Asset servicing is a critical component of the collateral ecosystem. However, as an industry, it is often an unsung, unseen and underappreciated afterthought both with regulatory and supervisory policymakers as well as market participants and market infrastructure providers that rely upon it to function. Even with the tome of change that the second Markets in Financial Instruments Directive (MiFID II)/Markets in Financial Instruments Regulation (MiFIR) has brought to bear in the run-up and start of 2018, the breadth of compliance workstreams will likely stay as the delayed transposition efforts continue. The pace of change is also likely to quicken on both sides of the Channel and the Irish Sea as the UK and the EU-27 move to meet reform goals of existing change as well as those that are in the pipeline let alone those that are Brexit driven.
There is also a deeper-rooted level of change afoot than just legislative and regulatory developments. Digital disruption is shaking up how processes work and who operates let alone supervises them. ??
The interest in and the prevalence of innovative solutions and processes in the post-trading space is being advanced by asset servicers as well as clients.
This has raised profound questions and debate on ‘man versus machine’ or ‘man leveraging machine’. It has also settled the importance of data as a commodity and data analysis along with regulatory reporting as a much more monetisable workstream in its own right and one that is beginning to propel new business models and client needs.
Yet, in many ways the uncertainty of Brexit, the risks that have begun to appear in relation to some automated offerings, both in terms of providers but also the solutions themselves, mean that the post-trade space is likely to remain reliant on human-assisted channels to ensure both responsiveness and resilience to known idiosyncratic and systemic risk exposures as well as the range of known and unknown risks being driven by political and macroeconomic uncertainty as well as increasingly tech-specific risks. To further complicate matters, much of the technology platforms in widespread use in the asset servicing space may be built on legacy systems, slow digital communication channels (in particular fax) and legacy operational arrangements, whether documented or undocumented. This means that digitisation, and more likely the bots that are coded and employed in these areas and across workstreams may have to come leaps and bounds and span a greater degree of interoperability.
Whereas some market participants have begun to take the plunge and prioritise replicating asset servicing of for instance cryptocurrencies and other digital assets and others have even begun engaging or facilitating in margin lending or other monetisation of such assets, this is very much a grey area regarding how it is taxed, regulated and supervised. So too is the full spectrum of what digital ledger technology, whether as private or public blockchain can do better in settlement efficiency than some existing systems and their relevant safeguards. The same is true in relation to the fragmented nature of standards in the tokenisation process, which would need to be made uniform to create smart securities that can be mobilised in one let alone across multiple asset servicing value chains and the relevant touchpoints of risk analysis, monetisation, accounting, transfer agent and corporate actions processes. It is not a question of whether innovative solutions and use cases exist in these areas, or in asset servicing as a whole, but rather, whether what can do better and be more resilient generally, as well as specifically due to the tech-related risks than non-digitised methods and whether the relevant supervisor agrees that this is the case.
Global as well as regulatory and supervisory policymakers at the EU and national levels of the European System of Financial Supervision are only beginning to find their feet in how to regulate and supervise financial technology and regulation technology and remain “tech neutral” and jurisdiction agnostic about it. One thing that is, however, clear as it was in the pre-digitised age, regulatory and supervisory reform can catch-up pretty quickly and have some very real impacts on market participants. Policy concerns are split between enabling the evolution of efficient and sustainable market practice yet still very much protecting against risks of ‘ghosts in the machine’ or from ‘bots behaving badly’.
Ignoring EU legislative and regulatory reform, the EU’s search for its financial technology strategy, the following Eurozone specific measures may be of relevance to the asset servicing industry. This may prompt some market participants as well as asset servicers to consider whether they might require new or have to re-document certain contractual arrangements but equally their compliance frameworks.
BMR and replacement rates
Benchmark rates and indices matter. They also play a key role for SFTs. In response to the issues around benchmark rates, the EU finalised reforms which fully entered into force in the form of the EU’s Benchmarks Regulation (Regulation (EU) 2016/1011 (the BMR)) on 1 January 2018. The BMR will have transformative effects across markets, asset classes and transaction types. It will also delineate between activity that is regulated and supervised in the EU and such activity that takes place outside the EU, for example in a third-country and, which will need to be given permission for access into the EU or for use by those entities that—as per the BMR— qualify as an EU supervised entity. This will be of particular importance once the UK leaves the EU and becomes a third-country.
Regarding impact, these rules go very much beyond cleaning-up Interbank Offered Rate (IBORs). For example, the interbank bid and offer rates that shot to prominence in the London Interbank Offered Rate (LIBOR) and Euro Interbank Offered Rate (EURIBOR) fixing scandals and which have meanwhile caused policymakers as well as private sector market participants to search for replacement rates. The European Central Bank has begun creating a replacement to EURIBOR. In Q4 2017, it announced the launch of a new working group and a methodology for an overnight benchmark rate. This rate would serve as a central bank-led backstop to private sector benchmark rates.
