May 2, 2023
IOSCO releases anti-fraud and anti-misconduct Toolkit
The International Organization of Securities Commissions (IOSCO) has recently published its comprehensive Retail Market Conduct Report (Report). Weighing in at 74 pages, the Report marks a major milestone in the evolution of regulatory control of conduct in contemporary financial markets. The Report is intended to respond to the rapid increase in retail investor activity within financial markets, including changing macro conditions, demographic trends, and technological developments. In its media release, IOSCO promotes the Report as a “Toolkit” for regulators to use in combatting financial market fraud and misconduct directed at retail investors. The IOSCO Board Chair Jean-Paul Servais is quoted as saying, “I would recommend the Toolkit suggested in the Report to regulators and supervisors around the world. IOSCO will continue to work on these issues.”
The Report itself states that it is “designed also to complement various IOSCO Committee and Task Force driven work, such as ones on digitalization, crypto-assets, “decentralized finance” (DeFi), sustainable finance and investor education, which may present more specific targeted tools to address particular retail market conducted related scenarios. The recently published IOSCO reports on Retail Distribution and Digitalization and Decentralized Finance are examples” (Report p.4)
The Chairperson of the Retail Market Conduct Task Force, Derville Rowland from the Central Bank of Ireland, is quoted in the media release as saying about the Report:
“Technological developments are permanently changing the way in which retail consumers interact with financial services and products. As digitalization enables retail investors to invest more easily via apps and online trading platforms, various external factors, including social media and cross-border offerings of complex products, including crypto assets, increasingly influence retail investor decision making. This can lead retail investors to products that might not be safe or suitable. In such an environment, regulators face novel conduct challenges and new forms of financial consumer protection issues, which traditional regulatory tools may not suffice to address. While it’s important that the potential benefits of innovation can be realized, it’s also critical that the risks are effectively managed. To deal with these issues, IOSCO´s Retail Market Conduct Report provides timely, practical and innovative guidance to regulators in coping with such challenges.”
The Financial Markets Authority (FMA) is a member of IOSCO and can be expected to attend closely to the findings of the Report and be guided in its plans and actions by the Toolkit provided. However, the Report is not only addressed to the membership of IOSCO:
Whilst this report primarily serves as a guide for regulators, there is utility in the findings and observations for all stakeholders in building greater awareness and engagement with retail conduct issues [our emphasis] given their transcendence across sectors and presence in both emerging and developed markets.
(Report p. 4)
In New Zealand, managed investment scheme (MIS) managers and debt issuers who issue retail financial products, as well as licensed Supervisors, should take the time to peruse the Report in order to better understand the current conduct concerns and expectations shared by regulators internationally, and the contemporary risks and vulnerabilities that these regulators perceive to apply to retail investors, even if they may not be involved with some of the kinds of financial products and platforms that the Report raises questions about. It can be taken as read that these same conduct concerns and expectations, and risk and vulnerability perceptions, are shared by the FMA.
The Toolkit approach addresses five areas:
The sheer breadth and detail of the Report means that only some of its topics can be surveyed in this article. We will take as part of our cue the statement in the IOSCO media release that, “Crypto-asset scams and greenwashing are two important examples of misconduct arising from global trends and technological developments,” as a guide to sampling some topics.
Retail revolution in financial markets
Among Covid-19’s multifarious impacts on societies world-wide, the Report observes that IOSCO members noticed big jumps in financial market participation by retail investors during the pandemic. Figures are not easy to come by, but estimates indicate that pre-Covid about 10% of all US equities trading volume was due to retail investors, doubling to around 20% in 2020 and surging to as high as 26% in January 2021. Coinciding with Covid-19 have been rapid advances in technologies associated with trading securities, which the report sums up as “digitalization and gamification” (Report, p. 8), with mobile apps and social media playing an important role in inducting a younger cohort of retail investors into financial markets.
The Report attributes a range of factors as causing the retail investor influx into financial markets and the higher levels of risk and vulnerability resulting. Demographic changes mean that retail investors of different generations are actively involved, with the overall average age of such investors declining as younger people - both male and female - become actively engaged in trading and investing in financial assets. The ability to buy retail investments with small amounts of money, for example through fractional share trading, has been influential on the rejuvenation of financial market participation. Regardless of age cohort, retail investors may be exposed to risks and vulnerabilities in common, as well as risks and vulnerabilities particular to their generation and other factors besides. For example, younger investors may be less experienced than older investors, disinclined to be interested in reading disclosures, and more likely to be affected by social media, peer opinion, and market pundit “Finfluencers”.
