By Rich Cooper, Director of Global Accounts, Fusion Risk Management
Regulators Will Hold Firms Responsible; Good News is Technology Is Here to Help
Everyone knows there are inherent risks in markets. Investors know and accept the risk that their investments may lose value. For the financial services companies that facilitate and stand behind the trades of ordinary investors, there are risks largely unseen by the public that must be reckoned with on a constant basis.
Financial Service (FS) providers (banks, brokers, asset managers, etc.) must work with a variety of vendors and third parties to be competitive in attracting investors as well as keeping their clients’ business. They range from back-office and IT outsourcing vendors to third-party trade-clearing, settlement and money-transfer providers. The economic services provided by the finance industry encompass a broad range of businesses that manage money, including credit unions, banks, credit-card companies, insurance companies, accountancy companies, consumer-finance companies, stock brokerages, investment funds, individual managers and some government-sponsored enterprises. Many of these relationships are intricate and multi-layered with risks imbedded in every layer. A vendor or third party providing direct services to you as an FS provider may also have several relationships with others that could put your direct relationship at risk.
Just this month (December 2019), the Bank of England (the Bank), Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA) published proposed new expectations to strengthen operational resilience in the financial services sector. This is major next step in evaluating “operational resilience” in the Financial Sector (in the UK defined as UK banks, building societies and investment firms (banks); and the Society of Lloyd’s and its managing agents (insurers) collectively called “Firms” and also Financial Market Infrastructure collectively called “FMI’s”). It likely will become policy in the UK in 2021, The European Union and Singapore by 2022 and possibly the U.S. soon as well.
The Federal Financial Institutions Examination Council (FFIEC) in the US came out with new guidance as well this month. The guidance notes: “Business Continuity Management (BCM) is the process for management to oversee and implement resilience, continuity, and response capabilities to safeguard employees, customers, and products and services. Disruptions such as cyber events, natural disasters, or man-made events can interrupt an entity’s operations and can have a broader impact on the financial sector. Resilience incorporates proactive measures to mitigate disruptive events and evaluate an entity’s recovery capabilities. An entity’s BCM program should align with its strategic goals and objectives. Management should consider an entity’s role within and impact on the overall financial services sector when it develops a BCM program.”
Two areas that present the most significant risk management and compliance challenges to FS providers are:
- Financial Market Infrastructures (FMI). These are critically important institutions responsible for providing clearing, settlement and recording of monetary and other financial transactions. A payment system is a set of instruments, procedures and rules for the transfer of funds between or among participants. An example is the SWIFT network for global banking and payments. In the US, the Federal Reserve Board supervises most market infrastructures.
- Outsourced Technology Services. FS providers that rely on third parties to provide operational services need those vendors to have sufficient resources and recovery capabilities in the event of a disruption. The FFIEC, which has a handbookfor business continuity management (BCM) planning, warns that: “Financial institutions should recognize that using such providers does not relieve the financial institution of its responsibility to ensure that outsourced activities are conducted in a safe and sound manner.”
The primary concern of regulators is the “systemic risk” that individual vendors and third parties present to the overall health of the financial/economic eco-system. Recall the snowball effects that the failures of several large broker-dealers and investment banks had in precipitating the great financial crisis of 2008. Regulators are also concerned that the FMIs, if not properly managed, can result in significant violations of consumer laws and regulations and expose an institution to supervisory enforcement action, as well as financial, legal and reputational risks.
This is the most important point to remember – as an FS provider, you OWN THE RISKS.
So, what can you do to mitigate your risks? As best practice, you should:
- Mark all of your vendor and third-party relationships from end-to-end. As an example, in payments and settlements, you vitally need to understand who your third parties are, where they are and what risks they may present. You need to plan on how you can mitigate those risks to the greatest extent possible.
- Make sure everyone in your organization who is responsible for these risks is informed – including C-suites and boards. The FFIEC handbook emphasizes that “the responsibility for properly overseeing outsourced relationships lies with the financial institution’s board of directors and senior management.”
- FS providers should do a deep dive into their current systems, their limitations and their liabilities. Many firms still have legacy systems with risks assessments built into spreadsheets or printed documents. State-of-the-art BCM systems allow for information inputs from across the organization with advanced technologies employed in risk assessments.
- Some firms keep their databases in silos (i.e.: equity trading department; mutual fund department) where one silo can be unaware of the risks of the other, putting the entire firm in jeopardy. A holistic system that covers the enterprise and allows prompt reporting to the board level is not a luxury. It is a must for today’s FS providers.
- Your system must be stress-tested constantly and vigilantly. Game-playing scenarios are helpful in identifying “what if’s?” as well as planning work-arounds for potential disruptions.
- Identifying “acceptable risks” is important as well. A one-hour outage may not be desirable, but it may be acceptable and not have any regulatory ramifications for your firm. But a 72-hour outage would be vastly different, as access to cash reserves and insurance may be limited or non-existent and your legal liabilities could be piling up.
