Regulatory Reform in the EU compared with the US: VALUE GENERATIVE OR VALUE DESTRUCTIVE?
The sheer volume of anticipated regulatory developments in the financial sector over the next five years is daunting, not least because of the potential for regulators on both sides of the Atlantic to arrive at different solutions for dealing with the same problems.
Dr. Anthony W. Kirby of Ernst & Young compares and contrasts the EU and US approaches to regulatory development.
The global securities industry is in the midst of a tsunami of change. The drivers include macro-/micro-economics, G20/political developments, and the sunrise of new technologies such as cloud computing. Given the turbulence in some Euro-zone countries and in the commodities markets in 2011, it is little surprise that governments, central banks and regulators are on constant alert, and this could be a semi-permanent feature of the investment landscape in the near-term.
Regulation has a gross impact across the business and operating models of players on the buy- and sellsides, as well as asset servicers and market infrastructure providers. Regulation impacts the supporting data structures, boosts the need for quality management information, increases the need for timely reporting and disclosure, forces changes in systems and controls, challenges firms to amend policies and procedures, challenges firms to review their appetites for risk and above all, encourages firms to ensure that their governance arrangements are fit for purpose (‘tone from the top’).
Looking at the plethora of regulations, several timelines for measures such as Solvency II, FATCA, Dodd Frank, MiFID Review and T2S have all become slippery with respect to target implementation dates. There are a whole range of different directives and regional variations, some ‘must-do’ and some ‘likely to happen’. Timeline slippages do not engender confidence – they are a symptom of several factors as work; a strain on drafting measures which cut across existing directives, political interference and shortages in the talent pool to mention but three reasons. They also spell opportunity costs and potential for fatigue among the early movers.
The EU’s regulatory processes post-Crisis feature a ‘trialogue’ co-decision approach to regulatory creation, with key roles played by the European Commission, the European Parliament and the European Council (of Ministers). There are several dozen measures taking effect over the next three to five years (we estimate around 70 since the start of the last decade) impacting corporate firms, the wholesale and retail banking world, the capital markets and the world of insurance. Europe also consists of several countries, so trying to apply directives to produce a consistent legal effect across every single Member State is not the same process as in America. The whole process must be driven by the national laws in each country.
In summary, the reasons lie in the history of Europe, its laws and its market mechanisms. Europe has different countries, different legislation (Code Napoleon, English common law, Greek civil law etc), different languages, different fiscal arrangements, and different currencies, not to mention the politics. There are numerous anomalies. No fewer than 30 states choose to comply with EU regulations, yet only 27 are actual EU members. There are 17 EU countries in the Euro-zone, yet 6 non-EU countries also make use of the euro. Therefore looking at comparisons with the U.S., it is perhaps unsurprising that business models differ, as do the market infrastructures that support them.
Just compare the DTCC in the U.S. against the current 33 CSDs and 22 CCPs in Europe, not to mention the differences in principal vs. agency models, or the differences in solvency regimes as applied to OTC derivatives such as interest rate swaps, FX swaps, credit default swaps and equity swaps.
The impact on business and operating models on both sides of the pond from both intended and unintended consequences is therefore likely to be significant in terms of both scope and cost. Some firms on the investment banking side are already relatively advanced by way of preparation, as are parties such as custodian banks who service the asset managers. Many asset managers, already looking to determine the impact to the business models under FATCA, are uncertain as to exactly how the measures will work in practice as the results are unknown, particularly with regard to the supply and segregation of collateral.
Dodd-Frank Title VII requires standardised swaps and security based swap ‘products eligible for clearing’ to be centrally cleared through regulated ‘clearing- houses’, and, where such facilities exist, traded on a designated contract market or swap execution facility (SEF). This approach is similar to the EMIR measures that propose mandatory CCP clearing for ‘eligible products’, by standardisation and liquidity. There are other commonalities; 1) The transparency of OTC derivatives enhanced through record keeping and reporting requirements and provision of trade data repositories; 2) Assets used to margin or guarantee swaps must be able to be centrally cleared with prudential regulators adopting rules providing for capital and margining requirements; 3) All OTC derivatives dealers and all other major OTC derivatives markets participants should be constrained by regulation, position limits, supervision, margin requirements and business conduct rules and consequent tightening of standards.
