Executive Summary

Over the next two years, the financial services industry will have to prepare for yet another series of regulatory changes, as the drive to improve control and regulation over financial markets and services continues to increase in scope, scale and complexity.

In particular, over the course of 2014 and 2015, global market regulation is predicted to tighten significantly in an attempt to increase financial market stability, improve the level of financial disclosure, reporting and investor protection, regulate trading, combat tax evasion and reduce market risk. Similarly, the risk of regulatory non- compliance is also set to increase with potential punitive measures now ranging from severe financial penalties, market and counterparty preclusion, the freezing of assets to criminal liability. For example;

  • The US Commodities Futures Trading Commission (CFTC) levied fines of $1.7bn in 2013, across 82 enforcement actions. These actions brought the total number of enforcement actions over the past three years to 283, nearly double the amount over the prior three years.
  • In 2013, the SEC levied fines of $3.4bn, filing 686 enforcement actions.

Unfortunately, in a market environment characterised by slow growth, constrained capital and decreasing return on equity, the high and ever-rising cost of compliance presents a significant organisational challenge to the majority of financial services firms.

A recent survey byElixirr focused on the current challenges of our clients and their approach to managing compliance. The survey confirmed the urgency and importance of developing an enterprise-wide strategy, aimed at improving the effectiveness of managing regulatory initiatives, whilst critically, mitigating the rising cost of compliance. Using our expertise in financial regulation and experience in assisting leading financial institutions,Elixirr highlights three opportunities to assist firms in developing an improved organisational response to managing regulatory change.

Firstly, there is an opportunity to minimise the cost of compliance. A centralised regulatory design authority enables firms to improve their efficiency in delivering on compliance objectives. By mobilising and embedding a multidisciplinary design authority, firms can harvest the power of centralised knowledge management, group-wide coordination, planning and governance of regulatory projects, lowering the cost of implementing compliance related initiatives.

Secondly, forward thinking firms should recognise the value of regulatory reform as an opportunity rather than a burden, since many regulations enforce the adoption of good business practices. As a result, regulatory projects can be used as an opportunity to motivate significant and more pervasive re-engineering or optimisation projects, improving the return on investment. Examples of this may include improving an organisation’s data integrity, motivating the upgrade of legacy systems, streamlining key business processes while reviewing and improving process control effectiveness and efficiency.

Finally, firms should formally integrate change planning into the organisation’s strategic management capability. Organisations that are able to actively predict, identify and assess the potential risks as well as the benefits of future regulatory initiatives, will be best placed to take advantage of the changes it will bring.

Introduction

The significant scope and scale of recent changes to financial regulation, such as Dodd- Frank, MiFID II, CRD IV, Basel III, FATCA, AIFMD and EMIR, to name a few, clearly illustrate the need for firms to ensure the effective coordination and execution of regulatory initiatives as quickly and cost efficiently as possible.

All financial institutions that currently – or plan to – operate in global markets need to be fully aware of all their regulatory obligations across the entire spectrum of their activities. The global financial crisis of 2008 has reminded firms that meeting regulatory obligations is not just an issue for compliance departments, but one that must be considered across all facets of an organisation.

The impact of upcoming regulations are as diverse as they are significant, from dictating liquidity levels held in group treasuries, to increasing transparency on OTC derivatives trading. Regardless of firm size or jurisdiction, all financial institutions will be required to navigate the complexities of the future regulatory landscape.

Regulatory requirements have become more stringent and intrusive, as governments and regulators strive to mitigate risk, increase transparency and create safer financial markets.

This trend is set to continue with financial institutions facing even greater regulatory challenges. In order to effectively deal with the rapid increase in cost and complexity of compliance, organisations should re-assess their current thinking and approach to meeting compliance targets.

A recentElixirr survey focusing on the challenges businesses face in managing regulation effectively, critically highlighted that a clear opportunity exists for firms to deliver more value from regulatory initiatives than just meeting minimum requirements. Extracting additional value from regulatory initiatives is possible. However, this will require significant changes in the way organisations develop strategy, manage execution, motivate and direct project funding, liaise with regulators and manage critical assets such as business, customer and process data.

The high and rising costs of non-compliance

  • For institutions seeking to expand their influence in global markets, regulatory non-compliance is not an option. It carries the risk of severe financial penalties, criminal liability and the freezing of assets in certain jurisdictions. Furthermore, it may restrict a firm’s choice of counterparties and preclude participation in certain key markets.
  • The scale of the penalties imposed against non-compliance organisations are highly indicative of the seriousness with which global regulators view any acts of non-compliance.
  • The US Commodities Futures Trading Commission (CFTC) levied fines of $1.7bn in 2013, across 82 enforcement actions. These actions brought the total number of enforcement actions over the past three years to 283, nearly double the amount over the prior three years.
  • In 2013, the SEC levied fines of $3.4bn, filing 686 enforcement actions.

