BY AMBER BISSELL
WITH ASSISTANCE FROM SOPHIE SCALES
As we look back over the past year, one thing is for certain: 2016 was a year of great change. A year dominated by Brexit, shock elections and overall uncertainty, there’s no doubt that 2016 was memorable. The most notable changes for the financial markets can be categorised into three main areas: technology, regulation and global markets. Below we discuss and acknowledge a number of new requirements, trends and events which have been the key external and internal drivers for change. Furthermore, we highlight the impact a number of these changes will have on the future financial markets landscape and what we expect from 2017.
Let’s get technical
As mentioned last year in the JDX Blog: 2015 versus 2016, the shift away from legacy IT systems to faster and smarter infrastructure continues. Most financial institutions invested heavily in updating internal infrastructures to increase accuracy, improve efficiency and provide a more real-time view of their data. The use of Blockchain technology was one area that came to the forefront in 2016. It helps to redefine data management by creating a golden source record of data. This data is split into blocks that become cryptographically linked together to form a chain. This cryptographic linking means that once a block is added to the chain it is impossible to change the data within, therefore all systems see the same data no matter what. This database becomes a source of shared knowledge, with the view that industry participants begin to work from common datasets. Though in its early days, the potential of Blockchain has gathered momentum throughout 2016 and sparked interesting conversations, such as the possibility of revolutionising the case for gold as a means of exchange and transforming trade finance. The concept remains a focus of the financial services sector – the Blockchain Summit on 10th October involved key figures discussing crucial questions in distributed ledger technology. It’s this highly secure nature of technology which has led to Blockchain’s popularity due to its resilience against cyber-attacks. However, Blockchain does not come without its faults and this year certain distributed ledger platforms have been hacked. Ethereum, an upstart digital currency platform, fell victim to this on 17th June when 3.6 million worth of ether was siphoned off, with the total amount stolen ranging from $64 million to $101 million. Whether limitations arise by human error or weakness in the technology, there is no doubt that financial institutions will continue to funnel funds into research and development of Blockchain over the coming years.
Robotics was also a major talking point of 2016 and began to influence the Change environment, as the industry continued to improve on efficiency and control. This technology is set to recreate the structure of transaction processing and enable standardised processes to become automated. Back-office predominantly will feel the effects, as this software has the potential to automate repetitive and rule-based processes currently performed manually by humans. Robots function by capturing and interpreting the organisation’s existing IT infrastructure which enables transaction processing, data manipulation and communication across multiple IT systems. By introducing robotics at minimal cost, back-office cost savings are achievable and certainly more cost effective than offshoring a process. However, robotics will not replace legacy IT systems and replacement programmes will incur large incremental cost. A number of financial institutions successfully experimented with robotics in 2016, testing the technology on manual, time-consuming processes. 2017 will see these proof of concepts roll into production environments and then more broadly across other functional areas.
The need to conform
Regulatory change continued to be a key area of focus in 2016, as current regulations were constantly built on, in order to decrease risk within the market. In 2016 the industry expected to implement the Uncleared Margin Rules globally – unfortunately the EU regulatory rule writing process was unable to meet this deadline and so the rules across Europe were delayed. This resulted in the U.S. also delaying its rules, albeit at the eleventh hour (as highlighted in JDX Blog: Uncleared Margin Rules (UMR) Does the no-action relief proposal provide any relief?), A European Commission spokesperson explained, “Our objective is to deliver the standard before the end of the year and for firms covered by the first wave of the rules to be required to comply before the middle of next year”. However, given the lateness of the no action relief in the U.S. a number of major dealers in the United States, Canada and Japan posted their initial margin successfully, complying with the original September 1st deadline. Posting of initial margin aims to reduce the broker’s exposure to the investor’s credit risk. The second section of this rule focuses on variation margin, which reports the daily change in the market value of the financial instruments. All jurisdictions are expected to post variation margin in March 2017 for all clients. This will be a tremendous stretch for the industry given the breadth of counterparties now in scope.
