Friday, March 04, 2016

Cyber Threats, Bond Market Liquidity Top IOSCO’s 2016 Market Risk Outlook

By John Filar Atwood

The increased frequency and sophistication of cyber attacks is one of the primary systemic risks facing the world’s markets in 2016, according to the International Organization of Securities Commissions (IOSCO). In its risk outlook report, IOSCO also identified corporate bond market liquidity, use of collateral in financial transactions and harmful conduct related to retail financial products and services as areas of focus.

IOSCO produces the risk outlook annually in order to identify and assess potential risks to the financial system stemming from activities in securities markets. In addition to key market risks, the 2016 report examines trends in global financial markets and their impact on securities markets, and discusses issues around the asset management industry, according to a press release.

Cyber threats. The report states that the growth in the number and cost of cyber threats, and the direct exposure of securities markets to the threats, is driving the growing knowledge that cyber attacks are a global systemic risk. Securities regulators have responded by working to increase the cyber resilience of financial systems.

Specifically, regulatory responses to cyber threats include increasing focus on cybersecurity as part of or within broader governance and operational management requirements, and the performance of examinations and self-assessments by market participants, according to the report. Regulators also are providing guidance to firms on reducing their risks, and identifying opportunities to improve cyber resilience such as increasing the collaboration between industry and government.

IOSCO said that it expects the focus on the impact of cyber attacks in securities markets to accelerate as the role of technology in the provision of financial services deepens. The growth in the interdependency and interconnectedness of the financial system also will heighten the focus on cyber threats, the report states.

Bond market liquidity. The IOSCO report also identifies corporate bond market liquidity as a potential market risk, noting that the expansion in corporate bond primary markets has raised concerns about whether the secondary market structure will withstand periods of market stress going forward.

Measures of secondary market liquidity present an inconsistent story, according to the report. On the one hand, the bond turnover ratio has decreased in U.S. and European secondary markets, while on the other hand trading volume within U.S. secondary markets and certain other secondary markets has been growing over the past five years. In addition, bid-ask spreads have tightened since 2008. The report suggests that contradictions in the picture of secondary market liquidity may be attributable to abnormal market conditions and changing market structure, away from a dealer-oriented principle-based model and towards an agency-based model.

Whatever the reasons behind the inconsistent information, ISOCO said that it is important, from both an industry and regulatory perspective, to be aware of the structural changes happening in secondary bond markets. Regulators must work to mitigate any potential risks that may arise as a result of these changes, the report states.

Collateral. A third risk that IOSCO focuses on in its report is the use of collateral in financial transactions. Collateral management activities such as collateral optimization, collateral transformation, collateral arbitrage, re-hypothecation and reuse will continue to increase. The report notes that these activities may have inherent risk transfer as part of their make-up, lead to greater market interconnections, have greater asset encumbrance and may create the potential of risk concentration in those participants that provide such services.

Harmful conduct. The final risk on which the IOSCO report focuses is harmful conduct on relation to retail financial products and services. While harmful conduct can appear in many forms, the report notes that a frequently cited case involves the mis-selling of unit-linked products and structured retail products. The products are inherently complex and hard for investors to understand, and may be pushed by advisers because of the high commissions on their sale.

The same can be said of certain unit-linked products, such as investment funds combined with a life insurance policy, the report states. IOSCO urged regulators to consider further investigation into abuses in this area.