The impact of the regulatory wave on the strategy of financial institutions

SFF Magazine December 2024

Topics: EU, Fund distribution, Legal, Trends

While the implementation of EMIR Refit has tested the ability of financial institutions to adapt to regulatory updates, the changes in the regulation of financial instruments expected in 2025 foresee an equally demanding year in this respect. The implementation of EMIR 3.0, the development of the MiFIR Review and the evolution of MiCAR may have a significant impact on the business model of banks and investment fund managers. Moreover, the amendments that the Retail Investment Strategy (RIS) will bring to the MiFID framework can also start being anticipated as of this year.

Evaluating adaptation to EMIR Refit

The go-live of EMIR Refit on 29 April 2024, brought important changes for financial institutions using derivatives in their investment and hedging strategies. Many banks have made a significant effort in adapting their reporting mechanisms or in working with their software providers to be able to report a greater amount of data with a higher level of granularity as required by the new regulation.

Moreover, investment fund managers are legally responsible for reporting the trades entered by their funds, a mostly delegated task that has triggered the review of the relevant delegation contracts. Due to oversight obligations, one of the main challenges has been to strengthen the monitoring processes over the data reported on their behalf by the service provider without losing the benefits of delegation.

The implementation of EMIR Refit has revealed challenges such as data availability, the interpretation of feedback messages provided by the trade repository, and most importantly, the notification to the regulator in case of reporting errors or technical problems preventing timely reporting.

Currently we observe different degrees of maturity in the market with regard to these changes. Banks are striving to streamline the management of data linked to reporting obligations, where costly manual processes and reliance on third parties persist. The multiple data conversions and the use of outdated supporting technologies make it even more difficult to adapt to such a rapidly changing landscape.

Quality control on reported data

The announcement of increased regulatory supervision by the CSSF and the obligation introduced by EMIR 3.0 to establish appropriate procedures and arrangements to ensure an adequate reporting indicate that data quality will become the focus in the coming years. Fines may be imposed on institutions that make systematic manifest errors in the data reported. While these changes increase the regulatory pressure, the overall impact of EMIR 3.0 for banks and investment fund managers will remain far from the seismic shift experienced this year with EMIR Refit.

Pending the technical standards that detail how this monitoring should be carried out, some solutions can already be implemented, ranging from sample testing reports to adopting monitoring tools that control the data reported and display key figures.

Nevertheless, the changes introduced by EMIR 3.0 focus on the obligation for institutions above the clearing threshold with a given volume in certain interest rate derivatives to have an active account with a central counterparty in the European Union that is operationally able to clear on a short-term basis. Counterparties with an outstanding notional clearing volume above 6 billion euros must clear on an annual average basis and, through that active account, at least five transactions per reference period in each of the sub-categories to be determined by ESMA.

Considering the current clearing thresholds, the scope of products subject to the clearing obligation, and the 6 billion threshold exemption, EMIR 3.0 is likely to have a minor impact on most small and medium-sized institutions established in Luxembourg.

“Nevertheless, the changes introduced by EMIR 3.0 focus on the obligation for institutions above the clearing threshold with a given volume in certain interest rate derivatives to have an active account with a central counterparty in the European Union that is operationally able to clear on a short-term basis.”

Revision of the MiFID/MiFIR framework

The MiFIR Review entered into force in March 2024, although the bulk of the technical standards underpinning it will be phased in over the coming year. A final wave of consultations is expected in January 2025, leading to a final ESMA proposal in October 2025.

Besides the changes in the reporting, one of the most significant changes in the MiFIR Review is the prohibition of receiving payment for order flows. The obligation to ensure the best possible price and execution is incompatible with the institution receiving any fee, commission, or profit for executing orders in a particular market on behalf of retail clients or those who have opted into the professional client regime. Where national rules apply, member states may be exempted from the ban until 30 June 2026.

The changes that the Retail Investment Strategy will bring to the MiFID framework after 2025 are centred in the ban on inducements, in the communication and marketing of products, as well as in their value for money. The prohibition of inducements is part of this EU proposal to ensure best execution and to encourage retail investors to participate in the markets. The new best interest test replacing the current suitability assessment, will be particularly challenging at the level of the distributor. Thus, entities wishing to successfully surf the regulatory wave will need to review their business strategies and product offering.

MiCAR

The emergence of crypto assets as a new asset class has been met with stagnating adaptation in Luxembourg over the last few years. To stimulate demand and provide additional regulatory certainty, the European Union has adopted a new regulation, the Markets in Crypto-Assets Regulation (MiCAR). This regulation classifies various types of crypto-assets and introduces new rules for providing related services, enabling their passporting in all EU member states. Banks and investment fund managers should consider adapting their operations to prepare for future demand in case of a bull run in cryptocurrency prices.

“To stimulate demand and provide additional regulatory certainty, the European Union has adopted a new regulation, the Markets in Crypto-Assets Regulation (MiCAR). This regulation classifies various types of crypto-assets and introduces new rules for providing related services, enabling their passporting in all EU member states.”

A change in the governance framework driven by the regulatory wave

The regulatory framework for markets is constantly changing, with a clear tendency to grow in complexity and sophistication, which inevitably entails additional costs. This leads the management of these entities to review their internal operating models as well as their relationships with service providers. During 2025, the challenge will be to focus on the choice of an efficient model and an adapted governance framework.

In the case of international groups, it is important to consider the different approaches that each regulator chooses to adopt and the different penalty regimes imposed by them. Locally, we have seen in Luxembourg a notable increase of the involvement of the second and third lines of defence in the process of adapting to new regulatory changes.

In conclusion, it appears that the regulatory framework is evolving at a much faster pace than the ability of the affected entities to adapt. While some see it as an obstacle in their predetermined roadmap, many others see it as an opportunity to review their strategy and to obtain additional revenues from new business streams.