Public Policy Objectives
   Overview: Systemic Safety
   Overview: Market Integrity
   Overview: Customer Protection


Public Policy Objectives

Overview: Market Integrity

Update for June 2000

This is one of the three broad goals of regulation - the other two being systemic safety and customer protection. It is defined as the need to ensure that markets operate fairly and safely in order to encourage the widest possible confidence in them, thereby promoting high levels of savings and investment. Public regulation of markets therefore looks at issues such as the integrity of price formation (i.e. they accurately reflect the forces of demand and supply), the prevention of manipulative behaviour which deliberately attempts to distort this market price, the provision of a sound legal basis for financial dealings and adequate laws for customer protection (which includes appropriate insolvency law and a code of sales practices.) So any document which is important to understanding customer protection is also key to market integrity. The dividing line between these key risk concepts is blurred and it is impossible to categorically divide the relevant on-line documents into the different key risk concepts. The highlighted documents below deal with the wider aspects of market integrity. (Those, which have, direct recommendations on customer protection, insolvency and sales practices are highlighted in their key risk concepts.)

"Objectives and Principles of Securities Regulation" (1998) sets out 30 principles, some of which are designed to ensure that markets are fair, efficient and transparent. They are grouped into eight categories - principles relating to (a) the regulator, (b)self-regulation, (c) enforcement of securities regulation, (d) co-operation in regulation, (e) issuers, (f) collective investment schemes, (g) market intermediaries and (h) secondary market. The document details each principle. To prevent market manipulation for example, it states that regulators must resort to direct surveillance, inspection, reporting, position limits, settlement price rules or market halts complemented by vigourous enforcement of the law and trading rules. These arrangements should trigger inquiry whenever unusual and potentially improper trading occurs.

It stresses that particular care must be taken to ensure that regulation is sufficient to cover cross-market conduct, for example, conduct in which the price of an equity product is manipulated in order to benefit through the trading of options, warrants or other derivative products.

One factor contributing to market integrity is product design. Regulators are less concerned about whether a product is successful than about whether it can be manipulated or whether it has an adverse impact on the underlying cash market. To address this concern, the IOSCO Technical Committee produced a report on the design of stock index futures, entitled "Coordination Between Cash and Derivative Markets (1992)". This report deals with all of the factors affecting product design: method of calculation, number of component stocks, liquidity of component stocks, dispersion of component stocks within or across business sectors, replacement of component stocks, selection of component stocks, and clearance and settlement.

Another factor contributing to market integrity is liquidity; ensuring that the market is designed to promote liquidity. The Committee on the Global Finanical System has issued "Recommendations for the Design of Liquid Markets" (1999). The report focusses on markets for government securities because the latter, being virtually free from credit risk, represents the best benchmark against which other financial assets can be priced. The report contains five guiding principles for the design of deep and liquid markets. They are: (i) a competitive market structure should be maintained; (ii) a market should have a low level of fragmentation; (iii) transaction costs should be minimised, (iv) a sound, robust and safe market infrastructure should be ensured and (v) heterogeneity of market participants should be encouraged.

To enhance market liquidity, the Committeee's five recommendations are: (i) ensuring an appropriate distribution of maturities and issue frequency so as to establish large benchmarks at key maturities; (ii) minimising the liquidity-impairing cost of taxes; (iii) ensuring the transparency of foreign issuers, issue schedules and market price and trade information, with due attention being paid to the anonymity of market participants; (iv) ensuring safety and standardisation in trading and settlement practices; and (v) developing repo, futures and option markets.

Clearing houses are vital to the efficient running of exchange-traded systems. Margins underlie the safety provided by the clearing houses since they reduce the risk of default by customers, as well as those who handle customer orders and by clearing members. Typically, daily variation margin is calculated to cover at least one day's possible loss (on historical and projected price volatility.) "Report on Margin" (1996) provides guidance on the use of margin to markets and how they are calculated. Even more valuable is the summary of margin survey responses from major exchanges in IOSCO member countries. Their margin requirements and related issues are detailed, illustrating the general principles outlined in the main text. The Futures Industries Association in their document "Financial Integrity Recommendations" (1995) proposes that margin requirements be set through the use of risk-based systems which evaluate portfolios, based on, among other criteria, pricing and volatility models. The parameters of each pricing model should take into account, among other things, the timing of margin, settlement and other payment obligations in the relevant market.

