The global economy is vulnerable to a “steep downward adjustment in asset prices,” partly due to the rise in index investing, says IIAC president and CEO Ian C. Russell.

In his latest letter, Russell offers insights from the Oct. 20 meeting of the International Organization of Securities Commissions (IOSCO).

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He says two conclusions emerged:

  • the risks of a steep downward adjustment in asset prices are acute and
  • co-ordination in rule-making among regulatory jurisdictions could be improved to promote greater cross-border rule harmonization.

Heightened risks for assets

Citing IOSCO chair Ashley Alder, Russell describes global economic risks, to which he adds his own concerns, including the rise in index investing.

“The emphasis on index-linked investment management, to lower costs and minimize risk, has caused all asset classes to move close together,” he says.

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He thus warns that external shocks could trigger steep declines in asset prices.

“Banks and dealers have limited scope as market-makers to absorb panic selling, particularly by asset managers faced with massive exposure to falling asset prices, accelerating withdrawals of client funds as values plummet, and limited liquidity to avoid major asset sales.”

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Regulators have acted to reduce fund managers’ balance sheet exposure to falling asset prices, through such measures as limiting leverage and ensuring significant holdings of liquidity.

“Regulators continue to examine the liquidity of corporate bond markets under stressed market conditions,” says Russell.

Challenges to regulatory harmonization

Russell also explains how massive regulatory reform following the financial crisis suffered from insufficient regulatory co-ordination among jurisdictions.

The result: “A global market in [over-the-counter] derivatives […] became quickly balkanized as markets were forced to centre activity within regions,” he says.

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That in turn led to “less choice, less liquidity and higher costs for market participants,” he says.

In the last four years, regulators have worked to modify rules and find approaches to recognize trading and clearinghouses outside home jurisdictions.

“Some successes have been achieved,” says Russell, but the challenges of competing regional concerns remain.

He notes, for example, that the EU’s regulatory initiative, MiFID II, means rules that will apply in Europe — in areas like transparency — will differ from those of other jurisdictions.

Further, he warns of the potential for continued uncoordinated global effort in the face of deregulation.

“Beyond MiFID II, the rule-making process in debt and derivative markets will continue, as U.S., European and other regulators deregulate markets to improve market functioning and capital-raising to boost growth,” he says.

While IOSCO doesn’t have authority to demand rule harmonization, the Financial Stability Board (FSB), with G20 governments as members, has authority to encourage national regulators to co-ordinate targeted rule-making, says Russell.

Such an agenda “should take priority at upcoming meetings of the International Council of Securities Associations (ICSA) with the FSB,” he says.

In his letter, he provides suggestions to achieve harmonization.

Read Russell’s full letter.