Technology, Training & Compliance in Light of the Fiduciary Standard

Technology, Training & Compliance in Light of the Fiduciary Standard
Capturing retirement assets is paramount for brokerages. When thinking about the word saving, it is hard not to think about retirement.  Brokerages are constantly looking for rollover assets, and as baby boomers retire, this search has never been more significant — which is why, when the DoL Fiduciary Rule was proposed, brokerages quickly reacted.

  April 10, 2017, when Phase 1 of the DoL Fiduciary Rule goes into effect, is quickly approaching.

  My latest report, The Quest for Retirement Assets: When the Light Shines on the Fiduciary Standard, explores ways that brokerages are reacting to the DoL rule. Brokerages continue to rethink their operating model. Brokerages are questioning their existing technology: Can it support a new business model? How should training be embedded and amended to support compliance with the DoL Rule? In my report I lay out some of the challenges facing brokerages, as well as best practices for compliance and training.   Regardless of whether the DoL rule is delayed, changed, or repealed, advisors need to know how to clearly communicate their offering to clients as it relates to the fiduciary standard. Investors are more aware than ever of the fiduciary standard. Even if the DoL relaxes its stance, there is no doubt that investors will continue to pressure advisors to act as fiduciaries. It won’t be long before clients ask for proof that portfolio transactions and ideas are made in their best interest.  

Improving Operational Efficiency in KYC-AML Using AI solutions

Regulatory scrutiny and growing cost pressures are severely impacting Know Your Customer (KYC) and Anti-Money Laundering (AML) operations of financial institutions. Discussions with several banks have revealed they are finding it hard to keep track of constantly evolving regulations, interpret and implement global regulatory changes at a local operational level, collect and refresh information from numerous sources and systems across different businesses and jurisdictions, manage and analyze growing volumes of structured and unstructured data to identify patterns, networks, and beneficial owners, while containing costs amidst a difficult economic environment.

Banks so far have looked to address the challenges by hiring more staff, as traditional rule-based KYC-AML technology necessitates significant dependence on manual efforts. But too much reliance on manual efforts can make the process costly, error prone, and inefficient. Banks therefore need to think out of the box and consider new and innovative solutions to alleviate operational and cost pressures.

Adoption of Artificial Intelligence-enabled solutions could be one way to mitigate current challenges, increase efficiency, and reduce costs, as they can not only automate significant parts of operations but also offer superior insights through advanced capabilities for analyzing structured and unstructured data. In a new report, Celent discusses several challenges plaguing financial institutions’ Know Your Customer (KYC) and Anti-Money Laundering (AML) operations, and proposes how Artificial Intelligence (AI) enabled solutions can help in addressing them. This report was commissioned by NextAngles, an Mphasis Fintech venture, while Celent kept full editorial control. The report is available for download here.

Benchmark manipulation and market surveillance

The CFTC has recently revealed the instant messages written by Citigroup traders related to benchmark manipulation. Having recently published a report on Market Surveillance industry trends and soon to publish another one on the leading vendors, this seemed quite relevant. Current surveillance systems, be it for trade or communications surveillance, use the latest technology to capture possible instances of market abuse or manipulation. The capabilities are far beyond what was available a few years ago, and are holistic and comprehensive in nature. But in the end, the system is only as good as the people using it. The recent revelations have put a question mark over not just the traders involved in the benchmark manipulation scandal, but also the management of some of the leading institutions. Some firms are now going to great lengths to monitor their traders, but this is not an end in itself. The industry culture has to be transformed. The next instance of manipulation will not be in the same place and firms would have to overcome the motivation to profit in order to ensure compliance. The rise in the levels of regulation in the last few years probably would play the part of a positive reinforcer in the decision-making process and help influence industry culture, but is not a guarantor of propriety.

