IS SYSTEMIC RISK RELEVANT TO SECURITIES REGULATION?
February 23, 2010
Anita I. Anand Faculty of Law University of Toronto
Associate Professor, Faculty of Law, University of Toronto;
[email protected]. Thanks to participants at a seminar at the Faculty of Law, University of Cambridge for helpful comments. Thanks also to Ben Alarie, Emily Bala, Brian Cheffins, Eilis Ferran, Toni Gravelle, Andrew Green, Michael Trebilcock and John Tuer for valuable comments. Thanks also to Bekhzod Abdurazzakov for very helpful research assistance funded by the Social Sciences and Humanities Research Council of Canada.
1.
Introduction
One of the implications of the global financial meltdown is a renewed focus on the purposes of securities regulation and the expansion of these purposes to include considerations relating to systemic risk. Mitigating systemic risk has traditionally been within the realm of financial institution (i.e. prudential) regulation rather than securities law. Yet the line between prudential regulation and securities law is becoming blurred given developments in financial markets which include the bundling and sale of derivative securities by a variety of complex institutions. This evolution in financial markets suggests that systemic risk is increasingly relevant to securities regulation. The policy consequence is that mitigating, or at least monitoring, systemic risk should be integrated into the securities regulatory regime.
Defining “systemic risk” is not straightforward. What types of risk are truly systemic? Does the term refer to a single event that occasions successive losses affecting both institutions and markets?1 Does it refer to the potential for substantial volatility in asset prices, corporate liquidity, bankruptcies and efficiency losses brought on by economic shocks?2 Does it refer to a “domino effect” whereby the risk of default by one institutions or market participant will impact the ability of other participants to fulfill
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See George G. Kaufman, “Bank Failures, Systemic Risk and Bank Regulation” (1996) 16 Cato J. 17 at 21, n. 5 [Kaufman]. See also Steven L. Schwarcz, “Systemic Risk” (2008) 97 Georgetown L. J. 193, online: SSRN [Schwarcz]. Schwarcz, supra note 1 at 197 citing Paul Kupiec & David Nickerson, “Assessing Systemic Risk Exposure from Banks and GSEs Under Alternative Approaches to Capital Regulation” (2004) 48 J. Real Est. Fin. & Econ. 123, at 123.
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their obligations to still other participants?3 The common denominator in these various explanations seems to be a trigger event that causes a chain of negative economic consequences that pervade financial markets.4 More specifically, we can say that systemic risk involves the risk of breakdown among institutions and other market participants in a chain-like fashion that has the potential to negatively affect the entire financial system.5
Regardless of definitional difficulties, both the G-20 and the International Organization of Securities Commissions (IOSCO), whose membership regulates more than 90 per cent of the world's securities markets, contemplate a relationship between the mandate of securities regulators and systemic risk. One of IOSCO’s three objectives of securities regulation is the reduction of systemic risk, though it does not define the term.6 In light of IOSCO’s position, it is curious that only a handful of individual countries have the concept of “systemic risk” integrated into their securities laws.7 Thus, the argument for
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U.S. Commodity Futures Trading Commission Glossary, online: CFTC , cited in Schwarcz, supra note 1 at 197. See C. Borio, “Towards a Macroprudential Framework for Financial Supervision and Regulation” (2003) 49 CESifo Economic Studies 181 [Borio]. See also Schwarcz, supra note 1 who states that in defining the risk, it is not clear whether the trigger event must occur or whether it merely has the potential to occur. See also Central Banks of the Group of Ten Working Group, “Recent Developments in International Interbank Relations” (Promisel Report) (Basle: Bank for International Settlements, 1992), which defines systemic risk as “the risk that a disruption (at a firm, in a market segment, to a settlement system etc.) causes widespread difficulties at other firms, in other market segments or in the financial system as a whole.” See Borio, ibid., at 186. IOSCO, Press Communique, “Objectives and Principles of Securities Regulation” (September 18, 1998) [IOSCO Principles]. The three objectives are as follows: “the protection of investors; ensuring that markets are fair, efficient and transparent; and the reduction of systemic risk.” See also Reuters, “Global Market Watchdogs to Focus on Systemic Risk” Reuters (10 October 2009), online: Sify . In reviewing securities laws of IOSCO member countries, we found that of 109 countries, the securities laws of 11 countries contained words “systemic risk(s)” with only one country (South Africa) actually defining the meaning of that term.
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including a concept of systemic risk in securities regulation must be carefully developed rather than blithely accepted as a foregone conclusion.
This is a novel argument in that securities regulation has traditionally been concerned with ensuring that investors are protected, that markets function efficiently and that the investing public has confidence in the market. 8 Monitoring systemic risk has been the responsibility of financial sector regulators and has been done largely on a microprudential basis which, by definition, entails the examination of individual financial institutions as opposed to the system as a whole.9 In Canada, authority for regulating systemic risk has rested with three institutions: the Office of the Superintendent of Financial Institutions (OSFI), 10 the Bank of Canada11 and the Canadian Deposit Insurance Corporation (CDIC).12 8
Section 1.1 of the Securities Act (Ontario) states the purposes of the legislation as follows, “to provide protection to investors from unfair, improper or fraudulent practices; and … to foster fair and efficient capital markets and confidence in capital markets.” Securities Act, R.S.O. 1990, c. S.5 [Securities Act (Ontario)]. 9 For the distinction between microprudential and macroprudential approaches to regulation, see Borio, supra note 4 and infra Part 4. 10 As the main regulator of Canada’s financial institutions, OSFI is required “to monitor and evaluate system-wide or sectoral events or issues that may have a negative impact on the financial condition of financial institutions.” This appears to be a mandate to evaluate system-wide conditions but only as they relate to microprudential considerations such as their impact on the depositors, policyholders and creditors of financial institutions. And, OSFI does not necessarily adopt a system-wide perspective when regulating, given that its role is to minimize the probability of individual bank failure. Office of the Superintendent of Financial Institutions Act, 1985 (3rd Supp.), c. 18, s. 4(d). 11 The Bank of Canada has a role to play in the reduction of systemic risk. In its preamble, the Bank of Canada Act, R.S.C. 1985, c. B-2 provides the Bank with the mandate “generally [to] promote the economic and financial welfare of Canada.” The Bank regulates credit and currency in the best interests of the economic life of the nation and controls national monetary policy in addition to its role in regulating systemic risk. The Bank’s power to regulate systemic risk is evident in provisions such as s. 18(ii), stating that “[t]he Bank may…if the Governor is of the opinion that there is a severe and unusual stress on a financial market or the financial system, buy and sell from or to any person any securities and any other financial instruments, to the extent determined necessary by the Governor.” Furthermore, the Bank has the authority to act as a liquidity provider of last resort in the financial system, and has responsibility for the oversight of clearing and settlement systems for the purpose of controlling systemic risk. 12 The CDIC insures savings in case a customer’s bank or other financial institution fails or goes bankrupt. Thus, in providing insurance the CDIC is a central facet of the stability of financial institutions. If
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Capital markets activity has changed significantly since the inception of modern securities legislation, suggesting that the traditional approach may require reevaluation. Securities legislation developed as a response to the fact that companies issuing securities using the public markets did so without adequate disclosure; legislation therefore mandated that firms completing a public offering had to issue a prospectus. Because the transaction costs of issuing a prospectus are onerous, another rule developed to allow firms to issue securities via the “exempt market” in which issuers can distribute securities without a prospectus providing that the issuers or prospective investors meet certain criteria. Today, the increasing volume and complexity of activity in largely private markets give rise to systemic risk which, in turn, compels us to reconsider the objectives of securities regulation.
