Thank you for that kind introduction Anthony. It’s a pleasure to be here today and to share in your discussions.
This is a good and a bad time for a regulator to be speaking at a major derivatives conference.
It’s a good time because we’re in the middle of implementing a once-in-a-lifetime reform of derivatives markets. So there’s plenty to talk about.
It’s a bad time because we’re in the middle of implementing a once-in-a-lifetime reform of derivatives markets. So there’s plenty to debate, particularly over global regulatory reform…
But I wanted to be clear today, from the start, that firms should not mistake regulatory scrutiny for regulatory opposition.
The derivatives market is one of the most important gears in the UK economic engine – and that means it is also one of the FCA’s most important responsibilities.
I take that responsibility seriously. Regulation should be a positive force for all your firms, clients and customers. It should work well for all financial markets.
And I think it’s important for us to remind the world that when this market works well, when it does its job effectively, it works well for everyone.
Derivatives are woven into the fabric of all our daily lives: supporting market liquidity, the allocation of resources, risk transfer, housing markets, the funds in our pension pots – even the production of the food on our plates. It is not just the Square Mile that profits - or traders in New York, Hong Kong and Singapore.
And that means the global financial community has a responsibility, a moral duty, to balance the interests of participants in the wholesale derivatives market, with the interests of the man on the street. You can’t untangle the two.
And it is this equilibrium – this balance of interests – that is the theme of my speech today.
How do we support the market to work well both for those who intermediate or stand in the middle of derivatives transactions – banks, global exchanges, clearinghouses, firms, trading platforms – as well as those who orbit that world?
The millions of retail consumers, homeowners, small businesses and others who – whether they know it or not – are affected by the derivatives market.
Cambrian explosion
Financial history tells us this balance isn’t easy to strike. There’s no ‘a b c’ formula to follow.
In one form or another, we today hear the same arguments and counter-arguments over the regulation of derivatives that have been playing out for some 300 years.
What has dramatically changed over the centuries is the sheer scale of the market. In the early 18th century, the major concern was over the ability of individual investors to cash out their positions on ‘time bargains’ – the Georgian equivalent of futures.
Today it is the liquidity and depth of vast global markets that make regulatory judgements over balance so profoundly important.
In the last 12 years, in particular, there’s been an explosion in the trading of derivatives. The daily turnover of OTC derivatives traded in the UK in 2001 stood at $238bn. By 2010, it was $1,235bn. A 500pc volume increase.
It would be irresponsible for regulators and governments to ignore the value of this economic activity. Global institutions need to be very aware of their responsibility to support your markets to work well. To support liquidity and depth.
But the inability of firms, of regulators as well, to aggregate information on highly complex risks and exposures in the high-tech derivatives market during the boom years - particularly from the mid-90s onwards – was brutally exposed by the economic crisis.
In the words of Alan Greenspan, the ‘whole intellectual edifice’ of risk management collapsed as the $62tn credit default swap market unwound. Playing its own part in the financial crisis. ¿
The remedy for that collapse, the medicine if you like, has been largely agreed and set in train.
So, at the domestic level, we have the new FCA, your market regulator, set-up to be more forward-looking – with an overarching objective to make markets work well.
To achieve that goal, we have a new style of regulation. The FCA will be more actively looking at trends, innovations and data to monitor risk and deal with it early.
We will also look far more closely at outcomes. In other words, not just at whether a firm is complying with rules, but whether customers are being treated fairly. The days of relying on box-ticking are long gone.
Transparency
At the international level, the game is also changing. And we’re beginning to see the 2009, G20 commitment to strengthen the financial system, play out in earnest.
That means that over the next 12 to 24 months we will see greater use of central counterparties, and more organised trading to encourage transparency and restore equilibrium. The market will be more visible.
And in terms of preventing, and mitigating against future market breakdowns, I think this makes perfect sense.
Even if you argue that over-expansions and over-contractions are inevitable phases of the economic cycle, irrespective of what regulators do, it’s very difficult to claim markets wouldn’t be in a better place today - a healthier place - had the systems and controls we are putting in place now been around ten years ago.
