Regulatory Summary Q2 2024

1. CONTENTS

1. CONTENTS
2. PURPOSE
3. EXECUTIVE SUMMARY
4. REGULATORY UPDATES
5. ITEMS TO CONSIDER

2. PURPOSE

The purpose of this document is to provide Behavox’ executive team with a summary of the key regulatory developments that have occurred over the last quarter. The aim is to flag changes in regulatory guidance, relevant enforcement actions and industry news that should be considered by the ExCo team because they may result in new opportunities or potential compliance gaps, provide new insights, or highlight market developments. This report will also highlight relevant enforcement cases or developments impacting Behavox’s existing clients.

3. EXECUTIVE SUMMARY

Current regulatory landscape

Recent regulatory measures highlight the increasing focus on maintaining the integrity of the financial markets. For example, the European Securities and Markets Authority (ESMA) has issued a warning to companies against sharing market-sensitive information with external analysts during “pre-close calls”. This warning was prompted by  several incidents where such disclosures allegedly led to share price volatility, raising concerns about potential market abuse. This situation underscores the critical role of voice surveillance in banks to ensure proper management of confidential information. 

In the U.S., the Commodities Futures Trading Commission (CFTC) has proposed a rule to ban derivatives that allow betting on U.S. elections and other significant real-world events. This proposal, driven by concerns over the potential undermining of election integrity and state gaming regulations, could have significant implications for banks. The proposed ban may limit trading opportunities and require adjustments in the firms’ compliance strategies. 

Moreover, the Securities and Exchange Commision (SEC) has continued its enforcement of insider trading laws, under the “shadow trading” theory. The SEC’s success in these cases signals increased risks for financial institutions. Consequently, banks should review and potentially update their insider trading policies and enhance their compliance monitoring systems. These regulatory shifts emphasise the heightened need for banks to actively manage compliance risks and adapt to the evolving legal landscape in financial markets. 

Regulator View on AI 

The UK FCA’s regulatory approach on AI does not prescribe or ban specific technologies but emphasises identifying and mitigating risks to achieve its objectives. This outcomes-focused approach offers flexibility, allowing firms to innovate while protecting consumers. Further, as AI models become more complex, the FCA expects regulation to evolve, focusing on testing, validation, and explainability of AI models. 

The FCA is also focusing on the risks posed by Critical Third-party Providers (CTPs) to the financial sector. The Bank of England, PRA, and FCA are reviewing their approach to CTPs as detailed in the Consultation Paper “Operational resilience: Critical third parties to the UK financial sector” (CP26/23). The proposed regulations aim to address potential risks to the UK’s financial stability that could arise from failures or disruptions in the services provided by CTPs to financial firms or Financial Market Infrastructure (FMIs). Although the framework isn’t specifically designed for AI, it is broad enough to include considerations related to the widespread use of AI models, such as data bias and model robustness. If AI service providers become crucial to the financial sector, they could be regulated under this framework if designated as critical by the HM treasury. 

Meanwhile, FINRA acknowledged the use of LLM and other generative AI (Gen AI) offers opportunities to enhance products and services through better data analysis, and as educational resources for investors. AI can also be used to help with compliance tasks such as identifying potential market abuses. Behavox’s James Burgess has put together a report that dives deeper into this topic, reviewing the guidance provided by major financial regulators on the implementation of AI in financial institutions. 

Similar to the FCA, FINRA maintains a technology-neutral approach to AI. FINRA advises that firms using Gen AI to review electronic communications, must have supervisory controls in place that address technology governance including data privacy, integrity and model accuracy. However, the use of Gen AI raises concerns about accuracy, privacy and bias. Further, FINRA Rules still apply whether firms develop their own AI tools or use third-party technology. Firms should also evaluate AI tools before deployment to ensure compliance with existing regulations. 

Regulatory bodies are also adopting AI to enhance their processes. For example, Italy’s Consob has been experimenting with AI for the approval of listing prospectuses and detecting trading anomalies. The AI system is said to identify errors in just three seconds, a task that typically takes a human analyst 20 minutes, according to Consob’s annual report. The shift to AI is expected to improve the detection of regulatory violations. The next step is to transition from the prototype phase to fully integrate AI into its regular operations. This trend among regulators reflects a broader global movement toward incorporating AI into financial oversight, with market participants and investors keenly observing the impact of these advancements on future regulation. 

Although AI offers significant efficiency improvements for financial institutions, it also introduces risks, such as increased operational vulnerabilities, dependence on third party providers, and the potential for sophisticated cyberattacks. The European Central Bank (ECB) has raised concerns about issues like herding behaviour and data privacy, emphasising the need for careful monitoring as AI technology evolves. While the European Union has implemented AI regulations, the ECB suggests that additional measures may be needed if current frameworks prove inadequate. 

Off-channel communications 

The SEC has continued its crackdown on firms’ failure to comply with recordkeeping requirements. Twenty-six firms have been charged over widespread failures to maintain and preserve electronic communications and failing to supervise personnel adequately, resulting in over $390 million in penalties. The firms admitted to using unapproved communication methods, hindering the SEC’s investigations. Meanwhile, three firms received reduced penalties for self-reporting. The SEC is also likely to continue pursuing record-keeping cases against stand-alone investment advisors. For instance, Senvest Management was charged $6.5 million by the SEC for use of off-channel communications. Similarly, Dawson James Securities, a small broker-dealer, was fined $500,000 by FINRA. 

In the case of Senvest, the SEC found that employees used off-channel communications for thousands of business-related messages, but provided little detail on what types of communications were considered non-compliant. This has raised more uncertainty than clarity regarding specific compliance expectations for firms. These actions suggest that regulators will continue to enforce strict penalties, including naming executives in enforcement actions often without providing context about the violations. 

According to the SEC, imposition of such harsh fines for record-keeping violations has caused significant changes in industry practices. These fines have prompted firms to enhance their compliance practices, particularly in maintaining electronic communications. This suggests that future violations on off-channel communications will continue to face similarly severe penalties. 

Non-financial misconduct and scrutiny against regulators 

Meanwhile, scrutiny over non-financial misconduct is intensifying, with regulators now at the forefront of controversy. For instance, an independent report by the law firm Cleary Gottlieb has revealed widespread sexual harassment, racial discriminarion, and bullying within the Federal Deposit Insurance Corporation (FDIC), implicating senior leaders including FDIC Chair Martin Gruenberg. The report, prompted by a Wall Street Journal Investigation, found that misconduct was pervasive and often tolerated, with those accused frequently reassigned rather than disciplined. The report recommends appointing new officials to address the toxic culture and creating an anonymous hotline for reporting misconduct. 

Similarly, the FCA is also facing criticism over mishandling of a bullying complaint against its former director of enforcement. Initially, an independent commissioner’s report supported allegations of Steward’s aggressive behaviour and recommended the FCA apologise. However, the report was retracted after it was revealed that Steward had not been informed of the complaint or given the chance to respond, and potential witnesses were not contacted. The FCA has admitted to errors in handling the complaint and has reopened the investigation, raising concerns about the independence and transparency of the FCA’s internal processes. These failures in handling serious complaints have further eroded trust in these regulatory bodies, with significant implications for the integrity and effectiveness of financial regulation, potentially undermining their mission to uphold fairness and transparency in the financial industry. 

4. REGULATORY UPDATES