South Africa's financial regulatory scene is in a state of flux, but change is proving to be slow. At a G20 meeting in 2012 the Government agreed to regulate hedge funds and it had already decided to have two main regulators: one for prudential matters and one for everything else. Plans for these are still on the drawing board.

Pravin Gordhan, South Africa's finance minister, stated in his budget speech of 2012: "As announced last year, we intend to shift towards a twin peaks system for financial regulation, where we separate prudential from market conduct supervision of the financial sector. Consultations will continue this year, with a view to tabling legislation in early 2013."

The 'Twin Peaks' model, named in the mid-1990s by Dr Michael Taylor of the London Guildhall University after a popular American TV series of the time, is the regulatory equivalent of Montesquieu's call for the 'separation of powers' in the wider world of government. It calls for the separation of a state's financial regulation between two bodies - a prudential regulator that keeps an eye out solely for systemic risk; and a 'market conduct regulator' (to use the South African term) that concentrates on how fairly firms treat their customers or each other.

Taylor's idea - borne out by the events of 2008 and thereafter - was that if a country were to have a single financial regulator, that body would find it impossible to keep its eye on the 'big picture' of market stability, spotting bubbles and monumental industry-wide scams that were doomed to fail, because it was responding constantly to the more lowly demands of 'conduct regulation.' Taylor's main reason for this was that these, rather than deliberations about prudential safety, are the themes that fill politicians' mailbags. Many a regulator claims to be free of politicians, but none truly is.

The rise and fall of the ultimate single regulator

In opposition, the Labour MP Alistair Darling (who was just about to become Chief Secretary to the Treasury) promised that the idea of a single regulator 'won't wash.' Once the party achieved power in 1997, however, things took a very different turn and within two months a gargantuan regulator - a private company wholly owned by HM Treasury - was planned and came into formal existence in 2001. This was NewRo, which later gained notoriety as the Financial Services Authority. It performed catastrophically in the credit crunch of 2008, when unwieldy tripartite prudential arrangements between it, the Bank of England and the Treasury fell far below the level of events.

South Africa's retail reforms

Many regulatory reforms are either in the pipeline or already in the rulebooks of South Africa and most of them are linked to 'Twin Peaks'. On the private client front, the South African Financial Service Board (FSB) has issued guidance relating to its "Treating Customers Fairly" (TCF) standards which 'went live' on 1 January 2014. Much of TCF is in line with the Consumer Protection Act and firms therefore face the 'double whammy' of court and regulatory action in many cases.

The problem with TCF is that it seems to be vague, with very little detail. It is, like its British predecessor, based on principles. It dictates that:

• The fair treatment of customers must be central to the firm’s culture.
• Products and services marketed and sold in the retail market (including HNWs) must be designed to meet the needs of identified customer groups and targeted accordingly.
• Customers must be given clear information and be kept appropriately informed before, during and after the time of contracting.
• Where customers receive advice, this must be suitable and must take account of their circumstances.
• Financial service providers' products must perform as they have led their customers to expect and their service must be of an acceptable standard and must be what your customers are expecting.
• There must be no unreasonable post-sale barriers to change product, switch provider, submit a claim or make a complaint.

Regulatory decisions can be expected to add detail in due course. The Financial Services Board has just published an assurance of this, stating: "The TCF framework is not solely principles-based, but is outcomes based. This means that the framework will comprise whatever combination of rules-based and principles-based regulation is deemed most effective to achieve the 6 TCF fairness outcomes.

Pending the next phase of the “Twin Peaks” legislation, there are already a number of other regulatory projects underway within the FSB, aimed at strengthening existing regulations to better support the six TCF outcomes."

The FSB has said that it still has to earmark categories of financial products and services that it regards as part of the ‘retail’ domain. These are the products over which financial firms will have to strive to achieve 'TCF outcomes'. The FSB has a slightly freer hand than the old British FSA, which European directives compelled to separate its regulated firms into ‘retail’, ‘professional’ and ‘eligible counterparties’. It did not have the freedom to be creative with the definition of 'retail,' which in virtually all cases takes in the HNW market unless there is a 'professional investor' who is both wealthy and an experienced dealer on the markets (see Compliance Matters September page 14 and October pages 9-10 last year). The FSA was wary of introducing a new definition of ‘retail for TCF purposes’ as it would certainly include some professional firms. It therefore insisted on TCF for all firms, but in practice concentrated its supervisory resources on firms - such as private banks - with retail clients. South Africa has no concept of a ‘professional client’, so clients can indeed be ‘retail for TCF purposes’.

