One of the implications of the global financial meltdown is a renewed focus on the purposes of securities regulation and whether these purposes should include considerations relating to systemic risk. Monitoring systemic risk has traditionally been within the realm of financial institution (i.e. prudential) regulation, not securities law. Yet the line between prudential regulation and securities law is becoming increasingly blurred given the complexity of financial markets, a complexity characterized by the growth of private markets in which derivative securities are bundled and sold by a variety of institutions. This evolution in financial markets means that securities regulators now need to care about systemic risk. Indeed, monitoring systemic risk should be a principle that is 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 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] But apart from this, the idea of systemic risk is vague[5] and when utilized by regulators, requires greater specification.
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] Despite this position, only a handful of individual countries have the concept of “systemic risk” integrated in their securities laws.[7] Thus, including a concept of systemic risk in securities regulation is an argument that must be set forth rather than a foregone conclusion.
This is a novel argument in the sense that securities regulation has traditionally been concerned with ensuring that investors are protected, markets function efficiently and the investing public has confidence in the market.[8] Monitoring systemic risk has rested with financial market 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 two institutions: the Office of the Superintendent of Financial Institutions (OSFI) and the Bank of Canada.
But capital markets activity has changed significantly since the inception of modern securities legislation. The legislation was originally intended to respond to the fact that companies were issuing securities using the public markets without adequate disclosure and thus mandated that firms completing a public offering had to use a prospectus. Because the transaction costs entailed in issuing a prospectus were onerous, another rule developed to allow firms to issue securities via the "exempt market", i.e. without a prospectus providing that issuers and/or the investors to whom they sold securities met certain criteria. The increasing volume and complexity of activity in the exempt market compels us to reconsider the objectives of securities regulation.
As part of this reconsideration, I will shortly be publishing a paper on this subject that asks whether securities regulators have a role to play in monitoring systemic risk. Should they have such a role? A broader conception of securities regulation’s objectives – and one that I espouse -- views the mitigation of systemic risk as related to investor protection and particularly market confidence. Ensuring that investors have confidence in the capital markets involves reference to whether particular market transactions could increase market volatility and give rise to systemic risk. Thus, monitoring systemic risk is not unrelated to the current objectives of securities regulation and is, indeed, a goal that is becoming more pertinent as risks arise from increasingly complex products (such as derivatives) and highly leveraged institutions (such as hedge funds).
Part 2 of the paper examines how the law has traditionally responded to the volume of activity in the public markets. It has been structured to uphold the various objectives of financial market regulation, which we understand here to be comprised of both securities regulation and prudential regulation. By undertaking this analysis, one is better able to formulate a view on whether objectives of securities regulation should change. Part 3 focuses on two facets of the exempt market -- derivative transactions and hedge funds -- 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. Part 4 considers policy options: if it is the case that securities regulation should include considerations relating to systemic risk, how should current regulation be framed or amended? Part 5 concludes.
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[1] See George G. Kaufman, “Bank Failures, Systemic Risk and Bank Regulation, 16 CATO J. 17, 21 n. 5. See also Steven L. Schwarz, “Systemic Risk” Duke Law School Legal Studies Research Paper Series, No. 163 available at http://ssrn.com/abstract=1008326.
[2] Schwarz ibid at 197 citing Paul Kupiec & David Nickerson, Assessing Systemic Risk Exposure from Banks and GSEs Under Alternative Approaches to Capital Regulation, 48 J. Real Est. Fin. & Econ 123, 123 (2004).
[3] U.S. Commodity Futures Trading Commission glossary cited in Schwarz, ibid., at 197.
[4] See C. Borio, “Towards a Macroprudential Framework for Financial Supervision and Regulation” CESifo Economic Studies, Vol. 49 (2003), 181-215. See also Schwarz, supra note 1 at xx 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 Promisel report 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.”
[5] See C. Borio, ibid. at 186.
[6] IOSCO, Press Communique (September 18, 1998). 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” online at http://uk.reuters.com/article/2009/10/09/financial-regulation-idUKL949005820091009.
[7] 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.
[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.”
[9] For the distinction between microprudential and macroprudential approaches to regulation, see Borio, supra note 4.