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search for yield poses systemic risk

The warnings are contained in IOSCO’s inaugural Securities Markets Risk Outlook – jointly written by the policy forum’s research department and committee on emerging risks – which seeks to give IOSCO members a better understanding of potential threats to the global financial system.

In relation to the search for income, IOSCO says heightened demand for high yield and emerging market bonds since 2009 – combined with a more recent resurgence of appetite for structured products – reflects low interest rates in the developed world and rising investor confidence.

A “sudden adjustment” of interest rates towards the long-term average could impose significantly higher borrowing costs on governments and companies, IOSCO warns, impeding capital formation. Alternatively, if interest rates remain low for an extended period, overvaluations may occur.

The return of CDOs

Similarly, the organisation notes “newfound demand” for leveraged collateralised debt obligations (CDOs) – a sector at the heart of the 2007-2009 subprime debt crisis, but which saw a rebound in issuance from $6bn in 2010 to an annualised $35bn in 2013, according to Dealogic.

As with high yield and emerging market debt, IOSCO says a normalisation of interest rates would adversely affect the CDO market, while a prolonged period of low rates could cause a bubble.

IOSCO welcomes greater forward guidance from central banks on the likely trajectory of interest rates, but says regulators should continue to monitor activity in such high-yielding assets.

“I would urge all IOSCO members and policy makers globally to carefully reflect on the Outlook’s observations and understand – and act on – the implications of the trends and risks it identifies for their markets,” wrote Greg Medcraft, chair of the IOSCO board.

Other threats highlighted by the report:

  • The diminishing availability of high-quality collateral;
  • The “challenging balancing act” of shifting risk from bilateral over-the-counter contracts to a single point of infrastructure; and
  • Risks related to emerging market capital flows.

As Expert Investor Europe reported, IOSCO warned earlier this year that a cyber-attack could leave securities markets vulnerable to a “black swan” event.

A copy of the Securities Markets Risk Outlook for 2013-2014 can be downloaded from the IOSCO website, here.

tom@ybc.tv

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