It seems that the controversies surrounding SEC’s newly adopted Regulation Best Interest rule (Reg BI), would continue to take center stage, even though it goes into effect next summer. The regulation is the culmination of a decade-long process that started in 2010, immediately after the great recession. The Dodd-Frank Act passed that same year authorized the SEC under section 913 to enact a fiduciary standard and best of interest rule to govern broker-dealers and investment advisors when engaging with private investors.
In the aftermath of the introduction of Reg BI, stakeholders, state regulators, investment advisers and broker-dealers have weighed in on various factors that could undermine or aid its effectiveness.
5 Key Takeaways
- Brokers Dealers required to adhere to new “best interest” standard
- Sets up U.S. Department of Labor (DOL) to synchronize rule-making (later this year)
- Big win for broker dealers → even bigger for financial services
- The New Common Reporting Standards (CRS) Says Broker = Advisor → confusion between broker vs fiduciary advisor
- Reverse focus on protecting brokerage role than consumer = more confusion
However, before we highlight these takeaways, let’s first take a look at the substance of the fiduciary standard clarification rule.
The Takeaways from SEC’s Regulation Best Interest Rule
SEC intends to subject broker-dealers, who currently are only required to meet suitability standards, under fiduciary standards.
On one hand, fiduciary standards presently govern the relationship between financial advisors and their clients. And it expects the former to only offer services that are in the best interest of the latter. On the other hand, suitability standards require brokers to ascertain that the investment they recommend suits their clients.
In essence, the rule looks to extend the fiduciary rule on broker-dealers who are increasingly taking up the roles of financial advisors, when their primary duty is to sell an investment product for a stipulated commission. Under the suitability standard, it is legal for a broker to recommend an investment product that avails him a good commission, so long the product is suitable to the customer.
While this is a given, it also presents a conflict of interest. It’s possible that there are cheaper investment products with similar features to the one the broker recommends, but with a less attractive commission. This conflict of interest is what the Reg BI looks to eliminate, as it requires brokers to place the client’s interest above theirs.
To do this, the rule would enforce brokers to explicitly disclose important information such as incentives and commissions that could influence their recommendations. More so, it would, to an extent, ban industry practices, like incentives in the form of vacations, that could spur brokers to betray the interests of their clients.
Knowing fully well that brokers could find a way around this requirement by disclosing conflict of interests with technical terms or in a voluminous document, the SEC also introduced another requirement that could counter such practices. The requirement states that brokers must outline conflict of interests and their compensation structure in plain English and in a concise manner on a document called form CRS.
Also, brokers would document the history of legal or disciplinary actions taken against the firm offering the investment product or its financial professionals. Another vital feature of the rule is Care Obligation. This requirement entails that financial advisors to make sure that they diligently and carefully ensure that their recommendations are in the best interest of their clients.
The last requirement is the Conflict of interest obligation. It requires the management and mitigation of commissions that could represent a financial conflict of interest.
Dissecting the Implications of The Regulation Best Interest Rule
As expected, critics left and right have dissected SEC’s Reg BI, and the prominent argument that many have brought up is the fogginess of the rule. For one, some critics have condemned SEC’s reluctance to clearly define what it means by “Best interest”, the actions that would suggest that an investment advisor is not compliant, and how to mitigate financial conflict of interest.
Chances are that broker-dealers would look to find a way around this rule, at least until SEC starts enforcing disciplinary actions against non-compliant investment advisors. Besides, Reg BI does not seem to have enforcement muscle. It is unlikely that non-compliance would lead to class action lawsuits and litigations.
Furthermore, there is an outcry that SEC’s rule has done nothing to clarify to investors the roles of Investment advisors and broker-dealers. Note that a majority of brokers-dealers are registered with the SEC. Technically, this means that they could assume the roles of Registered Investment Advisors (RIA), and yet, they are not fiduciaries.
