EU regulator questions rating agency funding model

LISBON (Reuters) - Watchdogs should consider changes to the current issuer-based financing model used by credit ratings agencies, which can cause conflicts of interest, a top European markets regulator said on Friday.

In an interview with Reuters, Carlos Tavares, head of the Committee of European Securities Regulators, also said Washington and Brussels were likely to resolve a row over EU licenses for foreign hedge funds, and that circuit-breakers to dampen trading volatility were needed in Europe.

The issuer-funded model “is (what) causes conflicts of interest. It is possible to consider alternative models” for rating agencies, he said.

“The ideal model would be for those who use the ratings to help fund their production.”

A swathe of credit agency downgrades on sovereign debt this year have caused unease in European capitals, notably on the euro zone periphery, with Greece and Ireland among others criticising their rationale.

Asked about lessons Europe may need to learn from the ‘flash crash’ in the United States triggered by a computer-driven sale in May, Tavares said the event and the U.S. SEC report on its causes could not be directly extrapolated to Europe, but regulators were analysing the findings.

“There are conclusions to be drawn here, but with due adaptations,” he said adding that trade-halting circuit breakers, adopted in the United States in June, “are necessary”.

Circuit breakers pause trading for five minutes when a stock moves more than 10 percent in five minutes.

The SEC last week detailed how high-frequency algorithmic trading can sap liquidity and rock the marketplace.

Tavares said the European Union and the United States looked likely to hammer out a solution in a row over granting licences to foreign hedge funds to operate in Europe. “I believe that in any case there will be cooperation and the final solutions will be positive for both sides,” he said.

The issue of giving foreign funds full access to the EU has escalated into a row with Washington after objections from Paris. U.S. Treasury Secretary Timothy Geithner this week warned French Economy Minister Christine Lagarde against curbing the freedom of foreign hedge funds in Europe.

Separately, a senior diplomat told Reuters a deal was imminent, with France ready to drop its objections to granting foreign funds a licence to work across the EU’s 27 countries in exchange for Britain surrendering more policing power to a European watchdog. [ID:nLDE6971R2]

Brussels is putting hedge funds them under the watch of a new pan-European supervisor that will succeed CESR in January 2011.

Tavares said he was confident that Washington and Brussels will find a middle ground.

“There is a strong will to avoid creating an unlevel playing field, to avoid opportunities for regulatory arbitrage... It wouldn’t be good to get into a process of regulatory competition, and that’s not the spirit that I’ve seen out there,” he said.

Tavares also said there was some concern about funds offering increasingly complex retail products within the EU-approved framework, known as Undertakings for Collective Investment in Transferable Securities (UCITS).

“That worries us somewhat and we are starting to discuss it. There is a trend for products that are growingly complex being offered in UCITS wrapping, targeted more and more at retail investors”, he said.

Such products often promise returns that are not achieved, while investors risk losing money.

“We need to reinforce the transparency especially for retail investment,” Tavares said.

He welcomed European Commission proposals on greater supervision of short-selling operations as well as transparency in over-the-counter markets, including sovereign debt, as well as in the derivatives trade.

“We hope the short-selling proposal becomes law as soon as possible,” he said. “Be it on short-selling, credit default swaps or over-the-counter derivatives, the European Commission proposal is balanced ... and generally in line with what CESR has been proposing.