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A fresh slant on the regulatory regime - the global picture

Jane Diplock AO

Chairman, Executive Committee IOSCO

& New Zealand Securities Commission

 Association of Superannuation Funds of Australia (ASFA)

2008 Conference

12-14 November, 2008, Auckland

A fresh slant on the regulatory regime - the global picture

Good afternoon distinguished guests, ladies and gentlemen. I am pleased to be with you today.

These are unprecedented times. The challenges of the current market turmoil are front of mind not only for those of us working in the financial markets but also for consumers and market participants alike, the world over. Actions we take now will have repercussions for generations to come. I plan today to discuss the issues which will confront us over the coming months as we try to address the greatest crisis the world has seen in financial markets in our lifetime. My theme today revolves around the future of global securities regulation.

In that vein I note a recent reflection of Professor Alan Kay: "The best way to predict the future is to invent it". I believe that we have the capacity to invent the future of securities markets regulation and we are well on the way to inventing it. Some of you may agree that we need some reinvention as the current framework has shown itself to be less reliant than we might have thought. However it is my thesis that the current rescue strategies could not have been contemplated without the substantial underpinning already achieved by the global standard setters. I will return to this point later on. Nevertheless it is clear that we need considerable further work, particularly in the areas of coordinated national policy responses and in the currently under regulated parts of the global markets:

Before I embark on what will be a speculative and over-the-horizon journey, please permit me to say how delighted I am to be here today. Your industry is vital. You make up a critical part of the financial services sector. I commend the organizers of this conference which is certainly very timely. How important it is that we come together to discuss the challenges and opportunities before us during these remarkable times. And how insightful that you have chosen to come together in this wonderful city of Auckland. I do hope you all take up the opportunity to explore beyond the confines of the meeting venue, and enjoy the golf or sailing or wine tasting that Auckland has on offer.

Financial crisis

As we saw over the last several weeks, the aftershocks of the US sub-prime market crisis continue to make huge waves around the global financial markets. In the very latest developments we have seen the crisis threaten the underlying foundations of the entire financial system. We have seen it has taken as extreme series of Government bail outs and bank acquisitions all around the world to rescue it.

Meanwhile as you know the stock markets have been very volatile, rallying with news of the possible US Treasury $700 billion rescue package and then diving when such a bail out seemed less certain. You will recall that the measures, rejected by Congress at first reading on 29th September, were then passed by the Senate in the first days of October and then by the House of Representatives.

In early October the G7 met in Washington and emerged with a five point plan to stop banks failing, unfreeze banking funding, inject capital into banks, reform deposit insurance and unblock markets for securitized assets.

Following that the 15 Eurozone countries agreed on a range of measures to shore up their financial institutions, including public lending for banks.

In our part of the world the Australian and New Zealand Governments announced blanket guarantees for bank deposits, which in our case also extended to deposits in non-bank deposit-taking entities.

At the end of this week the G20 leaders will meet in Washington to examine the global economy and financial market problems, and to explore solutions for the future.

It is important to consider the regulatory backdrop on which all this activity is now proceeding. The current urgent activity is to my mind only possible because of the significant underpinning that the modern global regulatory framework provides. The 21st century solutions are only possible because regulators and others have put in place the necessary preconditions to enable the solutions to be credibly proposed. The existence of a global consensus of regulatory standards, such as the Basel framework and the IOSCO principles, are to my mind a necessary precondition to policy makers having confidence that the institutions they are supporting are well regulated and will respond in an appropriate way. The development of globally agreed standards, for disclosure, transparency and consistent financial reporting standards are all part of the global landscape which makes the current proposed solutions to the crisis possible.

In fact it is impossible to imagine the interventions in the market currently being contemplated if in fact such global regulatory underpinnings were not accepted and in place.

Future regulatory work

Most of the solutions discussed so far have, of course, been to address the crisis in the banking sector, to free up inter-bank lending and to provide liquidity to the financial system. There will need to be a far greater examination of the causes of the crisis, the drivers of the current volatility and the risk assessments needed to ensure such a crisis does not occur again. Much of that work will need to be done by the conduct regulators around the world; IOSCO is the appropriate avenue for this work to be undertaken. Focus will need to be placed on the un-regulated parts of the global market and those parts of the market where there is inadequate transparency, poor or opaque valuation, poor or no price discovery and no regulated clearing systems.

Globalization

The crisis has certainly shown us that what there is no question about now is that the world's markets are truly global. From a US beginning, the turbulence quickly reverberated around the world.

