Timothy Lane: Curbing contagion - options and challenges for building
more robust financial market infrastructure
Remarks by Mr Timothy Lane, Deputy Governor of the Bank of Canada, to the Society for
Worldwide Interbank Financial Telecommunication Annual Sibos Conference, Toronto,
Ontario, 19 September 2011.
* * *
Introduction
Good afternoon and, to our guests from abroad, welcome to Canada.
This conference is taking place at a troubled time. Concerns over sovereign debt have
intensified, particularly in Europe's periphery. Economic growth in the United States and
other advanced economies now appears to be significantly weaker than expected. In the
face of these developments, there has been mounting skepticism in a number of countries
over whether policy-makers will be able to do what it takes to address these problems.
The current bout of turbulence, like the financial crisis of three years ago, serves as a
reminder of why it is fundamentally important to have a resilient financial system. Periods of
market turbulence are a fact of life. In a resilient system, financial shocks are absorbed,
creating losses for individual investors, but leaving the system intact. If the system is not
sufficiently resilient, however, shocks can be amplified. We saw this in 2008, when losses in
a relatively small segment of the U.S. housing market cascaded into a near-meltdown of the
global financial system. That process reflected a mixture of frailties - excessive leverage,
reliance on forms of liquidity that proved illusory in stressful times, the use of securitized
products with risks that were not fully understood, the complex web of counterparty
relationships that spread risk and bred fear in core funding markets, and the absence of
resolution mechanisms to deal with insolvency in systemically important institutions without
endangering the entire system.
In the wake of that crisis, leaders of the G-20 countries launched a broad agenda of reforms.
These reforms aim to ensure that financial institutions have adequate levels of
lossabsorbing capital and liquidity to cope with periods of market stress; to establish robust
financial market infrastructure; and to develop stronger resolution mechanisms for financial
institutions, particularly across borders. When implemented, the G-20 reforms will create a
more resilient global financial system. Canada will benefit significantly from these reforms.
Even though our financial system performed much better through the crisis than those of
many other advanced countries, we are certainly not immune to events beyond our borders.
In my talk this afternoon I want to focus on one element of the G-20 reform agenda: building
robust financial market infrastructure. That infrastructure includes a number of components:
payment and securities settlement systems, trading venues and exchanges, information and
price providers, and collateral management systems. For the most part, these key elements
not only functioned well during the crisis, they were in fact a source of strength. Just after the
onset of the crisis, the CLS Bank, which settles foreign exchange transactions, successfully
processed roughly three times its normal daily volume of transactions; and CDSX, which
clears and settles trades in Canadian-dollar-denominated debt securities, handled double its
normal volume. Efficient clearing and settlement systems such as these were able to perform
a stabilizing role during the crisis. That is exactly what they were intended to do.
The crisis did, however, illuminate some key areas in which financial market infrastructure
needed to be broadened and put to better use. Here, I am talking about expanding the use of
central counterparties or CCPs to replace bilateral clearing and settlement for a number of
core markets. In my presentation today I am going to review how bilateral clearing
contributed to contagion during the financial crisis, describe why greater use of resilient
financial infrastructure is needed and tell you how CCPs will strengthen the financial system.
CCPs are of particular interest to us at the Bank of Canada because we are responsible for
overseeing systemically important financial infrastructure that affects the stability of the
Canadian financial system and, therefore, the health of the economy.
What happens when robust market infrastructure is not in place?
During the crisis, we had two stark illustrations of why greater use of financial infrastructure is
needed. The crisis did not start or end with the following shortcomings in bilateral clearing
and settlement, but they were channels through which problems in an obscure part of the
U.S. housing market cascaded into a global crisis. Although these are familiar stories, they
illustrate the need for change.
One instance is the near-failure of Bear Stearns. Bear Stearns wasn't one of the largest
investment banks in the United States, but it was one of the most leveraged, with large
broker-dealer and proprietary operations. It played a pivotal role in the global repo market,
holding collateral for transactions and acting as a counterparty for repo financing. When the
firm's mounting losses, extensive leverage and reliance on potentially unstable short-term
funding markets threatened to cause its failure, there was a risk that Bear Stearns' collapse
would cause serious disruptions in the repo market - a core funding market. Anticipations of
disruptions in Bear Stearns' operations led cash investors and collateral providers alike to
withdraw, initiating a process of leverage reduction through asset sales. Funding conditions
for collateral providers deteriorated sharply, and the liquidity and efficiency of related markets
were severely affected. In the event, Bear Stearns was rescued and the immediate threat
averted, but the danger was real.
A second instance is related to Lehman Brothers and its role as a counterparty in myriad
bilaterally settled over-the-counter (OTC) derivatives transactions. Lehman's default and the
doubts it raised about the viability of the few remaining investment dealers struck at the heart
of both the funding and the OTC derivatives market. The strains broadened to a general
evaporation of market liquidity and a retrenchment from risk.
