30 March 2015

AFME response to ESMA consultation on competition, choice and conflicts of interests in the CRA Industry

“Issuer-pays” and alternative models

The CRA Regulation supports and formalises the basis on which conflicts should be managed. AFME  believes that any potential conflicts under the “issuer-pays” model are already being managed appropriately. While in principle the "issuer-pays" model can distort behaviour of CRAs and the market given the inherent conflicts of interests involved, the same is true for any other model in which a stakeholder in the rating process pays. No consensus has been reached by authorities or commentators on a superior alternative to the status quo.

AFME believes that it is important for the European regulatory regime to continue to support a plurality of business models and maintain a level playing field for CRAs based on market demand. Regulators should not legislate to reduce or prohibit use of the "issuer-pays" model where conflicts of interest can be shown to be managed effectively, and there is no compelling evidence to suggest that alternative models would be more effective. All of the alternatives to the "issuer-pays" model create their own issues in terms of feasibility and/or greater scope for conflicts, as explained in further detail below.

Subscriber/Investor pays model

This model would need to be in a form such that investors are required to subscribe to one or more agencies before being allowed to purchase. Such a requirement would be likely to reduce demand for such securities (given the additional cost associated with their purchase). It would also be likely to result in greater reliance by investors on CRA ratings, given the direct contractual nexus between the CRA and the investor. Furthermore, it would require multiple CRAs and AFME does not believe that the additional expense to investors and the market would not be justified on cost-benefit grounds.

Payment upon results model

This fundamentally misunderstands the process of credit ratings and imposes significant and unjustified restrictions on CRAs' economic model. It would be likely to increase the overall costs associated with ratings considerably, particularly given the cost of establishing a body responsible for independently monitoring and evaluating "performance" of ratings in order to determine the fees that should be payable to CRAs (assuming that this could not be established by CRAs' clients for conflicts reasons).

Trading venue pays model

This arguably does not mitigate any potential conflict (as issuers choose trading venues), and trading venues would in any case be unable to absorb the prohibitive costs associated with obtaining ratings for all traded instruments unless they were able to pass them on to issuers. This would be unworkable for non-listed issuers or instruments, which would have to be funded by an alternative model and furthermore could lead to inconsistent standards and practices for listed and non-listed issuers/instruments and create opportunities for regulatory arbitrage.

Government as hiring agent model

AFME notes the acknowledgement by the US authorities of the practical difficulties associated with such an approach (as proposed under the so-called "Franken amendment" to the Dodd Frank Act), particularly with respect to the criteria and procedures governing the hiring process, which we agree would be very difficult to determine. AFME refers to the submissions to the US Securities and Exchange Commission dated September 13th, 2011 made by AFME and our sister association SIFMA on this topic, and note that in the years that have intervened since then we are not aware that any action has been taken to implement such an approach.

Public utility model

There would be no guarantee that the involvement of the public sector would result in better ratings, though the likelihood of this would be increased by devoting substantial funding and expertise to any validating body. The creation of publicly subsidised and/or administered models also has the potential to create “moral hazard”, distort the market and compromise the independence of ratings.

AFME members are concerned that mandatory rotation:

• Interferes with the informed and sophisticated free choices of issuers and investors – the freedom of buyers of goods or services to choose their preferred sellers is critical to the free functioning of the internal market. This is as true in the context of credit ratings as in any other market sector. While we welcome new entrants and more competition, this should be allowed to develop naturally in response to the demands and requirements of issuers and investors. This is a long-term process, but is by no means impossible, as history has shown. We believe that it is wrong in principle to impose, through legislation, prescribed choices on issuers and investors. We believe that a better approach would be to continue work towards reducing reliance upon the use of credit ratings within the EU regulatory framework as this may assist in creating opportunities for a wider range of credit research and opinion providers, allowing such providers to compete on the basis of the quality and performance of their product


• Risks damaging the quality of ratings – rotation ignores the necessary commitment that both issuers and rating agencies must make in solicited ratings in order to ensure proper understanding not only of the issuer but also of its industry, the position of the issuer within that and applicable internal policies – particularly financial, underwriting and risk management policies. Rotation disregards the value of the necessary continuity in the monitoring of the issuer and its business sector. Forcing an issuer to rotate out a rating agency may therefore lead to the involvement of an agency without the necessary experience and reputation to provide a sound analysis. It may also lead to the involvement of agencies not recognised or accepted by investors under their permitted investment guidelines, reducing market stability and damaging liquidity


• Will give rise to uncertainty and rating volatility – ratings are not a commodity product. Methodologies are sophisticated, and different from each other. Rotation ignores this and assumes all ratings are the same. Forcing an issuer to rotate from one rating agency to another with a different methodology creates a high risk that the change of agency, in and of itself, will cause the rating also to change.

Mandatory rotation presents heightened considerations in this context, particularly for certain types of asset-backed securities where only one or two rating agencies may be perceived to have the most appropriate expertise. This is because the rotation requirement may operate in combination with the double rating obligation to place further stress on the practical ability to rotate and may effectively restrict the involvement of the most appropriate rating agency/agencies for the product at certain times.

Full AFME letter

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