Mr. Davies looks at the tasks of the UK's new Securities and Investments
Board and how it will affect the business community Speech by the Deputy Governor of the
Bank of England, Mr. Howard Davies, at the Futures and Options Association International
Derivatives Week Conference in London on 4/6/97.
Thank you for your invitation. And, particularly, thank you for not withdrawing it
when you discovered that, rather than having on your platform a benign, soft-centred Deputy
Governor of the Bank of England, you found yourself face to face with the all-seeing,
all-regulating head of super-SIB. This may have come as a surprise to you - but nothing like as
big a surprise as it was to me, I can assure you.
And I have to say that, in spite of the way I have been presented in some of the
newspapers, muscles rippling beneath a Superman T-shirt, I still feel rather more like Clark Kent
in his thick specs, stumbling myopically around the office. I haven't yet found a phonebox in
which to get changed.
I do not plan, this morning, to talk at length about my new responsibilities, partly
for the very good reason that I have not had the time to prepare a coherent plan of campaign. But
I might just say a word or two about the new SIB, and the way it will affect your business.
I have been quite encouraged, so far, by the market reaction to the proposed new
structure. Warning notes have been sounded, of course, about the need to avoid a lumbering,
slow-moving bureaucracy, and the need to ensure that regulation is appropriate for the type of
market. I understand those points and, particularly as far as you are concerned, the need to
distinguish between professional wholesale markets and the retail sector. There are some
interesting developments in that direction in the US at present, which we shall certainly look
carefully at as we decide our own new structures.
But, overall, I sense that we begin the task with some goodwill in the
marketplace. I was particularly interested to see the summary of the views of members of your
Association on regulation in the Price Waterhouse report published late last year. That is a
helpful document which we will take into account. I was struck by the importance you attached
to a clear but flexible regulatory environment, which scored highly as a success factor as far as
the London market was concerned. And I took the strong point made about the need for cost
control, on the one hand, and to provide a framework which facilitates innovation.
When it came to structure, your views were divided. But I was encouraged that
the option of an enlarged SIB incorporating the SROs was the one which received the strongest
favourable response. There was also quite a bit of support for taking banking supervision out of
the Bank of England. Unfortunately, I cannot readily assess the level of support for the particular
option which the Government have now chosen, since the researchers did not ask you to assess
it - which is certainly a tribute to the new Government's ability to surprise the market.
But in these surveys I am always fascinated by the outlying views - the small
minorities who express a contrary opinion. For example, when asked about the most appropriate
regulatory structure 2 per cent of those asked said they thought the best option would be to
abandon the SIB and the SROs, and the Bank of England, and that regulation should be carried
out directly by the Treasury. I would be very grateful if that 2 per cent of you could stay behind
afterwards, assuming they have not been institutionalised since the study was conducted.
The strongest message to emerge, though, was the need for regulators to consult
the market effectively on both structures and on rules. I am certainly prepared to undertake here
and now that we shall do so. We are charged by the Government to produce an over-arching
framework pretty quickly, so our discussions with the market will need to start now. But,
thereafter, we will consult intensively on the way in which the new structure will affect day to
day regulation. I give you my firm undertaking on that point.
But, as I said, today I am not speaking to you as the Chairman of the SIB. And
you have asked me, particularly, as Deputy Governor of the Bank to talk about Economic and
Monetary Union, and the way it will impact on your business. Let us, therefore, move quickly
on to that point.
Whenever I have accepted an invitation to speak about EMU over the last couple
of years, I have done so with the hope that when the day came to speak, the clouds of
uncertainty surrounding the project would have cleared - both in terms of developments among
the countries committed to going ahead, and in terms of the UK's position. But my hopes have
so far been confounded, and indeed the events of the last couple of weeks have complicated
matters even further.
This is not the time or place to talk in detail about the Bundesbank's little local
difficulty with Herr Waigel. And it is too early to assess the consequences for the project of the
results of the French election. But it is clear that new elements of uncertainty have entered the
scene, making it harder than ever to forecast the outcome next year.
