Bruno Gehrig: Global economic trends and their implications for financial
market infrastructures
Speech by Prof Bruno Gehrig, Vice-Chairman of the Governing Board of the Swiss National Bank, at
the 11th International Securities Services Association (ISSA) at the UBS Executive Development
Center, Wolfsberg, 12 June 2002.
* * *
Ladies and Gentlemen,
It is an honour and a pleasure for me to have the opportunity to give the opening speech at the 11th
ISSA Symposium. I am delighted that you have chosen Switzerland as a venue for your conference
and hope that you feel comfortable and relaxed in this beautiful spot on the Lake of Constance. I
gladly accepted your invitation although I am not an expert in your professional field. But I was, and
still am, using your services rather intensively: in the 1980s as Head of Securities Sales and Trading at
UBS, later on as CEO of an asset management bank, and now as investor of the currency reserves of
the Swiss National Bank (SNB). I would like to use the time allocated to me to reflect on global
economic trends and their implications for financial market infrastructures. Afterwards, I will outline the
consequences these changes have on oversight authorities, which face similar challenges as you in
your capacity as commercial service providers.
Global economic trends
What are the global economic trends that we all perceive in our daily business? Let me focus on some
of the most prominent ones: the alleviation of barriers to trade in goods and financial assets, and
factors affecting the overall demand and supply of securities.
Alleviation of barriers to trade in goods and financial assets
Barriers to trade in goods, services and financial assets have been progressively lifted during the last
few decades, leading to a growing interaction among national economic systems. This growing
interaction and connectedness is what people commonly refer to as globalisation. Countries
participating in this process have seen their domestic financial markets become more integrated with
markets abroad.
Two factors shape and characterise this process. First, technological innovation has sharply reduced
transportation and telecommunication costs. Some figures taken from an IMF study illustrate this
impressive change1.
Table 1
Communication and computer costs, 1960-2000
Cost of a 3-minute phone call, Price of computers and peripheral
New York to London equipment relative to GDP deflator
(in 2000, USD) (year 2000=1000)
1960 60.42 1,869,004
1970 41.61 199,983
1980 6.32 27,938
1990 4.37 7,275
2000 0.40 1,000
Source: IMF.
1
P. Masson (2001): "Globalization: Facts and Figures", IMF Policy Discussion Paper 01/04, International Monetary Fund,
Washington D.C.
BIS Review 37/2002 1
In only 40 years, telecommunication costs shrank by a factor of about 150, while computer costs
became around 1900 times cheaper. As a consequence, information is now disseminated almost in
real-time and at low cost.
Second, financial crises have become more frequent. Most of the time, they are driven by rapid inflows
and outflows of capital. We still vividly remember the crises in Mexico, Asia, Russia and Argentina.
Obviously, these crises have not been restricted to the financial sector, but have had a profound
impact on the real economy as well.
The lifting of restrictions to cross-border holding and trading of financial assets has unleashed massive
capital flows. According to World Bank figures, global debt and equity flows (excluding foreign direct
investment) expanded by more than five times since 1991, from USD 794 billion to USD 4.3 trillion2.
Without doubt, this development reflects a long-term trend. More and more investors decide globally
and on the basis of risk-adjusted expected returns. Taking place in a system of increasingly integrated
capital markets, capital allocation has become more efficient.
The other side of the coin, however, is the increased volatility on financial markets. Indeed, portfolio
investments, in particular those in markets with relatively high liquidity, have become more erratic, as
fund injections and withdrawals respond very quickly to new information. According to the IMF, assets
managed by institutional investors on mature markets are estimated at about USD 30 trillion in 1998.
Thus, any shift in such a huge portfolio is very likely to exacerbate economic cycles and will possibly
lead to contagion among financial markets. The impact of portfolio re-balancing will be all the more
powerful as macroeconomic policies seem to be unsustainable and as financial institutions show
fundamental weaknesses, often with regard to financial strength, supervision and transparency.
Experience has shown that enhanced financial integration has, on the whole, resulted in higher growth
and greater convergence among economies. Admittedly, not all sectors have gained in this process;
there have also been losers in practically all countries involved. Nevertheless, the benefits of
liberalisation have exceeded its costs. The call for a return raised by some voices therefore seems
inappropriate. On looking ahead, the path and success of the liberalisation process will depend on
how the effects of inequality gaps within and between countries, and the effects of increasing volatility
on financial markets, are dealt with.