In both cases, a basic problem was counterparty risk associated with financial contracts that
are cleared and settled bilaterally. Holders of such bilaterally cleared repos and OTC
derivatives were exposed not only to the market risk associated with the position taken in the
financial instruments themselves, but also the risk that their counterparty would be unable to
honour its commitment. Counterparty risk became a key channel of contagion, posing a
major threat to the global financial system. In contrast, some of Lehman's derivatives,
notably interest rate swaps valued at $9 trillion, were cleared through a CCP, which
successfully managed the impact of Lehman's failure.
What are the objectives for reform?
At the Pittsburgh Summit, the G-20 leaders moved to put the lessons learned from the crisis
into practice. Specifically, they called for all standardized OTC derivatives to be centrally
cleared and, where appropriate, traded on exchanges or electronic trading platforms. In
addition, all trades, whether centrally cleared or not, are to be reported to trade repositories.1
Efforts are under way in a number of countries, including Canada, to establish arrangements
for clearing interest rate swaps and other OTC derivatives that were not previously centrally
cleared. In Canada, we are also developing a new CCP for repo and fixed-income
transactions.
These reforms will have far-reaching effects on global and Canadian financial markets. The
move to CCPs is intended to reduce the complexity of the network and enhance netting
efficiencies, and to establish robust risk management practices and clear default procedures.
Since CCPs - which interpose themselves between buyer and seller in financial markets -
concentrate risk by becoming the counterparty to all transactions, they must have stringent
risk-management standards. The use of sufficiently robust CCPs is likely to increase the
strength of the financial system. It will also reduce the counterparty credit exposures of major
participants, which will be reflected in capital requirements for financial institutions.
To be safely cleared the contracts that CCPs process must, at a minimum, be sufficiently
standardized. And the push to standardize OTC derivatives contracts will have important
ancillary benefits for how these markets function. Standardization will create more liquid,
transparent and efficient markets for the contracts. It will also help set the stage for shifting
trading onto exchanges or electronic trading platforms.
The challenges of the G-20 reforms
The G-20 objectives are necessary and appropriate, but achieving them is going to be
challenging, for several reasons.
First, they may require the development of new CCP services, a complex and
timeconsuming process. We are experiencing this in Canada in connection with the work now
underway to build a CCP for repos and fixed-income transactions. The Canadian industry
selected the Canadian Derivatives Clearing Corporation (CDCC) to develop this facility.
The process of creating a CCP for repos in Canada, although not yet complete, has been
instructive. Two fundamental requirements are that the CCP has adequate and robust
riskcontrol systems and the capacity to implement them. Operational issues, such as developing
and testing the relevant software - both for the CCP and its participants - and its interaction
with existing systems, also take time to resolve.
The challenges of establishing a CCP for repos are considerable. But at least the overall
parameters are clear. Fulfilling the G-20 commitments on OTC derivatives is a more complex
task, requiring coordination among many stakeholders, with a wide range of possible
outcomes.
The complexity of clearing OTC derivatives
Central clearing of OTC derivatives transactions will reduce systemic risk by decreasing the
likelihood that one failing institution will bring down others. But, given the globalized nature of
the industry, there are several ways to make the transition to CCPs. Clearing could take
place on large international CCPs serving the global market (such as ICE Clear, CME or
LCH.Clearnet), or new central clearing services could be established in individual countries.2
We are seeing a variety of arrangements emerging. In some countries, such as Japan and
Singapore, new central clearing services are under development. Other countries are likely
to rely on offshore CCPs or - as in Canada - are still evaluating their options. The task
before us is to ensure that this emerging configuration of CCPs achieves a significant
reduction of systemic risk, both at the global level and for Canada. The G-20 commitment
sets a very tight timetable for developing a strategy to meet this challenge.
The selection of an appropriate CCP strategy for OTC derivatives is a particularly important
issue for Canadian market participants and regulators. To put it in perspective, Canadian-
dollar OTC derivative contracts have a notional outstanding value of just under $9 trillion.
Moreover, OTC derivatives, especially interest rate swaps, are closely connected via
arbitrage and financing relationships with other financial markets in Canada, including other
derivative, bond and money markets. That's big enough and connected enough that any
disruptions would likely result in significant reverberations throughout our markets. At the
same time, these derivatives markets are innately global: for example, over half of the trading
in Canadian-dollar interest rate products involves at least one party that is not a resident of
Canada; and Canadian-dollar OTC derivatives products are only about 2 per cent of the
global market. Whatever solution we adopt must come to grips with both of these realities
- the systemic importance of OTC derivatives to Canada and the globalized nature of the
market.
Large offshore CCPs serving multiple markets
Given the globalized nature of the market, clearing through large offshore CCPs has
important advantages. These CCPs can benefit from economies of scale and, potentially,
provide greater scope for netting and risk mutualization.
