July 2016

It’s no secret that regulatory overhauls come with increased compliance and, ultimately, higher costs. Janet Du Chenne explores the types of costs that banks can expect, to help them see the wood for the trees

The change to securities industry business models, stemming from several unprecedented regulatory initiatives, is set to bed down over the coming years. By supporting trends towards investor protection and asset safety, initiatives such as increased regulatory reporting, steering trades through market infrastructures and cybersecurity could mean increased liability for securities service providers, resulting in a change of focus and increased investment. Banks are working out what these initiatives will mean for their business and the cost of providing services.

Transparency and investor protection

The first cost comes with meeting the regulatory need for increased transparency and investor protection. This means providers, such as central securities depositories (CSDs) and custodian banks, should hold client assets in such a way that the ownership and location of those assets are easily determined, ensuring that if there is a problem with the wider infrastructure or the bank, investors can easily get their assets back. To this end, providers are increasingly being required to offer segregated accounts, as well as omnibus accounts, to hold client assets.
Several regulations are supporting this trend towards greater transparency and oversight. For example, the Markets in Financial Instruments Directive II legislates pre-trade execution and post-trade investor protection. Depending on how they are implemented, the Undertakings for Collective Investment in Transferable Securities Directive V (UCITS V) and the Alternative Investment Fund Managers Directive (AIFMD) require assets to be held in a way that allows liability to be determined.

The Central Securities Depository Regulations (CSDRs) requires CSDs and their participants to offer both omnibus and segregated account structures. Lastly, the Securities Financing Transactions Regulations (SFTRs) will affect the reuse of assets by another party.
The way assets are held could profoundly affect client relationships, says Angus Fletcher, Head of Market Advocacy, Global Transaction Banking (GTB) at Deutsche Bank. “The more we segregate, the fewer efficiencies there are in the model, and the greater the costs to support this through the intermediary chain,” he says. “The client benefits more as they have a choice between omnibus and segregated account structures. But they should be aware that there are different risks and costs that come with offering that choice and choosing one model over another.”

Increased liability risk

Certain regulations could also increase risks for securities services providers. AIFMD and UCITS V put depositary banks on the hook for any loss of assets to which investors could lay claim. These regulations also mean more focus on liability down the chain. “The regulations are about ensuring the client has a single point to go to in order to get their assets back,” says Fletcher. “This has consequences for a depositary bank since they need to account for the risk where the customer will hold them liable for the loss of assets in the intermediary chain. The depository bank must review their operational risk models, their intermediary relationships and potentially their pricing structures to account for that risk. This is difficult, as at the same time, the buy side is looking for its fees to go down.”

Regulatory reporting

Regulators also want more quantifiable transaction data and regular reporting to ensure banks and their clients are in compliance with the new regulations as they are implemented. This requires increased investment in technology and data management.

“Regulatory reporting brings a new set of challenges in the form of legal entity identifiers (LEIs), or standardised customer identifiers, which will need to be incorporated into systems and processes,” says Fletcher. First mooted for derivatives, regulators now want LEIs to be applicable to all asset types, with securities at the forefront of this expansion. An additional requirement to report unique transaction identifiers will need to be incorporated into processes for reporting purposes. These bring standardisation benefits, but also challenges for all parties as to how to incorporate them within the short timeframes required.

Added to this are the requirements for dual-sided trade reporting in the EU and single-sided reporting in the US, message formatting standards – ISO versus FPML – and whether those trades should be reported to central banks, regulatory repositories or regulators directly. Each financial counterpart will need to determine how to tackle these challenges and whether to report in-house or to outsource reporting to banks or utilities.

Shorter settlement cycles

The post-trade regulatory drive in CSDR towards reducing settlement risk means that settlement cycles are getting shorter. Most European countries have moved from a T+3 to a T+2 settlement cycle as part of CSDR, apart from Spain, which is due to transition in June 2016. The US and several Asian markets will look to move in 2017. This move could mean changes to liquidity management and operational processes, and potential technology upgrades. It could also have the positive benefit of a reduction in settlement exposure risk.

Knowing your customer

With the heightened regulatory focus on segregated accounts, regulators are asking securities services providers to show that they know their customer and potentially their customer’s customer. As providers operate omnibus accounts with certain clients, they will know their direct client, but not always their client’s client.

However, the International Securities Services Association has proposed an industry-driven solution – the Financial Crime Compliance Principles. These principles, once implemented in 2016, should allow intermediaries – wherever they sit in the chain – to request information on the beneficial owners who hold assets further up or down the chain. “We keep the omnibus structure but we can see who owns the assets if and when required,” explains Fletcher.

A move towards market infrastructures

In a bid to protect investors’ assets from potential default scenarios, and to enhance risk transparency and the overall safety of the system, EMIR, CSDR and Markets in Financial Instruments Regulations are pushing trading activity towards infrastructures including trading venues, clearing houses and CSDs. “There are clearly good reasons post-crisis why regulators have driven activity towards infrastructures,” says Fletcher. “For securities services providers and users, this affects business and risk models and can place restrictions on collateral processes,” says Fletcher.

“Moreover, all participants, be they direct or indirect, will need to consider their market connectivity options and the opportunities, risks and costs associated with that. For example, what obligations might they have towards an infrastructure’s risk waterfall (particularly pertinent to clearing house relationships)? What say do they have as part of the infrastructure governance? What control do they have over the infrastructure fees that they will need to pay?”

Disruptive digital

The disruptive potential of new technologies such as blockchain could meet the requirements for a safer and more efficient settlement system. “So far, the technology has raised many questions: Could you replace current clearing processes and change the intermediary roles that exist today in the market with a more efficient model? What would be the business standards required for a world of multiple co-existing blockchains, and how will that work?,” says Fletcher. “The infrastructure and regulatory landscape is built on current processes and players, so how does the regime today suit the new technology? If we have one set of securities and financial providers on the old system and another on the blockchain, how do we manage the interface between the two? We need to introduce blockchain properly, and ensure that it starts to deliver on its efficiency and cost reduction potential from the outset.”

With evolving regulation set to have implications for all parties in the securities industry value chain, some participants could take on more investment and liability than others in order to comply. To what extent that liability, and the need for increased investment, transforms business and cost models throughout the post-trade value chain remains to be seen. Things should become clearer as the full impact of the burgeoning regulatory landscape and emerging digital initiatives are realised, likely in the next few years.

Seven key changes:

  1. Increased transparency and investor protection costs
  2. Increased liability risk costs
  3. Increased regulatory reporting costs
  4. Shorter settlement cycles
  5. Increased KYC regulation
  6. A move toward market infrastructures
  7. Increased digital disruption

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