1 Serbian Securities Commission Conference Robert H. Singletary Serbia Economic Growth Activity December 3, 2009 The Global Economic Downturn and Securities

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Serbian Securities Commission Conference

Robert H. Singletary

Serbia Economic Growth Activity

December 3, 2009

The Global Economic Downturn and Securities Regulators’ Responses

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Economic Crisis and the Regulator’s Responses

Since August 2008, the World has been experiencing a financial crisis which has evolved

into a severe global economic downturn.

What are the consequences for Emerging Markets?

What actions should securities regulators in these markets be taking in response?

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The causes of the financial meltdown are not totally clear, although there are many opinions.

The impacts on emerging markets are much more evident.

Globally we see: sharp contractions in GDP, resulting budget deficits and efforts by the central banks to inject liquidity, confidence and stability, all while eyeing the impact on price stability.


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1. Initial rush to liquidity2. Retrenchment on risk profiles3. Capital flight to highly rated countries and

positions 4. From August 2008 through March 2009 most

were “sitting on their hands”5. Since March 2009 a return to the developed

markets

The Impact on the International Capital Markets is Clear

“Greed” again beats “Fear” (for now)


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1. Capital flight out of emerging market portfolio investments

2. Dramatically reduced foreign direct investment3. International Financial Institutions stepped in with

“budget support” (not sustainable)4. Sharply lower market prices5. Initial strong volume (on exits) then much lower

levels for the last 16 months

The Impact on Emerging Markets is Clear

“Fear” still beats “Greed”


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The prime responsibility for the macroeconomic issues falls to the government and central banks.

From the securities regulator’s viewpoint the most problematic current trend is lower secondary market activity. There is also some regulatory concern due to lower asset values.

Over time these factors can threaten the financial systemic integrity and the ability to sustain a credible capital market.


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0

1.000

2.000

3.000

4.000

5.000

6.000

2006 2007 2008 I H 2009

Mill

ion

sEU

R

BELEX Bucharest SE Ljubljana SE BSE - Sofia Zagreb SE

SEE Exchange’s Equity Turnover

Data Courtesy of Belgrade Stock Exchange

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0

10.000

20.000

30.000

40.000

50.000

60.000

2006 2007 2008 IH 2009

Mill

ion

sEU

R

BELEX Bucharest SE Ljubljana SE BSE - Sofia Zagreb SE

SEE Exchange’s Market Capitalization


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Systemic Consequences of Low Liquidity and Prices

Lower secondary market activity and a general decrease in prices have four negative areas of impact for the capital market system:

1. Lower revenues for firms with transaction-based fees. Erosion of capital. Danger of insolvency.

2. Liquidity concerns and asset valuation problems for investment funds. Failures to redeem on demand. Inaccurate performance and financial reporting.

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Four negative areas of impact for the capital markets (continued)

3. Lower revenues for firms with fees based on the value of assets under management. Erosion of capital. Failure of firm and disruption to fund operations.

4. Lack of access to capital by public companies. Failure of the capital market to perform its basic function for the economy.

Systemic Consequences of Low Liquidity and Prices

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“Primary Market” “Secondary Market”

Securities Firms Issuer Companies

Securities Exchange

Clearance and

Settlement Process

Securities Depository

Sellers

Buyers

Sellers

Buyers

Institutional and Retail Investors

Schematic of the Capital Market

Consequences of Low Liquidity

Investment Funds

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1. Securities Firms2. Stock Exchanges3. Clearance and Settlement Entities4. (Depositories and Share Registries?)

Participants with Transaction-Based Revenues

Why should a securities regulator care about the financial health of these infrastructure entities?


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But it is not a securities regulator’s function to keep financially dangerous firms from going out of business.

Loss of ? Leads to Concerns Over?

Disruption of Market Functions

Protection of Customer Funds and Securities

Securities Firms yes

Exchange yes T-date to S-date only

Clearance and Settlement yes T-date to S-date only

Depositories yes yes

Share Registries yes


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Securities Exchange

Clearance and

Settlement Process


Sellers

Buyers

Sellers

Buyers



Investment Funds

Consequences of Low Liquidity – Securities Firms

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1. “Low revenues” do not equal “losses”

2. Low revenues business decisions voluntary exit from the business

3. Persistent losses capital problems involuntary exits

Impact of Low Trading Levels


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1. The account transfer process must be orderly, with good communication with customers.

