Building for growth on solid foundations

To offer a credible alternative to bank funding, financial market infrastructures must be robust from both an operational and regulatory perspective. In this Q&A interview, Bert Chanetsa, vice chair of the growth and emerging markets (GEM) committee of the International Organisation of Securities Commissions (IOSCO), considers some of the key challenges facing market infrastructure operators in different economies globally. Also deputy executive officer for capital markets at South Africa’s Financial Services Board (FSB), Chanetsa reflects on global trends in financial markets regulation.

What is the main role of IOSCO’s growth and emerging markets committee? The GEM committee was previously known as the emerging markets committee, but its new name captures its membership more accurately, with some jurisdictions very much in the growth phase and others that are emerging or frontier. Whether you are an advanced or a fledgling economy, at some point your capital markets will face similar issues and have similar experiences. For us, GEM includes advanced emerging economies such as the BRICS, but also Romania, which recently acceded to the IOSCO Multilateral Memorandum of Understanding (MMoU), while African countries like Malawi are also knocking at the door.

In the smaller economies, bank financing is still prevalent. As regulators, we have been working to identify alternatives, but some jurisdictions have taken to capital markets more readily than others. In such markets, it’s a matter of encouraging retail and institutional investors to use the capital markets as a channel for investment.

The primary advantage of the capital markets is flexibility compared to the rigidity of bank funding. In the nascent markets, one looks for more patient capital that can demonstrate that it is serving the long-term interests of investors, with integrity, efficiency and safety.

In growing economies, what are the biggest threats and risks to the resilience and robustness of financial market infrastructures? The biggest priority for market infrastructures in fledgling economies is operational, i.e. the efficient implementation and running of systems for tracking the sale and purchase of financial securities and instruments, transaction clearing and settlement etc. Advanced and advanced emerging economies have dematerialised physical share certificates while nascent economies are still exposed to the specific risks attached to physical delivery, which can cause a fair amount of delay when settling transactions due to the need to locate the physical stock.

Fledgling economies are focused on getting the fundamentals right. Once these are established they can introduce some of the features found in developed economies. Most growth and emerging markets are keen followers of best practice with respect to observance of the principles of international securities and capital markets regulation, as articulated by IOSCO’s MMoU, which offers guidance on issues such as transparency and disclosure, the protection of shareholders’ rights and minority interests. The 101st signatory to the MMoU was admitted at the most recent IOSCO board meeting in Kuala Lumpur, Malaysia.

When talking about market infrastructures in the broad sense – including exchanges, central counterparties, central securities depositories, settlement systems, payment systems and trade repositories – IOSCO and the Committee on Payment and Settlement Systems recently published a set of 24 principles for financial markets infrastructures. Not all 24 principles apply to all financial markets infrastructures, but they are very useful guidelines, covering legal form and capacity, operational risk issues, systems issues, credit, liquidity and the plans that financial markets infrastructures should have in place in the event of failure.

IOSCO signatories have been closely scrutinising these principles and assessing their own financial markets infrastructures against them. Here in South Africa, we have been pushing the financial markets infrastructures we regulate through that assessment process to determine their levels of readiness and robustness and their ability to handle the kinds of risks associated with particular types of infrastructure.

The financial crisis refocused attention on addressing the causes of systemic risk and IOSCO now has a number of work streams associated with systemic risk.

Financial markets infrastructures all represent an interlinked value chain. Activities within each link of the chain have some unique risk elements as well as some common risk elements. The risk universe encompasses systems, operational efficiency, credit, collateral, liquidity and data integrity. Where any element of this risk universe is not managed adequately, it is likely to reverberate across the value chain and will have the capacity to destabilise the financial system.

What operational and infrastructure challenges are most common to the financial market infrastructures of growth and emerging markets? Capital markets exist to serve the needs of the particular jurisdiction. Where foreign investment is to be targeted, then local interests have to be balanced with the interests of foreign investors. Affected jurisdictions then feel obliged to liberalise capital flows, when their instinct may be to exercise some form of exchange control. What often happens to emerging economies is that the movement of interest rates up or down in the developed economies results in volatility of flows of capital, each element with its own associated risks, such as asset bubbles in the case of inflows and currency crises in the case of outflows.

