How are they preparing to respond? Based on my numerous conversations with hedge funds, asset managers and other buy-side firms, we should expect another year of heavily scrutinized budgets, difficult resource allocation decisions and additional staffing costs, as well as the need to implement new reporting systems and make technology upgrades.
In 2020, there are three key pieces of regulation running in parallel which will impact buy-side clients – the Uncleared Margin Rules (UMR), along with key provisions of the Securities Financing Transaction Regulation (SFTR) and the Settlement Discipline Regime (SDR) of the Central Securities Depositories Regulation.
UMR will impact firms globally. SFTR and SDR, although European in origin, will affect any company with transactions executed and settled in a central securities depository in Europe. At the same time, financial institutions are also feverishly readying for the Libor transition and Brexit adjustments. Needless to say, it’s going to be an intense period of change for the financial sector.
This regulatory tsunami is challenging traditional buy-side operating models and introducing new costs and regulatory reporting requirements. For instance, UMR’s waves 5 and 6, taking effect in 2020 and 2021, respectively, will predominantly impact funds and institutional investors, requiring some buy-side firms to acquire new skills and competencies in order to undertake functions which they’ve never performed before.
Many firms are expected to make securities lending a key element of their liquidity management strategies to offset the operational and funding costs of UMR. However, this will likely create a domino reaction because the reliance on securities lending will increase reporting obligations under SFTR and could have an adverse effect as firms look to mitigate settlement risk under CSDR. This illustrates the compounding impact of multiple regulations and serves as a reminder of the dangers of unintended consequences.
The implementation timeline of these regulations creates other challenges for the buy-side as they start preparing for compliance. With the forthcoming implementation of SDR, buy-side firms have to undertake an analysis of the cause of their failed trades as financial penalties will be incurred should a trade fail to settle under the mandated T+2 timeframe. More than that, failed trades will also lead to a possible buy-in process, which will have resource and cost implications.
For SFTR, while the implementation date for the buy-side is Q3 2020, certain information such as legal entity identifiers and unique trade identifiers may be required by their dealer counterparties before reporting obligations are phased in. This means that some institutions may need to be ready for a ‘soft’ go-live date ahead of the official deadline to ensure information requirements can be met.
Against this backdrop, buy-side firms, which are already grappling with intense cost-cutting pressure and tight operating margins, now find themselves in the difficult position of having to upgrade in-house systems or perform major overhauls of out-of-date platforms to comply with these and other regulatory mandates while still growing their client-service capacity. Increasingly, many buy-side firms are looking to outsource some of these functions to third parties to avoid the investment needed to modernize their in-house infrastructure.
Recently, a client told me that with regulation moving so quickly, it’s more cost-effective to have a vendor take on the responsibility of implementing ongoing technology revisions. In his view, a service provider has the subject-matter expertise and capacity to monitor ongoing developments in the regulatory environment, such as timetable revisions, expansion of scope and extension to new jurisdictions. We can expect to see this trend to gain steam in the coming years.
Given that regulation shows no signs of slowing down, the buy-side will need to continue preparing to comply with these new rules amidst a diverse set of ongoing business pressures. This creates opportunity for external service providers to tackle these challenges head-on so firms can focus on growing their business and meeting the needs of their clients.
This article first appeared in Global Investor/FOW on January 28.