Securities: demand and supply
Integrated capital markets operate primarily on the basis of supply of, and demand for, securities. This
has not always been the case. Bank deposits and loans used to play a much more significant role. Yet
with deregulation and the rise of institutional investors, securities have become the central tool of
capital allocation.
The United States' strong net import of capital illustrates this fact. Let's have a look at some figures
taken from an IMF report3.
The net foreign purchase of US long-term securities almost doubled between 1995 and 2000, rising
from USD 232 billion to USD 456 billion. Taking a closer look reveals some interesting facts. During
the same period, the net foreign purchase of corporate bonds and stocks increased by 3 and 15 times,
reaching USD 182 and 175 billion respectively. The net foreign purchase of corporate securities
amounted to 30% of the entire net purchase of US long-term securities in 1995. In 2000, it accounted
for about 80%. During the same five-year period, the net foreign purchase of agency bonds increased
by 5 times, while the net foreign purchase of US government bonds shrank massively due to a strong
supply reduction as well as the investors' move towards higher-yielding financial assets.
One major consequence is that demand for securities issued by the corporate sector has been
increasing impressively over the last few years. This strong demand reflects diversification needs and
the enhanced capacity of investors to apply sophisticated portfolio management strategies. In addition,
there has been a clear trend towards collateralisation of financial claims as a risk mitigation technique.
Indeed, collateral is widely used today in the underlying and derivative markets for financial assets,
including gold. Collateralised transactions have also gained momentum in payment systems with the
purpose of not only reducing credit risk, but also facilitating access to liquidity through readily available
collateral.
Table 2
Net foreign purchase of US long-term securities
Government Corporate Corporate
Governmentsponsored Total
bonds bonds stocks
agency bonds1
1995 134,115 28,729 57,853 11,240 231,937
1996 232,241 41,723 83,743 12,511 370,218
1997 184,171 49,853 84,358 69,597 387,979
1998 49,039 56,802 121,930 50,020 277,791
1999 -9,953 92,200 160,392 107,522 350,161
2000 -53,790 152,841 182,403 174,890 456,344
1
Includes bonds issued by U.S. government corporations and federal agencies.
Source: IMF.
Central banks around the world have been a driving force behind the trend toward collateralisation.
First, they have been relying increasingly on repo transactions to implement their monetary policy. Like
many of its peers, the Swiss National Bank, which traditionally operated exclusively on the basis of
foreign exchange swaps, now steers the liquidity supply primarily through repo transactions. Second,
central banks typically grant intraday credits, which are relevant for smoothing settlement in payment
systems, against collateral. Intraday repos have been available from the Swiss National Bank since
1999, on demand and at zero interest.
The trend toward collateralisation creates additional business opportunities for providers of financial
market infrastructure, but it also increases their systemic relevance. Indeed, since the linkages among
cash, securities, and derivatives markets have become so close, a failure - either by a provider itself or
by a major participant - is very likely to cause disturbances affecting different markets at the same
time.
In addition to collateralisation, the appetite for securities has been forcefully stimulated by the
changing needs of private and public wealth owners: the ongoing institutionalisation of the savings
process, the facilitation of direct market access through internet technology, the disintermediation of
the banking system due to credit risk considerations and the relative decline in attractiveness of bank
deposits.
On the supply side, the corporate sector has been increasingly relying on bond financing rather than
on traditional bank borrowing. In the US, private debt securities amount to about USD 7 trillion. The
ratio of bank credits to GDP has remained more or less stable at around 10% for the last 50 years,
while the ratio of bond financing to GDP has risen sharply from 15% in 1985 to 25% in 2000. Bond
financing within the European corporate sector has also caught up, strongly supported by the
inception of the euro at the beginning of 1999.
In short, the supply of securities is bound to grow further; cyclical ups and downs are likely, but the
trend will point upwards. Notwithstanding obvious differences between economies, it is generally true
that the corporate sector will make further progress in exploiting the potential advantages offered by
open capital markets. The European corporate bond market seems an especially interesting case.
