Regulatory Outlook: 7 Financial Services Developments to Watch in 2019br>
Regulations – the bane of existence to some, the saving grace of others. Like them or not, they’re here to stay, and they’re woven tightly into the fabric of the financial services industry – meaning it’s critical to keep eyes peeled and ears to the ground to be ready to react to new protocols or updates to old standards.
The coming year is likely to be no different from others when it comes to regulatory changes and updates – and 2019 may bring the answers to these seven regulatory developments.
1 – Brexit: Even as the deadline for the United Kingdom to exit the European Union creeps ever nearer, we’re still no closer to what the terms of the divorce are and what the aftermath will look like – including any regulatory changes.
While the United Kingdom has always existed under European Union regulations, it’s not clear what aspects of those EU regulations the U.K. will retain, and under what terms – or if it retains any EU regulations at all.
Another option is scrapping EU regulations and creating new ones, but if new regulations are put into place, they must be harmonious with those of the EU – otherwise, British firms will have a lot of trouble doing business on the Continent.
This uncertainty is causing a lot of firms with operations or headquarters in London to jump ship, as a financial firm based in London selling financial services to continental European customers may not be able to continue operating in the United Kingdom, depending on Brexit’s final terms.
2 – Cryptocurrency: From a regulatory perspective, no one really knows how to classify cryptocurrencies. Should they be a security, like a stock, and regulated by the Securities and Exchange Commission (SEC)? Should they be a commodity, like futures, regulated by the Commodity Futures Trading Commission (CFTC)? Or are they something else entirely?
There is no global agreement on these questions. Countries that do regulate cryptocurrencies all have very different rules in place; for example, China has abandoned crypto regulation entirely, while in Japan, it is highly regulated.
It’s anticipated that 2019 will be a watershed year for cryptocurrencies – meaning wherever crypto ends up at the end of this year will give the industry a sense of where it will be in 10, 20 or 30 years. Will it be a viable financial instrument with a place in the economy and larger institutions participating in its trade, or is it a flash in the pan that eventually disappears?
With more clarity around the regulatory conundrum, we will have a better idea of how to answer those questions; without regulations, it’s hard for a market to develop.
3 – LIBOR: The London interbank offered rate (LIBOR) gauges what banks say they would charge each other to borrow money. It’s the benchmark for $200 trillion in dollar-dominated financial products, mostly in interest rate swap contracts.
But its reputation as the market standard has been tarnished; an ever-slimmer underlying market and a rate-fixing scandal perpetrated by traders – for which multiple major global banks were fined billions – have prompted regulators to look for a replacement.
Regulators set LIBOR to be phased out in 2021 and are actively seeking alternatives to take its place, but there’s still a lot of work to be done to find a replacement.
Most would like markets to switch to overnight interest rates. British regulators are pushing for the Bank of England’s sterling overnight index average (SONIA), while the New York Federal Reserve and the Office of Financial Research, an independent agency at the U.S. Treasury, launched the Secured Overnight Funding Rate (SOFR) as a LIBOR alternative.
Sterling swaps referencing SONIA now account for 19 percent of the market, but new contracts referencing LIBOR are still being written for periods going beyond 2021. Meanwhile, a handful of companies have begun issuing floating-rate bonds using SOFR as a rate reference, and trading of futures-based SOFR has increased, but SOFR has not yet been widely adopted.
Either way, according to Greenwich Associates, the impact of replacing LIBOR with other benchmarks, like SOFR and SONIA, will create “a huge operational burden for the industry that will consume legal and operations teams for months to come. In the long run, the industry will adapt and move on, but the short-term fight to change will be intense and meaningful.”
Greenwich’s report added replacing LIBOR “goes beyond the $350 trillion face value of financial products currently tied to [it].” That means there’s still a lot of work to be done before an ideal solution is found.
4 – Treasuries: In 2015, several pension funds and wealthy individual investors filed a class-action suit, claiming that dealers at several banks shared client info to rig auctions of the bond markets; then, in 2017, a lawsuit filed in Manhattan federal court extended the class-action suit and alleged that Wall Street banks were rigging U.S. Treasury auctions.
Now, in early 2019, the investigation has stalled due to lack of evidence, and it’s unknown whether the federal government will charge the banks – the list of which included Goldman Sachs – with collusion to fix prices in the $13 trillion Treasury market.
Although the investigation has hit a wall, banks could still see some consequences from the allegations as the SEC trains a closer regulatory eye on Treasury market auctions. Additionally, the Department of Justice has subpoenaed multiple banks’ trading and chat records, so we may not have seen the end of this.
5 – Mifid II: The Markets in Financial Instruments Directive (Mifid) II is a European Union-wide law that, in theory, is designed to improve transparency and strength investor protection, by requiring European asset managers to separate the cost of research from trading commissions paid to brokers – a process known as unbundling.
Fallout came about a year after its implementation, with banks laying off hundreds of analysts as asset managers slashed their research budgets and cut down on external providers. Most European asset managers have chosen to cover the cost of their own external research; surviving analysts are spread thin due to increased workloads, and complain about declining research quality.
Despite these challenges, some U.S. asset managers have already signed up for Mifid II voluntarily; the $1.87 trillion Capital Group decided in early 2019 to absorb the cost of third-party investment research across its global business, citing the shifting regulatory environment and changing client demands as the reason for its global adoption of Mifid II unbundling.
There is no real regulatory imperative for unbundling outside the E.U., and current U.S. regulations make unbundling difficult, as local brokers can’t accept separate research payments unless they register as an investment adviser. Yet the trend toward unbundling is likely to grow on a global scale, which means more countries may see Mifid II-like regulations in the offing.
6 – Swap trading: The CFTC has been looking at how to revamp rules for swaps, but the proposed plan was recently abandoned after industry objections. Current rules are not perfect, especially a provision that allows trading platforms to make new swap products available for electronic trading, but no one agrees on how to fix them.
CFTC Chairman J. Christopher Giancarlo’s term is set to expire in April 2019, and amending regulations related to swap execution facilities and rulemakings is high on his list of things to do before he exits.
Dodd-Frank rules for swaps have been in effect since 2014. Changes are on the horizon either way, whether they’re updates to existing structures, or a move to ditch those entirely and start from the beginning.
7 – The Consolidated Audit Trail: In early 2019, the SEC ousted Thesys Technologies, the capital markets technology provider tasked with administering the consolidated audit trail (CAT) project, which is being built to allow regulators to track illegal or manipulative trades. The Financial Industry Regulatory Authority, Inc., a private corporation that acts as a self-regulatory organization, is now in charge of building the CAT system, the first phase of which launched in November 2018.
As the project transitions to its new developer, it’s likely the timeline to create a database for all equity and options trades executed on the U.S. stock exchanges will lengthen, perhaps significantly – and in the meantime, the SEC continues to lack a way to quickly determine what causes large, sudden price swings.
If another flash crash occurs, it may not be possible without the CAT to determine exactly why – so there will be no way to put in place safeguards that prevent the same thing from happening again.
New Year, New Regulations
Only time will tell how these seven open regulatory questions will play out in the coming year – and keeping tabs on these and other financial services challenges will help firms stay ahead of the curve and be ready to respond to any changes.