The Global Regulatory Challenge
IOSCO Secretary General, David Wright, discusses the major factors influencing global markets, and the future of the global regulatory framework.
IOSCO is the International Organization of Securities Commissions. It brings together securities regulators the world over. We have 200 members representing the vast majority of regulators. Of all the international organisations covering financial regulation at the global level, we are the most inclusive because we have all the emerging market countries with us. This organisation has been running for 30 years and we have become the voice of the global securities regulatory community. For example, we have a series of global standards, what we call the IOSCO standards, which are the benchmarks for any securities market.
These standards form the foundation of all the reviews of financial regulation covered by the FSAP process led by the IMF. Our standards are the global benchmark. We have many interesting pieces of work right now; the multilateral memorandum of understanding, which about 90 of our members have signed, is basically a memorandum whereby all the participants agree to share information for enforcement purposes. The memorandum was used to solicit the exchange of information during the recent LIBOR scandal.
We have a lot of policy positions and we have a critical role in the whole process of global financial repair and reform. A lot of the work that you see referenced in the G20 or working with the Financial Stability Board is of IOSCO origin.
We have worked on high frequency trading, we work on shadow banking, OTC derivatives and credit rating agencies, we work on market structure, we work in accounting and auditing, enforcement and so forth. Of course, as a result of this crisis our work is particularly important. The other thing that we do, which is unlike other organisations, is that we provide technical assistance, and education and training for emerging market countries.
One of the things that we’re going to be working on is to build an IOSCO Foundation in which we seek support from the private sector to develop our members’ markets.
Should regulation be leading or following, who should decide what gets regulated, what gets left up to the market and to what extent do those forces interact?
Historically regulation has been following rather than leading. I think it’s right to say that this crisis shows that a significant number of incentives were wrong in the financial markets. I think the depth and scale of damage in this financial crisis, not in all parts of the world, but in certain parts of the world, show that serious repair is necessary, and that is the focus of the G20 and the Financial Stability Board agenda, which we are major contributors to.
The industry can’t complain, to the extent that they are primarily responsible for what happened, so there is a huge amount of work going on at the global level to try to make the financial system safer and less systematically risky. We are going to work on resolution and frameworks; we’re going to work on OTC derivatives, driving more OTC transactions onto exchanges, and through clearance systems. We are working intensively on the shadow banking system, which I think has surprised everybody with its scale, estimated at $65 trillion or 25% of all global banking assets, making that safer and more understandable; we are looking at money market funds, securitisation, and non-banking organisations, which can build up large amounts of leverage. Those are certainly among the most important areas of work, of course on top of bank capital, which is set by the Basel committee. The world has lost 15% of GDP so far; there are very serious worries of severe damage to certain economies and so we need very strong collective efforts at the
local and global levels to try and put that right, and to try and make the system safer and more sustainable.
Are regulators struggling to keep up in terms of spending, and does this impact their oversight?
Regulators in general around the world always feel they are underresourced. When you look at the resources of one of the better resourced authorities, for example, the FSA, in London the FSA has over 3,000 people. But then you compare that to what used to be the head count of Citibank, which was 300,000 plus and that is just one organisation!
So when you multiply that across all the firms big and small they have to regulate and supervise, regulators in general feel underresourced. I think there are some good things happening though which may help them. For example the project being developed by the FSB called the Legal Entity Identifier which is a numbering system for all participants in financial markets. That I think would greatly simplify tracking market abuse, tracking data in markets, looking for systemic risk building up.
In general IT is helping the regulators detect market abuse, but there are huge markets to regulate and supervise. One of the problems has been particularly in the big complex markets, developed markets because, as has become clear, neither market participants nor the regulators or supervisors of those markets fully understood how they functioned.
We are now in year six of this crisis and we still are struggling our way through on the global regulatory level with the shadow banking system. Shadow banking is of enormous proportions, and we are still working it out. You can’t supervise or regulate a market unless you fully understand it.
I think that the one lesson of this crisis should be that unless you can fully understand not just the product, but how that product interacts, interconnects with other products, how risk can be propagated or, if things start to get difficult, what are the effects on liquidity etc, the effects on credit provision, and the effects on the system, then those products and processes should be held back until we are sure we understand.
Another area is measuring the impact of regulation; looking at the costs and benefits of regulatory change in highly interconnected complex markets, which is extremely difficult. Yet regulators should understand as far as they can the impact before calibrating final regulatory measures.
What do you think the greatest successes and challenges of MiFID were, and how are they being fixed moving into MiFID II?
I no longer work in the European institutions, but I think the biggest successes of MiFID were in crossborder trade of European stocks from one country to another. In other words, if a stock was homebased, let’s say Frankfort or Madrid before MiFID, you couldn’t trade that stock in London and now you can. I think this has been a big market opening move and I think it has largely been beneficial.
It opened up markets and allowed much wider trading and competition for trading, in particular equities and bonds. It’s also allowed new forms of trading to emerge across
all sorts of platforms, as well as competition to the traditional stock exchanges, which has driven down the cost of trading significantly. In theory that should follow through to lowering the costs of capital.
It’s been a disappointment that there’s been no consolidated tape. The industry was sure that the data industry was going to develop this, and gave us strong informal assurances that they would consolidate the tape, but that hasn’t happened. I think perhaps the surprise has been the rapid emergence, and the depth and scale of the unlit part of the market in dark pools. I think it is necessary to shed some more light here.
