Shanghai Clearing House and Fudan University - Clearing Members Training Seminar
Good afternoon and thank you very much to Fundan University, Shanghai Clearing House and CCP12 for asking me to speak here today and indeed to The People’s Bank of China and the Federal Reserve Bank of Chicago for inviting me to attend discussions over the last two days.
I have worked on European derivatives and clearing legislation for almost ten years - and have been lucky enough in that time to attend forums like this across Europe, the United States, Canada and now here with you in China.
The dialogue of the last few days has been invaluable to me and it has been a real privilege to have been able to listen and learn from the experiences and ambitions that have been shared.
Thank you very much again for your hospitality.
I have been asked to talk this afternoon about the opportunities and challenges of financial innovation, as well as how CCPs facilitate cross-border businesses for financial institutions.
I’d like to speak to you about my experiences as a legislator at a European level, how we approach these topics of the future - on the likes of technology, crypto assets and distributed ledger technology and the challenges we face here.
I’d like to then look at the cross border practises of CCPs in the EU, where we have done a huge amount of work aimed at easing and encouraging cross border business in this field.
And finally I’d like to take stock, examine the barriers that remain and discuss how financial innovation can contribute to a truly integrated clearing and post-trade market, not just within the EU – but indeed globally.
I always think it is good to end on an opportunistic note!
Innovation has a number of synonyms - alteration, change, transformation - even revolution.
When it comes to innovation in financial markets however, it will cause significant disruption and change.
This is one of the reasons that policy makers around the globe find legislation and treatment of this topic challenging.
When it comes to technology and innovation, financial markets policymakers, legislators and regulators often find themselves confronted by two seemingly opposing realities.
At one end of the spectrum, you have technology as the great disruptor– the new iteration of unknown risk with the potential to contaminate traditional pieces of market instruction, like CCPs.
And at the other end, technology is the ultimate efficiency. A resource that will bridge fragmented capital markets whilst requiring little political sacrifice at the same time as democratising financial service positions to the benefit of the consumer.
For a policy maker in Europe, like myself, this juxtaposition is exacerbated by the nature of the European legislative cycle – where in some areas we are still working on pieces of post-crisis legislation right alongside newer more forward-looking pieces.
We are making minor technical changes in some instances, like in parts of the ongoing review of the European Markets Infrastructure Regulation that I spoke about yesterday - and in other instances legislators are being asked to creating completely new structures to treat completely new products.
This makes some work seem instantly outdated and obsolete and other projects pre-emptive and risky.
Further challenges are presented by gaps in market regulation, or by very young regulation.
There is currently no jurisdiction in the world that has a legal process for the recovery and resolution of a CCP for example. Much of my time over the last year has been spent leading the negotiations to agree a common European approach - but progress has stalled.
Within the legislation I drafted, we looked very closely at the rules around reacting to a cyber attack - the type that could freeze a CCP and the market. Knowing that regulation has not been approved that accounts for this circumstance, makes me personally nervous. Although I am comforted by the expertise and consideration that CCPs own rule books give to this.
In Europe we have only just seen the implementation of a seminal piece of data protection law, the General Data Protection Regulation. Given the financial technology sector’s reliance on consumer data and given that this is the very subject of the new GDPR - we have not yet had a chance to fully examine and understand the effects of these new standards and therefore approach affected areas of the market accordingly.
Finally there is the challenge of education. I mentioned the pace of technological change a moment ago and to put it simply - it is hard to keep track and keep yourself educated on continual, fast paced advancement.
Moreover, whilst the G20 Pittsburg agreement on derivatives clearing and trading may seem a long time ago for the many in industry, for many policy makers - especially those with a more political than technical background as is common in Brussels, the move towards central clearing and the post trade world is still an unknown. To add technological innovation on top of this is a further challenge.
So how do we overcome these challenges? I would advocate two approaches.
Firstly, there needs to be a sharing of best practice between global regulators. My own markets regulator in London, the Financial Conduct Authority provide a good example here.
Their ‘regulatory sandbox’ approach, whereby technology businesses seeking to gain authorisation for a product, are given the opportunity to test products and services in a controlled environment - is being upscale to include a global version and currently they have nine bilateral cooperation agreements with other jurisdictions around the globe. Nine formal agreements which encourage greater dialogue between regulators.
The second approach would be an uptake in the use of technology for regulatory purposes - RegTech. If a regulator is tasked with reacting to Blockchain, their understanding and appreciation will only be enhanced by familiarity and trust in a Block-chain based application designed for their own regulatory needs.