The FIA generally speaks on behalf the futures and options industry. So its wide-ranging recommendations on how to promote the integrity of markets contained in "Financial Integrity Recommendations (1995)"is key to understanding what issues the private sector views as important. Its recommendations are broken into three sections, dovetailing the main participants in a market. The first section looks at the financial integrity issues for regulators, exchanges and clearinghouses. These issues are member and customer protection; margin requirements; how information is disseminated and shared, how customer positions and property is transferred; the need for annual independent audits and suggestions on how an exchange/clearinghouse assesses the risks of its member firms. The second section concentrates on brokers/intermediaries. They have an obligation to assess the risks of trading on a particular exchange/clearinghouse prior to trading on that market, the financial condition and operational capacity of other brokers with whom they are dealing as well as that of their customers. They must establish and enforce appropriate policies and procedures to protect customer property and the financing of customer margins. The final section has recommendations for customers who must ensure that they understand the risks of their trading activities, the nature of their legal relationships with, and the risks of using their brokers/intermediaries; and the risks of trading on specific exchanges/clearinghouses. (for more on this section, see customer protection.)

The FIA, together with IOSCO has also proposed actions to address concerns over markets and market infrastructure. Their thoughts are contained in a G-30 report on systemic risk, titled "Global Institutions, National Supervision and Systemic Risk" (1997) . Some suggested areas for consideration include:

  • Examining the need for overall standards at exchanges and clearing houses regarding back-up sites, contingency planning, etc.
  • Futures exchanges and related clearing organisations should publish information on their own finances, market protection mechanisms, sources of financial support and default procedures. Each exchange or clearing house should develop a mechanism for communicating information to market participants if and when default procedures are initiated.
  • Cross-border coordination and communication among exchanges, clearing houses and their supervisors needs improvement. In particular, if something is wrong in the market, supervisors that need to be told should receive the necessary information immediately so that they can take action.
  • Governments should strengthen laws and procedures for market default and for protection of customer assets, funds and positions.

The robustness of clearing-house-arrangements for clearing and settling trades is key to the markets operating safely and fairly. In the wake of the Barings' crisis, the Committee on Payment and Settlement Systems (CPSS) decided to examine clearing arrangements for exchange-traded derivatives in G-10 countries. "Clearing Arrangements for Exchange-Traded Derivatives (1997)" discusses the sources and types of risks to clearing houses and the risk control techniques they can employ to safeguard themselves against such risks.

The report identifies several sources of potential vulnerability:

  • Inadequate financial resources to meet losses and liquidity pressures from member defaults caused by extreme price movements
  • A lack of mechanisms to monitor and control intraday risks
  • Weaknesses in money settlement arrangements.

For each potential weakness, the Committee suggests ways to strengthen clearing arrangements:

  • Stress testing to identify and limit potential exposures to clearing members and to ensure that the clearing house's financial resources are adequate in such circumstances
  • Enhanced intraday risk management through more timely trade matching and more frequent calculation of exposures and through the development of the capacity to reduce intraday exposures by means of more frequent settlements
  • Strengthening money settlement arrangements by using real-time gross payments systems. (for more, see settlement risk.)

There is no doubt that the sternest test of a market's integrity is posed by market shocks. It is therefore no surprise that one of the best reports on market integrity is "Mechanisms to Enhance Open and Timely Communication between Market Authorities of Related cash and Derivative Markets During Periods of Market Disruption"(1993). Appendix 1 of the document details the measures used by major exchanges worldwide to minimise the adverse effects of market disruption. These include circuit breakers or trading halts, position and exercise limits, changes in margin requirements, price limits and cross-margining. The main body of the report concentrates on how exchanges can exchange information during periods of unusual price volatility or market crises to help markets operate smoothly and to dampen the impact of the crises itself. The main points of this section of the document are discussed in the key risk concept 'regulatory co-operation'.

