Tuesday, November 5, 2024

Capital markets regulatory risks and how to mitigate them?

By Mengistu Weldemariam

In my previous two articles I shared my perspectives on what it takes the Ethiopian Capital Market to thrive (The Ecosystem approach) and followed on my second article with a historical grasp on the genesis of capital market and shared one of the potential pitfalls to watch out (risk of market concentration) ( financial institutions in Ethiopian case)-hopefully without dampening the excitement and diminishing the opportunities the Capital Market brings to businesses and both institutional and retail investors !

Capital markets play a crucial role in powering the global economy. They facilitate the flow of funds between investors and borrowers, enabling efficient allocation of capital. Again, there is no perfect mechanism to bring market participant without a calculated risk and well thought regulatory framework.

So, in this article I discuss the importance of Capital Market Regulation and the risk and implications of not having well designed and resourced regulatory body.

The banking sector in Ethiopia is regulated by the National Bank of Ethiopia. Currently most businesses and individual investors access their financing needs through the existing banks. What is changing? Soon there will be other options to access finance (financial intermediation) in Ethiopia- the long-awaited Capital Markets. The advent of the capital market provides a mechanism to obtain finance through a nonbank financial intermediation (e.g., allows companies to issue debt securities and equity, insurers, mutual funds, and exchanges). It worth pointing out the nonbank financial firms represent almost half of the global financial system’s assets. While these have no role in Ethiopia at present the Ethiopian capital markets with enabled ecosystem have the potential to create a robust financial system in conjunction with the banking system.

The Ethiopian Capital market is starting with the Stock Exchange, as well as provides a regulated mechanisms for companies to raise funds through debt and equity instruments, then to follow other options to participate I the capital markets such as the Collective Investment Scheme (CSI) in due course.

The role of a regulator is to ensure risks such as Market conduct, liquidity, credit, operational and systemic risks are mitigated as much as possible.

Market conduct risk happens when individuals trade based on non-public information (insider trading), it undermines market integrity and deliberate actions to distort market prices or create false impressions can harm investors (Market manipulation). Market Conduct risks can be addressed through Surveillance and Enforcement: Regulators monitor trading activities, investigate suspicious behaviour, and enforce rules against insider trading. Similarly, market manipulations can be mitigated by requiring companies to disclose material information ensures transparency and fair access for all investors.

There is an overlap between the financial institutions market conduct regulation and large companies that are listed on a stock exchange and non-listed entities that raise funds either through debt and equity instruments. In many countries there are a number of regulators working in tandem. For example, in Kenya while the Kenyan Capital market Authority have a number of Regulatinions (over 30) that deals with specific areas e.g., The Capital Markets (Real Estate Investment Trust) (Collective Investment Schemes) (Amendment) Regulations, 2023) and Capital Market (Investment-Based Crowdfunding) Regulations 2022) that gives a framework to regulate the capital markets. Other Countries, such as Australia has various statutory bodies funded by governments and industry levies that deals with various aspects of the financial sectors with overlapping responsibilities from market conduct, liquidity and investor and consumer protections. These agencies have legislative powers to impose penalties and use the judiciary to correct any misconduct by institutions and company directors. Each countries have their own context and legal frameworks, which often is dictated by the size and maturity of their financial markets.

Liquidity risk occurs from liquidity mismatch (fund shortage if assets cannot be converted into cash during market stress and sudden withdrawal of funds from an investment vehicle can lead to a liquidity crisis. The way regulators can mitigate liquidity risk is by a established mechanism and assess how financial institutions and markets would perform under adverse conditions (Stress Testing). Further by providing guidance or directives institutions to maintain sufficient liquid assets to meet obligations during stress (Liquidity Requirements).

Credit risk is when a borrower or issuer defaults on its obligations as well as when an issuer suffers a down grade credit rating- This affects the values of debt securities. As part of the capital market ecosystem robust credit rating agency is critical.

A rating agency assesses the creditworthiness of financial entities. For e.g., an agency assigns ratings to their debt instruments. This evaluation helps to indicate the reliability of payment and the risks of default. Moreover, the ratings provided by these agencies shape investment decisions in capital markets. They offer investors a tool to measure the risk of any debt instrument and assess if the returns are worth the risks, that is, helps in creating a correlation between risk and return of an instrument.

Overall, Credit rating agencies contribute to the efficient functioning of the fixed income markets by providing an independent source of information on the credit standing of issuers of debt securities.

Other two equally important risks are operational and systemic risks. Operational risk in capital markets often happens around the integrity and safety of the technology employed and its ability to withstand cyber-attacks . Cybersecurity breaches can disrupt trading platforms, settlement systems, and financial institutions. Similarly technological failures such as glitches can disrupt market operations. Finally, one of an overarching responsibility of a

Capital Markets Regulator is to deal with systemic risk. Systemic Risk is the possibility that an event at the company level could trigger severe instability or even collapse an entire industry or economy. When a company is considered “too big to fail,” it means that its failure could have widespread repercussions. These institutions are either large relative to their respective industries or make up a significant part of the overall economy.

In a capital market context Regulators have two fundamental ways of addressing Systemic Risks: by monitoring interconnectedness and imposing additional requirements on systemically important institutions (Macroprudential policies) and ensuring there is  a resolution framework, that is a plan for orderly resolution of failing institutions prevent contagion. In summary, addressing regulatory risks in capital markets is crucial for maintaining stability, investor confidence, and sustainable economic growth

On my fourth and final article, I will return to discuss my area of interest – investor education and investor protection. I will deep dive and explain whose role is it and how can it be done at the national level. Who has the explicit mandate? What is the role of the capital Authority’s role if any?

Within a fast-evolving financial landscape where access to financial services is made easier while more risks are being transferred to citizens, financial literacy has become a key life skill for individuals as well as micro and small businesses. Financial education can help enhance financial literacy by increasing financial knowledge, skills and attitudes. In turn, this can contribute to individuals’ (including vulnerable and low income) participation in financial, economic and social life as well as to their financial well-being. As a complement to financial inclusion and financial consumer protection, financial education is also important to restore confidence and trust in financial markets.

I will elaborate on this on my next edition!

Mengistu Weldemariam is a Senior consultant in business and finance. Previously lecturer in corporate finance and accounting. Currently works in consumer and investor protection. -Senior Program Manager

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