Looking at the markets' own assessment, our interpretation of movements in the
forward FX markets since the autumn is that the markets have become more persuaded that the
euro will begin, but that it will be a broader, and possibly weaker euro. Until last summer the
assumption appeared to be that only seven or eight countries would make up the hard core. In
the last few months the expected future correlation of the deutsche mark/dollar and lira/dollar
rates has strengthened, suggesting a stronger market expectation of those currencies being part of
the first wave. Very recently, a few doubts seem to have emerged about the project itself, though
it would seem that, according to the market, the most likely outcome remains that a euro of some
sort would start on time.
I recognise that this is a difficult background against which businesses need to
plan. Our own advice, which we have maintained for some time now, is that it is prudent to plan
on the basis that the euro will begin on 1 January 1999, as set out in the Treaty. As far as the
position of the UK is concerned, the option remains open, the policy remains what the French
call 'le wait and see'. But the new Chancellor, like the old, has acknowledged that there are
considerable difficulties to overcome if the UK is to be a first wave member. This is not a tidy
position to be in, perhaps, but against the uncertain background, it nonetheless has a certain
practical appeal.
But taking my prudent assumption - that EMU will go ahead - what can we say
about the impact on the London market in general, and on the futures and options business in
particular? I note with interest that your own assessment is that the best option for the futures
and options business in London would be for EMU to go ahead and for the UK to participate in
the first wave. It is a moot point as to whether the impact on the profits and bonuses of
derivatives traders will be the number one criterion in the minds of Labour MPs when they come
to reach a view on EMU, but I will certainly draw it to their attention if you would like me to do
so.
By contrast, you are slightly, though not exaggeratedly pessimistic about business
opportunities in London if EMU goes ahead with the UK a 'slow track' country. I regard this as
a pessimistic assessment, and will attempt this morning to persuade you that you are wrong.
My first point, and perhaps the strongest, is that uncertainty about UK
participation in EMU has persisted now for a considerable number of years - perhaps indeed
since the late 1970s when the UK government's response to the original EMU plan was
distinctly lukewarm. And certainly no British Prime Minister has given an enthusiastic
endorsement of the most recent Delors Plan for EMU, at any stage. Yet at the same time,
London has remained the dominant futures and options market in Europe, and indeed it has
strengthened its position in many markets during that time so that, as far as on-exchange
business is concerned, London is by far the largest centre in Europe and second only to Chicago.
And the central bank survey of OTC derivatives markets in 1995 demonstrated London's
position as the premier centre for the trading and booking of OTC derivatives with 27 per cent
of average daily turnover, pushing New York into second place.
I do not propose to follow the traditional gambit of Ministerial speakers at trade
conferences, reciting figures far better known to the audience than to the speaker, but the growth
of LIFFE, the LME, the IPE and OMLX in recent years has been striking, and the most recent
development is that LIFFE overtook the Chicago Mercantile Exchange to become the world's
second largest exchange in the first quarter of this year. So if, as I was taught at Stanford
Business School, markets are efficient in the sense that they react in advance of events, in the
light of an assessment of probabilities, then they appear not to have been particularly distressed
by the prospect that EMU may start without the UK in the first wave. Certainly we have not seen
an anticipatory flow of business away from London and towards Continental European markets.
We have recently asked ourselves why it is that LIFFE has retained its position in
the three-month euromark contract and the ten-year Bund contract - Europe's most active
longer-term interest rate contract. And for those of you who like to go home with a reading list,
there is an interesting article on the subject of what makes for successful futures contacts in our
latest Quarterly Bulletin. (I am sure the restaurants and the bars of the West End will be empty
tonight as you sit in your hotel rooms poring over it.) Frankfurt has recently started making
inroads into LIFFE's share of Bund futures business - but the level of activity on LIFFE
nonetheless continues to increase.
