1. The Technical Committee of IOSCO published a paper 'Capital Adequacy Standards for Securities Firms' last October which set out a framework for the capital requirements of non-bank securities firms. Working Party 3 has followed this paper by considering in greater depth the scope for harmonization of various elements of the requirements. One of these elements is the equity position risk requirements.

2. This paper compares the equity position risk requirements for non-bank securities houses in France^l, Japan², the UK³ and the USA⁴. It is recognized that the regulators often need to take into account other factors, such as the structure of the market, when setting levels of capital, and to exercise their judgment accordingly which will lead to the adoption of rather different requirements in different countries.

3. The paper then assesses the scope for harmonization of the requirements in the light of these factors. There is increasing interest in the search for harmonized standards internationally, with the European Community developing common minimum standards for securities firms authorised by

4. The risk which is addressed by the equity position risk requirements is the possible adverse change in the price of positions held by the non-bank securities firm. (This risk clearly arises from trade date). The requirements are commonly called haircuts in a number of countries because the effect is to discount (or shave an amount from) the latest market value of positions held to cover an adverse price movement. Clearly the market valuation of the securities held is the starting point and where positions relate to issues traded outside an organized market a conservative valuation is used. Credit risk is subsumed in the haircuts and in the mark to market requirements. For most publicly traded issues (certainly all those traded on an exchange) the likelihood that the issuer might fail without warning is very small indeed although it can happen. A gradual deterioration in the standing of an issuer over a long period will be captured through the daily mark to market. What is of concern is the potential price volatility of the positions held, since the assets are all assumed to be held for trading purposes.

5. The rules described in this paper relate to firms which take-exposures in the equity market rather than, for example, those which act solely as agency brokers for which different considerations are important. In most markets worldwide, securities market intermediaries act solely as agency brokers rather than taking positions - the orders are matched on the floor of the exchange. But increasingly even in auction markets securities firms are taking positions, making the risks related to the books more akin to those of firms in competing market maker systems. In competing market maker systems the rules of the exchanges drive all the orders across the book of the market makers, giving them large quantity of positions on both side of the book.

Optional treatments for position risk

6. US firms are able to choose between two capital standards (the basic and the alternative * ) under which there are different equity haircuts - the haircut under the basic standard is 30% and under the alternative standard is 15%. Almost all the large firms are on the alternative standard and this equity requirement is therefore the one referred to in this paper. (There are also proposals to-reduce the haircut under the basic standard to 15%).

*Under the basic method, aggregate indebtedness cannot exceed 15 times net capital. Under the alternative the firms must have a cushion of capital equal to 2% of customer and customer related receivables.

7. The choices open to securities firms operating in the UK are more extensive. As far as equities are concerned, the firms can opt for a simple approach which gives no allowance for hedging or diversification (Equity Method 1) or more complex requirements which give allowances for hedging and also diversification of holdings in a particular market (Equity Method 2) or diversification of portfolios between the US, UK and Japanese markets (Equity Method 3).

8. In Japan and France there is only one treatment for equities.

Liquidity

9. There is general agreement in all four countries that illiquidity is a key concern. If a firm is holding a position in a stock which is thinly traded and therefore which it might have difficulty disposing it is exposed to the possibility of larger potential price movements than if it could easily and rapidly liquidate its position.

10. Both the UK and the Japanese requirements capture liquidity of the paper through categorising equities and applying graduated requirements. In the UK the sub-division can be seen most easily in the haircuts in the simplest (Equity Method 1) test but it applies to all the tests - in Equity Method 1 the requirement applies to the sum of the long and short positions. The table at the end of this section sets out the requirements for domestic equities in the UK (Equity Method 1) and Japan.

11. The UK and Japan have additional liquidity requirements which come into play if a firm has a substantial part of an issue and therefore might have difficulty liquidating it quickly. The requirement comes into force if a firm's holdings (after taking into account all commitments to buy or sell the securities in whatever form, including derivatives) exceed 5% of an issue - calculated with reference to the size of an issue remaining in circulation rather than the original issue size. The additional requirement is equivalent to 50% of the requirement on a single equity, if the firm holds between 5% and 25% of the issue, and 100% if the firm holds over 25%.

