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Does regulation offer investors 'an appropriate degree of protection'?

Investors should accept that the only people they can truly rely on are themselves.

REGULATION has always been an integral part of the financial system. As it is recognised today the regulatory framework resulted from financial market liberalisation and a general encouragement of private investors to partake in the markets in the 1980s.

The principal aim of regulation is to maintain both market confidence and financial stability while at the same time offer investors an 'appropriate degree of protection'.

In the 1980s the UK decided that investor protection was required through the entire life cycle of the investment process. I was involved in these initial stages as a young Chartered Accountant helping financial service clients establish compliance functions along with the required business operational processes to address the new regulatory requirements. My PwC partner at the time welcomed the change and regularly expressed his opinion that "regulation is the rule of common sense over stupidity".

Unfortunately, even today his view has never been widely accepted and from the early days I can still remember the wide-scale resistance of the UK financial service industry to adopting the regulation.

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This was particularly the case when at first, the industry was required to collect and document adequate information relating to their existing or potential clients which would allow them to not only offer the most appropriate and affordable solutions but provide a documented audit trail that they had indeed done so.

This "Know Your Customer" (KYC) process was seen by the regulator as a sensible way of protecting the investor while it mitigates the risk of mis-selling. For the providers they also believed that it would improve the overall quality of their book of business and ultimately lead to greater profitability.

Over time, however, the KYC process has developed from these humble beginnings to emerge as a widely viewed bureaucratic hurdle to any existing or future relationship. Additionally it now includes a raft of checks aimed at establishing the investor's 'source of funds' thus assisting governments in their fight against money laundering and terrorist financing.

As a result, can KYC still be regarded as an investor protection or is it more for the protection of the institution they may want to deal with?

Other developments in the area of regulation has spawned what can almost be called an industry in its own right.

The impact of these developments was recently brought home to me when I consulted a well-known European bank looking for advice on establishing a relatively small portfolio. Once we cleared the numerous internal and external regulatory hurdles, we were finally able to discuss my requirements as a customer.

After some time, the perfectly able relationship team presented me with a 64-page document covering suggested options for the planned portfolio.

What struck me the most about the document was not the 10-page options analysis concerning the portfolio but the 40 pages of risk analysis and 14 pages of disclaimers that came along with it.

When I asked the team for a reason for the inclusion of this information, I was met with the blanket answer that it was a regulatory requirement.

Later, studying the 40 pages of risks, it came across quite clearly that those identified were generic risks that apply to all investments but nowhere were they specific to the portfolio I was intending to create.

Again, I question if the regulation that creates such an example is really for the benefit of the investor or is it now just a tick-box exercise which, in my view, has limited or no value?

Clearly the call for ever increasing regulation is laudable when the investment environment is changing so rapidly that an independent investor has difficulty keeping up to date but do regulators have the necessary tools and resources to ensure that they are properly implemented while at the same time protecting the investor?

At a most basic level it almost seems incongruous that the activities of a trader earning $5 million per annum is being regulated by someone who is being paid probably no more than 3 per cent of that amount.

Not only is it just a question of resources but also whether they have the requisite powers to ensure their regulation is effectively implemented.

Although they can impose fines on organisations and in the most extreme examples even shut down businesses, does this address the actual cause of any failures which almost always stems from the actions of individuals or management teams in charge of the businesses concerned.

If one of the aims of regulation is to hold people accountable for their actions, should the regulators also be responsible for enforcing action against those who fail to comply?

This however, seems to be the responsibility of current legal systems which appear to have failed to keep pace with the rapidly changing landscape.

The Global Financial Crisis represents a case in point where despite a wide-scale failure to comply with regulations, no single or group of individuals has ever been held legally accountable.

In summary, there is no question that regulation is a critical element in ensuring the integrity of the financial markets and in the past has offered individual investors welcome protection on which they could place some reliance. However, as investors, given the accelerating changes in the markets, can we still have the same degree of confidence?

My concern does not just relate to regulators but also to other bodies that investors have historically relied on, including auditors, investment advisers, accounting standard boards and market exchanges.

Perhaps it is finally time that investors accept the uncomfortable reality that the future may be one in which the only people they can truly rely on are themselves.

  • The writer is a private investor and member of ICAEW