More concerning is the fact that the Form CRS requirement would do little to change the status quo. This notion stems from the fact that studies showed that consumers found it difficult to understand the contents of CRS forms.
While responding to many of the criticisms leveled against Reg BI, SEC’s chairman, Jay Clayton stated that “differing views were expressed regarding whether the standard should be more principles-based or more prescriptive — and in particular, whether to provide a detailed, specific, situation-by-situation definition of ‘best interest’ in the rule text.”
As such, after careful consideration, the agency concluded that the principle-based approach adopted for the rule “is a common and effective approach to addressing issues of duty under law, particularly where the facts and circumstances of individual relationships can vary widely and change over time, including as a result of innovation,”
Judging from the details of Reg BI discussed above, there is no doubt that the rule has elements of the fiduciary rule that the Obama administration proposed through the Department of labor. The difference is that the latter was looking to classify all investment professionals as fiduciaries. In other words, a client could decide to sue his investment advisor or broker once he notices any discrepancies that would suggest that his interests were not best served by the actions of his investment manager.
Recall that this rule hit a roadblock under the present administration, as the securities industry challenged its viability in court. And while DOL has also indicated that it is pushing for a new fiduciary rule, there is no guarantee that its future proposal would have the same grit as the previous one. This assertion is probable, considering the likelihood that Eugene Scalia, the attorney that led the case against DOL’s previous fiduciary rule, would emerge as the new Labor Secretary.
Also, it is important to note that the Certified Financial Planner Board of Standards plans on enforcing an ethics code that would entail that its 84,000 members adhere to fiduciary standards, irrespective of the regulatory frameworks that govern them. Interestingly enough, this code’s implementation date coincides with that of Reg BI’s.
More importantly, some states are contemplating on taking matters into their own hands by imposing separate fiduciary rules that would correct the apparent flaws of Reg BI. For instance, New Jersey’s security bureau has released a rule proposal that explicitly classifies brokers- dealers as fiduciaries. Other states that have taken a similar path are Nevada and Massachusetts.
In response to this development, SEC’s chairman, Jay Clayton, stated that “I and many others believe a patchwork approach to the regulation of the vast market for retail investment advice will increase costs, limit choice for retail investors and make oversight and enforcement more difficult. I am hopeful that our regulatory colleagues will continue to work with us to minimize inconsistencies and maximize the effectiveness of our collective efforts.”
However, regardless of the loopholes of Reg BI, and the controversies that spurred responses from state regulators, I believe that the SEC’s proposal is a step in the right direction in order to protect investors.
For investors, it is a matter of asking the right questions:
- Who pays your broker’s commission?
- How much he gets paid for encouraging you to buy an investment product.
- Are you a fiduciary?
- How does a broker apply investor protection rules?
The information provided here is personal opinion and provides only a subjective opinion of the rules and regulatory guidance provided by the SEC. It should not be read as legal or compliance advice. Consult with your compliance professional for further details.
New Framework Passed in Cayman Islands, Addressing Virtual Assets
This framework, which was first put forth in early May of 2020, is comprised of 5 bills; each of which has the goal of facilitating a transparent, and safe, environment for market participants. Finance Minister, Tara Rivers, noted the following points, elaborating on the goals of this framework.
- Innovate financial services
- Provide regulatory clarity
- Protect consumers
- Comply with FATF recommendations
By passing this framework, the Cayman Islands have put a good foot forward in their treatment surrounding virtual assets.
Found within this new framework are two notable highlights.
- The Virtual Asset Service Provider Law
- Under this newly passed law, virtual asset service providers (VASP) must register with the Cayman Islands Monetary Authority (CIMA)
- Regulatory Sandbox
- This ‘sandbox’ is essentially a program which allows for companies to test/prove the viability of new products and services, without the need for full licensing.
When commenting on the purpose of these bills, Finance Minister, Tara Rivers, indicated that one of the reasons behind this move is to attract ‘legitimate businesses’.
