IOSCO, the global standard setter for the securities markets, has on 7 September 2023 issued for consultation nine policy recommendations to address market integrity and investor protection concerns arising from Decentralised Finance (DeFi).
The Recommendations cover six key areas, consistent with the IOSCO Objectives and Principles for Securities Regulation and relevant supporting IOSCO standards, recommendations, and good practices: (1) Understanding DeFi Arrangements and Structures, (2) Achieving Common Standards of Regulatory Outcomes, (3) Identification and Management of Key Risks (4) Clear, Accurate and Comprehensive Disclosures (5) Enforcement of Applicable Laws, (6) Cross-Border Cooperation.
Jean-Paul Servais, IOSCO Board Chair said: “By supporting greater consistency of regulatory frameworks and oversight across member jurisdictions, the DeFi recommendations complement the Crypto and Digital Assets Recommendations published in May 2023. Once finalised, the two sets of Recommendations will provide a first clear, interoperable, and globally consistent policy framework for crypto and digital assets, including DeFi. This report marks a significant step forward in achieving regulatory outcomes for investor protection and market integrity that are the same as, or consistent with, those required in traditional financial markets across IOSCO’s 130 member jurisdictions.”
Tuang Lee Lim, Chair of IOSCO’s Board-Level Fintech Task Force said: “There is a common misconception that DeFi is truly decentralised and governed by autonomous code or smart contracts. In reality, regardless of the operating model of the DeFi arrangement, “responsible persons” can be identified. Our recommendations are therefore predicated on the need to identify these persons, whether legal or natural, who should bear responsibility for upholding investor protection and market integrity.”
IOSCO has opened a public consultation and aims to finalise its DeFi recommendations around the end of 2023, in accordance with its Crypto-Asset Roadmap of July 2022, and in conjunction with its CDA recommendations.
Comments on the consultation paper should be sent to DeFiconsultation@iosco.org on or before 19 October 2023.
A Game-Changer for Investors and Portfolio Managers Alike
In an ever-evolving financial landscape, innovation frequently finds its way to the forefront, pushing boundaries and redefining traditional investment strategies. A prime exemplar of such a transformation is the rise of Actively Managed Certificates (AMCs) both globally and locally.
Introduced to the Johannesburg Stock Exchange’s listings in July 2022, AMCs have since flourished with a market capitalisation of R8.5 billion as of 18 August 2023. A total of 32 AMCs have found their place in the market, showcasing the rapid adoption and trust they’ve garnered.
AMCs offer investors a chance to dip their toes into a diversified portfolio of underlying assets. Unlike traditional listed funds, investors aren’t buying physical assets; AMCs provide synthetic exposure, which means that they replicate the economic benefits of owning the actual assets without physical ownership. AMCs are issued by banks where the underlying referenced portfolio is managed by independent third-party experts and backed by robust regulatory frameworks. AMCs ensure that investment strategies are not just about returns, but also about safeguarding investor interests.
For discerning investors, AMCs emerge as an avant-garde solution, particularly when seeking avenues for offshore access. Historically, many issuers have opted to register funds in offshore markets, a process that often comes with the daunting prerequisite of possessing a substantial asset base, which not only acts as a barrier for smaller issuers but can sometimes slow the pace of entry. AMCs, in contrast, provide a streamlined gateway, enabling investors to bypass the cumbersome and asset-heavy offshore registration, rendering them particularly germane for those eager to expand their horizons without the associated bureaucratic weight.
Moreover, the allure of AMCs isn’t merely confined to accessibility.
Rather than re-inventing the wheel, third-party portfolio managers can deftly leverage the existing banking infrastructure, which includes pivotal components such as custody services and advanced trading infrastructure, thus mitigating the otherwise high operational costs and, by extension, enhancing the potential returns for investors. And, if the economic fabric were a ticking clock, AMCs, with their listed nature, would be its precise second hand.
