Address by Gareth Murphy, Director of Markets Supervision, at the Euromoney 3rd Prospectus Directive Conference

Introduction

Many thanks to Yvonne Hynes and her colleagues at Euromoney for the invitation to speak at this the 3rd Prospectus Directive (PD) Conference.¹  It’s great to be back in London.

Since the introduction of the PD, over ten-thousand prospectuses have been approved in Ireland making it the second largest jurisdiction for issuers in Europe. Whilst I have something to say about the Central Bank's experience of implementing the PD and our approach to the Amending Directive, I will also share with you some of my observations of how securities markets have functioned over the last twenty years drawing on my prior experiences as poacher and gamekeeper.

The key questions I would like to explore this morning are:

What level of investor protection can we reasonably expect from the Prospectus Directive and the Amendment to the Directive?
To what extent can a disclosure-based regulatory regime protect investors and deliver good primary market outcomes?
To what extent have investors held issuers to account for the quality of disclosure?
What other tools must operate in tandem with the PD in order to ensure orderly and efficient primary securities markets?

I will argue that disclosure-based regulatory regimes, on their own, have their limitations. The form, content and quality of information disclosed matters. Investors need to exploit the full benefits of in-house and third-party analysis as well as better information technology and they need to maximise their leverage over issuers to get better asset pool data. And policy-makers should be alive to the advances in regulation in other product arenas so as to avoid re-inventing the wheel.

Why Regulate?

Let me start be asking:

1. what is the purpose of primary securities markets?
2. what does it mean for them to work well? and
3. how can regulation help?

I think that this is the right sequence of questions because, ultimately, the purpose of regulation should be to support the economic function of the financial service being provided.

Economic Purpose of the Primary Markets

Primary securities markets match investors with issuers. Issuers seek capital for investment projects which ultimately support capital formation in the real economy. Investors seek to put excess reserves to work consistent with their return, risk and cash-flow preferences.

At its simplest, regulation should support the efficient functioning of this marketplace. That means safeguarding investor protection, maintaining market integrity and mitigating systemic risk. Insofar as there are impediments to market efficiency, regulation will seek to mitigate those frictions which distort prices or constrain the sustainable flow of investment capital to the real economy.

That all sounds like plain-sailing until we encounter the triple hazards of information asymmetry, incentive misalignment and imperfect decision-making which confound safe navigation through the unpredictable waters of primary securities markets.

To my mind, these hazards are ‘immutable forces of human nature’ which shape the world in which we live.

Since the Kansas 'Blue Sky' laws of 1911 and the reforms following the Wall Street Crash over 80 years ago, policy-makers have seen the need to regulate primary securities markets. Since the 1960's, economists have understood the need for regulation of primary securities markets. At times, issuers with good paper to offer have failed to achieve a fair price at issue and in some cases have not progressed to market at all. At other times, investors cannot assess the value of a prospective issue or worse, are disappointed by information which emerges subsequently. We know that the market for financial transactions is characterised by (i) sellers who know more (than the buyers) about what they are selling, (ii) agents (in the production and distribution process) who expect different payoffs from the same economic outcome and (iii) buyers who are struggling to make decisions in an uncertain environment ². These so-called economic frictions, justify the intervention of financial authorities through monitoring, regulation, supervision and enforcement.³

About the Prospectus Directive (PD)

Diligent investors tend to reward issuers who take the trouble to signal the quality of their securities[4]. Where investors cannot distinguish good issues from bad issues there is the risk of bad market outcomes – the classical example being the market for used cars: if too many dud cars are offered, the good cars do not trade.^{5 6}  Ideally a regime such as the PD should encourage disclosures which facilitate good investment decisions. And there is substantial evidence that better disclosure which differentiates higher quality in a way that can be priced is rewarded by lower costs of capital for issuers.⁷

The financial crisis has shown that when the banking system is paralysed, capital markets can play an important role in providing credit to the real economy.⁸   Given the current state of the European banking system, well-functioning primary markets matter now more than ever.

As you know, with the introduction of the PD in 2005, an EU framework was delivered for the preparation of prospectuses for securities issued by way of public offering and where they are to be admitted for trading on a regulated market.

