Regulation as the drive and brake for digital transformation
29 October 2024
Speaking with industry experts, Daniel Tison explores how evolving regulations are simultaneously accelerating and hindering digitalisation in securities finance
Image: stock.adobe.com/IBEX.Media
As the financial landscape is rapidly evolving, regulatory frameworks are becoming increasingly complex, and the pressure on companies and institutions to innovate is intensifying. While new technologies offer solutions to streamline operations and compliance, they also present challenges and security risks that need to be addressed.
According to Roman von der H枚h, managing director at RAQUEST, one of the key benefits that digitalisation brings to securities finance is the automation of regulatory reporting.
鈥淩egulation drives automation and digitalisation because the more regulations you need to cover, and in order to be compliant, the more technology you need to use,鈥� he says. 鈥淚t鈥檚 so many data points, so many interfaces and gateways to different authorities, and you need to play around with those, so you can鈥檛 do it manually anymore.鈥�
The traditional, paper-based method of regulatory reporting is inefficient, risky, and more costly, according to von der H枚h. To help companies with automation, RAQUEST provides financial institutions with software for reclaiming withholding taxes.
This includes compliance with the Faster and Safer Tax Relief of Excess Withholding Taxes (FASTER) Directive, introduced by the European Council in May 2024. The new rules aim to make withholding tax procedures in the EU more efficient and secure for investors, financial intermediaries, and national tax administrations.
For von der H枚h, EU FASTER has two angles: quicker tax relief for investors in digital assets, and prevention of tax evasion and tax fraud. 鈥淚f you have proper tax reporting along the whole custody chain of all intermediaries, you get so many data points that you can clearly address tax fraud and tax evasion,鈥� he says.
EU member states will have to transpose the directive into their national legislation by 31 December 2028, and these national rules will have to become applicable from January 2030.
However, as von der H枚h adds, regulation can also hinder the process of digitalisation for industry participants.
鈥淲hat we have seen over the last couple of years is that banks struggle so hard to comply with all the new regulations like GDPR,鈥� he says. 鈥淭hey spend all of their budgets with expertise and IT architecture on those pieces because they just have to, so then there is nothing left budget-wise to address innovation, to address digitalisation.鈥�
Fear of missing out
Phil Brown, CEO of Clearstream Banking, believes that there is an exciting future ahead by combining tokenisation and native digital securities with securities finance. However, he prefers a more cautious approach to make the transition suitable for a wider market.
鈥淥ne of the reasons a lot of these projects fail is because the market is not ready to adopt a totally new end-to-end infrastructure,鈥� he says, 鈥渟o we decided to provide a journey to a full on-chain world that made it easy for the market to move with us along that journey.鈥�
Brown warns against a 'fear-of-missing-out' mentality around technology where companies innovate just to stay with the perceived progress of the competition. He says that Clearstream instead wanted its technology to be 鈥渋mpactful鈥�.
鈥淭he key is to choose the right technology to solve the problem,鈥� he says. 鈥淲e started our D7 platform with a semi-DLT model, we put it into implementation, we tried to scale it, and we found that it had limitations. Then we went back and, with our partner Google, we鈥檝e retooled the technology into a much more scalable technological infrastructure.鈥�
On that note, Leo Labeis, CEO of REGnosys, stresses the importance of planning ahead and having an agreement within the company before launching new technology.
鈥淚t鈥檚 not just about coming up with shiny technology and then, suddenly, everything is going to work according to plan,鈥� he says. 鈥淚t鈥檚 about everything around it, and how you promote that transformation within the organisation, which means making sure that you buy in from the relevant stakeholders and making sure that you have an alignment internally that everybody effectively wants to move in that direction.
鈥淵ou need to have a very solid business case that is articulated, including the economic basis for doing it, so you don鈥檛 run a risk. The worst thing is when you embark on a transformation, and then it鈥檚 half-baked when suddenly people have a change of heart, and usually that鈥檚 because you have some of the key ingredients missing.鈥�
New technologies to the test
Some of the benefits of migrating into the cloud, according to Brown, are faster processing, cybersecurity coverage provided by proven companies, and the option to overlay digital native technology on top of the data stored in the cloud. However, there are also certain challenges to some of the new technology models.
