Including updates on derivatives, ETF's and systemic risk


ECB airs its views on OTC derivative rules under Dodd-Frank

Title VII of the Dodd-Frank Act sets out the regulation of over-the-Counter (OTC) derivatives, capturing virtually all derivatives market participants. The ambit of the OTC derivatives rules (the Rules) includes swap dealers, major swap participants and commercial end-users. The ECB highlighted potential issues in the interaction between Title VII of Dodd-Frank and the ECB including the Eurosystem, specifically raising concerns on the application of the OTC derivatives requirements to the functions of the ECB and national central banks. Official transactions entered into by the ECB and by national central banks within the Eurosystem will be in scope of the definitions of “swap” and “security-based swap” under the current Rules, consequently placing the ECB and the Eurosystem under the effective supervision and oversight of the SEC and CFTC. In its letter, the ECB argues that its functions are “broadly” comparable to those attributed to the Federal Reserve System, which are “expressly excluded” from the definitions under the Rules.

The ECB also contends that:
  • its transactions with private sector entities on market documentation for swaps, is done in performing its public mandate;
  • management of foreign reserves by central banks is not the same as private-sector “profit-maximising” transactions;
  • subjecting the ECB to supervision and oversight by a non-EU authority would be inappropriate;
  • the rationale for exempting the Federal Reserve System from the requirement of the Rules should also apply to the ECB; and
  • the Rules would introduce inconsistencies between EU and US legislation concerning central bank obligations in using designated CCPs.
The arguments enumerated by the ECB against applying the Rules to central banks would also apply the national central banks of the Eurosystem. In concluding its letter, the ECB requested the exemption and exclusion of any agreement, contract or transaction executed by a Public International Organisations such as the ECB and national central bank of a “market economy.”


ETFs: wolves in sheep’s clothing or regulators crying wolf?

An Exchange Traded Fund (ETF) is fundamentally a conventional investment fund that allows investors to buy and sell units not only from the fund but also from each other. Broadly, ETFs fall between two distinct categories – physically replicated ETFs, which own at least some of the assets, and synthetic ETFs, where the fund earns a return through investing in derivatives. Other types such as short or inverse ETFs – where the fund offers a positive return if the assets fall in value and leveraged ETFs – which promise an above normal return are also available to investors but are less common. Unlike other funds, investors can buy and sell ETFs at any time and for lower fees, essentially like ordinary shares traded on an exchange. Compared to other funds, ETFs provide a high degree of transparency regarding their assets and performance, which allows for accurate intra-day pricing. Consequently, an ETF can be cleared, settled and held in custody like other equity securities. Unsurprisingly, because of these advantages ETFs have quickly become extremely popular with both institutional and retail investors.

This popularity has translated into phenomenal growth in the industry: 31.8% for London listed ETFs over the twelve months ending 31 March 2011. By comparison, the mutual fund industry grew a “modest” 14.5%. Because of this rapid growth, and the increase in product varieties and the complexity of some ETFs, in recent months regulators have drawn attention to the potential risks ETFs may pose to financial stability. In April this year, the Financial Stability Board (FSB) flagged a number of “disquieting” developments in the ETF market seeing the possibility of increased liquidity risk as investors move to complex products in the search for higher yields. The US Securities and Exchange Commission (SEC) had identified certain potential risks much earlier: in March 2010 it suspended the launch of new synthetic ETFs while they reviewed how these funds use derivatives.

Not surprisingly, given the FSB’s warning, regulatory unease is now wide-spread. Jaime Caruana, head of the Bank for International Settlements (BIS) warned, “The lesson of the crisis is that authorities need to pay attention when we see complexity and liquidity and maturity transformation. In the case of some complex ETFs we have seen these things, and it is important that investors know what they are getting” . Steven Maijoor, the chairman of European Securities and Markets Authority (ESMA) referred to ETFs as “not just bread-and-butter products any more” but also “include complex structured products too” . Critics and regulators alike are drawing parallels to credit derivative instruments such as mortgage-backed securities and collateralised debt obligations, concerned that ETFs may constitute the next major risk to financial stability.

At the moment, the vast majority of ETFs in the European Union are UCITS funds, which allow these funds to benefit from a robust regulatory framework anchored on strong risk mitigation provisions. From the 1 July 2011, UCITS IV will introduce further improvements to the current framework by enhancing investor disclosure, transparency and risk management. UCITS ETFs are also subject to listing rules, EU wide requirements on prospectuses, national rules on securities lending and European-wide rules on transaction reporting. For these products, regulatory concerns around conflict of interests, counterparty exposure, transparency, leverage, synthetic exposure and use of collateral are addressed, if not mitigated, by the enhanced UCITS framework.

So are regulators concerns well-founded? Mr Caruana of the BIS is unequivocal, “Some people will say, ‘you are exaggerating’ and probably you have the problem of crying wolf. But authorities need to do that” . The FSB, as well as calling for regulatory attention, also called on industry to adapt risk management, disclosure and transparency practices to the pace of innovation in the market, early in the product cycle. Given the experience of the last few years of products with unanticipated systemic consequences, this note of caution seems a prudent approach to a relatively new and not yet fully understood asset class.