As part of this reconsideration, this article asks whether securities regulators should have a role to play in regulating systemic risk. The article espouses a broad conception of the objectives of securities regulation, in which the mitigation and/or monitoring of systemic risk in financial markets features prominently. Ensuring that investors are protected and that they have confidence in the capital markets involves reference to whether particular market transactions could increase market volatility and give rise to systemic risk. Thus, focusing on systemic risk would be an extension of the current objectives of securities regulation. It is becoming a more pertinent goal as risks arise from increasingly complex
deposit insurance did not exist or did not function effectively, uncertainty could increase, reducing confidence and making the system more vulnerable to economic shocks.
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products (such as derivatives) and highly leveraged institutions (such as hedge funds) that distribute these products.
Part 2 examines how securities law has traditionally responded to activity in the public markets. It discusses the history of securities law and how it has been structured to uphold various objectives, such as investor protection and market efficiency, while prudential regulation has focused on systemic risk. This history supports the argument that the objectives of securities regulation should be extended. Part 3 focuses on three facets of the capital markets – the exempt market, hedge funds and derivatives transactions – as examples of the increasing complexity of financial markets. This complexity compels us to reconceptualize the traditional objectives of securities regulation to include concerns relating systemic risk. This Part focuses on the Canadian ABCP crisis which suggested that systemic risk is no longer simply a matter of the possibility of failure among banks. It is now a concern for capital market participants, including investors, dealers and issuers. Part 4 considers policy options, exploring the problem of how securities regulation should be augmented in order to address considerations relating to systemic risk. It also probes the fact that separate regulatory bodies oversee various aspects of financial market activity; this separation makes less sense as capital markets activities demands that securities regulators coordinate with other regulatory bodies, including prudential regulators. The current Canadian model is compared to the UK Financial Services Authority in an attempt to illustrate the importance and benefits of integrated market regulation. Part 5 concludes.
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2.
The Objectives of Financial Market Regulation
What has been the purpose of securities regulation from an historical standpoint? An examination of the goals of securities regulation, as well as a discussion of the concept of systemic risk, reveals that securities regulation has not historically included concerns relating to systemic risk. Yet the discussion also demonstrates that it would not be unprecedented to broaden further the objectives of securities regulation to reflect changes in financial markets themselves.
(a)
Goals of Securities Regulation
The aims of securities regulation are generally thought to be investor protection and market efficiency. Canadian legislation is more explicit, stating that the purposes of the legislation are “to provide protection to investors from unfair, improper or fraudulent practices; and … to foster fair and efficient capital markets and confidence in capital markets.”13 Thus, there are at least three goals embodied in current regulation: investor protection, market efficiency and market confidence. On any given policy issue, there may be tension among these objectives, and securities regulators will frequently need to balance them.14
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See. For example, Securities Act (Ontario), supra note 8, s. 1.1. The notion that these objectives conflict has a firm basis in law and economics. A fundamental tenet of this literature is that, absent laws prohibiting fraud, regulation is unnecessary: private parties will enter into their own contracts and seek to protect their own interests through these contracts: see Ronald H. Coase, “The Problem of Social Cost” (1960) 3 J. L. & Econ.1; Frank H. Easterbrook & Daniel R. Fischel, “Mandatory Disclosure and the Protection of Investors” (1984) 70 Virginia L. Rev. 669. However, empirical literature has suggested that there is a baseline level of importance of investor protection laws. See Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer & Robert W. Vishny (LLSV) “Law and Finance” (1998) 106 J. Pol. Econ. 1113; Rafael La Porta, Florencio Lopez-deSilances, Andrei Shleifer & Robert W. Vishny, “Legal Determinants of External Finance” (1997) 52 J. Fin. 1131; But see Holger Spamann (2008) "'Law and Finance Revisited", Harvard Law School John M.
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Initially, securities law focused only on one of these objectives: investor protection. It was thought that unwary investors who were willing to purchase securities in a corporation should be protected from fraud committed by members of that company. Disclosure was conceived of as the primary means to provide investors with information about the securities that they might purchase, especially in the absence of corresponding enforcement actions beyond those authorized in the statutes of individual companies.15 Disclosure was meant in theory not only to inform otherwise ignorant investors, but also to keep all investors on a level playing field by providing each with access to the same information. Finally, disclosure was also considered important because it would keep firms honest, serving as a “disinfectant”16 by compelling firms to publish their news, both good and bad.
Initially, disclosure obligations were contained in corporations law statutes as opposed to securities legislation; indeed, securities law began as an offshoot from these statutes. For example, The Companies Act of 1867, an English statute that was law in the Dominion of Canada, required that every prospectus and subscription notice identify parties to the company’s contracts. It also contained civil liability provisions for failing to comply with
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Olin Center Discussion Paper No. 12, Feb. 2008 (Discussion Paper No. 12), online: SSRN whose work discredits the work of LLSV. For the need to balance, see Securities Act (Ontario), supra note 8, s. 2.1. See Province of Ontario, Report of the Attorney General’s Committee on Securities Legislation in Ontario [Kimber Report] at 7, para 1.07. …to borrow the words of Justice Brandeis. See also Easterbrook & Fischel, supra note 14 at 680 who explain that “[a] mandatory disclosure system substantially limits firms’ ability to remain silent.”
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its provisions.17 In the amendment to the first corporations statute in the Dominion, companies were required to disclose their corporate contracts.18 Companies were not required to register until the introduction of “blue sky” laws early in the twentieth century. These laws, which originated in Kansas, provided for the licensing of companies and mandated standards on their conduct.19 Canadian jurisdictions copied the blue sky laws and broadened them to apply to primary and secondary offerings.20
Licensing of those who sold securities was in fact the earliest form of investor protection. As far back as 1285, in a statute that authorized the licensing of stock brokers in London, the law has been concerned with improprieties in the sale of securities.21 Over time, this concern came to mean in legal terms that dealers should meet some sort of proficiency requirements. In Canada, the Security Frauds Prevention Act22 and related legislation were aimed at creating legal requirements for traders. These statutes also contained antifraud provisions which listed fraudulent acts punishable by fine or imprisonment. Thus, while disclosure, licensing and dealer registration comprised the ex ante aspect of investor protection, such anti-fraud provisions comprised the ex post protection.
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J. Peter Williamson, Securities Regulation in Canada (Toronto: University of Toronto Press, 1960) 3-14 cited in Condon, Anand and Sarra, Securities Law: Cases, Notes and Materials (2005) at 25 [Condon et. al.]. The Joint Stock Companies Act, 1877, cited in Condon et. al., ibid note 17, at 28. See Kansas Act (1911) and the Sale of Shares Act (Manitoba) 1912-1926, cited in Condon et. al., ibid., at 27-28. Sale of Shares Act, ibid. J. Peter Williamson, Securities Regulation in Canada (Toronto: University of Toronto Press, 1960) 3-14 cited in Condon et. al., ibid., at 25. See e.g. Security Frauds Prevention Act, R.S.N.B. 1973, c. S-6.
