Saturday, March 26, 2011

IOSCO Begins Initiatives to Involve Securities Regulators in Mitigating Systemic Risk

IOSCO has issued a discussion paper on the enhanced role that securities regulators can play in mitigating systemic risk through better surveillance, transparency, and the imposition of position limits. Traditionally, securities regulators have focused on transparency and disclosure. But IOSCO wants to push the envelope further out by having securities regulators monitor and manage systemic risk to the financial system. IOSCO believes that securities regulators can and should play a key role in addressing systemic risk. To do this, they need to incorporate the goal of reducing systemic risk into their everyday tasks and processes

This new role will require the development of a methodology for identifying, analyzing, monitoring and mitigating systemic risk, and promoting financial system stability. In turn, thus will require securities regulators to expand their role to enhance market transparency and disclosure, gain a better understanding of financial innovation that appreciates its potential risks and finds a balance between unrestrained innovation and overregulation, devote more internal resources to monitoring market developments and identifying emerging risks; and engage with other national and international regulators, and central banks and self-regulatory organizations, to produce a more robust, coordinated framework for promoting financial system stability.

The tools that IOSCO suggests securities regulators consider using to do this job include measures to improve transparency, business conduct rules, organizational, prudential and governance requirements, and emergency powers. Disclosure and transparency are critical for identifying emerging systemic risk. These are also what arm regulators for addressing it. Also necessary is robust regulatory supervision of business conduct essential for managing conflicts of interest and the build-up of undesirable incentive structures within the financial system.

Concretely, monitoring and tacking excessive leverage and concentration in the market will be very important in mitigating systemic risk. Securities regulators traditionally monitor firms and customers controlling or owning large positions in particular securities or derivatives. The goal is to prevent market manipulation but also to identify any risks relating to significant concentrations in the market, such as through counterparty risks.

The financial crisis has given impetus and a legislative imprimatur to these efforts. In Hong Kong for example, statutory position limits have been imposed on most of the derivatives products traded on the exchange. In the United States, the Dodd-Frank Act allows the CFTC to impose position limits across different markets, including the energy and agricultural markets, and with respect to trading in certain OTC derivatives. In March 2009 the IOSCO Task Force on Commodity Futures Markets called on all futures market regulators and other relevant authorities to have access to information that permits them to identify concentrations of positions and the overall composition of the market, comparable to the authority which the CFTC already has. Reforms of the commodities markets are also expected in the European Union in 2011.

Dodd-Frank also enhanced the regulation of hedge funds to allow the tracking of the potential for a hedge fund or group of funds to have systemic implications because of relative size or presence in a market. IOSCO has developed a template to enable the collection and exchange of consistent and comparable data amongst regulators and other competent authorities for the purpose of facilitating international regulatory cooperation in identifying possible systemic risk in the hedge funs area.

The new framework for hedge funds will allow regulators to better monitor their leverage through borrowing or from positions held in derivatives, as well as some other information such as the extent and nature of funding counterparty exposure. Regulators will then have the information necessary to take actions to impose limits on leverage when the stability and integrity of financial markets may be weakened.

In recent remaks, Jane Diplock, IOSCO Chair and Chair of the New Zealand Securities Commission, each IOSCO member will determine its response to this imperative based on its own mandate and domestic regulatory structure, as well as the size and characteristics of its securities market. Individual regulators will need to judge the scale of their response. They will need to develop their own risk indicators in the form of both qualitative information gained by general market surveillance, review of products and securities offerings, and business conduct oversight and quantitative data such as micro and macro-level indicators.

They will also need to judge the extent to which they can leverage, rather than duplicate, the work of other regulators, particularly by sharing information, combining expertise and coordinating action through such bodies as the Financial Stability Board and the Basel Committee, as well as IOSCO itself.

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