Peter Praet: Transition of the financial system 
in the wake of the
financial crisis
Speech by Mr Peter Praet, Member of the Executive Board of the European Central Bank, at
the 8th Annual European Market Liquidity Conference of the Association of Financial Markets
in Europe, London, 13 February 2013.
* * *
Introduction
It is a pleasure for me to give this keynote address on the occasion of AFME's 8th Annual
European Market Liquidity Conference. The ECB has a vested interest in the efficient
functioning of financial markets and, in particular, in their liquidity. In this context, I will also
address the important topic of trade transparency, including AFME's work regarding the
posttrade transparency calibration under the Markets in Financial Instruments Directive II
(MiFID II).
Restructuring funding and markets: central bank and market initiatives
The ongoing transition of the financial system in the wake of the financial crisis is driven by
market initiatives, regulators and central banks. Before addressing financial regulation, let me
start with some thoughts regarding the contributions of the central bank and respective
market participants.
As we know, bank funding channels have changed significantly during the crisis. Several of
the measures implemented by the ECB, notably the three-year longer-term refinancing
operations (LTROs) and the adjustments in our collateral policy, have been effective in
alleviating bank funding constraints and containing the risks of a disorderly bank
deleveraging process. Further, non-standard measures - most recently, the Outright
Monetary Transactions (OMTs) - have significantly contributed to an improved euro area
financing environment, mainly stemming from an improvement in financial market sentiment
and an alleviation of vulnerabilities affecting the supply of bank credit to firms and
households. In addition, the OMTs announcement has helped to narrow sovereign spreads
and to restore investor confidence.
However, the ECB's (non-standard) measures can only be temporary solutions. Most
importantly, market participants have to continue their efforts to facilitate the transition to a
less central-bank reliant, more market-based financial system, for which the ECB's
measures, as well as the recent progress concerning the Single Supervisory Mechanism,
have hopefully laid the foundations.
One market segment that suffered considerably during the financial crisis was the market for
asset-backed securities (ABSs), the revival of which I consider essential for the provision of
finance to the corporate sector. Given the restricted funding sources and elevated bank
funding needs, a trend towards more disintermediation from larger corporate issuers has
been observed in recent years, and this trend will most likely continue.
By contrast, small and medium-sized enterprises (SMEs) are more dependent on their
respective domestic banking sectors and are subject to tighter credit conditions than larger
firms that have greater access to global financial markets. The question arises as to how
these restrictions could be overcome. A reopening of the ABS market may be one way of
enhancing funding conditions for SMEs.
It will therefore be essential to better understand the factors that still constrain the recovery in
this market and why investors are shying away, despite proven good performance and very
few defaults on European ABSs. The regulatory treatment of ABSs, in particular the
proposed regulatory capital charges for banks and insurers, could be a factor, as could a lack
of secondary market liquidity and the relative opacity of the loans packaged in an ABS.
In this respect, let me also mention the Eurosystem's ABS loan-level initiative. In November
2012 the ECB informed the public about the implementation of loan-level data reporting
requirements for asset-backed securities as part of the Eurosystem's collateral framework.1
The ABS loan-level initiative makes use of the European DataWarehouse, the single
loanlevel data repository for the handling of loan-level data reporting, which became operational
on 3 January 2013. As a consequence, for residential mortgage-backed securities and for
asset-backed securities whose cash-flow-generating assets comprise loans to SMEs, the
reporting requirements became mandatory as of 3 January 2013. Commercial
mortgagebacked securities must comply as of 1 March 2013, and other asset classes (auto loans,
consumer finance loans, leasing receivables) as of 1 January 2014.
While the ECB launched this initiative in the context of its collateral framework, a positive
externality is that the initiative should also support the revival of this market segment by
increasing its transparency and therefore investor confidence.
The ECB also helps to accompany the fundamental change in the financial sector by
changing the market structure and infrastructure, e.g. by actively supporting the Legal Entity
Identifier (LEI) initiative as well as enforcing financial integration via the Eurosystem's
TARGET2-Securities (T2S) project, which will make cross-border settlement identical to
domestic settlement and hence the whole European securities market will become more
attractive and cost effective.
Financial regulation and transparency
I will now expand on this morning's discussion on "Making markets work: liquidity and
regulation". Apart from central bank and market initiatives, a number of measures in the field
of financial regulation, which are intended to prevent another crisis on the scale of the one
we have just witnessed, have been decided upon or initiated by various authorities. Such
measures contribute to structural changes in the institutional set-up of financial markets and
are expected to restore market confidence and, ultimately, to support growth.
Yet the intended positive effects of regulatory measures have to be carefully weighed against
their costs and unintended side effects. Market participants point out that the regulatory
measures must be consistent with one another. The speed of regulatory innovation should
not mean that too little consideration is given to the impact one measure will have when
taken in conjunction with others. Also, consistency on the international level has to be
ensured.
Very importantly, financial regulations should be designed and implemented carefully in order
to avoid potentially adverse effects on market liquidity and price formation. For the ECB,
efficient, resilient and liquid financial markets are a key prerequisite for the smooth
implementation and transmission of monetary policy. The ECB therefore strives to ensure
that regulatory reform initiatives do not impose restrictions which may hinder the efficient
functioning of markets or impair their liquidity.
