5.1 IOSCO objectives and principles of securities regulation

193. In 1998 IOSCO published its objectives and principles1 of securities regulation2 in which it stated that “securities and derivatives markets are vital to the growth, development and strength of market economies”.3 As the importance of securities and derivatives markets increases, “securities markets have become central to individual wealth and retirement planning”.4 As such, firms active on these securities markets should be subject to certain requirements to “foster confidence in the financial markets”.5 In 1989 IOSCO published a report stating the need for “a common conceptual framework regarding capital requirements for [investment firms]”.6 This report, although published in 1989, is still relevant, as it was the starting point for the work done on a global level to define the objectives and principles in the 1998 IOSCO report. Even though these objectives and principles were established in 1989, these main objectives of supervision have remained the same. The way these principles have been applied in the specific capital regimes has changed as a result of the ongoing development of financial markets or the impact of financial crises. This has not, however, changed the rationale for imposing capital requirements in the first place. According to IOSCO the “efficient functioning of the financial markets requires members of the financial community to have confidence in each other’s stability and ability to transact business responsibly. This, in turn, requires each member of the financial community to have, among other things, adequate capital”.7 Furthermore, IOSCO saw capital adequacy rules as a means for investment firms to show commitment to their business and thereby contribute to confidence in the financial system.

194. Securities regulation, or the regulation of firms active in the securities markets, should be designed around three objectives: “(1) the protection of investors; (2) ensuring that markets are fair, efficient and transparent; and (3) the reduction of systemic risk”.8 These objectives are also endorsed by IOSCO and as such from the basis of the various national prudential regimes for investment firms. Furthermore, regulation for various types of intermediaries or investment firms “should address entry criteria, capital and prudential requirements, ongoing supervision and discipline of entrants, and the consequences of default and financial failure. The oversight of market intermediaries should primarily be directed to the areas where their capital, client money and public confidence may most be put at risk”.9 The reasons for prudential supervision of investment firms are specified by IOSCO as follows:

195. The way prudential supervision11 of investment firms should be designed, when considering the 1989 and 1998 reports of IOSCO, therefore directly affects the confidence investors have in the market as a whole and the way individual firms can overcome financial distress. The above-mentioned reasons and objectives for prudential supervision of investment firms can be translated into two ‘goals’ for prudential supervision: (1) the financial stability and continuity of the investment firm and thus ensuring the continuing provision of this investment firm’s services for its clients; (2) reducing the impact of the failure of a single investment firm or the failure of a group of investment firms on the financial markets as a whole. These two goals of prudential supervision are important to keep in mind when identifying the types of prudential risk to which an investment firm can be exposed. Whereas some (prudential) risks directly affect the firm itself, other (prudential) risks might have a more profound impact on the market or its functioning.

196. With regard to the goals that prudential supervision of investment firms should achieve, it is important to note that “[…] the intermediation function (or investment services) provided by investment intermediaries [or investment firms] – […] plays a critical role in the financial markets by providing market access channels for capital providers and for capital seekers”.12 Investment firms facilitate market access for firms seeking capital. As such, firms without direct access to financial markets – and thus without direct access to capital – can enter the financial market through an investment firm. Investment firms facilitate this access either by providing a trading platform or by underwriting the placement of new financial instruments. Investments firms can also support liquidity in financial markets by being active as market makers or dealers on own account.

197. Investment firms can also provide services for those persons or firms that can provide capital and are thus seeking a financial return on their investment. “By providing services such as investment advice, discretionary asset management and brokerage services, and by acting as distribution channels for investment products, investment intermediaries act as a bridge between capital providers and the financial markets.”13 Investment firms, therefore, provide a valuable service for the financial markets which warrants adequate supervision, as recognized by the European Court of Justice in the Case of Alpine Investments,14 where it found that “the existence of professional regulations serving to ensure the competence and trustworthiness of the financial intermediaries on whom investors are particularly reliant was critical to ensure investor confidence in the securities markets”.15

198. Investment firms can provide certain critical functions in the global financial markets as brokers or as operators of trading platforms, but they can also provide valuable services for clients as asset managers. As the total amount of asset managed globally has seen a constant rise over the last decade,16 the risk that clients or counterparties of investment firms will be directly affected by the failure of an investment firm is thus increasing. Adequate prudential regulation of investment firms is essential to ensure that supervisory authorities have the appropriate tools to address these investment firms’ risk profile. The principles of securities regulation as established by IOSCO laid the basis for a first step towards harmonizing the prudential regulation of investment firms globally. The members of IOSCO, however, have implemented these principles of securities regulation in various forms. The European Union is nevertheless the only jurisdiction17 where the prudential principles that were designed for internationally active banks18 have been applied to all investment firms active in the European sector.19 Besides the EU, only Australia, Singapore and Japan apply a Basel or equivalent system to a subset of the investment firm sector. Al other countries included in the 2015 IOSCO report have a prudential framework based on the “net capital rule”, a concept that will be further explored in this Chapter.