The Implementation of FATCA and OTC Derivative Reform: Impact on Banks in Asia

These initiatives will no doubt address the aims of local regulators to strengthen the financial sector and for US authorities to minimise tax evasion. However, these new regulatory initiatives are also predicted to significantly increase compliance costs for banks in Asia, particularly where new processes are implemented tactically with limited automation, and where existing systems are employed, despite their limitations, with respect to these new directives.

1. FATCA

Background
To address the fiscal deficits created by the recent global financial crisis, many governments in the developed world decided to increase tax revenues by targeting individuals who are not fully disclosing their taxable income. With the US leading the way, the Foreign Account Tax Compliance Act, aka FATCA, became US legislation in March 2010, and was finalised and published in January 2013.

FATCA’s main objective is to combat offshore tax invasion by US citizens and US companies through measures which increase transparency, enhance reporting and strengthen sanctions. These measures will certainly affect US taxpayers, however the greatest impact will be felt by the banks outside of the US; a non-US bank will automatically be penalised with a 30% withholding tax on most US-linked income,unless it complies as follows:
Wolters Kluwer FS Regulation fig 1
For non-US banks to comply with FATCA, significant changes will need to be made to their internal systems, control frameworks, processes and procedures, which will be a time-consuming and costly exercise.

Additionally, with the fast approaching compliance deadlines below, there is not much time left for banks which have not yet worked through the changes that need to be made to internal processes:
Wolters Kluwer FS Regulation fig 2

Adoption of FATCA in Asia

Even though the FATCA compliance deadlines have been delayed several times, the global exchange of tax information is gaining momentum at a pace beyond what many would have anticipated. About 20 countries have now signed an Intergovernmental Agreement (IGA) with the US, which not only enables FATCA reporting to local tax authorities (instead of direct reporting to the IRS), but also provides benefits like relaxed deadlines and simplified due diligence for non-US banks.

In Asia, however, governments have not yet embraced FATCA in the same manner as their European counterparts; while about 10 European countries have now signed an IGA with the US, Japan is the only country that has done the same in Asia:
Wolters Kluwer FS Regulation fig 3
Some of the reasons why Asia is more reluctant to implement FATCA compared to other regions include:

  • Privacy concerns: Certain local laws prohibit sharing of private info, while others have the complexity of requiring customer consent first.
  • Cultural differences: Certain cultures have issues with asking their customers delicate questions and requesting legal oaths.
  • China’s dominance: With its large influence over the region, neighboring countries are waiting for China’s IGA to progress further.

It is further unlikely that many local regulators within Asia will allow banks to directly forward their detailed customer data directly to the US. Banks that do decide to send tax information to US regulators without local regulatory approval will risk losing their local banking licenses.

However, to ensure that banks do not have to incur FATCA penalties due to jurisdictional constraints, it is anticipated that many countries in Asia will ultimately sign IGAs which allow aggregating and transposing of bank data into local reporting forms first, before this information is sent to the US. FATCA reporting in Asia will hence likely evolve to incorporate a localised version of the reporting requirements.

FATCA Implementation Status of Banks in Asia
Most Tier-1 banks in the region have been preparing for FATCA for the past two years by focusing on the following aspects:

  • On boarding procedures: Analysis of existing procedures, and the creation of new procedures to ensure compliance with FATCA’s verification and due diligence requirements.
  • Monitoring procedures: Creation of procedures which regularly validates information such as account classification and customers’ circumstances.

Tier-2 and tier-3 banks, on the other hand, have prepared significantly less up to this point. Some smaller banks actually decided to try and avoid FATCA by ceasing to make US-linked investments, and/or exiting US customers.

