Overbond featured in Global Risk Regulator analysis as fintech platform that enhances regulatory compliance and regulatory reporting capabilities for primary bond market participants
Source: Global Risk Regulator
The market structures that help to mitigate systemic risk could be under threat if financial technology (fintech) firms become too successful too quickly.
In a speech given to a Deutsche Bundesbank G20 conference on January 25, 2017, Mark Carney, governor of the Bank of England (BoE) and chair of the Financial Stability Board, spoke about the systemic risks that could evolve.
“Changes to customer loyalties could influence the stability of bank funding,” he said. “New underwriting models could impact credit quality and even macroeconomic dynamics. New investing and risk management paradigms could affect market functioning. A host of applications and new infrastructure could reduce costs, probably improve capital efficiency and possibly create new critical economic functions. The challenge for policymakers is to ensure that fintech develops in a way that maximises the opportunities and minimises the risks for society.”
In February 2017, the International Organization of Securities Commissions (Iosco) and Committee on Emerging Risks (CER) published the IOSCO Research Report on Financial Technology. It looked for potential risks that would be thrown up either by innovative fintech business models or emerging technologies such as cognitive computing and distributed ledger technologies (DLTs) which “carry the potential to materially change the financial services industry”.
Fintech business models and emerging technologies often find opportunities where businesses have lagged in technology adoption, or exploit an information arbitrage. Bridging the gap in technology or information plays to the strengths of fast-moving start-ups. However, for regulators even a sedate pace of change can prove challenging.
When the US government bond market, the world’s most liquid bond market, experienced a ‘flash’ event on October 15, 2014, no regulatory body had oversight of the market or any reporting from the market.
The market was known to be dominated by high-frequency traders (HFTs). The CEO of the dominant interdealer broker market had stated that HFT participation was 55% as far back as 2012, and HFTs had been able to access colocation for superfast trading from 2007 in the interdealer markets. Yet these participants were not subject to the capital or clearing rules that large brokers adhered to, and the markets were left unsupervised.
A multi-agency report released in July 2015 by the Commodity Futures Trading Commission (CFTC), Securities and Exchange Commission (SEC), the US Treasury and Federal Reserve was unable to identify a definitive cause for the event. The rise of electronic trading and reduction of bank participation were both cited among likely triggers. The event demonstrated that regulators could be out of touch even with a seven-year lead on changes in trading behaviour.
The risks identified in the Iosco paper broadly fall into two camps for fintech providers: those of governance and those of operational risk. Industry practitioners may well have these on their radar. However, some, including Nicola Horlick, CEO of crowdfunding start-up Money&Co, have spoken out about activities stealing into newer businesses that would concern a regulated firm.
“I am actually a great fan of regulation, I think it’s very important to be properly regulated,” she told the 12th Annual European Market Liquidity Conference run by the Association for Financial Markets in Europe (AFME) on February 23, 2017.
Ms Horlick, who established SG Asset Management UK in 1997 and later Bramdean Asset Management, said she was using her knowledge of the fund management industry to set higher standards within her new fintech business than are required by the regulator.
“With what we are doing at the moment I could have a hedge fund approach and ask to build an application programming interface [API], to look into our credit system and cherry pick out loans – that is happening with other platforms,” she said. “I have not done it because I do not believe that is treating your customers fairly. But the FCA [Financial Conduct Authority] hasn’t actually got to thinking about that.”
Equally, technologies themselves do not determine the necessity of processes or rules in and of themselves.
“Whatever trading platform may evolve around DLT technologies it will still have to work under the model of exchange or central clearing,” says Satya Pemmaraju, founder of Droit, a fintech focused on post-trade analysis and regulatory reporting. “Around the question of who bears the payment risk or what happens under default, I don’t know of DLT initiatives that can resolve that question by themselves.”
It is incumbent upon regulators to impose rules that keep pace with innovation. Of the fintech operations reported on in the paper, concerns around wholesale markets were highlighted in two key areas: Institutional Trading Platforms and DLTs. The former are of particular interest because the bond market is transitioning from voice to electronic trading.
Consultancy Greenwich Associates estimates that the volume of electronic trading in US government bonds is around 49%, up from 31% in 2012, while 57% of volume for rates in Europe in 2015 was electronic.
By contrast, in the corporate bond market 50% of volume for investment-grade credit trading in Europe and 20% in the US was electronic in 2015. Corporate bonds are typically illiquid as the market is dominated by many small individual issues, which investors usually hold to maturity.