They facilitate intraday trading, a feature indispensable for those who thrive on market fluctuations. A regulatory requirement includes that liquidity providers facilitate intraday liquidity and that AMC issuers ensure the daily publication of an intraday reference portfolio value (iRPV) on their websites, thereby offering greater visibility of the referenced portfolio’s value. Furthermore, their T+3 settlement system ensures that security transactions culminate within a succinct three-day cycle, bringing efficiency to the fore.
The global AMC trend hasn’t gone unnoticed by major players.
UBS Group AG’s recent foray, with five new AMCs listed on the JSE in April 2023, speaks volumes about the direction in which the industry is heading. These portfolios, encompassing the likes of the SAAM Local Growth Portfolio and the Mergence Global Quant Equity Portfolio, aim to deliver real returns through a focused investment in high-quality growth stocks.
Yet, the attraction isn’t solely for financial giants. The AMC arena has witnessed a surge of local boutique portfolio managers. Firms such as BP Bernstein, NVest, and Mergence Investment Managers, to name just a few, are exploring the vast potential of AMCs, bringing with them a mix of local expertise and innovative strategies.
The JSE, recognising the potential of AMCs, has embarked on a journey of regulatory rejuvenation.
Proposed amendments – including alterations to Section 19 (Specialist Securities), the introduction of a new BEE section, and consequential adjustments to Section 18 (Dual Listings) – aim to streamline the listing process, eliminate ambiguities, and align with international best practices. A notable change on the horizon concerns the use of derivatives in the AMC referenced portfolio. This suggests a broader spectrum of portfolios may soon come under the AMC umbrella, further widening opportunities for both investors, issuers and portfolio managers.
In an age where financial agility is paramount, AMCs offer a blend of flexibility, diversification, and strategic expertise. They represent not just another investment option, but a paradigm shift in how we perceive and engage with financial markets.
Nicole Britton, Ernie Van Der Vyver and Kate Swart
On 3 August 2023, the Prudential Authority published four proposed guidance notices on climate-related risk practices and disclosures for banks and insurers:
a proposed guidance notice on climate-related risk practices for insurers (Insurers Risk Practices Guidance Notice);
a proposed guidance notice on disclosures for insurers (Insurers Disclosures Guidance Notice);
a proposed guidance notice on climate-related risk practices for banks (Banks Risk Practices Guidance Notice); and
a proposed guidance notice on climate-related disclosures for banks (Banks Disclosures Guidance Notice).
The proposed guidance notices constitute the anticipated regulatory guidance setting out the Prudential Authority‘s expectations on how climate risks should be integrated into supervised institutions’ risk management, governance and reporting processes, in line with Prudential Communication 10 of 2022 on Climate-related risks.
Insurers Risk Practices Guidance Notice
The Insurers Risk Practices Guidance Notice aims to assist insurers in complying with the requirements of the Governance and Operational Standards for Insurers (GOI) in relation to two Prudential Standards – the Risk Management and Internal Controls for Insurers Prudential Standard (GOI3) and Own Risk Solvency Assessment (ORSA) for Insurers Prudential Standard (GOI 3.1).
It is proposed that climate-related risks must be addressed through three key areas – governance, risk management and ORSA.
Governance: the board of directors retains ultimate responsibility for the effective governance of climate-related risks, and various roles and responsibilities of the board of directors and senior management are identified, together with a proposal for policies and strategies to be adopted.
Risk Management: an integrated and holistic approach must be adopted, with insurers incorporating climate-related risks into existing risk and corporate governance frameworks, and focussing on the impact of climate-related risks on assets, liabilities and the insurer’s business model, as well as its solvency. The approach to be taken by the risk management function, compliance function, actuarial function, internal audit function and control function competencies are also outlined. The potential impact of climate-related risks on outsourced service providers must also be considered, and transitional plans should be put in place.