Since the inception of the euro, it has staged an impressive take-off, even though its institutional, legal
and accounting environment is still far from optimal.
Central bankers have good reason to welcome such developments. Not only because they probably
make the saving-investment process more efficient, but also because they allow for a better
distribution of credit and market risk which should - if anything - enhance the stability and robustness
of financial systems.
Financial processes and markets will continue to become more and more internationalised with
obvious impacts on securities operations, liquidity and collateral management procedures. What kinds
of challenges will this create for market infrastructures on the one hand, and for oversight authorities
on the other hand? Let me address these two questions in the following.
Implications for financial market infrastructures
A first requirement for financial market infrastructures is that they must be capable of coping not only
with an increase in cross-border securities operations, but also with their time-critical nature.
Therefore, particular efforts should be made to ensure intraday finality, to shorten settlement cycles, to
co-ordinate operating hours among the individual systems and to standardize communication
procedures as well as message formats. As you know better than I, this is easier said than done, since
we still rely heavily on technologies and systems that are tailored to domestic needs and peculiarities.
The current coexistence of several non-interoperable platforms implies an extensive amount of costly
manual intervention.
A second requirement - which is linked to the first one - relates to the objective of reducing clearing
and settlement costs, especially the costs of cross-border securities operations. As discussed in the
Giovannini report4 mandated by the EU, domestic clearing and settlement arrangements within
member countries seem to have reached a level of cost efficiency, which is - by and large -
comparable to what DTCC (Depository Trust & Clearing Corporation) in the US has achieved. By
contrast, the whole cross-border domain is far from being cost-efficient, mainly due to fragmentation in
terms of market infrastructures and practices, as well as differing legal, tax and accounting
frameworks.
The obvious question is, therefore, how to realise efficiency gains in the cross-border context. One
way - and probably the most appealing one - is to consolidate market infrastructures. Within the
European Union, there are currently more than 20 Central Securities Depositories. Although
consolidation seems unavoidable, it is less clear how to achieve it and which model best suits
integrated financial markets. Should priority be given to vertical or to horizontal integration? On the
one hand, vertical integration presents some advantages. Since trading, clearing and settlement occur
within the same organisation, this reduces legal and operational risks. On the other hand, vertical
integration may entail cross-subsidies, which disguise the effective costs of trading, clearing and
settlement. In addition, this model may also tend to rely on rents, as it is impossible for users to switch
between providers. Horizontal integration, however, allows users to select between interlinked
providers, exposing them to ongoing competition. Yet the feasibility of this model depends on whether
there is a cost-efficient way for users to route transactions to their preferred provider. In any case, the
emergence of poles around Euronext and Deutsche Börse shows that the consolidation process has
begun. From a Swiss perspective, both SWX and SIS are engaged in the race - not really as hunters,
given their relative size, but as partners with proven technology and know-how.
Financial market infrastructures are also subject to higher competitive pressures. The driving forces
behind these pressures are, without doubt, technological innovation and the expected profits resulting
from the achievement of economies of scale and, possibly, economies of scope. Three kinds of
competitors can be distinguished. First, competition among exchanges, clearing and settlement
organisations within and across countries has increased. Indeed, for trading, clearing and settlement,
physical location has become less and less relevant. As you are confronted with these pressures in
your daily business, you certainly know better than any central banker what I am referring to. Second,
non-financial institutions may provide trading, clearing and settlement services to financial markets.
More precisely, I think here not only of alternative trading systems, but also of outsourcing partners
such as payment and securities processing centres. Third, and maybe less visible, but of growing
significance, are competitive pressures exerted by large custodians, especially by global custodians.
Indeed, global custodians not only rely on a worldwide network of sub-custodians offering easy access
to all markets, but they also develop in-house clearing and settlement procedures with very
competitive costs.
Without any doubt, financial market infrastructures are facing great challenges in terms of higher
technical requirements, the necessity to achieve efficiency gains, and higher competitive stakes. I
believe that market forces - rather than political pressure - should drive the consolidation process. The
many changes taking place also challenge oversight authorities. It is their task to analyse the systemic
implications of what goes on particularly at the cross-border level, and to make sure that these
changes will enhance, and not endanger, the soundness of the financial system. Let me address
these issues in the concluding part.
