The Importance of Transparency in Securities Markets - Colm Kincaid, Director of Securities and Markets Supervision

Remarks at Trinity College inauguration of new Postgraduate Law and Finance degree

Good evening, it is a pleasure to be here to mark the inauguration of Trinity College Dublin’s new postgraduate Law and Finance degree and to have the opportunity to say a few words with respect to the fascinating paper being presented this evening by Professor Henry Hu on the phenomenon of debt and equity decoupling.

I want to begin by congratulating Trinity College on its new degree. I wish the best of luck to both the faculty and its students. I am myself a graduate of law here in Trinity (now some time ago). I have many fond memories and will be forever grateful to Trinity for the gift of learning that I received. Working now as a regulator at the Central Bank of Ireland, and looking back to my previous roles as an in-house lawyer in the Central Bank and industry, as well as my time as a commercial lawyer in private practice here in Ireland and abroad, I can see the great benefit that the discipline I learned here and its ethical foundations has provided to me.

Professor Hu’s work on the topic of this evening - the impact of the phenomenon of debt and equity decoupling on financial markets - is, I would say, driven by these same ethical foundations. His is both a fitting and thought provoking body of work for this evening’s event.

I should also take the opportunity to voice the support of the Central Bank of Ireland for educational initiatives such as this Law and Finance degree. At the Central Bank we place a huge importance on the development of our people through continuous further learning across their career, and we invest heavily in supporting our people financially to do so. This includes funding further third level education as well as developing our own One Bank Curriculum to give more bespoke formal learning to our people.

We are also looking at how best to bring diverse talent into our organisation through combining our more traditional recruitment streams with new mechanisms, including a considerable level of dedicated graduate recruitment and a scholarship programme where students can commence full time work at the Central Bank while still completing their studies .

Standing here in Trinity’s new Business School building, I can remark that we also have a relatively new building, and (as those of you who work in this building will no doubt agree) it is great to work in a modern building with the benefits that brings.

Now I will stop my recruitment campaign for the Central Bank of Ireland (further details of which are on our website ), and return to the topic of debt and equity decoupling.

The role of financial services

Professor Hu’s work illustrates the critical role financial services play in the lives of all of us here in this room, and people all over the globe. Given Ireland’s prominence in global financial services, it merits close consideration. To give just a flavour for Ireland’s prominence, for example, by value, Ireland is home to almost half of EU authorised money market funds and over half of EU exchange traded funds. Total assets under management of funds incorporated and authorised in Ireland stand at just over €3 trillion. In 2018, we granted 1,117 fund authorisations, more than any previous year and 2019 shows continued growth. These funds have investors in up to 90 jurisdictions worldwide.

Also, we are the EU jurisdiction that authorises the highest number of applications from issuers for approval of EU prospectuses. These issuers come from countries in Europe, the USA, Africa, Asia and the Middle East.

We are also seeing a considerable growth in the secondary market activity carried on in and from Ireland, including both new firms and firm types. The advent of Brexit is accelerating this as UK firms establish new regulated entities in EU 27 jurisdictions in order to be assured of their ability to continue to provide their services across the EU.

Finally, since the financial crisis there has of course been a significant and necessary growth in regulatory requirements with which firms and issuers must comply, and which we have to supervise. These requirements are increasingly detailed, and increasingly come with extensive reporting obligations. In my own area of securities and markets supervision, we now receive and process millions of transaction reports every day.

As with the firms we regulate, we have to make greater use of technology to understand and interrogate this level of data. Indeed, in securities markets, we are increasingly supervising not just the conduct of individuals but also the conduct of machines, as firms use algorithms and artificial intelligence to provide their services. This raises challenges at both an ethical level and at the practical level of how to regulate this kind of activity.

So, there is plenty of new ground for the Law and Finance students of Trinity College to explore.

The approach of the Central Bank

As a Central Bank within the EU and the eurozone, with both a prudential and conduct supervisory mandate across virtually all sectors of financial services, at the Central Bank of Ireland we have a very particular perspective on these developments and how the various features of our mandate interlink to support one another. Our mission is to serve the public interest by safeguarding monetary and financial stability and working to ensure that the financial system is operating in the best interests of consumers and the wider economy. 

