Prince Henri Auditoire 02 BW

International Securities Market Association Conference 2001

by Yves Mersch, Governor of the Banque centrale du Luxembourg

International Securities Market Association Conference 2001 - Luxembourg

8 June 2001

Seule la parole prononcée fait foi

Ladies and Gentlemen,

It is a great pleasure for me to speak to such a distinguished audience of financial professionals. The subject I am supposed to address today, "The future framework for financial regulation within the European Union" is closely related to one of the objectives of your association, which pursues – I quote – "the implementation and the enforcement of a self-regulatory framework governing the orderly functioning of the international securities market." As a central-banker, I definitely favour this approach as one indispensable building block of the defence of the stability of the financial sector, especially in the still very fragmented securities market. In the following I will comment the latest development concerning the organisation of the regulatory decision making process of the EU public authorities from the viewpoint of a central banker and devote some time to the recent developments with regards of oversight of payment and securities settlement systems in Luxembourg.

1.   Capital markets: recent evolution and perspectives

As often stated, in Europe bank intermediation plays a dominant role in the financing of the economy in particular if compared with the US. The stock of debt securities for instance represents only half of the size of the US bonds markets.

The European capital markets have however experienced a remarkable development throughout the last years, not least because of the single currency. Over the last 7 years the stock of debt securities issued by all sectors have shown a steady increase of 5% on average. Since 1993 and until first quarter 2000, the growth rate of the stock market capitalisation has exceeded nominal GDP growth rates. The price effect was certainly determining, but new capital raised by euro-area companies on stock exchanges has been close to the funds raised on US stock exchanges. Despite the recent corrections in the stock markets, it is very likely that we are here confronted with a long lasting trend.

Another evidence of the increase of cross-border transactions relates to the way the counterparties provide collateral for the Eurosystem's credit operations. 18% percent of this collateral is provided on a cross-border basis. In Luxembourg, the forerunner of the trend, 83% of the provided collateral is issued abroad but presented to the BCL either through the links our depositor Clearstream Banking has arranged with other securities settlement systems or trough CCBM, the correspondent central banking model.

In the longer run, non-financial corporates as well as financial intermediaries will increasingly resort to the integrated European capital market to raise the funds that are required by their business. This future European capital market will be thus much deeper and more liquid. The expected benefit for the European economy is obvious: better allocation of resources in macroeconomic terms, which entails an increase of the productivity of capital and labour.

2.   The present challenges for the European regulators

This structural phenomenon will confront the industry and the regulators with new challenges because of the dynamics of market and with a higher volatility of asset prices and the resulting risk of liquidity shortages.

The last fifteen years have shown several unexpected and extreme changes in asset prices coupled with heavy leverage: Stock market crash in October 87, real estate slump at the start of the nineties, Barings in 95, the currency crisis in the Far East in 97, LTCM in 98, etc.

Prices of assets that are traded on open markets have a dual character: the fundamental value reflecting future profits and the speculative value, which equates the value of an asset as a potential claim for immediate cash. Market prices are a mixture of both. In times of market equilibrium it is the fundamental value, which predominantly determines the market price. The dynamics of markets however entail discontinuous price changes when the market equilibrium is lost and a new one is established. In such a situation the demand for liquidity prevails and future profit of a specific asset is often disregarded.

At the same time, securities are more and more considered to be substitutes for liquidity. The financial sector relies on the securities markets as repositories for liquidity. Extreme changes in market prices may thus have a direct impact on the overall liquidity situation.

This is the core of central banks' interest in the smooth functioning of securities markets. Central banks are the only regulators, which have a direct operational responsibility to sort out situations of crisis. It is therefore indispensable that they are consulted when new regulation is worked out in markets, which are of paramount importance for the financial sector.

The future financial regulation in Europe has to address two general objectives: competition and financial stability. It should enhance the framework for a truly integrated market in Europe based on free competition in all the areas of the securities business: ranging from issuing over listing to trading, clearing and settlement. New regulation should create a safe legal environment to mitigate at the same time legal and potential systemic risks.

These two objectives may in certain circumstances be at variance. Central banks, because of their competence in matters relating to financial stability, have to make sure that any new piece of regulation is thoroughly assessed against this latter objective.

This is not to say that the existing situation is satisfactory. The Wise Men Report correctly points to the actual barriers. Most of them are well known. One mentioned in the report is of particular importance for central banks. It relates to the fact that capital markets are based on different market infrastructures: stock exchanges and new electronic communication networks (ECNs), clearing houses and securities settlement systems. The European central banks are indeed important users of some of these market infrastructures, in particular the securities settlement systems, for the management of the collateral required in the framework of their credit operations. The proper functioning of these systems is thus a precondition for the secure and efficient execution of monetary policy operations. Securities clearing and settlement systems are furthermore tightly interconnected with payment systems for which the European central banks have a clear competence.

