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1
Serbian Securities Commission Conference
Robert H. Singletary
Serbia Economic Growth Activity
December 3, 2009
The Global Economic Downturn and Securities Regulators’ Responses
2
Economic Crisis and the Regulator’s Responses
Since August 2008, the World has been experiencing a financial crisis which has evolved
into a severe global economic downturn.
What are the consequences for Emerging Markets?
What actions should securities regulators in these markets be taking in response?
3
The causes of the financial meltdown are not totally clear, although there are many opinions.
The impacts on emerging markets are much more evident.
Globally we see: sharp contractions in GDP, resulting budget deficits and efforts by the central banks to inject liquidity, confidence and stability, all while eyeing the impact on price stability.
Economic Crisis and the Regulator’s Responses
4
1. Initial rush to liquidity2. Retrenchment on risk profiles3. Capital flight to highly rated countries and
positions 4. From August 2008 through March 2009 most
were “sitting on their hands”5. Since March 2009 a return to the developed
markets
The Impact on the International Capital Markets is Clear
“Greed” again beats “Fear” (for now)
Economic Crisis and the Regulator’s Responses
5
1. Capital flight out of emerging market portfolio investments
2. Dramatically reduced foreign direct investment3. International Financial Institutions stepped in with
“budget support” (not sustainable)4. Sharply lower market prices5. Initial strong volume (on exits) then much lower
levels for the last 16 months
The Impact on Emerging Markets is Clear
“Fear” still beats “Greed”
Economic Crisis and the Regulator’s Responses
6
The prime responsibility for the macroeconomic issues falls to the government and central banks.
From the securities regulator’s viewpoint the most problematic current trend is lower secondary market activity. There is also some regulatory concern due to lower asset values.
Over time these factors can threaten the financial systemic integrity and the ability to sustain a credible capital market.
Economic Crisis and the Regulator’s Responses
7
0
1.000
2.000
3.000
4.000
5.000
6.000
2006 2007 2008 I H 2009
Mill
ion
sEU
R
BELEX Bucharest SE Ljubljana SE BSE - Sofia Zagreb SE
SEE Exchange’s Equity Turnover
Data Courtesy of Belgrade Stock Exchange
8
0
10.000
20.000
30.000
40.000
50.000
60.000
2006 2007 2008 IH 2009
Mill
ion
sEU
R
BELEX Bucharest SE Ljubljana SE BSE - Sofia Zagreb SE
SEE Exchange’s Market Capitalization
Data Courtesy of Belgrade Stock Exchange
9
Systemic Consequences of Low Liquidity and Prices
Lower secondary market activity and a general decrease in prices have four negative areas of impact for the capital market system:
1. Lower revenues for firms with transaction-based fees. Erosion of capital. Danger of insolvency.
2. Liquidity concerns and asset valuation problems for investment funds. Failures to redeem on demand. Inaccurate performance and financial reporting.
10
Four negative areas of impact for the capital markets (continued)
3. Lower revenues for firms with fees based on the value of assets under management. Erosion of capital. Failure of firm and disruption to fund operations.
4. Lack of access to capital by public companies. Failure of the capital market to perform its basic function for the economy.
Systemic Consequences of Low Liquidity and Prices
11
“Primary Market” “Secondary Market”
Securities Firms Issuer Companies
Securities Exchange
Clearance and
Settlement Process
Securities Depository
Sellers
Buyers
Sellers
Buyers
Institutional and Retail Investors
Schematic of the Capital Market
Consequences of Low Liquidity
Investment Funds
12
1. Securities Firms2. Stock Exchanges3. Clearance and Settlement Entities4. (Depositories and Share Registries?)
Participants with Transaction-Based Revenues
Why should a securities regulator care about the financial health of these infrastructure entities?
Consequences of Low Liquidity
13
But it is not a securities regulator’s function to keep financially dangerous firms from going out of business.
Loss of ? Leads to Concerns Over?
Disruption of Market Functions
Protection of Customer Funds and Securities
Securities Firms yes
Exchange yes T-date to S-date only
Clearance and Settlement yes T-date to S-date only
Depositories yes yes
Share Registries yes
Consequences of Low Liquidity
14
“Primary Market” “Secondary Market”
Securities Firms Issuer Companies
Securities Exchange
Clearance and
Settlement Process
Securities Depository
Sellers
Buyers
Sellers
Buyers
Institutional and Retail Investors
Schematic of the Capital Market
Investment Funds
Consequences of Low Liquidity – Securities Firms
15
1. “Low revenues” do not equal “losses”
2. Low revenues business decisions voluntary exit from the business
3. Persistent losses capital problems involuntary exits
Impact of Low Trading Levels
Consequences of Low Liquidity – Securities Firms
16
1. The account transfer process must be orderly, with good communication with customers.
2. Protection of customer funds and securities is absolutely paramount.
Financially Weak Securities Firms Should be Allowed (Forced) to Exit the Industry
The securities regulator needs to execute a “managed failure”.
