Regulating Financial Products & Markets: Principles v Prescription

The regulation of financial markets and products in Australia has been widely accepted as being principles-based rather than prescriptive. This approach has been traditionally adopted by those drafting the Corporations Act, particularly Chapter 7, and it has also been followed, until now, by ASIC.

This sets the Australian regulatory model on a different footing from many offshore regimes, most notably that of the US. It is also an important element in the excellent regulatory profile which Australia enjoys. We are seen by many offshore regimes as having a cutting edge environment.

However, this may be changing in the post-GFC world. Regulation seems to be experiencing a marked shift – subtle and gradual though it may be – in its fundamental structure towards a more prescriptive approach.

Will this work? Is a more prescriptive approach balanced or sensible for Australia?

What has been the traditional approach?

The whole of our Financial Services Reform regime has as its philosophical foundation the efficient markets hypothesis. Underlying this hypothesis is the ideology that, subject to the very important need to ensure adequate investor protection, markets should be allowed to operate effectively, efficiently and with minimal interference. This involves permitting and recognising risk, but leaving it to investors – based on appropriate disclosure – to assess and price that risk. It also includes the option of walking away when investors so wish.

A concomitant feature of Chapter 7 is that, in essence, a product issuer can offer any product, no matter how sophisticated or complex, to any class of investor, so long as the issuer satisfies the applicable financial services licensing and disclosure requirements.

Until recently, ASIC’s stated preference has also been for outcomes-focused regulation, rather than prescriptive regulation.  ASIC has acknowledged that it has a limited role in a principles-based regulatory framework and that its function is analogous to that of a road traffic authority or police force. That is because ASIC does not make the rules, but rather it oversees the system.

What seems to be changing?

There appears to be a significant shift from the traditional principles-based approach, to a more prescriptive approach. This is demonstrated by various reforms currently under consideration by the Federal Government and by ASIC. For example, the government appears to be introducing far more stringent and prescriptive regulation in the context of financial advice.

In the case of ASIC – to borrow from its own metaphor as being a road authority or police officer – it appears to be contemplating the introduction of its own new traffic-control measures and traffic rules.

ASIC is increasingly using Regulatory Guides as de facto rule-making instruments, quite contrary to its past statements about the function of ASIC guidance. 

Let us look at some specific examples from recent regulatory reforms.

Future of Financial Advice reforms: In April 2010, the Federal Government launched the Future of Financial Advice (FoFA) reforms. The reforms, which apply from 1 July 2012, will involve significant changes to the Corporations Act, including introducing:

  • a prospective ban on conflicted remuneration structures, including commissions and any form of volume based payment,
  • a statutory fiduciary duty for financial advisers requiring them to act in the best interests of their clients and to place the interests of their clients ahead of their own when providing personal advice to retail clients, and
  • increasing transparency and flexibility of payments for financial advice by offering a flexible range of payment options for consumers to choose from and introducing an adviser charging regime, which will mean the investor will be able to opt into the advice by responding to an annual renewal notice.

Given that the Corporations Act currently requires financial services licensees to have adequate arrangements to manage conflicts of interest, it is apparent that the FOFA reforms represent an almost seismic shift in regulatory impetus.

Another example of this shift can be found in the options paper Wholesale and Retail Client Futures of Financial Advice, released in January this year by the Federal Minister for Financial Services and Superannuation, Mr Bill Shorten. Notably, one of the four options being canvassed appears to be the introduction of higher thresholds for classifying a client as a wholesale client, in the case of certain complex products or classes of products, which are considered to be inherently risky.

Equity Markets & CFDs:  Last November ASIC released a consultation package on enhancing regulation of Australia’s equity markets, including the introduction of competition between exchange markets. The package included Consultation Paper 145 Australian equity market structure (CP 145), which contains specific proposals such as:

  • new controls to curb extreme price movements and to require transparent cancellation arrangements
  • tighter controls for direct electronic access and algorithmic trading
  • imposing a formal best execution obligation on market participants, and
  • minimum disclosure about order and trade information, intended to promote efficient price formation on markets and reduce incentives for trading to shift to dark pools.

