Lynn Patterson: Markets calling - intelligence gathering at the Bank
of Canada
Remarks by Ms Lynn Patterson, Deputy Governor of the Bank of Canada, to the Calgary
Chartered Financial Analyst (CFA) Society, Calgary, Alberta, 28 June 2017.
* * *
I would like to thank Scott Kinnear and Harri Vikstedt for their help in preparing this speech.
Introduction
Good afternoon. Thank you for that kind introduction.
As participants in today's marketplace, you are likely experiencing how quickly technology and
markets are evolving. And I can relate. The changes that I saw during my years in fixed-income
and equity markets were remarkable. Shortly before I began working in fixed-income markets, if
you wanted to sell a bond, you would make a phone call and follow up with a teletype message
with all the details. Then, someone in your back office would physically descend into a vault to
pull the bond and have it delivered to the buyer by hand. Imagine how sluggish that process
would seem to today's traders who transact and settle securities worth millions of dollars with a
couple of taps on the keyboard.
The shifts in market function and participation that we are seeing globally today are as dramatic.
Some stem from central bank actions in certain jurisdictions, such as quantitative easing and
negative interest rates. Others are the result of regulatory reform, new technologies and investor
preferences. Think, for example, of the influx of investors in the commodity space using indexed
and exchange-traded funds (ETFs). Or how high-frequency trading (HFT) firms are compressing
bid-ask spreads in the futures and equity markets. Or the development in Canada and globally of
central counterparties for over-the-counter (OTC) derivatives and repos.
Keeping up to date on new trading practices and how the markets are functioning is important to
the Bank of Canada. Our mandate is to "promote the economic and financial welfare of
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Canada." So we closely monitor the vigour and health of the financial system.
My responsibilities at the Bank include the oversight of our activities in financial markets. This
includes market intelligence, which is my topic today.
Now market intelligence can take many different forms, including-in its broadest sense-the
macroeconomic insights we gain from talking face to face with businesses operating in the real
economy. This includes the important work done by our regional teams on a quarterly basis for
our Business Outlook Survey.
I can't emphasize enough how critical these real-time perspectives are to our overall
understanding of economic developments, particularly during periods of heightened uncertainty.
They provide us with timely insights that we wouldn't have been able to see in the data until
months later. In my remarks I will highlight an example of how this feeds into our policy decision
making. But my focus today will be on the intelligence we gather from financial markets.
Let me start by expanding on the significance of the Bank's market intelligence. I will then explain
how we gather it and how that has evolved. Finally, I will share with you what we are learning and
how we use what we learn.
Our need to know
The market intelligence we gather is a critical complement to our analytical work. Often, in
interpreting data, or through our modelling, we develop a view about the future direction of the
economy or inflation. Our intelligence work then offers us an opportunity to corroborate or,
occasionally, refute what we see in the data. It helps us fill in the pieces of the puzzle that may be
missing or that need greater clarity so that we can refine our judgment surrounding the outlook. It
can give us new insights into how markets are functioning and responding to regulatory or other
changes. All of this helps us shape Bank policies and is integral to our core functions. Let me say
a few words here about those functions.
First is the conduct of our inflation-targeting monetary policy. We have successfully maintained
inflation close to our 2 per cent target since 1995. The policy's effectiveness depends on the
efficient transmission of our rate decisions through to capital markets. It is therefore essential
that we have a solid understanding of how those transmission channels function and are
evolving.
Second, we act as fiscal agent for the federal government, managing its reserves, auctioning its
bonds and managing its cash. And that is why it is important for us to assess how market
developments could influence these activities.
Third, we are responsible for promoting the efficiency and stability of the financial system. We do
this in a number of ways. We consider financial stability issues in our decisions and operations.
We provide liquidity facilities and serve as lender of last resort. And we oversee the key payment
clearing and settlement systems that support the Canadian economy and financial markets. So
we need to understand how market developments could affect the financial system,
vulnerabilities to it or the effectiveness of our tools. I should underline that, payment and
settlement systems aside, we do not have regulatory responsibilities for financial market
participants. This is actually helpful and conducive to open, two-way exchanges. At the same
time, we maintain regular and open dialogue with the federal and provincial authorities that do
exercise such responsibilities. And we share with them our analysis of potential vulnerabilities
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and risks.
