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Consultation Paper No. 42 Proposed Enhancements to the DFSA Rulebook to Meet International Best Practice Standards
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Jan 3 2007 onwards

Consultation Paper No. 42 Proposed Enhancements to the DFSA Rulebook to Meet International Best Practice Standards



Download this Consultation Paper in PDF format.

Purpose of the paper

1. During the last four years, the Dubai Financial Services Authority (the DFSA) has been working intensely to develop the legislative framework for the regulation of financial services and related activities in the Dubai International Financial Centre (the DIFC). The DFSA took into account the international best practice standards when developing the core legislation for the regulation of the financial services industry in the DIFC. Having put into place the core legislation, the DFSA recently conducted a detailed self assessment of the DFSA's regulatory regime against the international best practice standards as reflected in the core principles and recommendations of the:
(a) International Organization of Securities Commissions (IOSCO) — which sets international standards relating to securities regulation;
(b) Basel Committee on Banking Supervision (BCBS, referred to as Basel in this paper) — which sets international standards for banking supervision;
(c) International Association of Insurance Supervisors (IAIS) — which sets international standards for the supervision of insurers; and
(d) Financial Action Task Force (FATF) — which sets international standards to prevent money laundering and funding of terrorism and crime.
2. This self assessment revealed that while the DFSA's regime substantially complies with the standards set by IOSCO, Basel, IAIS and FATF, there are some areas in the DFSA Rulebook that would benefit from augmentation. The proposals in this paper are designed to enhance compliance with the standards set by these international organisations for regulation of financial services and related activities.

Who should read this paper

3. The proposals in this paper would be of primary interest to persons who are currently conducting regulated financial services activities in the DIFC such as Authorised Firms and Ancillary Service Providers as well as persons who intend to conduct such activities in the DIFC.

How is this paper structured?

4. In this paper we set out:
(a) proposals relating to IOSCO principles in paragraphs 7–11;
(b) proposals relating to Basel in paragraphs 12–30;
(c) proposals relating to IAIS in paragraph 31–37;
(d) proposals relating to FATF in paragraph 38–40; and
(e) specific issues in paragraph 41.

How to provide comments

5. All comments should be provided to the person specified below. You may, if relevant, identify the organisation you represent in providing your comments. The DFSA reserves the right to publish including on its website, any comments you provide, unless you expressly request otherwise at the time of making comments.

What happens next?

6. The deadline for providing comments on these proposals is 19 February 2007. Once we receive your comments, we will consider if any further refinements are required to these proposals. We will then proceed to enact the changes to the DFSA's Rulebook. You should not act on these proposals until the relevant changes to the DFSA Rulebook are made. We will issue a notice on our website telling you when this happens.

Comments to be addressed to:

Roberta Julfar
Legislative Counsel
DFSA
PO Box 75850
Dubai, UAE

or e-mailed to rjulfar@dfsa.ae

Proposals relating to IOSCO principles

IOSCO Core Principle 16 — Questions 5a and 5b

7. IOSCO Core Principle 16, questions 5a and 5b, requires audited financial statements included in public offering and listing particulars documents and publicly available annual reports to be audited in accordance with a comprehensive body of auditing standards and that these auditing standards be of a high and internationally acceptable quality.
8. To be in line with IOSCO Core Principle 16, we propose to include in the Offered Securities Rules (OSR) Module of the DFSA Rulebook a new requirement (see Annex A) which ensures that financial accounts are audited by an independent, competent and qualified auditor in accordance with the standards of the International Auditing and Assurance Standards Board (IAASB) or the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), where relevant, or other standards acceptable to the DFSA.

IOSCO Core Principle 17 — Question 14

9. IOSCO Core Principle 17, question 14, addresses requirements to deal with best execution, appropriate trading and timely allocation, churning, related party transactions, and underwriting arrangements relating to a Fund. Although the current Collective Investment Fund (CIF) regime requires the Operator to act in the best interests of Unitholders, apart from the specific provisions dealing with related party transactions, we do not have specific provisions dealing with best execution and other requirements addressed in question 14. Therefore, we propose to include provisions in the Collective Investment Rules (CIR) Module of the DFSA Rulebook that require an Operator of a Fund to have policies and procedures to address these aspects (see proposed CIR Rule 6.4.1(8) and related Guidance in Annex B).