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In the first stand-alone securities act in Canada, the focus was on enhancing both the ex ante and ex post facets of investor protection. The Ontario Securities Act of 194523 sought to correct fraudulent stock promotion by reigning in the conduct of dealers and ensuring more comprehensive disclosure.24 In the Securities Act of 1966,25 disclosure requirements were imposed in a broad number of contexts, including primary offerings, insider trading and takeover bids.26 The Act compelled prospectuses to include certain mandated disclosures, and required “full, true and plain disclosure” of all material facts, which remains the legal standard of prospectus disclosure and liability today. 27
The 1966 Securities Act represents the first modern securities legislation in Canada. The statute did not contain a “purposes” section per se, but was influenced significantly by the Kimber Report, which stressed the importance of both investor protection and efficiency. However, as securities regulation developed over the next thirty years, efficiency concerns lacked prominence and investor protection became the focal point of the regulatory scheme, with disclosure laws as a means to ensure that this objective was fulfilled. Disclosure obligations became increasingly comprehensive, including both “periodic” and “timely” disclosure. Periodic disclosures came to include quarterly financial statements and MD&A, an annual information form (proxy circular), while timely disclosure rules compel issuers to communicate material changes by issuing a press release and filing material change reports with the Commission.28 23 24 25 26
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Securities Act, S.O. 1945, c. 22. Ibid. Securities Act, R.S.O. 1966, c. 142. Securities Act, 1966 (Ontario), R.S.O. 1966, c. 142. These reforms built on the recommendations of the Kimber Report, supra note 15, which in fact formed the basis of the 1966 Act. Securities Act (Ontario), supra note 8, s. 56. See Five Year Review Report (2003) and Condon et. al., supra note 17.
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The word “efficiency” did not form part of the explicit mandate of securities regulators until 1994. The Securities Amendment Act implemented a new section in the Ontario Securities Act which stated the purposes of the Act as being “to provide protection of investors from unfair, improper or fraudulent practices; and to foster fair and efficient capital markets and confidence in capital markets.”29 This language originated with the Daniels Task Force Report, which apparently drew from (or bore similarity to) two sources. First was the Canadian 1979 draft Act which stated the policy of securities regulation to be “to ensure investor confidence in an honest, fair and efficient market that will encourage investments in securities and increase the liquidity of trading markets and the general effectiveness of the securities market as a mechanism for allocating capital to the persons who will use it most efficiently.”30 The second source was the U.S. Securities Act of 1933, which states that “whenever…the Commission is engaged in rulemaking and is required to consider or determine whether an action is necessary or appropriate in the public interest, the Commission shall also consider, in addition to the protection of investors, whether the action will promote efficiency, competition and capital formation.”31
While the meaning of “investor protection” had been fostered and developed with decades of legislation, there was no indication of what “efficiency” meant in the new mandate contained in the Ontario legislation. Does “efficiency” mean informational 29 30
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Section 1.1 of the Securities Act (Ontario), supra note 8 Proposals for a Securities Market Law for Canada, vol. II (Ottawa: Consumer and Corporate Affairs Canada, 1979). An almost identically worded provision is contained in the US Securities and Exchange Act of 1934, 15 U.S.C. §78a.
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efficiency, which asks whether the observed market price of a security reflects all information relevant to pricing the security? Does it mean allocational efficiency, which refers to the effectiveness with which a market channels capital to its highest, most productive uses? Or, could it mean Pareto Optimality, a concept that asks whether a proposed legal change would make citizens better off without making any one person worse off?32
While all of these concepts of efficiency are relevant to different aspects of the regulation,33 it is likely that the use of the term “efficiency” in securities legislation is based on the concept of allocational efficiency. As the Kimber Report stated, “[t]he principal economic functions of a capital market are to assure the optimum allocation of financial resources in the economy, to permit maximum mobility and transferability of those resources….”34 The 1979 draft Act also supports this interpretation. 35 Regardless, the larger point remains that the mere fact of ambiguity in terminology does not negate the importance of including an objective of the regulation in the legislation in some form. This is a theme to which we will return when considering whether to include a concept of “systemic risk” in securities legislation.
A final but important point relates to the third objective stated in the Securities Act: market confidence. There is little discussion in the legislation or academic commentary about the meaning of market confidence, perhaps because its fulfillment depends on the 32
33 34 35
See Anita Anand “Balancing the Objectives of Securities Regulation” in background studies for The Task Force to Modernize Securities Legislation (2006) [Anand, Balancing the Objectives]. See Anand, Balancing the Objectives, ibid., for further discussion of this point. Kimber Report, supra note 15 at para 1.06. Proposals for a Securities Market Law for Canada, supra note 30.
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other two goals being fulfilled: markets that are efficient and that protect investors are two components “market confidence”. Indeed, issuers as well as investors are likely to have confidence in efficient markets. (Conversely, it is unlikely that a reasonable person will have confidence in an inefficient market.) Furthermore, confidence emanates from rules that ensure that investors are on a level playing field with each other (fairness concerns) and that issuers will play by the rules of the game or face regulatory sanction.
As will be evident below, market confidence is also impacted by systemic risk, although this link has not generally been drawn in discussions regarding the rationales for securities regulation. In particular, systemic risk affects allocational efficiency and creates reluctance to bear counter-party risk. Systemic risk can also lead investors to feel exposed, thereby fuelling reluctance to invest in capital markets.
(b) Systemic Risk It is clear from the foregoing that a concept of “systemic risk” has not historically been a facet of securities regulation. Rather, systemic risk has been monitored under prudential laws. Before we can determine whether this practice should change, we need to understand what “systemic risk” is. At the outset, we should note that Canadian legislation defines the term in a specific context, that of clearing and settlement.36 But
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The Payment and Clearing Settlement Act, S.C. 1996, c. 6, Sched., s. 2 defines the term as follows: the risk that the inability of a participant to meet its obligations in a clearing and settlement system as they become due or a disruption to a clearing and settlement system could, through the transmittal of financial problems through the system, cause (a) other participants in the clearing and settlement system to be unable to meet their obligations as they become due, (b) financial institutions in other parts of the Canadian financial system to be unable to meet their obligations as they become due, or (c) the clearing and settlement system's clearing house or the clearing house of another clearing and settlement system within the Canadian financial system to be unable to meet its obligations as they become due. EU legislation, like Canadian statutes, contains provisions in which systemic risk is related to clearing and/or settlement See
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the definition of systemic risk usually is taken to have a broader meaning though, as we will see, there is some lack of consensus about what this meaning is.
In its most general context, “systemic risk” refers to the “risk or probability of breakdown in an entire system.”37 The Bank for International Settlements (BIS) defines the term as “the risk that the failure of a participant to meet its contractual obligations may in turn cause other participants to default with a chain reaction leading to broader financial difficulties.”38 The Bank of England, in its pilot systemic risk survey, identified a variety of risks from feedback it received: economic downturn; borrower defaults; pressures in funding markets; sovereign risk; failure of financial institutions; regulatory and accounting changes; financial market dislocation; loss of confidence in authorities; tight credit conditions; disruptions to derivatives and insurance markets; loss of confidence in pitching, disclosure and ratings; operational risk; property price falls and infrastructure disruption.39 The phrasing of questions contained in the Survey suggests that the understanding is that “systemic risk” has broad meaning and that any risk that can potentially affect the system as a whole will qualify as a “systemic risk”.
This interpretation is consistent with numerous studies that conceive of systemic risk as risk relating to financial markets generally as opposed to financial institutions specifically. For example, Kaufman and Scott point to the relationship between The Financial Markets and Insolvency (Settlement Finality) Regulations 1999 No. 2979; Directive 98/26/EC of the European Parliament and of the Council “on settlement finality in payment and securities settlement systems” (29 May 1998). 37 George G. Kaufman and Kenneth E. Scott, “What is Systemic Risk, and do Bank Regulators Retard or Contribute to it?” The Independent Review, v. VII, n. 3, Winter 2003 371-391. 38 BIS, 64th Annual Report, Basel Switzerland (1994) at 177. 39 Bank of England Systemic Risk Survey, Table A1 “Key Risks to the UK Financial System”, online: Bank of England .
