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Newsroom & speeches
03 February 2010
Check against delivery
Thank you for the invitation to speak at this important conference.
This year’s Davos gathering focussed on the theme: ‘Improve the State of the World: Rethink, Redesign, Rebuild.’
The talks were aimed at finding global solutions to global problems.
Today, I would like to cover the need for reforms to strengthen OTC derivatives markets and the use of CCPs; two areas that are technical in detail, but global in nature.
One of the most used dictums for the banking sector since the onset of the global financial crisis has been the need for change.
Capital, regulation, fiscal policy, and even the social role of finance, have been under scrutiny as the costs of the crisis are still being felt.
Governments around the world have taken action to manage the fall-out from the financial crisis and to rebuild financial markets. But this is not a task that government can do alone.
Together, the Government and the financial sector need to secure a stronger, more resilient banking system that is less prone to failure
We need to have a system that is better able to resolve failing firms without systemic consequences; or calling on the taxpayer.
I want to be clear that this isn’t change for change’s sake; the reforms required are substantive, not presentational.
The industry has to change, not because ‘it knows it has to’ in the face of public pressure, but because the underlying rationale for change is right and justified.
Rebuilding trust in the system will take time. We – by which I mean Government and the banking industry – need to show that we have taken the recent crisis seriously and taken concrete action to reduce risk.
This means examining the ‘plumbing of the banking system’ and use of OTC derivatives and central clearing.
Despite not being a direct cause of the financial crisis, weaknesses have been revealed in OTC derivatives markets.
Most notably, there were deficiencies in the management of counterparty credit risk - raising systemic risk concerns - and a lack of transparency over risk concentrations.
As OTC derivatives markets are global, it is critical that regulatory responses to these shortcomings are co-ordinated globally, and consistently applied across all jurisdictions. If we do not achieve coordination and consistency, we will have left open potential for regulatory arbitrage that will undermine our policy imperative.
The G20 has agreed to strengthen transparency, use more standardised contracts and move towards greater use of central clearing.
So we welcome the proposed EU Clearing Directive, which the UK Government led calls for, which proposes the greater use of central counterparty clearing for eligible derivatives contracts.
The key to reform is the need to better manage systemic risk. To do this, we need to use standardised contracts wherever possible, make greater use of CCPs for “clearing eligible” contracts and set high global operational and prudential standards of CCPs.
We also need to remember, however, that intelligent risk management will always mean that at times bespoke arrangements will have a role to play in meeting business needs. Standardisation brings real advantages in terms of liquidity and transparency and will facilitate management of firm specific and systemic risk. But there will always be complex risks that require some form of bespoke response, albeit one that can frequently have standard contracts at the core.
Last year, the G20 called for greater standardisation of derivatives contracts, a call we strongly support.
Greater standardisation of economic and contract terms will reduce operational risk and facilitate the adoption of uniform post-trade processes, including clearing.
It is also likely, all other things being equal, to contribute to increased trading of derivatives on organised trading platforms and more meaningful availability and use of trade information, providing greater comparability between products.
These measures should in turn lead to more liquid markets, better price discovery and lower payments to intermediaries.
Standardisation will also encourage the use, where feasible, of simpler derivatives reducing unnecessary complexity and facilitating more robust risk management.
However, standardisation alone is not sufficient for CCP clearing. A CCP, in determining if a contract is "clearing eligible" will need to have regard to the following:
We consider these criteria are essential to determining clearing eligibility.
Once products eligible for clearing are identified, regulators should set challenging targets for CCP usage, with active monitoring of progress against these. I believe such an approach is preferable to attempting to require mandatory CCP clearing for all trades that could inhibit potentially valuable innovation. I stress the point because innovation, in seeking solutions to client needs, must continue to be at the heart of the successful City I seek to promote.
As part of an international effort to increase central clearing of derivatives, a target was set for the G15 dealers to clear 70% of new Interest Rate Swaps by the end of 2009, along with a target of 80% of all eligible Credit Default Swaps by October 2009. On average, they are exceeding these targets – and this bodes well.
Incentivisation will also come from insistence on increased bilateral collateralisation and higher capital charges for non-CCP cleared trades. Work on this is already afoot through the Basle committee.
I reiterate that in this complex space the Government recognises that there will always be a need for some bespoke derivatives, tailored to match corporate risk profiles and investor requirements.
