The Future Comes into Focus as a theme for today’s conference is a good one I think – for two reasons.
First, because it encourages us to look forward, which is clearly important.
Second, because a lot of the heavy lifting – the general reshaping of the international derivatives market – is now behind us, with the ink long dry on the pledges made in Pittsburgh.
So putting frustrations over pace of change to one side, I think we can be optimistic about the broad foundations for reform.
Progress has been made in reducing network risk. Governance is being improved. And in both the EU and US, the world’s largest derivatives markets, the majority of the rules breathing life into the G20 principles have already been written – and brought into force.
The key point is that to a large extent the course is locked in. We have agreed the big objectives – less risk, more transparency, better conduct – and we’re seeing them stress-tested by the markets in what is now the business-end of the reform process.
From my perspective, this is a critical moment of transition. A period when sleeves are rolled up and details attended to so global priorities can be faithfully translated into the markets.
Ultimately the big reforms succeed, or fail, on matters of small detail, not grand principle. So the custodianship of this final leap from paper to practice is an area we all have a stake in.
The main issue for firms and regulators is that the details we’re focusing on at the moment, in this final delivery stage, also happen to be some of the most important facing the derivatives industry:
- the cross-border application of derivatives rules
- implementing new requirements for the collateralisation of bilateral derivatives
- preparing for the current batch of European Market Infrastructure Regulation (EMIR) requirements
- resolving issues around benchmarks
These are all touchstone issues in the world of derivatives. Not matters of great public debate – not the stuff of front-page headlines – but our handling of them will go a long way towards determining how history judges our response to the economic crisis.
Cross border
The big challenge here, beyond legal niceties of how you couch clauses and write rules, is a pretty fundamental question of how financial regulators exert influence across international markets.
And for that reason, I want to touch on all four this morning, starting with the cross border issue.
The big challenge here, beyond legal niceties of how you couch clauses and write rules, is a pretty fundamental question of how financial regulators exert influence across international markets.
Central to this debate is whether regulators operate independently on global issues so they can intervene quickly in the national interest. Or whether they find international solutions to international challenges.
The broad appeal of the former is that serious risks to national interests can be monitored and managed by national institutions. Not left on trust to others.
It’s eye-catching from the enforcement perspective. Particularly in a world where so many fingers were burned, in so many households, by the uncontrolled risk taking and poor conduct we saw pre-crisis.
It is also psychologically attractive. All nations want to have control over their environment – so I don’t think we should be surprised, at all, to see this debate taking place today in relation to the application of Dodd-Frank rules to non-US firms, or transactions.
Quite rightly, the big global economies are unwilling to stand back and allow the derivatives market to stockpile risk in one corner of the world, only to see it transmitted back to their own consumers.
But in all the discussions I’ve heard, what I don’t think is clear yet, or well enough understood, is how the application of domestic rules in regulated international markets makes this stress scenario any less likely.
The important point here is that international derivatives reform is designed to do its job – in other words to reduce risk and increase transparency – with or without the application of domestic cross-border rules.
So the issue then becomes: does it make hard-nosed, practical sense for any one national regulator to attempt to regulate all derivatives activity with any link to its jurisdiction?
The clear risk is that a patchwork quilt of national and regional rules runs the risk of becoming unworkable. A mess. Creating space for overlaps and under-laps in regulation, with all the question marks that brings with it: opportunities for regulatory arbitrage; less protection for end users and lower margins for firms that operate by the book.
There’s also the linked danger that if every national regulator follows suit, you soon create a tit-for-tat environment where any one transaction, or participant, could easily be subject to three, four or five different regulatory regimes.
Clearly it is an imperative to make sure these fears aren’t realised. Not just in terms of commercial pressures on industry. But also on the more important prize of financial stability. No-one wants a repeat of 2008.
Our colleagues in the US Commodity Futures Trading Commission (CFTC), along with the European Commission, have made significant strides over the last year to resolve these issues, making real progress in the Path Forward agreement.
We should all welcome this momentum but it’s also important to remember the document is, as its title suggests, a roadmap rather than a complete solution. There remain significant points of detail to work through.