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correlation and causation in that when the first institution fails, it impacts others, causing them to fail in a domino or chain effect.40 In discussing the subprime mortgage crisis, Hellwig examines the interrelationships among a variety of contributing factors: fair value accounting, the insufficiency of equity capital at financial institutions, and systemic effects of prudential regulation.41 He contends that these developments were caused by flaws in financial system architecture, and that regulatory reform requires focus on issues of systemic interdependence.42 Again, the implication is that systemic risk can exist across financial markets (and indeed include securities markets43) and can arise from financial institutions as well as from other players, such as hedge funds.
Systemic risk need not be entirely vague. It can perhaps be measured by taking into account aggregate bank losses including those that arise out of failure (such as losses assumed by investors or the government (for bailouts)). Alternatively, systemic risk can be conceived as the potential amount that the government would have to inject to cover depositors and other bank liability holders (and to replenish capital) to keep the system functioning as it did before the crisis. Regardless, systemic risk is focused on reducing contagion risk (loss/impact given failure) as opposed to reducing the probability of failure in an individual institution.
Adopting a broad view of systemic risk, we would be shortsighted to maintain strict lines between our understanding of prudential regulation and securities regulation. As will be 40 41
42 43
Kaufman and Scott, supra note 37, at 373. Martin Hellwig, “ Systemic Risk in the Financial Sector: An Analysis of the Subprime-Mortgage Financial Crisis” (2009) 157:2 De Economist (from abstract). Ibid. Kaufman and Scott, supra note 37, at 372.
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discussed in sections 3 and 4, the complexity of financial markets means that these areas of law are becoming increasingly blurred. This complexity arises from the legal regime itself, the interdependence between market players, the types of institutions that distribute securities and the complexity of securities being traded. We turn now to a discussion of these factors.
3.
Complex Law, Institutions and Products
We have seen that securities regulation began as an area of law focused on protecting investors, and sought to regulate both primary and secondary public markets.44 Disclosure of information became central to the regulation in order to ensure that investors were well-informed prior to making their investment decisions.45 Over time, the regulation became bifurcated relating to public markets on the one hand and private or “exempt” markets on the other. The regulation relating to the exempt market allowed new institutions and products to develop. These institutions and products now raise questions about the content and scope of securities regulators’ mandate, since they appear to impact systemic risk. This section examines the exempt market, hedge funds and derivatives with a view to suggesting that appropriate scope of the securities regulatory mandate in relation to current capital market activity should be broadened.
(a)
Exempt Market
An “exempt” distribution is one in which the distribution of securities need not comply with the rules pertaining to issuers that have “gone public”, including rules relating to the 44 45
See Kimber Report, supra note 15. See Mary Condon, Making Disclosure: Ideas and Interests in Ontario Securities Regulation, (Toronto: University of Toronto Press, 1998).
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prospectus process, continuous disclosure and corporate governance to name a few. Exemptions often used include: the minimum investment exemption, which sets the minimum investment amount by investors at $150,000; the accredited investor exemption, which requires that investors have a minimum net worth; and the offering memorandum exemption, which requires the issuer to compile and distribute a disclosure document in the required format.46 Other exemptions, such as the “private company” exemption, seek to facilitate financing by smaller issuers. Finally, if an issuer such as a bank or other financial institution is regulated under another legal regime, it can fall within another set of exemptions, the underlying rationale being that the securities are relatively safe investments because of the application of another legal regime to those institutions.
A number of key points emerge. First, once the transaction meets the requirements of any one of these exemptions, it proceeds without the consistent regulatory oversight that is common in the prospectus process. Second, this idea – that certain transactions can occur without regulatory oversight – developed with the introduction of the “closed system” in Ontario in 1979.47 The underlying rationale was that there are times at which a prospectus should not be required because investors do not require such disclosure or because the regulator does not need to review the particulars of the transaction, either because they are sophisticated (as in the case of the “accredited investor” exemption), because of their close association with the issuer (the “family and friends” and related
46 47
Prospectus and Registration Exemptions, O.S.C. NI 45-106 (14 June 2005) [NI 45-106]. See Ontario Securities Commission, Five Year Review of Securities Regulation in Ontario, Draft Report (2002) and Final Report (2003).
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exemptions) or because of the application of another regulatory regime, as explained above.
Third, the rules relating to the exempt market function in what is known as the “closed system”. The closed system was conceived as a means to provide certainty by requiring that a prospectus be provided to all investors unless an enumerated exemption applied or a discretionary exemption had been granted. As a matter of practice, the transactions that the closed system facilitated tended to be smaller distributions completed by firms that were distributing equity securities to a small number of players. Firms sought to raise enough capital to undertake specific business projects and/or to position themselves to access public markets via an initial public offering in the future.
The ABCP crisis is a prime example of the complexities that arise in exempt market transactions, complexities that can cause systemic risk. Issuers of commercial paper can qualify for an exemption providing that they have received an “approved rating from an approved credit rating organization.”48 As a result of this exemption, credit rating agencies, not securities regulators, became the sole gatekeeper for distributions of ABCP.49 Once a credit rating agency provided a favourable rating, ABCP could be distributed regardless of other investor protection measures, such as disclosure regarding the securities, and the underlying assets, themselves.50
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49 50
NI 45-106, supra note 46, s. 2.35. See also John Chant, The ABCP Crisis in Canada: The Implications for the Regulation of Financial Markets, Report for the expert Panel on Securities Regulation. Online: Expert Panel on Securities Regulation . See Chant, ibid. at 13. See Chant, ibid. at 22.
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The exempt market, and the commercial paper exemption in particular, underpinned a growth in systemic risk manifested in the ABCP crisis. In July 2007, the US sub-prime mortgage market declined and investors in ABCP questioned the quality of their securities as they appeared to lose confidence in the values of the longer-term assets underlying their securities. These investors included retail and institutional investors, such as the Caisse de depot de Placement du Quebec (reported to have had $13.2 billion of ABCP51). Financial companies (referred to as “sponsors”) then announced that new ABCP would not be placed and that the maturity date on extendible notes would be extended. They also requested funding under their liquidity facilities and were denied by chartered banks and in some cases off-shore foreign financial institutions. The result was that issuers were unable to pay out obligations on maturing ABCP and the $35-billion ABCP market froze.52
The ABCP crisis implicated numerous aspects of securities regulation, including the regulation of the exempt market and in particular the exemption for commercial paper; the inadequate disclosure provided to investors; the registration requirement and in particular the scope of the suitability requirement; and whether dealers understand the
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See Bertrand Marotte, “Caisse Hase $13.2-billion of ABCP”, The Globe and Mail (28 November 2007), online: The Globe and Mail . The crisis was ultimately resolved in a two-part process: private negotiations led by lawyer Purdy Crawford on behalf of the investors and legal restructuring under the Companies Creditors’ Arrangement Act R.S.C., 1985, c. C-36. The restructuring plan was approved at two levels of court in Ontario, with the Supreme Court of Canada denying leave to appeal. See Miller Thomson, eSecurities Notes, online: Miller Thomson ; Financial Post, “Timeline of ABCP crisis” 19 August 2008, online: Financial Post .
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products they sell.53 It also highlighted the fact that many players, including non-bank sponsors and credit rating agencies, were apparently not subject to regulation at all. 54
But did the ABCP crisis suggest only that securities regulators had not effectively protected investors? As Covitz et al. have described with regard to the US, the ABCP market “may be inherently unstable and a source of systemic risk.”55 Without needing to draw conclusions about this possibility one way or another, the Canadian ABCP crisis at the very least suggested that systemic risk is no longer simply a matter of the possibility of failure among banks. It has become a concern for capital market participants, including investors, dealers and issuers.