Implications for oversight authorities
I begin by quoting Alexandre Lamfalussy, Chairman of the Committee of the Wise Men, which, more
than a year ago, published the famous report on securities regulation within the EU5. Lamfalussy was
current [securities] regulatory system is not
very clear when he asserted that "the working"6. Indeed,
unclear and sometimes even contradictory regulations or inconsistent implementation of regulations
among countries impair the creation of a single capital market within the European Union.
Starting from this premise, I would like to specify what kind of challenges oversight authorities face
and share with you some ideas on what the role of an institution like the Swiss National Bank should
be. But first of all, I would like to clarify a fundamental point. Some people claim that the oversight
authorities' objective of promoting the stability of the financial system hides an undue interventionist
activism. Well, these claims are beside the mark. Let me quote Andrew Crockett, BIS General
Manager and Chairman of the Financial Stability Forum7: "[...] systemic stability is critically determined
by the collective behaviour of individual market players. [...]. And supervisors need to analyse the
interaction between individual incentives and systemic outcomes." In other words, systemic stability
depends on how negative externalities, which are not priced or internalised by the market, are dealt
with. Thus, we should not waste our time discussing whether regulatory intervention is necessary or
not, but rather how oversight authorities, focusing on systemic risk, should shape the process.
Keeping this in mind, the challenges oversight authorities face are numerous and well-known. The
Giovannini Group lists no less than 15 barriers to efficient cross-border and settlement procedures
within the European Union. These barriers are categorised according to their technical nature, their
fiscal implications and their legal aspects. A remarkable feature of this report is the distinction between
what market forces can achieve and what regulatory authorities should do. In particular, there are
several issues that cannot be tackled by the private sector, e.g. the harmonisation of the legal,
regulatory, taxation and accounting frameworks.
A first challenge is the need for global oversight. This need arises from several factors. In terms of the
so-called horizontal approach, trading, clearing and settlement of securities operations already occur
in different institutions located in several different jurisdictions; virt-x and SIS-clear are just two
examples. For the time being, cross-border infrastructures deploy their activities in complement to
domestic systems, but it is very likely that they will play a significantly more powerful role in the future.
Oversight authorities tend to prefer a pragmatic approach, where one regulatory authority takes on the
role of a lead overseer and consults with other relevant authorities. Such a model has already been
put in place among central bankers in the context of the Continuous Linked Settlement system.
A second challenge that oversight authorities face lies in the risk dimension of cross-border securities
operations. Indeed, whereas the nature of the risks remains basically the same, both the probability of
occurrence of an adverse event and the risk exposures themselves have clearly increased. The added
dimension of cross-border activities lies in spill-over effects due to direct links between systems.
Credit, liquidity and operational risk events occurring in one jurisdiction may indeed trigger a systemic
crisis by spilling over to foreign financial markets. These kinds of linkages among different systems
explain why oversight authorities have recently focussed not only on payment systems, but also on
securities clearing and settlement systems.
A problem that is potentially relevant in systemic terms is the availability of intraday liquidity in foreign
currencies, which is typically restricted, if not non-existent. This restriction hampers liquidity
management in an integrated multi-currency environment. Nowadays, there is a much more urgent
need for market participants to make time-critical payments than previously. Moreover, they must be
able to react simultaneously in several currencies even in troubled circumstances. Their liquidity
management could be facilitated and strengthened significantly if they were able to obtain short-term
liquidity in the required currency through a cross-border collateral pool. Such a collateral pool would
boost the ability of the large market participants to react, thereby reducing the system's vulnerability to
disturbances. In addition, this would result in efficiency gains, as maintaining a pooled collateral
portfolio would certainly be less costly than keeping several currency-specific portfolios. In view of the
manifold legal and technical obstacles, one is tempted to deem such a collateral pool a vision.
However, visions can come true: take CLS, the Continued Linked Settlement system, which will go
into operation in the near future. Central banks and the private sector must direct their joint efforts at
researching the feasibility of a collateral pool, as does the Payments Risk Committee in New York8.
