Title Page

INTERNATIONAL MONETARY FUND

MONETARY AND CAPITAL MARKETS DEPARTMENT

DEPARTMENTAL PAPER

Strengthening Capital Markets Regulation—National Progress and Gaps

Prepared by Cristina Cuervo, Jennifer Long, and Richard Stobo

Copyright Page

Copyright ©2022 International Monetary Fund

Cataloging-in-Publication Data

IMF Library

Names: Cuervo, Cristina, author. | Long, Jennifer A., 1972-, author. | Stobo, Richard, author. | International Monetary Fund, publisher.

Title: Strengthening capital markets regulation – national progress and gaps / Prepared by Cristina Cuervo, Jennifer Long, and Richard Stobo.

Other titles: National progress and gaps | International Monetary Fund. Monetary and Capital Markets Department (Series).

Description: Washington, DC : International Monetary Fund, 2022. | 2022 July. | Departmental Paper Series. | DP/2022/012 |Includes bibliographical references.

Identifiers: ISBN 9798400208072 (paper)

9798400210983 (ePub)

9798400211089 (Web PDF)

Subjects: LCSH: Capital market. | Financial institutions -- State supervision.

Classification: LCC HG4523 .C8 2022

Publication orders may be placed online or through the mail:

International Monetary Fund, Publication Services

P.O. Box 92780, Washington, DC 20090, U.S.A.

T. +(1) 202.623.7430

publications@IMF.org

IMFbookstore.org

elibrary.IMF.org

Contents

• Acronyms and Abbreviations

• Executive Summary

• 1. A Longstanding Challenge

• A. Securities, Derivatives, and Financial Stability

• B. Insight on Progress and Emerging Issues

• 2. Institutional Framework

• 3. Asset Management Regulation and Supervision

• 4. Regulation and Supervision of Market Intermediaries

• 5. Regulation and Supervision of Financial Market Infrastructures

• A. Context

• B. Central Counterparties

• C. Trading Venues

• D. Operational Resilience

• 6. Emerging Issues

• A. Fintech and Cyber-Resilience

• B. Benchmark Transition

• C. Climate Transition and ‘Green’ Finance

• D. Debt Markets and Other Emerging Issues

• 7. Conclusions

• Annex 1. FSAP Securities Assessments 2015–20—Countries and Scope

• References

• FIGURE

• Figure 1. How FSAPs Addressed Post-GFC Securities Reform Agenda

• BOX

• Box 1. Analysis and Assessment of Securities Markets in the FSAP

Acronyms and Abbreviations

Executive Summary

Capital markets play an important role in supporting economic activity, and their resilience is vital to financial stability. Capital markets are playing an increasingly central role in financing the global economy and hedging economic risk, especially with the significant and rapid growth of nonbank financial intermediation (NBFI) over the last two decades.¹ The global financial crisis (GFC) and subsequent developments spotlighted key vulnerabilities and shock transmission channels in capital markets. The resulting regulatory reform agenda covered areas such as over-the-counter (OTC) derivatives markets, liquidity in money market funds (MMFs) and other investment funds, and the regulation of financial market infrastructures (FMIs), including central counterparties (CCPs).

This departmental paper distills key findings regarding the regulation and supervision of capital markets from IMF bilateral financial surveillance. Its analysis is based on assessments conducted during 2015–20, in the context of the Financial Sector Assessment Program (FSAP), of risks, vulnerabilities, oversight, and crisis management of these markets, including their infrastructures, intermediaries, and participants. Since the GFC, the FSAP itself has evolved, with an enhanced focus on financial stability. Correspondingly, besides core issues related to the institutional framework for regulation and supervision, the FSAP has focused on the “financial safety net” to manage the failure of a significant counterparty; the resilience of CCPs, whose growing prominence reflected the incentivization of central clearing by the post-GFC regime; asset management, notably the vulnerability of MMFs and other investment funds, particularly bond funds; and trading venues, with a focus on whether the scope of regulation adequately covered equity, debt, and derivatives markets, besides traditional exchanges.