(b) Hedge Funds The bulk of hedge fund activity in Canada occurs in the exempt market which has allowed hedge fund activity to grow exponentially. This market is an ideal venue in which hedge funds, as private investment vehicles, can raise capital. The goal of a hedge fund, like that of most funds and corporations, is to generate positive returns for these investors, but in the case of hedge funds, the investors usually form a select and limited group. A hedge fund is like a mutual fund with one important caveat: its investment 53
54 55
Investment Industry Regulatory Organization of Canada, “Regulatory Study, Review and Recommendations concerning the manufacture and distribution by IIROC member firms of Third-Party Asset-Backed Commercial Paper in Canada” (October 2008). Chant, supra note 488. Daniel M. Covitz, Nellie Liang, and Gustavo A Suarez, “The evolution of a financial crisis: panic in the asset-backed commercial paper market.” No. 2009-36, Financial and Economics Discussion Series from the Board of Governors of the Federal Reserve System (US), online: [Covitz et. al.]. Covitz et. al. conduct empirical analyses of runs in the ABCP market (“run” refers to the absence of new issuances during a week despite having a substantial shares of outstanding paper scheduled to mature). They find evidence of extensive runs i.e. in one-third of all ABCP programs and the ABCP market was subject to bank-like panic.
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mandate is typically much broader in terms of the techniques employed to generate profit.56 Hedge funds in Canada take one of three commercial forms: a stand-alone entity that operates under the aegis of a single advisor; a “funds of funds” investment vehicle whereby one fund invests in the securities of another fund, often referred to as the underlying entity or fund; structured investment products, such as principal protected notes (PPNs), which derive their value from an underlying investment such as a hedge fund.57
The relationship between hedge funds and systemic risk is bound up in their defining characteristic: to make immediate returns while maintaining significant levels of leverage vis a vis other market participants.58 Hedge funds’ reliance on leverage means that their positions are often larger than the collateral posted in support of these positions.59 Adverse fluctuations in market prices can negatively affect the market price of the collateral and dry up credit, and the “subsequent forced liquidations of large positions over short periods of time can lead to widespread financial panic….”60 A vicious cycle develops as contracting counter-parties seek to protect themselves by closing out their positions. Collateral is liquidated, assets are sold and prices decline sharply. 61 This decline in prices causes others to rush to close out their positions and investors to remove
56
57
58
59 60 61
Task Force to Modernize Securities Regulation in Canada, Final Report (2006) at 100 [Task Force Report]. The PPN is a product, not a hedge fund per se. But PPNs often have hedge funds as the underlying investment A. Fok Kam, “A Canadian Framework for Hedge Fund Regulation” vol. III. See Nicholas Chan, Mila Getmansky, Shane M. Haas and Andrew W. Lo, Federal Reserve Bank of Atlanta, “Do Hedge Funds Increase Systemic Risk?”, online: [Chan et. al.]. See also Schwarcz, supra note 1 at 203-204. Chan et. al., ibid., at 50. Chan et. al., ibid. See Schwarcz, supra note 1 at 213-214.
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their money from capital markets. Other investors are not inclined to snap up securities at deflated prices as they lack confidence that their investments will be profitable.
Hedge fund activity implicates the mandate of securities regulators first because there are efficient market and investor protection issues at stake. The exempt market is an attempt to render it easier for issuers to raise capital in that they can do so without having to comply with the disclosure obligations attached to the prospectus requirement and the subsequent costs of being a reporting issuer. It also expands the range of investments available to private investors (“angel” investors) with deep pockets. In terms of investor protection, hedge fund activity and its inherent risks give rise to various concerns: is there appropriate disclosure, including financial disclosure, made to investors and prospective investors in the exempt market, given that disclosure is not mandatory under most exemptions? Do dealers have sufficient knowledge of the products that they are distributing?
Second, hedge fund activity has the potential to impact market confidence as it can give rise to systemic risk. Various examples support this claim, including Long-term Capital Management (LTCM)62 and Amaranth63 in the U.S. and Portus64 and Norsheild65 in
62 63 64
65
As discussed below, LTCM was a highly leveraged hedge fund that lost $4.6 billion in 1998. Amaranth suffered a $6.5 billion dollar loss (70% of its capital) in 2006. It was alleged that the Portus had invested approximately $52.8 million that it had received from its customers and that over $17 million was unaccounted for. The Ontario Securities Commission filed a lawsuit against the hedge fund manager, seizing all of its assets. Portus was banned from trading securities under a temporary cease trade order, and ultimately reached a settlement agreement with the Ontario Securities Commission, online: OSC . When the hedge fund Norshield filed for receivership, about 1,900 investors had $131.9-million invested, while institutional clients had $210-million invested. See Globe and Mail, “Banks, Clients look to dodge Norshield Bullet”, online: The Globe and Mail (5 April 2009).
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Canada. Each of these crises occasioned domino effects that rippled through the capital markets. In LTCM, for example, one of the reasons for the crisis was a “flight to liquidity” across global fixed income markets.66 LTCM’s portfolio was over $100 billion with net asset value of $4 billion, swaps valued at $1.25 trillion notionally which equaled 5% of the global market in early 1998. It was an active player in mortgage-backed securities, a major supplier of index volatility to investment banks and was also investing in emerging markets.67 When Russia devalued its currency and declared a moratorium on $13.5 billion of its treasury debt, investors sought to liquidate their holdings and move to more secure US government bonds. Within months, this liquidity crisis caused LTCM’s equity to decline to $600 million. Ultimately, the Federal Reserve Bank of New York organized a consortium of leading banks to contribute $3.5 billion into the fund and take over its management in exchange for 90% of its equity. LTCM illustrates how investors – albeit sophisticated, institutional investors – suffered as a result of bets they made on the cheaper treasury bonds. LTCM also shows that because all of the leveraged Treasury bond investors held similar positions, the stability of global financial markets was in jeopardy.
Some may rightly argue that hedge fund activity is important because it maximizes social wealth.68 Furthermore, during the credit crisis, there appeared to be little contagion effect emanating from hedge funds per se and, in fact, hedge funds emerged as conspicuous survivors of the financial crisis, although the industry itself suffered. Hedge funds kept 66
67 68
See LTCM case study, Sungard Ambit Erisk, online: . Ibid. Soren Packer, “Hedge Fund Activity Defined by the Social good of Wealth Maximization”, online: SSRN .
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trading even when financial markets were low and when they failed, they did not seek government rescues.69 Even during the ABCP mess, for example, some hedge funds sought to return value to investors by offering creative solutions to deal with their frozen assets.70 Without disputing these valid arguments, the point here is that hedge funds, as was the case with LTCM, have the propensity to give rise to systemic risk, risk that can in turn undermine market confidence, investor protection and possibly market efficiency.
(c) Derivative Products Another aspect of securities regulation that can give rise to financial instability is derivatives trading. Derivatives trading accounted for notional positions greater than US$680 trillion in 2008.71 A derivative is an asset whose value is linked to the value of an underlying asset. A derivative contract is an agreement between a party and counterparty where the value giving rise to the contract is based on this underlying asset. Three main types of derivatives are futures (contracts to purchase or sell an asset on a future date), options (contracts that give the holder the right but not the obligation to purchase or sell the asset at a strike price), and swaps (contracts to exchange cash flows on a specified
69
70
71
See e.g. McKinsey Global Institute, The New Power Brokers: How oil, Asia, hedge funds and private equity firms are faring in the financial crisis, online: McKinsey&Company , at 28. Hedge Funds Fishing Around in ABCP Mess, Financial Post, online: Financial Post, http://www.financialpost.com/story.html?id=419689 (April 2009). See Expert Panel on Securities Regulation, Improving the Regulation of Derivatives in Canada, online: Expert Panel on Securities Regulation . Montreal Stock Exchange (the major stock exchange where derivative instruments are traded) reported that during 2006 in aggregate 40,540,837 derivative transactions took place with average volume of 161,517 transactions per day. See Montreal Stock Exchange, Annual Report, Financial Section, online: Montreal Stock Exchange, , at 5.