The metaphor of a butterfly flapping its wings in the jungles of Brazil, causing a tsunami on the other side of the world has now been overtaken by that of the householder taking out a mortgage in suburban Chicago and bringing on a tsunami washing over the financial institutions over the other side of the world.

Who would have ever thought that the rather pedestrian phenomena of suburban household mortgages combined with profligate lending practices and poorly valued securitization would lead to the brink of the collapse of the entire financial system.

As the Financial Times commented in its editorial this weekend "The crises might have started out in the United States but economic crises do not respect national borders".

Globalization means there is a need for global solutions. Never has global cooperation been more needed at every level. In relation to the securities markets, IOSCO, the International Organization of Securities Commissions, is a key organization to facilitate this cooperative solution.

IOSCO

Some of you may be aware of IOSCO and its work as the recognized global standards setter for securities regulation. With its 109 regulator members IOSCO actively promotes its 30 broad Principles for securities regulation for full implementation in the regulatory framework of every member jurisdiction. IOSCO has developed the facility, through its Multilateral Memorandum of Understanding (IOSCO MMOU) to which regulator members can sign up to share information and cooperate to engage in effective enforcement across borders. IOSCO is pivotal in bringing together securities regulators from around the world, and its Principles and MMOU are fundamental building blocks to the achievement of cooperation.

Crisis responses and issues

During the crisis we have seen attempts at coordination, and this type of approach is extremely encouraging. But there have also been a number of interventions taken unilaterally by national policy makers, driven by national imperatives which have had unforeseen implications for policy makers and regulators in other jurisdictions.

An example is the responses, jurisdiction by jurisdiction, on short selling. Despite some attempts at coordination we have seen various different approaches, from complete bans, to bans only on naked short selling, to bans on short selling of certain stocks. The implications for interlocked markets of the disparity in approach can be quite serious. Some commentators have suggested that these different approaches have increased rather than settled volatility in markets. While there appears to be an international consensus that naked short selling is not legitimate there needs to be more work done to assess the broader implications of short selling more widely. IOSCO plans to update some previous work done in this area.

Similarly the different approaches to circuit breakers, such as the temporary closing of markets, have also had implications for other markets. Never has the need for coordinated approaches been more obvious and more urgent.

Again I repeat how important it will be that remedies to problems arising in the future will need coordination and a cooperative approach in today's global markets.

As hinted earlier the crisis has also highlighted a number of issues around the unregulated parts of the market. During the financial crisis, as it has been difficult to ascertain the credit risk of hedge funds and credit default swaps (CDS) it has been difficult to ascertain the true risk to the broader financial market, both regulated and unregulated, until the problems actually happened. There is concern in industry and among governments that the reality is that the unregulated part of the market has been instrumental in driving much of the volatility in global markets and that this part of the market is not transparent. There is an increasing appetite for regulators and policy makers to consider these issues. Last week Christopher Cox, the Chairman of the US Securities and Exchange Commission noted in the Washington Post :

"The regulatory architecture of the early 20^th century did not anticipate and could not fully encompass the bewildering patchwork of unregulated financial instruments, exempted entities, competing legal fiefdoms and regulatory holes that have grown since then. The global financial crisis has exposed many of the weaknesses and holes in our regulatory system that are far greater and more consequential than was previously understood. The priority now must be to address those issues and rationalize that system."

It is vitally important that this endeavour be globally coordinated. I believe that IOSCO is the appropriate venue for this consideration. It is an organization with global reach, and has a structure which provides for technical expertise, trust and understanding and which is increasingly well connected with industry.

It is time now for world leaders to take the lessons learnt from this crisis to set standards and put in place mechanisms that will ensure that this situation is not repeated. The global nature of business means leaders will not only have to work in their jurisdictions but also cooperate closely with other jurisdictions to align their procedures and processes.

After every crisis there tends to be a call for tough, and even prescriptive rules to be put in place. The Sarbanes-Oxley Act introduced in the US in the aftermath of Enron is an example of this. It is important that leaders find the correct balance between over- and under- regulation. Regulation should not only protect the interests of citizens but also foster economic growth and innovation. It is also the correct time for regulators to move from short-term crisis resolving mode to finding long-term sustainable solutions.