ORSA: The climate-related risk exposure of an insurer impacts the nature and materiality of the relevant insurance, credit, market, concentration, operational and liquidity risks to varying degrees. By utilising the ORSA, insurers can assess the adequacy of its enterprise risk management and capital position in relation to climate-related risks. The ORSA must include scenario analysis and stress testing as part of the assessment process, incorporating an assessment of physical, transitional and liability risks. Specific reporting requirements in respect of the ORSA are set out where climate-related risks are assessed to be material by an insurer.
Insurers Disclosures Guidance Notice
The Insurers Disclosures Guidance Notice aims to provide guidance to insurers on climate-related disclosures, taking into consideration the recommendations of the Taskforce for Climate-related Financial Disclosures (TCFD) and the International Sustainability Standards Board (ISSB), under the four thematic areas of governance, strategy, risk management and metrics and targets. It emphasises the necessity of disclosures of climate-related risks and opportunities to promote market discipline within the financial markets industry through the provision of meaningful information to stakeholders on a consistent and comparable basis.
In this regard, insurers are required to produce climate-related disclosure reports, and principles governing the manner in which such reporting is carried out are set out by the Prudential Authority in the Insurers Disclosures Guidance Notice. A few disclosures that should be made in these disclosure reports, include:
the practices and processes in maintaining oversight over climate-related risks and their impact on the financial institution;
the current and anticipated impacts of climate-related risks and opportunities on the institution’s business, strategy, and financial planning where such information is material;
risk management policies and processes for identifying and assessing climate-related risks and managing these (including policies and transition plans), and how these are integrated into the institution’s overall risk management; and
the metrics and targets that enable stakeholders to evaluate the institution’s exposure, measurement and management of climate-related risks, clearly stating the ambition level and quantitative and qualitative aspects.
Although the disclosures are not expected to be subject to independent external assurance currently, it is recorded that such disclosures should work towards a future state in which external assurance is expected, and should be subject to internal governance processes.
Banks Risk Practices Guidance Notice
The Banks Risk Practices Guidance Note is intended to be issued in terms of section 6(5) of the Banks Act 94 of 1990 (Banks Act), which empowers the Prudential Authority to issue guidance notes to banks, controlling companies, representative offices, eligible institutions and auditors of banks or controlling companies with information in respect of market practices or market or industry developments within or outside of South Africa. The proposed Banks Risk Practices Guidance Note contains guidance to banks, branches of foreign institutions and controlling companies (collectively ‘banks’) on integrating climate-related risks into their governance and risk management frameworks, including guidance on banks’ internal capital adequacy assessment process (ICAAPs).
In light of the fact that climate change may result in physical and transitional risks that could affect the safety and soundness of individual banks and have broader financial stability implications for the banking system, the Prudential Authority intends to publish this guidance notice to contribute to the strengthening of the regulation and supervision of climate-related risk management within banks for the purpose of enhancing financial soundness and stability.
It is proposed that climate-related risks must be addressed through three key areas – governance, risk management and ICAAP.
Governance: The board of directors and senior management of banking institutions should develop processes and policies for assessing potential impacts of climate-related risks on their business model, overall strategy and environment in which they conduct business, as well as assigning clear roles and responsibilities to manage and oversee climate-related risks within the institution. Banks are tasked to adopt robust governance policies to identify, monitor, report and mitigate climate related risks impacting the bank, as well as managing climate-related risks within their overall business strategy and risk appetite.
Risk Management: banks should integrate climate-related risks into their risk management frameworks, managing such climate-related risks proportionately to the size and complexity of the institution, and demonstrating that climate-related risks have been considered as part of strategic planning and business practices. Exposure to climate-related risks should be identified, measured, monitored and reported on by banks. The approach to be taken by the risk management function, compliance function, actuarial function, internal audit function and control function competencies are also outlined. The potential impact of climate-related risks on outsourced service providers must also be considered, and transitional plans should be put in place.
