In Financial Services Regulation, Global Uncertainty Remains

by Julian Korek

According to the sixth annual Global Regulatory Outlook report published by Duff & Phelps, the financial services industry is seeing some benefits to current regulations, although the industry is doubtful that current regulations are sufficient to prevent another crash.

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Brexit and Donald Trump dominated headlines in 2017, causing a great deal of uncertainty when it comes to global financial services regulations. Despite some clarity from ongoing Brexit negotiations and the emerging priorities of SEC Chairman Jay Clayton, much of that uncertainty still exists.

That was the main takeaway from Duff & Phelps’ Global Regulatory Outlook 2018 survey. In the European Union, murkiness stems from the implementation of the Markets in Financial Instruments Directive (MiFID) II and the looming General Data Protection Regulation (GDPR), which will take effect in May. On the latter point, almost half of the survey respondents said they are not confident they are on track to comply. Meanwhile, struggles with the Senior Managers and Certification Regime (SM&CR) in the United Kingdom also continue and, in the United States, it is fair to say that Donald Trump’s campaign pledges to dismantle the Dodd-Frank Act remain mostly unfulfilled, as it pertains to private fund managers.

With those factors as a backdrop, few survey respondents expect the overall regulatory burden and impact to ease: 95 percent say regulations will increase their costs, and almost a quarter (24 percent) said they would spend more than 5 percent of their annual revenue on compliance by 2023. In fact, 11 percent say they would spend more than 10 percent on it by that year.

Cyber on their minds

Like 2017, the big regulatory growth area remains cybersecurity—only more so. About three in 10 (29 percent) say this will be regulators’ primary focus in 2018, and more than half (54 percent) think it will be among the top three priorities—leaving aside the 22 percent naming GDPR.

Cybersecurity is now ahead of even Anti-Money Laundering and Know Your Customer regulations among regulatory concerns. The cybersecurity focus will only likely intensify as regulatory expectations in this area are still shaping up.

The cyber focus is not just about regulatory pressure. The spate of cybersecurity breaches over the last year has contributed to firms’ determination to address the issue. As a result, 78 percent of respondents expect to spend more resources and time on it in 2018.

The key question is whether that spending, and the regulation prompting it, will prove effective.

How useful is regulation?

Compared to previous years, respondents are more confident in the effectiveness of regulation. A slim majority (51 percent) now say they expect financial services regulation to increase market stability -- up from 42 percent in 2017. Still, that leaves 29 percent saying that regulation has no effect on stability and 10 percent saying it makes it worse. Moreover, the proportion saying financial services regulation is likely to enhance investor confidence is down to about a third (35 percent), with 56 percent saying it has little impact and 5 percent saying it damages it.

Certainly, the limits of regulation are understood: As in previous years, few respondents believe regulatory changes have adequately safeguarded against a future crash. Most (57 percent) say the issues has only been partly addressed, while 28 percent said they haven’t been addressed at all.

Wanted: More harmonization 

Regardless, it’s clear that firms want greater regulatory harmonization. Almost one in five (19 percent) say it’s the single most important factor in maintaining an effective regulatory system -- second only to principles-based regulation. Most (52 percent) agree that regulators are improving their ability to coordinate across borders, but few (29 percent) think they have been effective in establishing consistent global regulatory standards. This is largely the same as in previous years of the Duff & Phelps survey. A more interesting issue, perhaps, is whether firms are right to yearn for those consistent standards.

Of course, it’s understood that regulation can have some positive impacts: A third of respondents said it “expands market reach” and almost three-quarters (73 percent) concede regulations encourage improvements in internal systems and control.

Regulatory harmonization might alleviate some of the burden and complication of complying with different standards across jurisdictions. Given the tendency when it comes to regulatory alignment to level up to the highest standards in operation and to harmonize without necessarily removing duplication, it’s unclear whether greater consistency across jurisdictions would reduce, or add to, the cost of compliance.

The Brexit effect

That’s particularly significant when it comes to Brexit. About one in five (21 percent) respondents said Brexit had an immediate impact on their compliance programs with changes already being made or planned for the next six months. Another quarter (26 percent) expect changes within 18 months.

As to how big those changes will be, much will depend on the final agreement reached, but United Kingdom Prime Minister Theresa May has recently ruled out passporting for financial services after the United Kingdom leaves the EU. This, she said, was “intrinsic to the single market of which we would no longer be a member.”

Brexit’s impact remains to be seen. Yes, it is a risk—and not one that many survey respondents feel terribly confident about. While 53 percent say London is the current pre-eminent global financial center, only 29 percent expect it to be so in five years. But Brexit also presents opportunities – and many firms are considering their options in anticipation of Brexit to continue marketing in the EU, such as using management companies and revising their operating models.

But Brexit may also open up opportunities in other jurisdictions through new trade agreements to distribute products. In any case, it remains a complex regulatory and market environment for the industry across the globe, and it will need to be managed dynamically. The success with which firms do so could prove a differentiator in the next few years.

Technology at the heart of it all

Brexit is not the only opportunity for firms in the regulatory space. The reason cyber risks are such a key regulatory focus is because of the increasing power and pervasiveness of technology in financial services. Just as firms are embracing this in their businesses, so too are regulators in their work in detecting and preventing market misconduct.

As regulators’ sophistication grows, their expectation of firms’ own capabilities to automate compliance and market monitoring does, too. On one hand, that’s a significant threat for those firms that fail to take up the challenge, particularly in light of the continued drive towards individual accountability evident in the UK’s SM&CR and Hong Kong’s equivalent.

On the other hand it could offer two benefits. First, the promise of more orderly markets, which should be good for the industry as a whole and prevent the unscrupulous and unfair gaining of advantage. And second, the potential for solutions that, through automation, actually ease the regulatory burden, and perhaps halt the rise in compliance costs.

Julian Korek leads Duff & Phelps’ Compliance and Regulatory Consulting practice.