Regulatory perimeters

The perimeters of financial sector regulation establish the population regulated within the prudential, conduct18 and retail payments frameworks. Each framework has unique objectives and, to the extent possible, should be clear and targeted.

Prior to the Wallis Inquiry, financial system regulators supervised by type of financial institution rather than regulatory function. The Wallis Inquiry sought to simplify the structure19 and redefine perimeters through the concept of ‘intensity of promise’.20 The RBA retained responsibility for stability of the financial system and for regulating the payments sector via the new PSB.

Today, the Wallis Inquiry’s structure remains; however, it has been adjusted for new and evolving markets, services and products. For example, the development of financial groups has resulted in adjustments to how the frameworks apply. Standards have also been developed under the licensing regime for clearing and settlement systems. Financial market infrastructure (FMI), such as central counterparties and securities settlement systems, is now regulated and overseen under a framework based on international standards.

An illustrative summary of the perimeter for each framework is depicted in Figure 7.2.

Figure 7.2: Current regulatory perimeters – illustrative summary by institution/activity type

This figure is an illustrative summary of the current regulatory perimeters.  It outlines the types of institutions and products that are presently captured by prudential regulation; conduct regulation, retail payment systems regulation, and also includes activity currently outside of these perimeters.  The list of institutions and products in the figure is not exhaustive and supports the discussion by exception contained in the Regulatory perimeter section of the Regulatory Architecture chapter.

Market developments and stakeholder consultations suggest re-examining the perimeters for:

  • Prudential regulation — consider the case for prudential versus conduct regulation of superannuation funds.
  • Retail payment systems — consider a simplified and/or graduated framework with clear and transparent thresholds.
  • Conduct regulation — consider the case to extend regulation for fund administrators and technology service providers of sufficient scale and apply select market integrity rules to securities dealers.

Observation

The regulatory perimeters could be re-examined in a number of areas to ensure each is targeted appropriately and can capture emerging risks.

Prudential regulation of superannuation

The growing importance of superannuation has warranted an in-depth treatment in this Inquiry, including re-examining the regulatory framework.

Prudential regulation and supervision has costs, both in terms of direct regulatory costs and costs to efficiency and competition. However, prudential regulation also brings benefits to the economy, as discussed in the Stability chapter.

The Wallis Inquiry recognised that superannuation and managed investments were operationally equivalent, but recommended that superannuation’s unique characteristics provided a case for prudential regulation: the compulsory nature of some superannuation savings, the lack of choice for a large proportion of members, the mandatory long-term nature of superannuation, and the contribution to superannuation of tax revenue forgone.

In the past 15 years, the superannuation industry has grown and evolved to reach more than $1.8 trillion in assets under management.21 Superannuation is now the second largest sector after banking and is continuing to grow rapidly. The wealth management divisions of financial institutions have also grown, resulting in a greater degree of vertical integration. Large financial groups with a material cross-industry presence account for approximately 40 per cent of total superannuation assets.22 The Superannuation chapter provides further detail on this sector.

On the one hand, imposing higher-intensity regulation and supervision comes at a cost, potentially affecting long-term returns to superannuation members. On the other hand, the unique characteristics of superannuation that the Wallis Inquiry recognised have largely persisted. This includes the expectation that superannuation is integral to the retirement income system.

Preliminary assessment

APRA’s prudential regulation of superannuation involves promoting safety and soundness in business behaviour and risk management on the part of trustees and superannuation funds. The primary supervisory focus is on the soundness of the governance arrangements, the competence and effectiveness of the trustee board and senior management, and the risk management and control framework. Where necessary, it also involves remediation and enforcement activities.

Registered managed investment schemes (MISs) and their operators (responsible entities) are regulated by ASIC with similar aims and, in some areas, broadly similar requirements to superannuation entities.23

Differences lie predominantly in the intensity of the requirements applying to governance and risk management and the intensity of supervision applied in respect of these standards. Differences also exist in the requirements for financial resources, reserving and liquidity (see Table 7.1).