ICAAP: climate-related risks may have an impact on banking institutions of any size, complexity or business model, and the regulatory capital framework therefore places increased emphasis on risk management. Banks are required to employ suitable process, procedures and systems to ensure capital adequacy commensurate with their risk profile in order to safeguard against these risks. It is therefore imperative for banks’ ICAAP to ensure adequate coverage to exposures. Banks are expected to use scenario analysis to understand the impact of climate risk on their solvency and liquidity, and they should have written policies in place governing scenario analysis and stress testing methodologies. The manner in which banks should carry out such stress testing is set out, as well as the reporting content which ICAAP should follow.
Banks Disclosures Guidance Notice
The proposed Banks Disclosure Guidance Notice is likewise issued in terms of section 6(5) of the Banks Act, and has the same purpose as the Insurers Disclosures Guidance Notice. The two disclosure guidance notices are almost identical in content, with the Bank Disclosure Guidance Notice providing guidance to banks on climate-related disclosures, taking into consideration the recommendations of the TCFD and the ISSB under the four thematic areas of governance, strategy, risk management and metrics and targets.
Insurers, banks and other interest persons are invited to submit their comments on all four of the proposed guidance notices to the Prudential Authority by no later than 13 September 2023.
In the world of finance and taxation, clarity and understanding are paramount. In line with this, the South African Revenue Service (SARS) issued a Binding General Ruling (VAT) 62 on 12 December 2022 under the authority of the Value-Added Tax Act 89 of 1991. This ruling sheds light on the intricate Value-Added Tax (VAT) implications associated with securities lending arrangements. With the financial landscape constantly evolving, it is imperative to comprehend the VAT implications concerning these arrangements, as outlined under Sections 2(1)(f) and 12(a) of the VAT Act.
Enoch Godongwana, Minister of Finance, has formally decreed that the operative status of sections 6 and 43 of the Financial Intelligence Centre Amendment Act, 2017 (Act no 1 of 2017), will commence as of the 18th of August 2023.
Section 6 of the Financial Intelligence Centre Amendment Act of 2017 introduces a profound shift in our approach towards combating the intricate web of money laundering, the financing of terrorist activities, and associated financial sanctions. This pivotal segment brings to the forefront a comprehensive framework of control measures designed to thwart these illicit activities. By interweaving financial vigilance and stringent oversight, Section 6 not only fortifies the security of our financial sector but also sends a resolute message that such harmful endeavors will not find refuge within our economic realm.
Section 43, on the other hand, pertains to the substitution of an existing section in the Act, specifically section 56. This substitution introduces significant changes related to the reporting of electronic transfers and the consequences for non-compliance.
The revised Section 56 underscores the importance of timely and accurate reporting of electronic money transfers to the Centre, as stipulated by Section 31. Failure to comply with this obligation now bears serious consequences. Subsection (1) of the amended provision establishes that an accountable institution failing to report the prescribed information pertaining to electronic money transfers commits an offence. This underscores the gravity of ensuring that financial institutions adhere to their reporting obligations, emphasizing the critical role these reports play in curbing potential financial misconduct.
Furthermore, Subsection (2) emphasizes that non-compliance in reporting electronic transfers is met with administrative sanctions. By imposing such measures, this amendment strengthens the mechanisms through which accountability is upheld and reinforces the necessity of transparent financial practices.
On July 6, 2023, the Basel Committee on Banking Supervision (“Basel Committee”) released proposed revisions to its core principles for effective banking supervision (the “Revised Principles”).1 The Revised Principles are substantially similar to the current version, which was adopted in 2012. However, they contain many revisions to reflect intervening standard setting by the Basel Committee as well as other developments.
Comments on the Revised Principles are due by October 6, 2023. The Revised Principles, if adopted by the Basel Committee, will not have the force of law on their own. However, the International Monetary Fund and World Bank assess the degree to which their member jurisdictions have implemented the Basel Committee’s core principles, and, therefore, we expect many jurisdictions will incrementally adapt supervisory practices from the Revised Principles.
Background
The Basel Committee is a group of several dozen central banks and bank supervisors that sets standards for the prudential regulation of banks and provides a forum for regular cooperation on banking supervisory matters. The Basel Committee standards do not have the force of law but, rather, must be adopted or transposed by its members (i.e., national regulators) into legal requirements that apply within a specific jurisdiction.
