Book 3. Operational Risk

FRM Part 2

OR 14. Case Study- Investor Protection and Compliance Risks in Investment Activities

Presented by: Sudhanshu

Module 1. Investor Protector Regulations

Module 1. Investor Protection Regulations

Topic 1. Important Regulations Designed to Protect Investors

Topic 2. Markets in Financial Instruments Directive (MiFID)

Topic 3. Dodd-Frank: Investor Protection Act

Topic 4.  Compliance Risk Management

Topic 5. Investor Protection Case Studies

Topic 1. Important Regulations Designed to Protect Investors

  • Purpose: To ensure investors are adequately informed about financial transactions and their risks.

  • Global Leaders: The United States and the EU are at the forefront of creating, enacting, and enforcing investor protection legislation.

  • Key Objectives of Regulations:

    • Protect investors against misrepresentation.

    • Facilitate global cooperation.

    • Ensure accountability against fraud.

    • Enforce Know Your Customer (KYC) due diligence to prevent improper business practices.

  • Categories of Regulatory Compliance:

    1. Client, Product, and Business Practices Focus: Suitability, disclosure, and fiduciary responsibilities.

    2. Improper Business and Market Practices Focus: Preventing and addressing market manipulation and other illicit activities.

Topic 2. Markets in Financial Instruments Directive (MiFID)

  • Origin: EU regulation, originally enacted in 2004, implemented in 2007.

  • Core Function: Investor protection regulation outlining proper business and organizational conduct.

  • Key Provisions: Prescribes regulatory disclosure and reporting requirements to prevent market abuse.

  • MiFID II (Revised Directive):

    • Came into force in 2014, accompanied by MiFIR (Markets in Financial Instruments Regulation).

    • Reason for Revision: Followed the 2007-2009 financial crisis to improve public disclosure requirements for trading data and strengthen investor protection.

    • Key Areas Addressed by MiFID II & MiFIR:

      • Trader and advisor pay.

      • Conflicts of interest.

      • Fair communication with customers.

      • Independent investment advice.

      • Sales and product governance.

      • Best execution of client trades, Dealing with counterparties.

Topic 3. Dodd-Frank: Investor Protection Act

  • Context: Part of the broader Dodd-Frank Wall Street Reform and Consumer Protection Act, U.S. legislation enacted in 2009.

  • Primary Goal: Enhance financial stability and prevent recurrence of the 2007-2009 financial crisis.

  • Investor Protection Enhancements:

    • Increased protection for whistleblowers.

    • Enhanced rules around over-the-counter (OTC) derivatives trading, including clearinghouse requirements.

    • Created a committee to consult with the SEC on new financial products, fees, and trading strategies.

    • Gave the SEC greater oversight responsibilities for OTC derivatives.

  • The Volcker Rule:

    • A key component of the Dodd-Frank Act.

    • Prohibition: Commercial banks are prohibited from engaging in speculative trading and proprietary trading (trading for their own accounts).

    • Limitations: Specifically limits bank investments in hedge funds and private equity funds.

  • ​Consumer Financial Protection Bureau (CFPB): Created by the Dodd-Frank Act.

    • Role: Government agency responsible for consumer rights protection, providing independent oversight of consumer finance markets (e.g., mortgages, student loans, credit cards).

Practice Questions: Q1

Q1. Which of the following regulations limits commercial banks' investments in hedge funds and private equity funds?

A. The Investor Protection Act.

B. The Markets in Financial Instruments Directive (MiFID).

C. The Markets in Financial Instruments Directive II (MiFID II).

D. The Volcker Rule.

Practice Questions: Q1 Answer

Explanation: D is correct.

