Capco Regulatory Reform Insight Series

Observations on the global trend toward stronger regulation of financial services

Legislative initiatives such as the Dodd-Frank Wall Street Reform and Consumer Protection Act in the U.S. are equipping regulators with new tools and greater authority to curb abuses, prevent market disruptions such as flash crashes, and establish greater transparency into investment instruments and markets.

The details of the new requirements will become clearer as regulators develop rules and guidelines in the months ahead. But among likely effects are new limits on proprietary trading, stronger controls on trade flow, and increased reporting requirements. This Capco Regulatory Reform Insight Series aims to help financial institutions better understand and address the reform surge from four perspectives:

Installment I: The future of proprietary trading
Recent attempts at financial reform, such as the Dodd-Frank Act, restrict proprietary trading for speculative purposes, but not for other purposes such as market making and hedging. This delineation raises immediate questions regarding the reach and enforcement of reform provisions. Also to be determined is the effect proprietary trading limits will have on trade flow.

Installment II: Controlling volume and flow
The flash crash of U.S. stock markets on May 6, 2010, intensified the regulatory reform focus on controlling trading volume and flow. On that day, a slight downward slide became a plunging spiral as algorithmic and high-frequency trading routines took over and started working across different exchanges.

Trading is now so heavily automated that market-shaking events can happen in milliseconds. Regulators have already moved to introduce controls to handle “fat-finger” erroneous trades and anomalous algorithmic behavior. They are certain to try and manage trading speed, identify clear mistakes, and throttle back volume to prevent disruptive events in the future.

Installment III: Transparency in the future
One of the key goals of financial reform is to increase transparency in the financial system. Transparency can only be meaningful if it reaches across exchanges and products.

How can transparency be established across different exchanges so that they can be managed and regulated in an integrated manner? In the U.S., how will transparency efforts be impacted by the pervasiveness of American Depository Receipt (ADR) instruments across U.S. exchanges? And, how will transparency requirements be extended into derivative instruments?

Installment IV: Banks’ technology response to regulatory changes
Traditionally, financial institutions have dealt with incremental regulatory changes through adjustments to their enterprise-wide regulatory and risk management programs. As a result, each successive compliance initiative produces small changes across the entire existing architecture, including components associated with data aggregation and reporting. With the significant changes ahead as a result of global financial reforms, this is not a sustainable approach. Instead, institutions should think of ways to address regulatory change and the need for business innovation concurrently.

The Capco insight
The Capco insight into Regulation is that it does not need to be an inevitable brake on revenue growth and profit. The often underplayed “silver lining” is that compliance, managed correctly together with finance and risk, and combined with understanding of the likely shape of the future, will bring sustained operational improvement and new opportunities.