Table 7.1: Differences in regulatory requirements for MISs and APRA-regulated superannuation funds
Managed investment schemes APRA-regulated superannuation funds
Financial resources Net tangible assets (NTA) requirement — where scheme property is not held by a custodian, the responsible entity (RE) is required to have a minimum NTA of an amount between $150,000 and $5 million or, if greater, 10 per cent of average RE revenue. Where held by a custodian, it is required to have NTA of at least $10 million, or if higher, 10% of the custodian’s average revenue. Cash needs requirement for REs — requirements for projecting cash flows over 12 months Operational risk financial requirement — required reserve against operational risk losses.
APRA expects a reserve of at least 0.25 per cent of funds under management to be held by the trustee or APRA-regulated fund. There is some offsetting of this allowed within groups.
Liquidity REs are able to freeze scheme redemptions in certain circumstances if the scheme becomes illiquid — as occurred during the GFC for some schemes. APRA — regulated funds are required to have a liquidity management plan. Legislated portability requirement — funds must meet rollover requests within three days.

Although not directly comparable, the MIS NTA requirements may be higher for smaller entities, whereas the superannuation operational risk requirement is likely to be higher for larger entities. The liquidity management requirements for MISs are not as detailed as those for superannuation, and MIS liquid assets include such assets as property. MISs do not have the legislative portability requirements that apply for superannuation and which affect the liquidity needs for superannuation.

Applying prudential regulation to superannuation is likely to impose additional costs. However, low levels of loss in the sector are a significant benefit that may justify or outweigh these costs. In the past decade, there have been lower levels of failure and loss in the prudentially regulated superannuation sector than in the MIS sector. In APRA-regulated superannuation, compensation is available to cover loss arising in cases of fraud, whereas there is no statutory compensation for MISs. Where there has been fraud, superannuation industry-funded compensation has been provided, and where there has been loss due to market movement, members have borne the loss.

The existing regulatory arrangements for superannuation reflect a number of differences between superannuation and MISs. This includes that superannuation is integral to retirement income policy, which is explicitly recognised through taxation incentives, mandatory participation in the system and restricted access prior to retirement.

Some stakeholders argue that prudentially regulating superannuation can lead to members having a greater expectation of Government support, and this can lead to moral hazard for the Government. Another concern is that imposing higher-intensity regulation and supervision comes at a cost, potentially affecting long-term returns to superannuation members. System inefficiencies can also be created by the complexity of having different regulatory arrangements for large financial groups that provide both superannuation and managed investments.

On the other hand, it can be argued that most members are not aware of the regulation that applies to superannuation, and members’ expectations of Government support for a failure in superannuation are linked to other characteristics such as its mandatory nature. Low levels of non-market losses in superannuation may offset additional costs of prudential regulation. It can also be argued that higher standards on superannuation trustees are appropriate to address reduced market discipline, potentially arising from the mandatory nature of superannuation. Prudential regulation takes a group-wide view and the high proportion of large financial groups with a material cross-industry presence, means that groups that contain superannuation benefit from consistency in governance and risk management standards and common supervisory practices.

The Inquiry is interested in views on whether there is a strong case for change.

Policy options for consultation

The Inquiry seeks views on whether the regulation of APRA-regulated superannuation trustees and funds should be aligned with responsible entities and management investment schemes.

With respect to prudential regulation, the Inquiry also seeks views on establishing a mechanism to adjust the prudential perimeter to apply heightened regulatory and supervisory intensity to institutions or activities that pose systemic risks. The Stability chapter provides further detail on this option.

The Inquiry would value views on the costs, benefits and trade-offs of the following policy options or other alternatives:

  • No change to current arrangements.
  • Align regulation of APRA-regulated superannuation trustees and funds with responsible entities and registered management investment schemes.

Retail payment systems regulation

Payment systems regulation has two functions:

  1. It seeks to address systemic risk and promote stability, thereby limiting failure and disruption to essential payment services within the financial system. In this case, the focus is primarily on high-value payment systems.
  2. It has a focus on competition and efficiency in payment systems. In this case, the focus is on retail payment systems, such as the card systems, where a large number of low-value payments are processed.

Regulatory perimeter issues are more likely to arise in the latter case.