The most urgent of these relates to trading venues – particularly trading venues in the EU and US – used by firms in both territories as major conduits for transatlantic derivatives trading.
It’s not uncommon for half of transactions on London-based trading venues to have a US firm on one or both sides. So you need to find an approach to cross-border regulation that allows this liquidity to be maintained.
The FCA, along with the EU, is pushing hard for this approach to be based on mutual recognition. The catch here is in the timing. We need to make rapid progress given the October deadlines we’re working towards under the SEF regime.
The second, related, area to mention is around the broader recognition of equivalence between different international regimes.
ISDA has already pitched a pretty convincing argument in favour of domestic regulators accepting compliance with foreign rules for cross-border trades – always assuming those rules yield an equivalent outcome.
On the face of it, I think this makes good sense. Otherwise you have to be able to demonstrate the value of insisting trades conform to your own laws, when they’re already doing so through someone else’s.
If you can’t do that, it’s hard to see how limits on the scope of provision for this kind of substitute compliance would work – except where it’s merited by a lack of equivalent foreign rules.
So, yes, we should applaud the additional commitments in the Path Forward paper for broader substitute compliance.
But I strongly suspect international regulators are going to come under pressure to make more progress in finding global solutions to these global challenges – not least in achieving some kind of international consistency on the regulation of market infrastructures.
As William Dudley warned in Paris last week: ‘we are not yet close to a harmonized, robust over-the-counter derivatives system. Thus, we can’t ascertain whether we have achieved what we set out to achieve.’
The crux of the issue here is that until you achieve consistency across borders, until nations agree on more than they disagree, you will create opportunities for regulatory arbitrage – a ‘race to the bottom’ if you like – that inevitably colours the way we look at issues like CCP margin requirements between the EU and US.
Collateralisation of derivatives
The second area of detail I want to look at is the collateralisation of bilateral derivatives.
Primarily, I wanted to welcome the principles recently published by the working group on margin requirements.
In the very complicated jigsaw of derivative reform, this was the last major piece of the puzzle to be placed and it owes much to the positive engagement of industry.
The big policy question has always been how and where to apply initial margin. Clearly without initial margin, without upfront payment, it would be difficult – probably impossible – to provide for a level of counterparty credit risk protection comparable to that in the cleared world.
The picture was also complicated by the fact bilateral initial margin is expensive, potentially pro-cyclical and operationally challenging for those involved. But in the end, I think we’ve reached a good space – with principles that broadly strike the right balance.
Not only do they provide for gradual phase-in and offer a permanent de minimis exemption, they also require margin to be calculated in a way that avoids pro-cyclicality as far as practically possible.
The next step will be to write up these principles into domestic law. After that, it will be the simpler task – I hope – of making sure there is good co-ordination among the authorities charged with enforcing the legislation.
EMIR implementation
A different kind of challenge – in so far as it’s already rapidly moving towards full implementation – are the EMIR requirements coming online, including:
- Portfolio reconciliation, dispute resolution and portfolio compression – which came into force this week.
- Trade reporting, which should come in over the first quarter of next year.
- And, of course, the rules requiring clearing members to comply with EMIR segregation requirements, which are likely to go live from quarter four this year, to quarter two in 2014.
The FCA is working closely with the market to build up a good picture of compliance against these requirements.
The general state-of-play is actually very positive, and I know the FCA team is happy with what they’re seeing from the larger players. Most firms are putting in a lot of effort to get ready for EMIR.
The major concern from our perspective is the tail of smaller firms who are finding implementation a bigger headache.
Given the complexity of the changes involved, I don’t think this is unexpected, but it is a significant concern.
So you will see the regulator working hard to support smaller firms in the months ahead. And there’s also an opportunity, I think, for the bigger names to play their part – to reach out to client bases and help them get ready for implementation.
But irrespective of the scale of business involved – big or small – it will be important to get back on the front-foot if you’re falling behind. Developing implementation plans and preparing for the obligations coming up.
