Nigel Jenkinson: New markets and new demands - challenges for central
banks in the wholesale market infrastructure
Speech by Mr Nigel Jenkinson, Executive Director, Financial Stability, Bank of England, at a
joint Bank of England/European Central Bank Conference on "Payments and Monetary and
Financial Stability", Frankfurt am Main, 12 November 2007.
I am very grateful to Mark Manning for his help in preparing this speech and to John Gieve, Victoria Cleland and
Ben Norman for helpful comments.
* * *
1. Introduction
1 Central banks sit at the heart of the monetary economy providing the ultimate
settlement asset and typically operating the large-value payment systems that underpin
financial activity. The modern central bank's twin objectives of monetary and financial
stability emerged from their early role in settling claims between banks.
2 But this traditional payments function is subject to the same forces for change that are
transforming the rest of the economy. In particular, developments in technology, the financial
innovation they allow, and the globalisation of finance are reshaping the landscape, exposing
new sources of risk and posing fresh challenges for regulators and central banks.
3 As markets become more interconnected and international, national authorities have to
work more closely together, cooperating in their oversight and operational activities and
coordinating their risk assessments. As new products and players emerge in the commercial
sector, they may also need to adapt the scope of their oversight and regulatory response.
4 I would like to take some time this afternoon to explore some of these issues, many of
which will resurface over the course of this two-day conference.
2. Early demands: the historical context
5 First some history. How did central banks come to assume their "central" role in the
financial infrastructure?
6 Internationally, Venice claims a key role in the story, but I will start later with the
activities of goldsmiths in 17th century London. Starting from their custody business,
goldsmiths began to settle transactions between merchants, across their books or via the
transfer of deposit receipts - the early bank notes. Merchants were thereby able to settle
obligations with one another without having to carry, count out and value coins: a welcome
development, considering that a £100 sterling bag of silver coins - a commonly used value
for notes - weighed over 30 pounds (14kg for those in the audience baffled by imperial
measures)!
7 Over time, so as to accommodate transfers between customers of different "banks", the
banks started accepting claims on each other and, once they found ways to settle these
claims, established the first British interbank payment systems.
8 So what were these early settlement mechanisms? At first, banks started settling
interbank claims using gold and silver coins. But these were in short supply and, again,
costly to transport and exchange.
9 Banks thus eventually innovated by switching to settlement in assets convertible into
gold and silver. For example, by the 1770s, London bankers had begun to settle in notes
issued by the Bank of England, a highly-regarded, but at that time, private bank.
10 A low-risk settlement asset was particularly important in the unregulated world of the
goldsmiths, in which credit risk was acute and liquidity shocks - like the one we have
experienced of late - were common and dangerous. In a sorry letter to an associate1, one
goldsmith wrote to another in the 1660s:
"I have beene by many accidents much
postpon'd...ye money due to mee is soe farre off that I can not make it useful to mee. All
Credit in London is much Shortened of late."
11 Showing all the optimism which continues to characterise bankers today, he added:
" I
am attempting a way to enlarge my owne (credit) and doubt not to effect it to his
Maties.[Majesties] advantage as well as my owne, if I am (like ye lame dogg) but helpt over
this style."
12 Further efficiency gains were then obtained by settling interbank obligations over the
accounts of a single institution. This innovation was sometimes put in place by the public
authorities; in other cases it developed naturally, such as when the London bankers adopted
Bank of England deposits as the ultimate settlement asset in 1854.
3. Payments and monetary and financial stability
13 To ensure that its liabilities continue to be perceived of higher quality than those of any
other issuer, the institution at the apex of the payment system - typically the central bank -
has an incentive to exercise close control over the terms on which they are made available to
the banking system.
14 That translates into the traditional monetary stability objective: preservation of the role
of the ultimate settlement asset as a store of value and unit of account. It also gives the
central bank a strong interest in the stability of the financial system. And within that a reliable
and resilient infrastructure for distributing the ultimate settlement asset is a key condition of
stability (and of implementing monetary policy effectively).
15 In an advanced monetary economy, of course, bank deposits constitute by far the
largest component of "money"; in the UK they make up some 96% of the broad monetary
aggregate, M4. Agents rely on interbank payment systems to facilitate the direct transfer of
deposits between banks and thereby also preserve their role as a medium of exchange. And
as the sophistication of securities and other markets has grown, the core payment systems
have become intertwined with the settlement and clearing systems for the key markets.
Together they have become a critical part of the infrastructure not just for the financial
system but for the economy more widely. And in the wake of 9/11, all central banks have
been giving more attention to the physical and financial resilience of these systems. For
example, in our regular the Bank of England has included the risk
Financial Stability Report,
of infrastructure disruption in the list of the top six vulnerabilities facing the financial system
over the last two years.