A third challenge relates to in-house clearing and settlement mechanisms at global custodians. This
commercial function has undergone a remarkable process of concentration in the last few years.
Some of these service providers have become very significant for the stability of the system as we
have seen after September 11 of last year. Independent of specific events the question arises whether
regulatory control has kept up with this development everywhere. From an organisational point of
view, it is problematic that custody activities lie in a grey area between banking supervision and
system oversight. In some countries - such as Switzerland - where the tasks deriving from banking
supervision and system oversight are performed by separate authorities, the regulatory framework
risks being incomplete or at least suboptimal unless the two authorities succeed in establishing a
strong cooperation link. This aspect seems all the more important as global custodians tend to
become direct competitors to traditional financial market infrastructures.
In view of these challenges, there is good reason to critically reassess rules and regulations related to
securities clearing and settlement as well as to the way oversight responsibilities are implemented in
practice. A predominantly national approach does not serve market needs any longer. And an
essentially sectoral solution, where payment system regulators and securities regulators do not
cooperate in an integrated way, is inappropriate. Indeed, all official and private sector initiatives that
can give an impetus to this debate are highly welcome. The CPSS-IOSCO Recommendations for
Securities Settlement Systems, the ISSA Recommendations 2000, and the Group of Thirty's ongoing
work all contribute to improving our understanding of the challenges we face. And it is only when
issues are really understood that appropriate responses can be formulated and implemented.
In Switzerland, as in several other countries, supervision of the securities clearing and settlement
system is still work in progress. A draft of the revised National Bank Law has been submitted and will
be discussed by Parliament in the near future. The revised law will presumably enter into force around
2004. It is intended to explicitly vest the responsibility of overseeing payment systems as well as
securities clearing and settlement systems in the Swiss National Bank. The revised law will thus
formally express that an efficient and secure financial market infrastructure is imperative for the
implementation of monetary policy and for the stability of the financial system. The inclusion of clearing
and settlement systems follows from the obvious fact that, given their linkages, these infrastructural
functions are of considerable systemic importance. This is all the more true since the SNB has, for a
few years now, implemented its monetary policy exclusively through repo transactions.
The SNB can fulfil this expanded mandate only by closely cooperating with other authorities.
Domestically, the SNB will work hand in hand with the Federal Banking Commission (FBC). The SNB
will focus on systemic issues, while the FBC - our bank supervisor - will deal with institutional aspects.
This job-sharing is based on the premise that each authority will be able to make use of its
comparative advantage. Internationally, market developments foster cross-border cooperation
between oversight authorities. For instance, institutions such as Sega Intersettle (SIS) through "The
Settlement Network" are heavily involved in the current reshaping of Europe's financial market
infrastructure.
However, as the legal reform is not yet in place, there are many open questions as to what exactly the
modus vivendi of the oversight function should look like. We will address them step by step in a
pragmatic way. Many issues such as the set-up of mechanisms for information sharing, the need for
on-site examinations, or the disclosure of oversight proceedings have still to be discussed and
clarified. We are in the process of defining basic principles and implementation tools pertaining to our
new oversight responsibilities.
Conclusion
I would like to conclude my speech with a fundamental remark. In the field of financial market
infrastructure, there is no alternative to close cooperation between private market players and
oversight authorities. On the one hand, it makes sense in this field as well to rely on market forces to
stimulate, as energetically as possible, an eagerness for progress and innovation. On the other hand,
we have to take into consideration that there are economic forces working in this area that limit the
free play of market forces and require oversight authorities to take on a more active role. First,
clearing, settlement and payment systems entail network characteristics with potentially negative
externalities not internalised by individually optimising market players. It is thus the aim of oversight
authorities to take into account the financial infrastructure as a whole, thereby focussing on the links
between all components. In other terms, some of these systems are "too interlinked to fail" and must
therefore be overseen with special care. Second, since clearing, settlement and payment services are
based on production processes with very high fixed costs, there is a risk that consolidation may lead to
a monopolistic market result. Oversight authorities must therefore also make it their goal to prevent
potential abuses of market power.
Against this background, a trust-based cooperation between financial service providers and oversight
authorities remains the key to a continued successful development of an efficient and secure financial
market infrastructure that meets the fast-changing needs of the future.