Regulation vs innovation: it’s a chicken and egg argument

The global financial marketplace is undergoing something of a facelift in terms of its regulatory and standards landscape. With the recent arrival of the Markets in Financial Instruments Directive (MiFID), a piece of legislation aimed at harmonising the trading of securities across Europe; the single euro payments area (Sepa), which is designed to tackle the proliferation of payments systems across European national borders; and the migration from SWIFT’s 15022 standard to 20022, the new XML standard for processing payments messages, it is easy to see how the global markets are undergoing a period of metamorphosis.

Technology too is undergoing a period of heavy evolution, and the intensity of innovation and change is at its most ferocious. But where does technology place itself in this space and is it driving the new standards and regulations or merely reacting to them?

The FSA and SEC have some pretty enduring regulations and principles that have stood the test of time. Most of the regulatory framework in the US comes from the Securities Exchange Act of 1934, a sweeping piece of legislation that built upon the Securities Act of 1933 to regulate the secondary trading of securities between persons often unrelated to the issuer of the security.

Longevity

This piece of legislation has been around for more than 70 years, and broadly speaking the principles set out in the act are the ones that most enforcement activities in the US are based upon. In terms of a broker confirming trade details to a customer, for example, that activity is governed by the Exchange Act which stipulates that a broker must confirm at or near execution the details of the trade stating the share amount, the settlement amount and whether the broker is acting as a principal or agent. The act itself also tells the broker what information they need to provide for their customer.

Back in 1934, that process was done with paper, but in the past 30 years technological innovation has allowed the system to become electronic.

In this case, electronic communication was acknowledged to be compliant with the 1934 Act, so the piece of regulation accepted technology innovation and allowed it to stand as compliant with the original principal of the regulation.

Steps ahead

“Technology innovation outpaces any consensus agreement by a community on the best practices of how a process should work,” says Tim Lind, managing director of strategic planning at Omgeo, the post-trade, pre-settlement solutions provider. “When you see a standard or piece of legislation emerge I think you are seeing a sign of maturation of a process, not innovation.”

This is a logical opinion to have. ‘Innovation’ implies that something is being done that nobody else is doing, but standards and regulation are aimed at getting everybody to do the same thing in a similar way.

That is not to say that a standard cannot then generate further innovation, and as Chris Pickles, industry relations manager at BT Global Financial Services, says, standards can build economies of scale, bring everyone’s costs down and create a useful cycle. “The innovation comes first and the standard comes second. People use the elements of the standard as a building block but then register what they have done so it becomes a standard and other people can use it, which then builds a community,” he says.

Unforeseen circumstances

If that analysis is extended to regulation then a similar process can be found. Regulation can tend to be reactive to innovation in terms of new financial product development, for example, where there are risks associated with the trading of new financial products. If unforeseen circumstances occur then the regulators may step in to make sure that a risk framework is established around that new product.

Not everyone shares this view, however, and some believe that standards and regulation can be the catalyst for innovation – not only in technology but also in market practices, which then trigger technology change.

Phillipe Carell, director of risk and trade management services at Reuters, is one such person, and believes that new products and instruments by definition are created to avoid standards.

The growth in CDOs and liability-driven instruments is a good example of this. Why are they here? Mr Carell believes it is because of the Basel Accords – recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. It said that a bank had to allocate its capital based on risk-weighted exposure that was measured on its balance sheet. Mr Carell says this is precisely why millions of dollars of CDOs have been issued over the past five years.

“You create a rule to make something transparent, like the exposure to credit risk or the transaction price, and at the same time you create the rule you also show the way to override it,” he says. “The same goes for standardisation. If you standardise interest rate swaps, for example, then fine, but I’ll attach a couple of barrier options and I’ll create a special feature swaption and all of a sudden you can’t really look at the spread against my competition. I have swamped and hidden the spread by attaching some other legs.”

Driving innovation

According to this view, if standardisation did not exist in the first place then the financial markets would not be as efficient or transparent, meaning that financial institutions would not suffer from stiff competition and so the creation of new products would be stemmed.

“My opinion is that the regulatory standards that a consortium will adopt will then tend to drive technology innovation,” says Gordon Burnes, vice-president of marketing at Openpages, the provider of risk management solutions. “I don’t see the regulatory environment being hampered by the ability to deliver a technical solution, and in most cases technology really can facilitate any way of interoperation between two firms.”

Standardised approach

In the US, the Securities and Exchange Commission (SEC) needed a more efficient way of filing financial reports while the industry agreed that it needed to standardise its approach, so XBRL (Extensible Business Reporting Language) emerged as an XML-based standard to define and exchange business and financial performance information. Here technology innovation was driven by the regulatory landscape.

While it can be argued that there are cases where standards and regulation are hanging onto the coat tails of technology innovation, it can also be seen that there are cases where regulations and standards have actually been responsible for innovation in the technological market.

So, do regulation and standards drive technology or does technology drive standards and regulation? It is an argument of chicken and egg and really depends on from where and when you are looking at it.

There is always a lot of talk and procrastination around standards and regulation before action and one problem is that the whole process is rather slow. It can be argued that the rate of technology innovation and implementation surpasses the rate at which regulation or standards come into play, and so there is a danger that the need for which those were designed has been fulfilled before the specific piece of regulation or particular standard comes into force.

