The legal loophole that could land IBs in big trouble

The legal loophole that could land IBs in big trouble – in the least likely place

Being an IB carries great responsibility toward clients. We investigate a regulatory loophole that puts them in a position of potential liability, and we speak to top industry executives in order to show how this important matter is handled by FX companies.

The Financial Conduct Authority. A bastion of regulatory supremacy and a pillar of the establishment. Or is it?

For large companies in London, which are among the most highly respected electronic trading businesses in the world with many having been established in the world’s largest financial center since the late 1980s, the Financial Conduct Authority’s prestige, understanding of even the most intricate and sophisticated of financial markets businesses, and respect for rule of law is a perfect match

Customers, both corporate and retail, from around the world flock to do business with firms that are regulated by the FCA, the regulator whose ability to keep up with the technological advancement and rapidly evolving nature of the multi-billion dollar brokerages that adorn the Square Mile being equally important as its comprehensive understanding of prime brokerage, and institutional liquidity provision and order execution.

All of this wealth of experience points to the FCA being the best equipped regulator in the world when it comes to ensuring that the entire structure that provides services to customers right the way from the point that the liquidity from banks is aggregated, to the point where a retail brokerage facilitates execution on a trading platform operates in a textbook fashion……. unless you are an IB.

Dieu et mon doit? Caveat Vendor….

FinanceFeeds has conducted an investigation into how exposed introducing brokers (IBs) from jurisdictions outside the United Kingdom are to criminal prosecution if they refer business to FCA regulated companies but do not possess the relevant regulatory license.

Our investigation brought an often overlooked but extremely important matter to light, that being that an unregulated introducing broker (IB) which could be a small business run by a private individual, or a large company that offers money management services as well as a fully staffed office to serve retail clients, only relying on the actual brokerage to which it refers business to execute order flow, is fully liable to be in serious legal hot water should a compliance inspection be carried out on a brokerage that accepts business from such an IB.

It can be interpreted that the FCA rulings on this take into account that the brokerage to which business is refered has an FCA license, therefore by onboarding clients that have been referred from an IB, the onus is on the brokerage to carry out AML (Anti Money Laundering) and KYC (Know Your Client) procedures before setting the trading accounts to a live status, and if this can be shown to the FCA, that is satisfactory.

Additionally, clients that have been referred to a brokerage by an IB are now under the responsibility of a licensed brokerage, which means that should something go awry, the brokerage can show that it complied with the regulatory rulings and as long as full reports can be shown to the FCA as to how the client was provided service by the broker, all is fine.

However, should something go awry and a client complains, the broker may well be able to demonstrate that all was carried out in good faith and according to the regulator’s stipulations, however the moment that the finger is pointed at the IB, things are not so favorable.

richard elston

Leading by example: Richard Elston, Head of Institutional, CMC Markets

Having discussed this with several IBs that operate large businesses outside the UK but wish to provide their clients with brokerage services from FCA brokers in London, a common parlance when the IB asks the broker about the licensing considerations of an FCA firm working with an IB that does not have a license to refer clients to UK brokerages, was rather surprising.

Partners managers within some companies that were approached recently by IBs had, consistently, explained that the brokerage would be fine, and that the IB could potentially be exposing himself and his business to a criminal investigation should a client complaint emerge.

This effectively means that the potential elephant in the room would be an IB referring business to an FCA regulated brokerage. Something then goes wrong, resulting in a client complaint. The FCA inspects the matter, the brokerage and the client resolve it, and then the IB who brought those clients in the first place is in big legal trouble.

One particular IB explained that it is entirely possible under British law to be sent to jail for up to 5 years for referring clients to an FCA brokerage as an unregulated IB – and by unregulated, that means not regulated by a recognized regulatory authority that is considered acceptable by the FCA for referring business to a British brokerage.

In short – an IB works very hard to generate a client base and make customer relationships long-lasting, refers them to a brokerage which then generates revenue from order flow that they may otherwise not have. Something goes wrong, client complains, broker banks the cash and the IB gets prosecuted.

Land of the Free – well, $45,000 is not quite free..

In North America, things are somewhat different. A brokerage which is regulated by the National Futures Association (NFA) is forbidden to onboard customers from non-NFA regulated IBs, and the NFA stipulates specific conditions for brokerages and IBs.

Whereas an NFA regulated brokerage has to maintain a $20 million minimum capital adequacy balance for regulatory purposes, an IB must maintain $45,000 and make constant reports to the NFA’s electronic reporting system, even though the IB is not executing trades. It is all about ensuring responsibility for client wellbeing right the way across the board from the moment a client forms a relationship with an IB, until the trade is executed and sent to the liquidity provider.

American brokerages are not allowed to work with overseas IBs, and American IBs must be NFA regulated, maintain capital adequacy requirements and make continual reports to the NFA, just as a brokerage would do.