In recent years, market and technological developments have gathered pace in the payments sphere. It is important that regulatory settings are well calibrated to prevent disruption, but also allow for continued innovation.

A number of submissions suggest re-examining the current regulatory framework for retail payment systems, specifically in relation to:

  • Simplifying the current framework
  • Inconsistent treatment of like products, that may result in an unlevel playing field

Preliminary assessment

Simplify the current framework

The complex structure of retail payment systems, and the level of public interaction with them, has resulted in the sector’s regulation being fragmented. Part of the complexity comes from the fact that regulation needs to be considered separately for:

  • The payment systems – the rules, infrastructure and arrangements that enable payments to be exchanged; for example, a card payment scheme
  • Payment system participants — the entities (in most cases financial institutions) that provide the services of a particular payment system to the public; for example, an issuer of credit cards under the rules of a card payment scheme

Submissions, particularly those from non-ADI payment participants, argue that the current regulatory framework is fragmented and unnecessarily complex due to the number of regulators providing oversight of retail payment activities. Although there are a number of regulators, this is not inconsistent with regulation in other areas of the financial system.

The sector is currently subject to regulation by the RBA, APRA, ASIC and Australian Transaction Reports and Analysis Centre (AUSTRAC). Each regulator has its own definitions and concepts relating to payment systems and provides a number of disparate exemptions. See the Technological innovation and Competition chaptersfor additional discussion of payments regulation.

Unlevel playing field

Submissions have also raised concerns with an unlevel playing field for providers.

The PSB regulates both retail and wholesale payment systems. The PSB’s approach is to encourage industry to undertake reform as required, and it has therefore not licensed and regulated every payment system. Instead, it has designated specific systems where there are concerns with respect to stability, competition or efficiency.

Concerns with regard to an unlevel playing field may also relate to participants that are not supervised by APRA being permitted to participate in a payment system.

One example of potential inconsistent treatment relates to stored value payment systems (purchase payment facilities or PPFs in the Australian legislation), which among other things may include prepaid cards and ‘mobile money’. These systems differ from other payment systems because they have a deposit-like element — a function that is the focus of APRA and RBA’s regulatory responsibilities, rather than the payment function per se.

In its submission, the RBA supports a closer look at the regulatory status of stored value systems, given that they hold customer funds and there is the potential for increased adoption via mobile devices and e-wallets.

The RBA is also monitoring the development and growth of open-loop virtual currencies in Australia.24 ASIC considers that virtual currencies are not, of themselves, financial products. However, where payments are enabled in a virtual currency, such as wallet software, these may be financial products. Further consideration should be given to whether these kinds of arrangements should be regulated. Presently, there is considerable divergence internationally in the way virtual currencies are treated for regulatory purposes.

Submissions also raise AML and Know Your Client (KYC) verification as a potential concern. New technologies in payments are also testing the perimeter of AML legislation. With the growth in a range of stored value systems, which could be used to launder money, this may develop into an issue. Strengthening the perimeter for transaction activity is on AUSTRAC’s agenda, including ongoing discussions with regulators in other jurisdictions.

Policy options for consultation

The Inquiry would welcome views on opportunities to simplify or streamline the current regulatory framework.

In establishing a level playing field for retail payment systems and participants, the RBA supports a review of the regulation of PPFs (including stored value payment systems) to provide adequate protection of customer funds. The submission notes that imposing regulation equivalent to ADIs on these players could be onerous, and a graduated framework may be more appropriate.

A graduated framework should consider aligning risk and the scale of activities with compliance requirements. Such a framework could be tiered with clear thresholds for when an activity or participant becomes regulated. Thresholds should take account of the risk posed by unregulated new entrants and new technologies weighed against the costs of imposing regulation and its potential effects on innovation and competition. Regulation should also aim to apply to any payment system or participant in a technology-neutral manner.

The Inquiry would value views on the costs, benefits and trade-offs of the following policy options or other alternatives:

  • No change to current arrangements.
  • Consider a graduated framework for retail payment system regulation with clear and transparent thresholds.