Cayman Islands has long been noted as a tax haven nation. Due to friendly regulations surrounding taxation, businesses world-wide seek to ‘set-up-shop’ in the tiny Caribbean nation.
While this may have been the case at one point in time, regulators have been working hard to change this narrative/perception. This new framework is just one such example, as it is structured to enforce compliance with international AML practices; in doing so, it is hoped that criminal activity, which often makes use of new technologies, will be abated.
With a population of roughly 65,000 people, Cayman Islands is one of the larger island nations found in the Caribbean.
On island, multiple regulatory bodies work together to ensure companies employ safe practices. Two of these, which had a hand in the passing of this new framework, include:
- The Caribbean Financial Action Task Force
- The Cayman Islands Monetary Authority (CIMA)
In Other News
While a newly established sandbox within Cayman Islands is a good thing, they are not the first to take the leap in establishing such a program. We recently took a look at another sandbox program, established by industry leading, Vertalo. While the former is overseen by government regulators, the latter offers similar benefits; the ability to test out services in a low-risk environment.
Facebook’s Libra Wallet Calibra Rebrands to Novi Financial
This week, the company responsible for Facebook’s Libra wallet services, Calibra, announced a rebranding. The blockchain-based provider will now go by Novi. The rebranding demonstrates Facebook’s continued commitment to introduce the Libra project to the market, despite heavy opposition from lawmakers. Additionally, it signals a fresh marketing strategy on the part of the Libra team.
As part of the rebranding, Facebook created a new subsidiary – Novi Financial. Interestingly, the word Novi is derived from the Latin words “Novus via” which means “New way”. The name seems fitting as Libra developers search for a new way to get regulator approval for their advantageous project.
In a recent interview, company executives spoke publicly about the decision to rebrand the firm. Importantly, they stated that the name change didn’t change the companies commitment to bring financial service to all parts of the world. Executives explained that the rebrand was part of a larger strategy to bring the company more in line with the fluidity of cryptocurrencies and the overall goal of the Libra project.
According to developers, the Novi crypto wallet features a host of helpful features to support the Libra ecosystem. The Dapp will function as a standalone feature. However, it will have full interoperability within Facebook’s sphere of influence. This strategy would see the Novi wallet available to all Facebook, Messenger, and WhatsApp clients.
Notably, the wallet will offer users near-instantaneous transaction times. Additionally, users can send funds between each other at a fraction of the costs of traditional money sending services. Executives didn’t sate how the fee structure for the system will work, but they did say there would be no hidden fees. One is left to assume that the company intends to take a small percentage of each transaction.
Importantly, the Novi Wallet features built-in AML and KYC compliance mechanisms. Speaking on these systems, developers stated that users will need to verify their identity in various ways. These verification systems can include providing government-issued ID and verification video chats. Novi executives also didn’t give any details on a potential release date.
Their hesitant is well warranted as the Facebook Libra project continues to go through court proceeding with SEC regulators. To date, regulators have shown no sign of budging on their anti-Libra stance. Despite the current atmosphere of distrust, Facebook believes it has the capability to sway the tides.
SEC Taking Wins
Surely, Libra has a rocky road ahead of it. For one, the SEC continues to block any cryptocurrency projects presented from large social media platforms. A perfect example of their entanglement strategy occurred this week when Telegram withdrew its application for the TON blockchain ecosystem.
Novi to Bank
Regardless of the fate of Libra, Novi may still find a comfy home in the crypto sphere. For now, the entire crypto community awaits to see how Facebook plans to transform the mood of regulators and bring the Libra concept to light.
A First: Cryptoassets and Gold in EU Benchmark Compliant Index
CoinShares Group, the digital asset management firm took another step forward in establishing the presence of digital assets in the institutional investing space.
