Exclusive Interview With IOSCO Chairman

The Global Securities Markets are shifting. At least the Global Primary Equity Markets are to this part of the world. In the 90s, 80% of global IPO's were done in OECD countries, now that’s down to 40%. In 2006 the value of emerging market IPO's was roughly equal to that of US based IPO's. Now US based IPO's are down to half. This is but one big change facing securities regulators from across the world. The other is technology driven innovation, so High Frequency Trading, Dark Pools and what not! I spoke to Greg Medcraft, Chairman of the Board of IOSCO – the International Organisation of Securities Commissions as well as the Chairman of the Australian Securities & Investment Commission about the key challenges facing regulators today.

Medcraft: There are three key challenges we face as global regulators. The challenges we face in terms of meeting what I consider today our two key objectives which is to make sure that investors can be confident and informed and the markets are fair, orderly and transparent. They are our key objectives collectively as regulators around the world in financial markets.

So, first of all what we see is structural change- basically market-based financing which is what we have to see. There is a definite trend of that growing around the world and there is a demand for it to grow. We are seeing with banking regulation, the cost of banking is rising with higher capital charges and liquidity, we are also seeing that there is that constant shift of movement of savings from the banking sector into the pension funds sector as emerging markets start to develop retirement saving system for their populations. But equally we are seeing with demographic change as more people move into that retirement phase in the developed world and even in the emerging markets more savings is moving into the pension fund system. Basically what they invest in is capital markets products a lot of the time. So the challenge is that there is a need to harness those savings.
Doshi: I think we have seen in the last 50 years that direct investments especially in the developed world have tapered off considerably. Are you saying that there could be a reversal of that and we will see direct investment in the market i.e. investment not going through intermediaries such as mutual funds in fact increase over the years to come?
Medcraft: I think that there is going to be a lot more focus on the efficiency of indirect intermediate investment, which is the fees that you pay for that intermediate investment. We are certainly seeing that evidenced by the growth of ETFs and that they purchase directly on the market as a product but they still have the benefit of being managed but they are very low fees. You will continue to see the growth of ETFs because of low fees. But again there are execution products in the market.
The other aspect I think you are going to probably see more direct investment is that investors are becoming more literate in terms of participating in market. So, you may have seen that trend over a long time, but I think that you may see a reversing of that trend. We have certainly seen that in Australia that the superannuation sector, a lot of it is moving more into self-managed funds from basically institutionally organized funds.
Doshi: If this is an aging population saving then does that mean that a lower risk profile then therefore now regulators look at the products that come to market to meet their investment requirements need to be regulated differently from how they have been in the last 10-15 years?
Medcraft: It is a good question. The self-managed superfund section in Australia is one what we consider to be of higher risk because they are managing their money and are investing in capital market products. Therefore, that is quite a challenge. But the approach to regulating the capital markets products is no different to what has always been is making sure that the conduct and the disclosure is appropriate, but one of the things that we are focusing on more and more is their limitation of disclosure as an effective way of communicating risk. If you think about a disclosure, it is just the way of explaining the risks of a product. One of the things that we are more and more focused on is behavioral economics- trying to understand how people make decisions and thinking about new tools that product manufacturers can use to communicate risk and I think that is the new aspect of how we are thinking about how we regulate financial products just to make sure that at the end of the day the investor understands what they are buying, absolutely critical.
Doshi: You bring up disclosure and I know in the last few years we have moved to a comprehensive disclosure regime, if I may say so, almost to the extreme as some regulators today have pointed out that we have three inch thick offer documents being filed which most average retail investors would find very difficult to understand. Is this changing post the global financial crisis, because people then have the disclosures but never understood the product. So are regulators now looking at disclosures differently and saying it is not the volume of disclosure that you make, but its ability to understood that is important?
