Race To The Top: In A New Era

To say that such pressure has increased exponentially over the past three to five years would not be an exaggeration. New economic substance requirements, changes resulting from Caribbean Financial Action Task Force (CFATF) mutual evaluation reports, the OECD’s BEPS (Base Erosion and Profit Shifting) driven initiatives and the UK’s call for beneficial ownership public registries are among the key initiatives that have threatened to push the economies of all faint- hearted IFCs over the edge.

In the past, it has been argued that when there is pressure to increase regulations many IFCs engage in regulatory competition by offering less regulation to attract the clients from the newly and more well-regulated IFCs, resulting in the so- styled ‘race to the bottom’. This argument has been used for more than two decades beginning with the tax arbitrage argument. This ‘race to the bottom’ is, of course, unsustainable because the less regulated IFCs will eventually come under so much global pressure that they can no longer offer services and they risk eventually being forced to close their financial services centres down entirely.

The reverse competition, referred to as a ‘race to the top’, has also been criticised because of the risk that an IFC could win the ‘regulatory awards’ but regulate itself out of a thriving economy and jobs. This theory behind this latter type of race is not that the IFC will now lose many unscrupulous clients. It’s that an IFC may well lose many good and reputable clients because the sheer and immense increased cost of doing business in the jurisdiction (as a direct result of having to abide by many new regulatory procedures) may make some legitimate transactions commercially unviable, leading to a similar fate as its sister race; a declining economy.

The actual experience in some jurisdictions that have been involved in the ‘race to the top’, such as the Cayman Islands, is quite different from the theory. At the same time as the Cayman Islands has introduced numerous amendments to existing legislation, as well as introducing new laws and imposing tens of millions of dollars in additional compliance costs on financial services institutions, the jurisdiction continues to demonstrate a robust financial services sector. The number of Cayman Islands hedge funds stood at 10,992 in 2018 and all signs are that the jurisdiction will very shortly surpass its peak of just over 11,000 funds which occurred in 2013.

The Cayman Islands banking sector remains one of the strongest among IFCs, with over 650 billion in assets and the jurisdiction’s captive insurance sector has maintained steady growth.
Several other IFCs, including Bermuda and the BVI, have also demonstrated resilience in the face of increasing regulatory requirements on their financial services industry.

The Pressure

The following 3 key developments have imposed extraordinary pressure on IFCs within the past 3 years:

Beneficial Ownership
Several IFCs introduced legislation to establish beneficial ownership registers in 2017. The UK applied pressure on all of its territories operating as IFCs to introduce this new regime. The new requirements mean that companies within the jurisdiction must create and maintain a register of beneficial ownership, unless they fall within certain categories of exemption. The Cayman Islands and several other IFCs have already established these registries. The purpose of the registries is, essentially, to enable law enforcement agencies and regulators the ability to easily obtain information on the ownership of entities to facilitate any investigations.

Despite being viewed by many clients as a risk to their legitimate right to financial privacy, the initiative has not had a material negative impact on IFCs.

Economic Substance Initiative
Although the pressure came from the EU, this initiative is influenced partly by the OECD’s BEPs project which focuses on the extent to which international companies can superficially engineer their operations to minimise their tax burden. The approach taken by BEPs is unique in that it does not distinguish between whether the reduction of taxes is carried out illegally or legally, but merely that there is a method to reduce payment of tax in one country.

Economic substance requirements seek to establish minimum legal requirements on international companies doing business from IFCs to demonstrate that these companies have a substantial economic presence in the jurisdictions from which they are earning profits. The onus is placed on each company to prove that it does indeed have a physical economic presence in the jurisdiction from which it earns profits from certain activities.

While, technically, economic substance laws have already been enacted in most of the mainstream IFCs, it will take some time for clarity on what is regarded as ‘adequate’ proof that each company meets the economic substance standards. This is the case largely because there are no current globally adopted economic substance measures and it’s likely that only through the courts when challenged, or via regulatory inspections, will precedents be established to give more clarity for IFC clients, For the time being, clients are advised to make some efforts, based on the best judgement of their advisors, to put in place measures to meet the general principles outlined in the legislation.

