The European Market Infrastructure Regulation (EMIR) emerged in August 2012 as Europe’s response, to the G20 2009 Pittsburgh Summit to manage OTC Derivative Markets. The European Securities and Markets Authority (ESMA) was created to draft and monitor EMIR, and quoted as saying “We won’t do this to the detrimental cost of participants”. Following this assurance, what have been the real costs of regulation to the financial services industry? Most industry participants would say “immense” and almost “prohibitive”. It is estimated that it will cost €15.5BN annually for the derivatives market to conform to EMIR (Deloitte, 2013).
Cost 1: Resourcing
The scope of regulatory change has driven participants to employ additional compliance and regulatory experts, to read, interpret and translate the newly developed rules. This introduced an additional management team and associated review processes for financial services firms. Multiple deadlines impacting in quick succession and a lack of clear guidance on in-scope activities have added further complexity to the analytical activities.
The number of new functions and departments set up to comply with the regulation comes at a cost. Below are just a sample of the functions that have had to be created within each participant as the regulation came into effect:
- Unique Trade Identifier (UTI) Creation
- UTI Matching
- Regulatory Reporting
- Delegated Reporting
- Portfolio Reconciliation
Compounded by the lack of advice and clear decision-making from ESMA, the industry continues to face ambiguity and rising costs. The Global Head of Regulation at a Tier 1 Investment Bank commented that there is “no transparency” around the regulation, despite it being developed on this very principle. Moreover, the lack of clear guidance regarding which derivative trades and entities are in scope, and under what timelines, has resulted in significant volumes of client queries. This has driven additional operational effort and further added to the financial burden of compliance.
Cost 2: Dual-side reporting
Unlike in the US, where the Swap Dealer or Major Swap Participant bears the responsibility to report, the EMIR requirement that both parties to a transaction have equal reporting obligations results in compliance costs on both sides of the trade. Furthermore, in a multi-repository environment and without clear guidance from ESMA, each repository interpreted the EMIR requirements independently. This resulted in mismatches between repositories approaches and therefore additional costs to monitor, reconcile, and clear differences. These are clear examples of where the industry has been burdened with unnecessary additional cost as a result of implementing the EMIR regulations.
Cost 3: Technology
In addition to the costs attributed to increased operational headcount, counterparties have incurred costs developing internal technology and infrastructure to support compliance. The regulations have forced firms to further develop often already-complex systems environments to be EMIR-compliant, in extreme cases leading participants to question the economic benefits of trading in the OTC Derivative market.
The erosion of revenue due to the reduction in OTC Derivative volume, coupled with the aforementioned additional cost burden, challenges the ongoing profitability of financial institutions. In addition, new layers of headcount, processes and functions limit firms’ ability to maintain operational flexibility, have transparency over their businesses, and to see the wood from the trees. Does this, therefore, improve the cross-market control environment or worsen it? If the latter, it clearly goes against the core objective of the G20 summit in Pittsburgh: that is, to reduce systemic risk.
Dealing with the costs
Financial institutions have three options:
- Fail to comply with the regulation;
- Exit businesses;
- Share the cost across all industry participants to achieve economies of scale.
Failure to comply is not an option due to the size of fines levied on poor compliance, and nor does it look likely ESMA will soften the rules. Exiting businesses is an option but ultimately cuts off risk management solutions to the end user, and / or increases systemic risk, as only a few financial institutions will offer these solutions.
The final option is the one to watch. Identifying standard functions, processes, activities and tasks; developing common industry technology solutions; pooling resources; and ultimately coupling the best of breed technology with shared resources into technology and resource-managed services will offer a long-term solution to regulatory cost pressure. Collaboration across Industry participants may well be the unintended consequence of the cost of additional regulation, and the new beginning for OTC Derivative Markets that supports both the market and its participants to grow stronger once more.