12. As to equity positions, the SEC rule equates those securities without a "ready market" to illiquid assets, which then receive no value for net capital purposes. Generally, all other equities receive a 15% deduction. This single test presumes that larger securities firms will have and in fact in the US do have a position in a broad range of securities over a wide spectrum of markets.

13. To discourage firms from holding excessive amounts of a particular issue or from holding less liquid securities, the SEC rule has other features. If a firm holds a position which is excessive in relation to the normal volume of that security, that amount in excess of the normal volume is assessed 100% charge.- A rule of thumb as to normal- volume is a twenty day training period. The concentration requirements in the USA (and in the other markets as well - see below) also help to discourage firms from holding excessive positions.

14. The French requirements at present do not reflect liquidity but the intention is to establish higher requirements for OTC issues and non-marketable equities. At present there is a single requirement of 20% of the long and short positions, for all equities. (As in the other three countries long and short positions in identical equities can be completely netted).

Requirements for Domestic Equities

 

	UK	Japan	USA	France
				Current require- ment	Future require- ment (9)
Most liquid	10.5(1)	10.0(4)			12.5
Liquid	15.0(2) 18.0(3)	15.0(5)	15.0(7)	20.0
Other marketable	25.0	25.0(6)			20.0
Unmarketable	100.0	100.0	100.0(8)		100.0
(1) Alphas. (2) Betas. (3) Gammas. (4) 1st section issues on the Tokyo, Osaka and Nagoya exchanges. (5) 2nd section issues on the TSE, OSE and NSE. (6) OTC issues. (7) "Additional charges may result from excessive positions relating to a firm's own capital or relating to a normal trading volume of stock." (8) Having no ready market. (9) Figures under consideration.

Structuring the requirements to reflect the risks

15. Equity markets are tending to become more alike in the risk characteristics of the firms. A number of auction markets (for example the Paris market) are moving more towards dealer markets with the brokers taking positions on their own behalf. In the auction markets in the USA and Japan the firms have traditionally taken positions on their own account reflecting their view of the market. The competing market maker system in London (which at present is a pure dealer market with all orders crossing the books of the firms) may in future be supplemented with a central limit order service enabling small orders to be matched, rather like an auction market.

16. Thus the tendency is for more and more securities firms worldwide to take long and short positions on their own account. Firms are also increasingly active in the derivative markets and are involved in various kinds of arbitrage activity. All four countries make very substantial allowance for the low risk of these arbitrage books.

17. One activity of this kind is index arbitrage where a basket of stocks is created which mirrors some 80-95% of the index and which is offset by a position in the index future. The gross positions are huge and the returns are very small (as -a percentage of the holdings). The risks are very small indeed. The firm has locked in a profit (over and above the funding cost for the positions) which is likely to be the minimum it will receive as long as it holds the positions to expiry of the futures contract. Likewise where a firm is holding convertibles hedged with the actual equity the cost of conversion is known and therefore the firm has a locked in profit.

18. The regulators have varying ways of treating such arbitrages to ensure that the requirements are not excessive relative to the risks being run. For example, the Japanese regulator enable the firms to use models with the requirements based on the observed volatility of the positions - the data on these volatilities must be shown to the regulators. The French requirements are reduced by a set amount depending on whether the hedge is general or specific Positions with a general hedge (for example general cash positions hedged with the index) carry an 8% capital requirement, rather than 20%. Positions with a specific hedge (for example index arbitrage positions) carry a requirement of 4%.

