Speech to International Compliance Association

On 29 November, Alex Duperouzel spoke to a group attending an International Compliance Association networking event on the role of compliance in 2007. Here is the text of that talk:

Good evening.

ComplianceAsia is an organization that provides consulting services to financial industry participants on issues that affect their regulatory profile, or their ability to work within their own international standards.

We work for a large number of firms who have operations in the Asian region including investment banks, trading banks, traditional asset managers, alternative asset managers, financial advisors, trust companies, institutional investors and government owned corporations. Geographically we cover not only Hong Kong and Singapore, where we have offices, but Japan, Korea, Taiwan, China, India, Thailand, Indonesia, Malaysia, Australia, Vietnam, Pakistan, the Caribbean and even Europe and North America from time to time.

We think that gives us an interesting perspective on what is going on in the financial industry in the Asian region, and so tonight I am going to talk about a few issues that we believe are going to be important to compliance officers in 2007 and beyond.

We are also here tonight to learn more about the International Compliance Association and many of you are compliance officers who will need to meet the challenges of 2007. Furthering your own technical knowledge will be a key part in your organization’s success and may be the difference between success and failure at your company.

The role of compliance in 2007 will be meeting these challenges while facilitating progress in the underlying business. Your role is to solve the challenges so you can say yes more often.

We believe there are six big compliance issues to consider in 2007:

1. Getting to grips with new products;
2. Conquering new jurisdictions;
3. Addressing the trend away from exchanges;
4. Working with regulators;
5. Dealing with the explosion in new market participants, particularly hedge funds; and
6. Learning to be vigilant in an ongoing bull market.

New Products, New Locations

Now lets talk about the first two, new products and new locations.

As the financial industry in Asia deepens there are many new products that compliance officers need to come to grips with.

Hedge funds who do quasi private equity deals, sophisticated bond funds that slice and dice illiquid debt products, banks that are really technology suppliers, prime brokers who are looking at how they can give a fund a competitive edge by leveraging off their private banking clientele, hedge funds using aggressive bottom up investing while chasing alpha, investment mandates that pretty much let a manager do anything, forex, options, indexes available online, on your phone and ultimately targeted at the retail level, these are just some of the new products.

These new products are being transacted into a resurgent Japanese market - the sleeping gorilla of the Asian scene - a rapidly developing India, an evolving and hot China, and the too big to be ignored markets of Korea and Taiwan. These markets are not all the same, they are developing at different speeds with different national priorities and legacies.

There has also been an explosion in new market entrants to both Hong Kong and Singapore. A lot of that has been in asset management, and I will cover that issue shortly. But in addition to those asset managers, we have seen a number of new administrators, trustees, prime brokers, and market makers and specialists all piling into the world’s fastest growing economic region.

Never has education and training been so important for compliance officers in Hong Kong. It is incumbent upon you to understand not only your own business as it grows, as it evolves with technology, but also you need to understand your counterparties.

The law of probability says that not every product, not every location will be a success. A good compliance officer will be able to assist in quickly recognizing failure and mitigating loss, as well as enabling great ideas to flourish.

You will only have the confidence to say yes when you understand the real implications of saying no.

The trend away from exchanges

Many of you may be familiar with the term ‘black pools’. Those of you who are not, will be in 2007.

Many years ago stock markets were formed by participants to set common rules and level playing fields to facilitate efficient capital distribution. Sharp practices in the lead up to the great depression resulted in a government intervention on those exchanges.

More recently those exchanges demutualised and became businesses in their own right.

During the last two years we have seen unprecedented activity in the exchange space as large exchanges look at taking over smaller or complementary exchanges, buyout firms invest in niche exchanges and or look at driving consolidation, and now we have a number of financial firms setting up their own facilities to attract client business and keep it in house either en masse, as a group of big players, or individually as a trading platform for specific clients.

These are the black pools that we believe are going to radically reshape the work of compliance officers in Asia.

The black pools are popular because they offer reduced transaction fees. There is certainly a perception that the big exchanges have grown fat on the trading volumes of their clients and the public. But black pools also present substantial compliance risks.

Just what goes on inside the pool and how that information is handled by the firm running the pool is going to be a key compliance issue as these products become more popular. With the cost of setting up such a facility dropping, as technology costs drop, you can expect to see a fragmentation of the business that goes through an exchange.

How compliance officers police their traders, their technology folks, the programmers, the vendors, the support teams and others with a stake in the system will be a great challenge.

To put this simply when you work through an exchange you are outsourcing the exchange compliance and IT security issues to that exchange. If you run the exchange in house then all of the issues you never considered before are now additional issues.

Just how regulators will get involved, or indeed whether they should get involved, in these platforms will also be an interesting question in 2007.

