January 30, 2020 / 5:46 PM / 21 days ago

INTERVIEW: Acing the 2020 U.S. compliance exams: advice from a veteran top regulator

NEW YORK(Thomson Reuters Regulatory Intelligence) - New examination priorities and rules from U.S. financial regulators put the onus on firms this year to carefully review their business models, products and contracts, and to make sure that their technological capabilities can match those of the oversight agencies come exam time, a former top U.S. regulatory official said in an interview.

Carlo di Florio, chief services officer ACA Compliance Group. Former head of SEC exam office and FINRA chief risk and strategy officer.

Carlo di Florio, who headed the Securities and Exchange Commission’s exam office and served as chief risk and strategy officer for the Financial Industry Regulatory Authority, identified topics of significant new emphasis in this year’s regulatory exams. They include: how investment firms are implementing Regulation Best Interest and other new customer-care rules, how firms are preparing for the discontinuance of LIBOR benchmark interest rates, how they ensure the legitimacy of any environment, social and governance (ESG) investment strategies and how they adapt to technology developments including the rise of “alternative data” trading information.

"We always tell firms ... do a health check against your own business, and then fix those issues," said di Florio, who now is chief services officer for ACA Compliance Group. "When regulators come in they are going to assume that you had the opportunity and if you haven't addressed the issues yourself, and if they're spotted by the regulators, then that can result in deficiency letters, enforcement actions and other problematic issues," he said in an interview with Regulatory Intelligence, a portion of which was videotaped{here}.


One of the biggest regulatory changes to affect Wall Street this year is the SEC's package of rules governing sales practices and customer relationships. The package, adopted last year, includes Regulation Best Interest for broker-dealers{here}, Form CRS for both brokers and investment advisers{here}, and investment adviser standard of conduct guidance{here}. The principle underlining the suite of sales practices rules -- aligning the firms with their customers' best interests – will require firms to review all of their operations, products and communications to consider whether their dealings are fair and transparent for clients and meet the new regulatory requirements.

Although compliance with the new SEC sales-practice rules will be a top examination priority for regulators, examiners from FINRA and the SEC have signaled their willingness to work with firms on how to implement what is the most comprehensive set of sales practice rules to be issued in decades. Regulators are aware that there will be “unanticipated or unintended consequences” in implementing the 2,000 pages of rules, di Florio said. The compliance date for Regulation Best Interest is June 30. This means examiners will spend the first half of the year looking at how firms are preparing for the new rules. In the second half, they will be scrutinizing how well they are complying.

The entire year, however, will be used as a learning experience for the industry and its regulators.

“In this early period they want to be helpful. They’re trying to promote compliance. They want to get out there and understand what firms are doing, how they’re doing it, what are the challenges they are facing,” di Florio.

Examiners will be looking to see that firms are providing clients with full and fair disclosures, that they are clear about how they manage conflicts of interest, and that they have a solid compliance framework governing policies in the area, he said.

The industry self-regulator FINRA will have the largest task, since Regulation Best Interest requires the biggest changes for the broker-dealers they oversee.

“Broker-dealers are going have to spend significant time … aligning their business models, their compliance programs, their systems, their operations and products with these new requirements. That’s a big lift,” di Florio said.

The required Form CRS customer relationship document may be a particular challenge for firms dually registered as broker-dealers and investment advisers, to be demonstrably clear about the disclosures, conflict managements, compliance controls and products relevant to each category of service, he said.

Although the pressure on firms to get it right will rise, this year will largely be about “gathering the lessons learned from this first year of exams and likely you’ll see the issuance of risk alerts and guidance” from regulators. Firms should not miss the chance to engage on the first round of inspections so that “everybody can benefit from that and invest in taking their programs to the next level,” he said. Failing to do so will raise future regulatory risk.


The SEC included environment, social and governance (ESG) investing in its examination priorities{here} for the first time this year, reflecting the rapid growth in investment products and strategies catering to growing market demand for socially responsible investing. Di Florio cited this priority as an example of how firms will need to consider compliance in new ways.

The SEC will examine firms to ensure that those handling ESG investments are fulfilling their declared investment strategies. The agency will be less concerned with measuring the real-world impact of environment, sustainability and governance strategies, but rather it will focus on the accuracy of ESG disclosures and how clients’ ESG preferences are carried out.

“This is a fast-growing asset class and strategy, and regulators want to sure that there’s some rigor and discipline about how firms and individuals market their services in this area,” di Forio said.