鈥淚t鈥檚 fine, as a proof of concept, to issue one security in a closed ecosystem where everybody agrees how it鈥檚 going to work and then works on that specific use case to get it to work,鈥� says Brown. 鈥淥ur experience is that when you try and scale it, you start to uncover the limitations of the infrastructure that you might have designed. So scalability is really critical. You also have to understand how you will move from a small-scale closed ecosystem to much wider adoption.鈥�
He believes that there needs to be a central bank digital currency in order to deliver widescale digitalisation of the European repo market, which is currently being tested in the European Central Bank (ECB) trials.
In these trials, running from May to November this year, market participants, including Clearstream, are exploring new technologies to settle wholesale transactions using real central bank digital money.
Brown comments: 鈥淭he ECB trials are a really important factor in figuring out what a future world looks like with settlement against a real on-chain coin issued by a central bank.鈥�
To allow financial firms in the UK to test new technologies in a safe environment, the Bank of England (BoE) and the Financial Conduct Authority (FCA) have recently introduced the Digital 麻豆传媒 Sandbox (DSS), which is now open for applications.
This follows positive feedback from stakeholders to a public consultation running between April and May 2023.
Sarah Breeden, deputy governor for financial stability at the BoE, says: 鈥淭he DSS will provide a guided live environment for innovators in this area to create and trade these digital securities so that opportunities created by this innovation can be maximised in a way that keeps our financial system safe.
鈥淲e鈥檒l apply flexible and proportionate regulations created specifically to facilitate this activity. Flexible rules allow us to make adjustments as we learn to support the safe development and implementation of these technologies.鈥�
The DSS, running at least until December 2028, is open to firms of all sizes and at all stages of development as long as they are legally established in the UK.
Breeden adds: 鈥淭aking this approach means we can shape a new, permanent regulatory regime that鈥檚 innovation-friendly and fit for purpose, and importantly, without compromising financial stability.鈥�
The sandbox also allows firms to test legislative changes in real-world scenarios before their implementation.
On the same page
Effective regulation is important, says Brown, to ensure that investors are protected in the same way as in the 鈥減re-digital world鈥�.
According to Labeis, there is currently a lack of standardisation in securities finance, which limits interoperability between new technological solutions. As head of a regulatory technology platform, he sees standardisation as a prerequisite for further digitalisation of the market to be effective in the long run due to its role in regulatory reporting.
He says: 鈥淚t鈥檚 very easy to see that if you did have a market operating with data standardisation at its heart, then being able to report transactions to the regulators, or trade repositories, would be drastically simplified, as opposed to the current way of doing it, which is each and every participant or their technology vendors have their own way of representing those transactions.鈥�
To reduce the susceptibility to cyber threats across the financial sector, the EU has introduced the Digital Operational Resilience Act (DORA), which will apply as of 17 January 2025. By creating a uniform regulatory framework across the EU, the regulation aims to harmonise national regulations regarding cybersecurity in the financial sector and strengthen the European financial market as a whole against cyber risks.
In addition, the European Supervisory Authorities (ESAs) have developed regulatory and implementing technical standards, which are also legally binding for financial entities and their IT providers.
Labeis is in favour of DORA because he believes that it will help increase the standardisation within the industry, bringing a capacity for stakeholders to switch between technology providers 鈥渕uch more easily鈥� than what they are currently able to do.
鈥淲hen you try to switch from one provider to another, it鈥檚 typically very costly, which is why there is a lot of stickiness,鈥� he says. 鈥淏y that reasoning, if you make it easier and more seamless for firms to be able to choose their solution provider for particular aspects of how they carry on their business, then it means it becomes a lot more cost-effective for them, and ultimately builds resilience.鈥�
Brown feels confident that DORA will not have a huge impact on Clearstream because the firm is already 鈥渉ighly regulated鈥�. However, he adds: 鈥淭he question is what does it do to companies that are not regulated, how do they respond to the DORA regulation, and what kind of pressures are going to put on there? That鈥檚 where DORA will start to shine a light on where the risks are in the supply chain from a digital resiliency perspective.鈥�
Looking ahead, Labeis anticipates that digitalisation will have a 鈥渕assive鈥� impact on the securities finance industry: 鈥淒igital first, as opposed to digital second, is going to be a theme for the next five years, and the interesting question is going to be, how do you manage?鈥�
As an example, he provides digitisation of legal agreements between counterparties. He believes that a greater degree of standardisation would also benefit the digitalisation of collateral management.