If you rewind the clock to 2008 when Lehman’s went bust, the firm had exposures of $800bn with thousands of counterparties. It was an intricate web of agreements and accountabilities. Yet neither its leaders nor global regulators had a solid grasp on network risk until it was too late.
In her book on Lehman’s collapse, Vicky Ward likened that moment of enlightenment to a ‘sleeping giant’ awakening. Six years later, we are much more alive to the interconnectedness of risk, largely thanks to the reforms of global regulators and governments.
So not only have we had the introduction of mandatory trade reporting, we have also had the move towards greater central clearing; and the demand for more use of on-venue trading. All designed to manage systemic risk more effectively. To restore balance.
One of the key questions now, is how these reforms land in the near term. Some have argued they will reduce liquidity. Making it more difficult to operate. Others in the market are worried about the extra costs of some clearing.
I’d argue the actual picture is more two-dimensional than that. Less obviously detrimental.
On the one hand, we know increased clearing and mandatory trade reporting will improve risk management and give regulators much more, and much higher quality information.
In other words, serious market disruptions should be easier to predict, and less likely to happen, because the scale of unmitigated counterparty credit risk will be reduced. The whole market will be more balanced towards the broader public interest.
On the other hand, central clearing gives market participants the ability to engage in ‘rank and serial number’ only, ‘anonymised’ trading. So liquidity is supported because there’s a lower requirement to filter the counterparties you’re willing to trade with.
Finally, and importantly, we know on-venue trading has powerful potential to make the price formation process more democratic – more competitive – by allowing prices to be set by all market participants. Not just a few big fish in a big pond. Meaning spreads could well be pushed south.
The challenge now for the international community, is to make sure we balance this reform, this requirement for clarity, with the need to preserve liquidity. That is a challenge for me. It is a challenge for the FCA, ESMA and our colleagues around the world like the CFTC.
The challenge for the market – for global exchanges, clearinghouses, trading platforms, banks, firms and technology vendors – is to continue making progress. To deliver on the expectations set out by G20 leaders.
The majority of the EMIR technical standards are drafted and in operation. The new requirements for timely confirmation came online in March. The rules on dispute resolution, portfolio reconciliation and compression will be switched on in September. The rules around reporting to trade repositories should follow a few months after that.
The prudential obligations – mandatory clearing and collateralisation of bilateral trades – are on a longer timeline of 2014 and 2015. They are likely to be a significant compliance challenge – I understand that – but firms have time on their sides if they start preparing now. Regulators are unlikely to be sympathetic, two years down the line, to any arguments that there were too few months to get the ship in order.
So, I do expect to see you on the front foot. I do expect you to be developing implementation plans. Preparing for the obligations that are coming up.
And let me also ask you to please work with the FCA, and international regulators, on resolving unresolved issues like non- equity transparency, G20 trading obligations and cross-border rules.
Probably the biggest challenge for regulators is to knit our domestic regimes together in a coherent way. A form that allows global markets to continue to function - but doesn’t create opportunities for regulatory arbitrage.
It’s no great secret to say there’s been lively debate between regulators over how you pitch this. What is the perfect outcome? And how do you get there? The truth is, it is nigh on impossible to promise perfect solutions to problems that require multi-tiered compromise.
But that is very different from saying we can’t reach a good compromise: international colleagues fully understand the importance of allowing cross border derivatives markets to continue to function, of avoiding conflicting or duplicative requirements and, perhaps most importantly, of delivering certainty to the industry as soon as possible.
These are all difficult conversations happening right now. The FCA is working closely with ESMA, and others, to achieve a shared interpretation. And that work will be published as quickly as possible.
One of my priorities, one of ESMA’s priorities and, I know, one of industry’s priorities is to work through how the G20 requirement to trade standardised OTC derivatives on exchanges, and trading platforms, will work in practice.
Alongside the current MiFID negotiations, ESMA is working to establish the ramifications of this. How might it affect liquidity? Or an even more fundamental challenge: how do we measure liquidity in the derivatives market?
Those kind of questions cannot be answered without direct input from the industry. We cannot achieve a positive balance of interests without your interaction.
LIBOR
But the most serious conversation, the most important taking place today, is the one around LIBOR and the future of benchmarks.