Next up on the diary is trade reporting, which firms should be preparing for now – if they aren’t already.
Clearly there’s a limit to the steps compliance teams can take before trade repositories have been recognised by ESMA.
But from a regulatory perspective, it does make sense to prepare internal systems early so you can capture and collect the right data, and begin engaging with the candidate trade repositories.
On segregation and portability requirements for client clearing, we reached a similarly critical point last week, with clearing houses submitting their applications for authorisation, including details of their own segregation models. It is an imperative that clearing members now pick up the baton and use the information to build out their own arrangements.
The deadline is tight – there’s no real wriggle room – so arrangements have to be in place by the point of authorisation of the clearing house, which will – for some – be as early as the end of this year.
Benchmarking
The key issue here is that restoring confidence and trust is not simply about LIBOR. It may well be the biggest benchmark – referenced in contracts worth some $600tn – but it’s by no means the only one capable of knocking market confidence.
The final area I want to touch on this morning, following today’s earlier session, is financial benchmarks, where there’s been a lot of activity, a lot of noise over the last few weeks.
Most important of all, the European Commission published its draft proposals for the regulation of benchmarks. This was a positive document, a useful document, and it’s encouraging to see the Commission using LIBOR reform as a broad template for benchmark regulation.
This makes good sense I think.
The reforms we’ve already introduced to LIBOR – and the work done by the International Organization of Securities Commissions (IOSCO) and the European Securities and Markets Authority (ESMA) – is explicitly designed to work for the wholesale and retail markets. To restore confidence to the benchmarking process and make it more effective.
Clearly it’s an imperative that this work continues – and expands its horizons.
The key issue here is that restoring confidence and trust is not simply about LIBOR. It may well be the biggest benchmark – referenced in contracts worth some $600tn – but it’s by no means the only one capable of knocking market confidence.
To protect against this, we’re seeing other administrators – like ISDA – announcing radical changes to the governance and methodologies of their benchmarks.
And that raises the obvious question: do we hold all benchmarks to the same broad standards, or do we allow the reputation of some to climb, others to fall?
The danger with the latter option, I think, is that you risk the integrity of an entire system. And that’s why Gary and I led the IOSCO taskforce this year to create a set of common standards of good practice for financial benchmarks.
The 19 principles we published in July establish key standards for good governance, transparency and accountability of benchmarks.
Once again, the big leap will be from paper to practice. How do we ensure benchmark administrators take these principles seriously? How do we enforce minimum standards of behaviour and integrity when you don’t always have formal jurisdiction?
We’re aware of these challenges and are working on them. But for the avoidance of any doubt, administrators should know that they will be expected to comply – both to the spirit and words – with all the principles we’ve set.
The timeframe for getting this right is a pretty generous 12 months. But once we’ve been able to review the extent of compliance by administrators, as well as the impact of EU regulation, we’ll look again at the principles. We’ll also take a position on whether they can be improved or made more effective.
The exception here is to the markets referencing LIBOR, TIBOR and EURIBOR, where the timing is more urgent. The Financial Stability Board (FSB) workstream, which Jeremy Stein and I lead, has asked IOSCO to review these bigger benchmarks in a shorter timeframe.
By June next year, the findings of these reviews will be published and we should be looking at a system that can hold the confidence of markets far more effectively.
On top of which, we’re also looking at the broader future of reference rates, with the FSB setting up a markets participants group to look at the feasibility of alternative reference rates.
Stephen O’Connor will be the vice-chair of this working group – as I’m sure was discussed earlier today – and we’re very grateful to him for sharing his time, and to ISDA for its support.
Conclusion
And that brings me, neatly, onto my final point this morning – which is a plea for ISDA, and its members to continue working closely with the FCA, ESMA, CFTC and IOSCO during this final stage of delivery.
The eye of the world may have moved on to other places, other reforms, other concerns since the G20 Pittsburgh conference in 2009.
But for the rest of us involved in derivatives reform, this is the most critical moment of getting the detail right. The regulatory equivalent of taking care of the pennies so the pounds can take care of themselves.