The risk from being out of compliance with regulations is rippling throughout the capital markets.

“The risk of non-compliance is greatest for firms struggling to stay abreast of the tsunami of new regulatory initiatives building from Dodd-Frank, one of the biggest all-time regulatory delegations from Congress,” said Tom Potter, partner at law firm Burr & Forman.

“It’s often very difficult to focus on efficiency when having to comply with many new mandates concerned principally with other objectives. So firms try to cope by building new compliance solutions into existing systems, routines and regimes to minimize inefficiencies.”

The appreciation for regulatory risk is especially keen for bulge bracket firms, with memories of massive trading losses by the likes of J.P. Morgan, Societe Generale and UBS still fresh.

“There’s a much greater appreciation of the need for an integrated, holistic approach to compliance risk management,” said Stephen Anikewich, head of compliance (Americas) at Nice Actimize, a compliance and risk management provider. “If they didn’t get it after SocGen and UBS, they’ll never get it.”

Identifying risk on an enterprise level is complicated by the interactions between individual traders and departments.

“You need to look at transactions in the context of all other activities of that trader, in order to determine whether its part of a trading strategy or hedging activity connected with other traders in his group,” said Anikewich.

Technology that’s sophisticated enough to “connect the dots” is mandatory.

“In the old world, risk management entailed the eyeball method, which then morphed into routine, rudimentary reports which just spit out volumes of transactions information, but left it up to compliance to make sense,” Anikewich said. “That method of risk management is equivalent to doing nothing.”

At the international level, variations among regulations and the philosophy of regulators themselves has escalated the likelihood of regulatory arbitrage.

“That’s a big discussion and one that’s been on the table for quite a while with consideration of the Basel III standards, the Financial Services Authority’s (FSA) move toward ‘principle-based regulation’ [in the U.K.] and others,” said Potter at Burr & Forman.

“It seems to shift back and forth as various initiatives ebb and flow. Like inefficiencies in a market, capital seeks a path of least resistance.”

Potter was referring to the U.K. government’s plans to transfer supervision for banks, insurers and major investment firms to a subsidiary of the Bank of England, and to rename the FSA as the Financial Conduct Authority, which will focus on consumer protection and market regulation.

The current expectation is the cutover to the new structure will occur early in 2013.

The new structure is intended to strengthen the hand of regulators in using a judgment-based approach, whereby they will look at the individual risk characteristics of firms in determining whether further action is warranted.

While the challenge for bulge brackets firms governed by regulations such as the Volcker Rule, which prevents banks from making certain types of speculative investments, is great, the challenge for regulators will be even greater.

“Regulators are woefully behind the ball at the federal level with respect to regulating the Volcker Rule,” said Anikewich at Nice Actimize. “If identifying risk is difficult for sell side firms, it’s almost impossible for regulators because they lack the resources available to connect the dots. Instead, [regulators] depend on data fed to them by those being regulated.”

The Volker Rule “will have a profound effect on firms’ business models and the pace of innovation as well”, said Anikewich. “It will change the business model from capital markets to more of an agency-type of model.”

In particular, market making will be scaled back significantly as a result of the Volcker Rule, said Anikewich.

“Market making will survive in the guise of a riskless principal business,” he said. “That is, as an agency business where they’re matching up buyers and sellers.”