The People's Bank of China & Federal Reserve Bank of Chicago, 2nd Annual Symposium on OTC derivatives – Keynote address
It is an honour to be here in Shanghai today, on my first ever trip to China - and to have been asked to speak to you on the European approach to OTC derivatives and clearing regulation.
As a Member of the European Parliament, I have been responsible for shaping and scrutinising numerous pieces of financial services legislation, nearing 80 pieces of law.
As a Parliamentarian, your role is to examine the legislative proposal presented to you by the European Commission, redraft it as you and your colleagues see fit and then defend and adjust this amended position in order to reach a compromise with the other European Institutions.
And of all of the near 80 times that I have been involved in this process - it is the work on the OTC markets and clearing of derivatives contracts - that has been the most satisfying but also the most challenging.
I became a Member of the European Parliament shortly after the global financial crisis, at a time when the regulation and supervision of financial markets had been tested and had fallen spectacularly short.
As a former Investment banker, I and other politicians from across the Continent and the political spectrum set about trying to rectify some of these inadequacies at a European level.
In the EU we devised a new supervisory architecture, with the introduction of the European Systemic Risk Board to monitor macro-prudential risks and the creation of the European Supervisory Authorities - three central agencies tasked with overseeing Markets, Insurance and Banking.
We mandated the use of new tools and processes for the recovery and resolution of Banks, as well as for the effective safeguarding of deposit accounts.
When the Eurozone crisis began to be felt in 2010, we put in place a Banking Union between members of the Euro, to ensure a truly integrated single currency.
These reforms were painstaking, highly political and required numerous compromises and trade-offs between Member States.
However, the European Markets Infrastructure Regulation (EMIR) the primary pieces of derivatives legislation in Europe, managed to avoid severe political interference due to the global agreement by the G20 in Pittsburgh in 2010. This resulted in an effective and well-devised treatment of the derivative market - that has been held up around the world as the gold standard ever since its implementation in 2012.
In my remarks today, I would like to look at some of the detail of this regime and the effect it has had on the European market, before focusing on why EMIR is being reviewed and how, given the geopolitical changes that are taking place, it will be a highly political process this time around. Before looking at the effect this will have on cross border business and how it will impact the global clearing model.
According to research conducted by the Bank for International Settlements, the volume of OTC derivative activity peaked in June 2008 at just fewer than 700 trillion US dollars.
At a European level and within many Member States, OTC derivatives were subject to low levels of supervision. Individual CCPs and CSDs had their own rules books pre EMIR of course and their own relationships with supervisors, but there was no standardisation, no macro oversight and no sharing of best practice.
The private nature of contracting, combined with limited public information and a complex web of mutual dependence had made it incredibly difficult to regulate and for market participants to understand the level and nature of risk that counterparties using OTC derivatives were exposed to.
The EMIR legislation had four primary aims.
Firstly, to give regulators and supervisors a holistic knowledge of the transactions taking place in the OTC market and consequently the positions build up in that market.
Secondly, to increases transparency relative to market users - so that more and higher quality information could be made available relating to prices and volumes.
Thirdly, to strengthen the operational efficiency of the derivatives markets. And finally, to mitigate counterparty risk and promote centralised structures.
To complement this drive towards operational efficiency, the use of central data repositories was also mandated. Data on the number and frequency of transactions as well as on outstanding positions was identified as key pillar of transparency.
A great amount of planning went into this question of CCP supervisory oversight - and it was recognised that these international pieces of infrastructure were important not just for regional risk mitigation but on a global scale.
It was also recognised that multiple market players, from direct clearing members, the clients of clearing members, trade repositories and the supervisors responsible for all of these entities would feature and have an interest in the risk management of a CCP.
So the EMIR college structure was devised, allowing for all stakeholders to be involved in the planning of crisis management and risk mitigation of these central counterparties.
This was a new approach to supervision, which fostered cooperation, information exchange and the continual sharing of best practise. These colleges became important forums for discussion as these complicated structures took on more and more responsibility.
In the EU, the equivalence decisions made by the European Commission remain the gatekeeper for international regulators involvement in these colleges.
Once the Commission deems that the legal supervisory framework overseeing either a CPP or a trade repository is equivalent to the EU’s treatment - EU counterparties are permitted to use a third country CCP to meet their clearing obligations and a third country trade repository to report their transactions to. And the Supervisors of these third country infrastructures are accepted into the supervisory college.
Key to all coordinated global activity, is a principle that was also adopted at the G20 Pittsburgh summit - one of supervisory deference. I quote:
“jurisdictions and regulators should be able to defer to each other when it is justified by the quality of their respective regulatory and enforcement regimes, based on similar outcomes, in a non-discriminatory way, paying due respect to home country regulation regimes’.
Deference and subsequent EU equivalence decisions, all require a huge amount of trust and cooperation between international parties, and the EMIR colleges have played an important part in aiding this.
This brings us to today and a new political discussion within the EU on Europe’s approach to OTC derivatives and clearing in 2018. Currently, the EMIR legislation is undergoing its first detailed review.
