15 May 2015

BoE: Financial Markets - identifying risks and appropriate responses

Andrew Bailey, Deputy Governor, Prudential Regulation and Chief Executive Officer, Prudential Regulation Authority delivered a speech entitled “Financial Markets: identifying risks and appropriate responses“ at Cambridge University.

“The PRA, as the UK’s prudential supervisor of major trading firms, will continue to develop its capacity to assess algorithmic or automated trading, including the governance and controls around the introduction and maintenance of trading algorithms, and the potential system-wide impact of crowded positions and market liquidity. We will assess the adequacy of existing risk measurement and management practices in capturing exposures from the large volume of intraday trading instigated by these algorithms. We will continue to develop our assessment of whether trading controls deployed around algorithmic trading are fit for purpose, and in doing so we will no doubt capture insights on the role of market making on electronic platforms.

This is all part of our task of supervising firms’ trading books. It should be assisted by the introduction of MIFID2 (the Markets and Financial Instruments Directive) in Europe, which will impose rules on algorithms and high frequency trading, including the introduction of circuit breakers, minimum tick sizes and maximum order-to-trade ratios, thereby seeking to improve the stability of markets.

First, maintaining the stability of the financial system means that we have to keep a close watch on how risks that can appear in financial markets and the non-bank financial system may wash back into and affect the critical functions performed by banks; in other words destabilise the core of the system. In order to enhance our protection against this risk, in this year’s Bank of England concurrent stress test, we are taking a substantial step to enhance the coverage of market risks. Our new approach to stress testing trading activities will capture how fast banks could unwind or hedge their trading positions in the stress scenario. This means positions that are less liquid under stress conditions will receive larger shocks.

And, we have developed a new approach to stressing counterparty credit risk, which focusses on capturing losses from exposures that would become large under the stress scenario and for counterparties that would be most vulnerable in the stress scenario. Second, the Bank of England, working with the FCA and HM Treasury has set up the Fair and Effective Markets Review to restore trust and confidence in the fixed income, currency and commodity (FICC) markets in the wake of the serious wave of misconduct seen since the height of the financial crisis. The Review is taking a fundamental look at the root causes of these abuses, the steps that have already been taken by firms and regulators to put things right, and what more is needed to deliver less vulnerable market structures and raise standards of behaviour in future. The Review will publish its recommendations in June 2015.

Out of this assessment, and based on consultations to date, will I believe come priorities on market structure “standards” and transparency, effective competition, professional culture within firms and effective, pre-emptive supervision which reduces the drama of ex-post enforcement. The third area of action concerns initiatives to improve the functioning of markets to support activity in real economies. Resilient market-based financing will help to support sustainable economic growth. The aim behind the European Commission initiative on Capital Markets Union is to strengthen markets in the EU to support growth and stability, and sustainable progress on this front will be welcomed. Likewise, sound securitisation is a goal of the wider financial reform programme. The Bank of England and the ECB have published a consultation paper to identify simple, transparent and comparable securitisation techniques, the use of which should be encouraged. This work is now being taken forward in international policymaking bodies.“

Full speech

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