Key regulatory trends to watch out for in 2019

    As part of a series of insight papers exploring the impact of regulation on its core client base, HSBC Securities Services takes a look at what lies in store for the post-trade industry in 2019. In a world being remodelled by disruption and transformation, clients have been confronted with a number of significant regulatory changes and evolutions over the last year.

    While some of these new rules are introducing additional costs and barriers to the industry, other reforms – chiefly market liberalisation and cross-border harmonisation programmes in emerging economies have been very constructive and are likely to result in greater foreign institutional investment and liquidity. HSBC Securities Services takes a look at some of these issues, and analyses their collective impact on the post-trade community.

    APAC: Looking outwards for inward investment

    More reforms coming from China

    China’s liberalisation reforms have not relented. The joint success of Stock Connect and Bond Connect – which gave foreign investors access to domestic equities and fixed income instruments respectively – has convinced China’s regulators to expand the number of gateways available to foreign institutions looking to participate in the local market.

    In 2019, regulators are expected to relax the rules on foreigners accessing the CNY market for foreign exchange (FX) hedging purposes,1 alleviating investor concerns about the limited CNH pool that has previously been available to them. Furthermore, London-Shanghai Stock Connect will be live in the next few months, enabling issuers in both jurisdictions to list in each other’s market through depository receipt programmes.2

    Other access channels are being cultivated too between China and Hong Kong. The regulators in both jurisdictions are enacting measures to facilitate the cross-listing of ETFs (exchange traded funds) under the Mainland-Hong Kong Mutual Recognition of Funds (MRF) scheme - and in due course through the ETF Connect initiative.3

    Index inclusion for China

    These reforms are likely to have tangible benefits. In 2018, MSCI revised the number of A Shares it was adding to its Emerging Markets Index upwards to 434, which may result in USD66 billion of flows entering China from 2020.4 More recently, it was reported MSCI was consulting with the industry on potentially quadrupling the number of A shares on its benchmark between May and August 2019.5 Full inclusion - which experts are fairly assured will happen - could lead to USD300 billion in inbound capital being invested in local equities.6

    FTSE Russell also confirmed A Shares would be added to its Emerging Markets Index, which could lead to approximately USD10 billion in active and passive money manager capital moving into the country.7 Meanwhile, domestic bonds are being phased into Bloomberg Barclays’ fixed income benchmark, and it is highly foreseeable that other important bond indices such as those operated by J.P. Morgan and FTSE Russell will follow suit in 2019.

    Regional-wide changes

    Other APAC countries are also looking to develop their capital markets. India has simplified its account opening process and rationalised its KYC (know-your-customer) and AML (anti-money-laundering) checks, which experts believe will lead to a pick-up in investment activity inside the country. Meanwhile, Taiwan is lifting its regulatory requirement that foreign investors use a domestic custodian when allocating to local managers on condition they already have an overseas custodian,8 a move designed to attract more international flows. 

    The global pivot to T+2 has not escaped APAC with Japan and Malaysia confirming their trade settlement cycles will change in line with international best practices. However, broader regional harmonisation efforts in the post-trade space do face constraints because of the significant regulatory divergences and striking differences in economic development.

    Middle East: More reforms to come in 2019 

    Market-wide diversification

    MENA countries – after many years of reliance on oil revenues – are looking to diversify their economies by attracting more foreign investment into their markets. Post-trade reforms in Kuwait, the UAE, Oman, Qatar, Bahrain and Egypt have been in progress for several years now, but it is the initiatives underway in Saudi Arabia which have generated the most client interest, on account of its deep liquidity pool and market capitalisation size.

    Saudi Arabia and Kuwait lead the way on market reform

    Saudi Arabia’s reform zeal is not losing its impetus as evidenced by the recent announcement by the Tadawul, the local exchange, whereby it confirmed the launch of a domestic central counterparty clearing house (CCP), in what could lead to the development of a derivatives market by the end of 2019.9 Kuwait is implementing ambitious reforms too, as the country is presently launching its own CCP under the far-reaching Market Development Plan.