Technological developments, such as digital trading platforms, mobile apps, and investment promotions through social media are popular, often cheaper to use than traditional broking arrangements, and ease the path into financial markets, but bring new conduct risks with them. “Self-directed trading” and especially “gamification” - otherwise known as “digital engagement practices” - favoured by younger retail investors can interactively influence usage and trading behaviour to cause over-trading and exposure to risks outside of tolerance or financial capacity.
Trends indicate that retail investors are increasingly attracted to riskier, more complex, and harder to understand investments and trading techniques such as crypto-assets, short-selling and margin lending, derivatives like options and forwards, exchange-traded leveraged products, leveraged certificates, and over-the-counter (OTC) leveraged products like Contracts for Difference (CFDs) and so on. Some retail trading patterns may result in greater investor losses, especially where investors seek higher returns against a background of rising inflation. The easier such potentially loss-making investments are obtainable, the greater their attraction becomes to the unwary. This risk is aggravated where excessive leverage magnifies losses.
Battling greenwashing
Another trend, towards valuing sustainability factors in investments, exposes retail investors to greenwashing risks. Greenwashing entails misleading or even deceiving investors about alleged distinguishing credentials of “green” investments, known in New Zealand as integrated financial products (IFPs), a term embracing both debt securities and managed funds. The Report defines greenwashing as “the practice of misrepresenting sustainability-related practices or the sustainability-related features of primarily investment products” (ibid. p. 9).
Increased risk of greenwashing is singled out in the Report as a serious problem, summarised as arising with “the rapid growth in assets under management (AUM) and global interest in Environmental, Social, and Governance (ESG) investments and sustainable finance products” (ibid. p. 2). Concern is expressed that, “Greenwashing can occur throughout an investment value chain. Greenwashing erodes the needed trust in disclosures for sustainable finance products, including trust in the retail segment.” (ibid. p. 20). IOSCO’s 2021 and 2022 Final Reports Recommendations on Sustainability-Related Practices, Policies, Procedures and Disclosure in Asset Management and Retail Investor Education in the Context of Sustainable Finance Markets and Products are referenced in the Report as the touchstones for IOSCO’s approach to combatting greenwashing.
In the Report itself, a subchapter is dedicated to discussing greenwashing (pp. 20-21). This section substantially summarizes the essential findings of the abovementioned Final Reports of 2021 and 2022, and in that sense nothing new is introduced. Key emphasis is placed on regulators working better to educate retail investors and financial advisers on how to understand sustainability-related investment information and spot and avoid greenwashing. The Report reiterates the three-point strategy that regulators are to follow:
In New Zealand, the FMA has responded to IOSCO’s call for regulators to become sustainable investment educators. The FMA has published:
Disclosure framework for integrated financial products (December 2020)
Integrated financial products: Review of managed fund documentation (July 2022)
Ethical investing journey research (July 2022)
Ethical investing (October 2022)
Ethical investing case studies: What kind of ethical investor are you? (February 2023)
Crypto scamming in IOSCO’s cross-hairs
The Report dedicates nearly four pages to close and damning analysis of crypto-asset trends and associated risks. Recent scandals engulfing crypto-asset markets would seem to justify such extended treatment by IOSCO. In one curiosity cited, it is stated that the US Securities and Exchange Commission (SEC) charged celebrity Finfluencer Kim Kardashian for touting a crypto-currency on social media without disclosing the substantial fee she was paid for doing so.
The Report diagnoses a number of concerns about the attractions of crypto-assets to retail investors. At market entry level there are enticements that could cause these investors to be incautious:
IOSCO members have identified a range of key risks presented by crypto-assets:
A particular concern raised in the Report is the reluctance of financial advisers to provide advice on crypto-assets to retail investors. The report cites research on licensed financial professionals that found that 55% of their clients sought advice on crypto-assets, but only 9% of the advisers were willing to provide it. Two basic reasons are given for the dearth of willing professional advice on crypto-assets:
(ibid. p. 24)
Further analysis revealed the underlying reasons as to why professional advice on crypto-assets was not forthcoming:
(ibid.)
Thus risk-aversion on the part of financial advisers explains why they tend to shy away from providing advice on risky crypto-assets to their clients. This avoidance of risk by advisers increases risks for retail investors who participate in crypto-asset markets. The Report explains:
This feedback highlights another important problem with the crypto-assets markets currently. Without access to professional advice mainly due to non-compliance in some jurisdictions, and lack of regulation and a regulatory framework in others - retail investors are relying on other forms of information to buy crypto-assets, often influenced by parties who do not have appropriate qualifications, professional obligations, or regulatory oversight to support them making appropriate investment recommendations or acting in the interests of the product purchaser.