Since 1997, the Basel Committee has maintained the core principles as minimum standards for the sound prudential regulation and supervision of banks and banking systems. The core principles are a series of statements that describe sound supervisory practices for banking regulators. Each statement is supplemented with “essential criteria,” which are the minimum baseline requirements for a sound supervisory practice, and “additional criteria,” which are suggested best practices that should be considered by jurisdictions with more complex banks. Over time, the Basel Committee generally expects that additional criteria will become essential criteria to reflect changes in baseline expectations.
Revised Principles
The Revised Principles would retain the 29 principles from the 2012 version, with few changes to the substance of the principles.
Cross-referencing
Each statement of principle would be cross-referenced to other Basel Committee standards and supervisory publications.
Changes to Particular Principles
Further:
Principle 14, discussing corporate governance, would be expanded to require banks to have robust policies and procedures that address corporate culture and values and suitability assessments
Principle 15, discussing the risk management process, would explicitly require banks to consider climate-related financial risks, emerging risks, and sustainability risks as part of their risk management practices
Principle 17, addressing credit risk, would require banks to explicitly consider forward-looking information when developing and executing the credit risk management process
Principle 25, originally addressing only operational risk, would be expanded to require banks to implement measures to maintain operational resilience during disruptive events
Changes to Criteria
Criteria for the principles would be modestly revised to address six key topics:
(i) Financial risks (ii) Operational resilience (iii) Systemic risk and macroprudential aspects of supervision (iv) New risks, including climate-related financial risks and the digitalization of finance (v) Non-bank financial intermediation (vi) Risk management practices
For example, the criteria for Principles 8, 10, 15, and 26 would be revised to impose specific obligations on banking regulators and banks with respect to climate-related financial risks. Similarly, the criteria for Principle 16 would be expanded to explicitly recognize and mitigate financial risk through a supplementary leverage ratio requirement.
Most Notable Changes: Risk Management Criteria
Most notable appear to be the revisions to the criteria for risk management practices. The criteria in the Revised Principles would give greater emphasis to:
(i) Establishing corporate culture and values (including aligning with compensation systems) (ii) Ensuring that bank boards have appropriate skills, diversity and experience (iii) Promoting board independence and renewal
The criteria also would focus on the attributes of a bank’s risk culture and risk appetite frameworks and risk data aggregation and require banks to understand the sustainability of their business model. Banks would be required to have whistleblower policies and report to their regulators on material information that may negatively affect the fitness and proprietary of their board members or senior managers.2
Conclusion
What’s Next
As with other BCBS pronouncements, the Revised Principles will not have the force of law in the United States. Rather, the US banking regulators would need to determine whether and how to apply the Revised Principles to the supervision of US banking organizations. This could be done through the supervisory guidance process or the notice-and-comment process and may result in a US approach to supervising banks that differs from the Basel Committee’s approach. Further, several changes in the Revised Principles would adopt concepts that already are being used in the United States, implying that the United States may be a leader in certain areas of banking supervision.
Concerns
Still, larger US banking organizations may consider engaging with the Basel Committee to ensure that the Revised Principles strike the right balance between essential and additional criteria. As the Revised Principles note, non-bank financial intermediation continues to increase, and imposing overly burdensome criteria on banks will do nothing to reduce that risk to the financial system. Further, as we have seen in the United States over the last several months, regional and community banks continue to face the problem of being “too small to succeed” due in part to regulatory burdens. Therefore, the Basel Committee should consider whether now is the right time to “upgrade” certain additional criteria to essential criteria if the result will be an even greater burden on the middle market.
The Board of the International Organization of Securities Commissions on 17 July 2023 published a final report on Compliance Carbon Markets (CCMs), which aims to support IOSCO members seeking to establish new or to enhance their existing CCMs.