The aim of the PD was to enhance investor protection and improve the efficiency of the single market by harmonising the requirements for the drawing up, approval and distribution of the prospectuses that are published. In particular, a key innovation was the provision of an EU passport to issuers whose prospectuses had been approved. This provision removed borders between EU capital markets.

The Amending Directive was implemented on 1 July 2012 and included various changes, such as:

• an increase in wholesale debt denominations (from €50,000 to €100,000)
• some restrictions on the content of Final Terms documents
• a more proportionate disclosure regime for rights issues and for SME issuers, and
• new requirements for the content of Summary’s

What worked well?

If we take stock on seven years of the PD, there are many positives:

• The passporting regime has been an undoubted success. It brought greater certainty for issuers wishing to access more than one market, it reduced the cost to issuers and it made it easier for documents to be compared across different sectors and jurisdictions. (The Amending Directive further underpins the benefits of PD regime by reducing to the maximum extent possible the administrative burden to issuers preparing a prospectus by enabling a reduced disclosure regime for rights issues and SME’s).
• The maximum turn-around times for comments on documents that are hard-coded into the PD provides issuers with certainty of process and identifies clear responsibilities for regulators;
• The PD promotes enhanced transparency – for example, with regard to risk factors, financial information prepared under IFRS (provides a common financial language), pro formas, valuation reports, material contracts and related parties.

It is worth noting that despite intense scrutiny there has been no call from investors to substantially revise the PD unlike other legislation in the financial services arena.

Areas for improvement

Casting a more critical eye over the evolution of prospectuses during that time, it is worth asking (i) whether the quantum of disclosure is excessive in some cases?, (ii) whether more could be done with the identification of risk factors such as explaining what mitigants are, or could be, in place? and (iii) whether the responsibility for certain disclosures may be so diffuse as to be legally unenforceable?

In recent years, investors have been faced with the herculean task of digesting the intricate contents of a document often the size of a large novel, penned by many authors with many inter-weaving plot-lines and a sure-fire cure for insomnia on a long-haul flight. At times, the quantum of disclosure has masked the key areas of risk. And the complexity of different scenarios envisioned in the document begs the question as to whose interests are being looked after: investors, issuers or the agents of the issuers? Lastly, my experience of bidding on initial offerings was that I often had little or no time to consider the detail in a prospectus before the books closed - but perhaps we should save that for a discussion on MiFID and PRIPS.

There are a number of issues to unpick here related to:

• the intent and effect of complex disclosure,
• the cognitive capacity of investors, and
• the extent to which issuers and their agents can be held legally accountable when there is mis-disclosure

And this final point leads me on to an important observation in relation to the PD, namely, the lack of case law in relation to possible breaches of the PD.

Lack of case law

It may, in fact, be too early to judge the success or otherwise of the PD. The PD has only been in place for seven years and for a significant portion of that time the economic and market environment has been quite turbulent. But it is puzzling that there is very little case law in this area. It begs two questions:

• were there no instances where investors saw themselves at the sharp-end of misleading disclosure by issuers?
• or is it simply the case, the PD does not empower investors to tackle issuers over possible misleading disclosures?

Effective regulatory regimes have a number of attributes but one of them is that civil lawsuits or enforcement proceedings are a strong deterrent against regulatory breaches. In particular, liability for failure to comply with regulations should be clear.

The lack of case law may suggest that the probability of successful prosecution of issuers under the PD may be too low.

Lessons from the financial crisis

UK Securitisation Market during the Financial Crisis

Back in 2010, I lead an extensive UK Tripartite consultation with the securitisation industry into the factors underlying the failure of the market for UK retail mortgage backed securities (RMBS). What is interesting is that the PD has been the underlying regulatory framework for the issuance of UK RMBS and ABS since 2005. And yet the market ground to a halt – save for retained issuance – in 2008.

Back then we learned that many significant high quality institutional investors and their advisors shunned the sector because they saw it as an insiders’ market.