(ibid. pp. 24-25)
Regulators are starting to act on the lack of regulation and enforcement for crypto-asset markets. The Report gives as an examples the EU, where the world-leading Markets in Crypto Assets Regulation (MiCA) and anti-money laundering Transfer of Funds Regulation (ToFR) have been developed to capture crypto-assets within the European regulatory framework, coming into full effect in 2024. In the US, the SEC has been busy applying existing federal securities laws to take legal actions against non-compliance concerning crypto-assets. The Financial Stability Board (FSB) has published a proposed framework for the international regulation of crypto-asset activities. IOSCO itself is coordinating a charge to regulate crypto-assets through its Crypto-Asset Roadmap.
Within the New Zealand context, developments as outlined in the Report are likely to have impacts on local market participants. Some sort of regulatory regime for crypto-assets is likely to emerge and in the meantime the FMA can be expected to continue applying its powers to police non-compliance with existing regulations where crypto-assets are involved, as it has done so already with a number of public warnings concerning dodgy operators. The FMA has issued information on regulatory requirements as they apply to crypto-asset service providers:
Crypto asset service providers (March 2021)
Spotlight on Crypto: Using New Zealand based cryptocurrency trading platforms (September 2021)
MIS managers will have to weigh up their risk appetites for investing their funds in crypto-assets and have policies for their financial advisers, if they employ any, to follow in respect of providing crypto-asset-related investment advice to clients. Possibly also debt issuers should consider their crypto-asset risk appetites, for example for issuing debt securities denominated in crypto-currencies. Supervisors will similarly need to assess their risk appetites for taking on supervision appointments with debt issuers and MIS managers that entail crypto-asset-related activities.
It should not be assumed that the risk appetites for crypto-assets of financial markets stakeholders such as MIS managers, debt issuers, and Supervisors will remain set in stone. These appetites are likely to change, adapt and evolve with time, not least due to retail investor demand pressure. At present, crypto-assets are living out the last of their Wild West days. For many MIS managers, debt issuers, and Supervisors, they are just too hot to handle right now and the high risks and erratic returns that they expose retail investors to are unacceptable to take on. But supposing the likes of the MiCA/ToFR regime can tame crypto-assets and their associated activities and marketplaces, and successfully bring them into the fold of fully regulated financial products and services, then all that could change. As matters stand, the FMA at its own discretion could use its existing regulatory toolkit to designate crypto-assets as financial products.
It could then become harder to refuse to manage or issue investments in crypto-assets, or supervise those who do so, when crypto-assets eventually become respectable and evidence mounts that issuing them as debt securities or including them in managed fund investment portfolios could serve the best interests of investors (for example, enhanced returns, reduced risks, portfolio diversification, reduced correlation). In this sense, MIS managers, debt issuers, and Supervisors will need to keep up with the play as at least some types of crypto-assets undergo a seemingly inevitable transformation into regulated financial products. Even after regulation, it might still remain debatable whether crypto-assets truly belong within retirement savings products, but that bridge is yet to be crossed.
Conclusion
“IOSCO’s Retail Market Conduct Report (Report) marks an important tipping point in the development of regulator powers and conduct expectations with respect to contemporary retail investor participation in financial markets,” said Matthew Band, General Manager of Corporate Trustee Services at Trustees Executors.
“The Report is both comprehensive and detailed in the way it sets out the risks, opportunities and challenges that face financial markets regulators as they seek to protect the best interests of retail investors and reduce harms that such investors may suffer in rapidly transforming markets.”
“However, the report is not written just for regulators such as the FMA: it expressly states that it is intended for use by stakeholders who have an interest in retail financial market conduct.”
“Within the context of New Zealand’s financial markets, these stakeholders include debt issuers, MIS managers, and licensed Supervisors.”
“The Report is lengthy, but logically indexed and laid out, and can be treated as a resource for studying particular conduct topics as they may arise for debt issuers, MIS managers, and Supervisors to consider, as it represents the current international best practice expectations shared by financial regulators.”
“As such, the Report can be regarded as the gold standard for retail market conduct and a roadmap for how regulation and enforcement can be expected to develop, including in New Zealand.”
“As our article has noted, greenwashing and crypto-assets can expect close regulator scrutiny and vigorous enforcement action for non-compliance, but this will occur within a framework of developing the international regulatory systems and support needed to enable markets for “green” financial products, crypto-assets and digital platforms to flourish to the lasting benefit of retail investors.”
“Debt issuers, MIS managers, and Supervisors will need to be agile and adaptable to thrive in the rapidly changing regulatory environment that the Report foreshadows.”
For comment or more information, or to be added to the free email subscriber list of “The Supervisor”, please contact Matt Band at [email protected].