IOSCO Core Principle 20 — Question 7

10. IOSCO Core Principle 20, Question 7, addresses the need for the price of the Units of a Fund to be disclosed or published on a regular basis. We propose to include such a requirement in relation to Public Funds in the CIR Module of the DFSA Rulebook (see proposed CIR Rule 6.5.1(a) and (c) and CIR Rule 15.4.1, item 14(e) in Annex B).

Miscellaneous IOSCO Principles related amendments

11. We also propose a number of minor changes to the CIR Module to better align our requirements with the IOSCO Principles. These include guidance relating to how illiquid assets may be valued (Guidance in App3, 6(b)) and criteria applicable to persons providing oversight functions (CIR Rule 17.9.1(1)) which are set out in Annex B).

Proposals relating to Basel principles

12. We note that since our self-assessment took place, there is a new set of Basel Core Principles published on 5 October 2006. While these do not raise any new issues for consideration, for convenience of reference, we have indicated, where relevant, reference to the new Basel Core Principle number within brackets.

Basel Core Principle 5 (new Core Principle 5) — Major Acquisitions

13. Basel Core Principle 5 requires the regulator to have the power to review major acquisitions or investments by a bank against prescribed criteria to ensure that corporate affiliations or structures resulting from such acquisitions do not expose the bank to undue risks or hinder effective supervision. In order to comply with Basel Core Principle 5, we propose to include in the Supervision (SUP) Module of the DFSA Rulebook new requirements (see Annex C) relating to reporting to, and prior approval of, the DFSA of acquisitions which amount to Major Acquisitions made by Authorised Firms that are conducting the Financial Services of:
(a) Banking Business, Insurance Business or Dealing in Investments as Principal (except as Matched Principal); and
(b) being an Islamic Financial Institution that conducts its entire business in accordance with Shari'a and which Manages Profit Sharing Investment Accounts.
14. The proposed requirements define a Major Acquisition to be an acquisition which is either:
(a) to the value of 10% or more of the Authorised Firm's capital resources (referred to as the 10% threshold); or
(b) even if it does not exceed the 10% threshold, is reasonably likely to have a significant regulatory impact on the Authorised Firm's activities. The DFSA has the discretion to determine whether or not an acquisition qualifies as a Major Acquisition under this category. An Authorised Firm may seek the DFSA's view if it is unsure whether an acquisition it proposes to make may qualify under this category.
15. There is no uniformity in international practice with regard to the threshold for triggering reporting and other requirements relating to major acquisitions. These vary from 10% of regulatory capital, which is the threshold used by the Australian Prudential Regulatory Authority, to 2% regulatory capital, which is the threshold used by the Monetary Authority of Singapore. The Hong Kong Monetary Authority uses 5% of the regulatory capital as their threshold. We have considered it more appropriate to use a 10% threshold to provide the industry more flexibility but seek public comments on this issue (see paragraph 41).
16. There are two types of acquisitions that are expressly excluded from the proposed definition of Major Acquisitions. They are acquisitions made either:
(a) as an incidental part of the Authorised Firm's ordinary business (for example, for the purposes of enforcing a security interest of a borrower or a loan workout with a customer as a per a loan agreement); or
(b) as an investment for managing the Authorised Firm's own investment portfolio (such as investments included in the Firm's trading book or those intended to be disposed of within a short term — e.g. within 12 months).
17. An Authorised Firm which is a Domestic Firm must give the DFSA prior written notification of any proposed Major Acquisition. The notification must include all the relevant information to enable the DFSA to assess the impact of the proposed Major Acquisition on the Firm. The DFSA has 45 calendar days to review a proposed Major Acquisition after it receives all the relevant information. If the DFSA has neither requested additional information nor objected in writing to a proposed Major Acquisition within the said 45 calendar day period, the Authorised Firm may go ahead with the proposed Major Acquisition. Also, the DFSA may, at its sole discretion, agree to a shorter period of review than the 45 calendar days if requested by an Authorised Firm.
18. The DFSA may only object to a proposed Major Acquisition where it considers such an Acquisition is reasonably likely to have a materially adverse impact on the Authorised Firm's ability to comply with its regulatory obligations or on the financial services industry in the DIFC as a whole. The DFSA may also impose conditions that the Authorised Firm must comply with in relation to a proposed Major Acquisition. Where it objects to, or imposes conditions relating to, a proposed Major Acquisition, the DFSA will give reasons for doing so. The DFSA decisions relating to a Major Acquisition can be appealed to the Regulatory Appeals Committee (RAC).
19. Where an Authorised Firm which is not a Domestic Firm (i.e. it is an Authorised Firm that conducts Financial Services through a Branch established in the DIFC) makes Major Acquisitions, we propose comparable requirements. These requirements take into account the reporting and approval procedures that may apply to an Authorised Firm incorporated outside the DIFC under its home regulator's regulatory regime. Our proposals in this context are aimed at ensuring that the DFSA is kept appropriately informed of the developments in the home jurisdiction. However, if there are no regulatory requirements relating to Major Acquisitions applying to a non Domestic Firm under its home regulator's regime, our proposals require such Firms to be subject to the same requirements as a Domestic Firm.
20. Under our proposals, Authorised Firms that are Prudential Category 3 Firms (as defined in PIB Rule 1.3.3) and Prudential Category 4 Firms (as defined in PIB Rule 1.3.4) do not have to comply with the requirements relating to Major Acquisitions. This is because we do not consider that acquisitions made by Prudential Category 3 and 4 Firms raise similar regulatory issues as Major Acquisitions made by Authorised Firms which are to be subject to our proposed requirements, i.e.:
(a) Prudential Category 1 Authorised Firms — i.e. Authorised Firms conducting Banking Business;
(b) Prudential Category 2 Authorised Firms — i.e. Authorised Firms Dealing in Investments as Principal (except as a Matched Principal);
(c) Prudential Category 5 Authorised Firms — i.e. an Islamic Financial Institution which conducts its entire business in accordance with Shari'a and which Manages a Profit Sharing Investment Account; and
(d) Firms that conduct Insurance Business.