Most of the trouble in financial markets has been in the opaque markets, which are usually controlled by a few participants. So I think high frequency trading was another area which at the time when MiFID was growing up was probably underestimated. So overall I think MiFID has been a good thing for Europe and I think the market would agree. There has been, some would argue, a worrying fragmentation of order books, but at the same time you have had much more competition, so I would stand by the above assessment.
What principle lessons do you think emerging markets and the bigger Asian exchanges could learn from the US and Europe?
I’ve recently been to an IOSCO regional meeting in Bangkok where all these things were discussed. At the moment there is not a lot of cross-border competition, in the sense of a direct competition in integrated markets. There are pools of liquidity all around Asia, but they are not competing to trade each other’s stocks. Actual cross-border flows of capital are quite small inside the region.
I think the more that you allow competitive forces to open up the better it will be for reducing the cost of capital and recirculation of capital in the region. That said, a lot of emerging market countries have done, in relative terms, extremely well in this crisis. Their markets were simpler, they understood them well, they didn’t have the complexity of western financial markets and probably they feel that having restricted the development of highly sophisticated instruments in their markets has paid off rather well. They feel they have learnt the lessons of the Asian and Latin American debt crises.
More competition at the local level, cross-country competition, and developing common standards across the markets will be a very good thing in Asia and I would encourage them to do that. But at the same time they need to make sure that the regulatory system fully understands all the consequences of growing complexity and interconnectivity.
Some regulators, such as ASIC are looking forward in an impressive way. Likewise we’re also trying to have very regular discussions about emerging market risks in all our major committees. In our board and main meetings, we start with quite in-depth discussions with market participants on, looking at where we feel risks are emerging and what should keep us up at night.
I think that is a good way of bridging public and private interests. Getting ahead of the curve is ideal, though you have to be realistic. I think that markets develop at such a fast pace getting ahead is always going to be a struggle.
So what is it that keeps you awake at night?
People worry very much about the shadow banking system, they worry about securities regulation, they worry about possible impact of algorithmic trading and high frequency, they worry about complex structured products; how those are developing and who they should be sold to.
I think the thing that worries me most, and I think this is the most important policy of all, is resolution. If we can’t move failed financial firms to the corporate graveyard, just like we would a concrete company, and wipe them off the commercial map, have their assets taken over by another firm or restructured without collateral damage and without the public, or governments on behalf of the public, supporting or subsidising or basically backing up failed firms then I think this whole global regulatory reform agenda will be seen to have been a failure.
In other words, you simply have to be able to deal with crises in firms clinically, surgically, early and without collateral damage, and that’s a huge challenge, particularly on a cross-border basis, and most of the big problems will be on a cross-border basis, where there are multiple branches and subsidiaries of major firms all over the world. We have to be clear about who is in charge, and how we avoid ring-fencing assets, which will just make their wind up and reallocation much more difficult.
So is that part of the purpose of organisations like IOSCO, to make sure there is cross-border cooperation between regulators?
This is an area which we are going to look much more deeply at in the future: defining what it is and how we recognise each other’s laws and jurisdictions. What are the conditions for establishing equivalence, recognition agreements or substituted compliance agreements? One of the biggest challenges we all face as global regulators,
whether it is IOSCO, Basel or the FSB, is that there are no enforcement tools; there are no legally binding obligations on any jurisdiction in the world to apply these principles and standards that we collectively determine. We don’t have a disputes settlement system like the WTO, we don’t have legally binding enforcement, and we don’t have any sanctions in the sense of a WTO case if a contracting party is found to have abused the rights of another contracting party. We don’t have any of those instruments at the global level and therefore the implementation of this repair agenda is very, very challenging. That’s an issue; whether we should start thinking about a global system where there are legally binding frameworks at the global level. I recently made a speech at the Atlantic Council on these issues. The financial world is evolving quickly and we need to be prepared for that change.
Do you think there is an appetite for a global enforcement framework?
In my speeches I always say that the world is very simple today. There are a few big capital markets and I suppose we can just about muddle through with the few big capital markets and different interpretations of global standards. Now in 15 or 20 years, there’s going to be a lot more big capital markets, and one of the reasons is that securities markets, and capital markets in general are going to have to provide a much bigger share of the global economy in terms of finance, because the banking system is going to be
constrained through the Basel agreements, i.e. with more capital, less leverage and so forth.
So instead of a three by three matrix we’re now going to have a 15 by 15 or 20 by 20 matrix, in which we are going to have many more big capital markets. The danger is that they all start to apply or interpret the global rules in very different ways. Now that is potentially destructive and fragmentary if there is nobody in the centre who says interpretation X or Y is wrong.
My view is that the situation is going to become much more complex in the future as capital markets in emerging market countries grow, and they are bound to grow extremely fast. If these countries realise that they can’t rely anymore long term on the international banking system, they have to develop their own indigenous local market capacity.
So that is why I think it’s incumbent on everybody to think about whether the current institutional structures are fit for purpose for this scenario.
There are solutions out there but these are very difficult things to get at the global level. For example, the WTO was established by an international treaty. If you want to move towards more global institutions with more enforcement authority you are probably going to have to establish that by an international treaty or agreement – no mean task!
IOSCO is facing a rather exciting future because the financing of the global economy is turning more towards securities and capital markets in general, which effectively enhances the importance of securities markets and securities regulators for those markets. So this is a real opportunity for my membership to work together to establish good standards and to ensure that they can implement them. I think this coupled alongside the tremendous growth in emerging market countries that we are beginning to see, makes it a very exciting time for IOSCO.
But the message I want to convey is that the status quo will not suffice for doing theglobal regulatory job before us.