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date in the future based on the underlying value of certain assets such as currencies, exchange rates, bonds, interest rates, commodities, stocks etc.).72
Derivatives can be traded over the facilities of an exchange or over-the-counter (OTC). In the case of the former type of derivative transaction, the exchange is not only an intermediary but also a counter-party to the contract. The rules of the exchange will apply to these contracts and performance is thus guaranteed by a third party. By contrast, OTC derivatives are traded directly between two individuals or entities. No exchange or intermediary is involved and the performance of the contract is not guaranteed; in other words, there is exposure to counter-party risk. OTC derivative contracts are flexible instruments that allow market participants to tailor their preferences for risk to the individual contract that they are executing. However, they also carry more risk for the contracting parties.73
In the mid 1990s, Darby argued that the OTC derivatives market does not contribute to systemic risk but rather serves to reduce it, because these transactions shift risk to those, such as sophisticated institutions, who are better able to bear it.74 Consistent with Darby’s position, some may contend that derivative transactions do not implicate the securities regulatory mandate given that financial institutions, rather than corporations, are typically parties to the OTC derivatives contract. They may argue, given that banks
72
73
74
This is a standard break down of various types of derivatives. For example, see online: . Consider Amaranth (which suffered a $6 billion loss) and Long-term Capital Management (which lost $4.6 billion in 1998) as two examples of failed funds trading in OTC derivatives. Michael R. Darby, “Over-the-Counter Derivatives and Systemic Risk to the Global Financial System” NBER Working paper No. 4801, online: SSRN , at 4.
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and financial institutions are main players in the OTC derivatives market, that prudential regulation, not securities legislation, should be enhanced if the derivatives market is seen as a concern. Alternatively, as regulators in Canada have suggested, they may assert that derivatives are not “securities” within the meaning of the legislation.75
To counter the arguments above, if we refer to the broad definition of “securities” in the Securities Act – one which refers to “investment contracts” as falling within the legislation – it seems difficult to exclude derivatives from this definition.76 To the extent that derivatives are financial claims that are a form of investment or loan, as opposed to solely being a risk transfer mechanism, derivatives can be understood to be securities. There seems little question that securities law applies to these instruments on a plain reading of the legislation alone.
Securities law is implicated also because there are investor protection concerns at stake with OTC derivatives. First, it is difficult to disentangle the myriad arrangements entered into by any one firm that fails as a counter-party in the OTC derivatives market. Second, exempt market transactions, such as those that rely on the accredited investor exemption, can occur without any disclosure despite the fact that investors (even sophisticated investors) could benefit from disclosure about the securities and underlying assets of 75
76
A further cause for the lack of regulation in this area has been that provinces have adopted differing approaches to the regulation, with BC and Alberta addressing derivatives through their securities legislation, Ontario through its commodity and futures legislation and Quebec through its own Derivatives Act. See Expert Panel on Securities Regulation, Improving the Regulation of Derivatives in Canada in Final Report text accompanying footnote 41ff. See Securities Act (Ontario), supra note 8, s. 1. This view seems consistent with O.S.C. Staff Notice 91-702 – Offering of Contracts for Difference and Foreign Exchange Contracts to Investors in Ontario, O.S.C. Staff Notice, (2009) 32 O.S.C.B. 9003 [O.S.C. Staff Notice 91-702]; See also Pacific Coast Coin Exchange v. Ontario Securities Commission, [1978] 2 S.C.R. 112 (1978) which adopts a broad definition of “investment contract”.
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these securities that they are purchasing. Third, at point of sale questions arise as to whether those who are acting as dealers have met proficiency requirements (i.e. obtained registration) and whether investors understand the underlying credit risk when they purchase these securities.
But there is more than investor protection concerns at stake with regards to OTC derivatives. These securities allow significant leverage to be created and risk to be concentrated among a small number of institutions.77 Individual firms can “obtain or reduce credit risk exposure to a single company or sector, thereby reducing or increasing that risk.”78 Furthermore, the relationship between creditors and debtors is such that the original lender does not need to monitor as heavily as lenders in other contexts because it does not bear the risk of default.79 Because the risk of default is borne by parties other than the original debtor, a market crisis can develop.80 The fact that a web of arrangements that any one firm has entered into is difficult to disentangle if that firm should fail as a counter-party can create broad systemic issues, especially if the firm is defaulting on numerous contracts. On a broader level, OTC derivatives can facilitate regulatory arbitrage as they allow a flow of funds out of the regulated (i.e. public) into less regulated (i.e. private) markets.81
77
78 79
80 81
Henry T.C. Hu, “Testimony Concerning the Over-the-Counter Derivatives Market Act of 2009” (October 7, 2009), online: SEC . Ibid. Janis Sarra, The Financial Crisis and the Incentive Effects of Credit Derivatives (2010), [unpublished paper on file with author]. Sarra, ibid. Henry Hu, supra note 77.
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That OTC derivatives warrant regulatory attention has been readily accepted at high levels of regulatory and governmental authority. The US government has proposed legislation regulating this market82 and Canadian securities regulators are discussing whether corresponding legislation is warranted in Canada.83 The UK Financial Services Authority has also proposed reforms to the OTC derivatives market.84
The concern relating to these derivatives, however, is not simply one about investor protection; rather, it extends to broader systemic issues. OTC derivatives may give rise to systemic risks – risks that implicate the entire financial system. While these instruments can have positive effects in terms of wealth creation, concerns regarding their use extend beyond investor protection issues and include the systemic volatility that can arise when original lenders in these transactions do not bear the risk of default, when the underlying assets for the derivative contracts consist of capital of little or no value, or when leverage ratios are high and highly concentrated among a few institutions. Even if one does not accept that the risks posed by hedge funds and OTC derivatives are systemic, one must accept that failure to address the investor protection issues that arise because of systemic risks undermines market confidence. While lack of market confidence itself is not the same thing as systemic risk, the former can arise from the latter.
82
83
84
The U.S. House Committee on Financial Services approved draft legislation to regulate over-thecounter derivatives on October 15, 2009. See Over-the-Counter Derivatives Markets Act of 2009, online: . See O.S.C. Staff Notice 91-702 supra note 76 which states that the notice is intended to provide interim guidance until a harmonized approach to the regulation of OTC derivatives is developed by the Canadian Securities Administrators and/or the Province of Ontario introduces derivatives legislation. U.K., Financial Services Authority & HM Treasury, Reforming OTC Derivatives Markets: A UK Perspective (London: Her Majesty’s Stationery Office, 2009). Admittedly, the precise relationship between systemic risk and derivatives products requires further analysis and, unfortunately, cannot be fully probed here.
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4.
Policy Directions
The previous section argued that there are aspects of financial market activity that implicate the mandate of securities regulators. Yet securities regulation does not currently include the reduction or mitigation of systemic risk as an objective. This means that in discharging their mandate, securities regulators are not bound to take into account the impact or potential impact that a particular transaction or activity might have on systemic risk. Should they be bound to do so? If so, what changes to the regulatory regime would be warranted?
(a)
Existing Calls for Reform
The proposal to expand the objectives of securities regulation is one that is echoed throughout the G-20 nations. The Joint Forum on global banking, insurance and securities market regulators asserted in a recent report that “[t]he formulation of each sector’s core principles should start with the observation that financial supervision and regulation aims, in part, to maintain financial stability by reducing systemic risk posed by financial institutions, markets and products.”85 The Report suggests that there is no obvious justification for the persistence of different regulatory regimes as between the banking, securities and insurance sectors.86 This may suggest that there are similar issues that pervade the institutions and stakeholders in all of these sectors.