    In addition to the establishment of a CCP, Kuwait is also looking to introduce stock borrowing, repo and other trading mechanisms.10 All of these reforms have been acknowledged by a number of the leading index providers such as MSCI and FTSE Russell, in what is likely to result in more investor flows and liquidity coming into the GCC region.11

    Europe: The regulation keeps flowing

    CSDR: Now a reality

    Having achieved EU-wide T+2 harmonisation in preparation of Target2Securities, the framers executing CSDR (Central Securities Depository Regulation) are now pushing ahead with its settlement discipline regime, a provision which will see cash penalties and mandatory buy-ins levied on financial institutions for settlement fails from 2020.12 A failure to comply with the requirements could be costly, so organisations must ensure their settlement processes are fit for purpose ahead of the next stage of CSDR.

    Safekeeping under AIFMD and potential changes to the Directive

    Conscious that individual EU markets have their own unique approaches to AIFMD (Alternative Investment Fund Managers Directive) and UCITS’ asset safekeeping arrangements, the European Commission (EC) is proposing the rules be homogenised.13 The EC is recommending depositaries enhance their recordkeeping and reconciliation processes across the custody chain, a requirement which many in the industry believe is going to add very little value or protection for the end investor other than duplication.14

    An EC-wide review of AIFMD – based on a survey conducted by KPMG – was finally released in January 2019. The review – despite congratulating AIFMD for providing a boost to market-wide harmonisation – did raise concerns that depositaries in different EU markets often had their own unique approaches to cash-flow monitoring and look-through provisions.15 The review also criticised existing asset segregation provisions, pointing out that operating omnibus account structures across the entire sub-custody chain “is seen as unnecessary and burdensome for the industry, without providing increased protection for investors.”16 Firms should therefore be mindful that reforms to AIFMD may occur in 2019. 

    SRD II

    After a succession of corporate governance failures, the EC is taking decisive action through its Shareholder Rights Directive II (SDR II), which will oblige corporations to outline how they integrate shareholder engagement into their strategies. As part of SRD II, an issuer must be provided “without delay” with the details of shareholders who own more than 0.5 per cent of its stock.17 As intermediaries, custodians will need to facilitate this data sharing exercise and simultaneously ensure proxy information is relayed to investors in a standardised format. SRD II, however, is not a regulation so local supervisors may interpret the rules differently, which could be problematic for custodians with footprints scattered across the EU.

    The post-trade harmonisation mission continues

    Efforts to further entrench European post-trade markets have been a work in progress ever since the Giovannini Group’s findings were released in 2001. Despite achieving partial harmonisation through T2S, EMIR (European Market Infrastructure Regulation) and CSDR, the European market is still fragmented.18 AFME (Association for Financial Markets in Europe) recently said more progress was required to create a legal basis for cross-border settlements; develop an efficient method of reclaiming withholding taxes; harmonise collateral management; and ensure open access and interoperability at EU CCPs.19

    It was hoped many of these ongoing issues facing post-trade would be remedied by the Capital Markets Union (CMU), but the scheme’s momentum has been impeded as the EU addresses more pressing geopolitical and market stability risks. Timelines for post trade reporting to trade repositories of securities lending and repo transactions - as part of the Securities Financing Transaction Regulation (SFTR) – are now likely to become mandatory in 2020 following the EC’s adoption of the rules.20

    Taxation

    Efforts to introduce a pan EU financial transaction tax (FTT) are likely to come back into focus after the Spanish government drafted a bill proposing such a scheme in October 2018, which it estimates will accrue around EUR 8.45 billion in revenues.21 The FTT will charge a 0.2 per cent levy on sales of shares in Spanish companies with a market capitalisation exceeding EUR 1 billion by financial institutions.22 Debt and derivative instruments will be exempted from this surcharge. 

