In this edition of the Navigator, we briefly review some of the geo-political changes that impacted financial services throughout 2018, share industry conference chatter and examine old news that resurfaced in the headlines last year. We follow this commentary by keeping you informed with a summary of relevant regulations taking effect this year. This edition wraps up with our thoughts on the most important trends for financial services and our prescription for success in 2019 and beyond.
Section 1: Regulatory Trends
Each year, our professionals engage with clients, colleagues and industry experts around the world to stay ahead of the latest regulatory trends and developments. Here, we summarize some of the most salient points heard buzzing at recent industry events.
Get with the (AML) Program
The Cost of Incompliance
On March 12, 2018, the U.S. Court of Appeals for the Ninth Circuit issued a ruling in the case, California Pacific Bank v. Federal Deposit Insurance Corporation. While the Opinion lays out a number of eye-catching anti-money laundering (AML) failures and poor management decisions by the Bank and its management, all AML, compliance, risk and banking executives as well as Board members should take particular note of Judge Gritzner’s comments regarding the enforcement of the Federal Financial Institutions Examination Council’s (FFIEC's) BSA/AML manual. The manual was created for bank examiners, but has largely been used as a guide by banking professionals whilst building, maintaining and enhancing their AML compliance programs. The industry at large has considered this manual (and all FFIEC manuals) as guidance tools, but not necessarily regulations. The conclusion of Judge Gritzner’s Opinion reads, "We hold that the BSA and its implementing regulations are not unconstitutionally vague, and the FDIC did not exhibit unconstitutional bias against the Bank. We further hold that the FDIC acted in accordance with the law by relying on the FFIEC Manual to clarify its four pillars regulation."
We suggest that as a result of the above underlined sentence, institutions take a proactive approach and reconcile their entire AML compliance program with that of the FFIEC's manual and clearly document gaps and/or variances with the manual. Management may wish to put a process in place to mitigate those gaps and seek the appropriate advice should it be warranted.
This summary does not constitute legal advice, but instead a means for identifying a potential AML/BSA regulatory risk.
Even More Guidance
On April 13, 2018, FinCEN issued enhanced FAQs covering the Customer Due Diligence Rule, which went into effect May 11, 2018. A&M reviewed the enhanced FAQs and highlighted some of the more common issues facing financial institutions. For example, the enhanced FAQs clarified requirements for indirect owners, provided additional information regarding methods of verifying beneficial ownership information and addressed renewals of low-risk products, such as loans or certificates of deposit.
Keeping up with the Customer Risk Ratings
With customer risk rating practices continuing to evolve, organizations must consider the following: (i) customer risk rating models must be tailored to each institution’s specific customer base and service offering, (ii) like any automated tool, the model must be tested and validated on a periodic basis, and (iii) due diligence doesn’t stop at the data required for risk rating; for higher risk customers, it’s just the beginning.
Section 2: State of the Market
Bills, Bills, Bills
We previously wrote about a promising Bill, H.R. 4373 (named The AML & CTF Modernization Act), that was introduced on November 13, 2017. While no major actions were taken on H.R. 4373 since its introduction, a similar Bill, H.R. 6068 (named The Counter Terrorism and Illicit Finance Act), was introduced and referred to the House Committee on Financial Services on June 12 of this year. Both Bills seek to reform the legislative landscape around AML in the U.S. with some common objectives like revising the SAR & CTR reporting thresholds. Despite being recently introduced to the House of Representatives in June 2018, H.R. 6068 has already garnered the support of the American Banker’s Association (ABA), the Credit Union National Association (CUNA) and the National Association of Federally-Insured Credit Unions (NAFCU).
Section 3: Forward Thinking
Blockchain and Cryptocurrencies
As the regulatory landscape for digital currency trading platforms continue to evolve, one of the most interesting issues to be addressed is the intermediary-like nature of these entities. In the traditional financial market structure, the roles of exchanges, intermediaries (e.g., broker dealers, futures commission merchants, swap dealers, etc.), and clearing houses are largely played by separate legal entities. However, thus far, we are seeing digital currency trading platforms take on all of those functions that may be analogous to traditional financial product market structures. In context of traditional customer business intermediation, there is a long regulatory history that has been focused on protecting customer interests and assets. Customer assets must be held separately from the assets of the intermediary, and in the event of a bankruptcy there are established procedures for identifying and moving customer assets to a new intermediary. Such requirements do not currently exist in the digital currency space. However, we may soon see regulators take steps to impose customer productions in the event of trading venue insolvency. Important topics for consideration may include:
- Should digital currency trading platforms have explicit fiduciary responsibilities?
- Are customer fiat assets segregated from those of the trading platform?
- What protections are in place to prevent misappropriation of customer fiat assets?
- If the trading venue provides proprietary wallet services, what mechanisms exist for the transfer of digital assets during a solvency event?
- Are additional regulations necessary to ensure secure custodial services for digital assets?
Non-Traditional Transaction Monitoring
Transaction monitoring is an area in which Financial Institutions (FIs) have never been able to find common ground. The exercise of uncovering all customer-initiated activity (financial and non-financial) and finding a way to scientifically detect “suspicion” in a deluge of noise is no small task. Artificial intelligence (AI) and machine learning (ML) are often discussed as solutions but may inherently cause confusion to regulators who need to understand the “black-box” identifying suspicious activity. Moreover, tuning the settings of a transaction monitoring system to appropriately detect the fluctuating risks at any given FI can quickly become a fruitless exercise.
As market and regulatory conditions are driving progress on the Transaction Monitoring front, we are also observing a fundamental shift from the traditional ways that money has been transacted. In order to meet this shift away from previously accepted norms, “non-traditional” Transaction Monitoring will need to move well beyond the industry’s antiquated cash-centric view of money laundering. Since we are still very early in this transition, we will not attempt to predict the future of Transaction Monitoring. However, based on our experience, we can assert that the following five factors will be the most critical enablers of reshaping the Transaction Monitoring landscape:
- The global population of underbanked, unbanked and underserved communities will gravitate towards non-traditional forms of money exchange (e.g. peer-to-peer);
- The Digital transformation of Banking (and demise of brick and mortar) will reshape the average volume and amount of transactions, as well as the nature of data being analyzed;
- Proliferation of UBO (Ultimate Beneficial Ownership) information as a result of global regulatory mandates (CDD rule in U.S., AML4 in Europe) will result in FIs having a better understanding of transaction networks and related parties;
- The onset of digital currencies presents an appealing alternative to cash, especially considering the ease by which users can transact without a centralized clearing authority while maintaining anonymity, transferability and expediency; and
The ability to (mis)use transaction monitoring technologies is a key challenge being addressed by the new breed of RegTech/AI tools. There is an emphasis on the importance of automation, intuition by learning, productivity/yield and continuous self-tuning; all the areas where the present breed of traditional, scenario-based Transaction Monitoring technologies lack.