Capital adequacy standards foster confidence in the financial markets and should be designed to achieve an environment in which a securities firm could wind down its business without loss to its customers or the customers of other broker-dealers and without disrupting the orderly functioning of the financial markets. Capital standards should be designed to provide supervisory authorities with time to intervene to accomplish this objective. They should allow a firm to absorb losses. They also should provide a reasonable, yet finite, limitation on excessive expansion by securities firms to minimise the possibility of customer losses and disruption of the markets.

The efficient functioning of the financial markets requires members of the financial community to have confidence in each other s stability and ability to transact business responsibly. This, in turn, requires each member of the financial community to have, among other things, adequate capital. In the absence of a supervisory authority setting objective capital adequacy standards, investors, other securities firms, and financial institutions would be reluctant to deal with securities firms. In an unregulated environment, the financial failure of a firm would call into question the solvency of other securities firms and could cause serious disruption of the markets. For example, broker-dealers often need financing from banks and institutions to carry or clear securities transactions. Any significant interruptions in the availability of bank financing, or any other source of financing, could significantly affect the broker-dealer community and the operation of the markets. If, because of doubts about the adequacy of the capital of foreign firms dealing through branches, market participants or investors in any market felt that they could deal safely only with indigenous firms, the further development and growth of international markets would be considerably impeded.

B. Risks Addressed by Capital Adequacy Standard

Finally, those entering the securities business should have a sense of commitment and obligation to their business in order to help promote responsible and reliable operations. One of the ways of demonstrating this is through adequate capital.

A capital adequacy test should address the risks faced by securities firms. Some of these risks and how they can be measured for capital purposes are set forth below.

1. Position Risk

Securities firms that trade as principal usually hold securities with a view to selling them in the near future at a profit. In others words, they are not in the business of holding securities as long term investments; their object is to run a "trading book". Consequently, they must be in a position to withstand losses whether realised or not, which result from their trading activities. Position risk (market risk) has various forms, There is the basic risk that the price of securities that the firm holds might fall or that the price of securities that comprise a short securities position of the firm might rise. Also, the risk of non-payment of principal and interest in debt issues must be considered.

There is also the risk associated with a position in a security that is large in relation to the total market for that security. In attempting to liquidate the position, the firm might experience a significant decline in the price of the security (or a significant increase if it is buying to cover a short position). Furthermore, the risk that a firm experiences when it holds a large position in one issue or a number of different issues of a single issuer relative to its capital must be taken into account. Risk stemming from other activities, such as foreign currency forward and interest rate swap transactions and other off-balance sheet transactions, also must be addressed.

In order to measure the potential market risk. one needs to gauge how much the price of a security might rise or fall in value. This requires a review of a number of factors. A supervisory authority should take into account the historical fluctuations in the market price of each type of issue. Other factors that might be taken into account include the nature of the issuer, the liquidity of the market for a security, and the ratings of recognised rating services which categorise debt securities as investment or non-investment grade.

The assessment of potential market risk should also take account of concentrated positions in one issue or in a number of issues of a single issuer as well as providing allowances which recognise the extent to which firms engage in the techniques which reduce the risks of other positions. The allowances provided should take into account and encourage firms to adopt risk reducing strategies. For example, some countries give consideration to offsetting long and short securities positions and hedged options and futures positions. Another country provides allowances for diversified equities portfolios.

All of the above factors, together with the supervisor s experience and judgement about the financial markets should be considered by the supervisory authority in reaching its decision regarding the levels of capital necessary to accomodate a given level of position risk.

2. Settlement/Counterparty Risk

The settlement risks faced by a firm depend in large part on the nature of the clearance and settlement systems in the various markets. In every system, firms will be exposed to the risk that their clients will renege on a transaction and also, in some systems to the risk that other market participants will renege. Some systems remove a large part of the risk between market participants through, for example, the simultaneous exchange of money and securities via book-entry transfer and/or the guarantee of settlement by the clearing house. However, if there is a clearing house guarantee, firms would still be collectively exposed where the risk of a member s default to the clearing house is, to some degree, shared by all clearing house members.