And finally events like these need to continue and expand all over the globe - to be able to return to Europe next week and pass on some of the lessons from the last days to my colleagues, will be invaluable.
I know that this initial section of my remark has focused predominately on the challenges innovation faces - but I believe that it is vital to understand the gap that exists between a supervisor’s compliance based culture, reliant on rules based models and the technological, fast-paced environment that industry is used to operating in.
Industry needs to make the positive case to politicians, regulators, and legislators as loudly as they can - especially in the area of clearing where there is a huge amount that can be improved and gained through the acceptance of technological solutions.
I’d like to turn now to CCPs and look in more detail at how they facilitate cross border business for financial institutions.
In the European Union, where we are concerned with easing both internal and external cross border business, CCPs play a vital role. Removing barriers for the free flow of capital and services across national borders is of huge importance as there is still a long way to go towards perfecting the Internal Market and specifically, creating a truly integrated post-trade environment.
Whilst the Internal market is a vast project, covering all industries and sectors - specific work has been done on the clearing and post-trade world and the improvement that need to be made here.
Longstanding barriers to integration were first identified and consolidated by an Italian academic Alberto Giovannini in 2003. The 15 ‘Giovannini barriers’ as they came to be known were subsequently taken up as a European policy focus.
In many ways, this was already well behind the times. Especially when you compare to the situation in the United States where integration of the clearing and post trade environment kicked off in 1976 with the consolidation of the NYSE, AMEX and NASD, to form the National Securities Clearing Corporation.
This consolidation of large pieces of markets infrastructure has allowed the US a strong cross border presence that the EU has tried hard to replicate.
In some areas, you have to recognise that this will not be possible - there is too much vested political interest in the EU to have a DTTC style mandatory public utility model for cash equity clearing for example.
However, in other areas the EU holds its own. In the case of CCPs for example.
CCPs facilitate cross border investment through their open structure, driving down cost and by being subject to effective supervision.
A CCPs’ structure, by nature, facilities cross border business - in that it allows clearing members in different member states and equivalent jurisdictions to do business with clearing members and clients in others - without having to have a physical presence in the same location.
Cross border business means a wider pool of participants which is obviously desirable for participants in a CCP, because of the netting features that are then enhanced and available to them.
A CCPs ability to provide netting, whereby multiple positions are consolidate into one allowing each party to make a single, simple transaction based on the net value of multiple transactions is a key selling point.
It is a characteristic that also benefits the administrative tasks involved. If clearing is the confirmation of several legal and administrative details between counterparties and brokers, a central organisation that can provide these services and expertise is highly appealing. As are well maintained relationship with other key players in the post-trade process, settlement for example.
Moreover the interoperability arrangements that have become commonplace between many global CCP, means that participants can avoid the loss of netting that occurs if positions are fragmented across multiple CCPs.
Formal inoperability arrangements are very common on the European equities market - for example EuroCCp, London Clearing House and SIX all clear on each other’s venues.
It is this concentration of staff, expertise and asset options that make it a convenient interface with which counterparties can interact.
It also serves to increase competition and drive down costs.
In 2007, the EU introduced the Markets in Financial Instruments Directive (MiFID) which removed many of the legal barriers to competition between trading venues within the Union.
This led to a rapid increase in the number of trading venues, greater levels of competition venues and in turn between CCPs. However, unlike trading venues which increased in number, CCPs instead began to consolidate.
And the effects on costs were drastic.
According to one report published by the European Commission - the average clearing fee fell by 73% between 2006 and 2009.
Quite simply lower costs broaden market participant’s access to clearing - with one membership fee and one set of default fund contributions.
This issue of default fund contributions brings us to the final point of this section; the contribution effective supervision makes to cross border business. Well executed and proportion regulation of CCPs increases market confidence and familiarity with these pieces of infrastructure.
Moreover, it paves the way for equivalence decisions to be made as it allows a comparison to be drawn between different markets.
With the merits of CCPs and cross border business evident, why then do barriers to this still persist?
I can speak to this confidently at a European level simply because many of the Giovanni barriers I mentioned before are still in place today. Differing national Securities laws, taxation requirements and bankruptcy procedures across the EU - which are politically very difficult to align, hinder cross border business.
New innovation will mean new challenges for Markets Infrastructure like CCPs and also for the regulators. I am confident however, that the risk management skills they demonstrate will always be needed – even if they need to evolve over time.