IOSCO publish principles for financial market infrastructures
Financial market infrastructures (FMIs) should prepare recovery and resolution plans to reduce systemic disruptions in the financial system in the event of their distress or failure. These plans should contain, among other elements, a substantive summary of the key recovery or orderly wind-down strategies, the identification of the FMI’s critical operations and services, and a description of the measures needed to implement the key strategies.
These and a host of other requirements form part of a seminal blueprint on FMIs which was published this month by the International Organisation of Securities Commissions (IOSCO) following consultation with other global regulators and industrial participants. The blueprint outlines 24 high-level principles which frame how FMIs should operate in the post crisis era, in terms of governance, risk management practices, settlement procedures, default management, transparency and supervision.
Updating and revising key and, in some cases, common recommendations for central securities depositories, payments systems, central counterparties and trade repositories, IOSCO’s publication is timely given worldwide efforts to implement G20 commitments on OTC derivatives. Measures taken so far in the European Union (EU) are in line with these recommendations: they provide some additional guidance for measures yet to come.
What was the rationale for overhauling the principles at this stage? Although FMIs performed well during the recent financial crisis, according to IOSCO wider events have highlighted important lessons for effective risk management that need to be taken on-board by all players in the financial system. FMIs form an important backstop in the new regulatory system with supervisors relying on these entities to promote financial stability and market confidence by recording, collecting and disclosing information and reducing/mutualising risks. IOSCO believes that this together with their growth in recent years provides is clear justification for strengthened principles in this area. If not properly managed, FMIs can pose significant risks to the financial system and be a potential source of contagion, particularly in periods of market stress.
There are clear vulnerabilities. FMIs and their participants do not necessarily bear all the risks and costs associated with their payment, clearing, settlement, and recording activities. Moreover, there may not always be strong incentives or mechanisms for safe and efficient design and operation, fair and open access, or the protection of participant and customer assets. In addition, participants may not consider the full impact of their actions on other participants, such as the potential costs of delaying payments or settlements.
However, (re)designing principles for this industry is not an easy task. IOSCO accepts that FMIs are a pretty disparate bunch, with different objectives, legal structures and functions. Some are operated by public authorities with clear public policy objectives which may override wider-industry best practice (e.g. principles around disclosure); some are arms of profit-seeking universal banks; while others are operated by non-bank entities, like stock exchanges, which may not always fall within the traditional financial regulatory remit. Differences can also arise in terms of whether FMIs are involved in domestic or cross-border business; are operated by horizontally or vertically integrated firms, which may have opposing efficiency and competition considerations; and the nature of their domestic financial regulatory, licensing and legal framework.
Within this context, IOSCO has taken a broad approach to defining FMIs at the outset, suggesting they are systemically important systems that clear, settle or record payments, securities, derivatives and other financial products. However, recognising that individual entities may provide a range of these functions, IOSCO applies a narrower definition to each function than previously taken by international supervisors to ensure principles are not watered-down by being all things to all types
of FMIs. However, a number of the recommendations are common to all types of FMI.
At over 180 pages, not counting separate reports on disclosure requirements and the assessment methodology associated with these principles, the report should be studied carefully by applicable firms and regulators alike. Much work and interpretation is required by firms and regulators to implement the principles and the responsibilities in this report, which IOSCO wants completed by the end of this year. For example, IOSCO wants FMIs to have “adequate” and “liquid” financial resources to cope with counterparty default or stressed market conditions but doesn’t prescribe specific capital targets. What is deemed an “adequate” capital buffer is dependent on a range of different factors, such as the health of the economy, the governance structure in the firm, and the types of transactions passing through an FMI.
