By Alastair Marsh, Risk Greater regulation of securitisation and credit default swaps (CDSs) is needed as current industry initiatives may prove insufficient in fixing the problems in these markets, the Madrid-based International Organization of Securities Commissions' (Iosco) Technical Committee has told supervisors.

In its September 4 report on unregulated financial markets commissioned by the Group of 20 leaders in November, Iosco said a "measured regulatory response" is necessary to restore confidence in securitised products and CDSs.

"Given the magnitude of the crisis and the need to rebuild confidence...it is unlikely that industry initiatives alone will be sufficient to restore transparency, market integrity and market quality," Iosco added.

Iosco's main recommendation to regulators for securitisation was a "reconsideration of the incentive structure in the securitisation value chain". This was to be achieved by replacing the originate-to-distribute model for securitisations with a system in which originators and/or sponsors of securitisations would be required to retain long-term economic exposure to these products "in order to appropriately align interests in the securitisation value chain".

The organisation's proposal ties in with similar suggestions by European and US regulators. On May 6 the European parliament approved an amendment to the capital requirements directive. This will force originators of securitisations to retain at least 5% of transactions when selling to EU credit institutions as of 2011.

Meanwhile, on June 17 the US Treasury advocated a similar rule for US originators or sponsors, although a formal proposal on such a move has not yet been issued.

However, a blanket approach to retention requirements should not be adopted, Iosco cautioned, stating the charge should be "carefully tailored to appropriately align interests in the securitisation value chain".

As a minimum, a retention charge should bear in mind the economic and regulatory features of the domestic securitisation market, it should be risk sensitive and it should pay attention to the underlying quality of the collateral backing a securitisation.

Iosco also advocated greater disclosure by issuers to investors about the performance of the underlying asset pool, the creditworthiness of parties with direct or indirect liability to the issuer, and the risk assurance practices undertaken by the underwriter, sponsor and/or originator.

Originators "should have an incentive to ensure that the quality and risks of the underlying asset pool are transparent to investors", Iosco concluded.

But greater disclosure from originators must be matched by improved risk management practices from investors, it added. "Improved information disclosure and dissemination to investors may not be effective if investors do not undertake, or do not have the capabilities to undertake, appropriate risk assessment and management of the securitised products they acquire," the report said.

In the financial crisis many investors in securitised products had effectively "outsourced" their own internal risk management to credit rating agencies.

Distributors of securitised products should be obliged to ensure that investors are only sold products that fit their financial requirements and risk profile, Iosco said. An investor suitability assessment should be undertaken to re-evaluate the definition of 'sophisticated investor', since many of these investors did not understand the risk profile of such trades.

Iosco also recommended ongoing training and education for buy-side and sell-side companies, development of valuation techniques by the buy side, and greater use of independent third parties other than rating agencies to evaluate risks in securitised products.

For the CDS market Iosco called on regulators to encourage financial institutions to continue work on standardising CDS contracts, and to "provide sufficient regulatory structure" for the establishment of robust central counterparties with sound risk management systems to clear standardised trades.

Regulators should facilitate timely disclosure of CDS prices, volumes and open interest by market participants, electronic trading platforms, data providers and data warehouses. They should also support information sharing between Iosco's members and other supervisory bodies, Iosco said.

Regulators were warned to "assess the scope of their regulatory reach" and consider which enhancements to their regulatory powers are needed to support these recommendations.