Equally, there are very important areas of difference too. A key difference pre-trade has been the national market system (NMS) which routes cash equity flow towards the most appropriate venue for execution on the basis of the ‘Trade-through’ Rule. There is also a U.S. direction of travel in favour of circuit breakers to regulate high frequency trading (HFT), plus a reluctance by the U.S. to follow the Europeans in classifying dark pools and broker crossing networks as ‘organised trading
facilities (OTFs)’ subject to volume thresholds. The Europeans meanwhile have shown a comparative reluctance to follow the U.S. example by developing the equivalent to the Volcker Rule (§619) or the swaps Push-out Rule (§716).
Post-trade, there are notable differences in terms of firstly, the carve-outs (the U.S. Treasury has recommended an exemption for CLS-settled FX trades for commercial corporates using OTC derivatives for hedging purposes vs. the Europeans who favour a Review Clause mechanism to exempt pension funds. Secondly, some Member States in the EU favour a role for the central banks to stand behind CCPs in some capacity (from providing intra-day liquidity, providing an overnight overdraft or even providing bail-outs in extremis) vs. no appetite for doing so in the U.S.
There are also lesser but not negligible differences concerning three other areas–client classifications as ‘professional’ or ‘retail’ (favoured by EU), how products should be classified as ‘simple’ vs. ‘complex’ (favoured by the EU), and regulatory product intervention approaches in France, Belgium and the UK.
The supply issue is a critical consideration because the key implication of third party clearing is that more use of cash for collateral will be required. Firms will face an increase in collateral for OTC products which cannot be centrally cleared and may need to review their OTC give-up procedures as well. Asset managers may find that they may be directly impacted by shortages of collateral types and extra charges, perhaps resulting in dislocations to the stock borrowing and repo markets, steeper haircuts and even liquidity shortfalls. If the Dodd-Frank implementing measures go through in their entirety asis, the need to post initial and variation margin for every OTC position will have significant implications for the end clients too – even the use of liquid OTC-traded instruments such as interest rate swaps for hedging purposes could become much more expensive.
The scope for differences between US and European rules means that segregation of accounts will be politically sensitive, particularly if any one jurisdiction proceeds down a direction of travel which could be construed by another as ‘extra-territorial’. One of the key questions asset managers are asking is whether their clients such as pension funds and non-financial companies using OTCs for risk reduction should be exempted from higher capital requirements. Others are asking about the extent by which firms will need to segregate collateral, and what kind of assets will be accepted for margining purposes. If this happens, alternative and traditional asset managers alike will need to re-think their business models.
Each of the parties are going to be interested in trying to find common standards, common market practices, and the means to scale what they offer. On the buy-side, firms are preparing for regulations by placing a focus on innovation, product design & manufacture, product distribution, compliance, leverage, attribution, capital, outsourcing and orderly wind-down etc. All styles of asset managers will be affected by regulation – it will change the way that risks are assumed, monitored, managed and priced for, with the activity of outsourcing increasingly placed under the regulator’s microscope.
Market intermediaries are likely to be impacted by future regulatory reforms to an even greater extent. Parties on the sell-side are aware that changes to regulations will affect issuance and securitization, principal and agency models, client take-on (KYC) processes, front- middle and back-office functioning, collateral management, client account segregation, clearing and reporting etc. Regulatory change will also impact the asset servicing, fund administration, middle office outsourcing, clearing, treasury, collateral management, financing, execution and network management for custodian banks. For market infrastructures such as exchanges, issuance (the primary function) will be affected as will disclosure and reporting, pricing and dissemination of other market and reference data information, clearing andsettlement, IT platforms and network services are likely to be affected.
Regulatory reform will be pervasive over the next 3-5 years. Reform will impact all players from the front through to back offices for all constituencies in all G20 countries, although the pace of change could well differ between local centres. With some industry professionals estimating that the cost of compliance alone in the EU will push USD 30 billion over the next five years (this does not include the cost of capital), different parties will need to raise their level of system flexibility by a quantum leap with the need for greater disclosure and transparency of ‘look through’ arrangements. It can be inferred that some intermediaries will find that the regulatory reform step beyond could well turn out to be a step too far.