Bespokeness begat indifference, caution and in some cases of outright suspicion. This was due to the intractability of the prospectus, the complexity of the structures involved and the untested nature of the embedded legal mechanisms. For example, the lack of market experience of non-asset triggers was dramatically exposed by Northern Rock’s Granite Master Trust in November 2008 ⁹ . This event crystallised the nature of RMBS in states of the world which had not been previously encountered and the adverse reaction in the UK RMBS market was dramatic. ¹⁰

During the boom in issuance of asset backed securities from 2003-2007, many investors simply did not read the prospectuses. In fact, during the consultation process, I often heard people say that ‘the prospectus was only read when something went wrong’. That's a bit like unwrapping the flight manual whilst the airplane is nose-diving.

Back then, most high-grade ABS issuers provided asset-pool data exclusively to credit ratings agencies (CRAs). That CRAs were the privileged recipients of this data should not be too surprising given the powerful position they were in vis-à-vis the issuers. In contrast, monthly loan-level data were available for UK sub-prime loan pools. Many respondents to the consultation questioned whether investor access to this detailed data for prime RMBS would have averted the disruption in the UK RMBS market.

I believe that access to this data is a necessary complement to a regulatory regime, like the Prospectus Directive, which aims to protect investors. It will also ensure better standardization of key concepts (such as mortgage arrears). It will enable investors to balance their own analysis with the recommendations of the CRAs and other advisors. It may also encourage them to challenge the ratings processes of CRAs. (In defence of CRAs, it may also help investors to avoid conflating credit ratings (which measure whether an issuer will pay as promised) with measures of liquidity (which measure how easy it is to buy and sell)).

The limitations of disclosure regimes

Whilst searching questions could be asked of the PD as a disclosure regime for providing investor protection, it is important to be realistic as to the limits of such a disclosure framework. Before I start, it is worth pointing out there is an extensive literature on disclosure covering non-financial markets such as medicine, nutrition, IT products to name but a few.¹¹  And whilst behavioural economics is like the new religion in the light of the financial crisis, many of its tools and concepts which have developed over the last fifty years have been applied in many markets for non-financial products.¹²

More disclosure – marginal gain or marginal pain?

There is a greater appreciation that there are costs to understanding financial products. In some cases, investors will need to enlist third-party experts to advise on particular complex matters. It may also be the case that complexity defies analysis due to flawed or ambiguous design or due to uncertainties in the legal process, eg the treatment of client assets in a corporate insolvency. There is a trade-off between the cost of information acquisition and the benefits of more information. For example, in the labelling of nutrition products, efforts have been made to present the additional information in a form which can be readily identified and understood by the consumer. In this arena, there is an understanding that more information requires greater efforts by the product producer to make the information easier to assimilate.¹³

Innovation vs Standardisation

Product differentiation is a feature of most markets. Issuers are incentivised to create something which can be distinguished from that of their competitors. In the market for structured securities, I have found that this is less an issue of brand identification and more a consequence of tailoring the payoffs of a security to the - often opaque - idiosyncrasies of the assets paying the cash-flows. In fact, these idiosyncrasies are often a function of the distribution model of a bank or another financial institution. One of the strong recommendations arising out of the financial crisis was that some form of standardisation of securities was necessary. Lack of standardisation was a barrier to investor understanding and ultimately it undermined trust between investors and issuers.¹⁴

Against that, standardisation can be the enemy of innovation.¹⁵  And such innovation may be necessary to ensure that new projects can be funded and that investors can achieve their preferred risk, return and cash-flow profiles.

Promoting Tractability

Disclosure is one thing. But if the structure of a security is difficult to understand or, more importantly, difficult to model it is likely that investors will struggle to determine fair value. I do believe that is probably beyond the scope of the Prospectus Directive, which is not a merit-based approval regime, to accommodate amendments which would aim to filter out securities with intractable payoffs. But the fact that this problem exists and that it confounds the investment decision-making process highlights the challenges of creating a primary market place where investors can make fully informed investment decisions. Designing a regulatory regime which promotes securities that are easy to price is difficult when modelling capability is proprietary and the models are quite imperfect in the first place. Industry standards – as opposed to regulation – may have a role to play here.

Making primary markets more efficient in the future

A more prescriptive disclosure regime?