Consequences of Low Liquidity – Securities Firms
17
Who are Your Danger Firms?
Notional Securities Firm Population
0
10
20
30
40
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Firms
Level
of
Cap
ital
Firm's Capital Level "Minimum Required Capital
Consequences of Low Liquidity – Securities Firms
18
1. Capital calculations are a snapshot in time; they are inadequate to foresee firm failure.
2. They do not include the impact of projected losses on future capital levels.
3. Early warning approaches speak only in terms of percentages above required minimums.
4. The regulator must either require the analyses of projected capital burn rates or do the math itself.
A Note on Net Capital Requirements
Consequences of Low Liquidity – Securities Firms
19
1. Track your securities firms’ capital burn rate; how fast is the capital decreasing?
2. Stress test individual firms at different multiples of current loses.
3. Stress test the system if trading levels stay at current volume; then project for even worse levels. How many firms will fail?
4. Be alert for “cooked books” and “cute accounting”
Recommended Responses for Securities Firm Oversight
Some Responses to Low Trading Levels
20
5. Revisit your financial responsibility rules
6. Should your rules take income statement issues into account?
7. Revisit your customer account segregation rules.
8. Revisit your procedures for overseeing voluntary withdrawals.
9. Revisit your procedures for closing firms.
10. Can your Commission handle closing more than one firm at a time?
Some Responses to Low Trading Levels
Recommended Responses for Securities Firm Oversight
21
“Primary Market” “Secondary Market”
Securities Firms Issuer Companies
Securities Exchange
Clearance and
Settlement Process
Securities Depository
Sellers
Buyers
Sellers
Buyers
Institutional and Retail Investors
Schematic of the Capital Market
Investment Funds
Consequences of Low Liquidity – Investment Funds
22
1. When securities are traded and have a valid, recent price, use this.
2. When the securities are not traded and there is no “market price”, what are your rules?
Illiquid Securities Pose Valuation “Challenges”
Treatment of “Restricted Securities” in the U.S. System
“readily available market” and “orderly sale in the course of business”
Consequences of Low Liquidity – Investment Funds
23
Notional Changes in Trading Dynamics
0
10
20
30
40
50
60
Traded Companies
Tra
din
g V
olu
mes
Pre-Crisis Level
Post-Crisis Level
Consequences of Low Liquidity – Investment Funds
24
Even the most objective professional has a difficult and inexact decision to make.
If the management fee is based on value of assets under management, there is an implicit pressure to inflate values.
If the management fee is based on performance, there is also an implicit pressure to inflate values (better NAV performance).
Illiquid Securities Pose Valuation “Challenges”
Consequences of Low Liquidity – Investment Funds
25
1. Who makes the decision on valuation of assets when no “readily available market” exists for the “orderly sale of the asset”?
2. If it is the fund management company a conflict of interest becomes much more apparent.
Illiquid Securities Pose Valuation “Challenges”
Also, watch for matched trades designed to “establish” the “market price” for the asset.
Consequences of Low Liquidity – Investment Funds
26
1. Revisit your valuation rules to understand how illiquid and non-traded assets are valued.
2. Does giving the valuation responsibility to the following entities really fix the problem?
1. Independent directors
2. Valuation services
3. Custodian
Recommended Responses for Investment Fund Oversight
Some Responses to Portfolio Valuation Issues
27
3. Revisit the Commission’s ability to object to (or override) clearly erroneous valuations
4. The goal needs to be to fix the problem before it escalates into an enforcement action.
5. On a sample basis, review the valuations by funds for their illiquid positions.
6. Recalculate NAV using the staff’s figures and assess impact.
Recommended Responses for Investment Fund Oversight
Some Responses to Portfolio Valuation Issues (cont’d)
28
Two concerns in the current environment:
1. Meeting initial wave of redemptions. To a certain degree we are past this stage.
2. Meeting a steady outflow. How are the redemption levels in your jurisdiction? What is the distribution across your various funds? Do some funds have more redemptions than others? Why?
Open-end funds and interval funds must have sufficient liquid assets to meet redemptions
Consequences of Low Liquidity – Meeting Redemptions
29
Can the fund generate sufficient cash to meet redemptions?
Will the actual sales price of assets = the stated value as used in calculating NAV?
Any mismatch between the actual price and the stated value creates harm to investors
Sales prices higher than stated means the NAV was understated. Previous redeemers harmed. Current investors benefit.
Sales prices lower than stated means the NAV was overstated. Previous redeemers benefit. Current investors harmed.
Consequences of Low Liquidity – Meeting Redemptions
30
What is the investment fund’s liquidity profile?
Highly Liquid
Medium Liquidity
Low Liquidity
Non-Traded
Relative Amount of Assets Within the Portfolio
Consequences of Low Liquidity – Meeting Redemptions
31
What is the investment fund’s liquidity profile?
