Moving to a ‘new normal’ in financial markets?
In the first of a two-part special, Allen & Overy’s Michael Huertas and Kai Andreas Schaffelhuber look at the consequences of a tumultuous 2016

A lot has changed over the past year with financial markets seeing a fair amount of turmoil. The bounce-back and the weathering of volatility have made for challenging markets.

A range of systemic, political and macroeconomic important events have shaped 2016 and will ultimately shape 2017.

These range from fears around a slowdown in China, troubles in the Italian banking sector, which many fear could make Greece a ‘sideshow’, and a general rise of populism and anti-establishment politics.

These fears have also spilled over into the banking sector, culminating in profitability stresses from new disruptive threats to business models, lower for longer interest rates and non-performing exposures into other asset classes.

However, in comparison to markets in previous years, performance has generally held-up.Nevertheless, it has been a busy year, and that was before one even looked at what was happening in EU legislative and regulatory work-streams.

The ‘regulatory pause’ that a number of European market participants and stakeholders called for in 2015 with a view to advancing supervisory calibration, i.e., harmonisation of rules and processes to existing rules or concrete proposals, did not materialise in 2016. What did surface was further clarity around the ‘end state’ that EU policymakers are committed to advancing.

Part of this is detailed in the EU’s capital markets union (CMU) project that started in September 2015 and was extensively promoted during 2016 to ensure it advances with sufficient impetus. The other part saw the finalising of the first two pillars of the banking union and delivery of key regulatory initiatives to create more resilience in the eurozone banking sector.

All of these items were also tied together by overarching initiatives, including the EU’s ‘better regulation agenda’, which is to be put in practice on CMU and non-CMU led regulatory work-streams.

It remains to be seen whether this ‘better regulation’ agenda, when put into practice, will have a transformative effect on how markets are traded. It also remains to be seen whether it will allow for easier delivery of regulatory change, both across ‘change the business’ and ‘run the business’ projects/work-streams in various thematic areas where regulatory change is moving from concept design to the implementation phase.

During 2016, planning and preparing for implementation of core items such as the second Markets in Financial Instruments Directive/Regulation (MiFID II/MiFIR), the European Market Infrastructure Regulation (EMIR) review, and the Securities Financing Transaction Regulation (SFTR), saw the move of these work streams from ‘horizon risks’ to firms and project teams hunkering down. 2017 is unlikely to be any different.

Making waves across the channel

The EU woke up to a very different reality on the 24 June, following what for many seemed a sure bet that the British electorate was marginally backing its participation in the EU project.

Brexit has introduced a new wave of uncertainty. It has also put the brakes on, both in the UK and the rest of the EU, a number of decisions while others are on the backburner pending clarification on direction of relationships on both sides of the English Channel and the Irish Sea.

This uncertainty has begun to have some real effects. Aside from costlier Marmite and slimmer Toblerones, it has triggered ‘Brexodus’, a term used to define the reallocation of financial services (and other) activities away from the UK and generally to other EU member states, and scenario planning for those firms wishing to ‘Brexit-proof’ their business, regardless of whether they remain or leave the UK.

For those remaining EU members, the UK’s domestic disagreement on a ‘hard’ or ‘soft’ versus flexible Brexit is testing patience. The recent changes in the US have also raised questions on the future ‘end state’ of regulation that the US is moving to and what that might mean for European markets and the worldwide competitive position of the continent’s credit institutions.

This political ambiguity has ushered in a new ‘new normal’ following the one last seen in the aftermath of the great financial crisis. Absent a regulatory pause, this uncertainty risks affecting the pace and content of regulation and that can cause fragmentation rather than harmonisation to take root.

To further complicate matters, a number of regulatory workstreams are now moving at quite different speeds of change. All of this affects how markets are traded, how documentation and compliance are approached by those supervised entities as well as non-supervised market participants. These all have important effects for those engaged in securities finance transactions (SFTs) and financial markets more generally.

The continued pace of regulation: a risk of greater fragmentation than harmonisation?

Even prior to the Brexit referendum, the EU has now found itself moving to a two-speed Europe.

One where the eurozone core is integrating deeper and making its own eurozone-specific rules that harmonise regulation and the rest of the EU, where harmonisation and convergence is advanced across some ‘total-EU’ projects, including the CMU but on others, looser cooperation is put forward as a palatable alternative to calibration and convergence for those non-eurozone member states.

While this reflects in many ways some of the political realities of 2016, it does affect those cornerstone pieces of EU regulation, such as prudential capital regulation but equally SFTR.

Since SFTR’s entry into force on 12 January 2016, it has contributed to creating uniform rules and standards of conduct in relation to the markets and market participants engaged in SFTs.

This is vital as the SFT markets, operations, processes, as well as the documentation and contractual master agreements that underpin their functioning, have varying degrees of fragmentation in rules and processes and some have more to do to meet SFTR compliance.

A number of these operations and processes are already in scope of other pending global, EU, eurozone or national-specific reforms. Not all regulatory concepts established in one area exist or are replicated in another area.

These divergences add to, or even accelerate, risks that gaps and inconsistencies could contribute to ‘conceptual translation risks’. Brexit complicates this exercise by introducing variability in the degree of fragmentation.

With the bulk of SFTR’s provisions starting to enter into force during 2017 and onwards, those risks, unless controlled, can exacerbate costs, inefficiencies and further drive fragmentation as opposed to harmonisation.

In many ways, fragmentation can be seen to be a goal that regulation seeks to tackle but can also (at the same time) be a product of it.

As a result, some market participants may also need to further ‘Brexit proof’ themselves. In part this might mean adopting a comprehensive yet concentric compliance approach.

This is especially the case as the UK, post-Brexit, may increasingly move to distinct UK rules from the ‘twin-peaks’ of the Financial Conduct Authority and Prudential Regulation Authority, some of which may not be equivalent to EU or global rules.

For firms, regardless of where they sit in the EU or the UK, compliance, legal and trading terms need to more joined up in 2017 as supervisory engagement sets to be more intrusive.

The second part of this article, which will look at the practical impact of this uncertainty from the perspective of SFTR, will be published in the next issue of Securities Lending Times.
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