The recent Wolf of Wall Street film highlighted some of the excesses associated with the financial services industry. Martin Scorsese’s portrayal of the rise and fall of Jordan Belfort, the chief of discredited brokerage firm Stratton Oakmont, is said to have stretched well beyond the realm of possibility.
Audiences loved it, more circumspect financial services professionals hated it, and film critics described it as ‘the rigging of the American game unveiled’.
Artistic licence allows for some blurring of fact and fiction, most notably that the original Forbes exposé was headlined ‘Steaks, Stocks – What’s the Difference?’ and alluded to Belfort’s transition from meat salesman to ‘pushing dicey stocks’, while there remains some debate as to whether he was actually ever referred to as ‘The Wolf of Wall Street’.
Nevertheless, several elements of the film ring true. Belfort did indeed work at investment firm L.F. Rothschild and was laid off after Black Monday. He subsequently got a job at a penny stock house before opening a franchise of Stratton Securities, a small broker-dealer Belfort later acquired to form Stratton Oakmont, which grew into one of the largest over-the-counter (OTC) brokerage firms in the country.
More importantly, the crux of the story is that Stratton Oakmont’s success was built on the fraud known as ‘pump and dump’ – a technique that works by buying up the stock of worthless companies through nominees, selling it on a rising market to genuine investors, and then unloading all of it. This practise eventually saw Belfort and his associates jailed. One only has to recall Michel Milken for his development of the market for high-yield bonds ("junk bonds"),and then for his conviction following a guilty plea on felony charges for violating U.S. securities laws.
The Wolf of Wall Street claims to serve as a cautionary tale. Certainly it is to the extent that it can be hard to see the wood with highly complex products being traded; where the debt is hiding (the trees) or whom you are betting on going bust. Moreover, investors need to be especially cautious when the wood (i.e. the bourse) happens to be inhabited by wolves.
Likewise, the fresh wave of regulation sweeping the financial services industry is necessary to protect the wealthy one per cent of potential investors that Belfort urges his ‘wolf pack’ to ‘harpoon’, or to guard against rogue traders committing securities fraud by pricing derivatives portfolios in a way that reduces reported losses.
Unsurprisingly, derivatives have become a focal point for regulators in their pursuit of monetary and financial stability. Famously described by Warren Buffet as ‘financial weapons of mass destruction’, derivatives are contracts between banks and other investors. Linked to corporate debt, commodities, currencies, and other assets, they are a major source of credit exposures between the largest global institutions. The collapse of Lehman Brothers in 2008 was the biggest corporate bankruptcy in US history and signalled the start of the global financial crisis. It came about because Lehman’s portfolio was tied up in highly complex and opaque OTC derivatives.
Lehman was just one of many major banks and financial institutions taking complex OTC derivative instruments and bundling them together such that the true risk inherent in transactions was not obvious. Due to this high complexity, lack of transparency, and a culture focused on financial gain, banks failed as things went wrong, bailouts ensued, and the leveraged debt around certain trades had a disproportionate effect both on financial systems and the global economy.
Subsequent investigations by regulators have implicated unregulated OTC derivatives markets as a major source of systemic risk and concluded that they ‘contributed significantly’ to the financial crisis. Recognising that consistent and comprehensive OTC derivatives regulatory reform was vital to ensuring global financial stability, in 2009 the G-20 Leaders made a commitment in three key areas:
- That all standardised derivatives be cleared through central counterparties (CCPs) and traded on exchanges or electronic trading platforms, where appropriate, by end-2012
- That all OTC derivatives contracts be reported to Trading Repositories (TRs)
- That non-centrally cleared trades be subject to higher capital requirements
As part of this commitment, numerous rules are coming in – including EMIR, Dodd Frank and MiFID. The primary aim of these rules is to reduce counterparty risk, improve overall transparency, and enable regulators to better assess, mitigate and manage systemic risk. The reforms call for significant change and therefore present substantial challenges for major financial institutions, smaller organisations and individual parties alike.