The Inquiry seeks further information on the following areas:

  • Is there firm evidence to support opportunities for simplifying the regulatory framework for retail payment systems and participants?
  • What are practical and appropriate options to simplify the current regulatory framework for retail payment systems and participants?

Conduct regulation: fund administrators and technology service providers

There are a number of areas where risks may be developing outside the conduct perimeter, specifically in relation to service providers of scale. Further, market integrity rules do not apply to securities dealers.

Preliminary assessment

Service providers of scale

Some service providers outside the regulatory perimeter are of such size and potential influence that service disruption or failure would affect regulated institutions. There are requirements on regulated entities to ensure certain standards. However, with service providers of scale, there may be a case for considering direct regulation. As for all regulation, the costs and benefits of doing so need to be carefully considered to ensure undue burdens are not imposed. Two potential direct regulation cases include administrators and technology service providers of scale.

Administrators of scale

The provision of fund or investment administration is not currently subject to direct regulatory oversight, although such providers often provide services to regulated entities.25 Such administrators are used by trustees of superannuation funds, operators of MISs and investment platforms, investment companies and life companies.

Many administrators service a significant number of funds, including self-managed superannuation funds (SMSFs). The industry is becoming more concentrated, and this trend is expected to continue. If an administrator of scale collapsed, this could cause disruption and loss for members of the superannuation funds and MISs reliant on the administrator.

Requiring an Australian Financial Services Licence (AFSL) for these entities would allow monitoring and minimum standards to be set.

Technology service providers of scale

A similar concern relates to vendors of IT systems relied on by market participants and financial market operators. If such an IT system failed, this could impede the fair and orderly operation of financial markets.

Technology service providers are subject to limited oversight, as any obligations to have appropriate risk management systems and resources fall on regulated entities, rather than the vendors. With providers of scale, there may be a case for considering direct regulation.

Requiring an AFSL for these entities would allow monitoring and minimum standards to be set.

Securities dealers

Securities dealers are AFSL holders that provide investor services. These dealers can provide services that are substantially similar to those provided by ‘market participants’ captured within ASIC’s regulatory perimeter. However, ASIC is currently unable to use market integrity–specific remedies to address misconduct by securities dealers, or their clients, in an equivalent manner to market participants. This includes suspicious trade reporting and market manipulation provisions.

Policy options for consultation

In relation to the conduct perimeter, the Inquiry has identified the following options for consideration:

  • Extend AFSL requirements to administrators and technology service providers of scale. Such an option has practical implementation challenges, including setting clear and appropriate risk-based criteria to identify appropriate entities without imposing undue burden on all service providers.
  • Apply market integrity rules for licensed securities dealers that provide investor services substantially similar to market participants of a licensed financial market.
  • Create a mechanism to allow a heightened level of regulatory intensity to be applied where risk arises outside the conduct perimeter. This option also has practical implementation challenges, including setting clear and appropriate criteria for making determinations.

The Inquiry seeks views on the costs, benefits and trade-offs of the following policy options or other alternatives:

  • No change to current arrangements.
  • Impose AFSL requirements for providers of fund administration and technology service of sufficient scale.
  • Apply market integrity rules for licensed securities dealers that provide investor services substantially similar to market participants of a licensed financial market.
  • Introduce a mechanism to allow a heightened level of regulatory intensity to be applied where risk arises outside the conduct perimeter.

18 Conduct regulation refers to both regulating markets and the conduct of market participants and other financial product providers.

19 The Wallis Inquiry merged 11 Federal and state regulatory organisations to create APRA, including parts of the RBA responsible for banking regulation.

20 The Wallis Inquiry held that “the higher the intensity of a promise, the stronger the case for regulation to reduce the likelihood of breach”.

21 Australian Prudential Regulatory Authority (APRA) 2014, Quarterly Superannuation Performance (interim edition), March 2014, APRA, Sydney.

22 Ibid.

23 Some managed investment schemes are not required to be registered with ASIC. For example, schemes with only certain classes of wholesale members.

24 Reserve Bank of Australia 2014, First round submission to the Financial System Inquiry, page 229.

25 Custodians are subject to AFSL requirements by ASIC, but this does not cover their activities as administrators.