85 86
Joint Forum Report (January 2009). Joint Forum Report, ibid. See also, Global Risk Regulator, “Joined-up regulation is urged for systemic risk” (January 2010), online: Global Risk Regulator at 21-22.
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While prudential regulation has always been concerned with the reduction of systemic risk, the same has not been true in other sectors, particularly securities regulation. If securities regulators were to be responsive to systemic risk, they would need to embrace the idea that some risks involve more than investor protection concerns and go beyond the traditional realm of their regulatory purview. For example, and as discussed above, risks arising from derivatives and hedge funds relate to systemic issues that can transcend investor protection and efficiency.
Some may argue that such risks ought to be addressed on an ad hoc basis as they arise under the existing mandate of securities regulators. Depending on context, the risks identified may relate to investor protection, efficiency and/or market confidence. Specific changes to the current mandate to specify the centrality of systemic risk might therefore seem unnecessary. Yet while the increasing complexity of securities products, and the institutions that distribute these products, can be addressed under existing legislation, there are phenomena that cannot be addressed under the current mandate. In particular, concerns emanating from OTC derivatives can be addressed in part through enhanced disclosure obligations applied to the institutions that distribute these securities. But the dramatic growth of the derivatives market and the prominence of private actors, including hedge funds, have the propensity to give rise to systemic risk, as argued above.
To respond to these developments, it makes sense to reconsider the traditional scope of securities regulators’ function. This function no longer concerns only investor protection and market efficiency, but should also should include considerations relating to systemic
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risk, which can define as those risks that occasion a “domino effect” whereby the risk of default by one market participant impacts the ability of others to fulfil their legal obligations, setting off a chain of negative economic consequences that pervade the entire financial system.87 Some sort of tool is required to function as a “regulatory circuit breaker;” this of course raises the question of what kind of tool is best for this task.
Before responding to this question, a word about market confidence. Recall that the objectives of securities regulation include the idea that securities regulators should seek to foster market confidence. Monitoring systemic risk is likely one aspect of fostering market confidence, though the two things (monitoring risk and fostering confidence) are not one and the same. In fact, they are likely inversely related; that is, as systemic risk increases, market confidence decreases. It is therefore possible to think of monitoring or mitigating systemic risk as an extension or perhaps a necessary element of maintaining market confidence.
(b)
Macroprudential Regulation
The G-20 countries’ call for macroprudential regulation has highlighted the importance of systemic risk in the securities regulatory context. Macroprudential regulation may be the “circuit breaker” required. It focuses on the financial system as a whole, seeking to minimize system-wide distress in order to avoid reductions in aggregate output (GDP). This is in contrast with microprudential regulation, which seeks to minimize distress in
87
See Schwarcz, supra note 1.
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individual institutions in order to protect investors and/or depositors.88 Macroprudential risk is understood to be endogenous (i.e. dependent on collective behaviour) and, as Borio explains, focuses on common exposures across financial systems and institutions rather than the entity-specific focus of microprudential regulation.89 Macroprudential regulation entails assessments of systemic risks.
Underlying the concept of macroprudential is the idea that rational behaviour on the part of individual institutions and market participants across financial markets may lead to unstable aggregate outcomes. Those bodies charged with administering macroprudential regulation will be obliged to continuously examine the financial system as a whole (including financial markets, financial instruments, and financial infrastructure as well as individual players, such as institutional and retail investors, depositors etc.). In contrast, those committed to microprudential regulation may not see such surveillance as important as they focus on other objectives such as ensuring that institutions are wellcapitalized. Microprudential regulators may not consider that if all financial institutions, acting in their rational self-interest, simultaneously adopted tighter lending standards, the system as a whole might become insufficiently liquid and that credit availability systemwide would be dangerously restricted. Because of this possibility, the US is following the G-20 call and appears to be moving towards forming a macroprudential committee
88
G20 London Summit, Declaration on Strengthening the Financial System, April 2009. See also U.K., Financial Services Authority, and the Turner Review: A regulatory response to the global banking crisis (London: Her Majesty’s Stationery Office 2009). 89 A discussion of the differences between macro- and microprudential regulation can be found in Borio, Claudio, “Implementing the macroprudential approach to financial regulation and supervision”. France, Banque de France, Implementing the macroprudential approach to financial regulation and supervision, by Borio, Claudio, Financial Stability Review, September 2009.
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comprised of representatives from existing regulators (including securities regulators).90 The EU has issued a proposal for the establishment of a European Systemic Risk Board that “would be responsible for macro-prudential oversight of the financial system…in order to prevent or mitigate systemic risks….”91
Some may argue that even if a case has been made for macroprudential regulation in general, and even if other jurisdictions are adopting some form of macroprudential regulation, this does not mean that Canada in particular needs to create a separate macroprudential regulator over and above existing financial market regulators. After all, Canadian financial markets fared relatively well through the financial crisis,92 despite ABCP. Furthermore, the creation of an additional, accountable body may be unrealistic, at least in the short-term, when Canada, like some other countries, already has many regulators.
While these arguments are important, the contention here regarding unprecedented developments in capital markets suggests that some regulatory changes may be warranted.93 Indeed, it is possible to use existing agencies to build the concept of systemic risk into our legislation by broadening the scope of certain regulators’ mandates. One option in this regard would be for current financial sector regulatory agencies jointly 90
91
92
93
See Mary L. Shapiro, “Testimony concerning Regulation of Systemic Risk” Chair, US Securities and Exchange Commission before the US Senate Committee on Banking, Housing and Urban Affairs (23 July 23 2009), online: SEC . EC, Commission, Proposal for a Regulation of the European Parliament and of the Council on Community macro prudential oversight of the financial system and establishing a European Systemic Risk Board, COM (2009) 499 (final). See Paul Krugman, “Good and Boring” The New York Times (January 31, 2010), online: The New York Times ; Anita Anand, “Canadian Banks Conservative By Nature” Financial Post (March 30, 2009). Chant, supra note 48.
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to share the macroprudential regulatory burden by creating a committee or body comprised of existing regulators. This body could be comprised of representatives from the relevant institutions: the federal Department of Finance, the Canadian Securities Commission (to be formed), OSFI, the CDIC, the Financial Consumer Agency of Canada and the Bank of Canada. The committee would be charged with assessing systemic risks on a regular basis and discussing measures for mitigating those risks. The relevant regulators would bear responsibility for implementation where policies fall within their respective domains and could be accountable to this committee. If this model were implemented, it would be easier to have securities regulators, armed with an appropriate mandate, to be part of this joint regulatory arrangement.94
A further option would be to look to Canada’s financial institution regulator, OSFI, for the task, given that its mandate includes “monitoring and evaluating system-wide or sectoral events or issues that may have a negative impact on the financial condition of financial institutions.”95 OSFI’s mandate, however, relates to microprudential purposes such as assessing the impact of such events on the depositors, policyholders and creditors of financial institutions. While macroprudential regulation relates to the functioning of financial institutions, it also involves markets, institutions and activities outside OSFI’s purview, such as derivatives trading, which was central to the securitizations at the heart
94 95
Anita Anand, “Why Macro is Prudent”, Financial Post (September 24, 2009). See OFSI Act, supra note 10. This appears to be the option favoured by Nicholas Le Pan in a 2009 report. See Nick Le Pan, “Look Before You Leap: A Skeptical View of Proposals to Meld Macro- and Microprudential Regulation” C.D. Howe Institute Commentary, 2009, issue 296, online: EconPapers . Le Pan argues that “macroprudential regulation is ill-defined and has the potential to conflict with both the regulation and supervision of individual institutions...” He argues against assigning responsibility for the stability of the financial system to a single agency because “what matters more are processes to promote the realistic consideration of risk…to resolve tradeoffs among different policies, and to strengthen the will to act.”