The Basel Committee on Banking Supervision (BCBS) continued to implement change into the regulatory environment through Basel III. This regulation has been under development since 2012 and the phasing process continues to expand, affecting additional entity groups within the banking sector. Basel III has a strong focus on capital, e.g., a stricter definition, more requirements for counterparty credit risk, and higher capital ratios. The optimisation of risk-weighted assets (RWA) has been prevalent within banks in recent years, with initiatives being undertaken to reduce capital exposure, e.g. closing overexposed legal entities and offshoring. The Basel III Monitoring Report presented the below findings:
- June 30th 2015 showed that all large internationally active banks meet the Basel III risk-based capital minimum Common Equity Tier 1 (CET1) requirements.
- Liquidity Coverage Ratio (LCR) increased from 60% in 2015 to 70% in 2016.
All twenty-four Financial Stability Board (FSB) jurisdictions currently possess the core elements of the regulations risk-based capital and liquidity rules10; this highlights a good foundation for the planned completion in 2019. However, RWA optimisation is likely to become increasingly important in 2017, as banks wish to grow but are restricted in the ability to increase their capital base.
MiFID II remains in the limelight and promises to reshape European financial markets. Although, with the deadline extension, there was a risk that attentions were shifted elsewhere (see JDX Blog: MiFID IIi Extension- What you need to know). The regulation’s aim is to reduce risk, increase transparency and introduce robust investor protection, with the ultimate goal of “levelling the playing field”. For the aims to be fulfilled and the MiFID II package to perform effectively, a complex technical infrastructure is needed, which has resulted in the current delay. Regulators have now agreed new adoption dates with the European Parliament. The negotiated deadline for the effected states to enforce MiFID II into national legislation is set for 3rd July 2017, followed by the application of both MiFID II and MiFIR on 3rd January 2018. Market participants now have under 12 months to ensure they comply, or face substantial penalties so tremendous focus and investment in MIFID II will dominate the Change agenda in 2017.
The impact of a vote
This leads on to arguably the biggest event of 2016 – Brexit – where, on the 23rd June, the UK voted to leave the EU by 51.9% to 48.1%. Financial markets slowed down ahead of the referendum and chaos ensued as many traders backed a “remain” result. Economists and the government warned of the shock impact an “out” vote would cause to the UK economy and consumer confidence. In reality, the pound plunged and reached a three-year low against the euro, whilst the number of houses for sale fell to 30-year lows. However, the UK economy performed better than expected following the vote, growing by 0.5% in the three months after, compared to the 0.3% predicted. The UK’s services sector, along with retail sales, helped this performance. Subsequent trends and statistics rely on the exit plan, which is dependent on Article 50 of the Treaty of the European Union being triggered. Exit negotiations will commence once this happens and will take place over two years, but the terms and legislative impact of Brexit (including MiFID II) remain uncertain until then. To add to uncertainty, the Brexit case went to the Supreme Court in a bid to see whether the Government needs MPs’ approval to trigger Brexit, suggesting a chance it could not go ahead. However, the Supreme Court confirmed it would not “overturn the result of the EU referendum”. Interestingly, the Bank of England now has a more bullish view on 2017, having increased its economic growth forecast from 0.8% to 1.4%, whilst its view on 2018 has been lowered from 1.8% to 1.5%14. Formal talks on Brexit are likely to start end of March 2017, meaning the European political landscape (and further – JDX Blog: Brexit - To what extent will it affect the U.S.?) is likely to be dominated by exit plans in 2017.
January 2017 sees President-elect Donald Trump take his position in the White House, as leader of the free world. A controversial candidate with little political experience (see JDX Blog: Clinton vs Trump: How will the 2016 Presidential Election affect Global Financial Markets?), who has divided the United States of America – what can we expect from a Trump term? The impact his presidency will have on the global economy is hard to predict due to the lack of clarity his campaign carried around economic plans and priorities. As a result, The Economist predicts volatility rather than a bear market. Though a likely cut in taxes would be most beneficial to the rich, basic economics would hope that this would also boost demand. However, government spending and borrowing are likely to increase (to aid defense, infrastructure, and potential deportation), which would undo progress made under the Obama Administration. Furthermore, concerns have been raised over the support an entirely Republican Congress will bring. What we do know, since his election was announced on 9th November, are his cabinet appointments so far. Wall Street titans, ex-Military, and white men seem to dominate, with little previous government experience also being a trend. Another relationship to watch will be the one America has with Russia, for example with Rex Tillerson as State post, who has ties to Vladimir Putin. The new year should bring more clarity around the appropriateness of each appointment and what he or she can provide.