The future is here

The pressures are well known in banking and the capital markets. Each month there are front page articles of scaling back, overhauling, reorganizing, or closing major bank lines. A continued reworking, a forging of a new business is occurring. Old models are shrinking and being replaced by new business models or being cast aside. Since the 2008 crisis, wave after wave of pressure has made this perfectly clear. Capital constraints, on-going regulatory pressures, and an ultra-low interest rate environment have all struck hard at the existing banking & broker/dealer system. Nearly all players-big and small- are rethinking the very core of their businesses. And this is a multi-threaded problem across all businesses: equities, FX, fixed income, and derivatives. Banks and broker/dealers are trying to balance their existing franchises against the pressures they are facing to create a lean profitable business that supports their clients. There are no easy answers, given the strong interdependence between the wealth, asset management, and capital markets businesses across all products. Many of the solutions are moving from efficiency, or cost-cutting to effectiveness. Costs are being cut-there are improvements in risk, compliance, processing. The cost side is getting better but the challenge remains on the revenue side. This drive for effectiveness is driving business models that support internal and external clients from a compliance, transparency, regulatory, fairness and cost perspective are driving more automation and electronic trading solutions. Celent will be discussing the evolving landscape of innovation in automation and technology at two upcoming roundtables. On September 15th in London we will be looking at changes in the US and European fixed income markets and how new technologies are driving change. Then on September 22nd in Zurich, we will be looking at wealth management and the capital markets and the many changes that are occurring in Swiss banking.

Operations challenges for APAC asset managers

The global capital markets have been going through a turbulent recovery phase in the last few years. Asia-Pacific is no exception to this rule and the region’s asset managers will come up against a set of operational issues and constraints to be addressed in a difficult market environment. Addressing regulatory pressures, be they from within their own jurisdiction, or from without, will be paramount in the mind of asset managers. It is important for managers to consider the various KYC and AML requirements internationally and how they affect their respective jurisdictions. This is not an isolated enterprise, and must be undertaken along with the task of upgrading the operational capabilities, and if required, acquiring the necessary platforms or systems to address these concerns. As much as possible, asset managers must try and use a comprehensive solution, underlining a desirable holistic approach to the issue. Most asset managers will meet their various operational requirements by using a mix of in-house and third party services. Outsourcing is nothing new to the industry, but can still be challenging. It has its own set of risks which need to be considered and mitigated for successful operations. Firms have to ensure a strong integration of the outsourced services with the in-house operations. Another challenge is the complexity of products being utilized by asset managers to meet their clients’ needs. With more choices available and structured products becoming popular again in leading Asian jurisdictions, firms have to ensure that their risk management systems are capable of handling greater product complexity. These are only some of the issues asset managers need to keep in mind, and overall they would be well served with taking a more holistic approach to operations management, and ensuring they make sufficient investment in their systems to help them handle the various challenges.

Market Surveillance issues

As I begin work on the last in the current series of Market Surveillance reports, there are some important points that we can reiterate from the recent research. The first is the all encompassing requirement for surveillance. The recent Deutsche Bank co-CEO resignations have shown the negative impact the benchmark manipulation related sanctions and fines had on not just this bank but the industry as a whole. Similarly, the investigation of a couple of British banks regarding the payments made in the FIFA bribery scandal also shows the need for constant vigilance on part of banking and capital market participants. Firms are embracing the need for holistic surveillance and compliance, which covers not just trading but also related areas such as best execution, cyber-security and AML. Firms that have legacy systems in place might want to continue with several systems, but for the better part, most firms would prefer to have one system that meets most of their requirements. As more advanced technology becomes available, this is becoming more of a reality. Another important aspect is the rising use of machine learning capabilities. Surveillance systems are becoming more advanced, processing both structured and unstructured data, especially through the use of cloud based processing and Big Data technologies. Machine learning takes this to the next level, as it reduces the need for human intervention, and allows for reduction in false positives and negatives. Furthermore, such advanced systems also allow firms to keep tabs with new compliance requirements more efficiently as they can anticipate problem areas based on learning from past experience. Finally, exchanges and sellside have been the main users of market surveillance technology. But increasingly regulators and buyside firms have also started acquiring these systems. For regulators, it makes sense because it allows them to monitor the market independently and reduces their dependence on the exchanges and the sellside for data and analysis. For buyside firms that are playing a more active role in the market, it is important that their trade surveillance is upto scratch, otherwise they are making themselves vulnerable to the same issues that are plaguing sellside firms at the moment.