19. There is a varying treatment of risk related to cash equity positions. In the US markets where broker dealers hold short positions in individual equities there is some allowance in the requirements for the holding of such positions. There is no requirement on short positions (in aggregate) totaling up to 25% of the long positions tin aggregate). However, there is a 15% requirement on the excess of short positions over this percentage. In the US, there has been no desire to reduce this cushion of capital by looking to diversity or any other theory of analyzing volatility or future prices. The US regulators believe that firms that are financial intermediaries dealing with the public should not be allowed to expand their risk positions significantly without a larger capital base. Thus, no offset is given if longs are offset by unrelated short positions. Shorts are haircut separately except for a percentage of the longs. The US believes that there is specific risk associated with short positions such as short squeezes. The firms, however, are encouraged by the rule to enter into risk reducing positions including warrants, convertible bonds, options, or futures.

20. The broker dealers in the US do not have a market making obligation in the auction markets - this function is performed by the specialists. The specialists do not deal with the public and therefore do not come under the SEC's capital rules (and therefore do not have to meet the 15% requirement). They meet a stock exchange minimum capital requirement of $1 million. The lower capital requirements which they face help them to comply with their market stabilization obligation.

21. In the UK market, firms which accept obligations, under the rules of the Exchange, to make markets in individual stocks have traditionally run relatively balanced books (ie books with similar amounts of short and long positions). (Books with a similar profile are seen in some other markets as well, for example the Dutch market). The evidence from the London market is that these books are much less risky in periods of sharp market downturn than unbalanced positions and the UK requirements give substantial benefit for such risk reduction, provided the firm holds diversified positions. A firm holding 25 long positions of equal value and 25 short positions of equal value (in the most liquid equities), amounting to £100mn and £90mn respectively, would have a requirement in the UK equivalent to 1 1/3% of the gross value of the positions (2S% of the net). To benefit from any allowance for long and short positions the firms must hold a minimum number of positions (ten in the UK market) and the requirement is adjusted to reflect the extent of the diversification of the book. On a fully diversified gross long book the minimum requirement is 4%%. Consideration is being given to an upward revision of this minimum requirement for long positions in the light of the price volatility in the equity markets in the recent past.

22. In the Japanese market (where firms are not able to short sell individual equities) there are no separate allowances for holding short as well as long positions.

Concentrated Positions

23. A significant risk occurs when a firm holds positions in equities (or bonds) which are concentrated in terms of the capital of the firm. This is because a substantial (unexpected) adverse move in the price of a single equity holding (for example because of a takeover) which is itself large relative to a firm's capital could leave the firm vulnerable A firm is of course also vulnerable, because of the possibility of default, if its exposure to a single issuer is large even though that exposure is spread over bonds and equities.

24 Under UK and Japanese rules a firm has a concentrated exposure to one issuer if the total value of its exposure to that entity exceeds 25S of its adjusted net liquid assets - i.e. in the UK case shareholders funds plus allowable subordinated loans and guarantees after deductions for illiquid assets and provisions and in the case of Japan the calculation is broadly the same but subordinated loans₅ and guarantees are excluded. Where a firm has a concentrated exposure there is an additional requirement, amounting to 50% of the haircut on a single equity of that type if the exposure is equivalent to 25% to 50% of the firm's adjusted net liquid assets, and 100% if the exposure is equivalent to over 50% of the adjusted net liquid assets..

25. The French have a limit on concentrations. The requirement is that a firm's exposure to one issuer, the sum of all the net positions in that issuer's paper (after allowable hedges in that paper), should not exceed 40% of the net shareholders funds of the firm.

26. The US requirements cover a concentrated position in an issue. They do not cover concentrated positions to an issuer comprising holdings of different types of paper (ie. a position spread over bonds and equities issued by one firm) because this has never been a problem in the US. The

requirement is that if the firm holds one particular type of paper issued by an entity, which exceeds 10% of its net capital, it must meet an additional position risk requirement of 15% on the excess. Also in the US, if a firm controls enough securities of a publicly traded company so that it has actual or legal control, it may not be able to sell any of the shares on the public markets. This could cause a 100% charge even if the shares in the hands of another person are otherwise liquid.

Scope for harmonization of equity position rising requirements

27. There are a number of objectives regarding the structure of the requirements which are agreed by the securities regulators in France, Japan, the UK and US. These objectives are that the requirements:

1. should reduce the likelihood of firms failing owing sums to clients/ counterparties
2. should generally reflect the risks and therefore firms reducing risk should be treated in a less severe manner
3. should not affect market practice perversely
4. should not be too costly to comply with nor too complex.