Progress in reform areas identified during the GFC has been significant, albeit further work is needed on reducing procyclicality and on safety nets and crisis management arrangements. This work has become urgent in view of the rapid growth of NBFI. On asset management, closing regulatory gaps is vital to sizing financial stability risks in some countries even as most securities regulators stand to benefit from access to a wider range of regulatory tools, especially in preventing and managing the systemic impact of liquidity shocks.² The need for enhancing stress testing by the industry and supervisors to ensure adequate and timely identification of vulnerabilities in investment funds is common to many countries. On market intermediaries, progress has been significant in strengthening regulatory and crisis management frameworks vis-à-vis significant dealers through enhanced capital requirements and safety nets to deal with failure. Greater clarity regarding consistency of banking and securities arrangements would add further resilience. For CCPs, margin models may need further calibration to avoid exacerbating procyclicality during stress. On the safety net, direct access for CCPs to central bank liquidity merits further examination, potentially as part of a similar examination for the NBFI sector more broadly. On crisis management, greater international coordination is needed given the significant cross-border nature of clearing.

Emerging challenges are raising the bar. Many countries have taken some steps to embed cyber resilience into core supervision and have enhanced arrangements to reduce and manage the risk of trading disruption, with some also increasing focus on venues’ technological and operational resilience. On fintech, starting with the early regulatory challenge posed by crowdfunding, authorities are now grappling with a range of innovations, including crypto assets and other applications of Distributed Ledger Technology (DLT), such as to clearing and settlement. Challenges in ensuring appropriate supervision of decentralized finance (‘DeFi’) are likely to grow, for example, if use of self-executing “smart contracts” becomes widespread.³ The cessation of the London interbank offered rate (LIBOR) and other widely used financial benchmarks provides a good test of international collaboration and of regulatory regimes’ ability to anticipate and avert market disruption and will be a source of valuable guidance about good practices related to controlled cessation of systemically important benchmarks. Finally, focus on climate change will increase in the period ahead given the risks to financial stability and to the achievement of wider public policy objectives if its impact is not appropriately reflected in financial statements, valuations, and issuer disclosures on which investors depend.

Looking ahead, additional focus is likely to be warranted on bond markets, accounting and auditing standards, and the impact of changing business models on investor behavior. The instability experienced in key bond markets, default of potentially systemically significant entities in some jurisdictions, and large outflows from emerging market bond funds during the pandemic are prompting reflection about vulnerabilities and potential policy responses. High-profile corporate failures and fraud cases have led to questions about whether audits are sufficiently robust, suggesting that renewed focus on relevant international standards may be warranted. Dramatic movements in trading activity and valuations have also been observed in some markets, prompted by changing retail investor behavior, facilitated by zero-commission business models remunerated by “payment for order flow.” Many jurisdictions are reflecting on potential vulnerabilities and how to respond amid signs that the commission-free model may become more broadly adopted.

A key question cutting across several of these areas is the need to regularly assess the adequacy of the regulatory perimeter vis-à-vis capturing the necessary range of actors, activities, and instruments. Work is ongoing or pending in many jurisdictions to secure post-GFC commitments to regulate key market participants and infrastructure providers in exchange-traded and OTC derivatives and in trading venues for equities and bonds beyond traditional exchanges. Fundamental gaps in regulatory coverage of the asset management sector appear to exist in some countries. More explicit consideration may be needed of which derivatives are within the regulatory perimeter, to manage potential risks in relation to commodity, climate, emissions, and other carbon-related futures, options and other derivatives, and of whether systemically important benchmarks and their administrators are covered. On fintech, the coverage of crypto assets will be relevant for more jurisdictions in the years ahead and new questions are likely to arise as the use of DLT and associated DeFi applications such as smart contracts evolve.

This array of challenges makes the repeated FSAP finding of insufficient resourcing of supervisory authorities— even in some of the world’s largest and most sophisticated markets—a matter of significant concern for the period ahead. Post-GFC reforms implied a material increase in the scope of entities and activities within the regulatory perimeter and raised expectations of the supervision needed to assess and mitigate risk. Yet securities and derivatives regulators rarely saw a commensurate increase in resources. With emerging and new challenges and the likely widening of the perimeter, it is ever more important for regulators to have a wider range of specialist expertise and to ensure that supervisory techniques and technology keep pace with the evolution of increasingly technology-enabled markets. In some jurisdictions, resource challenges are compounded by the lack of operational independence, which would limit authorities’ ability to effectively supervise and respond to risks. Further progress on these key aspects of the institutional framework underpinning securities and derivatives regulation must, therefore, remain a priority.