Basel Core Principle 7 (new Core Principle 8) — Credit risk

21. Under Essential Criterion 3 of Basel Core Principle 7 (new 8), the regulator must require, and also periodically confirm, that banks make credit decisions free of conflicts of interests and on an arm's length basis.
22. We propose to include in the Conduct of Business (COB) Module of the DFSA Rulebook new requirements (see Annex D) that require an Authorised Firm that conducts Banking Business to have in place policies and procedures to ensure that conflicts of interests between itself and its customers and between one customer and another are identified and then prevented or managed in such a way that the interests of a customer are not adversely affected. Authorised Firms must also ensure that their customers are fairly treated and not prejudiced by any such conflicts of interests. In particular, our proposals envisage that Authorised Firms use mechanisms such as Chinese Walls and disclosure of conflicts of interests to manage conflicts of interests.

Basel Core Principle 10 (new Core Principle 11) — Exposures to related parties

23. Under Basel Core Principle 10 (new 11), to address risks that may arise from exposures to related parties, Authorised Firms should enter into transactions with related parties only on an arm's length basis. Exceptions are to be provided in very limited circumstances, for example, where credit is extended to employees of an Authorised Firm on terms more favourable than those available to non-related parties.
24. We propose to include in the Investment, Insurance Intermediation and Banking Business (PIB) Module of the DFSA Rulebook new requirements (see Annex E) that:
(a) prohibit an Authorised Firm from extending exposures to Related Persons on terms more favourable than those available to Persons who are not Related Persons, except in the limited circumstances set out in (b);
(b) allow extension of credit to Employees of an Authorised Firm on more favourable terms than those available to non Related Persons (i.e. relating to credit assessment, tenor, interest rates, amortisation schedules and requirements for collateral) where there are stringent controls to ensure that conflicts of interests arising in such situations are adequately addressed. For example, these proposals preclude persons who will directly or indirectly benefit from obtaining credit taking part in the process of approving or managing the exposure; and
(c) in any case, even where exposures are made to Related Persons on terms no more favourable than those available to Persons who are not Related Persons, preclude Persons directly or indirectly benefiting from such exposures being part of the approval or write-off process of such exposures.
25. Our proposals define the term "Related Persons" to include subsidiaries, affiliates and Controllers of an Authorised Firm as well as its board members, senior management and their family members, and, corresponding Persons in affiliated companies.