It is a long held custom to build a mandatory review into every piece of EU legislation, usually a few years after its initial implementation. The review that is taking place today therefore, was determined back in 2012- before the significant geopolitical changes of the last few years.
The review has been divided into two distinct parts, the first part looks at the technical aspects of the existing EMIR legislation and focuses on any inconsistencies and unintended consequences.
It aims to simplify and lessen the burden of reporting requirement, align the reporting process with other pieces of similar legislation - like the Markets in Financial Infrastructure Directive (MiFID) and to remove front loading and backloading provisions.
The review also examines how proportionate the original regulation was. In this first offering, we created an exemption for certain, smaller non-financial corporates that use derivatives. This exemption removed those qualified from the clearing and certain reporting obligations.
In the review, it was decided to make this exemption less burdensome to apply by adjusting threshold calculations and allowing exemptions to be granted to individual asset classes. In a further effort to reduce burden, a similar ‘small’ category and exemption was created for qualifying financial counterparties.
These are all examples of some of the small tweaks to the framework that should improve the efficiency of the regulation. And, although we have yet to enter the final stage of the negotiations, where the Commission, Parliament and representatives of the EU’s Member States reconcile their positions - I expect this non-political section of the review to reach a united outcome that will be welcomed by industry.
The second half of this review - which looks at the supervisory oversight of CCPs both within the Union and outside of it is more controversial and highly political.
My concerns with the proposed approach are many, but two stand above all the others - the first is the role envisaged for the Central Bank of Issue and the second is the move away from the principle of supervisory deference between jurisdictions.
To begin with the Central Bank, of which there are multiple within the EU due to the multiple currencies.
In the Commission’s proposal, these central banks are given an opinion over any decision made by the markets supervisors, despite there being no mediation mechanism in case of a disagreement in place.
Thus giving the CBI an effective veto.
In the EU, the independence of our Central Banks of Issue and our supervisors is of great importance, as is a clear division of responsibility. In a Union where there is still much competition between Member States and between currencies, to conflate monetary policy with risk mitigation I believe, is highly undesirable.
The European Parliament has recognised this fact and has consequentially removed this veto from their drafting. However whilst doing so they have given the Central Bank the power to impose rules on third country CCPs in ‘an exceptional situation’ - again giving the European Central Banks an unchecked and inappropriate function on globally systemically important CCPs.
This is linked very closely to the second area of concern, the move away from supervisory deference.
Under this review, a new approach to third country CCP’s has been proposed and has gained support. As well as a jurisdiction undergoing an equivalence assessment, individual third country CCPs that wish to continue providing services to EU clients, must also be subject to a separate evaluation.
This evaluation is based on the level of risk this CCP is considered to transmit into the EU. In order to make this assessment, EU powers want to be able to look at the whole of a CCPs book - regardless of whether this relates to EU facing business, a European currency or neither.
This is a clear departure from deference - as it shows a lack of confidence in the risk management of a CCP’s activity in another jurisdiction.
Following the assessment, if it is considered that this third country CCP presents too much risk to the EU system, it will be forced to relocate their business to within the Union, so that it can be under the direct supervision of an EU power - or else be blocked from servicing EU clients.
The cross border implication for this approach are numerous.
The system under the original EMIR, inspired by a global commitment, respectful of a global system and promoting global dialogue is undermined and is replaced by a politically motivated reaction to geopolitical change.
If the requirement is for more supervisory oversight by the EU of systemically important CCPs, then a system of enhanced cooperation would surely be more constructive.
CPM - IOSCO earlier this year published a framework for supervisory stress testing of CCPs positions. This framework envisaged system wide tests, that simultaneously stressed multiple CCPs so as to allow supervisors to better understand the interconnectedness and possible amplifications of system wide effects across all market participants - including CCPs, Banks and end investors and possibly those Central Banks monitoring of currency effects.
Rather than duplicative supervisory oversight across global jurisdictions, surely a more coordinated system of stress testing, one that looks at the entire system, might be more appropriate in ensuring adequate exchanges of data between CCP supervisors and clearing member supervisors across borders. This would identify any points of weakness where interconnectivity may allow contagion and threaten financial stability in one or more jurisdictions. Advanced ‘fire drill tests’, regular exchange of data and a collective monitoring of market evolution would enhance the global clearing model, rather than fragment it.
The G20 ensured that the global clearing model become a reality, we need to ensure enhanced global co-operation going forwards to support this. I’m hopeful that the EU supervisors of CCPs and clearing members, will convince the EU politicians and Central Bankers that greater exchange of information and more trust, not less, will be the route to giving global investors the confidence to trust this systemically important, centralised risk management system.
I have 9 months remaining in the European Parliament and hope that during this time we can retrieve closer relationships and build trust, rather than creating regional clearing hubs and fragmenting the global derivatives market. EMIR’s greatest success has been to increase transparency and enhance cooperation through colleges - building on this rather than revisiting global rules, must surely be preferable. As greater knowledge of methods of risk transmission are identified by CPM-IOSCP, let’s work collectively across the global clearing system to implement any changes required.
CCPs are uniquely placed to manage global risks - let’s construct a regulatory system that allows them to serve the wider financial community. More dialogue, more exchange of data and information will best facilitate this outcome.