Another factor that varies from market to market is the extent to which settlement risks accumulate (i.e., the build-up of delivery obligations resulting from the failure of a securities firm to deliver securities on an agreed settlement date to a counterparty). In some markets! contracts remain valid until settled, but settlement of outstanding contracts can be accelerated. A firm can buy-in ⁽⁵⁾ securities that another firm has failed to deliver by the settlement date in order to enable settlement to take place. On the other hand in other markets unilateral cancellation of a contract is permitted against the non-delivering firm after the settlement due date.

Clearly, requirements to cover settlement risks must reflect the nature of the risks in a particular market. Some of the risks that could be faced vis-a-vis clients or other market participants are as follows:

1. Price Movements

   If a firm purchased securities and then sold them (with neither transaction having settled) and the price increased, it would be exposed to the risk that the original seller could default. Assume, for example that securities firm A sells to securities firm B, who in turn sells to securities firm C. If the price of the security rises and firm A fails to deliver the security and becomes insolvent, firm B must purchase the securities in the market at the higher price, without the ability to recover from insolvent firm A, because firm B is still liable to firm C. The risk in such a transaction, and indeed any transaction is that a firm would have to meet the money difference between the contract price of a securities transaction and the subsequent market price if the counterparty did not settle. The price difference is measurable at any time.

2. Unsecured Claims and Free Deliveries

   If a firm purchased securities from a counterparty and paid for the securities prior to the counterparty's delivery of the securities, it would have an unsecured claim. The firm would be exposed to the risk of loss if the counterparty failed to deliver the securities. Likewise, if the firm delivers securities and has not been paid it would be exposed to risk of loss. The risk is clearly increased if the total unsecured claims or those with respect to one counterparty are large relative to a firm's capital.

3. Funding Costs

   Even if the counterparty does not renege, the firm might incur additional funding or borrowing costs when delivery is delayed. A firm that bought and then sold securities could feel obliged because of business considerations to make delivery on the sale even though the firm from whom it purchased had not made delivery. To do so the firm might have to purchase or borrow securities in the market a day or two before it makes delivery on the sale. The firm would have to absorb the funding costs for carrying those positions.

   Timing differences in settlement create other funding costs and risks. For example, where a firm has paid a counterparty upon receipt of securities, the firm may be unable to settle with the client until the next day or the following day. The firm would have to fund the transaction either by borrowing funds or using other funds in its possession. In either case, the firm will incur a cost either in terms of interest expense or the opportunity cost of uninvested funds. These costs, again depending on the system, can be large ⁽⁶⁾ .

   Cross border exposures are also a very important consideration. A firm might have to settle in the market in country A today, but either stock or money might not be available in country B for two to three days. Major differences in settlement cycles increase the problems caused by cross border trading. A move towards standard settlement cycles would be a helpful development in reducing these types of risks.

   The exposure attributable to settlement related problems can be identified. In systems where contracts remain unsettled over long periods, time can be used as a rough proxy for the likelihood of default (de, the older outstanding contracts are likely to be at greater risk).

   Effective requirements for settlement risks should be designed not only to address risk but also to encourage firms to settle promptly and to facilitate more efficient clearance and settlement systems. More efficient clearance and settlement systems would reduce the risks to the financial system as a whole.

4. International Initiatives in the Area of Clearance and Settlement

   The Technical Committee notes the recent recommendations which the Group of Thirty⁽⁷⁾ has made regarding the structure for clearance and settlement systems on a world-wide basis. These proposals provide a blueprint for potential changes in clearing and settling securities transactions which could have a major effect in reducing settlement risks in the world s securities markets. In particular, settling trades on a continuous rolling basis (de, settling trades on all business days of the week) and standardised and reduced periods for comparison and settlement would reduce settlement risks. The development of effective, automated book-entry, central securities depositories and the institution of delivery versus payment systems would also be a major step which would have a positive impact on risk exposure. Thus, the implementation of the Group of Thirty recommendations could reduce the amount of capital firms might otherwise be required to maintain to cover their exposure to settlement risks.