2. Protection of customer funds and securities is absolutely paramount.

Financially Weak Securities Firms Should be Allowed (Forced) to Exit the Industry

The securities regulator needs to execute a “managed failure”.


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Who are Your Danger Firms?

Notional Securities Firm Population

0

10

20

30

40

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Firms

Level

of

Cap

ital

Firm's Capital Level "Minimum Required Capital


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1. Capital calculations are a snapshot in time; they are inadequate to foresee firm failure.

2. They do not include the impact of projected losses on future capital levels.

3. Early warning approaches speak only in terms of percentages above required minimums.

4. The regulator must either require the analyses of projected capital burn rates or do the math itself.

A Note on Net Capital Requirements


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1. Track your securities firms’ capital burn rate; how fast is the capital decreasing?

2. Stress test individual firms at different multiples of current loses.

3. Stress test the system if trading levels stay at current volume; then project for even worse levels. How many firms will fail?

4. Be alert for “cooked books” and “cute accounting”

Recommended Responses for Securities Firm Oversight

Some Responses to Low Trading Levels

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5. Revisit your financial responsibility rules

6. Should your rules take income statement issues into account?

7. Revisit your customer account segregation rules.

8. Revisit your procedures for overseeing voluntary withdrawals.

9. Revisit your procedures for closing firms.

10. Can your Commission handle closing more than one firm at a time?

Some Responses to Low Trading Levels

Recommended Responses for Securities Firm Oversight

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Securities Exchange

Clearance and

Settlement Process


Sellers

Buyers

Sellers

Buyers



Investment Funds

Consequences of Low Liquidity – Investment Funds

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1. When securities are traded and have a valid, recent price, use this.

2. When the securities are not traded and there is no “market price”, what are your rules?

Illiquid Securities Pose Valuation “Challenges”

Treatment of “Restricted Securities” in the U.S. System

“readily available market” and “orderly sale in the course of business”


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Notional Changes in Trading Dynamics

0

10

20

30

40

50

60

Traded Companies

Tra

din

g V

olu

mes

Pre-Crisis Level

Post-Crisis Level


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Even the most objective professional has a difficult and inexact decision to make.

If the management fee is based on value of assets under management, there is an implicit pressure to inflate values.

If the management fee is based on performance, there is also an implicit pressure to inflate values (better NAV performance).



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1. Who makes the decision on valuation of assets when no “readily available market” exists for the “orderly sale of the asset”?

2. If it is the fund management company a conflict of interest becomes much more apparent.


Also, watch for matched trades designed to “establish” the “market price” for the asset.


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1. Revisit your valuation rules to understand how illiquid and non-traded assets are valued.

2. Does giving the valuation responsibility to the following entities really fix the problem?

1. Independent directors

2. Valuation services

3. Custodian

Recommended Responses for Investment Fund Oversight

Some Responses to Portfolio Valuation Issues

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3. Revisit the Commission’s ability to object to (or override) clearly erroneous valuations

4. The goal needs to be to fix the problem before it escalates into an enforcement action.

5. On a sample basis, review the valuations by funds for their illiquid positions.

6. Recalculate NAV using the staff’s figures and assess impact.


Some Responses to Portfolio Valuation Issues (cont’d)

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Two concerns in the current environment:

1. Meeting initial wave of redemptions. To a certain degree we are past this stage.

2. Meeting a steady outflow. How are the redemption levels in your jurisdiction? What is the distribution across your various funds? Do some funds have more redemptions than others? Why?

Open-end funds and interval funds must have sufficient liquid assets to meet redemptions

Consequences of Low Liquidity – Meeting Redemptions

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Can the fund generate sufficient cash to meet redemptions?

Will the actual sales price of assets = the stated value as used in calculating NAV?

Any mismatch between the actual price and the stated value creates harm to investors

Sales prices higher than stated means the NAV was understated. Previous redeemers harmed. Current investors benefit.

Sales prices lower than stated means the NAV was overstated. Previous redeemers benefit. Current investors harmed.


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What is the investment fund’s liquidity profile?

Highly Liquid

Medium Liquidity

Low Liquidity

Non-Traded

Relative Amount of Assets Within the Portfolio


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What is the investment fund’s liquidity profile?

