Financial institutions have been working hard to keep their heads above water since the financial crisis, but in recent weeks, the COVID-19 pandemic has brought a gigantic wave of challenges ashore
With over 500,000 cases confirmed worldwide, and more than 20,000 lives taken, the COVID-19 pandemic has certainly rocked the globe – with most countries still not hitting the peak crisis stage.
COVID-19 has had detrimental effects on many markets around the world, and the financial services industry is one of many that will have a range of challenges to tackle because of the disruption caused by the pandemic.
The current situation in terms of financial markets has been compared to the financial crisis of 2007/2008, which caused major challenges. The markets were operating in opaque environments, however, since then the industry has worked alongside regulators to become more transparent.
In asset servicing, in order to aid transparency, the industry has seen waves of regulation including the European Market Infrastructure Regulation and the first and second Markets in Financial Instruments Directive. There are also upcoming regulations such as the Securities Financing Transactions Regulation, that has now, in light of the current pandemic, been puhsed back from an April go-live date to July.
Prior to COVID-19 national lockdowns in the UK, Spain, Italy, the US along with many others, industry experts discussed challenges within the asset servicing industry, with cost pressure being named as one of the most prominent.
Money, money, money
Post the 2008 financial crisis, the renewed focus on regulation meant that firms invested heavily into their risk management, compliance and technology infrastructures.
Dipesh Khira, principal consultant at Capco, explains that as a result, “keeping costs down has proved a significant challenge as they have sought to ensure compliance, enhance their competitive edge and retain investor confidence”.
Indeed, becoming more transparent as a result of the financial crisis is coming at its cost. Some of these costs stem from financial institutions implementing heavyweight technology to cope with the amount of data that is required for reporting obligations, as an example.
Emphasising on this point, Daniela Klasen-Martin, group head of ManCo Services at Crestbridge, notes that as there is a major focus on technology delivery and data architecture to enhance the client offering as well as to improve control and efficiency, this has resulted in increased costs in the short term that only sizable players can cover for.
Clive Bellows, head of global fund services, Europe Middle East and Africa at Northern Trust, explains: “Asset managers have faced challenges in generating alpha, resulting in some consolidation across the sector. This in turn has put pressure on fees and squeezed margins for asset servicers.”
Klasen-Martin adds: “Considerable margin pressure as asset managers are challenged to decrease total expense ratios, has compelled asset servicers to review their operating models, look for organisational efficiencies and new technologies to increase scalability and to protect their own margins.”
On route to efficiency
Although cost pressure is one of the negative effects of the crackdown on regulation and transparency since the financial crisis, opportunities have presented themselves, such as increased efficiency.
Klasen-Martin says: “The increasingly complex regulatory environment is in my view offering opportunities for new services such as outsourced risk management and compliance solutions. In particular we have seen players completing their offer of back-office services such as fund accounting and transfer agents with middle to front office services, such as regulatory reporting, risk management services and more complex front office services such as third-party management company solutions. I believe that the latter will continue to develop.”
According to Klasen-Martin, as we see increased substance and regulatory requirements for asset managers the need for cost-effective outsourcing solutions such as third party management companies will offer increased opportunities.
Similarly, Northern Trust’s Bellows emphasises that regulation continues to be a “key driver in the evolution of the financial services industry”.
Although costly, regulation has led the industry to invest in advancing and emerging technologies that have the potential to allow more room for automation, which will allow humans to pursue more creative tasks. Additionally, technology has helped to reduce the number of human errors.
Bellows comments: “A lot of activities which are manual in nature – and therefore more prone to human error – are being automated. And this means we’re ahead of client demands and servicing them more efficiently.“
“However, as an industry, we need to recognise that emerging technologies also require careful regulation. We welcome carefully considered and timely regulatory changes which will make the market more transparent and efficient.”