While regulators have gradually developed general standards (risk management, controls) since the crisis that are also applicable to FMIs, they face a host of different legal, credit, liquidity, general business, custody and operational risks unique to their businesses, that require careful examination. IOSCO principles should support efforts to hone operational and governance frameworks at FMIs and address many of these unique risks. Supervisory oversight should also improve practices at firms. In the accompanying assessment methodology report, IOSCO calls on national supervisors to regularly assess observance of the principles by FMIs in their respective jurisdictions. IOSCO has presented a series of templates, with various check lists, covering each principle which supervisors can use. Regular self-assessment is also encouraged; FMIs are expected to conduct formal periodic full or partial self-assessments of observance of the principles.
With a few exceptions, the principles do not prescribe a specific tool or arrangement to achieve their requirements. While, some principles establish a minimum requirement to help contain risks and provide for a level playing field, it’s generally up to regulators and firms to interpret the principles and design measures to satisfy their conditions. Even in cases where minimum standards are put forward, IOSCO wants authorities to have the flexibility to consider imposing higher requirements where appropriate.
The development of global standards which IOSCO members have agreed to adopt and apply “to the fullest extent possible” is a very positive development and may make it easier for authorities to implement reforms by reducing concerns about competitiveness of their financial centres. IOSCO will be monitoring compliance and benchmarking the performance of countries with their peers. However, well-intentioned promises from national securities supervisors do not always translate into binding legislation, or, when they do, may be subject to significant differences in interpretation. And the devil is always in the detail. Initiatives in different countries around the world to shore up national or regional regimes for FMIs are generally in line with IOSCO’s principles, yet there will be discrepancies in the details which will cause difficulties for firms operating globally and test the future ability of IOSCO as an effective global standard-setter, particularly given the inherent flexibility which it rightly envisages.
Raising the bar so high may discourage weaker operators from becoming a CCP/other FMIs and force others to desist. Concentrating risk in a very few providers, however well managed, may exacerbate risks to financial stability rather than remove them. The extra work heaped on, in the main, under resourced supervisors to check compliance by all FMIs is also a significant challenge. However, ensuring the safety and soundness of FMIs is positive for all; FMIs are a vital part of the financial system and they need to be adequately supervised.
FSB progress on shadow banking
In October 2011, the FSB published a report, Shadow Banking: Strengthening Oversight and Regulation Recommendations
, which presented a number of recommendations for effective monitoring and supervision of shadow banking. While the FSB stressed the difficulties and complexity associated with this task and that many unknowns still existed, it outlined a general roadmap which members agreed to follow.
First, supervision requires careful analysis of trends in non-bank credit intermediation (which are unique to each national financial system) that have the potential to pose systemic risk. To minimise the source of risk inherent in off-balance sheet activities, the FSB recommends that supervisors pay close attention to a series of connected risk factors, such as liquidity transformation, leverage and mismatch in maturity transformation. Moreover, to ensure the definition of shadow banking is sufficiently wide, the supervisor needs to assess the potential impact that the severe distress or failure of certain shadow banking entities/activities might pose to the overall financial system by looking at other factors, such as the interconnectedness between the shadow banking system and the regular banking system.
FSB are now keen to monitor progress against this framework across member countries. The FSB will conduct a monitoring exercise based on the end- 2011 data during 2012 in the next few months. The results will be reviewed by the FSB’s Standing Committee on Assessment of Vulnerabilities in September and will be reported to the Plenary as well as to the G20 later in the autumn.
Building on this work and on the invitation of G20 Cannes Summit in November 2011 to develop its work further, the FSB initiated five work-streams tasked with analysing the issues in more detail and developing effective policy recommendations:
- banks’ interactions with shadow banking entities
- money market funds (MMFs)
- other shadow banking entities
- securities lending and repos.
This month, the FSB indicated that the first, second and fourth workstreams will prepare their recommendations by July 2012. The recommendations from the other shadow banking entities workstream are expected by September 2012, while the securities lending/repo workstream is to prepare recommendations by the end of 2012. All workstreams will be reviewed by the FSB through its Standing Committee on Regulatory and Supervisory Cooperation as well as its Task Force on Shadow Banking.