Benoît Coeuré: Four years after Pittsburgh - what has OTC derivatives
reform achieved so far
Speech by Mr Benoît Coeuré, Member of the Executive Board of the European Central Bank,
at the at joint Bank of France, Bank of England and ECB conference on OTC derivatives
reform, Paris, 11 September 2013.
* * *
I wish to thank Patrick Föll for his contributions to this speech. I remain solely responsible for the opinions
expressed herein.
Introduction
Ladies and Gentlemen
It is a great pleasure for me to speak here in Paris and to welcome you, on behalf of the
ECB, to the conference on the OTC derivatives reform.
The over-the-counter (OTC) derivatives markets were at the heart of the financial crisis and
several root causes on what went wrong were identified. Increasingly complex and opaque
financial products, combined with a lack of transparency, were contributing factors, but also
the failure of public authorities to appreciate and address adequately the risks building up in
the financial markets. Not only did regulators and supervisors not keep up with financial
innovation, but they lacked the tools to monitor the risks adequately. Regulation also failed to
keep up with the dynamics in the OTC derivatives markets over the last two decades, which
saw an explosion in outstanding contract volumes. Post-trading infrastructures had become
increasingly inadequate for coping with the growing volumes and complexity of such trades.
In an unprecedented act of international cooperation, the G20 leaders met in 2008 and 2009
in Washington, London and Pittsburgh to coordinate action and address the regulatory gap.
As the crisis has shown, deregulation and reliance on self-regulation just do not work.
In the area of OTC derivatives, the objective was to have all standardised OTC derivatives
contracts traded on exchanges or electronic trading platforms and cleared through central
counterparties by the end of 2012. OTC derivatives contracts were to be reported to trade
repositories, and non-centrally cleared contracts subject to higher capital requirements.
No doubt, a vast amount of technical work has been undertaken during the last four years,
and substantial progress has been made in regulatory and supervisory reform in response to
the financial crisis.
Just to mention some examples: the Committee on Payment and Settlement Systems
(CPSS) and the International Organization of Securities Commissions (IOSCO) issued, in
2012, new and more demanding international standards for payment, clearing and settlement
systems and trade repositories, and have also recently published guidance on authorities'
access to data stored at trade repositories. The clearing and reporting obligation has been
implemented in major jurisdictions. The CPSS and the Financial Stability Board (FSB) have
issued guidance on the recovery and resolution of financial market infrastructures, including
central counterparties. However, it should also be highlighted that little more than half the
FSB jurisdictions have legislative frameworks in place that implement the G20 Pittsburgh
commitments.
Other important reforms are still underway or have only recently been adopted and
implementation is outstanding. Regulation implementing Basel III in Europe entered into
force two months ago. Tomorrow the European Parliament will discuss the regulation
establishing a Single Supervisory Mechanism, an important step towards a European
banking union. Under the Single Supervisory Mechanism, one supervisor will have a
complete overview of an entire large and interconnected banking group in the context of the
single currency. Furthermore, work is being undertaken to address cross-border regulatory
inconsistencies.
So where do we stand five years after Lehman Brothers and four years after Pittsburgh? Did
we achieve the overall goal of improving transparency, mitigating systemic risk and
protecting against market abuse in OTC derivatives markets? Are we now better placed to
monitor risks building up in the financial system?
I will limit myself to three of the many issues covered by this conference: lack of
transparency, the challenges remaining in central clearing and inconsistencies in
crossborder application.
Transparency
First, I would like to reflect on one of the main root causes of the financial crisis: the lack of
transparency relating to OTC derivatives in general. When I say "in general", I mean that
there was not only a lack of transparency on OTC derivatives at the level of the market, but
also at the level of individual institutions and counterparties.
There are two dimensions to the lack of transparency: lack of information due to a lack of
reporting requirements, and data fragmentation making it difficult to connect the dots and see
the full picture. Let me address them in turn.
The accounting treatment in many jurisdictions allowed such instruments to be reported
offbalance sheet. Furthermore, different valuation methods were used to estimate the risks
attached to these transactions.
Hence, information was either completely unavailable or incomplete and, even if available, it
could not be compared across the sector and jurisdictions owing to different accounting
assumptions and valuation methods. It was thus of little value to regulators and supervisors.
In addition, financial innovation and strategies that were intended to limit risk - especially
securitisation and insurance through derivative products - dramatically increased the
complexity of the financial system.
Unlike organised markets, such as stock exchanges, which were tightly regulated to protect
against market abuse, insider trading, and other transgressions, and were required to
disclose information on prices and orders, over-the-counter markets were not. At the height
of the crisis, neither market players nor public authorities could monitor the market for
corporate credit-default swaps. Hence market participants were unable to evaluate the
counterparty risk appropriately. Risk mitigation failed, which ultimately resulted in a drying-up
of the whole market.