Medcraft: Absolutely. I think it is about two things. One it is about multi-channel communication- so there are those that actually are very happy to read a 500 page prospectus and understand it, but there are those that because of inadequacy of time or lack of inclination to read through the document, they need information in a different form and that is why what we have been saying is to think about how we can use new tools like social media. If you think about it, the future is very much in terms of social media in terms of mobile, it is about video. Think about how you can use those sort of tools to communicate to investors. The other aspect is that it is about layering of information. There are some people on the first layer which is the key aspect to the deal and there are those that actually want to go into that depth. What is really important is to make sure that the way you are looking at disclosure document that it is layered appropriately and if you want the key facts statement it is very clear, concise for those people who do not have the time. So I think there is a lot more thought got to be given to how information is communicated and it is staggered into different audiences and that is really important. There is very much more a view these days that it is not necessarily about sort of a classical economic view that everyone is rational, but that people are human beings and we have got to think about how they behave. I think that is clear. To that end at the next IOSCO board meeting the topic that we are going to focus on is on behavioral economics and whether there are other ways in which we are got to think about how the disclosure of information is made.
It has been five years since the global financial crisis caused by Collateralized Debt Obligations (CDO), Credit Default Swap (CDS) and other Weapons of Mass Destruction (WMD). Innovation may still be a four letter word for most regulators, but markets have a mind of their own. For instance, by one estimate High Frequency Trading (HFT) -a technology driven innovation- constitutes 60 percent of US trading volume. In Europe HFT makes up for almost 40 percent of volume. Dark pools or off-exchange trading platforms used to execute large orders and suspected of distorting price discovery have now usurped more than 25 percent of US trade and Exchange-Traded Funds (ETF) comes with mounting systemic risk. Greg says he loves innovation as long as proactive regulators are quick to identify risks and distortions.
Medcraft: What you have got to do is you have got to call it out early. You call it out early if something then goes wrong what you see in the media is that the regulator had concerns about this product. He did not ban it, but had concerns about it and has had concerns about it for sometime. That is the way you deal with innovation. You are basically constructive and it does mean to a earlier point you do need to understand the product as well, so that also means having staff and not just lawyers but people who have come from investment banks who can get in there and understand the product. So having a mix of skills in the regulator is absolutely critical, particularly if you are a financial markets regulator and that is why we actually recruit quite a diversified group of people that we have the revolving door that people come and go. That is the starting point. Make sure you got an appropriate industry focus.
Doshi: I have been in the previous panel. In that we spoke about making the case for innovation and for easier regulation, but I have to ask this, innovation when it comes to HFT or dark pools or all the technology based innovations that we have seen take place in the last five or seven years- has that narrowed the market? Has it told retail investors this market is too sophisticated for you? This is not the place for you to be. Has it scared away smaller companies that do not have the ability to deal with this? Is this innovation only benefiting institutional investors?
Medcraft: You make a good point in that. One of the problems with HFT and dark pools from an retail investor perspective, they are concerned about when they are buying stocks in the market whether they are actually getting a fair price. That is a genuine concern that is coming from investors and equally smaller companies if they want to use a traded stock as a way of raising capital, yet there is all this mystery of dark pools, HFT, it is a disincentive. The objective for us as regulators is try and reassure both if you want the investor and the issuer that this new technology is the new norm and the case of dark pools that there is an appropriate regulatory framework there to make sure that the prices that they are getting are fair.
Doshi: I am just wondering if you think in your assessment of where global markets are headed. Whether the small guy is being left out because the market has now become so sophisticated, if 25 percent of US trade is dark pools, if 60 percent of US trade in volume is HFT, where is the place for the small guy in this? In India we are focused all the time on bringing the retail investor back. Should we give that up?
Medcraft: The small guy can still participate in the market. It is just that the volumes of trades that are occurring because something like HFT. At the end of the day the small guy is what most corporations want. They want real money investors. So we want the small guy.
India, mourning the desertion by retail investors, is looking for innovative ways to bring them back. For instance, Sebi’s proposed IPO price safety net mechanism is intended to give investors protection at a time when many primary issues have faired poorly on listing. The IOSCO Chairman would not comment on this much controversial protection measure, but he did say something rather interesting before the interview that Australia has taken investor protection out of the regulatory conversation.
Medcraft: I think that at the end of the day when you invest in market you take a risk. That is the nature of market. At the end of the day trying to protect investors is very difficult. My mandate legislatively is not to protect investors. It is to make sure that they are confident and they are informed. That is my mandate. Informed is a very important part of that mandate. Being informed or focused. The first thing we do in terms of achieving that mandate is our focus on education, financial literacy. We just trained 6,000 teachers in schools in Australia and our objective is to have financial literacy tool from kindergarten to year 12 in 12,000 schools in Australia. Providing educational tools to enable investors to understand what they are investing in is absolutely critical. That is an important part of what we do and then the second thing we do and that is the deal is we hold gatekeepers to account.