After Us, the Deluge
The financial crisis of 2008 shocked the world. A natural reaction to this disaster was the creation of new regulatory regimes in multiple jurisdictions aimed at preventing a reoccurrence. It’s hard to argue with the intent. The issue is one of appropriate design and implementation.
To say that these new regimes have increased the compliance and reporting burdens on financial services firms of all stripes is an understatement of the highest order. Some have criticized the extent and intrusiveness of the new fixed income industry regulations as an extreme case of regulatory overreach. Part of this argument asserts that the response to the failure of the regulators to prevent, mitigate or in some cases even to recognize the existence of the problems until it was too late, is for the same regulators to impose more of the same. It also has been suggested that the crisis was caused and then made worse, in significant part, by a government-backed regulatory regime in the U.S. centered around the unreasonable promotion of the housing GSEs.
One way to look at these claims is in the words of the renowned financial sage and market commentator Pete Townshend, who sang “meet the new boss, same as the old boss”. Less-often quoted was another of Townshend’s lines claiming, “the men who spurred us on now sit in judgment of all wrongs”.
"There are worthwhile regulations that have been put into place and they are unlikely to go away."
As prescient at these remarks might have been fifty years ago and as applicable as they might be to the current situation, they nonetheless fail to offer a concrete solution to a major market failing. While some of what has been imposed might qualify as unjustified, there are worthwhile fixed income industry regulations that have been put into place and they are unlikely to go away. And more are coming. A better course of action is to understand them and to develop programs that enable compliance and which also dovetail as closely as possible with the firm’s core competitive strengths, to permit an ongoing growth in revenue.
In Part 1 of this two-part blog post, we highlight some of the recent regulations, current and impending, that are likely to be among the most impactful for sell-side and for buy-side firms that traffic in fixed income securities. In addition, we argue for taking a holistic approach to the regulatory environment. In doing so, we identify a common theme that links the various regulations – a unified framework, so to speak.
In Part 2 of Won't Get Fooled Again: Fixed Income Industry Regulations, we go beyond this statement of the issues. By utilizing the unified framework identified in Part 1, we propose a path that offers solutions; one that enables firms a way to help assure regulatory compliance, while at the same time enabling them to grow revenues and profits through the intelligent use of technology.
An Abridged History of 21st Century Financial Services Regulations
We focus here on the last decade or so. Most of the fixed income industry regulations cited will be familiar to practitioners. Some are U.S.-centric, while others are more global in scope. The list is intended to be representative of some of the key regulatory requirements, rather than exhaustive.
Amongst the earlier fixed income industry regulations are Sarbanes Oxley (2002) and the Dodd-Frank Wall Street Reform and Consumer Protection Act (2010). The goal of SOX was to protect investors from the possibility of fraudulent accounting activities by corporations. It attempted to do this by mandating improved financial disclosures from corporations and preventing accounting fraud. Dodd-Frank essentially placed the regulation of the financial industry in the hands of the government.
FAS 157 (2007), which was superseded a few years later by ASC820 in the US (and by IFRS 13 internationally), defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP) and expands disclosures about fair value measurements.
The Volcker Rule is part of the Dodd-Frank legislation but the rule itself did not become effective until 2014. It restricts US banks from making certain kinds of investments that were deemed speculative and not of benefit to bank customers. In short, it prohibited banks from proprietary trading.
Best Execution and Investment Company Liquidity Risk Management Programs are SEC rules. Best Ex tries to codify the duty of investment services firms such as broker/dealers and asset management firms to execute orders on behalf of customers so as to ensure the best execution possible for these orders. The SEC’s liquidity management rules are intended to promote effective liquidity risk management by the mutual fund industry, by requiring enhanced disclosure about mutual funds’ liquidity and redemption practices and thereby to reduce the risk that funds will be unable to meet their redemption obligations.
Of more recent vintage are Markets in Financial Instruments Directive (MIFID II) and the Fundamental Review of the Trading Book (FRTB), scheduled to take effect in 2018 and 2019, respectively.
MiFID II focuses on increased market transparency, improved best execution, a move toward increased trading in structured marketplaces, orderly trading within markets, lower cost market data and making the costs of trading and investing more explicit. The FRTB seeks to overhaul the market risk capital requirements established under Basel 2.5, to address shortcomings in the current risk capital framework and to impose more standardization on the market risk weightings of various asset classes across jurisdictions.
It’s the Prices, Stupid
Cleary, the intent of the prior section was not to provide a comprehensive explanation and analysis of the new regulatory regime. Rather, it was to see if we can establish a unified framework that can aid fixed income firms on both the sellside and the buyside in addressing these fixed income industry regulations in ways that are efficient and cost-effective, within the context of how they operate their businesses.
We think we can.
A particular rule or piece of legislation might focus on accounting and reporting, another on trade execution and yet another on capital requirements. With a thoughtful consideration of the regulations taken as a whole, however, one can see that the primary and overarching goals are increased transparency, better liquidity and risk mitigation.
At their core, what these regulations have in common is their reliance on data, especially price data. At the end of the day, the value and therefore the safety of the enterprise is inextricably linked to the value of its assets and its capital as compared to the value of its liabilities.
"Financial firms must begin immediately to collect massive amounts of data that impact prices"
Even a cursory examination of these regulations makes it obvious that financial firms must begin immediately to collect massive amounts of data that impact prices. Ultimately, what these regulations require, however, is much more than merely the collection of more data. Not only must the data be collected, stored and used to generate regulatory reports, they must also be fully integrated into comprehensive systems that are utilized throughout the firm’s operations in a consistent way by everyone in the organization. The days of each department doing its own thing, in its own way and via siloed systems and platforms that don’t connect with each other is over. So are the days of reliance on data and models contained in spread sheets that are then passed upstream to reporting and compliance departments.
In Part 1, we have highlighted the set of key regulations that are the most impactful on the operations of financial firms that deal with the fixed income markets. Then, we posited the need to take a holistic view of these regulations. In doing so, this enabled us to identify a unified regulatory framework centered around the objectives of increased transparency, better liquidity and risk mitigation.
Armed with this insight and the resultant need for data, the essential role of access to accurate and timely price data was easy. Obtaining and utilizing such data in ways that enable compliance, while simultaneously facilitating ways to gain a competitive advantage in the market and grow market share are addressed in Part 2.