Expanded risk management requirements for responsible entities
Author: Fadi Khouri
The purpose of this article is to provide an overview of ASIC’s new Regulatory Guide 259 (issued March 2017) (RG 259), and identify key action items for responsible entities with a view to addressing ASIC’s expectations.
Responsible entities have a statutory obligation to “have adequate risk management systems”. ASIC’s detailed survey in 2015 of 118 responsible entities about their risk management systems has informed ASIC’s approach to administering this broad obligation. Further drivers for this new “tailored guidance” include the increase in the amount of assets under management, the growth in the number of schemes, the diversification in size and complexity of schemes and the high number of collapses of responsible entities.
“Expectations” and “good practice guidance”
ASIC’s regulatory guide is broadly divided into two parts. Firstly, ASIC sets out in detail its “expectations” for responsible entities in relation to
- Overarching risk management systems required to be put in place.
- Processes for identifying and assessing risks.
- Processes for managing risks.
Secondly, the regulatory guide sets out what ASIC describes as additional “good practice guidance”. ASIC provides that the guidance is “not mandatory”, and is intended to help improve risk management systems to operate at a level above the statutory threshold.
In the authors’ opinion, it would be prudent to endeavour to adopt many of the elements of the “good practice guidance”. ASIC acknowledges, however, that systems and processes may be adapted as appropriate depending on the nature, scale and complexity of the business and schemes operated by individual responsible entities.
Which entities are affected?
The guide is relevant for all responsible entities, including responsible entities also regulated by APRA, IDPS operators and MDA operators.
ASIC acknowledges that some aspects of its guidance may not be relevant to entities that operate unregistered schemes, however, operators are “recommended” to consider the guidance when reviewing their risk management systems.
There is no “transition period” for compliance with RG 259 as ASIC notes that its expectations outlined in RG 259 simply reflect what ASIC views as current requirements regarding risk management for responsible entities (in light of section 912A(1) (h)). Accordingly, responsible entities are encouraged to take immediate action to address compliance with RG 259. ASIC indicates it intends to take a “facilitative approach” to any breaches of the guidance for the initial twelve month period (if the responsible entity is taking steps to bring its risk management systems into compliance with RG 259).
Establishing a risk management system
ASIC outlines its expectations in relation to documented risk management systems, including a requirement to document a policy or statement on the responsible entity’s “risk appetite” and the “risk tolerance” for each material risk identified.
The guide singles out the requirement for the risk management system to deal with “liquidity risk management processes”.
ASIC expects a risk management system to be reviewed as frequently as appropriate given the nature, scale and complexity of the business, and at least annually.
If relying on an external service provider for risk management support, a responsible entity needs to have sufficient skills to independently monitor the ongoing suitability of the service provider.
Some notable “good practice guidance” items include
- At least every three years, conduct a comprehensive review of the risk management system.
- Segregate functions to allow for independent checks and balances.
- Establish a designated risk function or committee, and appoint a chief risk officer.
- Publicly disclose a summary of the key aspects of the risk management systems.
Identifying and assessing risks
This part of the guidance sets out ASIC’s expectations when it comes to identifying and assessing risks. Some notable inclusions include
When choosing methodologies for identifying and assessing risks, a responsible entity should ensure senior management involvement in the process.
A responsible entity should adopt appropriate methods to assess risks, which may (depending on the business) include self-assessment, stress testing and/or scenario analysis, loss data analysis, change management and electronic systems.
ASIC’s “good practice guidance” is to use risk indicators and regularly report on these to the board and senior management of the responsible entity.
Responsible entities should implement appropriate strategies for managing each of the material risks identified. This includes adopting a control monitoring and assurance process that considers the adequacy of coverage of controls and whether appropriate remediation strategies are in place, the effectiveness of internal controls designed to mitigate risks and the appropriateness of monitoring strategies and ongoing testing (such as by control assurance reviews by independent teams).
The framework for stress testing or scenario analysis should also be reviewed as frequently “as appropriate”, and at a minimum, at least annually. If a responsible entity does not conduct stress testing or scenario analysis, ASIC expects it to document why this is the case and to review this decision regularly. Also, the testing should include short term and prolonged adverse environmental impacts, and also take into account entity-specific and market-wide “shocks”. Some approaches acknowledged in RG 259 include sensitivity analysis, stress testing based on experience or historical events, reverse stress testing designed to identify a stress scenario that would cause failure, and a combination of scenarios.