In 2011 the Government made changes to Regulation 28 Pension Funds Act, which limits investments in certain asset categories in investment funds. It calls for an investment strategy for each fund and places the onus on the trustees to keep an eye on the strategy's performance, reviewing it if needs be. There is a maximum exposure of 75% to equities, 25% to property and 25% to foreign assets. Retirement funds (some used by HNWs) are its main target. The reform does not affect investments 'issued' before 1 April 2011, which need not be monitored until they become the subject of fresh transactions.

Then there is the FSB Intermediary Remuneration Review. The aim of this is to ensure that advisors and people who work for them are remunerated in line with the policyholders' and other customers' interests. This has some way to go.

In November 2012, after a consultative exercise with still no extant rules in sight, the FSB announced that the review would be broadened to include all aspects of sectors it was supervising, adding collective investment schemes and retirement products to insurance. At some point it decided to change the name to the "Retail Distribution Review" which, given its British connotations of turning the fee system upside down, has struck terror into the hearts of intermediaries.

The upcoming RDR discussion paper is to be published in the summer, after the end of another discussion process. Practitioners might draw a crumb of comfort from the fact that nowhere do the TCF principles mention the words 'fee' or 'commission', although that very same observation about the British TCF principles proved a source of false optimism in the wake of RDR.

The Financial Intermediaries' Association of Southern Africa recently published a paper to quell suspicions that "upfront commission payments are to be abolished, even for pure risk cover life business." It reassured its members that the RDR was not a regulation but a discussion document and that the Government has not published even an initial draft of an RDR bill.

Remuneration as regards 'risk products' is supposed to be 'informed' by the following principles.

• Commission structures should strike a balance between supporting a continuing service and adequately compensating intermediaries for up-front advice and intermediary services.
• Remuneration structures should promote a 'level playing-field' between independent intermediaries and in-house agents.
• An intermediary may not be remunerated for the same or a similar service twice.
• All policyholders' fees must be "motivated, disclosed and explicitly agreed to by the client."
• All remuneration must be reasonable and commensurate with the actual services rendered.
• Continual fees and commission may only be paid if continual advice and services are indeed rendered.

Meanwhile, the FSB is struggling to ensure that the South African short-term insurance market is fully compliant with all the regulations that regulate binder agreements concluded with South African domiciled intermediaries. These officially came into force in January 2012, accompanied by a rule that dictated that all South African binding authority agreements must have been compliant with the regulations by 1 January 2013. They were not, so this is also a work in progress.

A binder agreement is a kind of preliminary contract between a buyer and a seller pending the completion of their business transaction. Binding is, by definition, the act of imposing a duty to keep a commitment. In the world of insurance, binding (often done verbally over the telephone) ensures that coverage is in place, although a policy has yet to be issued.

A recent KPMG paper on the subject points out that "New Binder Regulations and Directive 159.A.i. means that all insurers will need to re-contract with all brokers who are mandated in any way, irrespective of whether they perform binder functions, or simply outsource administration functions, should their existing agreements not meet certain requirements."

Lastly, private banks are expected to be affected when the Banks Amendment Bill becomes law sometime this year. It proposes to align the Banks Act with the Companies Act and to give the Registrar of Banks the power to cancel or suspend the registration of a bank where material provisions of anti-money laundering legislation are contravened.

South Africa's hedge fund reforms

In 2012, South Africa, pressed by the 'G20' group of industrialised nations of which it is one, decided to regulate hedge funds for the first time, the better to forestall another global financial crisis like the disaster of 2008. On 13 September 2012, the National Treasury and the FSB published their proposals.

