01 June 2007 Features

 

It’s a small world …

Heather McKenzie

… and the convergence of regulatory regimes is making it ever smaller for those operating in the financial services sector.

A consoling factor for financial institutions tackling the myriad of regulatory requirements is that they are not alone — the world over, the financial industry is being transformed by legislation, regulations and directives. The drivers of this change vary, from a desire to avoid a repeat of financial accounting scandals and bank collapses that have marred the end of the 20th and beginning of the 21st century through efforts to stem money laundering to good old competition, where in Europe, regulators are making good on the Lisbon agenda to make the European Union “the most competitive and dynamic knowledge-driven economy by 2010”.

Another silver lining to this regulatory cloud is the potential to extend what are local, or regional, regulations into international requirements. This shouldn’t be a surprise — financial institutions and their corporate customers are increasingly global in their outlook. And being so, they want to do business in much the same way, no matter where they are based.

In a speech on cross-border regulatory and supervisory issues at the Institute of International Bankers’ conference in March, Sir Callum McCarthy, chairman of UK regulator the Financial Services Authority, said one of the main challenges financial services regulators faced, and would increasingly face over the next five to ten years, was “how we respond to the growing — and, I believe, entirely justified — concern of major international banks that they are subject to multiple regulatory regimes, whose requirements are at best duplicative and at worst mutually incompatible. It is a concern which we should recognise and to which we should respond.”

According to McCarthy, these concerns are being fuelled by the growing international nature of banking activities, the increasing concentration of international banking into the hands of fewer, bigger players, with big international banking groups now accounting for a larger proportion of banking assets worldwide and the increasing importance of the international profits of banks.

“I think we should recognise the scale of international regulatory initiatives with which major banks have had to cope: IFRS, Basel II, Sarbanes Oxley, the FSAP, whether EU or active in the EU. I am not surprised they are reacting to — and against — what is an uncoordinated and large quantity of regulatory initiative,” he said.

Regulators should recognise that they haven’t responded to this challenge very well, he said. “The major banking regulatory initiative, Basel II, has exposed a large and still unresolved difference between the US and the rest of the world which is certainly going to impose severe temporary strains for non-US banks operating in the US. There is every sign that these problems will indeed prove temporary. But were there to be any more fundamental problems with the implementation of Basel in the US, that would raise problems of an altogether different magnitude.”

McCarthy could have added to his list of concerns among banks are the huge investments they are making to comply with regulations. In order to squeeze every last drop of benefit out of this investment, organisations (including technology vendors) are extending their solutions beyond the geographical remit of legislation. Again with SEPA, companies such as Sentenial, the Ireland-based direct debit solutions company, has more far reaching ambitions. Its Eurodebit direct debit product range is a solution to SEPA, but, says the company, its reach and functionality will be extended to all direct debits.

SIA-SSB, the recently merged Italian payments processing company, also sees benefit in extending beyond regulatory borders. Cristina Astore, director of SIA-SSB’s payment system division, says SEPA has been a catalyst in the development of the company’s single architecture for payments area (Sapa). “Under SEPA, banks have to simplify and rethink their business philosophies in order to be unique.” Sapa helps credit institutions to create an integrated solution to manage the entire payment flow, be they in Europe or elsewhere.

While the payments divisions of European financial institutions are grappling with SEPA, their securities counterparts are putting the final touches on compliance strategies for the Markets in Financial Instruments Directive. The Directive comes into effect on 1 November 2007. Parallels exist between Mifid and Regulation National Market System (Reg NMS), a US initiative which began in March this year. Both are catalysts (that word again) for some fundamental changes in the way securities markets work. While the two have differences (Reg NMS applies only to equities; MiFID to all instruments), their outcomes are expected by some industry observers to be similar. Both aim to protect investors by ensuring best execution on every transaction.