The challenge of working with regulators

Regulators are facing significant challenges in 2007. The greatest challenge in our view is education. Regulators are in the same market for talent in Asia as the firms they regulate. There is a shortage of talent in Asia. This shortage is made more acute by the emergence of new products and the expansion of new entities into different geographic locations.

By and large we remain critical of the level of industry acumen that regulatory staff have in this region. There are indeed a number of clever people in regulatory positions. But are those bodies as up to date as they can be, do they understand what is going on inside the industry, do they have a clear perception of the role that a market regulator provides in a capitalist system?

There is no shortage of regulatory staff who can read a section of the law or the code back to you, but there is a genuine shortage of clear thinking personnel who can look at an issue from both a wider industry viewpoint and an individual risk assessment.

This is manifesting itself into inconsistent regulatory approaches, long delays in processing new business applications and, as in Korea right now, fundamental market distortions.

For the regulator my comments should be seen as a constructive challenge. Policy makers need to realize that a well trained and well funded regulator helps in the efficient development of the capital markets. The industry should support requests by the regulator for increased funding and staff development. Staff rotation amongst regulators in Asia, Europe and North America should be encouraged and facilitated. The firms run a global or multi regional operation, the regulators need to.

For the compliance officer, 2007 will be a challenge in this respect. Regulatory decisions will need to be considered carefully – the regulator could be right, they could be wrong. The uncertainty will add to existing workloads.

Will there be a hedge fund shakeout?

In Hong Kong there are currently some 499 Type 9 licensees and of those about 40 % are niche asset managers who by one definition or another could be generically termed hedge funds.

In Singapore there are over 300 firms falling into the broad definition of a hedge fund.

In our view this is too many. Too many firms chasing a large but limited number of investment dollars. Too many firms chasing experienced portfolio managers, back office personnel and compliance staff. Is there enough AUM to keep everybody in business?

The short answer has got to be no. There will be a shakeout.

However the nature of the shakeout will be varied. The good firms are going to become takeover targets, some of those will be consumed, others will remain independent but will close themselves off from new subscriptions.

Some mid tier firms will also be acquired.

Many small firms will fold. Hopefully most of them will return some portion of their AUM to their investors and they will shut down in an orderly fashion.

The danger is that with any large number of financial participants involved in a race for new volatility, and with the lure of amazing rewards for those that get it right, there are going to be massive trading miscalculations and, from time to time, just plain old fraud.

It would not surprise us if we saw one blowup a quarter during 2007 as the industry begins to mature and some funds go chasing larger and larger returns.

I am yet to meet any economist or financier who has convinced me that risk and return are not related, and so while this remains a law of nature, then you all should be wary of return and seek to understand the risk.

The Current Bull Market

I arrived in Hong Kong in 1991 and worked through the great bull run of 1992-1997 and the dot com boom that came after it. Before coming to Hong Kong I worked in the time leading up to the October 87 crash.

Those bullish days are back. Whether it be the enthusiasm for all things China related, the boom in India, the resurgence of technology and web 2.0, or the boom in private equity acquisitions and leveraged buyouts, this is one big bull market.

There are many dangers in a bull market for a compliance officer.

Firstly its very hard to say no to the guys and gals in the front office. The more deals we do, the more money we make. Compliance officers who try and check this process are not going to be popular. In economic terms this leads to a mispricing of the transaction risk.

Secondly frauds are harder to detect in a bull market. Rising asset prices mask deals which would get greater scrutiny if times were tight.

Lastly look around your front office. How many of them have freshly minted degrees to go with their lovely suits and designer clothes?

Due to the shortage of talent generally in Asia, people are given more responsibility at a younger age. For all the outstanding degrees that these high achievers have, nothing beats a bit of gray hair during a bull market. Someone who understands the importance of documentation, of kicking the tyres before a deal and who understands the realities of enforcing collateral and counterparty risk. Someone who believes that they are employed to protect, preserve and enhance their employer’s capital, not just generate a fantastic bonus.

In summary

2007 is going to be very challenging for compliance officers around the Asian region. Education is going to be the key to helping you protect your employer and enhance value, value that will survive industry consolidation and market correction.

Education will also help you respond in a crisis. It will provide a clear compass to set a path by and the confidence you will need to respond to rapidly developing events.

Those on the regulatory side need to be encouraged to develop their professional expertise. They need to ensure that the rapid evolution of the market place is not stifled by poor implementation of market rules. Better education, more rounded experience will give them the confidence to evolve without losing their fundamental mandates.

I am a poor investor. If I could read the markets I wouldn’t be standing here talking about compliance issues. However I do believe that there are warning signs in the current environment that should not be ignored if compliance officers are to provide maximum value in 2007.

That ladies and gentlemen, is our view on the role of a Compliance Officer in 2007. We hope you are up to the challenges ahead and thank you for listening.