Technology is central to the development of capital markets globally. There is often a gulf in the level of technology available in the developed, advanced emerging and emerging economies, largely attributable to cost. Market abuse is difficult enough to monitor and regulate in developed economies in which algorithmic and computer-based trading strategies are bound. Market abuse remains a challenge in emerging markets, with some jurisdictions grappling with similar developments to mature markets, whilst others remain more concerned with the traditional manifestations of market abuse.

How are technology advances helping to produce cost-effective solutions that support resilience of market structures in developing economies? In terms of the efficiency of financial market infrastructures, advances in technology have brought benefits and dangers. Technological advances have probably been more relevant to those jurisdictions that may be regarded as advanced emerging markets, with critical mass on their market infrastructures. These advanced emerging markets have experienced similar benefits to developed economies, but perhaps to a differing degree, such as electronic audit trails, enhancement of order and trade transparency, automated risk controls, the ability to monitor the establishment and use of controls, reductions in the cost of creating and accessing many pools of liquidity, and collecting and consolidating pre- and post-trade information. The downside of these technological advances includes duplication of operating and regulatory costs in the case of multiple trading platforms, an increase in the cost of market and reference data, the development of trading and business practices that diminish market efficiency and the dispersion of liquidity.

As a consequence of technological advances, regulators around the world have embarked on initiatives to ensure fair access to trading venues, for handling orders in a fair and non-discriminatory manner, for ensuring that orders are executed on the most favourable terms to clients, pre-trade transparency, post-trade transparency and consolidation of data. Issues raised by advances in technology may be applicable to a greater or lesser extent in jurisdictions with fledgling infrastructures.

How should interested parties (governments, central banks, regulators, market operators, market participants, investors) work together to ensure resilience of financial market structures? While these parties have different interests or motivations, they should all strive to support and enhance integrity and efficiency in the financial markets. Regulators (governments, central banks, capital markets and others) should not stifle innovation. Market participants (investors, intermediaries, product originators and others) should foster constructive innovation and not be obsessed with circumvention.

The authorities responsible for supervising financial market infrastructures should recognise the regulator best placed to regulate a particular activity and allow that regulator to lead the regulation of that activity. In some cases, effective regulation can really only be achieved through cooperation and a pragmatic approach by the respective regulators.

This is particularly relevant to those jurisdictions that are contemplating the twin peaks model of financial regulation. There is a degree of overlap, but the model should allow the prudential regulator – a central bank or unit connected to the central bank, for example – to cover financial soundness, capital adequacy and other largely prudential activities, while the market conduct regulator oversees issues relating to conduct of business, fairness, efficiency and integrity of capital markets. We have had to deal with that here in South Africa as we are moving towards that particular model of regulation.

What can growth and emerging jurisdictions learn from the experiences of financial market infrastructures in more experienced countries? A problem with the impact of financial markets regulation on financial markets infrastructures is that standard setters often mean well, but there really should not be a one size fits all approach to regulation. The G-20 has been very active following the impact of the financial crisis and heavily focused on identifying and managing systemic risk as it applies in particular to OTC derivatives. As a result, many countries are implementing regulation to get OTC derivatives centrally cleared, standardised and reported through a trade repository to improve the stability of the financial system.

This agenda does not always match the issues facing fledgling economies in the emerging markets. They can see the good in what the G-20 is seeking to do but are not in a position to implement some of the recommendations. In a fledgling economy where bank funding is still prevalent and OTC derivatives markets are still developing, these instruments are mainly entered into for hedging purposes rather than for trading.

Another area of concern is the extraterritorial reach of regulation such as the US Dodd-Frank Act and the European market infrastructure regulation. This has a negative impact on entities in fledgling economies which come within the definition of a ‘swaps dealer’ for the purposes of Dodd-Frank. IOSCO has a working group looking at these cross-border issues and creating guidelines for all jurisdictions.

Global principles have many good aspects and the fledging jurisdictions consider these carefully and incorporate as many as they can into their own markets. Before a jurisdiction can sign up to the IOSCO MMoU, for example, they need to demonstrate that their jurisdiction including their legal framework around capital markets is compatible. The MMoU’s primary aim is to facilitate the exchange of information and cooperation amongst regulators. IOSCO principles are not binding, countries are encouraged to adopt them but pragmatism rules at the end of the day.