Since that time, many jurisdictions have implemented regulatory frameworks ensuring that
counterparties report OTC derivatives trades to trade repositories. In Europe, all derivatives
contracts, not only OTC derivatives, are subject to this reporting obligation.
In the United States, the reporting and public dissemination of publicly reportable swap
transactions in all asset classes is already effective. The same in Japan, which has the most
active OTC derivatives market in Asia and where the country's first repository was approved
in March this year. In Europe, it is expected that the European Securities and Markets
Authority will adopt a decision on the registration of trade repositories still this month and that
counterparties will start to report all asset classes to the repositories as of January next year.
So, on the surface, it appears we have achieved our goal. But have we really? Does, for
example, the supervisor responsible for the supervision of a large cross-border financial
institution at the consolidated level have direct and immediate access to information on OTC
all all
derivatives transactions that encompass transactions entered into by entities of this
group? Is the information accessible, in other words can it be easily aggregated across trade
repositories and jurisdictions? My answer would be a clear no!
In the Single Supervisory Mechanism, the ECB, as I've already said, will be responsible for
the supervision of such large banking groups, some of which are global systemically
important financial institutions (SIFIs) with large derivatives businesses. The access to data
relating to foreign (that is non-EU) subsidiaries of financial groups, where an authority - in
this case the ECB - has supervisory responsibility at a consolidated level, is key to
assessing the overall risk exposure of a given banking group.
Of course, access to data should always be in line with the authorities' mandate and with the
CPSS-IOSCO guidance, issued last month, on authorities' access to trade repository data.
However, even if this is warranted, privacy laws, blocking statutes and indemnification
clauses which are in place in several jurisdictions restrict effective access to the detail of
OTC derivatives transactions.
Another important issue is whether authorities will be able to aggregate data across trade
repositories and jurisdictions. Where there is more than one authorised repository in a single
jurisdiction, it will be necessary to aggregate data across repositories. This in itself will be
challenging. If no central entity is responsible for such aggregation, it could well mean that a
plethora of public authorities with an interest in accessing data will need to conduct this task.
This would hardly be efficient.
It gets even more complicated if data, for example for all entities of a large financial group
which is present in several markets, have to be aggregated across jurisdictions, as the level
of information reported to repositories is different.
A lot of work has already been done to address these issues. The January 2012
CPSSIOSCO report on OTC derivatives data and reporting and aggregation requirements
identified the Legal Entity Identifier (LEI) as an essential tool for aggregation. Good progress
has been made in the development and implementation of the Global LEI System. In order to
promote the use of LEI at the start of the financial reporting obligations in the European
Union, United States and other jurisdictions, an interim pre-LEI system has been agreed.
The same report also identified potential data gaps, such as the availability of collateral
information which would be necessary to evaluate exposure, and therefore risks,
appropriately. Here in the European Union, for example, entities are required to report
collateral information, whereas in the United States no such requirement exists. So, even if
access issues are standardised across the board, a lot of data issues will still remain.
In short, I see three main issues that have to be addressed. First, information gaps still exist,
either due to a lack of or differences in reporting requirements. Second, data are fragmented
across trade repositories and jurisdictions. And third, there are still obstacles impeding
authorities' access to data.
In February 1999, in his report to the G7 finance ministers and central bank governors that
led to the establishment of the Financial Stability Forum, Hans Tietmeyer called for
"arrangements for the surveillance of global vulnerabilities, including the pooling of
information available to the international financial institutions and the international regulatory
groupings". This was almost 15 years ago and we are not yet there.
In fact, at the current stage, no authority has a complete overview of the risks in OTC
derivatives markets or is able to examine the global network of OTC derivatives in depth.
Hence, fragmentation of data, both at the data storage level and at the access level, is
putting at risk the implementation of the overall objective of the G20. The good news is that
the G20 leaders, who continuously monitor the implementation of the reform, are aware of
this issue. The Financial Stability Board, assisted by the CPSS and IOSCO, has only very
recently begun a feasibility study on various approaches to address these shortcomings and
intends to issue a report in the first half of next year.
Central clearing
The second area I would like to concentrate on is central clearing.
A lot of progress has also been achieved in the area of central clearing. However, although
legislation is in force in Europe, it may still take more than one year before the clearing
obligation becomes effective. Actually, this Sunday (15 September), the deadline by which
central counterparties in Europe have to apply for authorisation under EU legislation will
expire. Within another six months - by mid-March 2014, at the latest - the authorisation
process should be completed, after which the mandatory clearing obligation will be
determined.
