Uncertainty Surrounds Regulatory Changes

Institutional investors, and the financial community, face a whirlwind of regulatory change on a global scale, one of the many new aspects of risk that investors must address in the post-financial crisis environment.

While a number of changes are in various stages of review and implementation, one fact remains clear: these changes could dramatically alter the way they invest their portfolios while also placing greater importance on monitoring and compliance activities. As a result, investors should take the necessary steps to plan and implement appropriate risk mitigation strategies.

Recent regulatory efforts, many of which were initially introduced in the aftermath of the 2008 global financial crisis, aim to reduce systemic risk through a number of measures such as greater transparency and increased capital requirements. This year already was shaping up to be a critical time in terms of the volume and impact of actual and potential regulatory changes, but the situation remains murky because many details have yet to be finalized.

"We're looking at sweeping regulatory change in the United States, the United Kingdom and throughout the EU," notes Jean Sheridan, executive vice president and head of global financial regulatory change management at Northern Trust. "Most of the final regulatory language isn't settled."

Throughout the year, institutional investors will be sure to follow developments pertaining to key regulatory efforts and working with their financial advisors to develop strategies and systems for managing their impact. Among the regulatory efforts investors will be watching are:

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Dodd-Frank Wall Street Reform and Consumer Protection Act

The Volcker Rule: Since regulators announced proposed rules related to the Volcker Rule in October 2011, there has been tremendous focus on the potential impact of the proposed rule, with more than 18,000 industry comment letters filed during an extended comment period, which ended on April 16, 2012.

The Volcker Rule was intended to restrict banks from high-risk proprietary trading, and investing in or sponsoring hedge funds and private equity funds. As proposed, the rules would prohibit custody banks that sponsor or advise "covered funds" from providing credit to these funds, even in connection with routine payment and settlement services like intraday overdrafts, contractual settlement and contractual income payments. The rules, however, define covered funds so broadly that rather than being limited to hedge funds or private equity funds — the real focus of the Volcker Rule — substantially all foreign funds and commodity funds would be included.

The restrictions also are likely to have an adverse impact on the securities lending industry. As proposed, the rules may prevent banks from providing routine and low-risk payment services and short-term investment of cash for securities lending collateral pools that are within the definition of "covered fund," which would likely decrease market liquidity.

"Northern Trust has filed comments individually, with peer custody banks and as part of industry groups to highlight our concerns about the adverse impact the proposed rules would have on the ability of U.S. financial institutions to remain competitive. On May 9, 2012, Northern Trust testified before the Senate Subcommittee on Financial Institutions and Consumer Protection on aspects of the proposed Volcker Rule that may have a significant impact on Northern Trust and our clients," Sheridan said.

Status: On April 19, 2012 the Federal Reserve issued an announcement confirming that banking entities will have the full two-year period after July 21, 2012 to conform their activities to the requirements of the law and final rule when issued. "This development alleviates concerns about complying with the rule by July 2012," Sheridan noted, adding the Federal Reserve has not indicated when the final rule will be issued and can further adjust the conformance period if necessary.

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Swaps and Derivatives: In addition to the Volcker Rule, over-the-counter (OTC) derivatives and swaps fall under Title VII of Dodd-Frank, which is regulated by the Commodities Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC).

"Regulations pertaining to OTC derivatives and swaps will result in significant changes for the industry," Sheridan said. "We are continuously evaluating the services that Northern Trust needs to develop in order to assist our clients, and we are making necessary enhancements to our systems and technology based on expected regulatory requirements."

She said the central clearing of swaps in particular has many dependencies that require systems development to be flexible depending on changing regulations, adoption of rules, standardization of processes and acceptable accounting treatment.

Status: The CFTC issued several final rules pertaining to swap dealer and internal business conduct, which were effective in March 2012. On April 27, 2012, the CFTC published a final rule further defining "swap dealer," "security-based swap dealer," "major swap participant" and "major security-based swap participant."

The SEC and CFTC also have adopted joint final rules further defining the terms "swap," "security-based swap" and "security-based swap agreement." The SEC voted to adopt the rules unanimously on July 6, 2012. The rules will become effective 60 days after publication in the Federal Register. The rules also provide for some interim exemptions for security-based swaps (under federal securities laws) for 180 days after publication of the final rules.

These product definition rules provide guidance on classification of several derivative instruments as either:

• swaps
• security-based swaps
• mixed swaps
• none of the above

How an instrument is classified determines whether it is subject to regulation by the CFTC, the SEC, both agencies or whether it falls outside the general regulatory authority of either agency.

In describing the final rules, it appears that the CFTC has made several substantive changes to the proposed product definition rules. However, the most significant change relative to the final rules is the impact on timing — it allows the CFTC to begin moving from rulemaking to implementation — as the compliance dates for many CFTC Title VII rules are linked to the date when the final product definition rules are published.

While the effective date clock starts ticking with publication in the Federal Register, if recent history is an indicator, publication will likely be delayed similar to entity definitions that did not occur until almost a month after the final rule was adopted. In addition, even when the rules are final and effective, they are subject to enforcement delays. Many of these enforcement delays will begin to expire once the product definitions become effective, but the timing of enforcement will depend on whether an entity is a dealer, major swap participant, U.S. financial institution or end-user, as well as other factors. This is particularly applicable to clearing, which requires the availability of an swap execution facility to clear a particular swap.

Northern Trust continues to analyze all the rules to understand the impacts to our business and our clients.