Rodrigo Buenaventura, Chairman of the Spain CNMV and Chair of the IOSCO Sustainable Finance Taskforce (STF) said: “This report intends to facilitate the implementation of CCMs across IOSCO-member jurisdictions in a swift and efficient manner. It builds from the experiences of more advanced jurisdictions and gives other jurisdictions a solid starting point to avoid repeating past mistakes.”
The report looks at the specific characteristics of CCMs compared to traditional financial markets and outlines a set of recommendations aimed at making these markets efficient and ensuring they function with integrity, learning from the experience of others. As CCMs are typically overseen by different types of authorities who may regulate specific aspects of what – put together – constitutes CCMs, the recommendations are addressed to relevant authorities to allow jurisdictions and regulatory authorities the flexibility they may require consistent with their legal mandates as CCMs are established in their jurisdictions.
Verena Ross, co-Chair of the STF Carbon Markets Workstream and Chair of the European Securities and Markets Authority (ESMA) said: “Sound, efficient and compliant carbon markets can be a key tool to help jurisdictions meet their climate goals. Building on the experience of financial markets regulators at IOSCO, this report will support the continued development of these markets, that can contribute to reducing greenhouse gas emissions globally.”
The report includes twelve recommendations relating to primary market and secondary market functioning. At primary market level, the recommendations touch upon transparency and predictability of primary market decisions and market structures for primary markets, and, in doing so, cover allowance allocation mechanisms, market stability mechanisms and primary market access. At secondary market level, the recommendations focus on market integrity, transparency and structure. The report also includes a selection of applicable IOSCO Objectives and Principles of Securities Regulation and IOSCO Principles for the Regulation and Supervision of Commodities Derivatives Markets.
Rostin Behnam, IOSCO Vice-Chairman and co-chair of the STF Carbon Markets Workstream as well as Chairman of the U.S. Commodity Futures Trading Commission (U.S. CFTC) noted: “The report reflects valuable input from a broad spectrum of public and private sector stakeholders, presenting a comprehensive set of recommendations to help jurisdictions promote the integrity and the effectiveness of compliance carbon markets as firms manage relevant risks and transition to a low-carbon economy.”
Jean Paul Servais, IOSCO Chairman ad Chairman of the Belgium Financial Services and Markets Authority (FSMA) welcomed the publication of the document, noting: “As Chair of the organization, I would like to thank Rodrigo, Verena and Rostin for their efforts in leading the publication of this final report on compliance carbon markets. I encourage relevant authorities to adhere to the recommendations in the report in order to contribute to the integrity of these markets. I now look forward to our ongoing work on voluntary carbon markets, a sector in constant evolution and which will also have an important role to play where compliance markets currently do not exist.”
Following an extensive review of ETF markets, IOSCO has determined that the existing IOSCO Principles for the Regulation of Exchange Traded Funds (ETF Principles) remain relevant and appropriate. Since the publication of the ETF Principles in 2013, ETF markets globally have continued to evolve and exhibit sustained growth in assets under management. ETF industry developments include new products with exposures to less liquid and more novel asset classes and more complex investment strategies. The IOSCO Board has therefore concluded that ETF Principles would benefit from being supported, and further operationalised, by a set of Good Practices.
Jean-Paul Servais, Chair of the IOSCO Board, said: “With the publication of these Good Practices, IOSCO ensures that its policy framework for ETFs remains up-to-date, particularly in light of significant market developments since the publication of IOSCO’s ETF Principles. This report provides a rich discussion of major themes and recent developments in ETF markets as a backdrop to a set of Good Practices centred on the trading of ETF shares in the secondary market and the associated arbitrage mechanism.”
Martin Moloney, IOSCO Secretary General, said: “Recognizing differences and variances among jurisdictions in the way that ETFs operate, are regulated, and the markets in which they trade, IOSCO is providing a set of Good Practices, as examples of how a jurisdiction could implement the ETF Principles and other relevant IOSCO standards and guidance. IOSCO encourages regulators, responsible entities and trading venues to review and adopt these Good Practices, where appropriate, within each jurisdiction’s regulatory framework.”