Challenges of global capital markets

From an overarching perspective, the current financial turbulence has heightened the intensity of a very important discussion which has challenged regulators and the financial community for at least a decade. This discussion relates to the future global financial architecture. From a regulatory perspective how do we manage the tension which arises in the face of rapidly growing global markets and burgeoning cross-border trade, while our regulatory infrastructures remain nationally based?

Jurisdictions around the world have their sovereignty concerns and domestic priorities, and they come with different histories, and legal, cultural and political backgrounds, with different rules and traditions around commerce and trade, and with a great diversity of market systems. This is true of developed and emerging markets.

The discussion is today becoming more acute than ever as our political leaders grapple with the fallout from the current turbulence. I noted that late last month President Nicolas Sarkozy, while addressing the UN, called for more regulation and, in a similar statement, Prime Minister Gordon Brown called for a global approach to regulation.

There has been discussion over the years of the "holy grail" of financial regulation, the proposition that there needs to be a "super regulator" of global capital markets. A number of options have been proposed, and are now being proposed again, indeed even later this week at the G20 Summit, but all are to my mind impractical. All require that the domestic regulators cede jurisdiction to the "super regulator" at a time when domestic regulation in many jurisdictions is undergoing significant change to accommodate the changes in those domestic markets, and competition for the capital to further develop markets and economies is high. All solutions posited have been structural ones.

The volumes of domestic savings and investment make it also a political issue, and the very recent turmoil has demonstrated the power of the markets in driving domestic economic activity.

21^st century solution required

My view is that we need to look to conceptual (or virtual) solutions of the 21^st century for the regulatory outcomes suitable for the truly global capital markets of this century. I believe we may be seeing the beginnings of what might be called virtual super regulation. My suggestion is that this concept of virtual super regulation could emerge (it is only just beginning) from the network of recognition agreements that are being mooted around the world. These arrangements recognize and ensure the differences necessary in domestic regulatory approaches. Rather than requiring mirroring of regulatory approach, they rely on regulatory equivalence.

So the exciting prospect of virtual super regulation is, in effect, the sum of the recognition agreements entered into by the major capital markets of the world. IOSCO's Principles and the MMOU will be at the center of these arrangements although domestic concerns may mean other "add-ons" on a case by case basis.

Mutual recognition

Let me explain what we mean by mutual recognition. Mutual recognition is a system which is gaining international acceptance. There is an increasing international acknowledgement of mutual recognition as a solution for effective regulation in the world of cross-border capital market activity.

Mutual recognition does not require adoption of identical legislation. Rather than envisaging standardized model frameworks across jurisdictions, mutual recognition allows domestic laws and regulations to reflect national imperatives while providing the capacity for cross-border cooperation and enforcement.

To work effectively, mutual recognition requires coordinated responses and consistent approaches to regulating cross-border transactions. As a first step for achieving mutual recognition, there must be agreement on a common basis of principles on which to assess the effectiveness of foreign regulations and the work of the foreign regulator. The IOSCO Principles provide such a basis. Another important element of any mutual recognition arrangement will, of course, be the ability for regulators to share information and cooperate to engage in effective enforcement across-borders. To this end too, IOSCO's Multilateral Memorandum of Understanding (IOSCO MMOU) that I mentioned earlier, provides a fundamental tool to achieving this.

What will be core to the effectiveness of arrangements based on mutual recognition is confidence that the respective regulatory arrangements aim to achieve, and are capable of achieving, the same regulatory outcomes. Confidence in the capacity and willingness of the other regulators to enforce and cooperate will be equally critical. Put simply, it requires a comparable but not identical regulatory framework, and a similar appetite to take enforcement action.

Mutual recognition - recent developements

A worldwide application of mutual recognition is still a long way off. However, there have been a number of steps adopted in both bilateral and multilateral agreements recently which are edging towards a broader mutual recognition approach. There was, for example, the MOU of 2006 between the US Commodity Futures Trading Commission and the UK Financial Services Authority dealing with consultation and cooperation in relation to some US and UK exchanges. And in the European Union itself there are significant forms of mutual recognition.

The US Securities and Exchange Commission (SEC) announced in late March a series of actions to further the implementation of mutual recognition with a number of countries, notably Australia, Canada and the EU.

