Navigating Regulatory Challenges
Regulatory Challenges in 2024 for capital markets industry
Progressive and evolving global and jurisdictional regulatory frameworks have been a key feature in the financial sector since the global financial crisis of 2008.
The growing influence of AI-driven decision-making in the financial services sector presents challenges and opportunities. With the furore and uncertainty around the proliferation of generative AI models such as ChatGPT, it is crucial for regulatory frameworks to stay aligned with developments in order to provide adequate protection for consumers. The EU AI Act has sought to provide the first comprehensive set of AI-specific regulations in the world and address the risks associated with AI while providing safeguards and risk management protocols. Monitoring for biases in generative AI models, such as Large Language Models, will be crucial to its safe application and adoption.
The Act is due to come into force in June 2024 and will require financial institutions to integrate fresh AI governance and risk management requirements into their operational frameworks. Nevertheless, considerations should be given to how human judgement can be augmented rather than entirely replaced by AI, with humans focused on validating the AI model outputs.
Transparency, operational resilience, and regulatory oversight are emphasised as crucial in financial markets, with concerns about potential regulatory oversight of financial technology. In particular, the EU’s Digital Operational Resilience Act (DORA) was earmarked as a key regulatory development strengthening the financial sector’s resilience to ICT-related incidents and it is instigating a significant restructuring of ICT risk management frameworks. Although it is an EU regulation, UK financial firms maintaining operational ties with the EU through branches, partnerships, or direct market activities must remain compliant from the January 2025 application date.
The importance of reporting accuracy and completeness, the impact of operational resilience on clearinghouses, and the increasing volatility in markets due to margin calls stemming from geopolitical conflict have all come to the fore. Sanctions imposed on Russia following the declaration of war on Ukraine had a significant impact on commodity-backed derivatives, with the price of nickel spiking 250 per cent in 2022, leading to a brief halt in trading on the London Metal Exchange. Subsequently, working group CPMI-IOSCO was created to help improve transparency between clearing brokers, clients, and central counterparties on margin modelling and stress testing. One strategy devised by CPMI-IOSCO to improve stress testing is to conduct simulations of real-world situations to help identify and mitigate potential risks.
In the UK, the nature of financial crime is evolving. Once focusing on anti-money laundering primarily, the focus now appears to be mainly on preventing fraud. In particular, the FCA is prioritising a clampdown on investment fraud and push-payment fraud, with the number of warnings regarding fraudulent activities increasing by 21 per cent between 2022 and 2023. Following the delivery of an anti-fraud assessment framework from the FCA, financial firms can help ensure their controls and systems meet requirements.
Navigating the regulatory landscape while innovating is now more challenging as a consequence of regulatory divergence of the UK and EU. For example, the stance taken on operational resilience in the UK and EU is different. The EU’s DORA is a far more prescriptive approach to ensuring operational resilience than has been taken by the UK. DORA consists of legally binding legislative requirements, while the UK’s Prudential Regulatory Authority uses more discretion. However, divergences between the UK and EU across several key regulatory frameworks may not be as great as first thought. For example, with the EU’s European Market Infrastructure Regulation (EMIR) Refit and the UK’s EMIR Refit, the objectives of addressing disproportionate compliance costs, transparency issues, and insufficient access to clearing for certain counterparties are generally the same, with the main difference being transition periods and timeliness for compliance.
Another example is the application of a consolidated tape (CTP) for bonds, equities, and derivatives under the terms of the EU’s Markets in Financial Instruments Regulation, which seeks to provide a single and near real-time overview of the price formation for these securities to all market players. The EU is seeking to have its first CTP for bonds effective by the end of 2025. The UK is seeking to follow in the footsteps of the EU with its own CTP slightly later. The transition to T+1 trade settlement in the US presents another case in point, with the UK’s T+1 Accelerated Settlement Taskforce recommending that the UK transitions to a T+1 settlement no later than the end of 2027, while EMSA’s report is expected in Q4 2024.
Ultimately, financial firms should consider their dual regulatory obligations across different jurisdictions while understanding the striking similarities between regulatory frameworks. Given the increasingly complex and ever-evolving capital markets regulations, financial firms may take solace from the fact that regulatory divergences between different jurisdictions may not be as much of a problem as was initially feared.