If you think this is complex, you are right. Operational disruptions to the products and services that firms and FMIs provide have the potential to cause harm to consumers and market participants, threaten the viability of firms and FMIs and cause instability in the financial system. There are new regulations on the way to mitigate this risk to the economy and managing 3rd (and fourth) parties is a key area of discussion.
The infrastructure of financial institutions and FS providers is much like a tapestry whose resilience depends on the strength of the weave. But don’t be deterred by the complexity. The good news: there are technology-empowered platforms that can help you manage your vendor and third-party risks.
An effective outsourced business continuity management program will provide the framework to successfully manage your vendor and third-party risks now. It will employ up-to-date technology; will break down silos, and will identify, measure, monitor and mitigate the risks that otherwise may keep you up at night.
ACCELERATION OF DIGITAL TRANSFORMATION PUSHING ORGANISATIONS TOWARDS A MORE DATA-DRIVEN APPROACH
- 84% of businesses have seen more demand for data due to Covid-19, but nearly a third say data quality remains a fundamental barrier
New research from Experian reveals how the acceleration of digital transformation, through the Covid-19 pandemic, has led to greater demand for data insights to inform decision making and strategy.
The annual Global Data Management report, which surveyed 700 data practitioners and data-driven business leaders globally, found that changing customer behaviour has intensified businesses’ need for high-quality data. Eighty-four percent have seen more demand for data insights in their organisations due to Covid-19. In fact, 72% say that the rapid push to digital transformation is making their businesses more reliant on data.
Beyond underscoring its business value, the pandemic has also exposed data’s potential to be used for societal good – and business leaders are keen to explore this further. Seventy-eight percent see COVID-19 as a defining moment for organisations to set-up and use data for societal good where they can, while 86% would like to be able to use their data in some way to benefit society.
Increasing collaboration with other organisations to better support those in need, sharing talent and resources to develop and deliver products, or allowing their data practitioners to spend time on voluntary project were all highlighted as a potential approach to achieving this.
However, they will struggle to use data for either business or social good unless they can overcome endemic weaknesses in legacy data management practices. Experian’s report outlines key barriers that organisations must address:
- Data quality and maturity: On average, organisations believe a third of their data (32%) is inaccurate in some way. It’s unsurprising then that 55% of business leaders lack trust in data assets, and 51% say improving data quality is a ‘significant priority’.
- Data skills: Embracing the power of data is being stunted by a skills gap – 62% say a lack of basic data literacy skills impacts the value they get from their investment in data and technology, while 55% believe they lack skills/resources to leverage data assets fully.
- Agility: Sixty-two percent admit a lack of agility in data processes has hurt their response to changing business needs in the wake of COVID-19.
Andrew Abraham, Global Managing Director, Data Quality, at Experian, comments on the findings: “The pandemic has been a catalyst for long-awaited digital transformation. Businesses need to move fast to serve customers’ changing needs, and leaders know that data-based decision-making is key to evolving the right way.
“It’s also heartening to see organisations looking beyond the business applications of data, to how they can use it for societal good. However, if businesses are to succeed in either area, they must overcome fundamental barriers to effective data management.”
The paper also provides insight into businesses’ data priorities, as well as expert advice on how organisations can meet digital transformation objectives by making improvements in the following areas:
- People: With a data literate workforce, a business is armed with talent that can make timely, data-driven decisions. Reassuringly the report reveals that 85% of organisations are hiring data roles in the next six months.
- Technology: Technology has a critical role to play when it comes to modernising data management practices. Eighty-five percent of business leaders say sourcing more technology for staff is a priority.
- New ways of working: DataOps: DataOps aims to shorten development cycles, increase deployment frequency, and create more dependable releases of data pipelines, in close alignment with business objectives. This practice helps organisations adapt more quickly to changing conditions.
Getting back to basics: Before new initiatives complicate the issue, go back to basics – people, processes, and tools. To build resilience against future risk, invest in the right areas to recognise return on investment on data management more quickly.
SUSTAINABLE DERIVATIVES: THE “GIVING TREE”
Jennifer Kafcas, Lauren Blaber, Alvino Van Schalkwyk and Harry Polan
Momentum continues to gather pace towards building a sustainable economy, especially since the start of the pandemic. As a result, financial markets have seen a considerable increase in the focus on, and deal volume with respect to, sustainability-linked loans and bonds. It has been a logical progression that the sustainability tree sprouts a new leaf with the development of environmental, social and governance (ESG) linked derivatives. These products enable, among other things, firms and companies to hedge risks associated with sustainable investments including project risk, interest rate and currency risks. This will be all the more important given the need to hedge risks from any underlying loan and its related sustainability criteria.
