An Introduction to a Few Different Approaches to Regulatory Compliance

Regulatory Approaches Compliance

There are a few different ways via which a country or industry can establish its regulatory framework and set the many obligations its members must comply with. These generally vary based on the jurisdiction, the specific industry, the markets involved, and the cultural sentiment, among others.

More specifically, there are two general approaches that determine regulatory compliance and how it is run. These are:

  1. The Rules-Based Approach, which describes in detail the regulatory requirements and sets the rules that will determine a company’s or individual’s behaviour.
  2. The Principles-Based Approach, which is based on principles or values that are followed by the interested parties or shape their behaviour, henceforth leading towards complying with the relevant requirements.

Below we will break down each one of these approaches and shed light on a few more options that are specific to certain industries and jurisdictions.

Rules-Based Approach Compliance

The Rules-Based Approach

When applying a rules-based approach, regulated entities are required to adhere to strict and precise rules, which are applied by the regulator and do not have much space for self-interpretation.

So, for example, if there is a £700 fine for speeding in downtown London and you decide to emulate Lewis Hamilton right outside our headquarters on Lime Street and get pulled over by a police officer, you will have to cough up the money. It’s a strict and precise rule that offers no flexibility in how it is read.

Generally speaking, the rules-based approach is often considered a tick box activity. Therefore, it is essential to be sufficiently detailed and have enough information in order to be able to distinguish between what is right and what is wrong. 

In this instance, regulated entities have to adopt and implement control measures that will ensure compliance with the rules. A high degree of prescription related to the precise rules creates a significant strain on the regulator considering evolving business activities, technological advances, and a growth in the range of products.

The rules-based approach is usually introduced in highly regulated environments, e.g., the EU or USA, whereby regulatory bodies impose detailed rules that regulated entities must comply with in order to fulfil their obligations.

Principles-Based Approach Compliance

The Principles-Based Approach

The principles-based approach is based on establishing high-level and pre-set expectations for how and to what extent principles should be met. Rather than prescribing a particular process, it includes behaviours that regulated entities should incorporate into their activities and the types of outcomes that should be achieved from paying heed to said principles.

The realization of the requirements established by a principles-based approach will depend on the strong ethical standards of those individuals in control of the relevant regulated entities, as well as the introduction of processes and controls that will enable them to do the right thing because that is what they ought to do.

The principles-based approach is common in most offshore financial centres, whereby the regulators issue a set of principles that regulated entities must follow or comply with. These offshore jurisdictions usually do not have enough resources to implement a rigid rules-based approach.

The principles-based approach is beneficial for those seeking innovation and freedom to develop services and business models. However, their actions must be consistent with the principles and the outcome must be in line with the regulatory framework.

Self-Regulation Compliance

Self-Regulation

Self-regulation is an integral part of many regulatory schemes, in a variety of different markets, and involving different types of participants. In order to be effective, self-regulation must be defined within the context of government oversight.

More specifically, self-regulation is a governing collective of behaviours carried out by relevant participants that is based on the same principles as those identified for government regulation of the financial markets. The main objectives of self-regulation are to preserve the market and its financial integrity and protect investors.

Overall, self-regulation encourages adherence to set standards of best practice among its participants and operates within the parameters of national laws.

While differing between jurisdictions, they all have in common specific requirements for responsible behaviour that fall under the oversight of the statutory regulators.

Considering the rapid changes in complex industries, self-regulation provides greater flexibility in adapting to regulatory requirements.

In self-regulation, the rules that should be followed are drafted by market participants who possess a particular knowledge of the relevant market, and who have the ability to make the most of the regulatory benefits while minimising the business costs.

Self-regulation typically focuses on oversight of the market itself, qualification standards for market intermediation, and oversight of the business conduct of intermediaries, although some approaches may be applied purely based on ethics (e.g., avoidance of sectors such as weaponry or tobacco).

Key Elements of an Effective Self-Regulation Model

Here are some key elements that contribute to an effective self-regulatory model as explained by the International Organization of Securities Commissions (IOSCO), a global association of organizations that regulates the world’s securities and futures markets:

  1. Specialised knowledge in the industry, taking into account the increasing complexity of the different markets and their products.
  2. Motivation to operate a fair, financially sound, and competitive marketplace, considering that reputation and competition are powerful motivating forces for the establishment of sustained and proper behaviour.
  3. Contractual relationships that set ethical standards that go beyond national boundaries or governmental regulations.
  4. Transparency and accountability when it comes to professional standards of behaviour and issues related to confidentiality.
  5. Flexible compliance programmes that have the ability to modify rules in response to changes taking place in the industry more readily than government agencies.
  6. Coordinating and sharing information that address cross-market issues, including potential market abuse or systemic risk concerns that may impact more than one market.
  7. Development of guidebooks and other educational materials to help companies and individuals meet their regulatory requirements.

Below we look at a few good case studies of self-regulation in action.

International Swaps and Derivatives Association (ISDA)

Headquartered in the U.S., the International Swaps and Derivatives Association (ISDA) is an organisation that creates industry standards for the participants of OTC derivatives. Its primary goals are to build robust, stable financial markets and a strong financial regulatory framework to make global derivatives markets safer and more efficient.

ISDA introduced its Master Agreement, which includes the legal definitions of terms that should be used in contracts for OTC derivative contracts. The introduction of the agreement has assisted in a significant reduction of credit and legal risks applicable to its participants, which come from over 75 countries.

Islamic Finance

The Islamic Financial Services Board (IFSB) Council, which is headquartered in Jeddah, Saudi Arabia, introduced its Core Principles for Islamic Finance Regulation, dealing with the regulation and supervision of Islamic banking.

Its core principle is the faithful and ethical-based regulation of the Islamic finance industry in order to protect consumers and other stakeholders and safeguard systemic stability.

The IFSB’s main objective is to develop and promote a prudent and transparent Islamic financial services industry, one that is consistent with Sharī`ah principles. Moreover, the participants offering Islamic financial services are required to act in accordance with their fiduciary responsibilities, including those related to the profit-sharing investment accounts, Riba (prohibition on earning interest), and Ihsan (receiving more than is due).

Entities involved are required to implement relevant aspects of corporate governance, including compliance with Sharī`ah rules and principles. Additionally, they have to activate and manage the role of the Sharī`ah board in governance, the role of auditors in terms of independence and accountability, and the processes, controls, and transparency of financial reporting with respect to investment accounts.

The other sectors of Islamic finance (principally Takāful and the Islamic capital markets) are substantially smaller in scale than Islamic banking. Plus, like for other financial institutions, Islamic financial institutions are authorised and supervised by the regulatory authority in their country of incorporation.

Is there anything else we forgot when it comes to regulatory approaches in the financial services world? We cannot wait to hear what you have to say!

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