Since then on 25^th August they signed a mutual recognition agreement with the Australian Securities and Investments Commission (ASIC) which provides a framework for the SEC, the Australian Government and ASIC to consider regulatory exemptions that would permit US and eligible Australian stock exchanges and broker-dealers to operate in both jurisdictions, without the need for these entities (in certain aspects) to be separately regulated in both countries. Once implemented, these exemptions could permit US stock exchanges and broker-dealers regulated by the SEC, subject to conditions imposed by the Australian authorities, to offer their services to Australian wholesale investors and financial firms without being subject to most ASIC regulation. Likewise, eligible Australian stock exchanges and broker-dealers regulated by ASIC, subject to conditions imposed by the SEC could offer their services to certain types of US investors and firms without being subject to most SEC regulation.

In this part of the world, New Zealand and Australia in June this year introduced mutual recognition of securities offerings. This regime allows New Zealand businesses to raise capital in Australia using New Zealand offer documents - and vice versa. Investors will also benefit from having a wider choice of investment opportunities.

There have been developments in relation to mutual recognition of collective investment schemes: Australia (ASIC) signed a mutual recognition agreement around collective investment schemes with Hong Kong in early July this year.

Another example is a voluntary opt-in scheme for mutual recognition of general/non-specialised collective investment schemes offered to non-retail investors which was endorsed by the IOSCO Regional Committee for the Asia-Pacific Region at its meeting in Seoul last November. This arrangement is currently open to IOSCO members from the Asia-Pacific region, that comprise a majority of emerging market economies - provided that specific requirements, including implementation of relevant IOSCO Principles, are met. It is an important first step to possible wider recognition arrangements.

Other developments underfoot which will ultimately involve collective investment schemes include the moves by ASEAN (the Association of South East Asian Nations) towards integration of their capital markets. A blueprint adopted by ASEAN countries in November 2007 aims to transform ASEAN into a single market. Priority areas for mutual recognition or harmonization, where possible include, among other things, licensing of collective investment schemes as well as capital raising through initial public offerings, solvency of brokers, and qualification of investment professionals. Already the ASEAN integration programme has seen an agreement on harmonization, through common standards, of cross-border offerings of securities. This scheme, the ASEAN and Plus Standards Scheme, was announced early last month.

All these arrangements, and there are other examples I have not mentioned, recognize the importance of local regulation applying to local markets and create mechanisms for consultation and cooperation between regulators.

As I have mentioned, mutual recognition is enabled by a benchmarking process, by being able to recognize equivalence in each others regulatory frameworks. IOSCO, in my view, provides a set of necessary benchmarks with its 30 Principles which would constitute the fundamental core of mutual recognition arrangements. And IOSCO's MMOU provides a fundamental tool to enable regulators to share information and cooperate for enforcement across borders.

Thus as we explore the possible solutions for the future global regulatory architecture I remain convinced that mutual recognition provides a viable and compelling way forward. But this will not happen overnight. In the meantime a number of immediate actions and responses are being discussed and implemented to address the current crisis, some of which I discussed earlier.

I note the developments regarding a College of Supervisors to monitor more effectively the large financial institutions operating across-borders. This will be a positive step towards global coordination, but, depending on its design, may not be adequate for its purpose. Any College of Supervisors needs to establish a workable mechanism which will enable enforcement across jurisdictions otherwise the impact will be more limited.Mere exchange of information is unlikely to be sufficient. Mutual recognition may provide a solution.

Virtual super regulation

I return to my bold idea that there could emerge over the next ten years "virtual super regulation" as the sum of the recognition agreements entered into by the major capital markets of the world. I would like to elaborate a little more on how I think this might in fact occur.

Of fundamental importance to any economy, as all finance ministers and other political players know, are strong markets with sustainable growth potential. That's where mutual recognition arrangements add particular value. Far from merely facilitating regulatory activity, as they mature these recognition arrangements provide frameworks that effectively enhance the liquidity and resilience of markets. Once there is sufficient momentum in some of the world's large capital markets opening up access to deeper and more liquid markets, it is likely that the issuers, investors and other market participants in markets without such arrangements will bring pressure for similar arrangements to occur in their markets.

Mutual recognition provides a framework to build on the strength of markets around the world - bringing diversity, driving best practice and efficiency and opening up a multitude of opportunities for the local financial services sector, business and consumers.

As a result, it is likely that a market value will emerge for participation. In turn, politicians will wish to ensure that the benefits of greater liquidity flow to their domestic markets. It will be the demand from market participants which is likely, in my opinion, to provide the political will in jurisdictions to undertake these exercises.