Smaller buy side firms and regulation

Increased regulation has become a way of life in the financial markets. Buy side firms are also devoting a lot of time and energy to meeting regulatory requirements. The share of expenditure for regulation and compliance has also risen accordingly. Firms are often building their IT strategies around the various requirements arising from Dodd-Frank, MiFID II, FATCA, Basel III, EMIR and so on. In this environment, smaller buy side firms are possibly in a tougher position than some of their larger asset management and hedge fund counterparts. The reason is that they do not have the same financial and technological capability and hence have to often adopt a more piecemeal approach to regulation and compliance. Their IT systems and platforms are also not geared fully to meet these needs, and streamlining the same is often beyond the capacity of many such small firms. An interesting development that has resulted from the spate of regulations post-financial crisis is the reduced participation or even effective withdrawal of the banks from different types of risk-taking activities. This has been accompanied by the effort by buy side firms to fill some of these needs. While this is an important area of opportunity for buy side firms, it is also something they should be cautious about. The reason is that the increase in buy side activity has to some extent moved the sell side risk to the buy side. This is accompanied by some liquidity problems due to the declining sell side activity. While smaller buy side firms are probably affected less by this issue than some of the largest asset managers, nevertheless they need to ensure their risk management systems are capable of bearing any new and additional stresses that the larger systemic role of the buy side might bring. Celent is currently conducting a lot of research looking at the various requirements of buy side firms, and I am about to publish a report that discusses the specific needs of smaller buy side firms when it comes to regulation. This research would also look at some of the ways in which these firms can cope with their pressing demands, and discusses how it is important for them to stand back and take a more holistic approach to regulation.

Will There Be Another Financial Crisis? Yes

Note: I posted this, but it was written by Axel Pierron, Senior Vice President, Securities & Investments. – JC On the occasion of the fifth anniversary of the collapse of Lehman Brothers, people are asking whether there will be another financial crisis. The answer is: yes. Therefore the question is: Are we ready for the next crisis? The major regulatory push has been to address the issue of OTC derivatives trading, which was perceived as the source of the Lehman default, and the AIG bailout. However, with OTC derivatives being centrally cleared, we are raising the level of systemic risk by implementing a common process/infrastructure across the various asset classes. The first rule I learned in grad school was: to minimize your risk, you need diversification.  If you take the analogy of Darwin’s theory of the origin of species, the most adaptive species are the ones that survive. Mother Nature does not put all her eggs in one basket. Today, regulators are doing the opposite; hence the next crisis could be much more dramatic.  My overall concern is that the regulations will ensure that a minor crisis does not spread across the industry.  However, we are ill prepared for a “black swan,” and as we have known since 2007, black swans do exist. It’s a balancing act for regulators between leveling the playing field (for example, by syncing effort between the US and the EU to avoid regulatory arbitrage) and allowing some level of diversification and customization. Nevertheless, some fundamental questions have not been addressed, and we are not questioning how the crisis was handled. Maybe Lehman should have been bailed out as well? Or perhaps there should not have been any bailout? Capital markets are based on risk and reward; one could argue that the bailout program has removed the risk element and sent the wrong signal to the industry and the public. In summary, regulators are working to create a framework to avoid a 2007-like  crisis. However, while crises are integral to the functioning of financial markets (we call it a crisis, but in fact it’s a readjustment), their detonators are always a surprise to most people. It would be better to  learn from our experience to  develop a framework to respond (e.g., chain of command, bailout or not, synchronization of central bank policy, etc.), because crises are inevitable. The current regulatory approach reminds me of the French army in the 1930s leveraging their experience of World War I and building the Maginot line, when in fact World War II would be fought with tanks and airplanes. The last battle is over, and we need to prepare for the next one.