ASIC’s expectations are that there is “regular reporting” and “escalation of issues” to the board, risk committee and compliance committee, as appropriate.
Some of ASIC’s “good practice guidance” includes the update of a scheme “compliance plan” for additional procedures for ensuring material risks are identified and managed on an ongoing basis. ASIC notes that this is in addition to the existing statutory obligation for compliance plans and suggests that these procedures could be included as an appendix to the compliance plan lodged with ASIC.
Examples of ‘risk treatments’
The regulatory guide contains an appendix listing practical examples of measures that responsible entities “may consider” in treating typical risks arising in their businesses. ASIC indicates that the examples are “not mandatory”, unless otherwise stated in the other parts of the guidance. The examples reflect common risks and measures that ASIC has observed through its experience dealing with responsible entities across the industry. Outlined below is a selection of examples of risk treatments referable to several key risk categories.
Governance risk is any risk that threatens the ability of a responsible entity to make reasonable and impartial business decisions in the best interests of members. Examples of ways a responsible entity can treat this risk include
- Obtaining independent advice on related-party transactions.
- Appointing independent directors or maintaining a diverse board.
A further interesting example provided involves publicly disclosing a summary of the key aspects of the risk management systems of a responsible entity.
This is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. Some examples of risk treatments include
- Auditing compliance with policies and processes.
- In areas where potential conflicts could arise (e.g. valuation, risk management, compliance), segregating these activities from the investment management function with separate reporting lines.
Legal and compliance requirements
This is the risk that a responsible entity may not comply with financial services laws or become subject to legal action. An example of a risk treatment is arranging for ready access to legal advice, whether internal or external.
Outsourcing can be exacerbated when there is inadequate supervision. Examples of risk treatments include putting in place appropriate service level agreements and having mechanisms for dealing swiftly with any actions by service providers that breach service level agreements.
There is a high risk that a responsible entity may be subject to malicious cyber activity. Examples of ways responsible entities can treat this risk is by conducting regular cyber-resilient health checks. ASIC has set out specific guidance in this area in REP 429: Cyber Resilience: Health Check.
This is the risk of the conduct of employees not being aligned with the interests or obligations of the responsible entity, such as through employees providing inappropriate advice, causing loss to investors or the responsible entity. An example of a risk treatment is to have appropriate remuneration systems that support risk management and do not create incentives for employee misconduct. A further example is to maintain an internal audit function.
An example of a risk treatment is to implement whistle-blower policies, including externally managed confidential hotlines.
Leverage and short-selling risk
Examples of risk treatments include
- Implementing appropriate leverage ratios and ensuring ongoing monitoring of compliance with the ratios based on recent asset valuations.
- Implementing appropriate limits on the amount of the portfolio lent or borrowed.
- Implementing strategies to manage related counterparty risks.
These demonstrate a further move in expectations by ASIC beyond the traditional disclosure-focused approach, although ASIC has for some time prompted responsible entities to focus on risk management.
Counterparty failure risk
This is the risk that a counterparty will fail to meet its obligations where the responsible entity cannot put in place a replacement transaction economically and efficiently to meet any ongoing obligations of the responsible entity. An example of a risk treatment is to ensure that agreements entered into include regular valuations, collateral standards (i.e. requirements for essential performance) and indemnification commitments (i.e. the requirement for a payment in the event of non compliance). A responsible entity should also avoid excessive reliance on a limited number of counterparties. The authors note that responsible entities (whether dualregulated by APRA or not) may wish to refer to APRA’s recent prudential standard CPS 226 Margining and risk mitigation for non-centrally cleared derivatives (which sets out APRA’s risk mitigation practices for non-centrally cleared derivatives, including relating to trading documentation and valuation processes).
Valuation and pricing risk
SIC highlights that this risk is generally higher for mortgage or property based schemes where the market price of a scheme asset is more difficult to determine. Examples of risk treatments include
- Carrying out regular independent valuations.
- Rotating valuers.
- Segregating the internal functions in charge of calculating NAV and maintenance of accounting records from the investment management function.
Examples of risk treatment measures that may be adopted at the “scheme level” include
- Appropriate internal thresholds for liquidity which are proportionate to the redemption obligations and ongoing commitments of the schemes.