But it is right that the risks in this area are properly mitigated through capital requirements that are proportionate to the risks of the underlying contracts.
But in the rush to homogenise a complex market in response to the recent turbulence, we must be careful not to stifle innovation, or kill off more complex trades that can play an important role in hedging risk in the system.
We also need to ensure that CCPs are run to high global standards. Increased CCP clearing will inevitably result in increasing concentrations of risk within these entities.
This can in turn result in systemic implications which must require the highest standards of capitalisation, operational resilience and governance.
CCPs operate – and compete – on a cross-border basis. To satisfy host regulators as to the robustness of non-domestic CCPs, and to prevent a competitive ‘race to the bottom’ in CCP risk management, it is essential that CCPs satisfy a common set of high global standards.
There is international recognition that current EU and global CCP standards need toughening, and the UK fully supports the current CPSS-IOSCO review of CCP standards. These standards will cover the prudential requirements, operational requirements and conduct of business rules. This should result in the publication of revised standards in 2011.
We urge the EU Commission, which plans to publish a Markets Infrastructure Directive around the middle of the year, to align their proposals with the new CPSS-IOSCO standards.
It will be important that CCPs operate to high standards, that they have the ability to call margin intra-day, that accurate pricing data is available and that they have a large enough default fund and other financial resources to ensure that they can deal with the failure of two or possibly more of the largest market players. These are areas where CPSS IOSCO will be doing vital work to guide us to the right outcomes.
Finally, one last area I would like to see strengthened is the level and quality of CCP’s capital – the final buffer against failure.
UK CCPs and CSDs are currently required to hold sufficient capital to enable them to complete an orderly closure or transfer of their activities, which broadly equates to six months operating costs.
This could be adapted to explicitly cover operational, business and legal risks and to reflect the systemic importance of CCPs/CSDs.
These areas are already under consideration by CPSS-IOSCO. It will be important for industry to contribute to this work to ensure that the revised standards, once agreed, are fair, robust and do not unintentionally stifle competition.
Once the revised standards are agreed, it is critical that they are applied consistently and globally to avoid regulatory arbitrage, and to minimise risks of exposure to cross-border failure.
In the UK, we have seen that the taxpayer has had to stand behind risk-taking in the financial sector. Across the globe, other governments have had to step in.
It is therefore right that supervisory responsibility and authorisation should reside with the home state. But we will need to have confidence in the application of common standards across Europe and the globe.
In addition to greater standardisation and greater use of ‘clearing eligible contracts’, we need to have greater transparency of OTC contracts. This will be achieved by reporting those trades to trade repositories, so that market players and regulators can have full visibility.
Effective trade repositories will help identify potential sources of concentration risk and market instability and will support financial stability planning. In addition, the publication of aggregate knowledge to the public will provide valuable knowledge for the price formation process.
And again, given the global nature of OTC derivative markets, it will be essential that appropriate information sharing arrangements are in place between the authorities.
So we must continue to work hard to get this right and continue to engage with the Commission and international partners to achieve global consensus on the issues and to secure global implementation of higher standards
In conclusion, the crisis has shown the need for greater transparency and more robust counterparty risk management in derivatives markets. The necessary changes will confer significant benefits to the UK, bringing about stability and confidence that will help foster a competitive advantage for the City of London.
This requires getting two aspects absolutely right - tough incentivisation for CCP clearing, without stifling innovations that better hedge complex risks; and that CCPs are run to high, global standards.
Such standards must be geographically neutral. CCPs that are based in the UK must not be disadvantaged in their abilities to serve global markets and vice-versa.
Derivatives markets are global in nature and regulatory responses must be consistently applied across the EU, but also consistent with initiatives elsewhere, to limit the scope for regulatory arbitrage. We need to set a high bar across all markets.
The Treasury is actively involved in leading and contributing to processes that produce good outcomes for market users and deliver systemic robustness. I am encouraging my officials to ensure that the changes that take place provide plenty of opportunity for profitable engagement by a strong and responsible City of London.
I assure you that I am not caught up in ‘change for the sake of it’. I am convinced of the underlying rationale for these reforms and hope to see a real push to usher in a sustainable, stable, prosperous new age for the financial markets of Europe and the UK.
Thank you.