Lehman Anniversary Musings and Wish Lists

There are a multitude of Lehman Brothers anniversary stories going around, and perspectives can get lost. Hence, I decided to let a week pass before I commented on the fifth anniversary of the infamous collapse of Lehman. I promise to make these points short (and hopefully sweet). What have we really learned from Lehman and the last crisis? Apparently the financial industry is unable to regulate itself, so is it really a surprise that it now needs to be externally regulated? We have opened Pandora’s Box. Virtually every sector within financial services is facing heavy regulations. But the problem I have is that the current paradigm of external regulation is expensive for everyone (expect perhaps regulators, lawyers, and consultants), compared to a scenario where the industry can learn to govern itself appropriately. So, what can we take from five years ago? Many lessons have been identified around short-term funding concentrations, leverage, mispricing of risk, misaligned incentives, lack of governance at both board and industry levels, complexities in the valuation of “hard to value” assets, and the potentially fatal interplay of various risks.   Will we have another crisis? Despite the changes the industry has made, one gets a sense that the consequences — the unpalatable prospect of capital and liquidity shortages, negative impact to the cost of funding for banks, corporates, and small businesses; and the ongoing threat of counterparty failures — all linger in various guises today. By that token, you could say that we have treated the symptoms but not the causes. The “virus” of inappropriate culture, failing to govern (e.g., treating risk management as a formality), and not using the right information to make risk-adjusted business decisions are still in the blood of the industry. A new crisis may emerge before we know it. Some observations: In the last year, corporate earnings have failed to track recent market rises. Yet US equities are up 30% over the past 18 months, while earnings have only risen 6%. Has the investment community become trigger-happy to trade while ignoring fundamentals? How soon did significant operational risk failures and conduct incidences happen after the firms, regulators, and governments supposedly “learnt the lessons” of 2007/2008? Unfortunately, not long after. We are still seeing market trading failures (Knight, Nasdaq), whale trading losses, LIBOR rigging, and product mis-selling.  We have observed (and here, regulators and policymakers are not exempt) how L/ZIRP (low or zero interest rate policy) created a bubble in commodities (which has burst). It created a bubble in emerging markets (which has deflated), and it is creating a bubble in bond markets — all of which may pose a major risk in the event of rise in rates or aggressive QE tapering. The boom and bust dynamic seems to be rearing its ugly head again. Old habits die hard.   What does the Holy Grail of risk management look like? I will answer in terms of outcomes I would like to see, rather than how the mechanics of risk management need to look like. I will know that the Holy Grail has been found when: 1. Regulators and firms embrace the right rules and the right tools to spot future financial bubbles. 2. Frontline personnel that pursue risks (and rewards) within organizations are directly compensated (based on both soft and hard incentives) according to the risks they are taking. 3. We have resolved the “too big to fail” problem, and taxpayers no longer need to bail out firms they are not responsible for.   For me, the longer-term questions are: Has the industry taken the right medicine? We know that there were bitter pills prescribed, but were they the right ones? Are we still taking the medication, or have we forgotten? We need to follow through; if the lessons of the last crisis do not improve our ways to anticipate, prevent, or manage the next crisis, then what have we really achieved? Undeniably, stringent capital, collateral and liquidity requirements are some mechanisms that can preserve stability and mitigate risks during crisis scenarios, but these are not necessarily preventive in nature. In the end, perhaps cultural astuteness about risk-taking within financial firms and a better understanding of the collective behavior of capital markets globally are the most effective medicines to avert systemic failures. For now, my advice would still be: Buyer beware!

Uh Oh Moments: What’s coming next?