鈥淎nything that removes the frictions that are there to free flow of collateral between counterparties will unlock more liquidity that is effectively available to oil the system, which then supports economic growth,鈥� he says, 鈥渁nd you can鈥檛 achieve these dramatic increases in that collateral availability through that free flow if you don鈥檛 have digitalisation of those processes and themselves supported by a higher degree of standardisation.鈥�
Relationship-driven world
Although digitalisation saves time on a daily or monthly basis, it still requires regular manual maintenance due to regulatory overhauls, as von der H枚h explains: 鈥淵ou need to have the technical capabilities that dock on different interfaces, internally and externally. That is a big, huge challenge.鈥�
Complete automation of the system would require advanced machine learning and automatic software engineering, which does not seem possible to von der H枚h at the moment, but he sees a large potential for the near future, with the development of blockchain and smart contracts.
鈥淲hat I strongly belive is that AI will play a big role, and then digital interfaces like API, to transform and send over data to any kind of stakeholders, that will also be a part of it.鈥�
Despite increasing efforts to employ AI and machine learning in an increasing number of processes, Brown believes that the human touch is still needed because securities finance is a 鈥渞elationship-driven world鈥�.
鈥淸Trade matching] can be an automated process, as can basket construction, but you are going to have a human element,鈥� says Brown. 鈥淲e鈥檙e not yet in a world, and I don鈥檛 think we鈥檙e anywhere near a world, where you will predominantly meet people digitally and trade with them without having had a human interaction.鈥�
He adds: 鈥淚t鈥檚 so important, especially in stressed markets, that you have personal relations with people, so that you can actually look in the whites of their eyes and feel confident in your counterparty. Technology will facilitate the connectivity, and will certainly drive efficiency, but humans will continue to have to work together.
According to Roman von der H枚h, managing director at RAQUEST, one of the key benefits that digitalisation brings to securities finance is the automation of regulatory reporting.
鈥淩egulation drives automation and digitalisation because the more regulations you need to cover, and in order to be compliant, the more technology you need to use,鈥� he says. 鈥淚t鈥檚 so many data points, so many interfaces and gateways to different authorities, and you need to play around with those, so you can鈥檛 do it manually anymore.鈥�
The traditional, paper-based method of regulatory reporting is inefficient, risky, and more costly, according to von der H枚h. To help companies with automation, RAQUEST provides financial institutions with software for reclaiming withholding taxes.
This includes compliance with the Faster and Safer Tax Relief of Excess Withholding Taxes (FASTER) Directive, introduced by the European Council in May 2024. The new rules aim to make withholding tax procedures in the EU more efficient and secure for investors, financial intermediaries, and national tax administrations.
For von der H枚h, EU FASTER has two angles: quicker tax relief for investors in digital assets, and prevention of tax evasion and tax fraud. 鈥淚f you have proper tax reporting along the whole custody chain of all intermediaries, you get so many data points that you can clearly address tax fraud and tax evasion,鈥� he says.
EU member states will have to transpose the directive into their national legislation by 31 December 2028, and these national rules will have to become applicable from January 2030.
However, as von der H枚h adds, regulation can also hinder the process of digitalisation for industry participants.
鈥淲hat we have seen over the last couple of years is that banks struggle so hard to comply with all the new regulations like GDPR,鈥� he says. 鈥淭hey spend all of their budgets with expertise and IT architecture on those pieces because they just have to, so then there is nothing left budget-wise to address innovation, to address digitalisation.鈥�
Fear of missing out
Phil Brown, CEO of Clearstream Banking, believes that there is an exciting future ahead by combining tokenisation and native digital securities with securities finance. However, he prefers a more cautious approach to make the transition suitable for a wider market.