MiFID removes concentration regulations that until now have forced banks and brokers to trade and report through regulated exchanges. In theory, anyone can become a multilateral trading facility and already the industry is seeing this happening with the emergence of Project Turquoise, which is backed by investment banks including Citigroup and UBS, Chi-X, an equity trading platform operated by Instinet, and pan-European trading platform Equiduct.

The new trading venues created by MiFID could make inroads into the order flow of the traditional exchanges. “Domestic exchanges are unlikely to be the main exchange anymore and that is something that is not really accepted in Europe yet — the exchanges don’t want it to be accepted. But it is not about liquidity, it is about getting the best result for the customer,” says Robert Fuller, chief executive of Equiduct.

Anthony Kirby, head of risk, regulation and research (capital markets) at consultancy Accenture describes the scenario in the US as a “liquidity land grab” between the traditional exchanges, electronic trading platforms and the big broker dealers internalising more of their trades. “There is more volume to be managed and more data to be managed, while at the same time commissions are smaller and spreads narrower,” he says. Under Reg NMS, it is mandatory that an order goes to the venue that best fills it for the investor, but MiFID has no such requirement. The result is that the investor in Europe has to shop around for best price, says Kirby.

This has led to some buyside firms pushing responsibility for proving best price back on to their intermediaries, says Darshan Chanandra from software firm BEA. “Sell-side institutions are pretty much up to speed on MiFID and have stated goals, but buy-side firms tend to have buried their heads in the sand. Some buy-side firms will tell their intermediaries that if they provide a best execution report, they will place an order with them.”

A similar scenario has occurred in the US in the wake of Reg NMS, according to financial software developer SunGard. The company argues that the implications of the US legislation for buy-side firms are less significant than those for the sell side. For this reason, fund companies are depending on broker dealers to handle Reg NMS and “will probably do more business with those who are best prepared”, says the company.

Kirby says MiFID places more obligations on buy-side firms than Reg NMS does. “There will be more complexity to be managed by buy-side firms, who will have to go out and find the best price and also provide the evidence that they have achieved best execution. The bigger investment managers will be able to handle this, but it isn’t such good news for small or medium sized firms,” he says.

It’s not often that the US looks outside of its borders, but a speech on regulation and financial innovation by Federal Reserve chairman Ben Bernanke at the Federal Reserve Bank of Atlanta’s Financial Markets Conference in May, indicated that regulators there are looking further afield for inspiration.

Central banks and other regulators, said Bernanke, should resist the temptation to devise ad hoc rules for each new type of financial instrument or institution. “Rather, we should strive to develop common, principles-based policy responses that can be applied consistently across the financial sector to meet clearly defined objectives,” he said.

A principles-based approach is most commonly associated with the UK financial markets. “As in the United Kingdom, the principles-based, risk-focused approach to regulation has had considerable influence on this side of the Atlantic,” said Bernanke. “For example … the President’s Working Group on Financial Markets recently issued a statement of principles … relating to the regulation of private pools of capital, including hedge funds.”

The aim of the ten principles, said Bernanke, was to spell out how a combination of market discipline and government oversight could be most effective in addressing the challenges to public policy objectives. The principles make clear that regulators and supervisors should adopt the risk-focused approach of the FSA.

In implementing risk-focused and principles-based policies, said Bernanke, it must be recognised that finance “does not stop at the water’s edge. Financial globalisation and financial innovation are closely tied, with each trend promoting the other. As a consequence, global regulatory coordination and collaboration are more vital than ever.”

On this point, McCarthy would heartily agree — he is a proponent of collaboration between regulators, pointing out that the FSA is establishing groups of regulators who meet regularly to exchange information and discuss regulatory issues associated with particular bank groups. However, he also had some advice for banks: “I believe that there is more that the industry can do to improve the focus and effectiveness of regulation. They have a particular role in alerting regulators to market failures which may warrant regulatory intervention and to regulatory failures, such as where international standards for example are ineffective or incompatible.”