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Derivatives
Derivative trading is one of the many areas that have come under the spotlight. Indeed, derivatives continue to divide opinion. Some people would argue that derivatives were as much a part of the crisis as the sub-prime mortgage debacle, light-touch regulation, or low levels of liquidity and capital reserves. Others, including myself, would take the view that the problems concerning credit derivatives were more of a symptom of the crisis as opposed to an actual cause.
Nevertheless, there is agreement that action can be taken to improve the infrastructure surrounding derivatives. If we look at EMIR, for example, the idea that central counterparties should be used to clear certain classes of derivatives is a welcome one. This, if implemented proportionately, will reduce the systemic risk presented by the derivatives market. Not all derivatives deemed eligible for central clearing will necessarily be suitable for platform trading. When it comes to deciding which derivatives should be covered by EMIR, there are two different roads we could go down. The first would see all trades covered by this regulation, regardless of their venue of execution. The second would see only those derivatives executed outside an exchange being subject to this legislation.
All the arguments clearly favour the first approach. Why? The first one being that the purpose of clearing derivatives is to reduce systemic risk - it’s not obvious to me why a derivative would need to be cleared if traded off-exchange, but not if traded on an exchange.
And the second is market distortion - restricting the scope would create a rather sizeable regulatory loophole - which, if exploited, would lead to damaging asymmetry in the market. The arguments against a broad scope are hard to fathom, and seem to be about preventing competition in clearing – a subject I will come on to later.
Competition
Any measures to improve stability must look at the wider impact - particularly the impact on competition and on the effective functioning of these markets. Market regulation in Europe needs to recognise that member states don’t work in isolation to each other - and Europe doesn’t work in isolation to the rest of the world. We should bear in mind that protectionist attempts to close down our borders or Balkanise markets by currency or geography will do huge damage to European growth. As will seeking to impose so-called ‘strict equivalence’ to detailed European standards before anyone can do business in the EU. It’s clear that Fortress Europe is not the answer to strengthening our competitiveness.
We face fierce competition from overseas... not just from traditional financial centres in the US, but increasingly from Asia. And at the same time, these emerging economies present us with huge opportunities to serve new and expanding markets.
MiFID
We can look to MiFID for an example of the competition benefits that regulation can achieve. Ten years ago, Europe was an underdog, relative to the strength of the US capital markets. Member States worked in relative financial isolation; were hampered by high costs and low liquidity. And the Single Market had hardly got off the ground. But MIFID became instrumental in breaking down some of the barriers that were holding us back.
Today, as a result of the competitive pressure of MIFID, Europe has exchanges that are capable of competing globally:
Europe has become the destination of choice for many global companies seeking to access deep pools of capital. Competition has brought down trading costs, improved liquidity, and resulted in better protection for investors. In fact, I’ve read some estimates that suggest the single markets benefits of MIFID could have contributed as much as 0.8% to EU GDP.
And if we get the MiFID Review right, we have the potential to build on this progress. But if we get it wrong we could set ourselves back a decade. So what is our impression of the MiFID review so far?
Well, there are some clear positives to some of the measures on which the Commission has consulted, for example:
I also recognise that impressive progress has been made by the Commission in developing proposals for derivative markets. At the outset, I think it’s fair to say that they didn’t quite grasp all of the issues, but have worked hard to understand them through a genuinely consultative process. This should be commended. But the Commission has much more to do to convince me – and the industry - that they’ve genuinely grasped all the issues at stake.
And any changes will have profound implications for tens of thousands of firms. We must learn from the AIFM Directive and other proposals which - in their original form - were fundamentally flawed and lacked an understanding of how our markets operate.
So with MiFID, areas such as:
we must implement proportionate regulation.
A crucial part of this is understanding our markets. What works for regulation of equities - a homogenised trading instrument – should not be arbitrarily copied to bonds, sovereign debt, derivatives, or commodities markets. Also, within each asset class, the markets have their own dynamics and features, which only properly informed regulation will understand.
EMIR
In EMIR, there are opportunities to promote competition market structure - competition which is healthy and should be encouraged. We all agree that CCPs must be made safe – that is why so much of EMIR is focused on new robust prudential standards for CCPs. But we must not allow new standards for CCPs, combined with a legal obligation to clear derivative products, to embed monopolies in clearing that will result in costs passing back to the wider economy.
To prevent this, our view is that, while linked structures – so called vertical silos – can be effective, they must be subject to fair and open access requirements. Market participants should be offered a meaningful choice of using all or part of a vertical structure.
Full speech