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of ABCP. In short, there are limitations on OSFI’s ability to engage in macroprudential oversight.
Another option is to provide securities regulators with the legislative powers to engage in macroprudential regulation. Here we move closer to the argument suggested above, where securities regulators acknowledge the applicability of systemic risk to their mandate. If this strategy were adopted, and securities legislation included concepts of systemic risk, what specific changes should be implemented? To begin, the mandate of securities regulators should be expanded, perhaps along the lines of the IOSCO principles which state that the three objectives of securities regulators are as follows: “the protection of investors; ensuring that markets are fair, efficient and transparent; and the reduction of systemic risk.”96 While the precise wording of the mandate could vary as between “reduce”, “manage” and “mitigate” systemic risk, the explicit mandate of securities regulators should be expanded in the way that IOSCO suggests. The mandate may also involve monitoring systemic risk though this could be spelled out in other aspects of the legislation.
A further reform would be aimed at ensuring that regulators can assess potential threats to financial stability and act on such assessments if need be. Under an expanded mandate, securities regulators may for example need to issue early warnings that alert financial market stakeholders to the buildup of systemic risk in certain types of securities transactions or hedge fund activities. Such assessments may require that securities regulators seek disclosure from market participants and private issuers. On the basis of 96
See IOSCO principles, supra note 6.
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this information, they may wish to make recommendations to various regulatory bodies and other stakeholders regarding the prevention of activities that cause systemic risk, and to share information about Canada’s financial system with regulatory agencies both nationally and internationally. Alternatively, if it seems unrealistic for regulators themselves to assess systemic risks for individual market participants, perhaps regulators, with an eye on systemic risk (as part of their mandate) should find ways for the market participants to assess systemic risk themselves (via more constrained exemption rules, for example).
Finally, a specific head of rule-making authority may be warranted. For example, securities regulators may need to prohibit certain types of securities transactions or permit them only with certain conditions. They may need to compel disclosure by market participants or issuers with regards to certain derivatives transactions, disclosure that is not currently required under current law. These rules would, like all proposed rules,97 be subject to ministerial approval, but would allow securities regulators to act in accordance with the new objectives proposed in this paper.
Neither securities regulators nor other financial market authorities can completely prevent systemic risk from occurring. The function of securities regulators envisioned in this article is to adopt a risk monitoring role whereby they seek to understand, and alert market participants if necessary, if a buildup of systemic risk is likely to occur as a result of securities transactions within their regulatory purview, which of course includes the exempt market. Gathering and sharing information with other regulatory bodies, 97
See Securities Act (Ontario), supra note 8, s. 143.
36
domestically and internationally, is part of this function. International cooperation is crucial given that many market crises, such as LTCM and ABCP, were precipitated by events outside of the home jurisdiction.
This argument is not meant to exaggerate the potential impact of securities regulators’ ability to address systemic risk. The financial crisis illustrated the need for reforms in many areas, including evaluating the true leverage exposure of financial institutions by stress-testing correlated risk and changing the definitions of leverage exposure to encompass all forms of derivatives in setting capital ratios. Some of these reforms would ensure that if hedge funds do not have banks and large investment firms as counterparties, they would not be able to take on excess leverage, and that if they do fail, those affected are their own investors and other hedge funds who are their counter-parties. This reform, however, is one best suited to OSFI and the US Federal Reserve rather than securities regulators. While this paper has made the case for an expanded mandate for securities regulators, their role in monitoring systemic risk should be modest, and neither unrealistic nor duplicative in terms of the legislative jurisdiction of other regulators.
(c)
Merging regulators?
Some may agree that systemic risk is relevant to securities regulation but they may question whether “sectorally-based” regulation and supervision is possible in modern markets. Indeed, given the reforms proposed above (e.g. information sharing), it will be absolutely critical for close cooperation between securities and prudential regulators to
37
exist. Thus, in considering whether to empower securities regulators in this way, it seems essential to consider the overall framework of financial regulation, In this regard, Canada should consider emulating the UK’s integrated supervisory structure. The Financial Services Authority (FSA) regulates the financial services industry in the UK, including financial institutions, exchanges and firms. It sets the standards that they must meet and can take action against firms if they fail to meet the required standards. It has a broad range of powers which emanate from its three objectives: to promote efficient, orderly and fair markets; to assist retail consumers achieve a fair deal; and to improve business capability and effectiveness.98 One of the benefits of the FSA model is that regulatory functions are not separated. Where there is overlap, as there is in examining systemic risk, one single regulator can seek information and can respond to the market event as needed.
It is true that the Bank of England plays a role is maintaining the stability of the financial system, and does so through “risk assessment and risk reduction work, market intelligence functions, payments systems oversight, banking and market operations, including, in exceptional circumstances by acting as lender of last resort, and resolution work to deal with distressed banks.”99 This role is akin to the Bank of Canada’s role in Canada’s financial system. But the FSA model would be difficult to implement in Canada at present because of differences between the U.K. and Canadian regulatory landscape, foremost among which is the multitude of regulators in place at the current
98
99
Financial Services Authority of the UK, online: FSA . The Bank of England, online: Bank of England .
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time. These regulators include not only separate prudential and securities regulators but also separate securities regulators in each provincial and territorial jurisdiction. To the extent that information sharing is a significant aspect of cooperating to monitor and reduce systemic risk, the existence of “regulatory abundance” in Canada is no doubt a hindrance to merging prudential and securities regulators. A single securities regulator in Canada would need to be achieved before a merger of regulators could realistically be mapped out.
In the absence of such a merged structure, the focus of any regulatory reform relating to systemic risk should not simply be on the role of securities regulators but also on the relationship between securities and prudential regulators and the cooperation and information sharing that occurs between the two bodies. Information sharing among regulators will be important in seeking to mitigate systemic risk, as discussed above. Thus, both securities and prudential regulators will need to cooperate in this regard. While a full discussion of the form of cooperation between prudential and securities regulators is important, it is beyond the scope of this article. A few questions emerge: to what extent does regulatory cooperation in financial markets occur at present? What barriers are in place that may prevent such cooperation from occurring? Is such cooperation desirable from the point of view of monitoring systemic risk? A further set of questions that arise relate to institutional competence: can regulatory institutions charged with a mandate to mitigate or monitor systemic risk realistically accomplish this task
39
(especially with institutional investors and rating agencies failed to isolate these risks during the credit crisis of 2008)?100 Do they have the expertise and resources to do so?
5.
Conclusion
Currently, securities regulators are not legally compelled to take into account the impact or potential impact that a particular transaction or activity might have on the financial system as a whole. This article has argued that current occurrences in securities markets give rise to systemic risk – risk that cannot be monitored solely by existing prudential regulators such as OSFI. The exempt market, along with hedge fund and derivatives trading, has the capacity to create systemic volatility. It is not clear why the securities regulatory mandate should be framed so as to exclude oversight in this area. A sounder approach to regulating current financial markets is to ensure that the regulatory mandate can and does cover all aspects of capital market activity.
A final point relates to how financial markets as a whole are regulated. What is the rationale for having separate areas of law governing related if not similar aspects of financial market activity? When securities law was introduced over forty years ago, markets were less complex than they are today. Securities law has sought to ensure that investors in the public markets are adequately informed and that they purchase securities from credible individuals who are registered to engage in such transactions. In contrast, prudential regulation has focused on individual financial institutions and their stability including capital adequacy among other things. It seems that the historical separation 100
I will examine these questions in a subsequent paper.
40
between these two areas of law is no longer tenable and that a new, integrated framework for financial market regulation is warranted.
41