“A growing body of research shows that the way information is displayed can influence decision-making processes”.¹⁶  The introduction of the Key Information Investor Document (KIID) in UCITS products and the evolution of the Summary contained in prospectuses aim to solve the problems of selective disclosure and excessive disclosure. These documents set out to present the salient features of an issue in plain English in a few pages. What is significant from a regulatory perspective is that this is a refinement in the approach to disclosure-based regulation. It is a clear acknowledgement that caveat emptor and minimum disclosure requirements will not suffice to protect investors irrespective of their sophistication. The volume of information is limited and the informational content is refined. Some might say it is dumbed down and there is a genuine risk with this approach insofar as the description of certain products simply cannot be shoe-horned in this way without the possibility of causing confusion.

Gold Standards

Mindful of these limitations, I would suggest that for certain asset classes a level of standardization could be achieved through the creation of securities with certain standard features which can be easily summarized and which would lend themselves to being readily priced. Financial authorities have perhaps more of a co-ordinating role here rather than a rule-making role. As an aside, I would add that we should not underestimate the consequences (i) of new banking liquidity rules and (ii) the way central banks haircut collateral in exchange for liquidity in indirectly promoting certain types of securities.

Role of investors – ‘Physician heal thyself’

Drawing on an analogy from the medical world ¹⁷, it is well known that if there are a sufficient number of smart patients, then there is a healthier physician-patient dynamic where physicians are incentivised to deliver the best advice. In the context of the PD, if the content and quality of prospectuses is not challenged, the quality of disclosure will suffer.

One of my key messages this morning is that investors must take more ownership of their own investment analysis.

Back in my trading days, we often used to say that ‘a good trader was one who was never sold a pup’ – that’s colloquial Irish for spotting mutton dressed as lamb. Likewise, investors must do the necessary analysis to discern structures and products which may not be suitable for their risk appetite or cannot be readily understood.

Following the herd, because the product has an attractive yield and the risk seems low by virtue of its rating, recent performance or peer investor appetite is not good enough. Investors should have the analytical tools and access to the information to deconstruct the product, demystify the risks and then track the progress of the product along its different risk dimensions during the course of the investment holding period.

There is a role for consultancies and ratings agencies to act as advisors and third-party delegated monitors. My key point here is that investment managers must have the tools to challenge their advisors. If that cannot be done, then the advice should not be acted upon.¹⁸  But there must be solid base of (static and dynamic) data to work off, namely a digestible prospectus and regular issuer updates.

Need for more issuer information

I mentioned earlier that many investors and advisors did not see how access to asset pool data would have averted the interruption in the UK RMBS market in 2008. But, I have also argued in favour of the advantages of having this information as a complement to the wider disclosure regime which aims to ensure that investors are informed and can be protected. Just like low-fares airlines created a new market for air travel by flying to places people could not previously reach, the provision of this data could nurture investor demand for more data and improve the analysis of new issues and the tracking of outstanding issues.

Given the advances in information technology and improved monitoring infrastructure of issuers, the obvious gap in our disclosure regime is a reliable data collection, processing and analysis framework. Credit ratings agencies and credit reference bureaux fulfil these roles for rated securities and personal credit assessment, respectively, with varying levels of success. Both are examples of oligopolistic markets where access to information and economies of scale are a barrier to entry. The challenge is to build a data infrastructure framework which supports an analyst industry with lower barriers to entry. I think that there is a role for a number of well-established exchanges with strong primary markets listing franchises here. They see the flow. They have a natural touch-point with issuers. They are, increasingly, information technology companies. And, with some effort, there is a potential market to offer regularly updated asset pool data to investors. (Central Banks have entered this space in a limited way as part of their collateral management operations but it is not clear that they are natural providers of this service.)

Conclusions

In conclusion,

• The PD has created a more reliable issuance process and provided a surer path to market but the lack of case law, following the financial crisis, is puzzling and begs the question whether it sets too low a hurdle for the quality of disclosure;
• disclosure-based regulatory regimes are severely limited when issuers and issuers’ agents can control the form, content and volume of disclosure to the point of excess but prescriptive disclosure regimes will constrain innovation and may cause further confusion;
• so disclosure-based regulation must be complemented by other measures which are market-driven (like asset pool data warehouses) or prompted by financial authorities and industry bodies (like standardized products).