Formally, the Treaty on the Functioning of the European Union assigns to the ECB an
advisory role as regards proposed EU acts2, i.e. the ECB is consulted on proposed EU
directives (general framework legislation). Furthermore, delegated and implementing acts
qualify as proposed EU acts, and therefore the scope of the ECB's consultation also extends
to such acts as well as to draft technical standards.3
In addition, we continually exchange views with market participants, for example via our ECB
market contact groups.4 The regulatory debate has become a standard agenda item in those
meetings.
A number of regulatory measures target financial markets. Let me focus in the rest of my
speech on a very important regulatory initiative and on a concrete example: the review of the
MiFID II and, specifically, the proposed price transparency requirements. The ECB also
provided an opinion on the MiFID II proposal.5
As you know, the MiFID II proposal extends pre- and post-trade transparency requirements
from equity instruments (MiFID I) to additional asset classes such as bonds, structured
finance products, derivatives admitted to trading or traded on a regulated market, a
multilateral trading facility or an organised trading facility and derivatives considered eligible
for central clearing. The aim is to enhance price formation and to support the evaluation
process of such instruments.
The requirements cover pre-trade transparency - i.e. the provision of quotes and market
depth to market participants ahead of a trade - and post-trade transparency - i.e. the timely
publication of the prices and volumes upon trade execution. These mandatory transparency
requirements represent a major change, especially for the fixed income market. For brevity, I
will only address the issue of post-trade transparency.
As we have known since the publication of the seminal work of the Austrian economist and
philosopher Friedrich Hayek, prices reveal information that is dispersed among the numerous
individual members of an economy. As a consequence, market outcomes are directly
influenced by the time and degree to which prices and volumes are disclosed to the public.
In reality, different markets are subject to different transparency regimes and disclosure
requirements, which are a consequence of the existing heterogeneity among both financial
assets and market participants. While this implies that a one-size-fits-all level of transparency
is unlikely to exist, a number of economic forces are omnipresent and therefore allow us to
draw some conclusions from the academic literature on post-trade transparency.
In those market segments that the MiFID II review aims to address, liquidity providers play a
central role as they intermediate between end investors and thereby help to secure a
wellfunctioning marketplace. Yet an efficient and resilient market requires a sufficient level of
competition. Several studies6 show that a lack of transparency can be a serious threat to a
level playing field because intermediaries may use their private knowledge of customer order
flow as an informational advantage that allows them to exert market power. Therefore,
3
See opinion of the ECB of 25 January 2012 on a proposal for a Directive on the access to the activity of credit
institutions and the prudential supervision of credit institutions and investment firms and a proposal for a
Regulation on prudential requirements for credit institutions and investment firms (CON/2012/5).
4
In particular the Money Market Contact Group, the newly established Bond Market Contact Group, the Foreign
Exchange Contact Group and the Operations Managers Contact Group (see the ECB website for more
information on these groups).
5
See ECB Opinion of 22 March 2012 on (i) a proposal for a directive on markets in financial instruments
repealing Directive 2004/39/EC of the European Parliament and of the Council, (ii) a proposal for a regulation
on markets in financial instruments and amending Regulation [EMIR] on OTC derivatives, central
counterparties and trade repositories, (iii) a proposal for a directive on criminal sanctions for insider dealing
and market manipulation and (iv) a proposal for a regulation on insider dealing and market manipulation
(market abuse) (CON/2012/21).
6
See e.g. Madhavan, A., "Consolidation, fragmentation, and the disclosure of trading information", The Review
of Financial Studies, Vol. 8, No 3, pp. 579-603 and Bloomfield, R. and O'Hara, M., "Can transparent markets
survive?", Journal of Financial Economics, Vol. 55, No 3, pp. 425-459.
opacity enables the extraction of rents and can lead to increased price dispersion7, with
negative consequences for market integrity and fairness. Furthermore, a low level of
posttrade transparency can significantly distort the informational role of prices by preventing the
diffusion of value-relevant information, which may hamper market liquidity because of
adverse selection.
In line with this rather positive view of post-trade transparency, a number of empirical
studies8 have found that the introduction of mandatory trade reporting has significantly
improved formerly opaque market segments, such as the market for US corporate bonds.
At the same time, one must be aware of potentially negative side effects. For example,
liquidity providers may be reluctant to take on a large inventory position because they will
find themselves in an unfavourable bargaining position if this information is known to others.
They may ask for an additional premium in order to take on such a risk, which can raise
transaction costs for investors.9 Similarly, very large market participants, such as pension
funds, may find it more difficult to execute large transactions without being front-run by
predatory traders. In very transparent markets such as those for equities, this has become a
substantial concern.
With these issues in mind, it is imperative that the new regulatory environment carefully
considers all possible implications of increased market transparency. In particular, it is
important that the new set of rules is calibrated in a way that avoids excessive market
liquidity distortions, in particular in those market segments whose functionality is still partially
impaired as a consequence of the market disruptions that we have witnessed over recent
years.
With this in mind, the ECB explicitly welcomes private sector initiatives such as the AFME
framework for post trade transparency, which I believe is a constructive proposal because it
aims to fine-tune the reporting requirements across different liquidity categories, something
that is certainly a sensible approach given the economic trade-off I have just outlined.
Concluding remarks
So, I will now conclude my keynote address, and I look forward to participating in what I am
sure will be an interesting panel discussion.