Systemic Risk: will macro and microprudential policy be the silver bullet?

On 2 June 2011, José Viñals, IMF Financial Counsellor and Director, Monetary and Capital Markets Department, speaking at the Eleventh Annual International Seminar on Policy Challenges for the Financial Sector, discussed the inherent complexity and the intricate web of connections between various players in the “financial ecosystem”. He said that the financial crisis uncovered major failures in the supervision of the financial system and underscored the multiple facets of systemic risk that calls for strong and effective supervision of not only the “trees” but also of the “forest”. He enumerated the key elements of “good supervision” – underpinned by intrusive, sceptical, proactive, comprehensive, adaptive and conclusive regulation, noting that appropriate resources are an essential foundation for the ability to supervise. But ability needs to be complemented by the ‘will to act’.

Broad international agreement exists on the need for a ‘higher level’ or macro-prudential perspective on systemic risk but Viñals noted that the analytical underpinnings for such a policy are in their infancy: policymakers are “grappling with the issue both at the conceptual level and in practical terms”. An IMF policy paper, published in April, provides a roadmap for developing the policy framework, suggesting a combination of three pillars: a clear mandate and rulemaking powers, a set of macroprudential tools that can combat the cyclical and cross-sectional dimensions of systemic risk, and a coordination mechanism with both micro-prudential and macro-economic policies. But, all in all, Viñals sees a daunting task.

He highlighted some of the complexities. First, there needs to be clarity on what a macro-prudential policy is designed to do: it should focus on ‘risks arising primarily within the financial system, or amplified by the financial system’ - it should not substitute for robust micro-prudential standards nor be used to address macroeconomic shocks or imbalances. Quality data, though, is needed for clarity and that currently is missing. More progress is needed on analytical models, and also on international cooperation between authorities to ensure that qualitative assessments can complement quantitative analysis. Institutional arrangements have emerged at international, regional and national levels but “questions remain regarding the decision-making process within multi-agency macroprudential councils and the best arrangements for ensuring accountability for implementing actions”.

In terms of tools, a key issue to be resolved is whether their use should be based on rules, discretion or a combination of both - Viñals believes the latter offers the more sensible choice. Given that macro-prudential policy will interact with micro-prudential and macroeconomic policies in ways as yet not fully understood, and the policy conflicts will exist, he believes the need for coordination across policies is clear but work is needed here. Also, national macro-prudential frameworks will need to feed effectively into international frameworks, and macro-prudential policies will been to be balanced against other initiatives such as the anticipated regimes for systemically important financial institutions (SIFIs) and the work of colleges of supervisors, the efficacy of which is increasing with experience.

Overall, Viñals identified a relatively long list of issues yet to be resolved before regulators will understand how best to mitigate systemic risk. In the meantime, other reforms, such as the regime for SIFIs are to be based on an understanding of how much risk each institution contributes to the system as a whole. Clearly, initial measures or regimes may not be optimal: the science will evolve. Critical and iterative reassessments will be necessary as the science matures, not least to adapt to market developments.


Towards a European mortgage market?

According to the European Commission (EC), the proposed EU Directive on Credit Agreements Relating to Residential Property (the Directive) will offer residential mortgage borrowers increased protection delivered via robust regulations on mortgage advertising, advice, creditworthiness assessments, pre-contractual information, and right to early repayment. Ultimately, the Directive aims to create a “more efficient and competitive single market for mortgages.” Although possibly a laudable goal - in line with the ethos of the EU Single Market and protection of consumers - past experience in this area has illustrated the Herculean task the EC is committing itself to. According to Michel Barnier, European Commissioner for Internal Market and Services, though, this is not the culmination of the EC’s ambition in this regard. A second phase would look beyond the ‘retail’ market to the commercial property market. However, even before negotiations between legislators in Brussels have started in earnest, the storm clouds are amassing.

The UK industry has been quick to voice concerns, but the arguments are likely to resonate elsewhere. The UK Building Societies Association (BSA) has stressed that a single rulebook for mortgage lending across the EU will not be appropriate given the diversity in existing regulatory frameworks. From a UK perspective, concerns also focus on specific policy measures included in the proposals which may potentially stifle the private rental sector, limit the availability and accessibility of advice, reduce the amount of pre-contractual information provided to borrowers, and increase cost to lenders that consumers would eventually shoulder. The BSA highlighted certain proposed delegations of power to the Commission within the draft which it feels entail ‘essential’ elements – such as creditworthiness assessments, pre-contractual information and minimum competency requirements - rather than ‘non-essential’ elements of the legislation.