Whilst the PD may be subjected to a number of further improvements, there are a number of complementary regulations (such as MiFID, MAD and PRIPS) and complementary developments such as the FSB initiatives on data gaps¹⁹ which, in the fullness of time, may help to make primary securities markets more efficient.

One final point, looking at the genesis of the PD and, in particular the background literature supporting the drafting and consultation processes up to 2005, I find a lack of reference to the substantial work done in other product arenas such as nutritional products and medicines. This work has addressed some of the challenges with labelling and the limitations of human cognitive processes. I wonder, at times, whether significant parts of financial regulation, such as the PD, are akin to species which have evolved on an island in the South Pacific waiting to be discovered by a latter-day Darwin and paired with their cousins on another continent - or in this case another product arena.

References

Akerlof, G., (1970), “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism”, Quarterly Journal of Economics

Arora, A., and Telang, R., (2005) “Economics of Software Vulnerability Disclosure”, IEEE Computer Society

Bank of England, (2011) Quarterly Bulletin, Q1 Volume 51

Cumming, F., and Murphy, G., (2012) “Issuer retention as a signal of quality in the securitisation market”, forthcoming Bank of England Working Paper

Deb, P., Murphy, G., Penalver, A., and Toth, A., (2011) “Whither the credit ratings industry”, Bank of England Financial Stability Paper

Dennis, R., (1987) “Mandatory Disclosure Theory and Management Projections: A law and economics perspective”, Earle Mack School of Law at Drexel University

Fishman, M., and Hagerty, K., (1990) “The optimal amount of discretion to allow in disclosure”, Quarterly Journal of Economics

Grossman, S., (1981) “The informational role of warranties and private disclosure about product quality”, Journal of Law and Economics

Farrell, J., and Saloner, G., (1985) “Economic Issues in Standardization”, MIT working paper

Financial Stability Board (2009), “The Financial Crisis and Information Gaps” Report to the G-20

Haldane, A., (2009) “Rethinking the financial network”, Bank of England, speech delivered at the Financial Student Association, Amsterdam

Huang, H., (2011) “The regulation of securities offerings in China: Reconsidering the Merit Review Element in Light of the Global Financial Crisis” Hong Kong Law Journal

Tversky, A., & Kahneman, D. (1981) “The Framing of Decisions and the Psychology of Choice”, Science

Levy, A., Fein, S., and Schucker, R., (1991) “Nutritional Labelling Formats: Performance and Preference”, Food Technology.

Murphy, G., (2012), Address at InvestoRegulation Conference on Hedge Fund Regulation

Rochaix, L., (1989) “Informational asymmetry and search in the market for physicians’ services”, Journal of Health Economics

Schkade, D., and Kleinmutz, D., (1994) “Information Displays and Choice Processes: Differential effects of organization, form and sequence”. Organisational Behaviour and Human Decision Processes.

Teisl , M., and Roe B., (1998) “The Economics of Labeling: An overview of Issuers for Health and Environmental Disclosure”

Verrecchia, R., (1983) “Discretionary Disclosure”, Journal of Accounting and Economics

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¹ http://www.euromoneytraining.com/Course/4921/Legal-Training-UK-and-EMEA/CourseInfo.html

2 See Haldane (2009)

3 See Murphy (2010)

4 See Grossman (1981)

5 See Akerlof (1970)

6 See Cumming and Murphy (2012)

7 Bushes and Leuz (2005) and Arora and Telang (2005).

8 See Bank of England Quarterly Bulletin, 2012, Chart 6

9 See Regulatory News Service Number: 5496, 20 November 2008

10 In the case of the Granite Master Trust, the non-asset trigger lead to a change in the repayment priorities on the notes issued out of the trust when the issuer reduces their stake in the loan pool below a minimum level even though the assets are performing.

11 See Teisl and Roe (1998)

12 Kahnemann and Tversky (1981)

13 See Levy, Fein and Schucker (1996)

14 See Schkade and Kleinmutz (1994)

15 See Farrell and Saloner (1985)

16 Kleinmutz and Schkade (1994)

17 See Rochaix (1989)

18 See Deb et al (2011)

19 See FSB (2009)