The Governor of the Bank of Canada is a member of the Senior Advisory Committee, a
nonstatutory body that discusses macroprudential policy. Its other members are the Federal Deputy
Minister of Finance, the Superintendent of Financial Institutions, the Chair of Canada Deposit
Insurance Corporation, and the Commissioner of the Financial Consumer Agency of Canada.
Our intelligence gathering supports these functions by ensuring that we remain well informed of
market activity and structure. This is by no means a new activity for us. The Bank has been
observing markets since it opened in 1935.
However, until the 2007-09 financial crisis, intelligence gathering by the majority of central banks,
including the Bank of Canada, tended to focus on operations and monetary policy
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formulation. But the crisis made it clear that central banks missed some areas where risk was
building. We were familiar with traditional markets, such as those for government bonds and
foreign exchange, but much less knowledgeable about other areas, such as markets for
structured credit and OTC derivatives. Those were some of the areas where leverage had risen
to dangerous levels.
In 2009, the G20 called for new regulations to strengthen the stability of the global financial
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system. The measures that have since been put in place range from structural reforms to
capital enhancements. They include new solvency and liquidity standards and new risk
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requirements for products such as OTC derivatives.
These regulatory reforms have strengthened the global financial system. Today, the institutions
at the heart of the system-the banks and other financial intermediaries-are safer and have
lower levels of leverage. However, we all know that risk remains. It may now reside in some
areas that are not subject to as much or any regulation and, as such, is not easily observed.
The regulations have also affected the intermediary function that banks have long performed. As
they look to optimize their use of capital, they are allocating less balance sheet to certain asset
classes, such as corporate bonds. This has affected liquidity in these products and altered the
way investors execute and trade.
In response to these evolutions in market functioning and behaviour, we have adapted how we
track the health of the financial system. We've increased the frequency of our checkups, are
making contact with a broader set of players and have added new diagnostic tools. We now
devote more resources to the who, what, how and why of the vulnerabilities we identify and their
interplay with markets.
How we gather market intelligence
To undertake these new tasks, we have expanded our team at the Bank of Canada. Because
communication is key-not by email, or tweets, but with in-person meetings and discussions
with a wide range of market participants. We augment our conversations with analysis, research
and surveys.
To facilitate our exchanges, we maintain and, in some cases, have expanded our presence in
Toronto, Montréal and New York. We make regular trips across the country as well as to London
and other key international financial centres.
Across Canada, and around the world, we also hear from participants at our speaking
engagements. And while we are committed to communicating new information on the outlook
and policy only in public settings, the insights we garner in both public and private are invaluable
for our policy making.
Internationally, we collaborate closely with other central banks, and many of us sit on committees
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of various global institutions. For example, I'm a member of the Committee on the Global
Financial System of the Bank for International Settlements. My participation allows me the
opportunity to discuss market functioning from a Canadian perspective, while hearing about
developments in other parts of the world.
Another important source of intelligence, one that helps us understand developments in foreign
bond markets, is our reserve-management operations, which total roughly US$75 billion in
assets denominated in foreign currency.
And, along with other central banks and monetary authorities, we conduct regular surveys of
turnover activity in the foreign exchange and OTC derivatives markets to obtain information on
their size and structure.
Domestically, our own operations are an important source of intelligence on funding and liquidity.
Our traders maintain a continuous dialogue with participants in our Receiver General auctions
and repo operations. We combine what they learn with other sources of market intelligence in a
framework we developed several years ago to assess financial system vulnerabilities and
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risks. Some of you will be familiar with this framework from our biannual Financial System
Review (FSR). (The most recent issue was published earlier this month.) It helps us explicitly
identify underlying weaknesses, such as high leverage, asset price misalignments or maturity
and funding mismatches that could amplify and propagate shocks.
For example, a few years ago we increased our focus on ETFs, particularly those related to
fixed-income instruments, given their increasing popularity among investors. While ETFs are still
relatively small in Canada, if they were to grow substantially, they could, in some circumstances,
propagate liquidity shocks, especially where the underlying assets they hold are less liquid. We
currently have no concerns about the sector but will continue to monitor its functioning and
growth.
Our assessments are augmented by meetings with market participants that help deepen our
understanding of the vulnerabilities we have identified as well as the underlying drivers of market
activity. These meetings are a two-way exchange. We learn about market behaviour from them,
and we have an opportunity to explain our policy framework.
