The financial industry is experiencing continued regulatory changes with a high focus on transparency. The number of reporting obligations across jurisdictions continues to expand, leaving financial institutions with a multi-national reach exposed to regulatory risk and little time to comply. Sapient’s Clarisse Mallem and Mark Steadman explore the changing regulatory landscape, investigate the key challenges posed by new legislation and propose a strategic approach to plan and implement necessary changes.
Prior to the current financial crises, the main focus of many financial institutions has been on their ability to create innovative new products for their clients. Some support functions have been built to accommodate an infrastructure to meet real-time internal reporting requirements (risk and P&L driven), however, this infrastructure will not necessarily meet real-time external regulatory reporting requirements, since regulatory reporting has typically been on a T+1 basis.
Some of the impending legislation, which focuses on more transparency, requires real-time and more complex regulatory reporting. Therefore, internal infrastructures for regulatory reporting need to adapt to these new requirements. Additionally, firms may have evolved their systems using manual workarounds in response to past regulatory requirements, and these manual processes may create more problems if not automated. In this new global regulatory landscape, financial institutions will not only be under the scrutiny of their domestic regulator, they may also potentially need to comply with foreign regulators due to the requirements’ extraterritorial reach. The lack of harmonization across jurisdictions represents a challenge for firms, as does the fact that industry practices are still evolving as regulatory requirements across the globe unfold.
While the required regulatory changes were not explicitly designed to benefit those who need to become compliant, there is an opportunity for firms to respond in a way that provides a competitive advantage. A well thought out compliance strategy will mitigate regulatory risk and offer the opportunity to implement a more agile infrastructure, thereby enabling firms to respond more quickly to future regulatory requirements.
The Emergence of a New Regulatory Landscape
The financial crisis has highlighted the lack of complete transparency in financial markets—particularly in the over-the-counter (OTC) derivative markets—causing regulators to seek more visibility in both their domestic market and markets that will impact their core regulatory mandate. This need was addressed globally by the members of the G20 in their Pittsburgh statements through their commitment to report all OTC derivatives transactions to a central trade repository. This commitment, however, is not the only reporting mandate to supplement existing reporting requirements. For example in Europe, in addition to the member states’ central banks respective reporting and the existing Markets in Financial Instruments Directive (MiFID) transaction reporting, the European Commission is in the process of adopting trade repository reporting regulations in response to the G20 commitments with European Market Infrastructure Regulation (EMIR) and deepening the transaction reporting requirements within MiFID II, a revision of MiFID.
An exhaustive list of all regulatory reporting that might affect a financial institution would be difficult to capture within this article as a large number of jurisdictions are currently implementing regulations. A good indication of the scale of the reforms can be found in the progress report on implementation published by the Financial Stability Board (FSB) on the OTC derivatives market reforms (http://www.financialstabilityboard.org/publications/r_111011b.pdf). It is clear that the progress made toward trade repositories varies considerably from region to region.
Despite regulators’ attempts to provide a harmonized response (FSB, ODRF, CPSS-IOSCO guidance, etc.), the different requirements, timing and content required is creating a lack of harmonization. While the spirit of the G20 commitments was for a consistent global approach, the need for each regulator to exercise its sole authority in its own domestic market makes this approach a challenge. The regulator will require visibility into transactions made where at least one of the parties is domestic, and may also be interested in any transaction with a domestic nexus (i.e., some jurisdictions have included reporting requirements for trading of their local currency).
The Multiple Challenges of Increased Regulatory Reporting
The lack of harmonization causes a number of challenges to participants in the financial industry. The complexity and timing of the data attributes that need to be reported might require considerable changes to internal systems. Also, the extraterritorial impact is still unclear and could prove to be farreaching. The emerging service offering of trade repositories may not completely address those issues, because the offering is fragmented across various jurisdictions and the dataset requirements are not necessarily harmonized at the “provider of trade repository services” level.
All these reporting requirements are occurring at a time when the overall regulatory landscape is changing. The pace of these changes makes it difficult for institutions to adequately adapt to regulations and, in some cases, is creating rework of analysis already conducted due to changed or additional regulatory requirements. What’s more, the requirements to clear or trade OTC transactions on an exchange are being implemented in parallel with reporting requirements. This further stretches resources in institutions required to implement the necessary changes.