Table 1: Overview of current key regulations (Source:Elixirr Analysis)

The Current Regulatory Environment

Following the global financial crisis, governments and regulators have made transparency and control over the global financial services industry a top priority. This has made regulatory compliance more challenging than ever before due to a number of key factors:

Breadth & Depth : The global and connected nature of international finance has only now, fully been recognised. Multi-jurisdictional legislation, or substituted compliance clauses are now commonplace, in an effort by regulators to prevent legal entities engaging in jurisdictional arbitrage. The reach of financial regulation has also expanded to encompass previously unsupervised product types and legal entities. Examples of this include the regulation of OTC derivatives trading through EMIR and Dodd-Frank, and the regulation of legal entity types such as hedge funds and investment trusts through AIFMD. This deeper regulatory focus has also been seen with the financial activities of individuals frequently coming under the spotlight, as seen with the introduction of FATCA and further Know Your Customer (KYC) and Anti-Money Laundering (AML) rulings.

Severity : New regulations are more stringent than ever before, and existing regulations have been enhanced in order to strengthen perceived weaknesses. An example of this is Basel III, which adds further rigour to the capital requirements regulations, as introduced in the Basel II ruling.

Uncertainty : The regulatory environment is constantly in flux, as organisations face difficulties in clarifying key issues with regulators. Cutting through this complexity is made even more challenging when ambiguity exists over the regulations and the interpretations contained therein. For example, the release of an official European Securities and Markets Authority (ESMA) “Q&A” document at midnight, the day EMIR trade reporting compliance deadline entered into force, illustrates that ESMA had not fully clarified issues to key parties in weeks prior. In a similar vein, the CFTC caused widespread confusion across the industry by releasing several “No Action Relief” letters on September 27 th and 30 th 2013 – days before the swap execution facilities trading regime came online as part of the Dodd-Frank Act.

Three key considerations in meeting the regulatory challenge:

In light of these changes in the regulatory space,Elixirr has – by leveraging our expertise in financial regulation and engaging with leading financial institutions, including corporate and investment banks, asset managers, fund administrators and third-party service providers – highlighted opportunities that should be enacted as part of an organisation’s strategic response to meeting regulatory challenges.

These opportunities focus on:

  1. Minimising the cost of compliance
  2. Viewing regulation as an opportunity
  3. Adopting a strategic approach to future compliance

Minimising the Cost of Compliance

In an environment of rising compliance spend, firms must identify and mitigate the root causes of these costs

Across the industry, financial services institutions are scrambling to ensure compliance with new and existing regulation. These compliance efforts typically incur significant costs.

It is estimated by the Bank of International Settlements that derivatives reform alone will lead to an increase of $20-43bn in annual operating costs to the industry. It is reported that Global Tier-1 banks such as JP Morgan are spending as much as $4bn on compliance and risk controls alone.

Only by developing a clear understanding of the various costs incurred in meeting regulatory obligations can organisations best shape their compliance efforts to ensure requirements are effectively met whilst minimising the cost of compliance.

Four categories drive the cost of compliance

By breaking down the overall costs of compliance, firms may find it easier to identify opportunities for cost reduction.

  1. Regulatory Fees, Levies and Fines: Even for firms who avoid fines and settlements, costs can be significant. Typical costs incurred include fees for activities, such as registration and annual membership. To illustrate, fees associated with the UK Financial Conduct Authority (FCA) are estimated to amount to 39% of the UK Financial Services industry’s total compliance cost, whilst annual Dodd-Frank costs for ‘swap dealers’ incurs a minimum cost of $250,000.
  2. Direct Compliance Costs: This encompasses the resources, skills and systems required to implement and manage regulatory and reconciliation requirements in the BAU environment. Compliance staffing has risen across the industry by 12.5% between 2007-2011, primarily in order to manage increasingly complex and burdensome regulatory requirements. Elix- IRR estimates that direct compliance costs account for at least 31% of total compliance costs.
  3. Indirect Compliance Costs: This refers to time and resources spent on regulatory initiatives from departments that are not directly responsible for compliance. More than 50% of indirect compliance costs involves senior management time spent in supporting compliance issues.
  4. Compliance Change Costs : These costs are associated with costs incurred in preparing and implementing regulatory initiatives. Costs include the preparation, delivery and embedding of new regulatory solutions, including sourcing of external expertise, vendor selection and project implementation.

Based on theElixirr survey, the majority of our clients indicated that the cost of compliance has increased significantly over the last number of years – see Figure 1 below.