The good news is that the share of cleared contracts in relation to total OTC derivatives
transactions outstanding has consistently increased over the last five years. In the case of
interest rate derivatives, for example, the share of cleared transactions increased from 16%
in 2007 to over 50% by the end of 2012. We expect this share will increase continuously as
the clearing obligation comes into effect in many countries. Progress is, however, different
among asset classes, and substantial scope still exists for further increasing central clearing.
A number of challenges still remain. Let me mention two key points in this regard.
First, I would like to recall that the introduction of mandatory clearing obligations raises new
challenges in terms of the distribution and management of financial risk beyond the risk
concentration in central counterparties.
Indeed, mandatory clearing implies that an increasing share of the risks arising from OTC
derivatives transactions will also be concentrated in a few major clearing banks. This is
because the mandatory clearing requirement implies that a larger pool of market participants
will need to have access to central counterparties, while only a small part of this pool will be
able to access the counterparties directly.
Indeed, central counterparties need to ensure that their direct members meet adequate
standards in terms of financial soundness, technical and operational capacity, and product
expertise. The enforcement of robust standards in this area is a critical first layer of defence
against counterparty risk and ensures that central counterparties are able to swiftly manage
a potential default situation. It is clear, however, that many market participants will not meet
these stringent requirements and will therefore need to access central counterparties
indirectly via a direct clearing member.
A number of risks are associated with this development. In particular, the systemic risk
concentration in a small number of global financial institutions is further increased and an
increasing number of foreign jurisdictions are exposed to risks arising from the potential
default of those banks. This aggravates the risk that these financial institutions may act as
contagion channels for financial disturbances and may become or be perceived to be "too big
to fail". In addition, as several countries outside the European Union and the United States
have observed, an unfair cross-border distribution of the costs for central clearing could
arise. Finally, corporate governance arrangements of central counterparties may not be
sufficiently reflective of the interests of all stakeholders, particularly as regards indirect
clearing members.
I am aware that several measures to control these risks are underway. Rules for central
counterparties have been strengthened to ensure that they limit access restrictions to what is
really necessary in order to manage the incurred risks and to ensure the central
counterparties' orderly default management processes. Similar governance rules now
explicitly require central counterparties to adequately take into account the interests of clients
and not only those of their direct members. Similarly, arrangements for the segregation and
portability of client positions and collateral are being made. However, we will need to monitor
very closely how these new requirements will work in practice, given the strong interest of
global dealers in preserving their dominant position in the market. The aim of the new
financial regulatory framework is to reduce risk in the global financial system, not to turn it
upside down.
Furthermore, the measures adopted in this area are, in my view, not sufficient to capture the
macro-prudential dimension of the problem. To this end it will be necessary to achieve, in
addition to controlling the role of global dealers within each central counterparty, also a better
understanding of the interdependencies between central counterparties. Indeed, even though
OTC derivatives central counterparties are typically not interoperable, they are still closely
linked owing to the fact that the major clearing banks typically participate in several of them
at the same time. In order to be able to better identify and monitor the related contagion
risks, we will need to significantly enhance information-sharing across central counterparties,
including through access to relevant participant-level data, and conduct analytical work in this
field.
However, it is not clear at this stage to what extent this analysis can and will be carried out.
For instance, the European Market Infrastructure Regulation (EMIR) colleges focus on
individual central counterparties. While major central banks of issue, such as the
Eurosystem, could in principle support a horizontal risk assessment across central
counterparties, given our participation across several EMIR colleges, it is still unclear what
type of information we will receive and, in particular, to what extent this will include
participant-level data. It will therefore be critical to ensure, in the context of the EMIR
implementation, that information-sharing within the colleges will effectively address not only
the micro-prudential concerns of authorities but also the need for appropriate
macroprudential analysis.
Second, another important concern regarding the institutional setting is the fact that global
cooperative oversight arrangements for central counterparties are still lagging significantly
behind what has been agreed in the CPSS-IOSCO Principles for financial market
infrastructures.
Indeed, the respective gap between the EU level and the global level is striking in this regard.
In the European Union, given the introduction of legally binding requirements for central
counterparty supervisors to cooperate and consult with all relevant authorities - including
central banks, supervisors of major clearing banks and supervisors/overseers of
interoperable infrastructures - cooperative oversight arrangements for all EU central
counterparties, in the form of EMIR colleges are currently being set up. At a global level,
however, virtually no progress in cooperative oversight or even in terms of pure
informationsharing has been achieved for several major global central counterparties outside the
European Union.