Implementation is proving an exponential problem, as there are a number of regulators putting in different obligations at different times. There are also subtle differences between Jurisdiction A and Jurisdiction B and some of them can be contradictory – comply with one and you may breach the other.
Moreover, the tangible impact of regulatory implementation within any one jurisdiction is not always as expected, with markets adapting to the change in ways not initially envisaged, leading to further refinements. The new rules also continue to evolve, with the scope of products covered being expanded to eventually encompass all relevant OTC derivative asset classes.
Delivering business change to ensure compliance with multiple regulations that often have ambiguous requirements and scope (and are occasionally contradictory) is inherently complex. Employing a conventional project structure and approach to address regulatory change is therefore not an option for financial institutions. There is a diversity of internal and external stakeholders involved, and the fact that mandatory delivery timelines can move makes scheduling difficult.
Furthermore, the interdependency of rules calls for fundamental system changes, many of which will need to be delivered concurrently, and without impacting on ‘business as usual’ activities. The core concern for financial institutions is that regulations cannot be delivered to the required quality through existing organisational structures, leaving significant areas to address.
Ongoing analysis of the evolving market, deep industry knowledge and interpretation of the in-coming regulation will be essential in ensuring that new central clearing and e-trading platforms are delivered in a compliant way. It will be vital to clearly set out and communicate the new workflows and technical capabilities necessary to execute the electronic trades, and ensure that all members of staff have a full understanding of the behaviours no longer permitted under the new rules.
At the same time, the rationale for the workflows to be the way they are is important given the complexity of the often competing regulations cross-jurisdiction, such that key workflow aspects are not inadvertently removed leading to a regulatory breach, or obsolete elements left in place leading to inefficiency.
Building a strategic delivery capability
With substantial financial and reputational implications attached to any instance of non-compliance or breach, it is essential that senior decision-makers be engaged in the implementation of any rule issued. A strategic delivery capability is therefore required and can be achieved by establishing a governing committee to span all regulatory delivery. Led by a senior chair under which the required number of design authority committees can sit, this enables financial institutions to manage operational risk arising from regulatory change.
A dedicated business project should also be established to provide an effective conduit between programme sponsors managing trading sales activities and the IT teams making system changes. This way, aims are understood and requirements clearly defined before being fed into the IT teams. It is recommended that the business project team adopt a defined methodology in order to cover the following areas:
- Rule interpretation by legal, compliance and business experts
- Impact analysis by business experts
- Definition of IT requirements
- Dependency management and implementation scheduling (with integration in to change management roadmap)
It must be recognised however, that project teams are temporary by nature, thus the financial institution itself needs to embed the required responsibilities within the organisation. This is where many organisations opt to engage an experienced external provider to drive the structural change required and ensure that the necessary level of in-house competency is achieved to sustain the capability going forward.
Strong and collective desire
For an industry so often accused of gaming the system, regulation is the only game in town for the next five years, making it imperative that financial institutions enshrine compliance and transparency firmly within corporate culture. Naturally, regulation cannot ever expect to eliminate risk completely, but it can and will improve the way risk is managed as the system becomes more transparent, as all parties are aware of the risk profile – and provided it is approached with the appropriately level of gravitas.
Without a strong and collective desire to not only follow the letter but the spirit of the rules, organisations will always find ways to work with those rules to their competitive advantage – those then become industry accepted norms and the circle starts again. Industry-level cultural change is the only way to avoid such a circle, and requires strong, prohibitive action from regulators at individual and corporate level.
With a strategic delivery capability for managing business change built on a robust governance structure, strong senior-level buy-in to lead a drive towards greater compliance and including a communications programme embracing both internal and external parties, financial institutions will be better equipped to successfully transform their business with minimal operational disruption.
Importantly, they can employ the same mechanics and structure to respond rapidly and appropriately to further regulatory shifts, engage with trading partners compliantly, and intervene in a rapid and appropriate manner should issues arise.
LOC Consulting is a management consultancy that specialises in financial services.