To date, this initiative has not had any material impact on IFCs although it has the potential to have a significant impact. The new requirements provide an opportunity for increased economic activity within IFCs to the extent that companies need to establish a more significant physical presence. On the other hand, if such presence presents an overbearing increase in a company’s operational costs there is also a risk that IFCs may lose some clients. The net effect can be assessed over the next few years once the law has been in force for a longer period.

CFATF Mutual Evaluation Exercise
Many Caribbean IFCs have recently undergone their 4th Mutual Evaluation Review (MER) by the CFATF. This is by far one of the most significant developments impacting Caribbean IFCs and has resulted in many recommended enhancements to each IFC’s anti money laundering, terrorist financing and proliferation financing framework. A raft of legislative and regulatory changes are required in most IFCs, resulting in many tens of millions of dollars being allocated to increased public sector staff, systems, new departments, legislation, and additional public awareness and education. In addition, the increased reporting requirements on the financial services industry will most certainly result in a significant increase in compliance related operational costs for hundreds of businesses in the private sector.

Why Is the 'Race To The Top' So Different Now?

Despite all of these changes, many of the more established IFCs in the Caribbean are likely not only to survive but continue to experience growth in their financial services sectors. The so- styled ‘race to the top’ is likely to have a positive impact for the following two reasons:

Correspondent Banking Relationships

Access to the correspondent banking network can no longer be taken for granted by financial institutions operating in IFCs which need to move funds across borders to facilitate clients’ transactions. Over the past years, many US based correspondent banks have been engaged significantly in ‘De-Risking’, as a direct result of pressures from US regulators, by closing accounts held by institutions operating in certain sectors (for example, money remittance or casino services or certain jurisdictions deemed as high risk).

When a US- based correspondent bank considers the risk profile of each entity, it looks carefully at the jurisdiction from which that entity operates. The fact that several Caribbean- based IFCs have made significant enhancements to their regulatory frameworks will be viewed positively by many US- based correspondents.

In that sense, the ‘race to the top’ is no longer a luxury but essential to survival. It also means that there are significant benefits to an IFC in implementing these new onerous and costly enhancements to their regulatory frameworks. For an IFC Government, having a fully functioning financial system whereby the domestic and international financial sectors can participate fully in the globally markets through free movements of funds takes priority over whether several businesses may lose clients, or whether a jurisdiction might see a reduction in some of its financial services licenses.

Client Perception and Branding Considerations

Perception is reality and for IFCs there is no shortage of misperceptions perpetuating an image of a 1980s’ world where very few countries (including the OECD member countries) had anti money laundering legislation in place. For the most part, this perception issue did not have a material negative impact on IFCs between the early 2000s and 2015. But over the past three to five years, there seems to be a change in client perceptions based partly on pressures from onshore regulators as well as the fact that media coverage is included in the long list of information being assessed when a client considers doing business in a certain jurisdiction. Take, for example, a major fund group looking to establish a new entity for investors. Saying that the fund will be incorporated in country X which is on the FATF blacklist and has a long list of sanctions against it will make all the difference in comparison to creating that vehicle in one of the more well-known and highly regulated IFCs such as the Cayman Islands. In today’s era, and in addition to potential investors in the fund, third party service providers, such as fund administrators, auditors, and legal counsel will all require some level of confidence that the fund will be operating from a credible IFC. Indeed, very few credible investors will commit to the fund manager if that’s not the case.

While there are still several good reasons why IFCs need to ensure continued balance between the extent of regulation and commercial success, the lines between the two have become increasingly blurred simply because being well regulated is an even more important factor today than it was a decade ago.

IFCs that can afford to make the costly adjustments to their regulatory frameworks, providing that such changes are genuinely global standards and a level playing field remains, will continue to do well. But perhaps, more importantly, those that cannot won’t be in the race at all.

Paul Byles
Paul Byles is Director of FTS, a Cayman Islands compliance and management consulting firm and founder of the Cayman Islands Financial Services Institute. He also serves as an independent director and consultant to financial services firms. He is an economist and former regulator who has worked in the offshore sector for over 25 years. He is author of the books ‘Inside Offshore’ and 'Introduction to Offshore Financial Services: A BVI text'.