Sell-side risk trading has reduced because of capital adequacy requirements, and this has lowered liquidity even further.
The desire to capture more electronic trading has led to a range of new platforms launching to provide pre-trade liquidity data to help find counter-party, request-for-quote (RFQ) platforms which allow asset managers to request prices from select broker-dealers, auctions which automate trading via bidding and central limit order books (CLOB) which match up buyers and sellers in real time.
With approximately 50 platforms in play at present, knowing where to connect is challenging, both for buy- and sell-side firms. Getting it wrong is costly. One high-profile failure was Bondcube, which attracted may buyers and sellers but could not effectively match their orders. It failed within three months of launching in 2015. Iosco notes a range of challenges and risks faced by bond fintech start-ups and by the incumbent trading platforms, including tough market conditions, barriers to adopting new systems and product diversity.
For trading platforms, regulation in the US will typically be as an Automated Trading System (ATS) and in Europe as a multilateral trading facility (MTF) under the Markets in Financial Instruments Directive II (MiFID II), which comes into effect from 2018.
In both instances, the regulatory frameworks create responsibilities for platforms around market supervision, maintaining orderly markets and reporting. While the risks that members might face include a venue’s collapse or governance failure, the scope of regulation means that a firm of any significant size is likely to fall under existing regulation.
“In the state where the industry is not fintech-enabled it is really running a pen-and-paper process in terms of primary issuances,” says Vuk Magdelinic, CEO of Overbond, a primary market platform. “Where we move to a fully digitised investment banking workflow it will create some benefits. What are the risks that would create? Technology needs to have security and governance around it. We have to have policies and procedures around security, we have triple encryption.”
Spreading the load
DLT effectively allows firms to share a database, so that they can all see the same transaction information relating to them. It uses cryptography to ensure that only valid transactions can be recorded, removing the risk that one of the parties can alter the record.
The range of potential applications for this technology are huge. Its immutable shared record, lightweight technology build, shared infrastructure and consolidation of data sets to remove discrepancies are all very useful. There are many configurations of the technology, with access to the ledger being permissioned (only accessible by authorised parties) or public, with open access. The instrument transacted could be anything from a security to a smart contract, with the DLT automating connected transactions such as margin payments.
“A lot of the hype around DLT is that it could make certain aspects of core financial markets infrastructure (such as clearing) redundant,” says Angus McLean, partner covering Intellectual Property at law firm Simmons & Simmons.
As a shared technology resource, consortia have formed to develop technological standards that all participants in a DLT platform can integrate with. These tend to be either around a DLT provider such as Ethereum, R3 and Digital Asset Holdings, or around open-source initiatives. While the specific regulation applying to DLT providers will vary according to usage – for example, as a payments system or a clearing platform for derivatives – there are clearly operational risks that could develop in disputes over ownership.
“If the margins they were expecting to get from building or operating the system in question are significantly reduced because they have to pay licence fees to a third-party patent owner, that could jeopardise the viability of the system,” says Mr McLean. “That obviously has wider risks to it if the technology has become systemically important.”
The speed at which DLT could become a viable platform for transactions is reflected in the level of regulatory interest. In January 2017, the European Securities and Markets Authority (ESMA) issued a report, ‘The Distributed Ledger Technology Applied to Securities Markets’. It noted that a shared ledger could impede access to a market for new entrants, affecting fair competition and raised other issues, including data privacy concerns and cybersecurity. ESMA said it would continue to monitor developments.
In February, the Basel Committee issued a paper, ‘Distributed ledger technology in payment, clearing and settlement: An analytical framework’ for firms to consider when developing DLT to support risk management.
In the US, the Office of the Comptroller of the Currency (OCC) launched a consultation on December 2, 2016 with the intention of making special-purpose national bank charters available to fintech companies.
“The next step is for the OCC to consider the more than 100 comments on the paper it issued in December outlines issues associated with chartering financial technology companies and then publish a policy statement that clarifies our approach to evaluating charter applications from financial technology companies,” says Bryan Hubbard, deputy comptroller for public affairs at the OCC. “We are working to finalise that policy statement now.”
As a broader approach to inclusive fintech development, Mr Carney said the BoE supported the use of regulatory sandboxes to test ideas, the adaptation of existing authorisation processes, expanding access to central bank money to non-bank payments service providers and developing proofs of concept.
“As Mark Carney alluded to recently, if you disrupt one aspect of the business of a systemically important infrastructure provider through the use of technology, you also have to consider the risk that disruption has on the other key functions that infrastructure provider offers to the wider financial system,” says Mr McLean.