While ISDA has outlined the broad range of derivatives in sustainable finance, furthering the development of this product type (including, among others, sustainability-linked derivatives, ESG-related credit default swaps, exchange-traded derivatives on listed ESG-related equity indices, emissions trading derivatives, renewable energy and renewable fuels derivatives, and catastrophe and weather derivatives), this article focuses on more conventional derivatives transactions, such as interest rate swaps (IRS) and Foreign Exchange (FX) transactions used by market participants to hedge the risk arising from green bonds and loans. Though these transactions are no different conceptually from a product standpoint than any other IRS or FX transaction, it is important to understand the inherent structural and deal term differences.
Finance-linked sustainable derivatives (OTC)
A number of sustainability-linked derivatives have been issued in recent years, which add an ESG pricing component to conventional IRS and FX hedging instruments. The table below provides examples of recently issued sustainability-linked derivatives. As this is a developing market, the transaction volume has been very low, but uptake is expected to increase over coming years.
|BNP Paribas & Siemens Gamesa||€174 million FX forward, under which Siemens Gamesa will pay a premium on their forward if they do not meet certain ESG targets. If paid, that premium shall be used to finance local reforestation projects in Spain. The premium shall be calculated using a metric assigned by a third-party sustainable finance specialist.|
|Société Générale & Enel||Cross currency swap, by which Enel hedged their euro-dollar exchange rate and interest rate risk under a $1.5 billion sustainability-linked bond. If Enel does not meet certain renewable energy targets, the swap will be re-priced to their detriment.|
|New World Development (NWD) & DBS Hong Kong||Interest rate swap linked to the United Nations Sustainable Development Goals, hedging interest rate risk under NWD’s HK$1 billion sustainability-linked loan. If NWD generates at least eight business-to-business opportunities that contribute to the Sustainable Development Goals, DBS will sponsor certain NWD social innovation projects.|
As evidenced above, ESG-linked derivatives can take on a number of characteristics and structures, including:
- Derivative pricing. One counterparty having a number of prescribed ESG targets which, if met, will lead to a downwards ratchet in the pricing of the derivative (with such pricing often increasing if the targets are not met).
- Fixed payments. If ESG targets are not met by the corporate, a fixed payment can be required to the issuing bank, which will be put towards a green project.
- Triggers linked to a company’s ESG rating. If the ESG rating of the corporate increases, a benefit can be awarded to them (e.g. interest rate discount).
- Both parties having ESG targets papered into their derivatives contracts. Corporates can receive a discount on the interest rate under the derivative if they meet their ESG targets, with that discount increasing if the issuing bank fails to meet its own ESG targets.
- Charitable giving requirements. A failure by the corporate to comply with its ESG targets can lead to it being required to make contributions to non-profit organisations, with the bank having to make such contributions if the corporate’s ESG targets are met.
As sustainability-linked products gain traction, a degree of care will be required to ensure ESG targets are finely balanced and verifiable. Verification is essential for market transparency, for ESG products to be considered credible and for lenders and corporates alike to avoid reputational risks. Furthermore, the ability of a corporate to verify reliable compliance with ESG targets could provide a significantly smoother path through their lender’s credit approval process and in turn the lender’s ability to verify will enable it to better monitor the performance matrix set by the underlying loan or bond.
Renewable Energy and Renewable Fuels
In addition to the above OTCs, renewable energy hedging transactions (including power hedge transactions) are important for market participants to hedge the risk associated with fluctuations in renewable energy production, and in doing so, encourage more capital to be contributed to renewable energy projects.
Typical documentation with respect to the above type of trades are Power Purchase Agreements (PPAs) which document the purchase of power and associated renewable energy certificates between a renewable energy generator (the seller) and a purchaser of renewable electricity (the buyer). PPAs do not require companies to contribute directly to enhanced ESG standards, however they can help catalyse a shift to clean energy sources as they reduce market price volatility for buyers, and reassure sellers that a buyer will purchase power generated from renewable energy assets, thus encouraging the financing of such projects. In an ESG-linked transaction, these types of arrangements can be replicated by covering the credit risk element in the intercreditor terms. As an alternative the market may develop such that in lieu of these structures the underlying risk with respect to market price volatility is documented under an ISDA and secured under the financing and intercreditor documentation. This structure is fast approaching.
Expected developments in 2021
Climate change and, therefore, a sustainable economy remain front and centre for governments and regulators worldwide. In 2020,countries like Japan, China, South Korea, Hong Kong and the UK set net carbon neutrality objectives and most recently the USA, following the inauguration of President Biden, announced plans to spend $2 trillion over four years to aid in the fight against climate change, all following the commitment already set by the EU.
Whilst the need for banks and corporates to develop and consider bespoke products to promote true progress in ESG compliance may hinder any radical uplift in ESG-linked derivatives volumes over the course of 2021, we anticipate that as banks and corporates continue to familiarise themselves with the requirements of such products, integrating ESG elements into derivatives trades will begin to be common practice.
In view of this, derivatives market participants will be eager to continue to drive ESG-linked derivatives volumes and to develop new and innovative ESG products facilitating the mobilisation of capital towards sustainable investments to ensure that they continue to significantly improve ESG standards, and to strengthen their contribution to the green finance drive.
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