The UK Council of Mortgage Lenders (CML) has supported these concerns and enumerated others. In its current draft the Directive’s scope would include buy-to-let mortgages as well as lending on properties used for both residential and commercial purposes. Both of these types of mortgages are currently unregulated in the UK and unlike residential mortgages, lenders assess these mortgages based on rental income and not on borrowers’ income. CML argues that calculating the affordability of buy-to-let mortgages on this basis should be outside the scope of the Directive and that the current version fails to recognise the commercial nature of these mortgages. Lenders are also concerned with the legal obligation on lenders to refuse credit in the event of a negative assessment of creditworthiness because this could result to an unjustified refusal of a borrower in circumstances where the lender may actually be prepared to consider the mortgage application (e.g. young professionals with predictable rising incomes or first time buyers with a third party guarantee). Furthermore, lenders question the consumer benefit of requiring the detailed disclosure of the reasons for refusing a borrower. Lenders are stressing that instead of providing potential benefits to consumers, requiring this disclosure will in fact provide fraudsters valuable information about the approval process that they can use when applying with another lender. Equally controversial is the proposal to require lenders to consider the whole of the market when providing advice to a customer, which may potentially prevent lenders from providing advice on their own products.

Clearly, this proposal has a long way to go before it is adopted. Concerns raised in the UK are likely to be echoed, and supplemented, in other EU countries. The EC’s commitment is likely to be sorely tested in an area where attempts at reform have often fallen short in the past, particularly when the appetite for regulatory reform appears on the wane. However, this proposal is one to watch because, if adopted, it will have a widespread impact on residential mortgage markets across the European Union.


The long journey towards a cross-border insurance resolution regime

On 3 June 2011, the International Association of Insurance Supervisors (IAIS) published an Issues Paper (the Paper) highlighting a number of important issues and challenges in establishing an effective cross-border resolution framework for insurance legal entities and groups. The paper primarily builds on the existing legal and regulatory framework set out in IAIS’ Insurance Core Principle (ICP) 16, which provides the supervisory requirements for the orderly winding up of an insurer. However, ICP 16 is an incomplete framework, as it does not address the orderly winding up of an insurer or an insurance group that operates on a cross-border basis. In this regard, the paper underscores the heightened ineffective resolution efforts of individual jurisdictions resulting in the disorderly and disparate resolution of “certain” cross-border financial institutions during the financial crisis. The Paper, although identifying the complexities involved, proposes the “way forward” in addressing the challenges at the international level, by focussing on the following key areas:
  • Definition of “resolution” and “insolvency” in the context of cross-border insurance entities;
  • Underlying causes of on insurance company non-viability;
  • General challenges and considerations in the resolution of cross-border insurance entities; and
  • Current regimes and approaches to resolution of cr0ss-border insurance entities.
The primary focus of the Paper is on insurance groups with subsidiaries in multiple jurisdictions but with some consideration of cross-border insurance entities operating branch offices in multiple jurisdictions. The paper specifically excludes issues relating to financial conglomerates because these entities fall under other rules. It defines “resolution” as ” any action by an authority, with or without private sector involvement to deal with serious problems in an insurer or cross-border insurance group that imperil the viability of the insurer or the cross-border insurance group”. Conversely, “insolvency”, is triggered in “terms of excess of liabilities over assets”, when no surplus or equity remains. The paper recognises that the term “insolvency” has different meanings since it may relate to various financial positions, and that many jurisdictions specify insolvency in their corporate and or bankruptcy laws.

The Paper identifies failures of corporate and internal governance as the major underlying cause of insurance company “non-viability”, and stresses that in a group, the non-viability of one subsidiary may adversely affect other group entities, leading to the non-viability of the group as a whole in extreme cases. The Paper enumerated in detail factors that could potentially cause the financial distress of an insurance company including: poor risk management; failure to monitor credit risk; investment returns being lower than reserving or pricing assumptions; and actual underwriting results lower than expected claims due to random variations in claim amounts and frequency. Interestingly, the Paper also suggests that support at group level such as the transfer of funds or granting of guarantees from other group entities including the holding company mitigates the potential non-viability of a member of a group. However, non-viability of the dominant entity can result in the non-viability of the entire group, especially if some or all of the smaller entities are relying on the support from the dominant entity. These comments echo concerns, and the resulting controversy, over the group support concept which was eventually omitted from the Solvency II regime in the EU (at least in the first round).

Cross-border resolution is inherently challenging due to the existence of different legal and regulatory requirements and practices among jurisdictions. The IAIS notes that these challenges are amplified for insurance entities operating in multiple jurisdictions as these differences may lead to conflicts among the regulators involved, resulting in a sub-optimal resolution outcome for the entire group. Specific and unique challenges also arise from branches in different locations because branches do not have separate balance sheets and cannot be regulated and supervised separately from parent entities. Although the Paper does not make specific recommendations, the IAIS has identified additional issues for further consideration including harmonisation of insurance restructuring and insolvency laws and the use of supervisory colleges. Resolution regimes on a legal entity basis currently exist in many jurisdictions however, there is a wide disparity in principles underlying insurance resolution regimes globally. The US liquidation proceedings and the Canadian insurance insolvency regime are good examples of traditional winding-up resolution regimes that are currently available.

The IAIS intends to use the Paper as a basis for its contribution to international discussions on the resolution of complex cross-border financial institutions. Even as stakeholders take the first steps in realising the vision of a cross-border insurance resolution framework, it is obvious that the long journey towards a final framework has barely begun.