Basel Core Principles 11 & 18 (new Core Principles 12 and 21) — Information requirements relating to international exposures and impairment

26. Pursuant to the DFSA's powers under Articles 73 and 74 of the Regulatory Law of 2004, we propose to include a new reporting requirement in App 7 of the Prudential (PIB) Module of the DFSA Rulebook to require information relating to international exposures and impairment as required by Basel Core Principles 11 and 18 (new 12 and 21) (see Annex F).

Basel Core Principle 14 — (new Core Principle 17) — Internal controls adequate to the nature and scale of the business

27. Basel Core Principle 14 requires banking supervisors to determine that banks have in place internal controls that are adequate for the nature and scale of their business. These should include clear arrangements for delegating authority and responsibility, separation of the functions that involve committing the bank, paying away its funds, and accounting for its assets and liabilities, reconciliation of these processes, safeguarding its assets, and appropriate independent internal or external audit and compliance functions to test adherence to these controls as well as applicable laws and regulations.
28. We propose to insert new requirements by way of Guidance and Rules, as relevant, in the Authorisation (AUT), General (GEN) and Authorised Market Institutions (AMI) Modules of the DFSA Rulebook (see Annex G) with regard to Board composition, general compliance with high standards of corporate governance, responsibility of the Board, treatment of customers and internal financial controls.

Basel Core Principle 15 (new 18) — Provisions dealing with applicable standards of ethical and professional behaviour

29. Basel Core Principle 15 (new 18) requires banking supervisors to determine that banks have adequate policies, practices and procedures in place that promote high ethical and professional standards in the financial sector and prevent the bank from being used, intentionally or unintentionally for criminal activities.
30. We already require Authorised Firms to observe high standards of integrity and fair dealing (see GEN Rule 4.2.1). We propose to augment this by including Guidance under GEN Rule 5.3.20 indicating the desirability for a Firm to have in place a policy on ethics and professional conduct and clearly communicate such a policy to all people concerned including Employees and customers (see Annex H).

Proposals relating to IAIS principles

IAIS Core Principles 9 and 10 — Corporate governance

31. IAIS Core Principle 9 deals with matters relating to corporate governance and expects the supervisory authority to require insurers to comply with all applicable corporate governance principles.
32. IAIS Core Principle 10 expects the supervisory authority to require insurers to have in place internal controls that are adequate for the nature and scale of the business. The oversight and reporting systems should allow the board and management to monitor and control the operations.
33. To be in line with IAIS Core Principles 9 and 10, we propose to insert new requirements by way of Guidance and Rules, as relevant, in the Authorisation (AUT), General (GEN) and Authorised Market Institutions (AMI) Modules of the DFSA Rulebook (see Annex G) with regard to Board composition, general compliance with high standards of corporate governance, responsibility of the Board, policies on ethical behaviour, treatment of customers and internal financial controls.

IAIS Core Principle 21 — Contingency plans

34. IAIS Insurance Core Principle 21, Essential Criterion j, expects a supervisory authority to require that insurers have in place contingency plans to mitigate the effects of deteriorating (investment) conditions.
35. To be in line with IAIS Core Principle 21, Criterion j, we propose to insert new guidance in the Prudential — Insurance Business Module (PIN) of the DFSA Rulebook (see Annex I).

IAIS Core Principle 27 — Dealing with fraud

36. Insurance Core Principle 27, Essential Criterion e, expects the supervisory authority to require insurers and intermediaries to allocate appropriate resources and implement effective procedures and controls to deter, detect, record and, as required, promptly report fraud to appropriate authorities. In addition, Insurance Core Principle 27, Essential Criterion f, requires the supervisory authority to ascertain that insurers take effective measures to prevent fraud, including providing counter-fraud training to management and staff.
37. To be in line with IAIS Core Principle 27 Essential Criteria e and f, we propose to include in the General Module (GEN) Module of the DFSA Rulebook new requirements (see Annex J) requiring an Authorised Person to establish and maintain systems and controls to deter and prevent suspected fraud against the Authorised Person and report suspected fraud and other financial crimes to the relevant authorities.