As an EU competent authority working together with our fellow regulators in the EU, this includes looking to the interests of users of financial services across the EU as a whole, as well as the interests of consumers and investors here in Ireland.

In considering my remarks this evening, I gave some thought therefore to what connects the topics in Professor Hu’s work, our own work as a regulator and the principles and philosophy underlying Trinity’s decision to launch a Law and Finance postgraduate degree – and indeed my own experience as a Law student here in Trinity.

And the connecting point that comes through is that of Trust.

In particular, Professor Hu’s work on Decoupling and Transparency illustrates the effect where market participants can no longer trust that the market is operating in the manner in which they had understood when investing their money. Or, to put it more directly, participants do not trust that all the information they should have is being made available to them. Indeed, he describes the phenomenon of debt decoupling in these terms when he says:

"Debt decoupling involving the unbundling of the economic rights, contractual control rights, and legal and other rights normally associated with debt, through credit derivatives and securitisation. Corporations can have empty and hidden creditors, just as they can have empty and hidden shareholders.”

This concept of the ‘hidden’ and the concerns it creates for market participants, as well as the extent to which it can dissuade potential investors, is something we should be concerned about.

I have remarked before that it is interesting in this context to note that the EU’s largest capital market segment is its funds industry and the largest component of the EU’s funds industry comprises the highly regulated and retail investor focused UCITS sector. There is a lesson here about how a solid regulatory framework, with high quality disclosure, can overcome this fear of the ‘hidden’ when it comes to investment (especially for retail investors) and, in doing so, contribute to achieving the goals of EU Capital Markets Union.

This is one of the reasons we place such a focus on assertive supervision of UCITS, including in our recent reviews on performance fees and the topic of closet indexing. Indeed, the topic of closet indexing is one that goes to the heart of this concern for investors that something may be going on that is hidden from what appears on the face of things.

At the Central Bank of Ireland, we decided to tackle this concern about closet indexing by conducting the largest data driven review of our funds industry ever . We conducted over 143 million data tests comparing each of approximately 15,000 share classes of the 2,550 Irish UCITS funds that describe themselves as actively managed against a total of 2,500 worldwide indices, in order to identify those funds that (while describing themselves as actively managed) displayed traits of tracking an index consistently over a five year period. We also reviewed over 900 documents from the funds identified, from prospectuses to key information documents to sales literature and investment management agreements.

From this, we identified 182 funds for further review and we are now in the process of following up with those firms where we have identified disclosure or other deficiencies. This follow up includes requiring communication to investors where we consider that those investors were not given sufficient or accurate information.

Innovation

Professor Hu also outlines that this ‘hidden’ effect can also be facilitated by market innovation. This is a message that we as regulators need to continue to keep in mind as we consider and supervise innovation in financial markets. We need to be ever vigilant to the incentives that innovation can create, and how those incentives might play out in practice (including in times of market stress).

In an EU context of course, the 2013 amendments to the Transparency Directive recognised that financial innovation had led to the creation of new types of financial instruments that give investors economic exposure to companies and that disclosure of holdings acquired through these instruments was required to ensure that issuers and investors have full knowledge of the structure of corporate ownership and those that influence it. To this end, the range of financial instruments to be considered when determining if a notification threshold is crossed was extended to include instruments considered to be economically equivalent to holding a share e.g. options, swaps, CFDs. To provide clarity to the market regarding the types of instruments requiring disclosure, ESMA established an indicative list of instruments subject to the notification requirements. This list includes for example rights to recall loaned securities, warrants, repurchase agreements and other conditional contracts.

A proper and effectively supervised securities market

Where does all this leave us? Well, I think it reinforces the need for us as regulators, and for policymakers and industry, to be clear on what type of securities market we want to see. It is only through this lens that we can properly interpret what the laws we deal with every day are seeking to achieve.

As a person who cannot pass by a skateboarder in a public park without asking myself - ‘is that a vehicle?’ - I can see the sense in the dynamic environment of securities markets to not just thinking about the ‘core’ situation that the rule had in mind when it was written but also the ‘penumbra’ that surrounds that, where the hard cases lie. As supervisors, we deal with these hard cases every day, and it is simply not possible to write a rule to cover every scenario – as I think Hart realised with his skateboarding example. We need to resort to guiding principles to decide whether what we are doing is really delivering the public service that we have been asked to deliver by the legislation we have to police.