With the expansion of our intelligence gathering, we have developed a wider network of contacts.
Still, we know the financial sector is dynamic and our work will never cover all of the playing field.
Nonetheless, we now capture a broader sweep of market segments and participants. This
allows us to gather information when significant events that could affect Canadian markets
occur, such as the commodity price collapse, Brexit or the recent US election. The expansion
helps us track more closely how markets are positioned going into such events, gauge how they
will react, and, in the aftermath, understand the short- or long-term repercussions.
Let me get to that example that underscores why multiple sources of broader market intelligence
are so helpful for us, particularly at times when there is a great deal of uncertainty in markets.
You may remember that in the months following the commodity price collapse in 2014 the
outlook for oil prices was cloudy. The futures curve out to six months was upward sloping. This
implied that either market participants were expecting oil prices to rebound or, more negatively,
the cost of storage was increasing, given the high level of inventories, and oil prices would
remain low.
To obtain a better picture of what was happening, colleagues from our domestic economy
department, in particular, staff from the Bank's office here in Calgary, interviewed some of their
contacts in the oil industry. Those discussions led us to conclude that market expectations were
likely too optimistic. It was clear that the path to higher oil prices was not assured in the medium
term and that the negative real effects on capital spending were going to be larger than what had
been suggested by the data. This would have a major impact on the economy. That knowledge
fed into our judgment and, ultimately, our decision to lower our policy rate in January and July
2015. Two years later, it is our view that these cuts have helped facilitate the economy's
adjustment to the oil price shock and that the economic drag from lower prices is largely behind
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us. We will be updating our outlook over the next few weeks, and it will be released on July 12 in
our Monetary Policy Report.
Lastly, we have established a forum for gathering fixed-income market intelligence. We wanted
to better understand the shift in risk taking that we were seeing and its impact on market
functioning. So, some two years ago we created the Canadian Fixed-Income Forum (CFIF). Its
membership is composed of senior professionals from both buy- and sell-side firms across the
country. I co-chair the committee, which meets quarterly. Its goal is to explore developments in
the fixed-income market by tapping into the collective expertise of the membership, including
areas such as trading practices and changes in market infrastructure. The committee's efforts
involve research and analysis to identify potential enhancements and raise awareness of these
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issues. All of our meetings, presentations and minutes are published on the Bank's website.
What we are learning and how we use market intelligence
As the G20 financial system reforms were being put into place there was a lot of concern among
market participants about how these reforms could affect bond market liquidity. That's why one
of the first initiatives CFIF undertook was a survey of investors active in the Canadian
fixedincome market. We wanted to hear first-hand whether there had been changes in liquidity and, if
so, whether that had altered the trading, execution and portfolio-management practices of
participants, including active domestic issuers.
We learned a great deal from the survey. Participants confirmed that most fixed-income
instruments have experienced a slight decline in market liquidity over the past two years. They
also told us that liquidity for certain products, such as investment-grade corporate bonds, has
deteriorated the most.
One key takeaway was that many participants have adapted to the change in liquidity by
adjusting how they manage their portfolios. Those adjustments include taking more time to
execute by breaking up their trades into smaller pieces, holding more on-the-run securities,
holding less liquid assets for longer periods of time and reducing the turnover in their portfolios.
These changes in strategy are especially evident in the corporate bond space. Some buy-side
participants also told us that they were willing to provide liquidity by acting in a countercyclical
fashion to take advantage of market distortions caused by temporary illiquidity in certain markets.
The survey results are providing CFIF with a foundation for further work in areas where
improvements in market functions may be made.
Discussions at CFIF meetings are also inspiring new areas of research. Last year, members
commented on the increased use of Canadian bond futures for hedging by the dealers. In
analyzing the data, we noted an increased level of participation by high-frequency traders in this
space. In response, we undertook a study of HFT in the Government of Canada bond futures
market. We used data provided by the Montréal Exchange to understand the impact of HFT on
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market functioning.
Our analysis showed that its average effect on market pricing was slightly positive. Both effective
and bid-ask spreads, as well as price volatility, declined, while the average depth of the market
increased. HFT had a small beneficial impact on the all-in cost of the execution of smaller trades.
However, no effect was found on the cost of execution for larger trades (greater than $10 million).
It was also clear from the data that many participants now split their trades into smaller blocks,
something we have been hearing through CFIF and in discussions with market participants
across a range of asset classes.