Proposals relating to FATF

FATF Special Recommendation No. IV — Terrorism financing

38. FATF Special Recommendation No. IV states that a financial institution should be required by law or regulation to report to a competent authority a suspicious transaction when it suspects or has reasonable grounds to suspect that funds are linked or related to, or to be used for terrorism, terrorist acts or by terrorist organisations or those who finance terrorism. In order to comply with FATF Special Recommendation No. IV, we propose to amend the Regulatory Law 2004 to include, where relevant, references to terrorism financing; and to amend existing Guidance in the Anti Money Laundering (AML) Module and the Ancillary Service Providers (ASP) Module to highlight the importance of suspicious transaction reporting (see Annex K).

FATF Special Recommendation No. VIII — Non-profit organisations

39. FATF Special Recommendation No. VIII states that countries should review the adequacy of laws and regulations that relate to entities that can be abused for the financing of terrorism. Non-profit organisations are particularly vulnerable, and countries should ensure that they cannot be misused:
(a) by terrorist organisations posing as legitimate entities;
(b) to exploit legitimate entities as conduits for terrorist financing, including for the purpose of escaping asset freezing measures; and
(c) to conceal or obscure the clandestine diversion of funds intended for legitimate purposes to terrorist organisations.
40. In order to comply with FATF Special Recommendation No.VIII we propose to insert new Guidance in the AML Module which provides specific requirements which an Authorised Firm needs to consider when identifying a charitable organisation as a client (see Annex L).

Specific issues

41. We seek your comments on all aspects of these proposals including, in particular, whether the proposed 10% threshold for reporting of Major acquisitions is appropriate in light of the considerations set out in paragraph 15. If not, whether a higher or lower threshold is more appropriate and, if so, why?

Download this Consultation Paper in PDF format.

Annex A — Proposed Amendments to the Offered Securities Module (OSR) — Compliance with IOSCO Core Principle 16 — Audited financial accounts PDF format
Annex B — Proposed Amendments to the Collective Investment Rules Module (CIR) — Compliance with IOSCO Core Principle 17 — Question 14 (best execution etc) PDF format
Annex C — Proposed Amendments to the Supervision Module (SUP) — Compliance with Basel Core Principle 5 — Acquisitions and investments PDF format
Annex D — Proposed Amendments to the Conduct of Business Module (COB) — Compliance with Basel Core Principle 7 (New Core Principle 8) — Credit risk PDF format
Annex E — Proposed Amendments to the Prudential — Investment, Insurance Intermediation and Banking Business Module (PIB) — Compliance with Basel Core Principle 10 (New Core Principle 11) — Exposures to related parties PDF format
Annex F — Proposed Amendments to the Prudential — Investment, Insurance Intermediation and Banking Business Module (PIB) — Compliance with Basel Core Principles 11 and 18 (New Core Principles 12 and 21) — Information requirements relating to international exposures and impairment PDF format
Annex G — Proposed Amendments to the Authorisation Module (AUT), General Module (GEN) and Authorised Market Institutions Module (AMI) — Compliance with Basel Core Principle 14 — Internal Controls adequate to the nature and scale of the business and IAIS Core Principles 9 and 10 — Corporate governance PDF format
Annex H — Proposed Amendments to the General Module (GEN) — Compliance with Basel Core Principle 15 — Provisions dealing with applicable standards of ethical and professional behaviour PDF format
Annex I — Proposed Amendments to the Prudential — Insurance Business Module (PIN) and General Module (GEN) — Compliance with IAIS Core Principle 21 — Contingency plans PDF format
Annex J — Proposed Amendments to the General Module (GEN) — Compliance with IAIS Core Principle 27 — Dealing with fraud PDF format
Annex K — Proposed Amendments to the Regulatory Law 2004, Anti Money Laundering Module (AML) and Ancillary Service Providers Module (ASP) — Compliance with FATF Special Recommendations No. IV — Terrorism financing PDF format
Annex L — Proposed Amendments to the Anti Money Laundering Module (AML) and Ancillary Service Providers Module (ASP) — Compliance with FATF Special Recommendations No. VIII — Non-profit organisations PDF format