be taken to remedy any potential compliance breaches.

3)      Efficiency and costs

Expenditure is minimised by keeping compliance simple wherever possible. Meanwhile, performance indicators should be tracked, such as for vulnerable areas within an organisation's operations - for example, to calculate the cost of process improvements versus the risk of inaction, and to measure the ease with which the firm's compliance environment can adapt to changes.

4)      Holistic approach to compliance and risk management

Given the overlap between these two areas, risk should be closely monitored and managed in conjunction with compliance. In addition, firms should have a holistic view of trading compliance, since neither pre- nor post-trade compliance is effective on its own. 

5)      Software

Sophisticated software is required to automate the key compliance controls, including limiting the risk of manual errors in the trading process, and ensuring compliance with regulations and key mandates. As such, it enables key personnel (i.e. traders and portfolio managers) to focus on their area of expertise rather than on compliance. In addition, the right software tools can future-proof a firm by giving it the flexibility to easily adapt to changes as they occur.

While it is easy to have a pessimistic view of the current economic and financial conditions, a market change like the one at present is, we all hope, a once-in-a-lifetime experience. However, even if we cannot predict what the future holds market participants can limit the potential risks by implementing a robust, efficient and adaptable compliance management environment.