Internal challenges also exist. Most institutions do not currently have an infrastructure designed to accommodate large real-time reporting requirements. Information is typically stored across various systems and is siloed by product. The level of detail required by new mandates means that sourcing data from the primary trading system might no longer be enough. Numerous logic rules and calculations might be required to query data from static or collateral systems. The complexity of such rules and calculations can increase due to the difficulty firms may have interpreting the new reporting requirements. And, the jargon used by market participants is not necessarily the same as the terminology used by the regulator. For example, the legislator’s interpretation of the terms “swap” or “swaption” within the Dodd-Frank Act is broad since those terms designate derivatives and options, rather than the more conventional meaning.
Another challenge is the current lack of global consensus on industry-standard identifiers that will be essential to the effectiveness of new reporting processes. Unique identifiers are tools that will be used by regulators to ascertain a clear understanding of a trade’s origins and the parties to the trade and will help avoid ambiguity of transaction type. In the CPSS-IOSCO consultation report on OTC derivatives data
reporting and aggregation requirements, Unique Transaction Identifiers (UTI or USI under Dodd-Frank), Legal Entity Identifiers (LEI) and a product classification system, known as Unique Product Identifiers (UPI), have been identified as the prerequisite to effective data reporting and aggregation.
Making the Most of a Difficult Situation
The new regulatory landscape is not necessarily creating a favorable environment for market participants. The pace of cross-jurisdictional regulatory changes means that analysis required to successfully plan and implement changes cannot be postponed any further. The regulatory changes will prompt many institutions to implement a structural change and modify the way in which they have been doing business. Implementing the right strategic approach will be the key to successful compliance.
Firms will need to conduct a thorough business analysis that takes into account numerous aspects to avoid the pitfall of having a limited usefulness, since any analysis conducted today runs the risk of having to be reworked within a very short timeframe. Those factors include understanding the internal infrastructure and the external requirement changes (both from the relevant regulator and service providers). Therefore, ensuring compliance requires an exhaustive knowledge of the applicable laws and regulations, as well as a deep understanding of the products needed to be reported across asset classes.
An effective business analysis requires an inventory of all data attributes stored in every system and a formal identification of the appropriate data source. This analysis can vary based on the type of information required, and must also take into account the problem of where best to source data to meet timing requirements.
The complexity of capturing the correct data source is not the only challenge. In many instances, the reporting requirement implies that the logic to report a field needs to source information captured in various systems. This means that firms must capture where the data fields are sourced and understand how they are sourced and how to combine them to report the information required. Often, this knowledge is not explicitly documented and instead exists with particular employees, making it difficult to proactively respond to regulatory mandates. This challenge, coupled with the real-time reporting requirements, might prompt the need to provide a tactical solution.
Another challenge is when internal information is not captured properly within the system. These issues have never been an institution’s main concern because the impact of common practices was considered immaterial. However, the review now needed in order to facilitate regulatory reporting is a great opportunity for institutions to assess their internal operations, infrastructure and gaps in explicit knowledge. In effect, the new reporting mandates will ultimately help firms improve risk management and provide insurance that processes and systems are optimized.
A Scalable Approach to Business Analysis
A review to enable successful change planning and implementation should include an inventory of all data elements stored in all relevant systems and an inventory of all data attributes required by regulators and service providers. This will allow institutions to adequately assess the effort needed to become compliant and facilitate the work of the compliance department, because interpretation of how each data field is captured can be easily available for review by the regulator, if needed.
The inventory is also an essential step to implementing a reporting hub in an organization. Assuming that an organization decides to implement a reporting tool that compiles data feeds from all relevant systems and applies logic to report to the relevant regulatory body, the quality of the analysis can prevent failed implementations. It facilitates easy fixes of any reporting error identified during the testing phases. Furthermore, the analysis will act as a link between the business and IT department because it allows them to have a common reference and consistent understanding within the organization.
Meeting new regulatory requirements is a major challenge for financial institutions. The current infrastructure in firms was not built for the volume and complexity required by current regulatory changes. Additionally, the different jurisdiction requirements make developing a global regulatory platform both difficult and expensive. Firms that can implement a reporting infrastructure rapidly and in a controlled manner will be in a far better position to respond to future regulations and data queries than those who do not.