The Volcker Rule is part of the Dodd-Frank Act that prohibits commercial banks from engaging in speculative trading and proprietary trading, and it limits their investments in hedge funds and private equity funds.
The MiFID is an EU investor protection regulation that describes proper business and organizational conduct and prescribes regulatory disclosure and reporting requirements. MiFID II is an update to MiFID and addresses trader pay, execution of client trades, conflicts of interest, communication with customers, investment advice, and governance. The Investor Protection Act is also part of the Dodd-Frank Act. It increases the powers of the SEC, and provides increased protection to whistleblowers and enhanced rules around OTC derivatives trading.

Practice Questions: Q2

Q2. Which of the following legislations explicitly deals with whistleblower protection?

A. The Investor Protection Act.

B. The Markets in Financial Instruments Directive (MiFID).

C. The Markets in Financial Instruments Directive II (MiFID II).

D. The Volcker Rule.

Practice Questions: Q2 Answer

Explanation: A is correct.

The Investor Protection Act is part of the Dodd-Frank Act that increases the powers of the SEC and provides increased protection to whistleblowers and enhanced rules around OTC derivatives trading.

Topic 4. Compliance Risk Management

  • Definition: Deals with compliance breaches in investment activities.

  • Causes of Breaches:

    • Unintentional: Human error, ineffective policies.

    • Intentional: Fraud.

  • Focus of Risk Management: Developing a framework to prevent compliance breaches.

  • Internal Drivers of Compliance Risks:

    • Poor employee engagement or dissatisfaction.

    • Employee stress.

    • Weak ethics culture within the firm.

    • Insufficient resources allocated to business units.

  • Broader Drivers of Compliance Risks:

    • Asymmetric Information: Sellers possess more information than buyers.

    • Conflicts of Interest: Traders acting for both clients and their own firm.

    • Economic Conditions: Increased market volatility can lead to trading errors and encourage insider trading.

  • Elements of Efficient Regulation & Compliance Risk Management:

    • Effective supervision of employees and trades.

    • Enhanced middle-office and back-office functions.

    • Adequate employee training.

    • A strong ethics culture.

Topic 4. Compliance Risk Management

Topic 5. Investor Protection Case Studies

  • Context: Regulatory fines levied against large investment banks (UBS, JPMorgan, Deutsche Bank Securities Inc.) for investor protection violations.

  • Nature of Fines:

    • Punitive: To penalize for past violations.

    • Deterrent: To discourage future improper practices and encourage other firms to improve compliance.

    • Offsetting Benefits: Fines were set high enough to negate any benefits accrued from the breaches.

  • Case Study 1: UBS (2008)​

    • Penalty: $11.15 billion (largest penalty against a single organization to date).

    • Violation: Misrepresenting securities to investors as safe.

    • Reality: These securities had significant liquidity risk, contrary to representations.

  • Case Study 2: JPMorgan (2020)

    • Penalty: $920 million fine by the U.S. Commodity Futures Trading Commission (CTFC).

    • Violation: Market manipulation and deceptive conduct, primarily related to "spoofing."

    • Spoofing Practice:

      • Spanned over eight years.

      • Artificially created the appearance of high trading volume by entering and then rapidly canceling orders.

      • This practice manipulated prices to benefit JPMorgan.​

  • Case Study 3: Deutsche Bank Securities Inc. (2022)

    • Penalty: $2 million fine by the U.S. Financial Industry Regulatory Authority (FINRA).

    • Violation: Violating best execution practices between 2014 and 2018.

    • Nature of Violation (Unusual): Not related to misrepresentation or manipulation, but failure to secure the most favorable trade terms for customer orders (price and speed).

Topic 5. Investor Protection Case Studies

Practice Questions: Q3

Q3. Which of the following reasons is least likely a consideration for regulators when imposing fines on financial institutions against financial breaches and violations?

A. To cover the cost of litigation.

B. To deter other firms against manipulative bank practices.

C. To ensure that fines cover at least the benefits of breaches.

D. To signal to other firms to change their compliance practices.

Practice Questions: Q3 Answer

Explanation: A is correct.

Covering the cost of any litigation is not a direct consideration in imposing fines. All other reasons are valid considerations for regulators in determining fines.