Figure 1: Changes in regulatory spend between 2013 and 2014.
Source:Elixirr Survey (2014)

Establishing a design authority responsible for all regulatory reform can significantly reduce costs

While the regulatory fees and direct compliance costs identified earlier are often difficult to reduce without placing regulatory compliance at risk, more significant opportunities exist to reduce the costs associated with indirect compliance and change costs.

One strategy to help reduce costs in these categories is to centralise much of the responsibility for delivery of regulatory change.

Design Authority: A Core Component

By mobilising and embedding a multidisciplinary design authority, financial institutions can centralise all knowledge, planning, and governance of regulatory projects. This will enable firms to optimise project compliance costs and achieve efficiency gains. Moreover, indirect compliance costs will also fall, as senior stakeholders are able to manage projects in a more considered and controlled manner, without investing significant time in projects on top of their ‘business as usual’ activities.

Some of the benefits of creating a design authority are outlined below:

  • A central source of knowledge that is able to educate all relevant stakeholders within the bank in order to ensure a full understanding of the regulatory requirements.
  • Ensures a holistic approach to regulatory compliance (e.g. creating a regulatory roadmap that supports delivery of current solutions and also anticipate future regulatory requirements). This will enable banks to realise synergies between regulatory projects, saving costs in the process. For example, using the same trade reporting solution to achieve compliance with the relevant areas of both EMIR and Dodd-Frank.
  • Provides an opportunity to involve senior stakeholders that are able to mobilise disparate individuals and teams within large bureaucratic organisations in order to reduce dependencies and speed up the processes involved to meet regulatory obligations within short time frames.

TheElixirr survey shows that only 40% of our clients stated that they did have a function akin to a design authority. 50% stated that all regulatory compliance projects were managed by disparate teams or that there was no central change function at all (see Figure 2).

The survey results confirmed that financial institutions should critically review their approach when planning and executing regulatory reforms. A more considered method involving the creation of a central design authority will enhance effectiveness and ultimately result in a lower cost of compliance.

Figure 2: Regulatory change functions within FS Institutions (Source:Elixirr Survey 2014)

Viewing Regulation as an Opportunity

Regulatory reform projects should be used to drive value beyond just compliance

Regulatory requirements are a legal obligation, and therefore are typically prioritised above other change programmes. However, forward thinking firms should realise that many regulatory reforms, focused on improved risk management, are often aligned with good business practices – aimed at driving effectiveness and efficiency. Firms should view regulatory compliance as more than just an additional administrative burden. Instead, regulation initiatives can offer an opportunity to improve operational efficiency, reduce risk, and lower the cost of doing business.

In theElixirr survey, 30% of respondents cited their greatest regulatory achievement as meeting regulatory requirements on time. 10% referenced improvements in operational efficiencies as a by- product of regulatory compliance, indicating that the majority of respondents have not yet fully considered the wider benefits that regulatory compliance may achieve, or were not unable to extract additional value from it.

Improve Data Integrity

The increased regulatory reporting requirements have placed greater demands on data integrity for all financial institutions, while the movement towards real time reporting (e.g. Dodd-Frank trade reporting) has added a temporal element to contend with. Firms should look to use these requirements as impetus to improve data integrity, by strategically replacing or upgrading existing systems and processes in order to gain business value, some of which are identified below:

  • Consolidating data sources into a single ‘golden source’ of information: a firm will be able to increase their confidence in data accuracy, which will in turn lead to more effective data risk management.
  • Real-time reporting obligations: activities such as data mapping and internal calculations, which typically run according to batch processes, will need to be enhanced and changed as regulatory requirements begin to drive toward real-time reporting obligations. By updating and replacing legacy systems to meet real-time reporting requirements, firms can simultaneously tackle other key data management challenges such as the requirement for early identification of data reconciliation and quality errors and the need for real-time operational process control reporting.
  • Service-based and open connectivity between systems: will enable more frequent, cost-effective and accurate reconciliations, while increased data quality will provide clear and concise reports, thus facilitating more informed and accurate decision making.

Regulatory Solutions can Address Multiple Objectives

Financial institutions should be using regulatory reforms as an opportunity to drive additional organisational value.

Examples include the re-use of aggregate business activity data typically used for regulatory benchmarking and threshold monitoring, to develop valuable business insights and intelligence into segment, product and customer behaviour and performance, used for tactical and strategic decision support.

Case Study: European Investment Bank

  • Elix-IRR helped a European investment bank perform their Dodd-Frank De Minimis calculation in order to ascertain if the bank should classify itself as a swap dealer entity type, increasing its regulatory compliance obligation under the Title VII act significantly.
  • While the scope was purely compliance focused,Elixirr’s work generated a key secondary benefit for the bank: providing a clear, single point of view on their trading activity across all product types, counterparties and legal entities.
  • This was used across business functions, enabling the firm to perform an audit of existing trading activity, which led to more accurate strategic planning.