It was interesting last year to hear one of LIBOR’s creators, Minos Zombanakis, talk about the corruption of the rate.
In his words, when LIBOR was introduced in the late 60s: ‘you assumed that people acted honourably because they couldn’t afford to act otherwise.’
If that sounds old fashioned now, I think it’s more a reflection on the markets of today than yesterday. Rate submitters over the last few years willfully ignored the importance of the benchmark they were contributing to. Choosing personal gain over the greater good.
In their world, it simply did not register, or else they did not care, that their actions had consequences for consumers. The mental leap was not made.
But the LIBOR scandal was not just a story of individual weakness. You can’t explain it away as a series of personal failings. Fallibility only blooms in the right environment. And the system itself was broken.
There was too little independent governance; inadequate oversight of systems and controls; perverse incentives on behaviour; and designed-in conflicts of interest, all of which created the potential to profit from trading positions.
So LIBOR needed overhauling. It needed to be reformed and that journey has begun. As from April, we’ve had a very different regime in place to monitor the benchmark. It is now a regulated activity, with direct oversight by the FCA of the administration and submissions to LIBOR. It is far more belt and braces.
That is good news. It is a step forward. But there are questions global regulators and market participants still need to answer.
For starters, how do we secure sensible, viable, long-term benchmarking solutions? How do we restore public confidence in the rate setting process?
And, perhaps most importantly from the market perspective, how do you encourage a genuinely healthy marketplace – a genuinely competitive space – in which participants have a meaningful choice of benchmarks to select?
But in looking for perfect solutions, I do think we need to be careful not to make the best the enemy of the good. The reforms we’ve introduced to LIBOR are explicitly designed to work for the wholesale and retail markets. To restore confidence to the benchmarking process and make it more effective. To achieve a balance of interests.
If you want more profound change - a revolution in benchmarking - then international banks and regulators quickly begin to encounter more complex financial questions.
So what happens, for instance, if some benchmarks are obliged to substantially change in character? Or, even more drastically, if one or more is scrapped?
The truth is these are questions that still need to be fully answered. There are gaps in knowledge. We know there would be winners. We know there would be losers. But we don’t yet know the exact ratios.
At its most granular, what happens to the value of an individual’s pension contributions if their fund is switched to another rate? Do your neighbour’s mortgage payments go down, even as yours go up?
What we do know, and what is beyond debate, is that there are sound economic, and ethical reasons for strengthening the regulation of benchmarking as a whole. Not just LIBOR, not just regulation in the City of London, but the entire suite of benchmarking rates.
The FCA has started that process through my review. The governance of LIBOR is in a better place today than it was.
But the international community has to decide the long-term health of rates like LIBOR and EURIBOR. These are decisions that need to be made in concert with the rest of the world – with the expertise of colleagues in government, IOSCO and ESMA, as well as the other city watchdogs.
As was announced this week, the Financial Stability Board is setting up a group of regulators and central banks to coordinate a wide-ranging review of interest rate benchmarks. I am leading that work, with Jeremy Stein at the US Federal Reserve Board, and we’ll be involving industry during those discussions.
So, this will be a consultative process. It will be engaged with your firms. And that means we will ask market participants to put forward robust, reliable reference rates that meet the needs of the private sector. We will also look to you to identify any transition issues.
And at that point, as we move further forward in the process, the group will look at whether these suggestions pass muster. Whether they meet agreed international standards. Are these the right reforms, at the right time and in the right place?
All members of the FSB group – including the FCA – are highly aware of their responsibilities here. There is appreciation of the fact you can, with proper interventions, rebuild trust in benchmarks over time. But you can’t easily unpick poorly instituted reform.
Conclusion
So, let me end by stressing the importance of the work the industry is doing to improve LIBOR and support the FCA in these discussions. And let me repeat our commitment to make your markets work well.
The derivatives industry is hugely important to the UK wholesale markets – it is a key driver of liquidity and depth.
But the significance of your trades and deals is far more profound than that. It spans from the global to the individual. From the largest international markets to smallest domestic businesses.
It is our joint responsibility to ensure there is balance between those two poles. That both sides of the equation are considered.