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Regulatory Equivalence: How Brexit Could Trigger Better Risk Exposure Modelling

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By Volker Lainer, VP of Product Management, GoldenSource.

When it comes to the future relationship of EU/UK financial services, alignment has been touched on regularly by policy makers and the UK has begun a series of assessments for its post-Brexit vision for financial services. Either way, the EU has ruled out access unless the UK adopts all EU rules – both current and future – which the UK has in turn ruled out. If the latest rhetoric is anything to go by, full equivalence is unlikely and, although this will provide structural obstacles, this could be the catalyst that sparks better risk modelling.

Since the Brexit vote, announcements have trickled in about banks creating new offices in continental Europe. Initially, this redomiciling was more of a precautionary measure in case trade barriers suddenly manifested. So, currently, the UK and EU’s financial infrastructure are one and the same, with a large proportion of trading activity taking place in London. But at some point soon, trades will start flowing through Frankfurt, Paris or Luxembourg so firms face the reality of separating their UK/EU trading operations.

Although new continental entities have been created, they are not yet capable of executing all of the trading that still goes through London. As such, every organisation is going to have to suddenly create relationships with new counterparties because their new entities will have to begin taking on responsibility and ownership of new trading activity. It’s not something which can be picked up overnight. And, from an operational standpoint, there are some distinct obstacles. For example, these new entities will require settlement instructions and have all of the operational data attached to allow it to do business.

Fundamentally, now things are more “certain”, it’s becoming clear that banks have been waiting for the dust to settle and most of them do not have a strategy in place to make these legal entities functional. Regional operations of banks are currently siloed and most banks have lots of different systems in place across all their legal entities. With so many different arms operating across different markets, the larger banks will now have a number of entities which are working with hundreds of different counterparties. To make matters worse, everyone else is doing this at the same time, meaning there are new parties popping up everywhere. It’s a very difficult process to manage and, assuming there is no extension to the transition period, all in a relatively short space of time.

This fragmented operational landscape means it’s next to impossible for firms to obtain a full oversight of their risk exposure – it comes right back to what caused the Lehman’s crisis. In the immediate aftermath nobody could figure out what their exposure was. How do you measure exposure when you do not have a single party view of all of your entities and what subsidiaries they are invested in? You can’t. Particularly when it comes to some of the more complex OTC contracts. Most firms cannot figure out who the ultimate parent is.

If an organisation does not have data modelling which can update all counterparty data across the whole business, there is no chance firms can unravel such an extensive web. Even if you manage to get all the risk modelling in place in one location, it can rapidly go out of date because firms are unlikely to have a system in place which ensures accuracy of all counterparty data across all locations at any one time, new and old Updates are not made centrally.

This complex landscape has been growing organically for years and firms have been putting off gaining a holistic understanding of all their counterparty risk for too long. Therefore, it’s possible that this may act as a catalyst which will push the industry towards better risk aggregation. Firms must introduce systems which can quickly and easily set up new entities in a consolidated way, which cannot be coordinated with a fractured infrastructure but only be done via a centralised platform.

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