Their interests as user of SSSs led the European Central Bank together with the national central banks to issue standards against which these systems are assessed before being used for the Eurosystem's credit operations. These standards have meanwhile become a de facto regulation

The approach favoured by the group of experts around Mr Lamfalussy is to propose a rule-making process, which should produce a flexible and homogeneous regulatory framework to support the further integration of the EU securities market. Savings in time and homogeneity are the main goal of the proposal.

The implementation of the four level process does not require an amendment of the Treaty, a very lengthy and uncertain process.

The Wise Man Report is hence an attempt to create within the existing institutional set-up a regulatory process, which should produce completely harmonised national regulation at a much more rapid pace than today.


3.1.   Scope of the reform

The present shortcomings of the EU decision making process as stated in the Wise Men report exceed the area of securities. But the report, due to the mandate given to the group of Wise Men, does obviously not address other areas. Also, it is questionable whether similar procedures with new committees could be the response to all the existing shortcomings. In particular, differences between legal systems have to be reduced in order to foster cross-border transactions and business.

3.2.   Complexity of the reform

The procedure and the involvement of different entities, EU Commission, EU Parliament, the Council of Ministers, the two new committees: the EU Securities Committee (ESC) and EU Securities Regulators Committee (ESRC), is not straightforward.

For instance, the ESC and the ESRC have different capacities depending on the level at which the process is situated. The ESC is a regulatory Committee under Article 202 of the Treaty. At the same time, it has also advisory capacities to the Commission with respect to Level 1 legislation and it advises the Commission on Level 2 mandates for the ESRC.

3.3.   The commitment of national regulators

The voting procedure of the new ESRC depends on the level at which a proposal is discussed. Whereas in Level 2 issues the ERSC should not decide on a unanimity basis, but with qualified majority, the same committee should decide by consensus in Level 3, when it tackles the day to day transposition and implementation of Level 1 and 2 legislation. This may not be the best guarantee for complete homogeneity. National regulators need to have a far-reaching commitment to the whole process and its results, especially when they have to implement detailed regulations concerning decisions they did not support previously.

3.4.   The recourse to the comitology procedure

To speed-up the regulation process, the Wise Men report proposes that the Council delegate to the Commission the powers to issue technical rules implementing Level 1 legislation. These rules approved by the ESC would be binding on all Member States. The success of the procedure depends among others on the speedy adoption of a comprehensive framework at Level 1. As this stage is of paramount importance for the whole process, appropriate safeguards for efficiency and transparency should be guaranteed.

3.5.   The involvement of central banks

The ECB has on the basis of Art. 105.2 of the Treaty the task to ensure the smooth functioning of payment system and, on the basis of Art. 105.5, the task to contribute to the smooth conduct of policies relating to prudential supervision and financial stability.

As any market failure may entail liquidity shortage for a single or for several impacted institutions, central banks as ultimate liquidity provider are responsible for the resolution of such crisis.

The Eurosystem therefore considers that it has a true interest in the whole new decision making process, in particular in matters relating to Level 1 legislation or Level 2 regulations, all the more the ECB itself has a regulatory power on the basis of Art. 22 of the Statute of the ECB and the ESCB.

The Wise Men initiative is certainly a step forward as it signals the awareness of the political sphere concerning the present inefficiencies and the necessity to correct them. Since the institutional set-up cannot be streamlined in a near future, it is of utmost importance that existing competencies are recognised and that all the involved parties are consulted in this new rule making process. This is certainly true for central banks, this is not less true for the market participants.

4.   The situation in Luxembourg with regard to the oversight of SSSs

4.1.   The legal situation

In transposing the settlement finality directive (law from 12 January 2001), the Luxembourg Parliament has formally recognised the competence of the BCL over payment systems and securities settlement systems. This new law indeed entrusts the BCL with the oversight and the notification to the EU commission of those payment and securities settlement systems the BCL itself or any other EU central bank participates in.

4.2.   The way forward for the BCL

The BCL is preparing the framework for its new competence relating to oversight of payment and securities settlement systems. We are about to publish two papers explaining our assessment of the various risks resulting from participation in those systems. The broad categories are financial risks - mainly credit and liquidity risks - operational risks that are all the more important that those systems are highly automated and, last but not least, legal risks. We furthermore are drawing up the detailed requirements system operators under our oversight have to comply with.

To ensure coherence with the work carried by other central banks out in the area of oversight of payment and securities settlement systems, we will build up our framework in line with two recent reports. I am referring to the "Principles for Systemically Important Payment Systems" published by the CPSS ("Committee on Payment and Securities Settlement Systems") and "Recommendations for Securities Settlement Systems" published by a joint task force established between the CPSS and the IOSCO (International Organisation of Securities Commissions"). This latter report has been published in a consultative release to gather comments from all the market participants. As you may have noticed, most European and other countries are right now in the process of setting up similar frameworks and organising the day to day monitoring and oversight.