In developing these Good Practices, IOSCO undertook a comprehensive review of the ETF market, surveying regulators and industry participants, conducting extensive stakeholder outreach, reviewing recent academic literature, considering major market events affecting ETFs including the COVID-19-related market volatility in March and April 2020, and engaging with the Financial Stability Board. In particular, IOSCO published a Thematic Note – Findings and Observations during COVID-19 Induced Market Stresses, summarizing its findings regarding the operation and activities of the primary and secondary ETF markets during COVID-19.
The ETF structure has generally remained resilient during historical stress events. No major gaps have been identified, and no major regulatory issues were reported by IOSCO members or industry participants. As of the date of this report, IOSCO has identified no structural issues related to ETFs that bear on financial stability.
The Good Practices highlight issues for regulators, responsible entities and/or trading venues to consider when putting into practice the ETF Principles and other relevant IOSCO standards and guidance.
The 11 Good Practices set out in this report can be broadly categorised under four themes that encompass the full life cycle of ETF products: [1] product structuring (including range of assets, strategies for ETF offerings, effective arbitrage mechanisms), [2] disclosure requirements (including on fees and on clear differentiation of ETFs from other Exchange Traded Products and Collective Investment Schemes), [3] liquidity provisions (including market monitoring and ensuring orderly trading), and [4] volatility control mechanisms (including communication between trading venues).
The International Organization of Securities Commissions (IOSCO) will celebrate its seventh annual World Investor Week (WIW), from 2 to 8 October 2023, although participating jurisdictions may choose any other week in October and/or November to conduct their WIW-related activities.
As reflected in the IOSCO WIW Public Report 2022, published today, the participation of different jurisdictions, in both developed and emerging-market regions, keeps increasing. Hence, notwithstanding the challenging conditions experienced during the global pandemic, the number of WIW participating jurisdictions and stakeholders increased in the 2020, 2021, and 2022 campaigns, underscoring the need for financial education to enhance retail investor protection worldwide.
This year, the WIW campaign will focus on three main themes: Investor Resilience, Crypto Assets, and Sustainable Finance, which the IOSCO Board has identified as particularly relevant given current and expected global market conditions. Other themes cover Frauds and Scams Prevention, Basics of Investing, Technology and Digital Finance.
Mr. Jean-Paul Servais, Chair of the IOSCO Board, and Chairman, Financial Services and Markets Authority, Belgium said: “Investor protection is a key IOSCO objective. Securities regulators use different tools to promote and enhance investor protection, including policy, supervision, oversight, enforcement, and financial education. During the global pandemic, retail investors encountered new and bigger risks; some of these risks may continue into the future or evolve. In response, the IOSCO Work Program 2023-2024 will continue supporting investor education as a critical pillar of investor protection, together with other measures aimed at combating retail market misconduct and fraud, promoting investor confidence and financial inclusion, and protecting the investor interests.”
The Board of the International Organization of Securities Commissions (IOSCO) has concluded its Review of Alternatives to USD Libor (Review), which assessed the extent to which four benchmarks developed as potential substitutes for USD LIBOR – two credit sensitive rates (CSRs) and two Term SOFR rates – have implemented IOSCO’s 2013 Principles for Financial Benchmarks (IOSCO Principles) in the areas of benchmark design (Principle 6), data sufficiency (Principle 7) and transparency (Principle 9). IOSCO used the Federal Reserve Bank of New York-administered Secured Overnight Financing Rate (SOFR1) as a comparator. IOSCO identified varying degrees of vulnerability of concern with each rate’s implementation of the Principles in scope, as compared to SOFR, along with areas for improvement.