16 As Alan Greenspan notes in his memoirs: "We'd always thought that if you wanted to
cripple the US economy, you'd take out the payment systems. Banks would be forced to fall
back on inefficient physical transfers of money. Businesses would resort to barter and IOUs;
the level of economic activity across the country could drop like a rock."
17 In a paper to be presented at this conference tomorrow, Andrea Gerali and Franco
Passacantando consider this in the context of the Great Depression. As confidence in the
banking system evaporated, bank deposits ceased to function as a medium of exchange.
"Scrip", or substitute money, emerged, typically taking the form of vouchers or coupon books.
Such monies had otherwise only been commonly used in isolated lumber or coal-mining
communities in the United States - communities lacking banks or financial intermediaries.
But while adequate for the purchase of provisions at the local general store, such forms of
money were clearly an imperfect medium of exchange and created otherwise unintended
credit exposures between agents.
18 The recent market turbulence offers a further reminder of the importance of resilient
infrastructure for conditions in financial markets. When markets are fragile, any interruption to
normal service could have particularly serious implications: further clouding judgements as to
individual participants' solvency; undermining agents' risk management; or affecting asset
prices in dependent markets. With volumes and values in several markets having hit record
levels during the market turmoil and remaining high for a sustained period, infrastructure
providers have experienced a severe stress test and, by and large, have passed with flying
colours. CLS, for instance, processed nearly 860,000 transactions (more than $8trn in value)
on 19th September, 21⁄2 times the daily average in June.
4. Current trends in the wholesale market infrastructure: new markets and new
demands.
19 Today, central banks around the world still typically provide the ultimate settlement
asset and sometimes operate, and also own, key components of the payment and settlement
infrastructure. For key elements of the infrastructure central banks have assumed an
oversight role. Depending on the particular regulatory architecture in place, this is sometimes
shared with the financial regulator, as in the UK.
20 But this is a dynamic environment: the landscape is broadening and deepening, with
niche market-specific facilities, cross-border systems, new entrants and commercial bank
providers becoming more important. New sources of risk are emerging, presenting new
challenges for central banks in their pursuit of monetary and financial stability.
Financial innovation and technological advancement
21 The way technology is transforming markets and therefore payment systems is
illustrated in the rapid growth in OTC derivatives markets; and the increased penetration of
electronic trading platforms - and automated trading strategies - across a range of markets.
22 According to data released by the Bank for International Settlements, notional amounts
outstanding in global OTC derivatives markets rose by almost 40% in 2006 - up more than
260% over the past five years. The outstanding value of the credit segment of the market
doubled in value in 2006 alone and trading activity has remained high through 2007,
especially during the recent market turmoil.
23 These markets have traditionally been cleared and settled via bilateral arrangements
between the counterparties to the trade, but new automated infrastructure services have
emerged, partly in response to an international regulatory initiative led by the Federal
Reserve Bank of New York (FRBNY). Major dealers now confirm almost 90% of credit
derivatives trades electronically, as against less than 50% two years ago.
24 An important recent addition to the landscape is DTCC Deriv/SERV's Trade
Information Warehouse, which maintains a so-called "golden copy" of each credit derivatives
trade. With appropriate interoperability between systems, these data can support a range of
ancillary services: calculating and settling payment obligations, managing collateral,
terminating trades and reconciling portfolios. The Warehouse is likely ultimately to be rolled
out for other products.
25 The declining cost of technology has also been a key driver of the rise of electronic
trading in recent years. Almost 60% of trade in foreign exchange is now executed
electronically and close to 50% in repo.
26 Automated and algorithmic trading strategies are becoming more widespread across
asset classes. The London Stock Exchange (LSE) reports that the proportion of the order
flow on the exchange that is automated has risen from negligible amounts just four or five
years ago to approaching half today. This not only has implications for the scale of trading
activity - volumes have tripled on the LSE's SETS system over the past five years - but also
the design and location of the trading infrastructure. For many algorithmic trading strategies,
processing speed is critical. The faster systems can process trades in just one or two
milliseconds: a tiny fraction of the blink of an eye. But ultimately speed and thus the ability to
gain a competitive advantage depends on proximity to the platform; hence, the old
geographical pull of markets has begun to re7 emerge with exchanges selling space near
their trading platforms to those who want to be first in the queue.
27 Many new entrants to the trading arena are therefore competing with incumbent
exchanges on the basis of processing speed. These new platforms are also looking for lower
cost post-trade solutions. As such, those emerging in Europe have looked beyond incumbent
providers: new entrants and commercial bank providers of clearing and settlement services
have featured strongly in their plans. Such providers not only aim to meet demands in terms
of flexibility and cost, but also to offer sufficient breadth to deliver a multicurrency clearing
and settlement service.