    The Americas

    Simplifying the Volcker Rule 

    In 2018, reform of the US Dodd-Frank Act began to take shape with smaller domestic banks - whose assets total between USD50 billion and USD250 billion - being exempted from a number of the legislation’s “too big to fail” clauses. Banks with less than USD250 billion in assets will now no longer need to draft living wills or conduct mandatory stress tests. 23 In 2019, financial institutions will likely be monitoring further efforts to simplify the Volcker Rule’s requirements on proprietary trading and holding certain interests in hedge funds and private equity funds.24

    Digital: Technology comes under the regulatory spotlight

    Securities markets are facing unprecedented change as new technologies such as Blockchain and artificial intelligence become increasingly integrated in the industry’s operational infrastructure. Stock exchanges in APAC – namely in Australia, Hong Kong and Singapore are beginning to adopt distributed ledger technology (DLT) in what could bring a number of efficiency benefits into the securities chain.25 The emergence of disruptive technologies is, however being scrutinised by international regulatory bodies such as the International Organisation of Securities Commissions (IOSCO) and the Financial Stability Board (FSB).26

    At the same time, digital assets (i.e. cryptocurrencies, tokenised assets, ICOs [initial coin offerings]) are slowly acquiring a loyal institutional investor following, which may in turn create a market for crypto product solutions.27 In January 2019, the European Securities and Markets Authority (ESMA) published advice on digital assets, whereby it said the risks facing crypto-custody needed to be properly considered, namely validating that custodial wallet providers safekeeping private keys to digital assets have adequate measures in place to safeguard and segregate their assets.28

    ESMA added regulation may be necessitated as existing rules do not take into account for these new instruments along with their underlying DLT infrastructure.29 This growing regulatory interest and scrutiny into disruptive technologies could herald increased oversight and supervision30 during the next 12 to 18 months.

    References

    1Baker McKenzie (June 2018) China liberalises capital repatriation and allows CNY-FX hedging for QFII/RQFII

    2Bloomberg (October 12, 2018) China issues latest proposals for Shanghai-London Stock Connect

    3Reuters (May 24, 2018) Hong Kong “working very hard’ on ETF Connect - official

    4Financial Times (September 26, 2018) MSCI eyes near-doubling of China weighting in EM index

    5Global Custodian (November 13, 2018) MSCI proposing significant increase of China A Shares in Emerging Markets Index

    6Reuters (April 27, 2018) What is China’s A Share MSCI inclusion?

    7FTSE Russell (September 26, 2018) FTSE Russell promotes China A Shares to Emerging Markets Index -

    8Asia Asset Management (May 18, 2018) Taiwan’s FSC plans to ease custodian rule for foreign investors

    9Global Custodian (May 3, 2018) Saudi exchange establishes independent CCP, targeting new asset classes

    10Kuwait Times (November 28, 2018) CMA sets timeframe for third phase of Boursa Kuwait development

    11HSBC – The evolution of MENAT: Navigating the regulatory landscape (PDF)

    12ESMA - Settlement

    13Global Custodian (July 10, 2018) EU asset safekeeping review may disrupt custody activities

    14Eversheds Sutherland (June 5, 2018) Changes to safekeeping requirement for UCITS and AIFs

    15EC (December 10, 2018) Report on the operation of the Alternative Investment Fund Managers Directive

    16EC (December 10, 2018) Report on the operation of the Alternative Investment Fund Managers Directive

    17Broadridge (September 2017) Shareholder Rights Directive: Advancing to a State of Readiness

    18AFME (May 11, 2018) Now is the time for integrated and efficient post-trade services

    19AFME (May 11, 2018) Now is the time for integrated and efficient post-trade services

    20Deloitte (December 20, 2018) Commissions adopts package of rules to increase transparency in securities financing markets

    21Forbes (November 29, 2018) The Spanish Financial Transaction Tax will see the light soon

    22Forbes (November 29, 2018) The Spanish Financial Transaction Tax will see the light soon

    23Reuters (May 22, 2018) Small banks trump Wall Street on Dodd-Frank rewrite

    24Federal Reserve – Proposed revisions to prohibitions and restrictions on proprietary trading and certain interests in and relationships with hedge funds and private equity funds

    25The Trade (October 31, 2018) HKEX confirms Digital Asset partnership for post-trade blockchain prototype

    26FSB (July 16, 2018) Report to the G20 on work by the FSB and standard setting bodies

    27Global Custodian (October 16, 2018) Fidelity Investments unveils dedicated crypto-trading and custody business

    28ESMA (January 9, 2019) Advice initial coin offerings and crypto-assets

    29ESMA (January 9, 2019) Advice initial coin offerings and crypto-assets

    30Deloitte (June 19, 2018) The future of regulation

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