Banking and financial organizations are going through dramatic changes in recent years. The pandemic was the ultimate gut punch, testing the resilience of this sector in every possible way. Yet, good news is that they are emerging stronger with every unforeseen events. A new report highlights some significant emerging risks for today’s financial companies that can help them understand .
Digital finance and digital assets risks
Digital finance and digital assets, such as Bitcoin, have grown phenomenally over the past 10 years, now reaching almost US$3 trillion in market value. The growing sophistication of these markets is evidenced by the fact that trading volumes of derivatives based on digital assets now regularly outpace those of the underlying assets.
For example, the report notes that in June 2021, trading volumes in digital asset derivatives across all trading venues amounted to $3.2 trillion, surpassing those of spot transactions and achieving a 53.8% market share of the total market in digital assets.
According to a recent analysis, this represents an almost eight-fold increase in global trading volumes in digital asset derivatives since June 2019. As most seasoned GRC professionals know, this kind of tremendous growth brings a whole range of risks with it. Regulators around the globe, including the Basel Committee, are formulating digital finance rules and industry bodies, such as ISDA, are publishing their own standards and definitions.
However, the accelerating growth of these markets almost certainly means that the rules will be steps behind where the markets are – for example, in June 2021 the Basel Committee published a consultation paper on the prudential treatment of cryptocurrency assets and, as of early January 2022, the next stage of rule making is yet to take place. Rulemaking is also very fragmented across jurisdictions, making things even more challenging for financial services firms. In this kind of environment, firms need to think proactively about how to anticipate and manage potential risks related to digital assets, such as legal risks related to contracts, operational risks around the trading of these assets and compliance risks as the rules come into force. Firms should also consider potential reputational risks around these assets as risk issues emerge into the public eye.
Open banking risks
The report states that the Open Banking project in the UK – which is essentially a project that is designed to make it easier for customer data to flow between financial services firms, via APIs, to enhance competition among those firms – has continued to develop. For example, recently NatWest was the first UK bank to conduct a live transaction using Open Banking-initiated Variable Recurring Payments (VRPs). VRPs enable customers to connect authorized payments providers to their bank account so that the payment providers can make payments on the customer’s behalf within agreed parameters. However, the risks associated with Open Banking are also becoming more evident too. For example, there are risks associated with the third parties within the Open Banking system, potential process risks, technology risks, and data risks.
There are also significant concerns that AML, counter-terrorist funding and KYC processes that firms may currently have are insufficient to meet regulatory obligations within an Open Banking context. There are fears that these risks could lead to an increase in fraud within the UK. Firms working with Open Banking should also consider the operational resilience implications of engaging with the platform. Managing the risks around Open Banking would be a good area for financial services firms to collaborate on during 2022.
Financial services and the vulnerable
According to one law firm, a “vulnerable customer is somebody who, due to their personal circumstances, is especially susceptible to harm particularly when a firm is not acting with appropriate levels of care. Vulnerable customers may require additional measures to ensure good outcomes and their needs are likely to vary significantly. There is a huge array of different circumstances that may lead to a customer becoming vulnerable and the UK FCA’s guidance should not be taken as containing the only indicators of vulnerability. Instead, the FCA refers to vulnerability as a spectrum of risk.”
The FCA published a paper in 2014 on the consumer experience of vulnerability when accessing financial services, which was followed in February 2021 by FCA guidance on the fair treatment of vulnerable customers. One of the more interesting aspects of the FCA’s operational resilience programme is its insistence that firms take into account the vulnerable when planning their resilience programmes. Specifically, firms need to consider the vulnerable when setting their impact tolerances and also plan how they will communicate with vulnerable customers in the event of a business disruption. UK banks are beginning to respond – a group of them recently announced the launch of shared banking hubs in communities where bank branches have closed.
The rate of bank branch closures increased dramatically in 2021, cresting between June and August when 298 branches shut down, an average of 99 per month, according to consumer campaigning group Which?. Certain types of vulnerable people – such as the elderly – have been hit hard by the branch closures. Also, although some FinTechs are working to develop solutions to support different types of vulnerability, there are also concerns that Open Banking could negatively impact vulnerable consumers.
Financial services firms can expect much more action on the treatment of vulnerable customers in 2022 from the UK FCA. This is a theme that is beginning to spread internationally and so financial firms in other jurisdictions can expect their regulators to begin to explore this area in the coming months too.
The future of blockchain
Blockchain was once hailed as the future of finance, but over the past few years, it has sometimes seemed as though the technology’s critics are winning the argument. For example, the Bank for International Settlements published a paper in December 2021 that calls out specific challenges with blockchain technology in terms of governance.
The paper argues that without proper governance around blockchain transactions, the consensus mechanism that is part of the blockchain system could result in the concentration of power in the hands of those who would not use that power for good. Academic research is showing the truth of this, with bots front running cryptocurrency transactions on blockchain platforms. Nonetheless, banks are pressing ahead with using the technology in some back-office processes. For example, HSBC and Wells Fargo announced in December 2021 that they will be settling their FX trades directly between themselves using blockchain. This cuts out the role of CLS, a utility with 70 large financial institution members and 28,000 users, which was created to reduce systemic, financial and operational risks associated with trade failures.
Also, in December 2021, JPMorgan and Siemens announced that they are using blockchain to automate certain kinds of payments between the two organisations. The system was developed by JPMorgan’s blockchain unit, Onyx, which says it has a waiting list of other firms interested in using the new technology. JPMorgan has also used crypto coins and its own blockchain technology for bank-to-bank transactions for more than 400 institutions. Another project has blockchain aggregating and distributing market data to financial services firms.
Even the UK FCA admits that blockchain could be useful for regulatory reporting – it is exploring using the technology to speed up and increase the accuracy of the information it receives from financial firms. So, at the moment, the opportunity – and risks associated with – blockchain seems to depend on the kind of application it is being used for. As with digital assets and CBDCs, so much is so new and regulatory action is playing catch-up with what is evolving within the industry. Companies and firms should consider the strength of any third party relationships that involve blockchain, as well as the potential regulatory view of the activities that are being undertaken.
In summary, the report states that as the world hopefully emerges from or learns to live with the Covid-19 pandemic, there are set to be an interesting portfolio of fresh emerging risk challenges for financial firms and companies alike to tackle.
Firms should seek to minimize these risks by collaborating with other firms through industry associations, groups sponsored by regulators and other forums to share information about risks and potential management of them – particularly when risk could be systemic in nature. At the same time, many of the emerging risks on this list also contain the seeds of significant opportunity – making these very exciting times indeed.