One of the most important ways of protecting market integrity is monitoring the market on a regular basis for potentially manipulative behaviour. One sign of possible market manipulation is unusually large positions in a single contract. In a "Report on Cooperation between Market Authorities and Default Procedures" (1996), the Technical Committee of IOSCO recommends that market authorities establish qualitative and/or quantitative criteria appropriate to their markets as trigger levels for identifying large exposures. Market surveillance by the authorities should also include finding out the beneficial owners of such positions to assess the risks posed.

"Legal and Regulatory Framework for Exchange-Traded Derivatives (1996)", provides a concise but comprehensive overview on the main issues of market integrity. It looks at the role of regulators in promoting market integrity, noting that regulatory flexibility is key to the long-run success of markets. The issues which regulators should look at are product design; fair order execution; surveillance; operational capacity and capital standards of the brokers/intermediaries; clearing facilities; margins; how customer funds are protected normally and during defaults and insolvencies; how market disruptions are handled and how brokers/intermediaries are registered and licensed to deal.

The document also discusses structures for regulating derivatives exchanges. While it is universally recognised that there is a need for a governmental agency to regulate exchanges, the report questions whether there should be one or a couple of agencies who should take on such a role. It also discusses the issue of self-regulation, realising that a self-regulatory organisation (SRO) has the ability to impose ethical standards which go beyond those imposed by government, and, precisely because of its roots, is more attuned to what rules will be workable and beneficial to market users. The report advocates an oversight system of shared responsibility between market intermediaries, market operators and the government authority. This pyramid structure will have the market intermediaries, members of the SRO, at the bottom tier. The second tier consists of SROs, which include exchanges and other market operators. At the top of the pyramid is the government agency.

The repurchase agreement (repo) markets are crucial to the smooth functioning of today's financial markets. Financial institutions use it to hedge as well as leverage their activities while central banks use it both as an instrument of monetary policy and as a source of information on market expectations. In "Implications of Repo Markets for Central Banks" (1999) , the Committee on the Global Financial System lists the features and market practices which promote the integrity of repo markets. They are: adequate and efficient legal framework, secure and efficient settlement systems, adequate transparency and appropriate haircuts and margin call practices.

While the use of collateral reduces credit risk, market participants remain exposed to credit risk arising from volatility in the value of the collateral, counterparty default and liquidity risk. Good practices relating to haircuts and margin calls are essential to limiting risks that arise in repo markets. Some areas where practices with respect to haircuts need to be addressed are:

  • Competitive pressures may lead to haircuts being pushed below the level needed to compensate for the risks faced by lenders
  • There is a tendency to rely on collateral as the principal means of controlling risk and not to adequately take into account the risk of the overall position of borrowers in financial markets. Reliance on collateral cannot substitute for comprehensive credit analysis as a way of controlling risk.
  • Haircuts, once set, are sometimes not adjusted even when conditions are more volatile. Other practices, such as those relating to timely delivery and fail rules, contribute to efficiency and help reduce the scope for market manipulation and abuse.

    See also customer protection, regulatory co-operation, systemic safety

    • Coordination Between Cash and Derivative Markets (1992)
    • Authorities of Related cash and Derivative Markets During Periods of Market Disruption"(1993)
    • Mechanisms to Enhance Open and Timely Communication between Market Authorities of Related Cash and Derivative Markets During Periods of Market Disruption (1993)
    • Financial Integrity Recommendations" (1995)
    • Financial Integrity Recommendations (1995)
    • Report on Margin" (1996)
    • Report on Cooperation between Market Authorities and Default Procedures" (1996)
    • Global Institutions, National Supervision and Systemic Risk (1997)
    • Clearing Arrangements for Exchange-Traded Derivatives (1997)
    • Implications of Repo Markets for Central Banks" (1999)

    Update for June 2000


Key Risk Concepts * Public Policy Objectives