A number of the proposals, such as the new controls on extreme price movements and cancellation arrangements, appear to be very prescriptive and to demonstrate a real departure from principles-based regulation and the efficient markets hypothesis.

Another example of this regulatory shift can be seen in ASIC’s gradual introduction of different disclosure standards on a product-by-product basis through the release of new regulatory guides. For example, certain categories of financial products, including unlisted and unrated debentures, and unlisted property and mortgage trusts, are subject to an ‘if not, why not’ disclosure regime. This regime introduces additional disclosure benchmarks ‘so that retail investors can make more risk informed choices’ about these specific products. 

In November 2010, a recent example of this trend was the release by ASIC of Consultation Paper 146 Over-the-counter contracts for difference: Improving disclosure for retail investors (CP 146). In CP 146 ASIC set out ways for issuers to improve product disclosure for people investing in over-the-counter (OTC) contracts for difference (CFDs) and proposes an ASIC benchmark-based disclosure model for OTC CFDs.

Under CP 146, product disclosure statements (PDSs) and ongoing disclosures will be required to address the benchmarks on an ‘if not, why not’ basis. The benchmarks themselves focus on a number of areas of concern to ASIC, such as ensuring client suitability; disclosing counterparty risk; appropriate stewardship of client monies; and practices where issuers make margin calls on clients.

CP 146 attracted numerous detailed submissions identifying a number of concerns about ASIC’s proposals. One chief concern is that the proposed regulatory guide will apply only to OTC CFDs, when it appears that most of the issues ASIC is seeking to address in CP 146 apply equally to exchange-traded CFDs (e.g. client suitability and margin calls). The proposed requirement for CFD issuers to undertake suitability testing for prospective clients has also caused concern. This is because, by virtue of having conducted such testing, issuers would be aware of clients’ personal financial situation, objectives and needs and therefore risk being deemed to be providing personal financial product advice to those clients.

Finally, in February 2011, ASIC released Consultation Paper 147 Hedge Funds: Improving Disclosure for Retail Investors, in which ASIC proposes to introduce new disclosure benchmarks for hedge funds.

What are the issues with this apparent shift?

We see a number of issues arising in relation to this shift in regulatory approach.

First of all, are there really fundamental flaws in the principles-based approach to regulation and the efficient markets hypothesis?

Secondly, will a move to prescriptive regulation be effective to achieve the objective of protecting vulnerable retail investors from such notorious failures as Sonray, Westpoint and Opes Prime?

Thirdly, this regulatory reform appears to be piecemeal, being implemented through discrete proposals under consideration by the Federal Government and ASIC. We suggest that a more consistent approach is preferable, if in fact comprehensive reform is required.

A final point is that regulatory reforms reflecting a more prescriptive approach are being introduced with limited or ad hoc consultation, on an issue-by-issue basis only. Australia’s financial services industry needs to be informed about any such fundamental change and to have the opportunity to comment on the efficacy of any shift away from principles-based regulation towards prescription.

1  ASIC Statement of Intent from ASIC Chairman Tony D’Aloisio to the Hon Peter Costello MP, Treasurer, 27 June 2007.

2 “Unlicensed drivers can be on the road. When accidents do happen, we turn up at the scene, clear the mess, care for the injured and punish wrongdoers (including those unlicensed drivers). ASIC also examines the scene of the accident and makes or recommends changes to Government (through Treasury) to improve road safety. We might decide to recommend an extra set of traffic lights, for instance.” Speech by ASIC Chairman Tony D’Aloisio to the American Chamber of Commerce in Australia (AmCham), Melbourne, on 3 September 2010.

3 In a speech by Belinda Gibson, Deputy Chairman Australian Securities and Investments Commission, at the 16th Annual ACLA National 2010 Conference, 11 November 2010, Ms Gibson stated: “Our guidance is just that. It is a statement to the regulated community about how we will apply the law…The guidance is not a rule in itself, but does exhort practices that will ensure compliance in ASIC’s eyes…”.

4 Article by ASIC Chairman Tony D’Aloisio as published in The Age on 13 July 2010.