Let me devote some words to a recent event, which caused concern not only here in Luxembourg and which one could consider as a case study of oversight. As you all know, the Luxembourg financial centre together with its authorities has been put under scrutiny after the decision of the Luxembourg prosecutor to start a formal investigation into the activities of Clearstream Banking.

As regards the BCL, I have to note that money laundering as such is not part of our competence as overseer of securities settlement systems. Our role in this respect is first of all to make sure that Clearstream as securities settlement system functions properly and that it still deserves the confidence of its customers. Although our new responsibilities as overseer of Clearstream only started in January, we had in the last couple of weeks frequent contacts with representatives of Clearstream and the involved auditors. We did not until now come across material evidence, which would lead to a fundamental questioning of the settlement system run by Clearstream Banking. We therefore issued a press release on 16 May to reassure the financial markets in this respect. A final assessment will be made after the results of the judiciary investigation have been made public.

I have also noticed that this event gave a new impetus to speculations concerning the future of the European securities settlement industry. For some observers, the future of Clearstream itself seems to be rather cloudy, which, concerning a major building block of the Luxembourg finance centre, would be particularly worrying. Together with other Luxembourg authorities, we have to make sure that the child is not thrown out with the bathwater.

As regards the future of the securities clearing and settlement industry, two different models, supported each by two different banking communities, seem to be opposing: the vertical silo against the horizontal model of a merger between the two ICSDs. Whatever the outcome of this battle will be, a lot of issues will have to be tackled first. Any further step in the consolidation process will for instance raise the issue of competition and the related choice of the corporate structure of the new entity: profit making company versus public utilities. Other issues relate to the interlinking of the new entity with other market infrastructures: other SSSs, Clearing houses, Stock exchanges, ECNs, and so forth.

Unless solicited by the private sector, central banks have to keep out of these decisions. They have however to ensure that:

  • the new system is eligible for the management of the ESCB collateral,
  • a level playing field is granted for all financial institutions from the big players down to modest regional banks, be they investors, issuers, intermediaries or market infrastructures,
  • that the new system adds to a more integrated and efficient European securities market and, last but not least,
  • that it accurately addresses the various risks inherent in securities settlement systems.

The recent events around Clearstream have also clearly shown the indispensable co-operation between the Luxembourg banking supervisor, the CSSF, and the BCL. Both institutions have signed last April the "Memorandum of understanding on co-operation between payment systems overseers and banking supervisors in stage three of Economic and Monetary Union", which has been worked out between the Eurosystem and the national banking supervisors. But we have to go further and flesh out the co-operation between the CSSF and the BCL as laid down in this MoU through a regular exchange of relevant information and close co-operation, as BCL had already proposed in a draft bill. This will undoubtedly be an important aspect of the seriousness of our finance centre in the future.

To conclude and to broaden somewhat the scope of the topic, I would like to quote from a recent opinion of the ECB on the role of a NCB of a country where prudential supervision has been entrusted to a separate supervisory agency:

The national law should make clear that the central bank has responsibility for the overall stability of the financial system as a whole, as a separate function from hands-on supervision and financial regulation. (...)  Central banks are in general in an advantageous position to fulfil the responsibility for financial stability, given their insight into money and financial markets developments and involvement in payment systems and monetary policy operations. This is both on an ongoing basis and in crisis management situations. (...)  An NCB should be expressly assigned the task of contributing to the conduct of prudential supervision of financial intermediaries, in close co-operation with the supervisory agency. (...)  Exchange of information should occur on an ongoing basis, not be dependent on the occurrence of specific events. The principle of co-operation should be expressly included in the establishing laws of the NCB and the supervisory agency. (...)  This includes that a NCB should remain a recipient of information from reporting institutions and that access to information should include the other sectors of the financial system, which may be deemed relevant for the stability of the financial system. The central banks should have the means to assess possible systemic implications of the behaviour of complex financial groups on money and capital markets as well as on payments and settlement systems. (...)  Market and credit risks are related in many aspects (...)  and an NCB should be involved in on-site inspections. (...)  In view of its financial stability role, a NCB should be provided with on advisory role for all national legislation falling within such field of competence. (...) 

In the area of payment systems, an NCB should be granted "a regulatory power (...)  consistent with the objectives and principles defined at the level of the Eurosystem in case no ECB regulation has been adopted. NCB should also be entitled to impose sanctions in cases of non-compliance with its regulation.

Ladies and Gentlemen, I thank you for your attention.