This year, U.S. regulators plan to tighten leverage requirements and oversight of foreign exchange brokers. Securities firms with operations in the United Kingdom will need to increase liquidity reserves and begin daily monitoring of assets that can be converted easily into cash. Meanwhile, Asian countries continue to implement the Basel II accords, under which institutions that offer banking services must measure and report operational risks.
Many more regulatory reforms are in the pipeline, designed to protect the global and national economies from future financial shocks. The challenge: developing a global standard on how to approach the regulation of risk and the reporting associated with it.
The biggest difference in international approaches, philosophically, is that of the United States and the United Kingdom, said Andreas Fillman, a banking and capital markets expert and the European partner in the global law firm of Squire, Sanders & Dempsey. The U.S. approach is more prescriptive and rules-based; the U.K. approach is a principles-based approach.
But even within Europe itself, there are significant differences, he added.
For example, Russia has many laws and regulations that are not “harmonized” with Western Europe, he said. “They have no compliance requirements overall-it’s nice, but it’s a little bit tricky.”
That situation pales compared with the problems now facing Swiss financial institutions that also do business in other countries. Switzerland has strict privacy laws, and allows customers to have secret financial accounts, the contents of which are not reported to other nations. This enables these customers to hide assets from tax authorities in their home countries.
Last week, Credit Suisse warned Swiss employees that they might be arrested if they travel to Germany, in connection with that country’s tax-evasion probes.
The laws of one country often conflict with those of another, causing compliance headaches for companies that do business in both. For example, a company may want to collect data on ethnic backgrounds of its employees to comply with U.S. rules or protect itself from discrimination lawsuits. European data privacy laws, however, severely restrict the ability to collect this data and to ship it to another country. Similar privacy rules protect sensitive customer data.
“It is quite complicated to transfer data from Germany to the U.S.,” said Fillman. “Quite complicated and very time-consuming.
For example, to collect sensitive data, companies must obtain written consent from the employees or customers involved, which can be hard.
“For some U.S. firms, it creates a very tough burden to enter into the market,” he said.
“In a perfect world, we would have one set of regulations which would cover everything worldwide, and this would make things easier and firms would know what kind of compliance they have to implement,” Fillman said.
Companies doing business in multiple jurisdictions need to be aware not only of such broad differences in laws and regulations, but also in specific procedures surrounding the compliance process in each jurisdiction. As these regulations mount up, so do the associated costs for companies.
Brokerage firms will need to increase their compliance-related spending, he said. “Maybe even have different compliance officers — one for the U.S., one for Europe, and for one Asia.”
Companies may save money in the long term, he said, by implementing technology and systems that can support the strictest regulatory regimes.
NEW LAWS COMING DOWN
“Broadly speaking, there is a general recognition by regulators that we have this worldwide crisis, and supervision needs to be increased in all places,” said Rich Spillenkothen, director in the Deloitte and Touche regulatory and risk strategies practice.
“Many of these regulations or rules will raise capital requirements, reduce the acceptable amount of leverage, and enhance risk cushions,” he said. “And some of these have implications for financial firm profitability and performance.”
The broad principle is that reforms have to be put in place globally, he said. “Otherwise, you have the potential for an unlevel playing field or the potential for regulatory arbitrage.”
There are several international bodies working on making that happen. They include the International Organization of Securities Commissions, the Basel Committee on Banking Supervision and the International Stability Board, he said.
Helping bring regulations closer in line is the 2004 Basel II agreement, which covers operational risk and capital requirements at global banks. The United States, the European Union and many other jurisdictions have either implemented it or are beginning to, and 95 countries pledged to implement it in some form by 2015.
The basic principles of Basel II are that financial institutions need to develop ways to measure credit, operational and market risk and to maintain adequate capital reserves to protect against these risks in a uniform manner across the world.
Regulators in different countries have adapted this agreement, however, for local conditions, said Cubillas Ding, an analyst at financial markets consulting firm Celent’s London office.
“They don’t usually subtract things, but regulators at the country level might add things to it,” he said.
For example, other countries are now looking at the U.K.’s liquidity regulations, Ding said, scheduled to go into effect this summer.
The new liquidity rules cover financial ratios that measure the amount of debt, shareholder investment and cash or cash-like assets a company should have on hand. The rules also require firms to do regular stress testing, to figure out how much capital to have on hand, to weather bad times. The firms also should report on the parameters of those tests, said Ding. The U.S. had its own version of a stress test, in which 19 of the country’s largest banks participated in last year.
Firms also have to create “living wills”-plans for what they will do in case of insolvency, he added.
In discussion are plans to reform the OTC market infrastructure and create a central clearing body, he said.
However, while there might be a common direction for regulatory reform worldwide, different regions will move at different rates, said Marcus Cree, head of risk solutions for SunGard Trading and Capital Markets.
