The first quarter of 2021 proved eventful for financial services, with significant implications for capital markets firms in the UK and their focus for the year.
UK-EU regulatory cooperation
As expected, Brexit led to a rapid reduction in trading activity, particularly in European equities where EU and US financial centres experienced a boost.
The UK and EU's memorandum of understanding set out plans for a joint financial regulatory forum to support voluntary cooperation, with biannual meetings between the UK chancellor and EU commissioner for financial services.
This will reduce regulatory uncertainty and help prevent arbitrage, which are both important criteria to achieve regulatory equivalence in the future.
The Financial Services Act 2021
No doubt helping this cause, HM Treasury's Financial Services Bill has received royal assent and become law in the Financial Services Act 2021. This is to maintain an effective UK regulatory framework that continues to protect markets and consumers, ensuring the UK remains an open and dynamic financial centre.
The Act emphasises LIBOR transition and prudential reforms aligned to the implementation of Basel 3.1 standards, while also considering UK competitiveness and market access. UK regulators will be granted new powers under benchmark regulation to support a smooth transition from LIBOR.
LIBOR cessation announcement
At the beginning of March, the Financial Conduct Authority (FCA) made the highly anticipated announcement on cessation and loss of representation of the LIBOR benchmarks. They also outlined plans for a future synthetic LIBOR publication, covering all 35 LIBOR settings in the five currencies currently published.
Publication on a representative basis will cease at the end of this year for all LIBOR settings, except five major USD tenors, for which panel banks' submissions will be sustained until the end of June 2023.
As an index cessation event under the International Swaps and Derivatives Association (ISDA) interbank offered rates (IBOR) fallbacks supplement and protocol, this triggered fixing of credit spread adjustments on the announcement date. The spread fixings also serve as references for many cash products.
UK regulators expect firms to adhere to the roadmap, progressing active transition where viable by the end of Q3 and phasing out new LIBOR contracts, with Q1 key milestones for most products.
Subject to legislation, the FCA intends to oversee publication of one, three and six-month tenors in GBP, JPY, and USD on a non-representative basis for some time, to support tough legacy contracts and will consult on relevant policies in Q2.
Meanwhile, New York state legislation to support the transition of tough legacy contracts has been enacted into law and will particularly facilitate floating rate debt and securitisations issued under state law.
LCH has announced a backstop conversion process for CHF, EUR, JPY, and GBP LIBOR-linked cleared derivatives outstanding close to the index-cessation effective date and will commence charging fees from the end of September due to increased risk management effort and to encourage proactive prior transition.
Preparing for a large-scale conversion event in December is a significant task, as is prior portfolio reduction in line with regulators' expectations.
Implementing Basel 3.1
The Prudential Regulation Authority (PRA) has completed a consultation, proposing capital requirements regulation (CRR) rules to support timely implementation in the UK of the remaining elements of Basel international standards, including previously on-shored EU legislation (CRR II).
The implementation target date is 1 January 2022, which provides additional time for firms to optimise solutions and embed supervisory reporting, such as market risk under the standardised approach of the Fundamental Review of the Trading Book (FRTB).
ESG
A wave of environmental, social and governance (ESG), and climate risk regulation was published in 2020. Investment decisions now regularly consider ESG and demand for green bonds has risen exponentially.
Capital markets firms undertake a range of activities that need to consider ESG for bond issuance, securitisations, participating in the underwriting of corporate bond issuances as part of a syndicate, as well as entering into derivatives contracts with corporates or providing credit facilities to commercial clients.
Due diligence must include ESG assessments, which extend beyond climate risk to cover governance structures, board oversight, diversity and inclusion, non-discrimination, forced labour practices, gender pay-gap, energy, emissions, and waste management.
In 2021, capital markets firms face greater regulatory demand for ESG disclosures, and increased commercial demand for sustainable and socially responsible products. Patterns of lending rates for green labelled products need careful consideration.
Assessing operational resilience
The UK supervisory authorities have published their final policy and supervisory statements to strengthen the operational resilience of financial services firms and market infrastructures.
These rules come into force in March 2022, and firms must identify their important business services, set impact tolerance levels for disruption, map resources, and test relevant scenarios against tolerance levels.
The PRA also published a supervisory statement on outsourcing and third-party risk management. These policy and supervisory statements provide firmer guidance to assess the current state of resilience and rapidly embed a robust framework to address any gaps.
The Basel Committee on Banking Supervision has issued updated revisions to the Sound Management of Operational Risk and complemented this with Principles for Operational Resilience. This aims to promote a principles-based approach to improvements, as well as international and cross-sector collaboration.
Shadow banking in the spotlight
The first quarter ended with Greensill Capital and Archegos Capital Management in the headlines.
Both collapse incidents resulted in significant losses for major global banks and prime brokers, ongoing criminal investigations, parliamentary debate and probing by European and US regulators into their operations.
With the Wirecard scandal still fresh in mind, shadow banking will come under increased scrutiny with a focus on risk management and obscurity in implicated financial instruments. A greater emphasis on risk culture, internal risk controls frameworks and effective challenge across all lines of defence will benefit all financial institutions, supported by the Senior Managers and Certification Regime (SM&CR).
Even if financial stability wasn't compromised by these incidents, systemic shocks may be lurking, and shadow banking needs greater regulatory consideration. The UK has another opportunity to make an impact when designing its future regulatory framework.
If you would like to discuss these challenges and opportunities in the capital markets sector, contact Alex Ellerton.