The current working title thereof is the Euro unsecured overnight interest rate (EUOIR). Both the ECB’s consultation process and the submission date to join the working group closed on 12 January 2018, and a further consultation on EUOIR is set to follow. Work by the regulators has been replicated by industry associations in creating an IBOR Roadmap of who is doing what and where.
ECB’s pension fund statistics regulation
The ECB has also, together with the European Institutional and Occupational Pensions Authority (EIOPA), been active in mapping how pension funds engage in financial markets and its impact on resilience and systemic risk. In 2017, the ECB published consulted on and held a public hearing on a draft regulation on statistical reporting requirements for pension funds (the ECB PF Regulation). Once finalised, this will prompt reporting requirement that start during Q1 2019.
The rules are clear and far-reaching. They seek to capture asset-level data on a quarterly and annual basis. They call for submitting granular data on securities borrowing against cash collateral, claims under reverse repos, any form of lending (including securities lending), cash collateral received in exchange for securities lending and similar transactions.
However, what the ECB pension fund regulation, at least in its current form, does not do, is interlink with defined terms that already exist in Securities Financing Transactions Regulation (SFTR) and/or the MiFID II/MiFIR Framework. Given that most in-scope pension funds are likely to expect their dealer entities, including on the Securities Financing Transactions (SFT) side of things, to take the lead on preparing regulatory reporting to fulfil the ECB pension fund regulation’s obligations, this could cause both conceptual and practical problems for buy and sell side participants unless preparatory action is taken on both sides.
ECB-led market infrastructure changes
The ECB as the gatekeeper of the Eurosystem’s settlement systems (TARGET2 and T2S) has since their inception undertaken some consultations and initiatives to improve their functioning and efficiency. This has been a catalyst to create more common standards and greater efficiency including with respect to asset servicing. In 2016, the ECB put together a Task Force on the Future of Real Time Gross Settlement Services and, in 2017, that group made large strides in its mandate to deliver the TARGET2 and T2S consolidation project. This project is set to advance further along four distinct workstreams, which are:
Technical consolidation of the Eurosystem market infrastructure with an aim to provide more cost-efficient and resilient services to users
Consolidated and harmonised connectivity solutions across the Eurosystem market infrastructure services
Functional convergence and sharing of common services between TARGET2 and T2S both regarding payment and user interface (multi-currency services, additional payment fields and collateral options)
Introduction of new real-time gross settlement services, such as the TARGET Instant Payment Settlement (TIPS) solution
Also, the ECB coordinated Advisory Group on Market Infrastructure for Securities and Collateral (AMI-SeCo) will finalise the remaining 24 Priority 1 and Priority 2 activities. These deliverables aim to improve the harmonisation and efficiency of the T2S environment as well as the interaction with CSDs for cross-CSD settlement and the provision of ancillary services. A further update will be released in the ‘Eighth T2S Harmonisation Progress Report’ in Q1 2018.
Brexit, new and alternative dispute resolution venues, possible changes to governing law clauses in financial transaction documentation
The uncertainty of Brexit has also raised questions on governing law and jurisdiction. As a result, some industry associations have begun to explore how to replicate English law governed master agreement documentation suites used across an array of financial transactions and subject them to the laws of other EU Member States.
Concurrently, a number of these EU ‘challenger financial centres’ have begun to amend existing venues or build new dedicated dispute resolution venues that embed English as the lingua franca in resolving their disputes. This is welcome in many ways but does not displace the use case for English law in financial market transactions post-Brexit.
Even if the UK is leaving the EU, the enthusiasm for English law as the governing law for financial market transactions and as the use of English as the language for dispute resolution has not diminished. Even the European Court of Auditors found in its report that the Court of Justice of the European Union ought to consider adding English as a procedural language. Those market participants affected the question on how to “Brexit-proof” their documentation and dispute resolution options may want to consider the range of challenger venues that are being set-up in Paris, Amsterdam, Brussels or Frankfurt. With some of these new bespoke or anglicised venues starting their operations in 2018 through 2020, the race is on to find an alternative to the Courts of England and Wales. Those that can evidence sufficient “bench strength” and cost efficiencies will score first-mover advantage.
Outlook towards 2019
Asset servicing professionals, management and strategy teams may wish to consider how all of this will impact upskilling functions and make them more technology aware regardless of the pace of disruption and the future of who processes and supervises which operations and where. In the absence of the EU’s Capital Markets Union (CMU) action plan, which was originally intended to be complete by 2019 (lest political troubles and Brexit delayed it) having sidestepped some fundamental issues on (further) improving the pan-EU harmonisation and interoperability of asset servicing, market participants may want to continue how to lobby their interests and/or to revisit earlier pre-CMU proposals, such as the proposal for an EU Securities Law instrument, that aimed to bring greater efficiency and legal certainty across the value chain running through front, middle and back office.
Technology, including digital ledger solutions, which come with their risks and uncertainty on resilience and regulatory treatment and may thus not be as much of a panacea as first promoted. As a result, market participants, asset servicers and their clients, will want to consider how to leverage both tech and the legal/regulatory drivers of change to ensure that the engine room of the collateral ecosystem and thus financial markets remain fit for the future, compliant and ahead of the curve.