鈥淥ne of the reasons a lot of these projects fail is because the market is not ready to adopt a totally new end-to-end infrastructure,鈥� he says, 鈥渟o we decided to provide a journey to a full on-chain world that made it easy for the market to move with us along that journey.鈥�
Brown warns against a 'fear-of-missing-out' mentality around technology where companies innovate just to stay with the perceived progress of the competition. He says that Clearstream instead wanted its technology to be 鈥渋mpactful鈥�.
鈥淭he key is to choose the right technology to solve the problem,鈥� he says. 鈥淲e started our D7 platform with a semi-DLT model, we put it into implementation, we tried to scale it, and we found that it had limitations. Then we went back and, with our partner Google, we鈥檝e retooled the technology into a much more scalable technological infrastructure.鈥�
On that note, Leo Labeis, CEO of REGnosys, stresses the importance of planning ahead and having an agreement within the company before launching new technology.
鈥淚t鈥檚 not just about coming up with shiny technology and then, suddenly, everything is going to work according to plan,鈥� he says. 鈥淚t鈥檚 about everything around it, and how you promote that transformation within the organisation, which means making sure that you buy in from the relevant stakeholders and making sure that you have an alignment internally that everybody effectively wants to move in that direction.
鈥淵ou need to have a very solid business case that is articulated, including the economic basis for doing it, so you don鈥檛 run a risk. The worst thing is when you embark on a transformation, and then it鈥檚 half-baked when suddenly people have a change of heart, and usually that鈥檚 because you have some of the key ingredients missing.鈥�
New technologies to the test
Some of the benefits of migrating into the cloud, according to Brown, are faster processing, cybersecurity coverage provided by proven companies, and the option to overlay digital native technology on top of the data stored in the cloud. However, there are also certain challenges to some of the new technology models.
鈥淚t鈥檚 fine, as a proof of concept, to issue one security in a closed ecosystem where everybody agrees how it鈥檚 going to work and then works on that specific use case to get it to work,鈥� says Brown. 鈥淥ur experience is that when you try and scale it, you start to uncover the limitations of the infrastructure that you might have designed. So scalability is really critical. You also have to understand how you will move from a small-scale closed ecosystem to much wider adoption.鈥�
He believes that there needs to be a central bank digital currency in order to deliver widescale digitalisation of the European repo market, which is currently being tested in the European Central Bank (ECB) trials.
In these trials, running from May to November this year, market participants, including Clearstream, are exploring new technologies to settle wholesale transactions using real central bank digital money.
Brown comments: 鈥淭he ECB trials are a really important factor in figuring out what a future world looks like with settlement against a real on-chain coin issued by a central bank.鈥�
To allow financial firms in the UK to test new technologies in a safe environment, the Bank of England (BoE) and the Financial Conduct Authority (FCA) have recently introduced the Digital 麻豆传媒 Sandbox (DSS), which is now open for applications.
This follows positive feedback from stakeholders to a public consultation running between April and May 2023.
Sarah Breeden, deputy governor for financial stability at the BoE, says: 鈥淭he DSS will provide a guided live environment for innovators in this area to create and trade these digital securities so that opportunities created by this innovation can be maximised in a way that keeps our financial system safe.
鈥淲e鈥檒l apply flexible and proportionate regulations created specifically to facilitate this activity. Flexible rules allow us to make adjustments as we learn to support the safe development and implementation of these technologies.鈥�
The DSS, running at least until December 2028, is open to firms of all sizes and at all stages of development as long as they are legally established in the UK.
Breeden adds: 鈥淭aking this approach means we can shape a new, permanent regulatory regime that鈥檚 innovation-friendly and fit for purpose, and importantly, without compromising financial stability.鈥�
The sandbox also allows firms to test legislative changes in real-world scenarios before their implementation.
On the same page
Effective regulation is important, says Brown, to ensure that investors are protected in the same way as in the 鈥減re-digital world鈥�.