Globalisation, regulatory change and the market structure of infrastructure
28 This is part of a general reshaping of the infrastructural landscape in a global market
place. Market participants are becoming increasingly international, operating in multiple
markets and facing obligations in multiple currencies. Latest international banking data from
the Bank for International Settlements revealed growth in excess of 20% in reporting banks'
total cross-border claims in the year to end-Q1 2007, taking the total to $28.5trn.
29 Banks, therefore, seek infrastructural solutions that will accommodate the international
organisation of their businesses. So, while, historically, financial infrastructure has typically
evolved along national lines, cross-border alliances and mergers are now more common,
both in trading and post-trade: e.g., NYSE Euronext; LCH.Clearnet; Euroclear Group. And
alliances in the form of cross-border clearing and settlement links are also widespread,
enabling, for instance, securities traded in Italy to be settled and held in an account in the
securities settlement system in Germany.
30 Commercial bank providers - namely, correspondent banks and global custodians -
may be best placed to meet the demand for multicurrency settlement, leveraging their
extensive international connections. This could then reinforce their important position in the
infrastructural landscape. Indeed, the major global custodians each posted growth in assets
held in custody in excess of 20% in just the past year.
31 And differences between the regulatory regimes for incumbent providers of
infrastructure and those for either commercial bank providers or smaller new entrants could
tilt the playing field. For example, CLS is subject to close central bank scrutiny, operates as a
narrow bank, and has to meet exacting - and costly - resilience standards. New clearing
arrangements and bilateral netting schemes are now penetrating the foreign exchange
markets, threatening the volumes passing through CLS. In messaging, too, SWIFT - which
submits voluntarily to central bank oversight - is beginning to face competition in certain
markets from new entrants not subject to oversight. Authorities must be alert to the
challenges these competitive developments provide.
32 Other regulatory initiatives are contributing to a reshaping of the landscape. MiFID, in
the EU, and RegNMS, in the US, have sought to encourage increased competition in trading;
and the Code of Conduct, recently signed in the European Union, establishes terms under
which infrastructures operating in one member state can clear and settle (initially equity)
trades in another. More than 20 applications have now been made under the terms of the
Code.
33 Whether trading, clearing and settlement infrastructure markets can support a wide
range of providers in the long-term remains an open question. There is generally a tendency
towards concentration in infrastructure provision because of increasing returns to scale in a
fixed cost business and often powerful network effects. This applies equally in the case of
commercial bank provision of infrastructure: ECB survey evidence reveals that the ten
largest correspondent banks in euro account for around 80% of correspondent banking
payment values; and the top-4 global custodians now account for three-quarters of total
assets in custody. Indeed, regulators have been giving increasing attention to the potential
systemic spillovers from operational or business failures at major commercial bank providers
of infrastructural services. That has led, for example, to the initiative in the US to implement
"New Bank", a dormant shell company to take over the functions should one of the two major
clearers in the US Treasury market cease operations.
34 It may be that a competitive environment can be sustained, particularly as the cost of
technology falls, lowering barriers to entry, and liquidity bridges and other forms of
interoperability are established between systems. But, the jury is still out. Recent evidence
on the trading side, particularly in the US, is mixed: some trading platforms, such as
Archipelago and INET, have been swallowed up by the incumbent exchanges; others, such
as BATS Trading are thriving, keeping the pressure on the exchanges to cut costs and
upgrade their services.
35 I suspect what we are seeing is a redefinition of the market on an international scale. In
the process, national incumbents are being challenged by a combination of ambitious foreign
incumbents eager to exploit economies of scale and nimble, unencumbered new entrants
sometimes specialising in niche products. A process that is likely to lead in time to greater
consolidation at international level is currently manifesting itself in terms of fragmentation at
the national level as local incumbents are challenged.
36 The end-game may well be lower transaction costs at both the trade and post-trade
level and more concentrated (if not monopoly) cross-border infrastructure in each. But it may
take some time to reach a new equilibrium. Central banks and regulators need not only to
prepare for and perhaps help shape the end-game, but also address challenges arising
during the transition.
5. Issues and challenges for central banks and regulators going forward
37 Two key challenges, in particular, will need to be met:
(i) Preserve enough influence to protect the collective interest while maintaining
a level regulatory playing field
38 The resilience and efficiency of the core infrastructure is an important public good and,
given the tendency to monopoly, the authorities need to ensure that they maintain sufficient
influence to ensure resilience in this increasingly complex landscape. That requires
consistent and objective criteria to be applied to new as well as established systems. Such
criteria might include: size - the volume and value of flows; type of flow - the extent to which
interdependencies are generated with other systems or underlying financial markets; and
- the potential for rerouting flows to other systems.
substitutability
39 A changing market structure may also alter the nature of risks posed by the systems
themselves. For instance, to the extent that we are entering a phase of competing provision
of services at the national level, issues might arise around the potential fragmentation of
system liquidity. Equally, we are also seeing pressures for greater consolidation of systems
at an international level, where the challenges of lowering single point of failure risks remain
at the top of the agenda.