CoinShares Launches New Digital Asset Index
The CoinShares Group announced the launch of the Coinshares Gold and Cryptoassets Index (CGCI). This is the first index that has exposure to a digital asset and is also compliant with the EU Benchmark Regulations (EU BMR).
A huge milestone for cryptoassets, as Bitcoin which is often touted as the digital version of gold as an asset class, becomes an integral part of a financial product for institutional investors that seek to have exposure to digital assets.
Moreover, the pairing with gold in this index is done to combine the high volatility of cryptoassets with the low volatility of the precious metal. The risk profile of the index is smoothed out considering that there is no high correlation between gold and Bitcoin, according to CoinShares Group.
The index methodology maintains a basket of 5 equally-weighted cryptoassets weighted against gold. There is no fixed list of cryptoassets eligible for being included, but the criteria is based on 6 month-rolling market capitalization and excludes any ERC-20 tokens and privacy-focused cryptoassets.
The financial product goes through a re-balancing process, which occurs monthly, with the cryptoasset basket rebalances to include the top 5 eligible market cap weighted cryptocurrencies as of the time of rebalancing. The calculation of the index relies on Kaiko cryptocurrency market data along with Messari’s supply data – two leading data providers in the digital asset space.
Meanwhile, the weights between the cryptoasset basket and gold is determined based on a weighted-risk allocation scheme.
The development of the CGCI resulted from research conducted between CoinShares and Imperial College London, published in 2019, identifying that the pairing of gold and cryptoassets delivers a risk and return profile that is superior to holding either alone.
Cryptoassets Paired with Gold for Better Risk-Reward Profile
The index methodology was created from the research and experimentation conducted with the EU registered benchmark administrator, Compass Financial Technologies to ensure a robust and benchmark compliant index. As the first EU BMR compliant index, the CoinShares Gold and Cryptoassets Index is also live on popular financial data providers like Bloomberg Terminal and Refinitiv.
There are already several options for institutional investors to get exposure to cryptoassets, but with the high volatility of the market, investors may shy away from committing. This new weighted pairing with gold – one of the assets that is known to have a low volatility – allows investors to enter the digital asset space and benefit from higher returns while minimizing their exposure to volatility risk.
The CoinShares Group already has a great track record in the cryptocurrency space with several financial products which include the first regulated Bitcoin hedge fund and the first exchange-traded Bitcoin product.
Daniel Masters, Executive Chairman of CoinShares believes this is a major step forward for the digital asset space drawing parallels with the institutional adoption of commodities, stating:
“Robustly researched and documented index products were the catalyst for institutional adoption of commodities in the late ’90’s through the advent of the Goldman Sachs Commodity Index. This crypto and gold index aims to do the same, by using academic research and its benchmark regulated status to pass muster with even the most stringent investment committees.”
The Evolving Space of Digital Assets
The digital asset space has been longing for the attention of institutional investors for some time. In the last couple of years there have been several incursions by big institutions into cryptoassets. Established traditional financial institutions like Fidelity or ICE have launched separate entities for the digital asset industry since then.
However the crown jewel for the crypto space remains to be an approved Bitcoin ETF by the SEC, which would cement the asset’s place in its separate category. Nonetheless this goal seems to be as elusive as two years ago.
Several applications from different asset management firms have been rebuffed by the regulatory authority, and each one of them citing reasons related to the supply side of the cryptocurrency market – the lacklustre custody options, the inaccurate price data and uncertainty over exchange volumes.
Even though the cryptocurrency space developed ever since and more custody solutions appeared for institutional investors, and data providers seem to have built more robust price indices, there is no talk of progress towards approval of a Bitcoin ETF.
Maybe the key lies in the demand – when there is a sufficiently high institutional demand for digital assets, regulators may quickly change their tune.
CoinShares is part of this cohort of companies working to improve the infrastructure for digital asset financial products. With this new product, the company not only has the potential to generate institutional demand for cryptoassets, but also blazes a trail for further product innovation for others in the space.