Our assessment is that, in these markets, there is a considerable and long-term
advantage inherent in being the first mover. That helped LIFFE to achieve a very broad and
international membership, with only 27 per cent of members being UK-based. It has meant that
London has an established skill base and good support functions in law and accountancy. Also a
good telecommunications system - though fewer of those old telephone boxes, which may be a
problem for me at super-SIB. London also has a strong clearing function and we should not
forget the advantage of the English language, which is increasingly the lingua franca of the
European Union, and I believe that even some Americans can now speak a kind of pidgin
version which allows them to be understood.
But EMU will create change. This raises three interesting questions. What will be
traded in an EMU environment? How much will be traded? And where will the new instruments
be traded? Let me take these points in turn.
What will be traded when the euro makes its debut?
Looking first at on-exchange markets, it seems likely that, in EMU, there will be
room for only one three-month euro short-term interest rate futures contract, although the greater
depth of the new euro market may allow other products at the short end of the yield curve, such
as a one-month euro contract, to co-exist with the three-month benchmark product.
In the bond markets, one - and perhaps the most likely outcome - is that a
particular government's bonds will become the benchmark for the new euro bond market. We
may all speculate idly on which that country might be. These issues would then anchor the euro
yield curve and futures contracts would follow naturally. The greater depth of the new euro bond
market may well mean that it can support a greater range of futures contracts further along its
yield curve, as is the case now in the US. Five and two-year contracts, which do already exist in
the Bund market, may develop further. The exchanges themselves recognise this point and are
seeking to fill in the yield curve in their various markets before the start of EMU.
Other national bond markets will be keen to run alongside the main market and
futures contracts on those markets may also exist. But their number will depend on the basket of
deliverables of the futures contracts and how those baskets are defined. The alternative would be
for a group of different countries' bonds to be traded interchangeably, but that seems an unlikely
outcome.
On the OTC markets, the last 18 months has seen the proliferation of trades based
on changing perceptions of the likelihood of convergence for the traditionally high-yielding
countries and trades based on the differential yields of French and German government bonds.
If I might embark on a regulatory diversion here, just for one moment, we at the
Bank expect those banks involved in convergence trading to undertake rigorous stress testing of
their portfolios to assess the market risk they are running on open positions. That testing should
also shed light on the potential for changes in their credit risk - for example if an OTC contract
is moving further in the money due to a market movement, the bank would become more
exposed to its counter-party. We believe that the credit exposure implications of stress testing
should be taken seriously too and are encouraging banks as best practice to do that. In our view
not enough institutions do so yet.
After EMU, one would expect to see the elimination of exchange rate risk
narrowing yield differentials in the bond markets. With exchange rate risk removed and a single
monetary policy in operation, national bond yields will differ principally because of differential
default risks and differences in market liquidity. That should leave default risk more readily
monitorable and more efficiently priced. We should therefore see an enhancement of banks' and
investment houses' credit analysis functions and more trading of credit differentials.
My second question was how much will be traded in a post-EMU world?
This is not an easy question to answer. Volumes are difficult to predict. On the
one hand, EMU may bring about a more stable interest rate environment, as well as eliminating
national interest rates and exchange rates, reducing the need for hedging mediums and hence for
derivative products. On the other hand, increased liquidity in the euro bond markets could
encourage business and we could well see new participants entering the capital and derivative
markets. My hunch is that the latter possibility is more likely. And that the market for carefully
constructed derivatives contracts, properly sold to customers with a genuine need for them, will
continue to expand.
That brings me to my third question, where will the trading be done?
I do not think that there is a determinist answer to this question. Nor, certainly,
should it be a matter of decision by politicians, central bankers or financial regulators. Certainly,
our predisposition is to think that competition will and should determine where business is done
and the outcome will depend on the imagination and effort of the managers and controllers of
the different markets. There will be lively competition between LIFFE, the DTB and Matif, I am
quite sure. And LIFFE do not need me to argue their case for them. I see from the programme
that they are sponsoring the coffee and the tea at this conference. As a regulator it will of course
be quite impossible for me to accept such lavish and unreasonable hospitality, but the rest of you
are welcome to do so.