With MiFID this is seen right away. One consequence of MiFID is that liquidity will become virtual. In the years and months before the directive came into operation, all the large global investment banks invested in large execution venues so they could adapt their order management system in order to create their own liquidity pools. Even though MiFID has only recently kicked off, in this space all the global banks are ready.

Taking it slowly

“I think we are going to have to accept it as part of the business reality. If regulation or standards were at pace with innovation, or close to the cutting edge, we would enact standards and laws that were unfortunately ill-conceived,” says Omgeo’s Mr Lind. “If you rush a standard to market without sufficient perspective and contemplation and industry buy-in then you are going to miss a lot of things.

“The quality of what you produce will ultimately be suspect and you are going to have to live with it.”

Both the FSA and SEC go through a contemplation process and comment period so that the intended and unintended ramifications of enacting any piece of legislation are understood. Certain laws can change certain behaviours within the market and once a law comes into play it can be very difficult to reverse. The same is true with standards. Back in the late 1980s the early stages of securities messages were being established at SWIFT, the secure messaging services and interface software. They were then replaced by 15022 in the late 1990s and in the early part of this century and the migration plan was fairly painful.

As Carlo Palmers, head of payments development in the standards department at SWIFT, explains, the move to ISO20022 was originally proposed for 2008. This sparked a unanimous reply from the banking industry that it would not be ready in time. Now the date the industry is working towards is November 2009. The standards update itself will be done in late 2007, with banks requiring two years to do the actual implementation.

Different speeds

“It is very optimistic to say that the speed of innovation within financial institutions might surpass standards or regulations and I’m not sure it is going that fast,” says Mr Palmers.

“If I was going to put everything in order of speed then regulation is the fastest moving, then standards and then technology innovation. There is very often the request to develop the standards faster but whenever that is being done the adoption is never going faster than in the past.”

Even though standards bodies and regulators can act in a measured and calculated manner, not all of them produce standards and pieces of legislation in the same way. We only need to look at the standards space to see the differences in the approaches taken by standards bodies such as SWIFT and FIX which really represent the opposite ends of the spectrum.

SWIFT would argue that it wants to do standards ‘right’, where as FIX, the industry-driven messaging standard for trade-related messages, would argue that it wants standards ‘right now’. Many versions of FIX have been released and there is a real version control issue with the organisation throwing out a new version of its messaging standard and then replacing it or amending it within a very short space of time. By comparison, the SWIFT approach would be to update its standard once every few years after careful deliberation and assurance that the time is right for the marketplace to receive something new.

Both approaches have their merits but most industry players feel that if they are looking at a standard that is going to be embedded in a lot of applications across a regional or global market they would prefer not to migrate more than they have to.

“It is a fair reflection but it is very much dependent on the different areas that you are looking at,” says Mr Palmers at SWIFT. “If you are looking at the derivatives market then it doesn’t make sense to wait two years for a new standard because the products are being created every two weeks, but that is completely different for something like payments. The payments market is such a stable and widespread market that you cannot afford to introduce a standards update every few months because the institutions would not be able to follow and the applications would not be able to be adapted at that speed.”

Bank dictatorship

TWIST, the provider of XML-based standards for the financial supply chain, is also an interesting example, particularly in the bank to corporate environment. Classically, banks have told corporates how they must communicate with them and the banks’ attitudes have always been quite dictatorial. TWIST standards, however, have been developed from more of a business and corporate perspective, allowing corporates to challenge the usually interaction between it and the bank.

“I’d say that FIX and TWIST and FPML are definitely the most responsive standards bodies,” says Mr Pickles at BT Global Financial Services. “As with MiFID, they can come out with a new standard within six months, so the MiFID-capable version of FIX was done in April 2006 whereas the new ISO standards only came through in August this year.”

Mr Pickles maintains that market participants have always complained about the length of time it takes to develop a new ISO standard, as compared to a new element or version of FIX which can be implemented much more quickly.

Standardisation

He says: “The difference with FIX is that its approach is more like giving the industry a box of mixed up Lego and saying ‘you pick the bits that you need’. So one person wants to build a house, one person wants to build a boat, but it’s all made out of the same building blocks and you agree on the standardisation at that point. The ISO approach on the other hand tends to be that you have to agree to build the same thing with the same tools and materials but life isn’t like that.”

One of the problems with taking a more prescriptive approach is the more prescriptive you are, the more you give a blueprint to institutions to circumvent that rule, which can allow companies to get to the stage where they comply with the letter of the law but not the spirit of it. This is inevitably counter-productive to the standard or regulation.

The industry as a whole seems to prefer the light touch approach to standards and regulation because it allows financial institutions freedom.

While this is the case, the role of standards and regulation should not be undermined as they can give the building blocks for product and technological innovation which will invariably drive evolution forward.

The debate here is not necessarily around whether regulation and standards drive technology innovation or the other way around, as this will always be a chicken and egg debate, but how cautious or efficient market participants feel standards and regulatory bodies need to be in bringing new influential frameworks to the market place.