40 Where new services are offered by commercial bank providers, central banks need to
cooperate closely with banking supervisors to ensure that potential sources of financial
stability risk in their infrastructure roles are embedded within regulatory assessments.
Indeed, to the extent that new services are multicurrency in nature an international dialogue
may be necessary. I am pleased that the Basel Committees on Banking Supervision (BCBS)
and Payment and Settlement Systems (CPSS) have agreed to strengthen communication
between the committees, for example by holding joint meetings of sub-groups, which will
help to support this dialogue.
41 As recent events have underlined, regulation and public intervention can not only
change market incentives for the better but can also have unintended side effects. For
instance, the creation of the off-balance sheet vehicles at the centre of the recent market
turbulence may be seen in part as a response to the crude regime for capital charges
established under the original Basel Accord, under which liquidity facilities under a year in
maturity were exempt. That is being remedied under Basel II. But it is a reminder that we
need to be very careful to watch for these distortions in the regulation and oversight of
payment systems and other infrastructures, so as to ensure that we do not inadvertently alter
incentives in a way that may hamper the future development of the landscape.
42 This issue arises for example in the context of the establishment of ESCB-CESR
standards for securities settlement systems. The Bank of England supports the principle of
risk-based functional regulation, which implies that regulatory standards should be applied to
a function - such as settlement - regardless of the status of the institution providing that
function. We hope that further moves towards implementation will adhere to this principle,
thereby establishing a level regulatory playing field at least between CSDs and ICSDs, but
ideally also between traditional infrastructures and commercial banks offering infrastructural
services.
43 Finally, with a wider spectrum of participants, issues arise around the way in which
members interface with infrastructures. It is important to ensure that individual member
behaviour cannot threaten the smooth-functioning of the system. Some incidents during the
recent market turbulence revealed issues around members' processing capacity, underlining
the value in member-level testing to ensure that participants can always support the delivery
of the network benefits from the smooth operation of the infrastructure.
(ii) Ensure effective international cooperation in oversight and operations, and
coordination in risk assessment activities
44 The second main challenge is to allow market participants to reap the benefits of
globalisation, while ensuring that the risks are adequately controlled. An extended and highly
connected network can simultaneously be both robust and fragile: because risks may
robust,
be more effectively shared and dispersed across the system; fragile in that major risks can
flow more rapidly through the system.
45 Naturally, market participants have been pushing hard for the removal of obstacles to
efficient cross-border settlement and barriers to the seamless cross-currency management of
liquidity. Central banks have been urged to consider accepting foreign collateral or
implementing other arrangements to facilitate cross-currency liquidity management. Some
already do so - the Bank of England, for instance, routinely accepts euro-denominated
collateral in its operations - and a recent report from the CPSS encouraged other central
banks to consider accepting foreign collateral, at least in emergency circumstances. The
Eurosystem has recently begun to explore new options.
46 Provision of cross-border collateral arrangements may entail a high degree of
coordination and cooperation between central banks internationally, for instance in opening
custody and correspondent accounts, and sharing information on local infrastructures and
market practices.
47 More generally, strong international cooperation in the sphere of risk assessment and
crisis management responses is also clearly important. With increased links between
infrastructure providers in different centres and the emergence of new cross13 border
infrastructures, greater cooperation is also required in the conduct of oversight: not only in
terms of assessment of particular overseen cross-border infrastructures against international
standards, but also in identifying potential interdependencies between national
infrastructures. While existing cooperative arrangements work well, the model needs to
expand and continue to evolve.
6. Concluding remarks
48 The resilience of the infrastructure of wholesale payment, clearing and settlement
systems to both operational and financial shocks remains a key requirement of financial and
monetary stability. But the landscape is changing fast in response to technological change
and the financial innovation and globalisation it allows. Cross border and global networks are
squeezing our national monopolies and commercial banks are playing an increasing role.
These changes present several challenges for central banks and regulators:
• We need to establish and apply consistent criteria for the scope of oversight, in
order to maintain a level regulatory playing field;
• We need to take full account of new interdependencies between systems when
assessing financial stability risks at a national and international level;
• We need to work more closely together in risk assessment and oversight and
ensure that cross-border operational arrangements are robust ;
• We need to ensure that financial stability risks posed by financial firms operating key
infrastructure functions are adequately captured in their regulation.
49 Meeting these challenges will deliver a robust, resilient financial infrastructure, which
the global financial system and the global economy depend upon.