IOSCO Securities Markets Risk Outlook: Leverage, Collateral, CCPs, Emerging Market Capital Flows
The launch of the International Organization of Securities Commissions’ Risk Outlook report in London this week marks the first public foray into systemic risk monitoring by global securities markets supervisors. The report is the latest addition to a series of publications from national and international bodies tasked with monitoring and mitigating systemic risks — bodies that include the U.S. Financial Stability Oversight Council, the European Systemic Risk Board (under the auspices of the European Central Bank), the U.K. Financial Policy Committee (under the auspices of the Bank of England), not to mention the efforts of international bodies such as the Financial Stability Board and International Monetary Fund. One might therefore reasonably ask, what is IOSCO’s contribution to this crowded space?
As the above list implies, systemic risk oversight is largely the preserve of central bankers and finance ministers under the guise of “macroprudential supervision”. At the launch of its report in London, IOSCO set out to clarify that it does not compete with those bodies but complements them — in effect, it is the securities markets analogue to these macroprudential bodies. However, the principal risks identified by IOSCO, such as leverage, collateral practices, and derivatives, clearly overlap with those identified elsewhere. The difference would thus appear more philosophical than substantive. Indeed, as Greg Medcraft, chairman of the IOSCO board, explained, securities regulators focus on the process — the frameworks surrounding markets, products, and activities — rather than outcomes, as is the case with prudential regulation (such as maintaining a certain level of capital or protecting depositors from loss). Consequently, although the issues identified by IOSCO are not necessarily unique, the approach to analysing them is somewhat different. And ultimately, it is only by viewing risks through multiple lenses that regulators can make informed and effective policy choices.
The Four Risks
The report itself sets out key trends, developments, and vulnerabilities in securities markets, and identifies four key risk areas to monitor going forwards. These include, firstly, the return of leveraged products in investment portfolios, such as collateralised debt obligations (CDOs), collateralised loan obligations (CLOs), and leveraged real estate investment trusts (REITs), which reflect the search for yield in the current low interest rate environment. For example, the report notes that CDO issuance has increased from around $6 billion in 2010 to an estimated $35 billion (annualised) in 2013, though this is still below the $42 billion of issuance in 2008. Nonetheless, the clear upward trend in holdings of leveraged investments could pose vulnerabilities as these instruments are susceptible to falls if nominal interest rates go up sharply from their current levels of near-zero. This makes the careful unwinding of expansionary monetary policies crucial.
Secondly, the report identifies risks associated with collateral management in a stressed funding environment. This risk relates to relative scarcity of high-quality collateral due to more stringent margining requirements for OTC transactions (though the absolute level of collateral in the system has remained stable), as well as innovation in the use of collateral, such as collateral transformation and optimisation, repo, and rehypothecation. These collateral practices are cited by IOSCO as lacking in transparency and thus better disclosures are needed to more effectively monitor these off-balance sheet activities.
The third risk area identified by IOSCO relates to OTC derivatives, specifically in relation to central counterparties (CCPs). Central clearing of OTC derivatives was identified as a key risk-mitigation tool following the financial crisis; however, given that central clearing concentrates risk within CCPs, clearing arrangements must be carefully calibrated. IOSCO cites three issues for securities markets regulators to monitor: first, the effect of competition that could lead to some CCPs accepting lesser quality collateral to generate business; second, shared risk management models for calculating margin requirements that could expose CCPs to the same model risks; and third, the interconnectedness of CCPs with the banking system.
The fourth risk identified in IOSCO’s report relates to the susceptibility of emerging markets to a reversal of capital flows. The potential trigger for this risk is again the unwinding of ultra-loose monetary policies in developed markets, which has spurred capital inflows into developing economies as investors have sought to profit from the higher interest rates on offer in those markets. The unwinding of carry trades could lead to a sharp drop in asset prices in emerging markets as capital flows outward.
The publication of its risk outlook and engagement on systemic risk issues demonstrates a more forward-looking and expansive approach by IOSCO. It should now be incumbent on regulatory authorities to continue to track these issues (and others) and engage with macroprudential authorities to deliver a holistic approach to systemic risk oversight.
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