So, what should those principles be?

While there are many ways to articulate what a proper and effectively supervised securities market should look like, at the Central Bank of Ireland we contend that it must satisfy five principles:

• It must have a high level of protection for investors and market participants.
• It must be transparent as to the features of products and their market price.
• The market must be well governed (and comprise firms that are well governed).
• The market must be trusted, by both those using the market to raise funds and those seeking to invest.
• The market must be resilient enough to continue to operate its core functions in stressed conditions and to innovate appropriately as markets evolve.

These principles guide us in our work. I would be interested to hear what Professor Hu thinks of them – and I expect he can put forward many aspects in which securities markets need to improve if they are to continue to satisfy these principles.

And perhaps there is the bones of an exam question or academic paper forming in the minds of staff members in the audience. Just a suggestion.

Concluding Remarks

It is inevitable perhaps that, when we look at topics such as the ones we are discussing this evening, our outlook is heavily influenced by the events of the last financial crisis and its aftermath. It is also fair to say that, be it MiFID II, EMIR, SFTR or other measures here in Europe and around the globe, we are only now seeing the full suite of post-crisis reforms taking effect. It is also fair to say that more remains to be done here to develop an EU capital market to serve investors and the wider economy.

We are at a critical point therefore in terms of both taking stock of how successful we have been in enhancing the regulatory framework in the wake of the last financial crisis and considering the resilience of that framework for the years ahead.

It is an interesting time therefore to commence the study of law, finance and how they inter-relate. Both the financial crisis itself, and the groundbreaking work of Professor Hu and others in this field, should continue to warn us all to both recognise the potential of innovation and be vigilant to its risks and unintended consequences.

I want to thank Trinity College once again for the opportunity to speak to you this evening. Congratulations to everyone involved in launching the Law and Finance degree and to the students embarking on it, I wish you well. As you can see, there is plenty to get your teeth stuck into, and when you conclude your studies there will be plenty of thorny issues for you to grapple with in our securities markets.

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I want to thank Helen Ward for her assistance with these remarks.

¹ Central Bank of Ireland: Learning and Development

² Central Bank of Ireland: Graduate Programme 2019/2020

³ Central Bank of Ireland: Scholarship Programme 2019/2020

⁴ Central Bank of Ireland: Careers

⁵ European Commission: Ethics guidelines for trustworthy AI (8 April 2019)

⁶ Kincaid, C: The role of RegTech in financial services, 8th DCU Fintech Symposium (4 December 2018).  

⁷  Central Bank of Ireland: Strategic Plan 2019 - 2021 (2018)

⁸ Central Bank of Ireland: Transcript of Director General, Derville Rowland interview with Siobhan Riding, Financial Times FTfm (20 May 2019).

⁹ Hu, Henry T.C. and Bernard S. Black: Debt, Equity, and Hybrid Decoupling: Governance and Systemic Risk Implications, University of Texas Law, law and Econ Research Paper No. 120 (2008)

¹⁰ International Monetary Fund: A Capital Market Union for Europe, Staff Paper (2019)

¹¹ European Commission: Capital Markets Union - A plan to unlock funding for Europe's growth

¹² Central Bank of Ireland: Thematic Review of Closet Indexing (18 July 2019)

¹³ Europa: Directive 2004/109/EC of the European Parliament and of the Council on the harmonisation of transparency requirements in relation to information about issuers whose securities are admitted to trading on a regulated market and amending Directive 2001/34/EC (2004)

¹⁴ Europa: Recital 9 of Amending Directive 2004/109/EC of the European Parliament and of the Council on the harmonisation of transparency requirements in relation to information about issuers whose securities are admitted to trading on a regulated market, Directive 2003/71/EC of the European Parliament and of the Council on the prospectus to be published when securities are offered to the public or admitted to trading and Commission Directive 2007/14/EC laying down detailed rules for the implementation of certain provisions of Directive 2004/109/EC (2013)

¹⁵ European Securities and Markets Authority: Indicative List of Financial Instruments, Ref 2015/1598 (2015)

¹⁶ See Hart-Fuller Debate, Harvard Law Review 1958

¹⁷ See also HLA Harte, The Concept of Law 1961