   Furthermore, the International Federation of Stock Exchanges is expected to publish soon a study containing recommendations as to the ways in which cross border settlement procedures can be improved in order to reduce both the costs and the risks involved. This work is expected to be in a form which will be complementary to the Group of Thirty recommendations.

   Finally, the Technical Committee of IOSCO will be considering suggested initiatives for improving clearance and settlement in the world's securities markets.

3. Other Risks

Firms face a myriad of other risks in the securities business. One such risk is execution errors that result from misunderstandings or negligence. For example, errors may result from mix-interpretation (1) of instructions received from a client, (2) between the front office and the back office, or (3) in communicating instructions to third parties. Other common errors include the purchase or sale of an incorrect amount of securities, a sale intended as a purchase (or vice versa), and delays in executing a client order. Some of the costs created are of an administrative nature, but there are also the costs of having to make good any transaction by buying or selling securities at the current market price and absorbing any loss incurred as a result of adverse price movements (ie, the price difference). The risk can be assessed by trying to examine the prevalence of these mistakes. This risk generally tends to increase in periods of heavy volume.

Other basic risks faced by securities firms are reduced revenues, increased expenses. increases in back office paperwork. and fraud. For example. an unexpected decrease in a firm's transaction volume may result in reduced income to the firm while expenses remain constant or increase. On the other hand, an unexpected growth in the firm's business may result in increased back office paperwork. This could strain a securities firm's capabilities causing recordkeeping and settlement problems. These are generally unmeasurable risks that need to be captured in a cushion of capital based on a firm's scale of activities.

C. Approaches to Capital Adequacy

1. Liquidity and Solvency

A capital adequacy structure for securities firms should cover both securities and non-securities activities and should cover liquidity and solvency. Lack of liquidity can cause difficulties for a firm because it might not be able to meet its liabilities as they fall due. Furthermore given the risks in the activities of securities firms, significant losses can occur quickly causing difficulties for a firm. Therefore, some regulatory structures provide that a firm at all times should be able to meet all liabilities including all claims by customers and counterparties.

The Technical Committee acknowledges the existence of two different methods of addressing liquidity. In the larger markets. the standard, after the proposals recently announced by Japan. will be a net liquid assets test for securities firms. The objective of this test is that a firm should be able to wind down quickly its activities and repay all of its liabilities including the claims of other securities houses and customers. Under this requirement, which is a combined test of liquidity and solvency, a firm at all times must have liquid assets which exceed its total liabilities by a sufficient margin to cover the risks to the firm's net worth. Securities and commodities positions are marked to market daily which prevents the securities firm from storing up losses which could lead ultimately to its failure or bankruptcy ⁽⁸⁾ .

A key feature of the net liquid assets approach is that all intangible. non-marketable, and illiquid assets, such as goodwill and property, are deducted from capital ⁽⁹⁾. Most unsecured receivables are treated as illiquid assets and? therefore, are also deducted from capital.

An alternative approach to the net liquid assets test is to treat liquidity as an additional risk faced by the firm. This has led some countries to set a ratio of liquid assets to short-term liabilities as part of a number of ratios linking the capital of the firm to the risks faced. For example, a firm could be required to hold liquid assets which exceeded the total of all liabilities with a maturity of less than one year. This would ensure that the firm had adequate day to day liquidity while it remained in business but it would not provide that the firm could meet all claims by customers and market counterparties. Countries that use this approach have separate solvency requirements. These solvency requirements are designed to provide that a firm has sufficient capital to cover the risks to its net worth. It is also important in this approach that securities and commodities positions are marked to market daily so that losses are not stored up.