For the moment, LIFFE has a dominant position in short-term interest rate futures
and is the leading contender to capitalise on that position, whether or not the UK elects to join
EMU in the first wave. It has already amended its contract specifications and from March 1999
onwards these contracts will settle against the three-month interest rate for euros, a move which
has been widely welcomed in the industry.
The new euro bond market is likely to support a range of futures contracts, as I
have said, and it is not impossible that more than one identical contract will continue to exist
post-EMU, due to arbitrage opportunities, as happens now between the LIFFE's and the DTB's
Bund contract. That will be an interesting competitive arena to watch.
As far as OTC derivatives are concerned, there is little reason why London should
lose its pre-eminent position as a result of EMU. OTC markets by definition have no centralised
trading platform and their location will depend on, for example, the regulatory environment, the
availability of staff of sufficient quality and in sufficient numbers and the other success factors I
described earlier.
It is also worth noting that other changes are under way in the markets as well as
EMU. The most notable is the advances in technology which have enabled electronic trading to
start to challenge traditional open outcry. In response, open outcry exchanges are looking to
automate and streamline their trading through technology to reduce costs. And it would seem
that the exchange-traded futures industry is coming under some pressure from the OTC
derivatives market, which appears to be expanding at a more rapid pace. All of these changes
will run in parallel with the introduction of the euro, and as far as competition is concerned,
success in those areas may well dominate the euro factor.
But I said earlier that the outcome of these competitive skirmishes cannot be
simply determined in advance by an analysis of existing competitive advantages. It will depend
on the efforts of the different players and on the extent to which they are well prepared in
advance.
Here I found your own survey rather depressing. The assessment was that
relatively few market participants in London had made serious preparations for EMU, and
seemed unsure of how to proceed. Only 6 per cent of brokers and own account traders had made
contingency plans for the introduction of EMU. But this survey was undertaken in April of last
year, and I am confident that the responses would be different today.
Certainly, a lot of work has been done in the London market, co-ordinated and
steered by a team in the Bank, to ensure that London is as well prepared as other European
centres for EMU. And our assessment now, which I believe is shared by the EMI and the
Commission, is that London is as well prepared as most if not all European centres.
I can assure you that the Bank of England itself will be ready for EMU on 1
January 1999, whether or not the UK is a member. We will be able to offer euro accounts and
euro settlement facilities. We have taken the lead in work on market conventions across Europe.
EMU is likely to bring harmonisation of conventions such as day count and frequency of coupon
payments among Europe's bond markets, and the London market is ready to do that.
We have been in regular discussion with ISDA which is taking a leading role in
co-ordinating preparations of those involved with swaps and other OTC derivatives. And a
recent working group chaired by the Bank has examined the adaptations that may be needed in
the gilt market, covering re-denomination of gilts into euro, whether to quote in decimals or
fractions, the frequency of coupon payments, etc. There seems a reasonable chance that the
dramatic move to abandon 30 seconds as the basis for gilt pricing may come about before too
long. This could be the only unambiguously, incontestably good thing to come out of Economic
and Monetary Union.
We have also conducted some really exciting discussions on the issue of
rounding - a subject which I find can cause great excitement among accountants and lawyers.
And anything which brings excitement to their sad lives should clearly be welcomed by us all.
My general conclusion - and I will end here, you will be pleased to know - is that
while EMU will significantly affect your markets, it does not negate the usual rules of
competition and success. EMU changes the raw material which you work with to generate your
exotic, and sometimes dangerous products. But it does not change the rules of economics, nor
does it alter the dynamics of competition. It closes down some aspects of current financial
market business, but opens up a big set of new opportunities at the same time. Those who seize
those opportunities will be the most innovative, most cost effective, and most fast moving. At
the moment, on this side of the Atlantic, most of those people are found in London. I see no
reason why they should move.