Is ‘caveat emptor’ being regulated out of existence?
David Lewis of SunGard’s Astec Analytics looks at inappropriate regulation and whether it will hit beneficial owners in the pocket
Caveat emptor, or ‘let the buyer beware’, is a fundamental tenet of the laws governing contractual relationships. There are, of course, a multitude of laws in existence with the objective of making sure the seller of a product or service doesn’t mislead or defraud the buyer, but a great deal of the responsibility in any contract lies with the buyer. Underpinning this point is the principle that the law cannot, and will not, undo what is simply a poor deal. If you agree to buy a product or service that is poor value for money or uncompetitive in the marketplace, the law cannot help you simply if you were uninformed.
Regulations about protecting the consumer both in terms of their physical health and safety, such as the ever-present warnings on food and drink (classics include ‘contents may be hot’ on coffee packaging, or ‘may contain nuts’ printed on peanut packing), as well as their financial security, seem to get increasingly invasive. The objectives of regulators and indeed the regulations they set can be easily understood, especially in the light of the recent financial crisis. However, is there a point at which the regulations harm the very people they are intended to protect?
A commonly used and easy to apply ‘stick’ is a fine for transgressions. The Central Securities Depository Regulation (CSDR) is one such regulation, which intends to levy fines for non-settlement of securities and apply mandatory buy-ins where settlement failures extend too long. These changes are combined with the move to settlement dates of trade date plus two days (T+2), which was widely welcomed in the marketplace. However, the same shortening places extra strains on the securities lending market, which would also need to comply with the new tighter settlement periods.
For example, when a security is lent out at, say, 10 basis points, that security is then sold by the beneficial owner and must be recalled from the borrower in order to effect settlement. The proposed CSDR fines equate to one basis point a day, or an annualised rate of 365 basis points, which is somewhat greater than the 10 basis points per annum being earned by the loan. The result of this situation is the likely withdrawal from the lending market of certain firms not willing to risk the fines.
Less lending in the market would mean less liquidity and far fewer opportunities for beneficial owners to earn revenue and provide lendable securities, which can be lent to cover settlement failures. While in theory the regulations that are intended to tighten settlement certainty are more than welcome, the actual approach could, in practice, be counterproductive.
The Financial Transaction Tax (FTT, or sometimes known as the ‘Tobin Tax’) as proposed, is a levy rather than a fine, and much has been written and spoken about it. The jury remains out as to whether the repo and securities lending markets will be exempted from the 10-basis point tax, but the International Securities Lending Association (ISLA) has been clear in what it believes the introduction of this tax will do to the securities lending market: reduce the market size by some 65 percent, resulting in a loss to beneficial owners of around €2 billion per annum, with €500 billion of European government bonds likely to be lost from collateral markets just when other regulations will be increasing the demand for such assets.
Little will happen on this before 2016, as the European Council continues its deliberations, but the potential impact is hugely damaging for European beneficial owners, the very people these regulations are meant
While there is a strong expectation that countries participating in the FTT will gain useful taxation revenues, this is not felt to be the main motivation. It is inferred that the primary reason behind the levying of such a punitive tax is to reduce the size and influence of the market, deemed to be a significant part of the so-called ‘shadow banking’ sector.
Shadow banking is, many feel, a label implying darkness and something that is hidden, or intentionally hides away from the spotlight and safety of the regulated markets. Other directives seek to open this shadowy area to more scrutiny through greater transparency. The appropriately named Transparency Directive aims to measure the securities finance market defined as securities lending and repo transactions and “economically equivalent” contracts. This last point is arguably the most important as it brings in almost any type of trade that has the same economic effect as a securities finance loan or borrow.
The Financial Stability Board (FSB) is also working towards transparency and disclosure in the securities finance market through its own Shadow Banking Review, with local jurisdictions being made responsible for gathering data at the national or regional levels. The European Securities and Markets Authority is managing this effort across Europe. The work of the FSB and its data experts group (of which SunGard’s Astec Analytics is a member) is currently being carried out behind closed doors in advance of publicly announcing exactly what data they are looking to gather.
It should be unsurprising that this project is one of enormous magnitude. As a wise man once told me, if you can’t measure it you can’t manage it. On that basis, one can understand what the FSB is trying to achieve in terms of measurement, but it is the management part that seems to elude many who are looking at this initiative. Once the number is known—specifically, the size of the market—what then? How would you decide whether a market is too large, or too small, mispriced or efficient? You could of course argue that if the FTT does indeed come in as proposed and financing transactions are included, then the FSB’s task will suddenly become a lot more manageable.
The prime objective of such transparency should be to understand the interconnectedness of market participants and the extent to which the failure of one market participant could lead to more firms suffering financial difficulties through contagion or a domino effect.
Such a measurement of the market would be of great value in the fight against systemic risk. Systemic risk is certainly of great concern and much new regulation is being created to counter such knock-on effects. In almost any other industry in the world, the sudden loss of even one major participant would cause shockwaves. For example, if British Airways were to suddenly stop flying, there would be disruption and certain financial costs, but the entire industry wouldn’t be in dire trouble. However, if one major bank goes down, it could very easily bring down others and their clients with them. This creates understandable concern, and the tightening of capital requirements such as those stipulated in Basel III and the Capital Requirements Directive IV, as well as transparency initiatives, are understandable in their ultimate objectives to make the world’s financial markets safer.
However, risk comes in many forms and cannot ever be legislated to zero. If it could, we would all invest in everything and all make endless returns while exposing ourselves to no risk at all. Clearly the industry requires protections—in the UK, the miss-selling of payment protection insurance (PPI) was a real scandal in the retail banking arena, and regulations have rightly been tightened and compensation paid out, but are we at risk of extending the ‘hot coffee warnings’ so far that markets cannot function properly or efficiently anymore?
Few would sensibly argue against improving and clarifying legislation and regulation of the financial markets, but not to such a point where that market is obstructed from providing services and returns for the investors it serves. Investors need returns, and in order to receive returns, there has to be some risk. More information and transparency will lead to better informed clients who must decide on the levels of risk that they themselves are comfortable with.
As a final analogy, food establishments of all types, sizes and standards in London display their food hygiene ratings on a bright green poster, ratings given by local authority inspectors. The ratings run from one to five where five is the highest. The regulations and tests behind this bring a level of transparency as well as a clear indicator of the risk for the buyer. It is then up to the buyer to decide whether he or she may buy that burger from the restaurant with a hygiene rating of three, and take the risks and consequences that such a decision may bring, but the industry itself is not strangled and the supply not reduced.
Appropriate and proportionate regulation of the food industry keeps us healthy, so let’s hope the forthcoming waves of regulations in the securities finance market serve to keep our industry’s pockets healthy, too.