They suggested a new set of rules to be effected through the existing Collective Investment Schemes Control Act, No. 45 of 2002 (CISCA), as a declared scheme by the Minister of Finance in terms of section 63 of that Act. They asked for public comments, which they then considered. Such is the glacial slowness of the reform process that it has taken them until now to respond publicly.

The comments largely welcome the Government's regulatory ideas. Sooner or later, there will be draft regulations. One concern was raised about the distinction between retail and restricted hedge funds. It is now proposed that restricted hedge funds should be renamed Qualified Investor Hedge Funds (QIHFs), to accurately reflect their nature and the commensurate regulation. Retail hedge funds are expected to comply with stricter regulation to ensure commensurate protection of ordinary investors, while the restricted (qualified investor) hedge funds will target qualified investors and focus on systemic risk reporting, monitoring and adequate disclosure to investors.

Concerns were raised that the definition of the phrase 'hedge fund' in the so-called framework differs from that issued under the Financial Advisory and Intermediary Services Act, No 37 of 2002. The fear, according to the FSB, was "that this could lead to anomalies and inconsistent approaches." The Government prefers the definition in the FAIS legislation for the upcoming hedge fund regime.

The Minister of Finance is going to declare hedge fund business as the business of a collective investment scheme. Thereafter ALL managers of hedge funds, both retail and qualified, will be required to register in terms of the applicable regulations.

The government has decided not to include a separate category of a 'fund of hedge funds' and will only have qualified and retail hedge funds. It believes that minimum subscription requirements should be set in order to protect investors, although managers are welcome to amend their subscription requirements as long as they are not below the minimum levels that are to be set.

Existing collective investment scheme (CIS) managers will be able to establish hedge fund schemes, qualified investor hedge funds (restricted funds) will be able to invest in retail funds and most of the hedge fund managers (FSP IIA) currently managing hedge fund portfolios will fall within the QIHF category and will not need a MANCO (Management Company or Collective Investment Scheme Manager).

To put it another way - and to answer concerns thrown up by the consultative exercise about the status of existing hedge fund structures in the new regime - the Government is accommodating existing hedge funds in the retail hedge funds (RHF) structure and/or the QIHF structure. Both the QIHF and retail hedge fund will have to register their respective current and proposed structures with the FSB, following rules laid down underCISCA. The RHF structure will be similar to the current structure for Collective Investment Schemes in Securities, which requires a CIS manager and a trustee to establish a scheme. An existing hedge fund structure will be able to convert itself into a retail hedge fund, as long as it complies with the regulations for a retail hedge fund.

The QIHF will also be required to register as a CIS Manager and will be able to register any current structure (partnership, company or trust). A QIFH will also be required to have a governing body to ensure proper accountability; for example, if the hedge fund is structured as a partnership, the board of directors of the general partner is the 'governing body'. A QIHF manager intending to also undertake retail hedge fund business will have to establish a scheme with a trustee, as contemplated under CISCA.

Hedge fund reforms: ancillary issues

• Valuation. The Government still believes that the valuation of hedge funds should be done only by valuators "separate from the group."Liquidity. A tiered approach to liquidity requirements is recommended, with proposed 14, 30 and 90 day requirements for vanilla CISs, RHFs and QIHFs, respectively.
• Separation of Assets. There should also be a legal and physical separation of assets between the prime broker and custodian, to protect investors from sharp practice and to make hedge funds more stable financially. Only prime brokers regulated by the SA Reserve Bank and/or JSE Securities Exchange will be endorsed.
• Debt. As part of commensurate tiered regulation, each QIHF will be required to set its own debt (the Government uses the word 'leverage') limit and to reveal this to investors. For RHFs, though, there will be set limits. The regulator might also consider setting a "higher industry soft upper limit" to allow it to monitor markets for systemic risk.
• Pricing. Lastly, the pricing frequency of hedge funds’ assets will be dependent on the funds' trading frequencies.

The draft regulations are promised any day now. The final regulations, along with the relevant CISCA ministerial declaration, are expected in the second quarter of the year. The slowness of the Government's progress so far might stem from the fact that South Africa did not suffer such a severe financial meltdown as the largest onshore centres in 2008.