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Research Reports » Clearstream June 2019

Focusing on where the risk is

Mark_GemMark Gem, Chair of Clearstream Risk Committee and Member of the Executive Board at Clearstream, questions why it has become so challenging to fulfil compliance requirements around transparency and disclosure in the collective investments industry when these tasks have been managed efficiently for cash securities instruments for many years.

For asset management companies, there is considerable value in sourcing detailed information on how funds are being sold across their global distribution networks. This is important, for example, in monitoring sales performance across regional marketing teams, in benchmarking local distributors and in analysing retrocession flows. It may be important also for meeting product governance requirements under the second Markets in Financial Instruments Directive (Mifid II). This directive requires that a management company identifies ‘target markets’ for its fund products and takes reasonable steps to ensure that the financial product is distributed only to this identified target market.

While this information flow is important to management companies for commercial and regulatory-compliance purposes, we need to look more closely at how this information is gathered and who is responsible for passing distributor or end investor information through to an upper tier intermediary. In particular, AML-related duties of asset managers, their management companies and distributors have become unnecessarily confused with the role of custodial intermediaries delivering platform services for distributors. This confusion has led to complexity and friction whilst doing little, if anything, to protect the industry from AML-related vulnerabilities.

Often requests for information on end investors holding units in a nominee account are being justified in the name of meeting customer due diligence obligations under anti-money laundering (AML) and countering the financing of terrorism (CFT) legislation, when in many cases the request is not risk-based or AML/CFT-related or, at the very least, is a request rooted in the fund’s relationship with its own distributors.

Platform services
As a specialised fund custodian, Clearstream provides a suite of investment fund services via its Vestima platform designed to support the cross-border distribution requirements of the investment fund industry, embracing order routing, delivery-versus-payment (DvP) settlement and asset servicing functions (including fund custody and provisions to facilitate the use of fund shares as collateral).

As a matter of course, we provide details to asset management companies of the distributors that are marketing units in their funds through transactions supported on Vestima. This distributor information is supplied to the transfer agent appointed by the management company with the intention that the agent makes it available to the management company.

As market infrastructure providing fund platform services, Clearstream is regulated at a number of levels – as a securities settlement system in line with CPSS-IOSCO Principles for Financial Market Infrastructures, as a CSD under the CSD Regulation (CSDR) in the EU, and as a credit institution through holding a banking licence in the Luxembourg market.

Beyond this, Clearstream has a system of risk-based triggers in place and will request further disclosure on end investors in a fund when there is a risk-based reason for doing so. This is in accordance with our responsibilities under AML and CFT responsibilities outlined by the Financial Action Task Force (FATF).

This is consistent with the approach that we have long adopted in cash securities markets where, as an industry, a strong contractual architecture has emerged to support a risk-based approach to financial crime-related disclosure. As such, CSD participants holding a security on behalf of an end investor in a nominee account at a Clearstream CSD will, in certain risk-based situations, have a contractual obligation to disclose the identity of that end investor.

It is increasingly worrying in the investment funds segment, however, that pressure is being placed on platform operators to obtain end investor disclosure and documentation from nominee account holders (a fund distributor in this instance). In some cases, we believe that this pressure is not even AML-related but, where it is, the duty to obtain and supply it lies with the distributor with whom the management company has a direct contractual agreement in place.

Clearstream’s position is that it is not the responsibility of AML-regulated cross-border settlement platforms such as Vestima to provide a ‘look through’ of nominee accounts – other than for specific risk-based reasons. This is not required under FATF correspondent banking regulations and we do not believe this contributes to the efficiency of the market. If a management company is concerned that a distributor has failed to comply with the terms of its distribution agreement, this is a matter that the ManCo should take up directly with the distributor.

FATF has issued guidance on correspondent banking services in the wake of the global financial crisis. Importantly, these FATF recommendations do not require that financial institutions conduct due diligence on the customers of their customers.
Rather, these advise that a correspondent banking institution conducts enhanced due diligence on its direct intermediary (distributor) customers and that it “will monitor the respondent institution’s transactions with a view to detecting any changes in the respondent institution’s risk profile or implementation of risk mitigation measures, along with any unusual activity or transaction on the part of the respondent, or any potential deviations from the agreed terms of the arrangements governing the correspondent relationship.”