Looking over the horizon then, I see a world where all major markets recognize the others throughout the full gamut of their financial market activities. From the issuers and issues of securities, to brokers and other intermediaries, to exchanges, managed funds and other entities - all could come under recognition regimes. The regulation of cross-border entities and transactions could all be covered, as could multi national agencies such as credit rating agencies. This network would cover the globe ensuring that there were high standards, based on the IOSCO Principles and the IOSCO MOU. Hopefully it would lead to a world wide raising of standards as each jurisdiction strives to ensure its standards were high enough to be considered equivalent to others for the purposes of mutual recognition.

Some other developments have occurred more recently which are providing the pathway for mutual recognition to more easily occur. Notably the work being done by the International Accounting Standards Board (IASB) towards a truly global set of high quality accounting standards with IFRS is critical. It has opened up a mechanism for greater levels of convergence or cooperation across jurisdictions.

The analogy that resonates most forcefully in my mind is the very mechanism that underpins the internationalization of financial markets.

The Internet and associated technological advances have created a closer, more connected marketplace. Its fundamentals are not one centrally controlled brain, but a series of inter-connected systems, vibrant in their differences but connected through adherence to a set of agreed protocols that facilitate the sharing of information. Can the custodians of the laws that drive the world's financial markets learn from this paradigm? I think so. How much more elegant and sustainable is the concept of fostering and growing an interconnected web of mutual understandings, than a quixotic search for a centralized regulatory big brother.

Challenges for virtual network

The vision of virtual super regulation, being a network of recognition arrangements spanning the global capital market, will have a number of critics and naysayers. In fact I have heard some rather cynical views from fellow regulators daunted by the practical difficulties recognition agreements face. They are not simple and can require significant political will. These should not be underestimated, as there will need to be significant thought leadership, as well as practical leadership in facing challenges along the way.

Some of these challenges for instance will include the question of legitimate national interests that would need to be considered in the world we live in. There are likely to be voluntary opt-in arrangements that jurisdictions will choose to participate in. Enforcement models such as the lead regulator model compared with the exemption route will need to be considered.

There will need to be further exploration of issues around asset freezing. Compensation and dispute resolution models, particularly in regard to retail investments, will need to be considered.

In my view the challenges to be confronted in evolving the way forward as I see it, will not in fact be insuperable.

Let's consider for a moment the significant progress IOSCO has already made in circumstances that have required significant political will. If ten years ago, there had been a speaker at a conference such as this suggesting that a number of jurisdictions well known for their banking secrecy would have carved out or abolished that secrecy for the purposes of an international IOSCO MOU, the speaker might well have been laughed from the room, and yet that is precisely what has been achieved. It has been achieved because the reality is that there is a market value perceived in being a signatory to the IOSCO MOU which issuers, investors and other market participants require, and to which political forces have responded.

It is my belief that a similar set of forces could well be liberated as domestic market participants, investors and issuers see, and demand, the deeper more liquid markets that recognition agreements will enable. Of course mutual recognition (or unilateral arrangements for that matter) will be easier and will probably start between like minded jurisdictions which have close links in foreign policy or other spheres. In some cases they are likely to commence in the wholesale markets as the potentially more thorny issues of protections for domestic retail investors are worked through. It is my belief that they will probably not stop there. The demand of market players for access to deeper liquidity will only increase and the demand for access to others markets will also increase.

It is probable that there will continue to be a need for some 20^th Century structural solutions for specific problems that arise. For example, it is still an open question as to whether there needs to be a global IOSCO structure to oversee credit rating agencies or whether national regulatory frameworks and the IOSCO Code of Conduct will suffice. IOSCO has recently updated its Code of Conduct Fundamentals for Credit rating agencies.

Concluding comments

In closing I reiterate that the current consensus-based international framework of securities markets regulation, through the work of IOSCO, provides a sound basis for future developments in the global financial architecture. Building on the foundations laid by this organisation I now see a possible solution to challenges which have confounded financial markets players, national governments and regulators alike. An answer may be attainable, and attainable in our lifetime.

First we have some immediate problems to resolve, calling for short term actions and politically led responses. After the crisis is over it will be important for us to address the major learnings and issues that have emerged and to consider the ways in which we look at the drivers of market behaviour and liquidity in the 21^st century. I can't help thinking we may discover that a viable solution in our lifetime is the concept of super regulation - virtual super regulation that is a network of recognition arrangements spanning the globe.

What role IOSCO will play in those future developments remains an open question. But one thing is very clear; IOSCO will be an instrumental and important participant in the exciting developments of the future. IOSCO will certainly be at the centre of the invention of the future of global securities markets regulation.

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