10/02/2012 Financial Innovation and Market Dynamics. The Role of Securities Regulation Welcoming address Speaking notes Good morning everybody. Now is up to me to welcome you all, and to thank a lot those who actively contributed to this event. Let me mention the academics and researchers who sent their papers, Prof. R. Masera for having accepted to be our Keynote Speaker, Prof. M. Onado who co-chaired the Scientific Committee and the Professors joining it, the colleagues that both in Bocconi and Consob have helped to organize our working day and, last but not least, the Bocconi University for hosting us today. Now I would like to spend a few words on why a security regulator, like Consob, is strongly committed to understand the financial innovation process under way. ***** 1
1. During the last few years, well-known dynamics have significantly reshaped the financial landscape. Among them we have had: - a pervasive financial integration that has increased interdependence, amplified diversification opportunities and widely dispersed risk; - a greater interaction between technical progress and financial innovation; - finally, the emergence of new complex financial products and new intermediation models, both relying on sophisticated risk management techniques, posing new micro and macro threats. For instance, the ETF mutation towards derivative replicating structures and the appearance of new breeds of products outside the regulated remit (like ETN, ETC, CDOs-squared ), are clear examples of how financial innovation - by adding further layers of complexity through derivatives, securities lending, collateral handling, conflicts of interest - can amplify the typology of the underlying risks and the opacity for investors as well. At macro level, the process innovation underlying the OTD model has already revealed its ability to trigger uncontrolled systemic consequences. In the recent past, an intense debate helped in understanding financial crisis dynamics and revealed a diffused skepticism on the existing regulatory and oversight set-up. I do not intend to go through the lengthy spectrum of the regulatory and oversight shortcomings. Rather, I will overview some of the aspects soliciting the Authorities to reconsider in-depth their attitude and tools towards innovative processes. These moves are guided by the need of being able to intercept what can be detrimental to the efficient and sound functioning of the 2
financial markets, by a strong commitment to improve the protection of retail investors, along with the shared view that these objectives can no longer be pursued without taking into account also the systemic implications of financial innovation. 2. From this perspective a quantum leap is required in several directions: - first of all Regulators need to invest more in knowledge and stateof-the-art methodological tools for a better understanding of the innovative trends. By the way, I think that this is also an effective antidote to the temptation, in emergency spells, of doing nothing at all or banning new products or processes, because of our incapacity to early detect and fully understand the micro and systemic implications of the growing financial complexities we are supposed to face; - next Regulators are solicited to be more proactive than reactive. This change is imposed by a regulation whose timing is no longer compatible with the rapidity, complexity and pervasiveness accompanying the mutation of the financial landscape. The time needed to address the drawbacks of the rules in place, and define new shared alternatives, inevitably opens up the distance between the real world on one hand and the regulatory system on the other. That s why not to be caught lagging behind, Regulators not only have to up-date their rule-book but their oversight and enforcement approaches as well. Understanding and identifying in due time the implications of financial innovation must be among the distinctive characters of this new attitude; 3
- finally, Authorities are asked to foster the convergence of their approaches, to prevent any potential regulatory and oversight arbitrage, if the above mentioned re-orientation is to be successful. Less but more effective rules, balanced with more focused oversight and enforcement practices, in a more cooperative context are among the ingredients necessary to build the new world very often idealized in the debate. Unfortunately its implementation is not so trivial. 3. In Europe we are trying to face these issues within the new European System of Financial Supervision, relying on the European Systemic Risk Board (ESRB), three new European Supervisory Authorities (ESMA the European Securities and Markets Authority; EBA the European Banking Authority; EIOPA the European Insurance and Occupational Pensions Authority), along with the already existing national ones. To ensure an adequate understanding and monitoring of financial innovation, the 2010 EU Regulations oblige the three European Supervisory Authorities to set up a Committee on financial innovation to address, in due time, any possible negative implications for retail investors, as well as on systemic financial stability. Recital 11 of the regulation establishing the European Securities and Markets Authority recalls the overarching principles guiding the new architecture, in underlining that ESMA is expected to: protect public values such as the integrity and stability of the financial system, the transparency of markets and financial products and the protection of investors ; moreover it should also prevent regulatory arbitrage and guarantee a level playing field, and strengthen international supervisory coordination. 4
In connection with the term financial innovation used in art.9 of the Regulation, the working assumption is that it relates not only to innovative products/activities in retail markets (to protect retail investors), but also to those in the wholesale market that could impact on market integrity. Moreover the same article states that the Authority may temporarily prohibit or restrict certain financial activities that threaten the orderly functioning and integrity of financial markets or the stability of the whole or part of the financial system in the Union. As already underlined, the Authorities should use their prohibition power wisely, as it would be wrong to bar, de facto, the evolution of financial innovation. In a globally ever more interconnected context, we do need new up-dated, state-of-the-art tools to effectively keep under control, and manage, the growing riskiness surrounding us. 4. The overarching principles outlined by the European Parliament and Council require a rethinking of tools and practices to be used at national level, to better address retail investor protection and granting the stability and integrity of financial markets, in the light of their country-specific characteristics. In this context, some years ago Consob decided to develop methodologies to facilitate a better understanding and handling of some complexities brought to the fore by the market dynamics in our country. For instance, instead of relying on the simplistic distinction between complex and non-complex products, we set our transparency requirements, oversight priorities and enforcement actions after having addressed the issue of how to unbundle the complex financial products to better detect and measure the underlying riskiness of their components.,. Along these lines we have also contributed to the European debate. 5
The adoption of rigorous measurement methodologies represents the necessary condition not only for understanding the micro-implications of financial innovation, but also for properly detecting the market dynamics that might end up in systemic disruptions. The ongoing financial crisis and the intense confrontation under way among the European competent Authorities have taught us that a rigorous understanding of market complexities can help in shortening not only the distance between market practices and rules, but also the differences among the oversight approaches the Authorities are deploying. It is for sure that the wider these distances are, the more likely the possibility is of ending up with an ineffective and burdensome set of rules. Rules that in the past proved very often not to be up to the task of assuring the ordered functioning of the markets, the prevention of wrongdoing, a fare competition among market participants and an effective protection of retail investors. I am convinced that the key task of realising a level playing field must go beyond market participants and cover the competent Authorities as well. A shared, rigorous approach to financial innovation may be a good starting point and a move in the right direction. That s why I hope that the academic debate will continue to trigger our doubts and to feed our decision making as well. 6