A key concern, however, is access. Until recently, access was limited to the largest financial
institutions with global reach. Access is now is being broadened, but the global dealers - the
so-called "G-14" - have considerable entrenched advantages in settlement costs. Those
institutions that do not have direct access to offshore CCPs would have to clear indirectly
through one of the direct clearing members.
The primary rationale for restricting access is risk control. Direct clearing members of a CCP
are required to share the losses and take over positions in the event that another member
fails - which requires that they have large financial resources and a wide scope of activities.
But here lies an important challenge. In carrying out the G-20 mandate requiring all OTC
derivatives to be centrally cleared, it is essential to ensure that we do not unduly concentrate
risk in a relatively small number of institutions that are direct clearing members of global
CCPs. These were the very institutions that spread and amplified contagion through the
global financial system in 2008.
This potential concentration of risk has several dimensions. First, if one of the direct clearing
members fails, that poses risks to the CCP and to the other direct clearing members.
Second, the failure of one of these large institutions would pose risks to institutions that clear
indirectly through it. Third, the offshore dealers may be able to use their dominance in direct
clearing to heighten their competitive edge in other financial market activities, such as trading
and other investment banking services. That, in turn, could lead to greater concentration of
business, and of risk, across a whole range of activities.
So if we are going to rely on central clearing through large offshore CCPs, direct access has
to be broadened in a manner compatible with ensuring that these CCPs have robust risk
controls. Indeed, financial market infrastructure standards are now being revised to ensure
that CCPs and their members can withstand such shocks.
There is also a need to ensure that indirect clearing is safe and efficient. Here, a key priority
is to ensure that these indirect clearers' positions are protected through appropriate
segregation of collateral and portability of positions in the event that the direct clearer fails.
The Bank of Canada is working at the international level, in co-operation with our colleagues
at other Canadian agencies, to design measures for the safe and effective use of offshore
CCPs no matter where they are located.
Domestic CCPs
While offshore CCPs may be a suitable choice for some jurisdictions, a few countries have
decided to develop their own CCPs, particularly for products that can have important
repercussions on their domestic financial systems.
So what would be the advantage of building a Canadian CCP to clear OTC Canadian-dollar
interest rate derivatives? First and foremost, it would be more straightforward for Canadian
authorities - including the Bank of Canada - to exercise our responsibilities for overseeing
systemically important financial infrastructure if a CCP were located in Canada. We would
also be better placed to manage a crisis and provide emergency liquidity support for a
Canadian CCP should that be necessary. While cooperative arrangements for oversight and
crisis management of offshore CCPs can be developed, and are currently being discussed at
the international level, this work is still in progress. Such arrangements will need to be
adequate to enable the Bank to fulfill its responsibilities for overseeing and safeguarding the
stability of the Canadian financial system.
A domestic CCP could offer other advantages as well. It could, in some situations, reduce
- although certainly not eliminate - the impact on Canadian markets of financial shocks from
abroad. It could be tailored to the needs of the Canadian financial system and support the
development of market expertise and innovation.
The key questions are whether a domestic CCP would be economically viable and whether it
would support financial stability and efficiency. We know that much of the OTC market is
global in nature and that, for a Canadian clearing service for OTC interest rate swaps to be a
success, wide participation of both Canadian and global firms is necessary. Without that, the
market could become fragmented, market liquidity could decline and the domestic CCP's
own risk controls could be undermined. Yet another key question is whether a domestic CCP
would adequately address the clearing needs of Canadian financial institutions. As a related
point, a Canadian CCP would need to be reasonably cost-effective; otherwise it could push
transactions offshore, undermining its potential benefits.
Developing links between CCPs in different jurisdictions could help to minimize
fragmentation of the market. But establishing such links would be a complicated undertaking,
and risk within the links would have to be properly managed. In practice, while a few CCP
links exist and are in operation (for cash markets, in particular), there is not yet a generally
accepted model that could be used for the establishment of links among CCPs clearing
trades in OTC derivatives.
In assessing the best clearing strategy for Canadian OTC derivatives, the Bank of Canada is
moving forward on two fronts. First, we are working with our domestic and international
counterparts to ensure that global CCPs, particularly those of systemic importance to
Canada, are able to deliver the intended benefits of financial stability. Second, we are
actively exploring the possibility of developing a Canadian-domiciled CCP, in collaboration
with the financial industry and other public policy institutions. We must choose the
arrangements that best support the stability and efficiency of Canada's financial system.
Conclusion
We are in the midst of an enormous financial regulatory transformation, easily the most
sweeping set of reforms in 70 years. Not only are the issues complex, they present
crossborder challenges that must be addressed at both the global level and in Canada. The Bank
supports the objectives of the G-20 reform agenda. Reform is critical if we are to prevent a
crisis similar to that of 2008 from occurring. However, we must be alert to the risk of
unintended consequences. At the Bank of Canada, we are working actively, both here and
internationally, to ensure that the proposed reforms to the global and domestic financial
infrastructure substantially improve the functioning of the financial system and significantly
reduce systemic risk.