The wave of financial regulation about to wash over Europe and North America could eventually overwhelm Asian institutions.
The world has become a safer place financially in the decade since the global financial crisis, but ongoing regulatory reform continues to present challenges to financial institutions and market participants.
In the wake of the GFC, the G20 has made solid progress in building resilient financial institutions, making sure that nothing is too big to fail, making derivatives markets safer and, finally, regulating shadow banking.
But there is one area in which it has not performed so well.
One of the principal aims of the global FSB (Financial Stability Board) when it was formed by the G20 was to ensure a level playing field for each of the 24 jurisdictions it covers. But this hasn’t always happened, with different nations implementing the new regulations in different ways.
Take the reporting of derivatives trades as an example. Under Dodd Frank, the US requires single-sided reporting of derivatives trades. However, EMIR (European Market Infrastructure Regulation) requires double-sided reporting. Meanwhile, Australia is a combination of the two – double-sided reporting with a mandated delegation to a third party for certain “Phase 3B” or small counterparts.
All of this is leading to regulatory inefficiency. Not only is the regulation inefficient, the actual market infrastructures that support the various reporting regimes are very fragmented.
There are 33 separate trade repositories in the world collecting transaction reporting information, with seven in Europe alone. Each one requires things done in a different way and with different data formats.
We can see the results of this fragmentation in a shocking statistic from Europe, where double-sided derivatives reporting is required. One party reports to one repository and the other party reports to a different repository and the repositories are supposed to match up the trade, but three years after the start of EMIR, the inter-repository matching rates are close to zero.
Firms’ regulatory systems are fragmented
These sorts of problems don’t just affect banks and market participants in Europe or North America. The effect of the regulations spills over into Asia.
MiFID II (the 2nd Markets in Financial Instruments Directive) is coming and its impact will be massive. The new European regulation covers all asset classes and other jurisdictions will likely follow. It aims to improve price transparency for things that were previously done over-the-counter like bonds and derivatives and also to improve equity price transparency, as well as capture market abuse and set conduct of business rules for investment firms.
This is important, because if an EU firm is using an Australian fund manager, the EU firm has to prove that they’ve got best execution. They will likely be asking Australian and Asian firms to provide the information that they need to fulfil those obligations.
There is also research unbundling. For the first time in the EU, research needs to be split out from the commission structure and investment firms and brokers have to explicitly price their research. There isn’t a direct obligation on Asian brokers is to do the same thing but EU clients are highly to want the whole infrastructure changed to cover all their counterparties. Asian firms trading with MiFID regulated entities will also need an LEI (legal entity identifier, a 20-character, alpha-numeric code.
Finally, there is trading equivalency. Within MiFID, certain instruments must be traded through a venue, not OTC (over the counter) anymore. Furthermore, the venue must be an EU venue or an equivalent third country market – but as of now, ESMA has not formally indicated which markets will be equivalent for trading obligation purposes. So, if a counterpart in Asia or Australia is dealing with an EU counterpart subject to the trading obligation, they won’t be able to trade those products on a local venue.
On top of this, firms’ own regulatory systems are fragmented. Some build their own solution for one set of regulations, Dodd Frank for instance, and then need to build a new solution when EMIR comes along.
Compliance is a data problem
Firms have had to rush to comply with each new wave of regulation and have underestimated the magnitude of the change. The end result is that few firms have really strategic end-state platforms that cover multiple jurisdictions.
It is costing banks a fortune to maintain their infrastructures and there isn’t really a competitive advantage in regulatory reporting so firms are looking at alternative solutions, such as vendor solutions.
Vendor solutions mutualise costs, but more importantly they also mutualise rule interpretation. If a vendor has got a number of customers, they will all be trying to do the same thing and customers get that mutualisation of effort and interpretation, which gives comfort in numbers.
Mutualisation of regulatory reporting is part of the continuing trend of firms becoming more specialised and focusing on what they’re good at and outsourcing those things that they are not good at.
At a recent Broadridge event in Sydney, attendees said they expect this business model to continue to grow because it’s very hard to keep up with all the change and all the reporting requirements in each jurisdiction, particularly for those firms which aren’t large global players.
In many ways, regulatory compliance is ultimately a data problem. Regardless of the regulatory regime and any changes in future, reporting is about the extraction and harmonisation of data. Firms that get this right will have more cost-effective and simple compliance.
The Securities Financing Transaction Regulation, which will regulate shadow banking, is the “final bit of the jigsaw” of the reforms started in 2009.
It will for the first time require the reporting of repos, secured lending and margin lending, and like EMIR and MiFID, will capture Asian entities that have branches in the EU or EU entities with branches in Asia.
It’s wider than EMIR and will require reporting of new data elements for the first time. It hasn’t been decided yet when it’s going to go live but it’s coming and other jurisdictions can be expected to introduce similar regulation.
There is plenty to do.
David Farmery is the Chief Operating Officer, Message Automation at Broadridge, a global fintech leader. A well-known expert on all matters regulatory, David is an ISDA member and helps companies to reduce risk and enhance compliance while improving operational efficiency. He is actively implementing MiFID II solutions with global firms in preparation for the January 2018 deadline, and in advanced planning for SFTR.