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EU Regulations

The Alternative Investment Fund Managers Directive: AIFMD regulates non-UCITS funds that are: (a) managed in, (b) domiciled in and/or (c) marketed in the European Union — including private equity, real estate and hedge funds. AIFMD will become effective in July 2013.

Under AIFMD, new EU managers seeking authorization after July 2013 will need to be compliant right away. Existing managers have until July 2014 to become compliant. Non-EU funds and managers must comply with AIFMD by the beginning of 2015 if they want to be able to "passport" or offer their funds within the EU,) or by 2018 in other cases. Under AIFMD there will be an enhanced depositary liability regime, although the full extent of the depositary's liability remains undefined until final guidelines are released, which is expected in September 2012.

Status: The European Commission is expected to finalize AIFMD rules in September 2012. Northern Trust is analyzing the potential impact of the measures and building new reporting requirements in preparation for AIFMD.

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European Market Infrastructure Regulation: This regulation provides a Europe-wide regulatory framework for OTC derivatives, central counterparties and trade repositories. In February 2012, the EU authorities reached political agreement on proposed EMIR regulation. The regulation was adopted by the European Parliament in March and was approved by the EU Council on July 4, 2012.

Status: The European Supervisory Authorities have begun their consultation process for implementing measures, which will be submitted to the European Commission by the end of September 2012. The expected implementation date is January 2013.

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The Foreign Account Tax Compliance Act

The Foreign Account Tax Compliance Act of 2010 (FATCA) requires, among other things, foreign financial institutions (FFIs) to identify and report U.S. account holders to the U.S. Internal Revenue Service (IRS). Those FFIs that do not comply will be subject to a 30% withholding tax on all U.S.-sourced payments they receive beginning in 2014 — and this includes interest, dividends and proceeds from the sale of U.S. securities. FFIs also must obtain evidence of FATCA compliance from their account holders and withhold certain payments to any account holder that does not provide such evidence. Furthermore, FATCA requires U.S. individuals (and certain U.S. institutions) to report to the IRS their ownership of foreign financial assets if the value of such assets exceeds certain thresholds.

"Other countries are going to want to know more about their taxpayers," said Kathy Dugan, senior vice president in Northern Trust's Institutional Product Group. "There's a 'you can run, but you cannot hide' message out there, and we're living at a time when technology can trace people and their activities anywhere in the world."

Consistent with their earlier guidance, on February 8, 2012, the IRS and U.S. Treasury Department (Treasury) issued proposed regulations that re-affirm their phased implementation approach for FATCA withholding requirements In addition, the United States has issued joint statements with other countries announcing their commitment to explore an intergovernmental approach to FATCA implementation. A joint statement was released between the United States, France, Germany, Italy, Spain and the United Kingdom on February 8, 2012. Separate joint statements were released on June 21, 2012 between Japan and Switzerland with the United States. A Model Intergovernmental Agreement to Improve Tax Compliance and to Implement FATCA (Model IGA) also was published with a joint statement released between the United States, France, Germany, Italy, Spain and the United Kingdom on July 26, 2012. Under this Model IGA, FFIs would report directly to their local tax office instead of the IRS, and the United States would reciprocate in collecting and exchanging information on accounts held by residents of those countries. Other countries may adopt this Model IGA, or other Model IGAs yet to be released.

The proposed FATCA regulations and the joint statements indicate a general intent to move the FATCA rules in a direction that may be more practical for financial institutions to implement. However, the proposed regulations are complex and there are several outstanding issues pertaining to how FATCA will be implemented across jurisdictions.

Subsequent to the release of proposed regulations, the IRS issued preliminary draft copies of the modified Certificate of Status of Beneficial Owner for U.S. Tax Withholding—Forms W-8 BEN and W-8-BEN-E. The draft forms have been redesigned to accommodate the proposed FATCA regulations; however, they do not reflect comments on the proposed rules currently under consideration by the IRS and Treasury. The draft forms are expected to change before the final forms are issued. New W-8 forms are expected to become effective on January 1, 2013 at the earliest. Draft instructions have not been released.

Status: The Treasury and IRS have stated their intention to publish final FATCA rules by late summer or early fall of 2012.

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Money Market Funds

Since the 2008 market crisis, the SEC has focused considerable attention on systemic risk that it believes could be triggered by redemption runs on money market funds. In 2010, the SEC amended the rules that govern how money market funds are invested in an effort to increase safety and liquidity for money market fund shareholders.

While the 2010 changes tightened the requirements that pertain to the maturity, credit quality and liquidity of securities held in money market fund portfolios, the SEC has had growing concerns about how money market funds would perform in a future significant financial crisis.

As a result, the SEC has indicated its intention to propose additional reforms in an attempt to address those concerns. Proposals focus on the need to maintain a capital buffer, the enforcement of redemption restrictions and the implementation of a floating net asset value (NAV).

Status: Northern Trust has an established cross-functional team to evaluate the impact of the expected changes. Proposed rules on money market fund reform are expected sometime this year. The SEC staff has issued a confidential draft proposal for review by the SEC commissioners; at least three commissioners must vote to release a proposed rule.

Regulators have stated that reform must be introduced to reduce the systemic risk created by money market funds:

• SEC Chairman Mary Schapiro testified at the Senate Banking Committee on June 21, 2012, emphasizing her focus on money market fund reform.
• Federal Reserve Governor Frank K. Tarullo frequently speaks on the topic, most recently at the Federal Reserve Bank of San Francisco.

Several industry groups have opposed money market fund reform, citing the reforms implemented by the SEC in 2010 as sufficient.

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