Although the consensus forecast for North America and the world calls for steady economic growth, there still are certain risks to capital markets in the year ahead, said Ian Russell, president and CEO of the Investment Industry Association of Canada (IIAC), at an annual investment outlook luncheon presented to the Empire Club of Canada in Toronto on Thursday.
"Global markets face the threat of [regulatory] fragmentation, the shortage of liquidity and the potential of being upturned by a significant shock," said Russell.
In the case of regulatory fragmentation, if individual jurisdictions create different rules for similar market activities, it affects the flow of cross-border capital, leading to higher costs and market inefficiencies to users and providers of capital, Russell said.
Although Canada is attempting to move away from regulatory fragmentation with the expected establishment of the Co-operative Capital Markets Regulator (CCMR), Russell said, the CCMR includes only five provinces and one territory. Furthermore, it will be at least another year before the CCMR is operational.
"[Canada] still is the only industrialized country lacking a single body to regulate its securities markets," he said.
The second threat to capital markets is the risk of illiquidity, Russell said, as liquidity is essential to facilitate trade flows.
"Investors will buy only if they're sure they can sell, and they can sell only if there are buyers," he said. "The liquidity problem can be traced to various factors, from narrower dealing spreads to more expensive capital."
Weak liquidity is a threat because it leads to less efficient pricing of new securities and can cause markets to be more exposed to external shocks, Russell said.
The third risk is an increased danger of sudden shocks to the financial system — and the financial services sector's ability to handle them.
"Our financial markets are especially vulnerable because of the growth in ETFs," Russell said. "Increasingly, investors are putting their money in diversified index funds — buying the market rather than individual companies — to reduce costs and preserve capital. Large institutional funds and asset managers are also investing in ETFs."
These large holdings of index-linked products and mutual funds in individual and institutional portfolios are susceptible to asset price declines across the market and shocks from external influences, such as rising inflation rates or geopolitical events, Russell said.
"The consequent[ial] downward asset price adjustment could be faster, more correlated and more intense than adjustments in markets driven by fundamental factors," Russell said. "The potential is there for an unprecedented herd mentality, leaving market makers with limited scope to absorb panic selling."
Another shock to the financial system could come from a lack of cyber resilience or cyber defence, Russell said, as cyberattacks have the ability to disrupt trading venues and capital markets.
"The risk is amplified by the significant outsourcing by investment dealers and asset managers to enhance efficiencies, compensate for scale and reduce costs," Russell said.
To prevent against the risks of regulatory fragmentation, liquidity shortage and significant shocks, regulators need to co-ordinate more effectively. As an example, Russell pointed to the International Organization of Securities Commissions' plans to study cyber outsourcing services and develop a template for due diligence.
"Regulators within a country or jurisdiction also need to co-operate and co-ordinate with each other across the domestic financial [servoces] sector, involving insurance, banking and securities firms," he said.
The Financial Services Regulatory Authority in Ontario, which will create thorough regulations for the insurance industry and other financial services institutions in Ontario, serves as a good example, Russell said.
In addition, the financial services sector can protect itself against cyber threats by creating a disciplined approach to regulation by settling on the most appropriate and cost-effective rules to provide financial advice.
"We have made good progress," Russell said, "but we need to rely even more on evidence-based analysis and more extensive cost-benefit work."
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