2. Risk-Based Requirements

It is essential that firms have sufficient capital to cover fluctuating risks such as position and settlement risks⁽¹⁰⁾ plus a cushion to cover risks that are not measurable⁽¹¹⁾. One approach would be to require firms to have such a high capital base that this alone would provide adequate capital to cover these risks. This approach has the disadvantage that, in general, firms would have to hold capital substantially in excess of the risks that they were facing. Capital in excess of these risks would have to be held to provide that a firm had the necessary capital to allow for extreme positions which might be taken both in terms of the size of particular positions and the price volatility of the securities. Furthermore, unless there were strict limits on the size of positions taken, there would also be the danger that with a sudden change in market conditions a firm's capital base could be endangered.

In view of the disadvantages of the above approach. the Technical Committee strongly favours the adoption of risk-based requirements with a cushion of capital to cover unmeasurable risks. The advantage of a risk based approach is that it provides that firms hold a level of capital appropriate to the amount of risk. Thus, the capital requirements are neither too severe! which would increase costs for the firms and affect their efficiency, nor too slack, which would enable firms to run excessive risks relative to their capital and leave the markets vulnerable to the failure of participants. By making allowance for techniques such as hedging, this method also has the benefit of encouraging firms to engage in risk reduction techniques which further help to reduce risk in the markets.

3. Minimum Requirements

It is appropriate to require firms wishing to enter the industry to demonstrate a level of commitment by requiring them to meet certain minimum capital requirements. The Technical Committee's view is that these minimum requirements should not be uniform for all firms. Some countries believe that substantial minimum capital requirements are necessary to enhance confidence in the financial safety of the markets. However, since a principal effect of a minimum requirement is that it acts as a barrier to entry, too high a requirement could adversely effect competition in the marketplace. To address this concern, the Technical Committee believes that differential minimum capital requirements should be based on the type of business being conducted by the firm. In general, higher minimum capital requirements should be imposed on firms which hold customer funds and securities or engage in trading activities for the firmís account.

4. Definition of Capital

The Technical Committee notes that different approaches to the definition of capital are used in different regulatory regimes. A number of the countries which currently have capital requirements which are closely tied to the risks associated with a securities firm's business allow firms to use both short-term and long-term subordinated loans⁽¹²⁾ in addition to ownerís equity. as capital to cover these risks. Some of these countries also make some allowances for bank guarantees as a substitute for capital. This enables a firm to meet its fluctuating risks. and if a firm were to fail. the subordinated loans or funds called for under the guarantees would be used to meet the claims on the firm by customers or counterparties. Subordinated loans are permanent capital in the sense that repayment to the lender is not allowed if it would result in a firm s capital falling below a threshold set above its required capital. In all regulatory systems, though, the degree to which these forms of capital or substitutes for capital can be used is limited relative to owner s equity. Some systems. however, do not make allowances for subordinated loans or guarantees. The Technical Committee recognises that at present the definition of capital varies between systems to reflect their differing regulatory structures.

Footnotes:

5. In a buy-in transaction, the firm failing to deliver has to pay the price difference. In practical terms, however, buy-ins will not work unless a market exists in which a particular security can be purchased at a fair price. For example, the market for a particular security may be so thin that buy-in price cannot be established.

6. If there were doubts about a firm`s capital and the funds were not made available by lenders the firm could experience difficulty.

7. See Group of Thirty Report on Clearance and Settlement in the World`s Securities Markets

8. If a firm incurs substantial losses,it might have to take action such as liquidating some positions or increasing its capital in order to remain in compliance with a net liquid assets test.

9.Some regulators make some allowance for property which secures a loan.

10.Of course,the level of risk associated with the conduct of an investment business (such as position risk and settlement risk) can vary depending upon the nature of the securities market and related clearance and settlement systems. Securities regulators would ,of course ,take these differences into occount in establishing the risk-based standards.

11.Different ways can be used to provide for this cushion. For example, one country ties the required cushion to a firm`s volume of business measured by criteria such as customer receivables,total liabilities (other than subordinated liabilities ),or position risk. Other countries tie it to a proportion of firm expenditures (eg,one quarter of a firm`s annual expenditures ).

12.Short-term and long-term subordinated loans are permitted as capital under certain conditions .Subordinated loans are subordinated to the claims of all present and future creditors,including customers.