By Tobias Adrian and Jay Surti
Countries have made substantial progress toward implementing capital markets regulatory reform, but important gaps remain and new challenges have raised the bar.
Capital markets are like engines that help power the global economy: they perform best with regular tune-ups. In this spirit, the major regulatory overhaul following the global financial crisis was aimed at shoring up key segments, from over-the-counter derivatives to investment funds and market infrastructure, closing fault lines revealed by the crisis.
But now, even after historic enhancements in recent years, countries still need to keep pushing to lower risks and strengthen the tools to manage future crises, and ultimately to reduce fluctuations tied to economic cycles.
So, to better gauge progress on reforms to market regulation and what further gains are needed, our latest research surveys IMF financial sector assessment programs in several countries over the past seven years.
These regular reviews tracked risks, vulnerabilities, and arrangements for market oversight and crisis management, with a focus on safety nets to manage any potential failures of major firms.
They also looked at the resilience of central counterparties, the entities that function as buyer to every seller and seller to every buyer to guarantee performance of open contracts, which have grown in prominence under derivatives-clearing reforms. The reviews also examined the vulnerability of asset managers like money market funds and bond funds, and whether trading venues beyond traditional exchanges are adequately regulated.
Making progress
One main reason we see a need for greater reform even after the significant progress seen in recent years is that it has been accompanied by rapid growth of financial services firms that don’t have banking licenses or take deposits, such as insurers, mutual funds, and exchanges.
Nonbank financial intermediation, as it’s known, has grown to represent almost half of the assets of the global financial system, thereby playing a much bigger role in the global economy . Regulators must better ensure that its vulnerabilities and business models don’t amplify future shocks to markets and financial stability. Applied to the asset management sector, a key priority is to broaden the range of liquidity management tools that are available to investment funds managers.
Another priority for regulators is to reinforce financial safety nets and crisis-management arrangements, while a third is to strengthen early warning capabilities, for example, through enhanced stress-testing tools and capacities.
Emerging issues
Issues like these are challenging on their own, but securities regulators can’t limit themselves to just implementing the capital markets reform agenda that followed the global financial crisis. Rather, their priorities must also evolve and broaden in-step with the financial systems they safeguard.
That’s especially true in capital markets, where cyber resilience, fintech, and climate change are key emerging issues. Trading venues are a focus for cybersecurity, as both supervisors and market participants aim to boost their technological and operational resilience to minimize potential market disruptions. And fintech’s promise also involves risks stemming from crypto assets and decentralized finance.
Regulators also must be vigilant amid the shift away from benchmarks like the London Interbank Offered Rate to new references for interest rate swaps and other key financial contracts. Finally, the impact of climate change will need to be appropriately reflected in financial statements, valuations, and issuer disclosures on which investors depend.
Appropriate perimeter
A key priority highlighted by this wide-ranging, future work program is ensuring the adequacy of the financial regulation perimeter so that it covers all the relevant actors, activities, and instruments.
Our financial-sector assessments are still uncovering important shortcomings despite all of progress that has been made since the global financial crisis began a decade and a half ago.
Some countries, for example, appear to have regulatory gaps for asset management firms. Also, policymakers need to consider more explicitly which derivatives to regulate as part of efforts to manage risks from commodity, climate, emissions, and other carbon-related instruments.
This array of challenges raises concern given the insufficient resources for supervisors even in some of the world’s largest and most sophisticated markets—a finding IMF financial sector assessments confirm. Post-crisis reforms implied a significant expansion of the regulatory perimeter and raised expectations of supervision needed to assess and mitigate risk, but securities regulators rarely saw a commensurate increase in resources.
Emerging challenges like new market technology and a broadening of the regulatory perimeter make it important for regulators to have a wider range of specialist expertise and to ensure that their supervisory techniques and technology keep pace. Strained resources in some jurisdictions are compounded by a lack of operational independence for authorities, which limits their ability to effectively supervise and respond to risks.
Therefore, we must keep prioritizing our push to make further progress on these key aspects of the institutional and regulatory framework underpinning capital markets.