Most significantly, the review confirmed regulatory authorities’ concerns that certain CSRs currently in use exhibit some of the same inherent “inverted pyramid” weaknesses as LIBOR.2 Absent modification, their use may threaten market integrity and financial stability. For instance, the Review concluded that due to liquidity risks in the bank-issued commercial paper (CP) and certificates of deposit (CD) market data, they are not sufficiently deep, robust and reliable to underpin alternatives to USD LIBOR. Further, gaps in data and volatility related to reliance on a very small number of transactions mean that USD LIBOR alternatives based on these markets are unlikely to sufficiently implement the IOSCO’s Principles relating to benchmark design.3 Structural issues with bank-issued CP and CD markets stem from changes in the way banks fund their operations leading to low volumes with heterogeneous rates during normal conditions. During stressed conditions, market liquidity tends to decline further. Low transaction volumes, coupled with the use of quotations, could not only cause deviation from rates that might be available to participants in the markets if they chose to transact, but can also increase the risk of benchmark manipulation.
The Term SOFR rates reviewed were somewhat better placed among the rates reviewed, but still fell short of SOFR. IOSCO believes that the Term SOFR rates are suitable for limited use only, as already highlighted by the FSB and National Working Groups4 and Regulators. Term SOFR rates are different from SOFR because Term SOFR rates are based on derivative market transactions, and they rely on the continued existence of a deep and liquid derivatives market based on overnight SOFR.5 The use of Term SOFR rates in derivatives markets should remain limited so that these rates can remain sustainably available for more limited appropriate use cases. If reference to Term SOFR rates were to become too widespread, at the expense of trading in the underlying SOFR derivatives (i.e., futures or swaps) markets, it would undermine the Term SOFR rates themselves.
IOSCO has communicated its rate-specific findings and recommendations to the relevant administrators. For all administrators, IOSCO recommends that:
Administrators should consider and clearly disclose how they have considered applying the “concept of proportionality” in assessing compliance with the IOSCO Principles.
Administrators should consider licensing restrictions for use of CSRs and Term SOFR rates within certain products or by certain user groups, in line with recommendations from National Working Groups where relevant, to the extent that similar restrictions would be appropriate for their rates as a way to prevent widespread usage which would be disproportionate to the underlying markets a benchmark seeks to measure.
Administrators should consider whether to improve the transparency of their rates, either through their methodology documentation or by making underlying statistical data more readily available. Generally, IOSCO believes that the highest standard of transparency would require administrators to publish samples of input data, methodology and calculation such that users can replicate published rates. Some of this input data or details of the methodology could be proprietary, so administrators should decide how to best share this information.
Based on the findings of this Review, Administrators, as well as their auditors and independent consultants, should refrain from any representation that the CSRs reviewed are “IOSCO-compliant”.
IOSCO notes that some market participants (primarily in the US markets) have referenced CSRs in contracts, particularly in certain lending products, and that CSRs may continue to be offered and used going forward, despite the conclusions of this Review. IOSCO emphasizes market participants should proceed with caution if they are considering using CSRs and take into account the risks identified in the Review. IOSCO also urges regulated market participants considering using CSRs to contact their relevant authorities before doing so.6
Alternative Reference Rates Committee (ARRC) recommended USD LIBOR replacement rate. The inverted pyramid problem refers to the disproportionality between the low/modest volume of transactions underlying CSRs and the increasingly higher volumes of activity in markets referencing them.
The inverted pyramid problem refers to the disproportionality between the low/modest volume of transactions underlying CSRs and the increasingly higher volumes of activity in markets referencing them. This raises concerns about market integrity, conduct risks and financial stability risks and can make a benchmark vulnerable to manipulation.
Principles 6 provides that a benchmark´s design factors should include (but are not limited to) Size and liquidity of the relevant market; Relative size of the underlying market in relation to the volume of trading in the market that references the Benchmark; Market dynamics and more.
United States’ Alternative Reference Rates Committee (ARRC) and United Kingdom’s Working Group on Sterling Risk-Free Reference Rates (RFRWG).
SOFR is a fully transactions-based rate underpinned by a daily average of roughly US $1 trillion in transaction volume based on thousands of transactions. Source: https://www.fsb.org/wp-content/uploads/P161222.pdf
The UK FCA has previously urged UK regulated firms to contact the Authority before referencing CRSs within their contracts.
