November 2012

INSIDE VIEW: The pace of change

ThinkerSeveral years after the post-crisis G20 summit, Sandrine Leclerq of Baker & McKenzie analyses how close regulatory-induced change is to becoming reality and if objectives will be met. The deadline for the release of many legal pieces of work resulting from the post-crisis G20 summit in 2008 is this year. However, the implementation process has revealed to be more difficult than expected. The euro crisis has added a layer of political complexity, and with the US presidential elections, uncertainty remains as to whether federal regulators can push through their agendas. Although the necessity to engage with reforms is not debated, the relevance and direction of certain reforms raise concerns for many. Following on from the Mexico G20 summit in June, can we say that governments will reach their goals? What are the remaining challenges that need to be overcome and what will it really take from the industry? Regulatory responses
Today there are around ten pieces of major legislation or regulation either recently issued or in progress in the EU. Among the most impacting pieces for the transaction chain are the Markets in Financial Instruments Directive II (Mifid II), the European Market Infrastructure Regulation (Emir), Central Securities Depositary (CSD) regulations, the Alternative Investment Fund Managers Directive (AIFMD), Ucits V, regulations on short selling and the recent consultation on shadow banking. All tend to realise the G20 objectives and all share at least a common objective: reducing the legal, operational and systemic risks through transparency and harmonisation. The US is working on the Dodd-Frank Act. The text covers about the same domains as the entire European compilation of texts. Although originally meant by Congress to limit its effects to US-based players, the text might have some extraterritoriality and partly unexpected reach resulting in overlapping regulations for EU banks. And the Foreign Account Tax Compliance Act regulations, although not part of the global G20 agenda, necessarily has an impact on the overall process, because of the burden that its implementation involves. Irreconcilable constraints
The global nature of the crisis creates the need for harmonised regulatory responses. These have prompted some changes in the structure of international agencies (increasing role of the International Organisation of Securities Commissions, the creation of the European Securities and Markets Authority in 2008, and of the Financial Stability Board in 2009). However, the political project still involves irreconcilable constraints. Every state faces the difficulty to reconcile the need for boosting growth while also implementing their austerity programmes. Difficulties also arise from the fragmentation of sometimes conflicting, individual interests between countries. This is not only slowing the process; it creates a serious threat for the accurateness of the end rules. The fragmentation of legal frameworks is another source of potential inconsistency in the implementation of the reforms. Finally, it remains uncertain whether the regulatory objectives at stake will suffice to make the system healthier. Further technical responses will certainly need to be brought in the field of crisis and conflict of law resolutions. As an example, today many EU banks are reported to be stuck in clawback actions engaged by US courts against them in relation to assets beneficially owned in Ponzi schemes by their underlying clients. The impact of such a situation is certainly counterproductive to the sound progress of the regulatory agenda by raising defiance in the industry towards the US. Fighting for appropriateness
The goal of bringing financial markets back to health is about identifying the illness, finding the right treatment and applying it properly while considering possible side effects. Although there has been general agreement on a list of factors having contributed to the crisis, there is less consensus on which of these were important and the consequences in terms of need for regulatory change. Certain issues are being actively debated. However, it is clear that the industry will have to live with a degree of uncertainty as to the overall impact for them until the rules are effectively implemented at the level of each country. At minimum the industry needs to get prepared to cope with a certain amount of additional burdens and changes in order to meet the new standards. Adaptation will be mainly driven by the need to limit costs. The AIFMD involves depositaries developing new functions like country risk monitoring or the legal assessment on effective segregation of assets. To reduce their costs, some depositaries might be looking at outsourcing solutions or may consider adopting models whereby typical middle management functions like matching, reconciliation and collateral management are outsourced. They may enter into partnerships with prime brokers to limit legal and negotiation costs, as well as control other operational risks. The need to limit risks is another factor that might drive the evolution of business models: in reaction to the strict liability regime that will likely apply to assets held under the custody of prime brokers or to collateral assets which are not transferred in full ownership, some predict depositaries might impose limits on levels of leverage or collateralisation set-ups. Playing the card of competition
The magnitude of the changes imposed makes it extremely difficult to evaluate the consequences for the industry on a macro level. Are CSD regulations, combined with the AIFMD reform, likely to encourage direct custody structures? Will it at least mean the end of complex holding structures involving regional custodians? Will smaller players survive? Who will absorb the ultimate costs? Some have predicted greater attractiveness of the US for clearing derivatives. And MIFID might open the door for third-party competition on EU territory. Dodd-Frank might lead Europeans to withdraw from certain operations and investments on the US markets, or the European industry will finally cope with Dodd-Frank and dispense with some activities in their business models. The revamp of activities could also translate on the commercial side with EU providers chosing to close accounts for US investors, or taking this as an opportunity to reorganise their business around the need to service this segment of clients. It is too early to say whether the G20 will meet its goals and what the consequences will be for the global industry models. At this stage, all scenarios remain plausible in terms of possible reorganisations, be it geographically or around the functional chain. Beyond this, the industry will have to live with the lack of visibility and control on whether and how new organisations could impact existing, well established risk management set-ups. The monitoring of hidden risks will probably be the next challenge to go through in the coming years. Sandrine Leclerq is counsel at Baker & McKenzie ©2012 funds europe

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