In summary, it is clear to see that 2016 will go down in history. New infrastructure, rules and leaderships will all help shape the future landscape of financial markets. As we look forward to 2017, it marks almost a decade since the Financial Crisis began. Therefore, it is no surprise that regulations will continue to play a key part in aiding structural changes. For example, seven of the 13 elements of the Basel III framework have been adopted so far, meaning six are still outstanding. As well as MiFID II and the Uncleared Margin Rule, focus will be on other regulations such as the Central Securities Depositaries Regulation (CSDR). CSDR looks to “harmonise certain aspects of the settlement cycle and settlement discipline” and the first central securities depositaries (CSDs) are expected to be authorised under this regulation next year. Furthermore, International Financial Reporting Standard 9 (IFRS 9) requires all firms holding financial debt instruments to embed forward-looking “expected loss” impairment models into their business to predict credit losses. It has an implementation date of 1st January 2018 meaning 2017 will be the year to implement these models into business-as-usual. Financial institutions should seize the opportunities further technology-driven change will bring. The use of robotics is expected to increase within banks and the industry, whilst the industry continues to shape and develop the concept and use of Blockchain to improve security; though hacks and certain limitations may affect the adoption speed in some firms. However, despite all of this, we expect Brexit and Trump to dominate headlines in 2017.
Overall, 2016 kick-started all of this change, but 2017 and will be the year to feel it and we will only know the true impact when we look back this time next year.
 Blockchain could revive gold’s role as a payments currency, EuroMoney, 8th September 2016. http://www.euromoney.com/Article/3584180/Blockchain-could-revive-golds-role-as-a-payments-currency.html
 Fintech: Blockchain landmarks point to transformation of trade finance, EuroMoney, 15th November 2016. http://www.euromoney.com/Article/3601960/Financial-technology-Blockchain-landmarks-point-to-transformation-of-trade-finance.html
 The Blockchain Summit, MarketForce, October 2016. http://www.marketforce.eu.com/events/financial-services/blockchain-summit
 How a $64m hack changed the fate of Ethereum, Bitcoin’s closest competitor, CBC, 28th August 2016. http://www.cbc.ca/news/technology/ethereum-hack-blockchain-fork-bitcoin-1.3719009
 The robots are coming, Deloitte, 2016. https://www2.deloitte.com/uk/en/pages/finance/articles/robots-coming-global-business-services.html
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 Commission Delegated Directive (EU), European Commission, 7th April 2016. https://ec.europa.eu/transparency/regdoc/rep/3/2016/EN/3-2016-2031-EN-F1-1.PDF
 Commission extends by one year the application date for the MiFID II package, European Commission, 10th February 2016. http://europa.eu/rapid/press-release_IP-16-265_en.htm
 European Council confirms MiFID II delay, Finextra, 18th May 2016. https://www.finextra.com/pressarticle/64489/european-council-confirms-mifid-ii-delay
 Latest FCA consultations on the UK implementation of MiFID II, DLA Piper, 7th October 2016. https://www.dlapiper.com/en/uk/insights/publications/2016/10/latest-fca-consultations/
 The economic consequences of Donald Trump, The Economist, 9th November 2016. http://www.economist.com/blogs/freeexchange/2016/11/global-economy
 Trump’s cabinet picks: here are all of the appointments so far, The Guardian, 14th December 2016. https://www.theguardian.com/us-news/2016/dec/09/donald-trump-administration-cabinet-picks-so-far
 Navigating the year ahead, Deloitte, December 2016. https://www2.deloitte.com/content/dam/Deloitte/uk/Documents/financial-services/deloitte-uk-fs-emea-regulatory-outlook-2017.pdf
 Settlement, ESMA. https://www.esma.europa.eu/regulation/post-trading/settlement
 IFRS 9 Financial Instruments (replacement of IAS 39), IFRS. http://www.ifrs.org/current-projects/iasb-projects/financial-instruments-a-replacement-of-ias-39-financial-instruments-recognitio/Pages/financial-instruments-replacement-of-ias-39.aspx