“The SEC wants to make sure that, 'if you say you're doing that, show us,'" he said. "They will look to see that you have put some form of control in place and that you are going to apply that basis in a consistent, repeatable way and that you have monitors and testing to make sure.” He cited standards such as UN Principles for Responsible Investment{here} or the World Bank's International Finance Corporation sustainability framework{here+framework} as an example of guidelines asset managers have signed onto as a demonstrable foundation for their ESG strategies.


The transition away from the LIBOR (London Interbank Offered Rate) interest rate benchmark will have relevance for both professional and retail investments, and the SEC considers the issue one of its top priorities. Di Florio cited the need for firms to begin reviewing benchmarks “now with a sense of urgency — because it’s not a light lift.”

LIBOR is scheduled to be phased out at the end of 2021. But since it is the most widely used reference point for interest rates in millions of financial contracts across the financial industry, regulators around the globe are sounding increasingly strident warnings that firms already risk being unprepared. “You have to be able to identify all the places where that (LIBOR) is referenced,” di Florio said. Changing numbers in contracts unilaterally will not suffice; “You have to engage all the parties to that agreement,” he said.

U.S. examiners will be looking for firms to show how they are preparing, that clients understand the implications for their contracts, and that they have a path to compliance with the replacement reference rate. Examiners “will want to understand how are you are looking at all these issues and making sure that there is a smooth transition here in your firm and a smooth transition for clients of your firm,” he said.


Technological advances sweeping the financial industry will be reflected by examiners in several ways. The SEC has targeted the use of “alternative data,” or new sources of information analyzed with computing technology, in making investment decisions. Firms using data from sources such as web sites, satellite imagery and consumer credit card information in driving investment strategies will need to make sure that the data does not violate insider-trading prohibitions or privacy rules or yield unsupported claims.

Firms need to have “have an effective compliance program to control it” and must understand that use of alternative data could give them “an unfair advantage in using material non-public information,” Di Florio said. Firms must understand that they will be held accountable. Alternative data vendors may often lack experience in the regulated securities industry, but investment firms will be liable.

“It has become a huge focus now for regulators,” di Florio said. “Firms must get comfortable with having due diligence, compliance monitoring and testing the data that you acquire and use.”


Private funds pose a growing challenge and regulatory priority, di Florio said.

“Last year there were some implicit indications around the expectations for private funds, but this year there was an explicit section in the priorities letter that focused on private funds,” di Florio said. The use of alternative data by managers of hedge funds, other private funds and asset managers in general will be one likely focus, he said.

“Whether you’re a large asset manager or whether you’re hedge fund, private equity firm or small investment adviser, if you are buying data you need to be able to demonstrate to the regulators ... how you have an effective compliance program to control that that’s material non-public information,” he said. “They want to understand how that data is being used to inform investment decisions. They want to understand how it’s being surveilled and tested.”


FINRA, the brokerage industry self-regulator, has reorganized to create five specialized sectors — retail, capital markets, carrying and clearing, trading and execution and diversified. The goal is to give examiners a deeper level of expertise to understand the risks faced by the sectors, so they can “better organize to execute exams” and develop technology tools to add efficiency.

Such specialization positions FINRA examiners, as they carry out the regulator's 2020 exam priorities{here}, to become “more expert and able to go deeper into each of those business models, and I think that it's going to be a positive for investor protection,” said di Florio, who served as co-chair of the committee heading the FINRA restructuring. It also helps the agency stay relevant and effective as the traditional brokerage offices overseen by FINRA decline and the industry adopts new models.


Firms will need to keep pace with the regulators’ growing ability to accumulate and analyze vast amounts of data as they examine firms. Regulators no longer have to hope that spot checks or random samples of trade information will point them to problems. Now, they can analyze vast, comprehensive data on a firm’s policies and practices, transactions and communications, and firms need to use similar processes to pinpoint problems and start fixing them before examiners identify them.

“In the old days, you (as a regulator) had to look at some simplistic data, do random sampling, and try to find a needle in a haystack,” he said. “You’re seeing new technologies like artificial intelligence, machine learning, natural language processing and robotic process automation being deployed to help surveil our markets ... So rather than looking for a needle in a haystack you’re actually ingesting the whole haystack and identifying the specifics spots where there are likely to be needles.”

“Where firms want to be is that they have similar tools, that they’re looking at their own data and identifying those issues before regulators come in ... and find regulatory issues,” he said.

*To watch the videotaped interview with di Florio, please click: here)

*To read more by the Thomson Reuters Regulatory Intelligence team click here: bit.ly/TR-RegIntel

(By Richard Satran of Regulatory Intelligence)

This article was produced by Thomson Reuters Regulatory Intelligence - bit.ly/TR-RegIntel - and initially posted on Jan. 30. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters

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