Also discussing technology, Capco’s Khira notes that with robotics process automation and machine learning being increasingly explored, this has fostered a new wave of innovative solutions to address perennial challenges around manual processing, timely reporting, real-time transparency and of course cost management.
Addressing the cost issues, Khira adds: “Investing in new technology solutions may result in a short-term spike in costs, but opens the way for long-term cost savings when executed effectively. However, for new technology to be successful, adoption requires effective change management and core business transformation knowledge.”
A clearer view
Although increased regulation brings both challenges and opportunities, has it paid off? Are firms now operating in a more transparent environment since the crisis?
Khira suggests that firms are now more transparent, but “there is still some way to go”.
He says: “For instance, MiFID II – whose scope spans equities, fixed income, currencies and commodities – is wide-reaching and highly complex. MiFID II has also expanded its reporting obligations to the buy-side, widening its footprint across the financial services industry.”
However, Khira identifies that there is still a lack of harmonisation with jurisdictional nuances and the increasing cost of compliance can place a huge strain on firms presenting challenges to provide complete, accurate and timely reports, suggesting that “transparency cuts both ways”.
He explains: “Again, take MiFID II as an example. The regulation went live in January 2018 and the Financial Conduct Authority (FCA) reviews of submitted reports are taking place now, with adjustments to the regulation expected to follow in due course. In the past, a regulator did not have access to a great deal of data when it came to establishing a baseline for regulation and supervision.”
“That is rapidly changing, however – for instance, in 2019 the FCA received circa 10 billion MiFID II transaction reports. That data will assist the regulator to reach a far more comprehensive and detailed understanding of market activities, and will thereby be better positioned to impose and enforce its supervisory remit,” Khira adds.
In June 2021, the new Prudential Regime for investment firms is set to go live, which according to Khira, is expected to have a significant impact on asset servicers’ operations via stricter requirements around capital requirements and remuneration.
Riding out the storm
Aside from regulation, the asset servicing industry has also had other challenges to combat over the past five years, including the persistence of very low or even negative interest rates.
Khira also notes further challenges such as the ongoing evolution of technology, globalised capital markets, margin pressures, economic headwinds, the higher cost of compliance and cybersecurity concerns.
Meanwhile, Klasen-Martin adds: “One of the biggest challenges has been to balance the need of keeping cost efficiencies and offering quality services. Companies have had to review their operating models to seek efficiencies and standardisation while determining the right target clients to achieve good margins.”
Looking to the year ahead, industry experts believe that regulatory challenges, data, fees, technology cost, shifting product demand and pressure from the competition will be some of the most prominent challenges — along with the COVID-19 pandemic disruption and challenges also thrown into the mix.
Bellows suggests the use of outsourcing will “evolve in a manner similar to cloud computing where in-house teams are supported with cost-effective and reliable solutions”.
He says: “Outsourcing is here to stay and asset managers need to embrace this change.”
Focusing on the regulatory challenges, Matthew Johnson, associate director, institutional trade processing, DTCC, highlights that with less than a year to go until the Settlement Discipline Regime (SDR) implementation deadline, custodians are emerging as one of the groups expected to be most significantly affected by the regulation.
“At this stage, the challenge for the custodian community is encouraging their clients to prepare well in advance of the SDR go-live date next February, while communicating the ways their relationships with their clients will likely evolve,” Johnson predicts.
Additionally, custodians may need to have challenging conversations with their clients around the allocation of costs. This is because of the financial penalties and potentially expensive buy-in regime which SDR mandates for late settlement, where the buy-side is the cause of inefficiency in the settlement and matching process, according to Johnson.
On a positive note, Johnson suggests that SDR may create new revenue streams for custodians due to the need to provide clients with new services such as enhanced stock borrow/loan facilities, late settlement penalty reconciliations and performance analytics, to help them comply with SDR.
However, with uncertainty around the current COVID-19 pandemic and the impact it will have on worldwide financial markets, the short and long-term priorities of the market will likely adjust to meet the challenges emerging from this current crisis.