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Regulatory Challenges for UK Prime Brokers in 2022

Iain Sheridan Iain Sheridan

2022 is seeing a marked increase in new financial regulatory requirements on UK FCA and PRA regulated firms. Paul Young and Iain Sheridan look at how these challenges will impact prime mortgage brokerages. 

A key focus is on the changes affecting compliance, operational and risk functions.

For prime brokerage business units, there are three specific challenges that must be negotiated from now until the end of this year. At the outset, it's important to underline that for reasons of efficient project implementation, all three challenges need careful assessment before the end of Q1 2022. This is because, where feasible, changes to control, governance and risk management processes may more efficiently apply to multiple regulatory expectations.

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A systemic review of prime brokerage operations

Brought to light by the default of Archegos in March 2021, resulting in reported market wide USD 10 billion losses, global primary brokerage businesses are under increased scrutiny. The FCA and the PRA co-published a Dear CEO letter on 10 December 2021, outlining a supervisory review of these firms. The joint PRA-FCA letter sets out their expectations, targeting all prime brokerage services to complete systemic reviews. These expectations consist of:

Business strategy and organisation

Firms need to establish consistency of controls, monitoring, and risk measurement across all relevant business units. If a bank is offering prime brokerage services from more than one business unit, they must establish detailed mandates for each to meet best practice.

Onboarding and reputational risk

Firms must also make continuous client re-assessment processes that require high level decision making and sign-off from senior management. Firms are expected to dynamically combine new reputational risk due diligence, independent credit checks and variation in risk profiles across different business units.

Financial risk management controls and governance

Firms need standard contractual terms appropriate for different types of client accounts in place, including flexible clauses that allow for post-trade margin changes. This is expected to be achieved through consistent contract negotiation policies and procedures across different business units.

Furthermore, in-house risk management teams are also required to support all prime brokerage units in a holistic way. Data quality and stress limit frameworks must also be combined to reflect each firm’s risk appetite across all types of client portfolio exposure to ensure.

Liquidation and close-out

Firms should ensure that they're calibrating and scaling risk exposures to the firm’s own ability to exit positions in the event of default and liquidation. If not already in place, firms can manage these events by producing default and liquidation playbooks that provide detailed reviews on their responsibilities, roles and scenarios.

Dear CEO expectations

The PRA and FCA expect firms to provide detailed plans for remediation and ensure that any necessary improvements are identified. A tight deadline, end of Q1 of 2022, has been set to complete reviews and plans.

The Dear CEO letter states that although Archegos did not have financial stability impacts, consequent events provide strong evidence of the effects of leverage in the non-banking sector on other counterparties. Additionally, the FCA and PRA highlight the pitfalls of poor risk management, stating that firms should ensure that equity financing businesses strengthen their risk practices to ensure financial stability in the future.

Providing accurate data and a timely response will require one or more senior managers to be responsible for oversight of the remediation plan and confirm it's reported correctly to meet best practice. The supervisory review of equity finance businesses should ensure, where relevant, the highlighted themes cover all major brokerage activities including fixed income and derivatives. All reviews should also address broader observations on risk culture across the firm and the infrastructure in place.

Operational resilience rules

From 31 March 2022, the FCA and PRA operational resilience rules present a further level of risk management responsibilities.

The 'what' of operational resilience

By the end of March 2022, all firms must have identified their important business services (IBS). These include services provided by a firm or by an agent acting on its behalf to a client based on two scenarios. First, if the IBS was disrupted it would cause intolerable levels of harm to any one or more of the firm’s clients. Second, disruption of the IBS poses a risk to the soundness, stability or resilience of the UK financial system, or the orderly operation of the financial markets. Additionally, firms must set impact tolerances for each IBS. In sum, by the end of Q1 2022, firms must have implemented these two requirements.

The 'how' of operational resilience

The subsequent operational resilience challenge is the ongoing requirement to perform more sophisticated mapping exercises of resources that support IBS processes, with the policy documentation approved at board level. All relevant IBS processes need to be considered, including customer account provision, IT systems, outsourcing, and payment systems. Therefore, developing the initial mapping exercise and related scenario testing plan in Q2 2022 becomes a high priority. From the regulators’ perspective, it may be indicative of weak operational resilience if senior management functions have not progressed to sign off on at least the first mapping exercise.

Changes to OTC derivatives reporting and related data quality standards

For those unfamiliar with the significance of the proposed changes to both FCA and PRA policies on derivatives reporting, the detail, including proposed changes to existing rules, are found in its joint 237-page Consultation Paper CP 21/31, November 2021 (CP 21/31).

The primary aim of CP 21/31 is to align UK derivatives reporting with the international guidance jointly issued by the Committee on Payments and Markets Infrastructure and International Organization of Securities Commissions (CPMI-IOSCO). Simultaneously, alignment with CPMI-IOSCO guidance make the incoming UK rules consistent with EU rules.

Firms should make sure they are up to date with the latest regulation to ensure that they're meeting best practice, and given that the technical rules may be effective as early as June 2022. The rational way forward is to plan compliance changes from mid-2022 onwards.

For prime brokers, the two key relevant aspects of CP 21/31 concerning (a) changes to OTC derivatives reporting fields, and (b) the standardising of data formats submitted by counterparties.

First, the changes to the existing reporting fields under UK EMIR to match the CPMI-IOSCO guidance. This change would make UK OTC derivatives reporting consistent with not only EU reporting, but also the likely compliance with CPMI-IOSCO guidance in Australia, Singapore, and the US (CFTC).

Second, CP 21/31 aims to increase data quality of derivatives trades by proposing that counterparties use standardised XML schemas. To maximise the consistency of XML schemas, counterparties will be required to also apply ISO 20022 – a prescriptive global quality standard. For those new to ISO 20022, in essence it's both an internationally recognised methodology and taxonomy for financial services transactions and associated message communications.

CP 21/31 sets out draft technical standards covering both changes. What is most challenging is perhaps not so much the technical IT implementation of new reporting fields and higher data quality standards, but the time constraints to comply with both changes. In short, the regulators are planning on imposing an 18–24-month transition period from when the technical rules are implemented. Given the technical rules may be effective as early as June 2022, the rational way forward is to plan compliance changes from mid-2022 onwards.

Planning ahead

The regulatory changes affecting prime brokerage firms over the remainder of 2022 present a pressing need to plan how each will be covered and how to most efficiently synchronise action points that apply to more than one set of the rule changes to avoid duplication of effort. For example, it's likely that a review of liquidation and close-out risks (required in Q1 2022), overlaps with senior management decision making and expenditure on operational resilience mapping and scenario testing. The table below encapsulates the three challenges and applicable deadlines.

Rules Deadlines and other timings
FCA/PRA Systemic Review of Prime Brokerage Operations Report findings and detailed plans for remediation to be submitted by the end of Q1 2022
FCA/PRA Operational Resilience Ongoing mapping exercises and senior manager approval from the start of Q2 2022.
FCA/PRA UK EMIR changes (CP 21/3) Begin detailed planning of implementation from Q3 2022.

For more insight, get in touch with Iain Sheridan.