In line with the market’s deliberations around systemic risk, central clearing, and its subsequent impact to demand/supply dynamics around collateral assets, BIS Committee on the Global Financial System recently released a paper on Asset encumbrance, financial reform and the demand for collateral assets on 27th May. As I poured through the pages of this well-constructed report, there were a couple of “Uh Oh” moments in my head as I examined the paper’s key policy (and eventually, market) implications. Here’s what caught my eye:   1) Disclosures on asset encumbrances: “Market discipline can be enhanced by requiring banks to provide regular, standardised public disclosures on asset encumbrance… Such disclosures would include information on unencumbered assets relative to unsecured liabilities, on overcollateralisation levels, and on received collateral that can be rehypothecated… Supervisors, in turn, should receive more detailed and granular data, as required, including the amounts and types of unencumbered assets.”

Uh Oh #1: More granular regulatory reporting and requirements around the level of “free” assets on an institution’s balance sheet look to be coming. There are profound implications for how financial firms manage and inventorize the components of their assets, liabilities and shareholders’ equity at any given time (including collateral).

  2) Risk-sensitive deposit insurance: “… deposit insurance schemes could be made risk-based (e.g. through the inclusion of a dedicated risk premium in deposit guarantee pricing), taking into account the funding structure of insured institutions in normal times. The pricing could differ depending on… resolution rules.”

Uh Oh #2: “Pricing in asset encumbrance in deposit insurance schemes” seems to imply regulatory capital/RWA increases, through Basel IV or sooner through Basel III.5??

  3) Expansion in scope of stress testing: “…banks should be asked to perform regular stress tests that evaluate encumbrance levels under adverse market conditions.”

Uh Oh #3:  Expansion of dimensions to stress test – in this case, related to asset encumbrance levels, funding scenarios and collateral frameworks. Institutions need to ensure stress testing practices are sustainably repeatable and sufficiently automated.

  4) Oversight and possible regulation of the currently unregulated: “Central banks and prudential authorities need to closely monitor and oversee market responses to increased collateral demand and their effects on interconnectedness… in securities financing markets [e.g. securities lending, repo] and for shadow banking activities.”

Uh Oh #4: There seems to be an undertone that anything “unregulated” is “bad” and risky. We anticipated this trajectory in our recent “Shadow Banking Products in Europe and North America” report and highlight how different products are used, risk management implications and technology advancement opportunities that various products may represent in the coming years. What’s coming could include the possible central clearing of securities lending and repo activities, more position/exposure reporting, restrictions on re-hypothecation of assets and other forms of transparency reporting, etc.

One wonders if regulators are now stepping into the territory of choking economic activity. Do we really need to fix what is not really broken? Is transparency for transparency’s sake necessarily beneficial to the way markets operate?

  5) Extend of collateral rehypothecation permitted: “A particular aspect that has received considerable scrutiny in the policy debate on securities financing markets is the extent to which rehypothecation activities should be permitted. The recent crisis experience suggests that greater reliance on rehypothecation in financial intermediaries’ balance sheets will increase interconnectedness and make them more vulnerable to financial shocks. Rehypothecation of client assets can also delay the recovery of assets or even impose losses on beneficial owners.”

Uh Oh #5: “Interconnectness” of the financial system is a concern, but it is also inevitable given the manner capital, derivative market reforms and collateralization rules are implemented. Instead of working to stop this interconnectedness from happening, regulators could do well to put in place “in-time circuit breakers” in the financial system to only “trip” when stress scenarios and adverse market conditions bubble up (pardon the pun).

  Whilst the above points remain “thinking points” and nothing is concrete, it does provide us with a possible glimpse of what is coming. If we think that regulatory burdens in the financial industry are onerous now, regulators are only getting started! Keep your strategy nimble and technology sufficiently flexible – built not just for current requirements, but for future changes. These changes may come sooner than you think! ————– For more detailed perspectives, please see the following: Maximizing Collateral Advantage: A Survey of Buy Side Business and Operational Strategies Shadow Banking Products in Europe and North America Equipping the Front Office for the New Risk Environment Cracking the Trillion Dollar Collateral Optimization Question Strength Under Fire in Risk Management