Adopting a Strategic Approach to Future Compliance

In the long-term, firms must see regulatory compliance as a key component of their business strategy

Regulatory change will shape markets, business models and even entire industries. Organisations who are most proactive in assessing and understanding the upcoming regulatory environment will be best placed to take advantage of the changes it will bring.

By incorporating regulatory change as a core component in defining future business strategy, financial institutions will be able to better anticipate upcoming reforms and adjust their business and operating models accordingly.

Incorporate Regulatory Compliance into BAU Activity

CEOs and board members should begin to integrate regulatory reform into their strategic thinking when planning growth strategies for the coming years. Due to the greater impact that regulatory compliance requirements have had on the bottom line, boards should become further engaged in governance and risk issues in order to formulate business strategies which include a greater emphasis on risk controls and meeting future compliance requirements.

Consider More Specialised Business Models

It is anticipated that more specialised and differentiated business models will begin to emerge, as firms focus and narrow their attention to specific business areas where their internal competencies provide them with a competitive regulatory advantage or where the costs of doing business are acceptable given the regulatory landscape. There are numerous examples of banks that have exited businesses due to the increased cost of compliance brought about by regulatory reform. Macquarie, Credit Agricole and Royal Bank of Scotland have all sold equity derivatives and structured products businesses over the past two years, predicting that their costs were going to substantially increase due to incoming OTC derivatives regulations such as EMIR and Dodd-Frank. It is important to recognise that a cumulative build up of costs, driven by regulatory reform, is highly undesirable for a firm unless the business unit that incurs the cost is seen as a core component of the firms current business model.

Perhaps the most relevant example of integrating regulatory compliance planning into business strategy can be seen in the actions of Goldman Sachs towards its Sigma X dark pools business as of April 2014 (see case study below).

Continue the Conversation with Regulators

Firms must, either directly or indirectly, ensure frequent and extensive communication with all regulatory bodies in order to establish clarity over upcoming directives. This is made even more important due to the piecemeal and fragmented nature within which regulations are currently being released, resulting in a lack of industry wide consensus over the implications of several directives. Of the clients surveyed byElixirr, 50% cited a lack of clarity over the regulations as the biggest challenge they encountered with respect to meeting regulatory compliance.

Case Study: Goldman Sachs

  • In early April 2014, the Wall Street Journal announced that Goldman Sachs was considering closing its dark-pool trading operation, known as Sigma X.
  • Dark pools refer to trading venues which allow investors a higher degree of anonymity than in public markets as shares are traded privately.
  • Executives are considering whether revenue generated from Sigma X outweighs significant risks recently highlighted.
  • Greater competition in an already fragmented market, increased regulatory restrictions as seen in MiFID II directives, as well as a spate of recent technological glitches, have all factored into concerns over the future of this business, and it is expected it will be divested before the end of 2014.

Conclusion

Firms must adopt a proactive stance toward managing current and future regulatory change

Financial services firms now face a challenging and rapidly shifting regulatory landscape. To successfully navigate through this, and achieve high standards of compliance while minimising cost, they must be prepared to think differently.

By recognising the business opportunities that regulatory change can bring, firms can differentiate themselves, benefit from reduced operational risk and even add to their bottom line.

More so, through considering regulatory change with a forward-thinking perspective, organisations can gain more control over how regulation will impact their business, benefiting through a more coordinated and predictable response to the challenge.

With the right advisory and execution partner, firms will be able to implement effective regulatory change whilst simultaneously realising business value beyond that of pure compliance.

In summary, in order to improve the effectiveness, cost and execution of compliance requirements,Elixirr identified three opportunities for firms to consider as part of their next steps:

Minimise the Cost of Compliance Establish a Central Design Authority responsible for all Regulatory Change
Create a central source of knowledge able to fully educate relevant stakeholders of all upcoming regulations.
Ensure a holistic approach to compliance that supports delivery of current solutions and enables firms to realise synergies between different regulatory projects.
View Regulation as a Business Opportunity Improving Data Integrity
Upgrade legacy systems, streamline current operations, and create a single ‘golden source’ of data.

Leverage Regulatory Solutions to meet Business Objectives
Ensure that regulatory compliance projects are not viewed within a silo, and that their outputs are used to aid other business functions
Adopt a Strategic Approach to Future Compliance Critically Evaluate Business Strategy in light of Regulatory Compliance Obligations
Incorporate current and future regulatory compliance initiatives into existing BAU strategic planning.

Liaise with Regulatory Bodies
Continue developing relationships with regulatory bodies in order to gain clarity over key issues and anticipate future regulatory changes

References

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