According to Labeis, there is currently a lack of standardisation in securities finance, which limits interoperability between new technological solutions. As head of a regulatory technology platform, he sees standardisation as a prerequisite for further digitalisation of the market to be effective in the long run due to its role in regulatory reporting.
He says: 鈥淚t鈥檚 very easy to see that if you did have a market operating with data standardisation at its heart, then being able to report transactions to the regulators, or trade repositories, would be drastically simplified, as opposed to the current way of doing it, which is each and every participant or their technology vendors have their own way of representing those transactions.鈥�
To reduce the susceptibility to cyber threats across the financial sector, the EU has introduced the Digital Operational Resilience Act (DORA), which will apply as of 17 January 2025. By creating a uniform regulatory framework across the EU, the regulation aims to harmonise national regulations regarding cybersecurity in the financial sector and strengthen the European financial market as a whole against cyber risks.
In addition, the European Supervisory Authorities (ESAs) have developed regulatory and implementing technical standards, which are also legally binding for financial entities and their IT providers.
Labeis is in favour of DORA because he believes that it will help increase the standardisation within the industry, bringing a capacity for stakeholders to switch between technology providers 鈥渕uch more easily鈥� than what they are currently able to do.
鈥淲hen you try to switch from one provider to another, it鈥檚 typically very costly, which is why there is a lot of stickiness,鈥� he says. 鈥淏y that reasoning, if you make it easier and more seamless for firms to be able to choose their solution provider for particular aspects of how they carry on their business, then it means it becomes a lot more cost-effective for them, and ultimately builds resilience.鈥�
Brown feels confident that DORA will not have a huge impact on Clearstream because the firm is already 鈥渉ighly regulated鈥�. However, he adds: 鈥淭he question is what does it do to companies that are not regulated, how do they respond to the DORA regulation, and what kind of pressures are going to put on there? That鈥檚 where DORA will start to shine a light on where the risks are in the supply chain from a digital resiliency perspective.鈥�
Looking ahead, Labeis anticipates that digitalisation will have a 鈥渕assive鈥� impact on the securities finance industry: 鈥淒igital first, as opposed to digital second, is going to be a theme for the next five years, and the interesting question is going to be, how do you manage?鈥�
As an example, he provides digitisation of legal agreements between counterparties. He believes that a greater degree of standardisation would also benefit the digitalisation of collateral management.
鈥淎nything that removes the frictions that are there to free flow of collateral between counterparties will unlock more liquidity that is effectively available to oil the system, which then supports economic growth,鈥� he says, 鈥渁nd you can鈥檛 achieve these dramatic increases in that collateral availability through that free flow if you don鈥檛 have digitalisation of those processes and themselves supported by a higher degree of standardisation.鈥�
Relationship-driven world
Although digitalisation saves time on a daily or monthly basis, it still requires regular manual maintenance due to regulatory overhauls, as von der H枚h explains: 鈥淵ou need to have the technical capabilities that dock on different interfaces, internally and externally. That is a big, huge challenge.鈥�
Complete automation of the system would require advanced machine learning and automatic software engineering, which does not seem possible to von der H枚h at the moment, but he sees a large potential for the near future, with the development of blockchain and smart contracts.
鈥淲hat I strongly belive is that AI will play a big role, and then digital interfaces like API, to transform and send over data to any kind of stakeholders, that will also be a part of it.鈥�
Despite increasing efforts to employ AI and machine learning in an increasing number of processes, Brown believes that the human touch is still needed because securities finance is a 鈥渞elationship-driven world鈥�.
鈥淸Trade matching] can be an automated process, as can basket construction, but you are going to have a human element,鈥� says Brown. 鈥淲e鈥檙e not yet in a world, and I don鈥檛 think we鈥檙e anywhere near a world, where you will predominantly meet people digitally and trade with them without having had a human interaction.鈥�
He adds: 鈥淚t鈥檚 so important, especially in stressed markets, that you have personal relations with people, so that you can actually look in the whites of their eyes and feel confident in your counterparty. Technology will facilitate the connectivity, and will certainly drive efficiency, but humans will continue to have to work together.
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