If regulatory changes take place at different rates, firms may find themselves in a position of shopping for the best jurisdiction in which to conduct business-or risk losing market share to competitors.
Take, for example, leverage requirements, said Bill Cline, managing partner of The Cline Group, based in New York, which provides consulting, research and advisory services to the financial markets.
“Capital is quite fungible. At the end of the day, it will simply migrate to other jurisdictions that allow a greater degree of leverage,” he said.
Take, for example, a new rule by the Commodity Futures Trading Commission, he said. This regulation-which recently finished its public comment period-is expected to cut leverage on foreign exchange transactions from 400-to-1 to 10-to-1 in the United States. This means that foreign-exchange customers will need to have $1 deposited in their accounts for every $10 notional amount they can trade. By comparison, other countries allow much higher leverage, of 50-to-1 in Japan, and unlimited leverage in the United Kingdom.At New York-based OANDA, one of the three largest forex trading, technology and information providers in the U.S., approximately 75 percent of clients are based overseas, said CEO Michael Stumm.
“They trade with us through the platform regulated by the CFTC, but we do have other subsidiaries overseas,” he said. “Many of these clients-especially the foreign ones-will move to the subsidiaries if they find the 10 to 1 rule offensive.”
Other kinds of regulatory arbitrage may create even bigger problems for the global financial community.
For example, surveillance of market abuse happens on a country-by-country level, said Bob McDowall, an analyst at TowerGroup, in Needham, Mass. “So its much more difficult to detect market abuse when you’re executing part of an order in France, part in Germany and part in the U.K.”
It will be hard for the international community to get a handle on market abuse because it’s treated differently in different jurisdictions. “It is viewed in some places as a civil offense, not a criminal offense, and in some countries it hardly registers,” he said. “And they all have difficult judicial processes.”
For example, the U.K. considers market abuse to be a criminal issue, he said. In Italy, it is a civil offense. Meanwhile, Romania and Hungary fall into the “hardly registers” category.
The G20 has market abuse on its agenda, McDowall said. But, he warns, “the principles will be interpreted differently in different countries based on culture and law.”
Under the Basel II agreements, some of the opportunities for regulatory arbitrage based on capital requirements will be eliminated -at least, for the financial institutions with banking operations, said John Jay, an analyst at the Aite Group. That’s because the requirements would be more uniform around the world.
Opportunities for regulatory arbitrage in the area of OTC derivatives are likely to be diminished as well, said Andrew Barber, strategist at Waverly Advisors, a New York investment research and asset management firm.In OTC derivative trading currently, companies have some latitude about where to book the transactions.
“If you’re doing a transaction between a hedge fund and an investment bank, and both of them are in Greenwich, Conn., but the transaction is booked in a European bank owned by the investment bank, and the counterparty is a British Virgin Islands company controlled by the hedge fund-you’ve migrated the transaction to a location, which is more favorable from a credit risk standpoint,” he said. “I think that what is going to happen is that those types of facilities are now going to change because they’re tightening standards in Europe and tightening standards in the Americas.”
COMPLIANCE OUTSOURCING
Securities firms can’t outsource their compliance obligations-but they can have vendors do some of the ground work.
Largest firms typically build all their own systems, said Celent’s Ding, but mid-tier companies would have a hard time doing the same.
“If they’ve been struggling with internal systems and managing these systems in-house, and this whole raft of regulations is coming in, and they’re facing significant cost overheads, moving to a third party that handles all these multiple jurisdictions makes sense,” he said. However, this doesn’t absolve individual firms of final responsibility.
“When you outsource to a third party and something goes wrong, you’re still responsible,” he said.
One such external provider is Quod Financial, a London-based provider of adaptive execution software.
Quod’s platform is built around flexible, service-oriented architecture and common standards, said managing director Dhiren Rawal.
For example, new U.S. regulations about sponsored access and the removal of naked access mean that pretrade compliance is a necessity, not an option, he said.
“Our technology has a lot of pretrade risk validations built in,” he said. “So our clients using our software can turn it on if they’re providing sponsored access.”
Similarly, the software is already set up to handle new rules changes around flash orders and dark pools, he said.
Internationally, the platform is also compliant with Europe’s e MIFID and the U.S.’s RegNMS, he said.
The platform even allows firms to pick the best international venue in which to place a trade based on the different regulations in those countries.
SunGard is trying to keep its risk-management products flexible. “We’re still a way away from knowing what the regulatory framework will be,” said SunGard’s Cree.
Previously, SunGard sold a single platform for storing data, running analytics, and showing reports. Now, it’s a collection of components that can be either arranged in the traditional manner, all from SunGard, or embedded, piece by piece, in a firm’s own system and framework.
