Opinion by, Rachel Scanlon, Managing Director for APAC, D2 Legal Technology
Historically, financial services regulation has been panic-driven – a result of one crisis or another. The 2007 financial crisis, for example, led to significant regulation of the derivatives market, and was successful in reducing risk throughout the sector and rebuilding trust in financial services globally. But what lessons can we take from this approach to financial services regulation? How can we be better prepared and create a framework that allows a series of minor tremors rather than a massive seismic event?
Markets are increasingly instable, concerns over digital assets are escalating, and we face geopolitical unrest and global inflationary trends. As such, Rachel Scanlon, Managing Director for APAC, D2 Legal Technology, highlights the importance of the data-driven regulatory approach in delivering stability in preparation for the next financial crisis.
Collaborative Progress
Financial services regulation has changed fundamentally over the past 15 years. An historic lack of consistency between jurisdictions has been addressed through impressive global collaboration, with regulators and industry participants alike making good progress in achieving equivalence. ‘Too big to fail’ precautions, and a move away from decentralized bilateral transactions through the introduction of central clearing have created a market that is now far more resilient.
Regulators have far more visibility than they used to, such as with derivatives trade reporting, ensuring fast insight into evolving risks. Add in capital and margin requirements, and market participants have greater protection, resulting from a better structure around the giving and receiving of collateral. Moreover, regulators are not acting in isolation; financial institutions are increasingly imposing their own additional compliance demands. For example, following the September 1st deadline for Phase 6 of Initial Margin, financial institutions may expect even those entities that are out of scope for the regulatory margin requirements to provide buffer collateral if they want to continue to trade at the same pricing levels.
This stronger push to meet community expectations is in direct response to escalating market risks. With heightened concerns around interest rate shocks, crypto, and global inflation, financial institutions are planning ahead and beginning to agree additional safeguards between themselves.
A New Set of Risks
However, will the changes made over the last 15 years deliver the desired – indeed required – resilience in the face of a different set of financial risks? Markets are increasingly unsettled and digital banks have been failing. In just the last 12 months, the crypto market has experienced incredible volatility. 23% of European hedge funds hold crypto assets in their funds, yet since November 2021 the market has seen a reduction of more than USD$1 trillion with more than $200 billion of that being lost recently due to the crash of Luna.
The result is decreased confidence in the space, and has proven the need for increased regulation to protect consumers, not only for crypto but also government digital currencies. The decentralised nature of cryptocurrency is a strange counterpoint to the clearing-house centralisation that has historically been the foundation of regulatory change. Ensuring regulatory oversight and appropriate regulation will bring the digital asset class far closer to traditional banking, and into the mainstream.
Yet, digital assets are not the only potential crisis on the horizon. Market confidence is being undermined by geopolitical instability, and inflationary pressures are adding substantial unpredictability. Critically, where the era of cheap money has lasted decades, many individuals now have no experience of high interest rates and do not know how to respond. How well protected is the industry against irrational behaviour from players unfamiliar with this set of financial circumstances?
Data Evolution
We can identify the risks, but it is more difficult to identify how and where the next crisis will develop, as we ask ourselves whether the recent market plunges are a warning sign. Fortunately, we have significant advantages in 2022 compared to the position in 2007/8. Not only has regulation added resilience to the market, but over the past two decades data has become the new religion. The vital importance of understanding and managing legal data for day-to-day operations and essential crisis response is now recognised by regulators and institutions alike.
As a result of diverse trusted data flows, we are seeing a very different regulatory approach from the past. With access to data from multiple sources, regulators and clearing houses are sharing data with other organisations, including tax offices. As a result, inquiries can now be far more specific and timely.
Many institutions have also recognised that data can be used to drive tangible business benefit and have moved beyond a regulatory-first model of data collection and management. However, there remain those who are still operating on outdated models – models that not only add cost but will constrain those institutions’ ability to respond. Why negotiate contracts by attaching a Word document to an email, where it is then updated by the counterparty and returned, when the entire process can be achieved seamlessly in the cloud by securely sharing a link, in a way that is transparent and visible to all relevant stakeholders?
The use of platforms to negotiate contracts and hold information (rather than shared drives or MS Outlook folders) is driving positive behavioural change, including better contract lifecycle management. Enhancing the quality of legal data is ensuring institutions have far better insight into their exposure; it is allowing better dialogue with regulators; and supporting greater collaboration across the business. It is this data that will be key to ensuring institutions are best positioned to weather the next crisis.
Consistent Framework
Combining this data-driven approach with increasing regulator coordination, the industry can move towards a consistent international framework that will further mitigate volatility and instability. While true global regulator coordination remains a work in progress, regulators are becoming more assertive and leveraging their information resources far more meaningfully.
The availability of data and technology also allows better linking of transactions to the legal information that supports them, whether this means bespoke trade terms, ratings triggers, or protection against insolvency via the ability to net transactions upon a default.
Regulators are paying attention, and firms are responding by overhauling their systems and processes. The investment in automation and netting engines, for example, is providing a chance to move forward, to use data to mitigate internal risk and reinforce the importance of regulatory capital and close-out netting in addressing global financial risk. As with the margin requirements outlined above, industry players are coming together to find solutions – not only ahead of the regulator but also taking their own internal initiatives to better reflects market risk and operational requirements.
Conclusion
Without any doubt, regulatory change has improved financial resilience. Regulators and the financial industry have done a hugely impressive job of achieving major structural change, protecting companies against insolvency, improving transparency and adding collateral rules to improve protection against failure.
The COVID-19 pandemic did not tip the global market into financial crisis. The war in Ukraine continued for six months before inflation began to spike and recession became more likely. Whether our framework can hold off the next crisis and instead allow a series of minor tremors rather than a massive seismic event is yet to be seen.
Yes, additional challenges lie ahead. And while we have learned meaningful lessons from the lack of global coordination that undermined the response to the 2007/8 crisis, and the reliance on tactical solutions to meet unachievable deadlines, we must now build on the depth of digital data resources at our fingertips. Although existing data quality does threaten to slow down progress of internal initiatives, firms and regulators are at least starting to understand the importance of digital data resources and are planning to address these issues.
If financial regulations are to continue to improve stability and reduce investor risk in the face of emerging crises, it is vital that the industry takes advantage of the new data era and the availability of both information and systems that can transform our understanding of risk, and support intelligent response.
