RegTech Intelligence 
JWG analysis.
As financial regulations keep piling up in the post-crisis world, it becomes increasingly difficult to recognise the similarities and differences between them. The interdependencies on the Know Your Customer (KYC) front are present, but somewhat tangled. Here we provide an overview of the current and upcoming client classification requirements under prominent regulations, and attempt to locate the hidden rules which might link them all together.
EMIR
Under the European Markets Infrastructure Regulation (EMIR), investment firms and corporate entities need to report their Over-the-Counter (OTC) trades to ESMA in real-time. To do this, they will have to know their counterparty’s classification – whether they are a Financial Counterparty (FC), a Non-Financial Counterparty (NFC) or a Non-Financial Counterparty over the clearing threshold (NFC+).
While distinguishing FCs from NFCs can be done in little time, firms must assess whether any of their OTC derivative activity with NFCs has a value above the designated clearing threshold (and is not counted as activity designed to reduce risk) in which case the counterparty becomes an NFC+.
Failure to classify clients correctly may have a severe impact on a firm’s ability to do business, and can bring about fines for non-compliance – of which there have been plenty so far. The issue is that a firm’s customers are under no legal obligation to self-certify their categorical status to anyone but their competent authority and ESMA and, due to the cost and complexity of assessing whether they are over the clearing threshold or not, many customers have been reluctant to cooperate.
This has highlighted the cracks in current regulatory client classification requirements, and the industry has been keen to work on this … see below.
MiFID II
MiFID II will require that clients are also classified as either professional or retail, or eligible counterparties, which will determine the services that can be offered to them and the reporting requirements they will be subject to.
Professional clients are entities, such as credit institutions, investment firms, collective investment schemes, and will be given less protection in comparison to retail clients. Eligible counterparties include those who are opted up on the basis of their experience and expertise, and retail clients covers all others, and these are offered significantly more protection.
Due to mis-selling concerns, municipalities have been downgraded to retail clients, but they can choose to opt up. With this in mind, client classification is just as important under MiFID as it is EMIR … it’s just a pity that the classification categories are different!
AMLD IV
MiFID II often appears as the be-all-and-end-all, but it has not been the only regulation we need to watch out for on the KYC front. The fourth Anti-Money Laundering Directive (AMLD IV) provides financial institutions with access to a wider range of information, allowing them to conduct enhanced customer due diligence, and this must be used to their full ability. AMLD IV is a clamp-down on financial crime in the markets, and the increased remit given to participants to assess and classify their customers must not be taken lightly – non-compliance can lead to fines of up to €5 million or 10% of a business’ annual turnover.
Here, clients will be classified on their risk level (low, medium or high) adding yet another layer to the KYC cake. Member States are also required to maintain lists of beneficial ownership of companies and trusts, which is an important thing to keep note of.
FATCA/CRS
Under the Foreign Account Tax Compliance Act (FATCA), Foreign Financial Institution’s (FFIs) have been put under pressure to register with the Inland Revenue Service (IRS) and submit specific information about their customers, with the aim of locating tax avoiding US citizens. Once FFIs have registered, they are provided with a Global Intermediary Identification Number (GIIN) in order to be kept in the IRS database.
The FATCA method has since been expanded by the Organisation for Economic Cooperation and Development (OECD) to facilitate the exchange of account information across jurisdictions under the Common Reporting Standard (CRS). CRS is a global attempt by all participating countries to clamp down on the citizens that are hiding their money abroad. It is a step in the right direction for the free transfer of data on the accountability and transparency frontlines, but there is still a long way and a whole lot of confusion to go through before it becomes fully operational.
Are there any connections?
Behind all these clouds there is a silver lining. The legal entity identifier (LEI) 20-digit unique code provides market participants with the first universal identification mechanism for (almost) all the upcoming client classification regulatory requirements. Only FATCA excludes the use of the LEI due to its GIINs – the complexities associated with this were reviewed in an earlier article. All legal entities involved in financial transactions can obtain an LEI, which must be used under MiFID II and EMIR when participants are reporting their counterparty trades.
The level 2 relationship data for LEIs is also based on mapping beneficial ownership between legal entities, and, thus, gives Member States a hand in meeting their AMLD IV requirements for listing beneficial ownership. The Capital Requirements Regulation (CRR), the Alternative Investment Fund Managers Directive (AIFMD) and the Dodd-Frank Act all also require the use of an LEI.
Perhaps this can pioneer a new form of financial regulation but, first, the LEI needs to really take off. With just under 400,000 legal entities already having obtained LEIs, the bulk of the journey is still to come; but the MiFID II requirements under the recently released Regulatory Technical Standards for the inclusion of LEIs in all trade reports will significantly expand the remit. When this huge regulation comes into force, every single legal entity in the EU that is party to a transaction must hold an LEI, and it is the firm’s responsibility to obtain these for all their clients who don’t already have one.
In addition, the Global Legal Entity Identifier Foundation (GLEIF) have recently published their accreditation programme for organisations wishing to issue LEIs. This re-establishes the GLEIF’s authority in the global LEI system, as all provisional LEI issuers must go through them first if they wish to be official – including those issuers that were authorised based on previous procedures. The GLEIF’s statement also signals a move towards the development of a solid and foundational base full of robust procedures for the LEI system to be built upon.
Last week, the Regulatory Oversight Committee for LEIs (LEIROC) also released a statement clarifying that individuals acting in a business capacity are eligible to obtain LEIs, provided they conduct an independent business activity and can prove this by evidence of registration in a business registry. This should hopefully allow for an even broader base on which the LEI system can build upon, and reduce client classification complexities with more legal entities being defined by a single code.
A recent Alacra update highlighted the steady growth of about 20,000 new LEIs being issued per quarter, along with a slowly decreasing lapse rate. It also points towards the appearance of the ‘Super-Local Operating Unit(LOU)’, whereby a small handful of LOUs (the organisations which allocate LEIs) have come to dominate a large portion of the issuances.
All this news points towards a system which is beginning to take off, thanks to the MiFID II push under the recent Regulatory Technical Standards, LEIROC and the GLEIF’s foundational work on establishing formal issuing procedures, and the increasing business – and even competition – stemming from LEI issuance.
So, while the complexities of the initial classification remain, there is some harmony on the horizon. The LEI may be a start to the crucial process of regulatory synchronisation, providing a crossover point for market participants and their clients in their bid to reduce costs and complexity. Should this be the case, complementarity, rather than conflict, may well be the key characteristic on the client classification front.
As the Global LEI system gains prominence, there is a chance it will finally provide a top-down universal identification code that allows market participants to begin to untangle their regulatory complexities. For more client classification issues and reviews, follow this tag or, to sign up for our alerts and receive frequent updates on the increasingly lively regulatory landscape, click here.