The UK’s FCA published the results of a review of dividend arbitrage practice in the UK this month.
The regulator urged firms using trading activities such as securities lending and derivatives to sidestep withholding tax during dividend season to make sure they have adequate processes in place to assess and monitor transactions.
“Most firms executing transactions with, or on behalf of clients engaged in dividend arbitrage, appear to comply with our requirements,” the FCA said in its June Market Watch newsletter. “However, some firms may not have identified the risk posed by contrived or fraudulent trading for the purpose of making illegitimate withholding tax reclaims.”
“As a result, some firms may not have adequate processes to allow them to assess the purpose for dividend arbitrage trading by prospective clients and/or do not establish or monitor clients’ trading abilities and the true nature of the transactions involved. This could result in firms failing to identify clients who may be using this strategy for inappropriate purposes.”
The FCA looked at the activities of a number of inter-dealer brokers, settlement agents and custodians involved in trading European equities around ex-dividend dates.
Those that were identified as failing to adequately assess and monitor transactions did so in a number circumstances, including the use of back to back securities lending agreements and over-the-counter derivatives instruments to hedge stock trades.
Areas of concern for the FCA also included potential connections and associations between the owners of offshore funds and the firms involved in the custody, settlement and clearing of the stock, as well as a lack of transparency as to both the source and availability of funds supposedly being used to fund the trading and the source of stock needed to fulfil a trade.
The FCA reminded UK-based firms engaged in dividend arbitrage that they need to comply with requirements covering financial crime risk.
“They must also have effective processes for carrying out due diligence on new business proposals, on new clients and for monitoring ongoing business.”
“We also expect firms to have a good understanding of the risks that are relevant to their business, as well as strong controls for mitigating those risks. A firm must have the appropriate management oversight and controls in place to minimise the extent to which it is possible for its business to be used for a purpose connected with financial crime.”