So what's on our horizon these days?
As we outlined in the recent FSR, changes in mortgage rules late last year have led to important
shifts in mortgage activity. Because of significant growth in house prices in some of Canada's
largest cities, we have seen an important increase in the uninsured mortgage space. This has
highlighted the potential need for market participants to develop additional sources of funding,
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particularly for the smaller lenders in this market.
To diversify funding sources, one solution would be the development of a private mortgage
securitization market. This option has come up in several of our recent conversations. If poorly
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structured, securitization markets can have significant vulnerabilities. However, if appropriately
developed, private-label securitization could benefit the economy by helping lenders fund assets
while broadening available collateral to promote market functioning. We will continue to monitor
developments in this space.
Another initiative we are working on is a new systemic risk survey that we will launch next year.
We plan to conduct the survey biannually to seek views on key financial system risks and
developments, as well as measure overall confidence in the Canadian financial system. The
survey will support our surveillance of the financial system, inform policy decision making and
help strengthen our network. We are finalizing the details and expect to launch in early 2018. The
results will be published in the FSR.
Conclusion
As a central bank, we rely heavily on our excellent models and incoming data for our forecasts.
Yet we know that the intelligence we gather is a critically important complement to them,
particularly during times of transition or when sentiment is playing a bigger role. This information
gives us a deeper understanding of how the economy is performing and how markets are
functioning and evolving. And what we learn from all of it-our models, the data, our analysis and
intelligence from our contacts-feeds into our judgment on policy actions.
I want to emphasize that although our policy judgments are guided, in part, by our intelligence
gathering, we know that financial markets are dynamic and that we will never have a perfectly
complete, up-to-the-minute picture of all activity. We are realistic about this and are constantly
learning and seeking to know more. So it is essential that we communicate regularly with
participants across all dimensions, be they investors or issuers, the operators of financial market
infrastructures, regulators or other capital market facilitators.
And we share much of what we learn. While we are committed to transparency, we are mindful
of the need to respect the confidentiality of what we hear from individual firms. We publish our
findings broadly in the FSR and other Bank publications and in CFIF minutes posted on our
website to educate and raise awareness both domestically and internationally.
So let's talk. Our ultimate goal is to promote a stable and resilient financial system that serves all
market participants. We need and value your collaboration and feedback.
1
Bank of Canada Act.
2
The Governor of the Bank of Canada is a member of the Senior Advisory Committee, a non-statutory body that
discusses macroprudential policy. Its other members are the Federal Deputy Minister of Finance, the
Superintendent of Financial Institutions, the Chair of Canada Deposit Insurance Corporation, and the
Commissioner of the Financial Consumer Agency of Canada.
3
Bank for International Settlements, "Market Intelligence Gathering at Central Banks," December 2016.
4
Under the terms of Basel III, the minimum amount of capital that banks must hold was increased by about five
times. The largest, most complex firms were obliged to hold even more. The quality of capital that banks must
hold was also increased with new standards established for bank liquidity and funding. See Bank for
International Settlements.
5
Committee on the Global Financial System, "Market-Making and Proprietary Trading: Industry Trends, Drivers
and Policy Implications," CGFS Papers No. 52 (November 2014).
6
Bank of Canada staff are active participants in the Financial Stability Board and its Standing Committee on
Assessment of Vulnerabilities, the Bank for International Settlements Committee on the Global Financial
System and its Markets Committee, as well as the recently formed Global Foreign Exchange Committee.
7
See Financial System Review, June 2014.
8
See Carolyn A. Wilkins, "Canadian Economic Update: Strength in Diversity" (speech to The Associates of the
Asper School of Business, Winnipeg, Manitoba, 12 June 2017) and CBC Radio interview the Governor Stephen
S. Poloz, 13 June 2017.
9
Canadian Fixed-Income Forum page on the Bank's website.
10
See the Canadian Fixed-Income Forum Survey results.
11
Canadian Fixed-Income Forum, "High-Frequency Trading in the Government of Canada Bond Futures Market."
12
The uninsured mortgage market is now worth more than $650 billion. See Box 2, Bank of Canada Financial
System Review, June 2017.
13
Market features that could mitigate those vulnerabilities include standardization of the underlying collateral and
transaction structure, meaningful disclosure requirements and risk retention. See Box 3, Bank of Canada
Financial System Review, June 2017.