- Ongoing assessments of the liquidity profile of the assets and liabilities (including the scheme’s investor profile and investors’ historical and expected redemption patterns) held by the scheme to ensure they will be able to meet investor expectations about redemptions.
- The use of tools to manage liquidity (where appropriate) and the regular assessment of those tools. Examples include redemption fees, suspension of withdrawal requests, redemption gates, in specie transfers, swing pricing, etc. The availability of such (useful) tools will likely depend on the constitution of the scheme as well as disclosures.
- Access to relevant information about liquidity management for investments such as information about the investor profile and liquidity management approach adopted by underlying funds invested in by a scheme.
- Further disclosure in product disclosure statements of investor redemption rights, liquidity risks, the liquidity management process and if the responsible entity has power to use any liquidity risk management tools.
Australia and Hong Kong seal agreement on FinTech cooperation
Author: Zein el Hassan
Australia and Hong Kong have recently signed a co-operation agreement which provides a framework for cooperation to support and understand financial innovation in each economy.
There is an argument that the financial services sector is always changing and that FinTech is a case of déjà vu. For those of us with some grey hair we have seen important innovations such as credit cards, automated banking machines and, more recently, online banking. But such innovation did not revolutionise financial services, even though they provided huge advances in convenience for customers. The key reason for this was that the established players in the financial services market continued to dominate the market, adapting to the changes, often by buying competitors and/or adopting their technology. However, there is now a strong argument that change is definitely in the air for the financial services industry. Customers, their faith and patience already shaken by the 2008 financial crisis, are demanding more. Given how accustomed we have all become to instant access to goods and services, it may come as no real surprise that we are also demanding the same from our financial services industry which is changing with the emergence of well-funded companies outside the financial space, such as Apple and Google.
The type of change that technology is producing includes adding interesting twists to existing technologies and business models promising lower costs, improved services and wider access. Peer-to-peer lending is one example, so-called “robo-advice” is another. On the other side of the spectrum is new technology that could truly transform the financial services industry with the main example being distributed ledger technology whose best known application is Bitcoin. Though innovative technologies offer opportunities to improve customer service and reduce prices, they also pose significant regulatory challenges with the key ones being consumer protection, market integrity and the rules that guard against money laundering and terrorism financing.
In September 2016, the Australian Securities and Investments Commission (ASIC) published its new corporate plan which noted that two of the five long term challenges it faced were FinTech related – digital disruption and cyber resilience and complexity driven by financial innovation. “We continue to see new and established firms explore digital platforms and service offerings in areas such as digital advice, crowd-sourced equity funding, market place lending, payments systems and distributed ledger technologies,” the report said. As part of its action plan to manage the challenges it faces the report stated that ASIC would negotiate and implement bilateral and multilateral agreements and understandings, including FinTech related agreements.
Recently, the Hong Kong Securities and Futures Commission (SFC) and ASIC signed a co-operation agreement which provides a framework for cooperation to support and understand financial innovation in each economy. The agreement will enable the SFC and ASIC to refer to innovative FinTech businesses to each other for advice and support via ASIC’s Innovation Hub and its Hong Kong equivalent, the SFC’s FinTech Contact Point. This means that Australian FinTech businesses wishing to operate in Hong Kong will have a simple pathway for engaging with the SFC, and vice versa. The cooperation agreement also provides for a framework for information sharing between the two regulators. This will help ASIC keep abreast of regulatory and commercial developments in Hong Kong and use this to inform Australia’s regulatory approach. To date, AISC has entered into FinTech related referral and information-sharing agreements with the SFC, the Monetary Authority of Singapore, the UK’s Financial Conduct Authority and the Ontario Securities Commission. In addition, information-sharing agreements have been entered with Kenya’s Capital Markets Authority and Indonesia’s Otoritas Jasa Keuangan.
Interestingly, the co-operation agreement was signed after the Asia Securities Industry and Financial Markets Association had issued a paper calling for better coordination among regional regulators and the adoption of a set of best practices for fostering FinTech in the region.
“The cooperation agreement is a significant boost for Australia’s burgeoning FinTech sector and will ease entry into this important market for innovative Australian businesses,” ASIC Commissioner Cathie Armour said in a statement.
NewLaw 2023 Careers Series Seminar
Stephanie Hamon, Head of Legal Operations Consulting at Norton Rose Fulbright will be participating as a speaker on the Legal Tech Engineer and Developers panel at Cognia’s Virtual NewLaw Careers Series.