28. To achieve harmonization it would be necessary for any standard to meet all these objectives.

29. As far as the first objective is concerned there is general agreement that with additive requirements a regulator should not attempt to cover extreme market conditions with each and every element. To do so would lead to such high capital requirements overall that firms would be hampered in their ability to hold positions. This is particularly the case in those countries where the base requirement provides a substantial extra cushion for all firms. It is in any case unlikely that a large diversified firm would -have problems in all aspects of the business at the same time. The other elements of the requirements (counterparty risk and position risk for bonds) therefore also provide a cushion in short-term extreme periods.

30. A concern is that the risk of firms failing is significantly increased if they are able to maintain very large books with a very small capital base relative to risk.

31. To meet the second objective the regulators believe that it is important to look at past price volatility. Although past price volatility cannot provide a perfect guide to future volatility, either of individual stocks where there could be substantial specific risk, or for the market as a whole in extreme periods, it will give supervisors an important guide to the level of requirements needed to capture the risks and therefore greater confidence in the requirements set.

32. The third objective is very important but has different implications in different markets. There is general agreement that lack of liquidity should be reflected in the requirements, although it is accepted that there are different ways of achieving this which are appropriate for different markets. For some markets graduated requirements for marketable equities are thought to be appropriate whereas this is not the case for others - in part because there is a concern about how it could be achieved given the way markets change and also because there is a concern that in some markets tiering is complicated and subjective and could widen spreads and reduce liquidity for lower grade equities.

33. Given the different practices in relation to tiering, harmonization of requirements could only be achieved at a minimum level linked to liquid equities in a particular market. But regulators should apply higher requirements (than the minimum) to positions in some equities to capture lack of liquidity. This would give scope for those countries with a tiered approach to continue to impose higher requirements for less liquid equities than for liquid equities and for other countries, which want a single requirement for all marketable equities, to have a higher requirement across the board.

34. To meet the third objective it is essential that the requirements for arbitrage books (involving a wide variety of instruments such as index futures, warrants, convertibles and options) should reflect the almost negligible risks which some of these positions entail. Excessive requirements relative to the risks would simply discourage firms from carrying out this kind of activity, because the low returns (relative to the large positions taken) would not give an adequate return on capital employed.

35. The third objective also influences the attitude towards short positions. In some auction markets broker dealers have traditionally taken long positions and only modest short positions. Indeed rules governing market practice in some auction markets are designed to discourage firms from running short positions.

36. In contrast, in other markets (both some auction markets and competing market maker systems), firms run more balanced books. In these markets the concern is that requirements which penalized such books (by rising the more balanced the book) would discourage firms from running their books in this way leading to more risk in the market.

37. To take account of these different concerns it would be necessary for harmonized requirements (which would provide a minimum) to avoid a treatment of risk which would have a perverse effect (by discouraging either arbitrage activity or balanced books) in some markets. The minimum standard could, however, be built on, with extra requirement, to discourage firms from taking short positions in markets where such behaviour was seen as adding to risk.

38. The fourth objective is a major concern for regulators in many markets. Finely tuned requirements which closely reflect risk are more complex and require the firms to invest in systems to handle them. It enables firms to have lower capital requirements and also the firms can make use of the systems for their own risk management purposes. In any international standard a balance will therefore need to be struck between capturing risk closely and the costs of doing so.

Footnotes:

(1)The French requirements were introduced from the beginning of January 1989.

(2)The Japanese requirements were introduced on an experimental basis from the Summer of 1989 and were fully implemented from 1st April this year

(3)The UK (SIB/TSA) requirements were introduced in April 1988.

(4)The current US haircuts were introduced in 1975. a member-state and with the Basle Committee on Banking Supervision looking for appropriate requirements to cover the securities positions of banks.

(5)Subordinated loans have not traditionally been used as a form of financing in Japan.