Weathering the Regulatory Storm
Although many firms are still struggling to come to terms with some aspects of legislation that have recently come of age, in particular Dodd-Frank and the Basel III capital adequacy regime, the regulatory storm is far from over. Most notably, imminent deadlines for the European Market Infrastructure Regulation (EMIR) and the US Foreign Account Tax Compliance Act (FATCA) weigh heavy on the minds of firms. But while market participants wade through extensive preparations for EMIR and FATCA compliance, they should also be keeping a watchful eye on current discussions with regards to the next phase of the Markets in Financial Instruments Directive (MiFID).
The majority of firms have now completed, or are in the process of switching on, Basel III reporting. Although most systems are now operational, it will take some time for organisations to work through the array of post-operational glitches and issues that many of them have encountered. Numerous organisations are also working on tools and systems for risk-weighted assets, credit variation adjustments and regulatory capital analysis and allocation which, although not mandated by regulators, are important tools towards achieving transparency and control.
Further on the compliance horizon is the implementation of solutions surrounding mandated liquidity coverage ratios (LCRs) and net stable funding ratios (NSFRs). Banks are required / expected to have NSFR coverage ratios of 60% or greater by 2015, and ratios in excess of 100% by 2016. Although timetables for NSFR and LCRs are not as aggressive as initially feared, significantly, they will impact treasury functions more than the risk control functions that were impacted by Basel III.
EMIR trade reporting obligations were originally expected to be enforced from 1 July 2013 onwards for credit and rates, and 1 January 2014 for foreign exchange (FX) and equities. However, in part due to delays in the approval of trade repositories by the European Securities and Markets Association (ESMA), the mandatory reporting requirement for all trades will now start next month on 12 February. There has also been much confusion with regards to the products that are classified as a derivative trade under EMIR, and therefore fall within its scope. For example, FX spot transactions have been confirmed as out of scope by the UK Financial Conduct Authority (FCA) in line with MiFID, although any type of FX forward remains within scope. To further complicate matters, ESMA’s recommendation to delay exchange traded derivatives (ETD) reporting due to lack of clarity in the marketplace was rejected by the EU Commission. It was initially anticipated that ETD transactions would not need to be reported until 2015. This revelation has proved troublesome for those firms who have deferred the implementation of an ETD trade reporting solution.
A number of aspects of the trade reporting mandate are currently proving difficult to implement. Foremost amongst these is the creation of a unique trade identifier (UTI), which both counterparties will need to use in order to identify the trade with a trade repository. Deciding which counterparty will need to generate the UTI, and then determining how best to exchange, consume, track and maintain it over the life of a derivative transaction are just some of the IT and business processing headaches currently being experienced. Allied to this issue is the task of back-loading. ESMA has stipulated that all trades that were live between 12 August 2012 and the go-live date need to be back-loaded to the chosen trade repository. This is no trivial task and when the need for an agreed UTI is also thrown into the mix it causes many an operational nightmare.
There has been some speculation that the increased cost of trading over-the-counter (OTC) swaps resulting from both EMIR and Dodd-Frank, its North American counterpart, could drive market participants to the less regulated (and therefore less expensive) futures market as an alternative. Whether or not this ‘futurisation of swaps’ will actually happen remains to be seen, but we can be certain that any marked shift into the futures markets will not escape the attention of the regulators.
In North America, Dodd-Frank has been implemented – in the most part. Firms are now turning their attention to FATCA, the US legislation which requires foreign financial institutions (FFIs) – such as banks – to enter into an agreement with the Internal Revenue Service (IRS) for identifying US account holders and disclosing their details to the IRS. It also requires US payors to withhold 30% of gross payments to those FFIs who have not registered with the IRS. The first withholding date is 1 July 2014
The Act has caused some consternation among the finance industry with regards to the perceived extra-territoriality of the requirements; for instance, does the IRS overstep its boundaries with its requests for information? Legally, this question has been answered by inter-governmental agreements with the US. However, FATCA does create some big process overheads for businesses as each company will have to formalise their relationship with a new government body – the IRS. Additionally, firms will need to put processes and systems in place to collect, store and then report new client data to the IRS. They will also need to have due diligence processes in place to ensure firms’ income on investment is taxed correctly.
The extent of the impact of FATCA on any corporate treasury department depends largely on their answer to the following question: ‘Does your firm want to do business with US persons or assets?’ Firms who answer ‘yes’, will have to put in place all the policies and procedures required to support the business. This will include conducting a full operational risk assessment for of each component of the chosen solution.
Those firms that answer ‘no’ need to seriously consider the implications for their organisational liquidity. For example, the liquidity of a firm whose primary source of borrowing and lending is a US-based entity would be greatly impacted if doing business with that entity were no longer an option. In such an instance the firm would need to seek alternative sources of cash, and this could be a costly endeavour.
FFIs that do not comply with FATCA will be subject to withholding tax of 30% on any US income.
It would be easy to assume that MiFID II is an extension of the original MiFID regulation. However, the proposed regulation is in fact far more extensive than its predecessor and covers a broader range of topics and products. For example, while the original MiFID covered topics such as trade reporting and client classification, MiFID II has been extended to include market developments related to technological innovation (e.g. high frequency and algorithmic trading). Additionally, while MiFID I requires the reporting of shares, the latest proposals expand the transparency and reporting mandate to include depositary receipts, exchange traded funds, derivatives, bonds, structured finance products and certificates.
Firms may wonder about the potential overlap between EMIR and MiFID II, as both relate to trade reporting. EMIR focuses on transparency and oversight for exchange traded and OTC derivatives, whilst MiFID II has a wider scope and looks at the trading of most financial instruments along with the regulation of the market and trading structures themselves.
One of the highest profile elements of the MiFID II regulation relates to so-called ‘dark pools’, where firms trade without revealing pre-trade price information. Current proposals point to the capping of trades in dark pools under MiFID II. The speculative volumes quoted are 4% on a per venue basis, and 8% on an EU market-wide basis with the added requirement to offer trade pricing that is more competitive than that which is publicly available.
Ongoing discussions in the market between regulators and participants indicate that MiFID II will come in to force in 2015, or perhaps even the year after. Given this, there is still much uncertainty about the exact scope of the directive and the impact it will have on the market and its participants. However, firms should already be thinking about where the impact of the directive will be felt and what they can do to comply with it.
Although the clouds have yet to clear and there is much uncertainty ahead, it is becoming apparent that treasurers face a future of increasing sophistication and ever greater transaction volumes, which they will need to manage in order to balance finances effectively. While regulators have established basic requirements and principles that firms must meet, market leaders are ceasing upon the opportunity to revisit and optimise their core processes in order to gain competitive advantage.
Although much progress has been made, regulators will continue to drive for increasing transparency and reduced risk within financial markets throughout 2014 and beyond. In seeking shelter from the regulatory storm market participants may be driven to new markets (as with the potential ‘futurisation of swaps’). However, we can be certain that wherever the markets move, the regulators will be quick to follow.
Forecasting future regulatory developments is difficult, and firms will need to remain vigilant if they are to avoid falling victim to the regulatory storm, especially given the extensive lead-times often needed to make the required system changes.