In practice, where such concerns are detected, the correspondent institution is expected to request further information on the transaction(s) and the customer(s) involved. However, the correspondent banking guidelines state clearly that “there is no expectation, intention or requirement for the correspondent institution to conduct customer due diligence on its respondent institutions’ customers”.

Risk Factors
The general guidance that is provided at regulatory level in Europe regarding money-laundering and terrorist financing risk assessment is laid out in the European Supervisory Authorities (ESA) guidelines on AML/CFT Risk Factors. These guidelines, issued by the ESA in June 2017, are intended to promote a common understanding of a risk-based approach to AML/CFT and how this should be applied.

These include guidelines on due diligence and details of where enhanced due diligence (EDD) should be used in ‘higher-risk’ situations – for example, when a transaction involves a politically exposed person, an unusual transaction, a high-risk country or a high-risk correspondent relationship.

The ESA Risk Factors document is aligned in many areas with the standards laid down by the International Securities Services Association (ISSA) for preventing crime in securities markets (known as the Financial Crime Compliance Principles for Securities Custody and Settlement, FCCP). However, section 219 of the ESA Risk Factors specifies that a market participant may apply risk-sensitive measures to assess the adequacy of a service provider’s due diligence procedures; and it may also ask for documentation on beneficial owners upon request.

At Clearstream, we strongly support the first of these principles, notably the right of market participants to apply risk-sensitive measures to evaluate the due diligence standards of their service providers. However, the second provision, the requirement to ask nominees to provide supporting documentation on end investors, is often difficult to fulfil. The General Data Protection Regulation (GDPR) in the EU, for example, often limits our ability to access and pass on identification documentation (e.g. a passport or national identity card) of a beneficial owner.

When this level of look-through is required by a national regulator, a potential solution is to outline this provision in Clearstream’s market guidelines. It is then clear to investors that they must adhere to this requirement as a condition for investing in a specific market or product. However, it is uncertain whether either the Luxembourg investment community or the Commission de Surveillance du Secteur Financier (CSSF), the Luxembourg financial regulator, will favour this approach.

A more general concern is that this provision under Section 219 of the ESA Risk Factors is not consistent with global standards around transparency and disclosure. As we have noted, this is not required under FATF Correspondent Banking regulations. Moreover, in the US, the world’s largest mutual fund market, the Securities and Exchange Commission provides clear guidance that there is no obligation to look-through a regulated financial intermediary. The industry and the European supervisory community might perhaps ask themselves whether there is a sufficiently strong case to justify departure from global norms, especially when the effect might arguably be to undermine the standards that European regulators apply to all other asset classes whilst relieving key actors of the burden of fulfilling their AML-related duties.

Concluding thoughts
Clearstream is working constantly to offer efficient, automated operational processing and to maintain the highest standards of asset protection. However, we believe that applying AML standards to request information that is not already captured under the EDD provisions of correspondent banking standards is not a good way forwards for the industry.

When a fund processing platform such as Vestima is already regulated as a securities settlement system, as an ICSD and as a bank, asset management companies need to place their confidence in the application of the EDD requirement and to recognise that the identity of the distributor is already being communicated by our fund platform to the TA in a variety of machine-readable formats each and every time a subscription or redemption order is placed.

Any further information, over and above this EDD standard, is best captured through having appropriate risk triggers in place. As an industry, the general principle from an ISSA-compliance standpoint is to focus resources where the risk is. We believe that such an approach is also appropriate for the marketing of investment funds. From an AML perspective, UCITS or OEICs are low-risk financial instruments. Criminal parties wishing to launder money or to finance terrorism are unlikely to select these collective investment vehicles - which are publicly offered, tightly regulated and marketed through a closely supervised distribution network – as a means of doing so.

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