Further, since reporting is considered as the last step of the FATCA compliance chain and local requirements are not yet clear, there has been limited analysis completed to date on this aspect. As reporting forms an integral part of FATCA, this work outstanding should not be underestimated; just as for other compliance regimes, banks will need to have a robust reporting solution in place to manage the complexities relating to data quality, data security, automation of reporting, analysis of information, whilst also being able to accommodate further regulatory change as FATCA evolves locally.
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2. OTC derivatives reporting

Background
The over-the-counter (OTC) derivatives reforms across the globe are a direct result of the global financial crisis. The US has lead the way by signing the Dodd-Frank Act into law in July 2010, which has a principal aim of improving transparency of the OTC derivatives market. Recognising that the limited availability of current and accurate information was a key catalyst to the financial crisis, regulators across the globe have been overhauling their fragmented and outdated systems into more transparent ones which ultimately allow better oversight of the various risks being taken across the banks that they supervise.

In essence, the OTC derivatives reforms require very detailed and timely reporting of individual OTC derivatives trades and positions, where, depending on the regulator, up to 200 fields may need to be reported per trade on a real-time basis. Further, given the global and open nature of the OTC derivatives market, a single trade may involve counterparties domiciled in different countries, which could potentially require separate reporting of the same trade to different regulators, who, in turn, may not have consistent reporting requirements:
Wolters Kluwer FS Regulation fig 4
The complexity of the OTC derivatives reform is not only limited to very detailed reporting at high frequencies, but also requires cross-border analysis to determine where a trade needs to be reported, who needs to report it, by when it needs to be submitted, and what information about the trade needs to be included.?

Adoption of OTC derivatives reporting in Asia
Unlike for FATCA, the OTC derivative reform has seen a fast adaption by the developed countries in Asia, where Japan, Hong Kong, Singapore and Australia are leading the way with the first (phased) compliance dates:
Wolters Kluwer FS Regulation fig 5
Note that up to this point, only Japan has required reporting of all classes of derivatives; most other countries decided to focus on Interest Rate Swaps first (to a large extent), while other classes of derivatives (i.e. foreign exchange derivatives) will only phase in at a later stage.

OTC derivatives implementation status of banks in Asia
Tier 1 banks that have exposure in the US as well as Asia are a long way towards completing implementation of OTC Derivative reporting given that global requirements have been known for some time and in certain cases leverage from previous trade reporting initiatives implemented by regulators (e.g. MIFID in Europe). These trade reporting systems are largely operational however still need to be configured for the various local regulatory discretions and will also need to be supported by additional processes to ensure reconciliation back to other regulatory submissions made by the bank.

For Tier 2 and Tier 3 Asian banks who have had limited exposure to individual trade reporting to date, the OTC derivative reform will be a challenge as systems need to be put in place to support these new submission requirements. Initially these banks may look to generate this information manually from trade booking systems, or look to minimize OTC derivative trading in certain locations by centralizing operations. Over time these banks will upgrade their systems and include the automation of OTC derivative reporting as a principal requirement given the anticipated difficulties in dealing with this manually.

The key challenges across all banks will be:

  • Data enrichment: Enriching trades and positions with static, valuation & collateral details (often coming from different source systems).
  • Timely processing: Automatically generating good quality data at outset, which will in turn requires to more efficient processing and transaction monitoring.
  • Reconciliation: Ensuring that OTC derivative submissions reconciles with other regulatory submissions (which, at most banks, is currently done by separate teams).
  • Business rules: creation and maintenance of logic for regulator-specific requirements regarding
    o Where to report?
    o Who to report?
    o When to report?
    o What to report?

3. Conclusion

The FATCA and OTC derivative regulatory requirements will certainly be onerous for banks, however there is also an opportunity for achieving a competitive advantage within the industry for those who are able to implement these initiatives in a manner that not only meets external compliance, but also generates greater transparency internally allowing reduction of regulatory risk and enhanced management information.

The success of these reforms and the ability for banks to adopt them in a cost-effective and compliant manner will depend on the investment made to put in place an infrastructure which collects and automates the production of the required regulatory information; the best positioned banks will be those that upgrade existing infrastructure to collect the additional information required by regulators, while simultaneously consolidating and centralizing this information with other data currently being used for internal and external purposes. Such a single data repository would then form the basis of all regulatory requirements, including FATCA and OTC derivative reporting.

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