Including updates on shadow banking and improving financial market surveillance


ECON publishes draft report on shadow banking

The Committee on Economic and Monetary Affairs (ECON) at the European Parliament has entered the debate on shadow banking through drafting an Own Initiative Report.

The draft report, published on 23 August, supports broad and far-reaching regulations on shadow banking entities, including the proposals currently being discussed in relation to the Capital Requirements Directive IV, namely:
  • imposing capital requirements on liquidity lines provided to structured investment vehicles
  • setting a large exposure limit of 25% of own funds for all unregulated entities
  • extending CRD IV to include non-deposit taking finance companies not captured by the Capital Requirements Regulation.
The draft report underlines that a robust reporting regime needs to be at the heart of shadow banking oversight. ECON wants supervisors to have appropriate powers to collect more and better data on shadow banking transactions, market participants, financial flows and interconnections, in order to obtain a full overview of the sector.

It calls for greater transparency in the structure and activities of financial institutions. All shadow banking entities, linked or sponsored by a bank, should be included in the bank’s balance sheet for prudential consolidation purposes. This will help identify inappropriate situations where shadow banking activities are financed through insured deposits.

ECON members recognise the important role that repo and securities lending market have on liquidity in the financial system. However, greater transparency requirements for the main players, their activities and exposures are important to mitigate the systemic risk posed by this market. Regulators should also be given powers to impose minimum haircuts or margin levels for the collateralised financing markets.

The securitisation of debt instruments, one of the main vehicles which spread risky products in the run-up to the financial crisis, is given particular attention by ECON. It wants to limit the number of times a financial product can be securitised; require suppliers of securitisation to retain part of the risks associated with the product; and introduce independent valuation of the underlying assets and standardisation of securitisation products.

Last but not least, the report highlights that money market funds (MMFs), in particular those offering a stable net asset value to investors, are susceptible to runs and stresses. MMFs are increasingly being used as an alternative to bank accounts by households and corporations, particularly in the US. They have a fixed share price and offer higher yields than bank deposits but are not guaranteed. The recent financial crisis demonstrated that MMFs have limited ability to absorb losses above a certain threshold without breaking the fixed price. MMFs are also particularly susceptible to investor runs in times of stress.

In light of these perceived weaknesses and their size and importance, ECON want either MMFs to adopt a variable asset value (floating ‘NAV’) with daily mark-to-market valuations, or, if retaining a constant value, to be subjected to capital requirements.

Similar proposals were recently stalled in the US (see here), after a majority of the Commissioners at the Securities and Exchange Commission (SEC) informed its Chairman, Mary Schapiro, that they will not back proposed reforms. Schapiro wanted the industry to either switch to a floating price for its funds, or to build-up capital to absorb losses and penalise investor withdrawals during times of stress.

SEC Commissioner Gallagher and Paredes noted that the Chairman’s proposals were “not supported by the requisite data and analysis and were unlikely to be effective in achieving their primary purpose”. Moreover, they would impose “significant costs” on market players while potentially introducing new risks into the financial system. They called on further preparation to be made before any structural changes to the $2.6 trillion industry were implemented.

In light of this impasse, Chairman Schapiro, called on other US regulators to now take the baton from the SEC and push forward reforms in this space. The Federal Reserve may be charged with this role in the future if the Financial Stability Oversight Council deems the MMFs industry is systemically important.

Regardless, global regulators are going to continue to push on reforms in this area, as confirmed in an IOSCO statement on 25 August. In Europe, ECON looks ready to call on the European Commission to develop legislative proposals on reporting, repo and security lending, securitisation, structural reforms, Exchange Traded Funds, as well as MMFs, by early 2013. The draft Own Initiative Report will go for vote in the full ECON Committee probably in September.


IOSCO consults on technology challenges to market surveillance

The International Organization of Securities Commissions (IOSCO) is seeking public feedback on a series of proposed high-level recommendations aimed at helping financial supervisors improve market surveillance.

In the consultation report, Technology Challenges to Effective Market Surveillance Issues and Regulatory Tools, IOSCO finds that monitoring financial markets is becoming increasingly difficult and complex. Markets are more dynamic, competitive and fragmented with trading venues aggressively competing for order flow by offering innovative order types, such as new data products and services. Investors are able to trade cross-market, cross-asset and cross-border on multiple trading venues in milliseconds due to technological advances. These advances have combined to increase the vulnerability of markets to manipulation and fraud as traders are able to hide inappropriate activity in sophisticated transactions.

Supervisors are struggling to uncover these activities and respond to the pace of market developments. Current surveillance tools (e.g. an audit trail system) are insufficient to capture all necessary data in time to detect possible instances of market abuse and/or identify rule breaches and erroneous activity (e.g. malfunctioning algorithm errors). Moreover, there are wide differences on what data is collected, how it is collected and the level of cooperation across jurisdictions. There are disparities on reporting even among different trading venues within a single jurisdiction, especially with respect to the type of information captured.

To overcome these problems, IOSCO recommends that supervisors:
  • ensure they have the necessary legal, organisational and technical capabilities to monitor trading venues effectively
  • periodically review and update their surveillance capabilities in light of market developments and technology advances
  • use direct market participant identifier codes to associate the customer and market participant with each other and transaction (and adopt the forthcoming Legal Entity Identifier codes when they are finalised)
  • require firms to report data in a usable and consistent format
  • implement security safeguards to protect all reported data
  • require trading venues and their participants to synchronise the business clocks they use to record the date and time of any reportable event.
IOSCO found that most national supervisors do not conduct cross-market or cross-asset surveillance. This concerns IOSCO; increasingly many of the instruments traded on domestic exchanges are often listed or traded on other markets or tied to instruments listed on other foreign markets.

A single uniform electronic cross-market order and execution-tracking system (or Central Reporting Point) within jurisdictions might enhance the ability of supervisors to conduct cross-venue or cross-asset surveillance. However, this would be expensive and difficult to establish and operate. Moreover, using the Central Reporting Point for cross-venue surveillance would not be non-trivial: supervisors would have to reconstruct the sequences of events occurring in different trading spaces and eliminate the effects of feed latency on alerts, amongst a host of other problems.

Cross-border surveillance is an even greater challenge. IOSCO calls on supervisors, as a first step, to understand the extent of their cross-border surveillance capabilities, having regard to the inter-linkages between their domestic markets and those abroad.

Cross-border surveillance capabilities may take many forms, from a supervisor having an automated audit trail system that gathers information from multiple jurisdictions to Memorandum of Understandings (MoUs) and bilateral agreements. MoUs are particularly pervasive but are fraught with problems. The length of time it takes to obtain the requested information and the legal restrictions preventing supervisors sharing information are the two most prominent problems according to IOSCO’s survey.

The consultation period on this report runs until 10 October 2012. IOSCO will issue a final report probably by the end of the year after analysing the responses received.

IOSCO’s paper highlights some of the key challenges in an area which even within the European Union has not been solved. EU law clearly imposes cross-border cooperation and collaboration requirements on EU supervisors, and the MiFID regime already requires the sharing of information on transactions between key supervisors. However, this does not equate to effective cross-border and cross-venue surveillance which Arlene McCarthy in the European Parliament is advocating for inclusion in the revised Market Abuse regime. IOSCO’s consultation is timely, therefore, as it reveals some of the major implementation challenges in this proposal.