Highly Liquid OverallTroublesome

Stacked


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Level of Liquidity of the Position

Fund Management Preferences for Liquidating Positions

Yie

ld o

r E

xpec

ted

Ret

urn Which 1 of These 11

Positions Will the Fund Manager Wish to Liquidate First, Second and so on … ?

Where is the Portfolio’s Liquidity Wall?


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Will the fund be allowed to limit redemptions?

Is this in their Charter?

Are they allowed to convert to interval or closed-end?

Does a failure to honor redemptions result in automatic liquidation of the fund?

Regardless of the legalities, a limitation on redemptions leads to hard feelings and a loss of trust and confidence by investors


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1. Analyze each fund’s portfolio liquidity levels:– Stress test for current redemption rate– Stress for multiples of current outflow– When will the fund hit its liquidity wall?

2. What are the fund’s contingency plans if redemption requests cannot be honored?

3. Revisit the Commission’s rules and procedures for allowing the suspension of redemptions?


Some Responses to Portfolio Liquidity Issues

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Securities Exchange

Clearance and

Settlement Process


Sellers

Buyers

Sellers

Buyers



Consequences of Low Liquidity – Fund Managers

Investment Funds

Fund Management Companies

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0,00

10,00

20,00

30,00

40,00

50,00

60,00

70,00

80,00

90,00

100,00

EUR

Mill

iona

Pension funds Investment funds


NAV of Pension and Investment Funds

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Consequences of Depressed Prices – Fund Managers

Investment Funds do not become insolvent, Fund Managers do.

Broadly lower securities prices within a market mean that the “assets under management” are lower and thus the manager’s fee. Persistently low securities prices thus result in lower revenues and erosion of capital.

When Fund Managers go out of business:

Liquidate all managed funds; or Transfer the management contract

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1. The transfer process for the fund management contract must be orderly, with good communication with fund shareholders and custodian.

2. Process differs between contractual plans and corporate funds (internal vs. external managers)

Financially Weak Fund Management Companies Should be Allowed (Forced) to Exit the Industry

The securities regulator needs to execute a “managed transfer”.

Consequences of Depressed Prices – Fund Managers

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1. Analyze each fund management company’s financial condition using the same techniques as applied to securities firms.

2. Track the firms’ capital burn rate.

3. Stress test individual firms at different multiples of current losses.

4. Stress test the system if trading levels stay at current volume.

Recommended Responses for Fund Manager Oversight

Some Responses to Fund Manager Revenue Issues

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Securities Exchange

Clearance and

Settlement Process


Sellers

Buyers

Sellers

Buyers



Investment Funds

Consequences of Depressed Prices – Access to Capital

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In the ‘pure’ disclosure-based securities regulation system, it is not the place of the regulator to promote local issuers or the overall primary market.

Emerging market securities regulators do not have the luxury to take a overly purist approach and “sit on their hands”.

In a Timid International Market, Public Companies in Emerging Markets Will Have Difficulty Raising Capital –

Both From International and Domestic Investors.

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1. This is difficult territory. The regulator must support development of markets, not issuers.

2. Even supporting development of specific market segments – such as municipal bonds -- can be worrisome.

3. The focus must be on overall support of the markets, accurate and fair representations, and strict investor protection requirements.

4. The fact that issuers need capital is not a reason to relax our standards.


Some Responses to Access to Capital Issues

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Please:

See slides 20 - 21 for Securities Firms

See slides 27 - 28 and 35 for Investment Funds

See slide 39 for Fund Management Companies

See slide 42 for Public Issuers

Summary of Recommendations

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Conclusions

Overall Goals:

Maintain the system’s financial integrity

Maintain the system’s professional integrity

Maintain trust and confidence by investors

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Don’t wait for the problem firms to implode

Know your participants Project their financial futures

Don’t Hesitate to Close Firms

Bear Hugs Official routes

Conclusions

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Be Ready

Rehearse what the staff will do to close a firm

Have more than one team

With Regard to Public Company Needs

Understand Your Philosophical Limits Understand Your Political Limits

Conclusions

Documents

1 Serbian Securities Commission Conference Robert H. Singletary Serbia Economic Growth Activity December 3, 2009 The Global Economic Downturn and Securities