If something goes wrong and the NFA has cause to make an inspection into a broker’s affairs, it is publicly documented and the brokerage is then in legal trouble for working with an unlicensed IB, unlike in Britain where the brokerage is in the clear and the IB, who does not have to maintain any capital requirements, can be from any nation in the world, and does not specifically have to be licensed if the country of origin of the IB does not license FX or electronic trading, is then in very big trouble.

British companies that are getting it right

One particular firm told an IB last week during a meeting “We will be alright, it’s you that will be in trouble.”

To look at how brokerages in various locations view this, FinanceFeeds spoke today in detail to some of the most prominent companies in London, which are, refreshingly, taking this matter seriously and have large departments which police their relationships with their IB networks, for the greater good of clients, and the IBs themselves.

Richard Elston, Head of Institutional for Europe at British electronic trading stalwart CMC Markets explained to FinanceFeeds today here in London “”It is important to categorize the different types of IBs that exist, and we consider that there are two such categories.”

“There are those which operate in an added value capacity such as asset managers, and then there are also introducing agents which are entities that introduce the clients but do not trade on their behalf” explained Mr. Elston.

“Some firms are very large introducing brokers that have international presence, such as TD Ameritrade. They simply intro clients into the brokerage and then let them get on with it.”

“Here in the UK we would not deal with an IB unless it was regulated. We take this through two levels of checks, the first being to establish if the IB entity is regulated and the second is to check that the activities that the IB engages in are covered by the persmisisons that they have from the regulatory authority” said Mr. Elston.

“If the capacity of a particular IB is advisory, we would look at the advisory aspect under FCA rules, however if the IB wanted to trade on behalf of clients, they would have to be able to manage positions as well under their own license” – Richard Elston, Head of Institutional for Europe, CMC Markets.

Mr. Elston explained that CMC Markets polices its IB activity via two internal teams, the first being the compliance department, and the second being the company’s financial crime team.

“The FCA specifies what type of activities an IB performs, and the type of activities within the specific asset classes that the IB operates in, therefore this constitutes regulation of IBs that is specific to the right permissions, within the right asset classes” said Mr. Elston.

Mr. Elston clearly pointed out that if the IB does not have the correct regulatory license that covers the type of activities that it engages in, or pertaining to the relevant asset classes, then CMC Markets will not conduct business with that particular IB.

“Just to make the introduction between client and brokerage requires covering all brokers making arrangements. We have sought legal advuce in the past and there are certain countries such as Germany or France where there is no regulation needed but that applies to introduction only and if an IB is unregulated in those regions, the IB can still not provide financial advice, cannot trade on behalf of clients and client data cannot be shared between IB and broker.”

Helen

Helen Astaniou, FXPRIMUS

With regard to FinanceFeeds discovery that there are firms in the UK that will accept this, Mr. Elston said “If those brokers are working with unlicensed IBs that are trading on behalf of clients, then it is a very poor practice.”

“There is a responsibility within the company to police the IB network that we have brought onboard, and therefore the onus is on us to ensure proper practice” he said.

“We have recently terminated a lot of legacy business that we were uncomfortable with. This is a constantly ongoing schematic review, we are not going to onboard anything that is not approprioately regualted to conduct business.”

“Andrew you are right, the onus of administration and all the legals sit with the broker. A lot of work goes into administering clients from specific IBs, even though sometimes they bring only a few clients. Regardless of that, we view an IB as an entity that operates according to volume based transactions, therefore it requires full due diligence on an ongoing basis” concluded Mr. Elston.

In other jurisdictions that are populous with FX brokerages, a similar responsibility is required to that in the UK. CySec regulated firms have similar responsibilities, as the onus is indeed on the brokerage there too.

FinanceFeeds today spoke to FXPRIMUS, where Helen Astaniou explained “The team at FXPRIMUS onboards partners who work in line with our own ethical operations.”

“It is of utmost importance to us to identify with like-minded individuals and organisations who believe in the safe-trading strategy of the company. To this end, our strong KYC and risk management teams monitor any new IBs both prior to joining the company, and during their time with us on an ongoing basis. This is done in order to protect the IB, to protect the company, and ultimately to protect the client.”

FinanceFeeds reached out to CySec to ascertain whether an unlicensed IB referring business to a licensed brokerage would be liable for prosecution whereas the brokerage would be exempt should a complaint or breach of compliance rulings arise, however whilst CySec acknowledged the meaning of our request, the regulator did not proffer a comment.

This is a loophole which is important to consider for both IBs and FX brokerages, and indeed whilst London’s top quality brokerages are very well organized and have taken this responsibility into their own fold for the greater good of their business as well as the IBs, this is a matter that the FCA could address in future.

#compliance, #regulation

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