Highly Liquid OverallTroublesome
Stacked
Consequences of Low Liquidity – Meeting Redemptions
32
Level of Liquidity of the Position
Fund Management Preferences for Liquidating Positions
Yie
ld o
r E
xpec
ted
Ret
urn Which 1 of These 11
Positions Will the Fund Manager Wish to Liquidate First, Second and so on … ?
Where is the Portfolio’s Liquidity Wall?
Consequences of Low Liquidity – Meeting Redemptions
33
Will the fund be allowed to limit redemptions?
Is this in their Charter?
Are they allowed to convert to interval or closed-end?
Does a failure to honor redemptions result in automatic liquidation of the fund?
Regardless of the legalities, a limitation on redemptions leads to hard feelings and a loss of trust and confidence by investors
Consequences of Low Liquidity – Meeting Redemptions
34
1. Analyze each fund’s portfolio liquidity levels:– Stress test for current redemption rate– Stress for multiples of current outflow– When will the fund hit its liquidity wall?
2. What are the fund’s contingency plans if redemption requests cannot be honored?
3. Revisit the Commission’s rules and procedures for allowing the suspension of redemptions?
Recommended Responses for Investment Fund Oversight
Some Responses to Portfolio Liquidity Issues
35
“Primary Market” “Secondary Market”
Securities Firms Issuer Companies
Securities Exchange
Clearance and
Settlement Process
Securities Depository
Sellers
Buyers
Sellers
Buyers
Institutional and Retail Investors
Schematic of the Capital Market
Consequences of Low Liquidity – Fund Managers
Investment Funds
Fund Management Companies
36
0,00
10,00
20,00
30,00
40,00
50,00
60,00
70,00
80,00
90,00
100,00
EUR
Mill
iona
Pension funds Investment funds
Data Courtesy of Belgrade Stock Exchange
NAV of Pension and Investment Funds
37
Consequences of Depressed Prices – Fund Managers
Investment Funds do not become insolvent, Fund Managers do.
Broadly lower securities prices within a market mean that the “assets under management” are lower and thus the manager’s fee. Persistently low securities prices thus result in lower revenues and erosion of capital.
When Fund Managers go out of business:
Liquidate all managed funds; or Transfer the management contract
38
1. The transfer process for the fund management contract must be orderly, with good communication with fund shareholders and custodian.
2. Process differs between contractual plans and corporate funds (internal vs. external managers)
Financially Weak Fund Management Companies Should be Allowed (Forced) to Exit the Industry
The securities regulator needs to execute a “managed transfer”.
Consequences of Depressed Prices – Fund Managers
39
1. Analyze each fund management company’s financial condition using the same techniques as applied to securities firms.
2. Track the firms’ capital burn rate.
3. Stress test individual firms at different multiples of current losses.
4. Stress test the system if trading levels stay at current volume.
Recommended Responses for Fund Manager Oversight
Some Responses to Fund Manager Revenue Issues
40
“Primary Market” “Secondary Market”
Securities Firms Issuer Companies
Securities Exchange
Clearance and
Settlement Process
Securities Depository
Sellers
Buyers
Sellers
Buyers
Institutional and Retail Investors
Schematic of the Capital Market
Investment Funds
Consequences of Depressed Prices – Access to Capital
41
Consequences of Depressed Prices – Access to Capital
In the ‘pure’ disclosure-based securities regulation system, it is not the place of the regulator to promote local issuers or the overall primary market.
Emerging market securities regulators do not have the luxury to take a overly purist approach and “sit on their hands”.
In a Timid International Market, Public Companies in Emerging Markets Will Have Difficulty Raising Capital –
Both From International and Domestic Investors.
42
1. This is difficult territory. The regulator must support development of markets, not issuers.
2. Even supporting development of specific market segments – such as municipal bonds -- can be worrisome.
3. The focus must be on overall support of the markets, accurate and fair representations, and strict investor protection requirements.
4. The fact that issuers need capital is not a reason to relax our standards.
Consequences of Depressed Prices – Access to Capital
Some Responses to Access to Capital Issues
43
Please:
See slides 20 - 21 for Securities Firms
See slides 27 - 28 and 35 for Investment Funds
See slide 39 for Fund Management Companies
See slide 42 for Public Issuers
Summary of Recommendations
44
Conclusions
Overall Goals:
Maintain the system’s financial integrity
Maintain the system’s professional integrity
Maintain trust and confidence by investors
45
Don’t wait for the problem firms to implode
Know your participants Project their financial futures
Don’t Hesitate to Close Firms
Bear Hugs Official routes
Conclusions
46
Be Ready
Rehearse what the staff will do to close a firm
Have more than one team
With Regard to Public Company Needs
Understand Your Philosophical Limits Understand Your Political Limits
Conclusions