This is a key concern especially in the field of OTC derivatives, given the global nature and
interconnectedness of these markets. Indeed, if we want to ensure that the introduction of
mandatory clearing is implemented in a way that ensures that central counterparties manage
systemic risk effectively, it is not enough that they are supervised and overseen in their home
jurisdiction. Instead, robust cross-border cooperative oversight arrangements are essential to
ensure that they take fully into account the implications across jurisdictions and currencies in
their on-going risk management, as well as in crisis situations, and that effective cross-border
arrangements for the recovery or potential resolution of central counterparties in a crisis
situation can be put in place. We should not wait for a potential emergency to remind us of
the urgency of this problem. It would be too late to address it then, as the cross-border
upheaval in the banking sector in the context of the 2008-09 financial crises amply
demonstrated. And the consequences in the case of central counterparties would be even
more devastating than what we have seen in the banking sector.
Cross-border application inconsistencies
Finally, let me briefly mention another area of concern: the cross-border application of
different rules. I leave entirely aside the question of whether or not we are finished with the
standard setting. There are areas where additional work would be beneficial: think of
collateral transformation and settlement cycles, and of the success of Target2-Securities in
fostering harmonisation around T+2 settlement in Europe. But this would require another
conference and I will focus here on the application of existing rules.
It is clear to all of us that due to the global nature of the OTC derivatives markets,
international coordination is absolutely indispensable to avoid inconsistencies, gaps or
overlaps, or conflicting rules. At a more general level, the lack of a level playing field in the
enforcement of the new financial standards has a potential to fragment the global financial
system and to lead to a suboptimal allocation of capital of liquidity and to overconsumption of
scarce resources, such as the safe assets used as collateral by financial market participants.
OTC derivatives are a case in point.
I therefore strongly welcome the recent agreement reached between the European
Commission and the US Commodity Futures Trading Commission (CFTC) on a common
path forward regarding a number of measures on how to approach cross-border issues. In
this context, the notion of substituted compliance is a useful tool, as it will help to reduce the
risk of duplication and potential frictions of rules. Clearly, convergence at a very granular
level may not be achieved. It may not even be desirable, as specific differences may reflect
the specific institutional and regulatory frameworks in the jurisdictions concerned.
Nevertheless, it needs to be ensured that the outcome in all material aspects is similar. A key
objective of the G20 mandate for OTC derivatives reform was to ensure effective systemic
risk reduction in these markets. It is unlikely that we will achieve this objective by converging
on the lowest common denominator rather than by achieving common best practices.
However, this may be the result if substantive regulatory differences are not addressed and
consequently, opportunities for regulatory arbitrage open up. The respective risk is
pronounced, especially in view of the fact that most major OTC derivatives dealers are large
cross-border banking groups that may be in a position to shift their OTC derivatives business
to the most leniently regulated group entities.
As the European Commission and the CFTC noted in their recent statement on the "common
path forward", one important open issue in this regard is the material difference in central
counterparties' initial margin coverage between the European Union and the United States,
for example in terms of confidence interval, procyclicality buffers and the scope for portfolio
margining. I would like to add that different coverage requirements for central counterparties'
financial resources, in terms of the liquidity and credit risk arising from the default of their
largest members, are at least equally important.
In addition, it would seem helpful to broaden somewhat the attention concerning the global
regulatory level playing field beyond the immediate concerns regarding EU-US divergence to
all relevant jurisdictions.
Conclusion
It's time for me to conclude:
Yes, we have come a long way and a lot has been achieved since the Pittsburgh summit.
But as highlighted before, additional work will be required:
In the area of data and transparency we need to remove barriers to access and provide a
mechanism to aggregate data across trade repositories and jurisdictions in order to be able
to have a comprehensive overview of the risks in OTC derivatives markets. This is what the
G20 leaders had in mind four years ago.
In the area of clearing
we need to monitor the impact of mandatory clearing not only on
central counterparties, in terms of capacity and risk management, but the focus should also
be on whether an increase in indirect clearing changes the risk profile of the direct clearing
members.
The reform will also have an impact on collateral needs, and we will hear more on this in
tomorrow's academic session on the topic. However, authorities should monitor the
availability of high quality collateral and related collateral management services. New risks
that appear as a result of innovation, such as those relating to collateral transformation, need
to be analysed and addressed. We should not wait for the next crisis to happen but need to
be constantly vigilant.
Though substantial progress has been made, it is also true that only just over half of the FSB
jurisdictions have implemented the reform agenda so far. Although these include the
jurisdictions of the most important OTC derivatives markets, we need to be vigilant in order to
avoid regulatory arbitrage - that is to say, business moving from jurisdictions that stick to the
agreed agenda to others that lag behind.
Little over two weeks ago, the BIS published its macroeconomic impact assessment of OTC
derivatives regulatory reforms. The results are promising. It concludes that the effects of
(i) mandatory central clearing of standardised OTC derivatives, (ii) margin requirements for
non-centrally cleared OTC derivatives and (iii) bank capital requirements for
derivativesrelated exposures will result in overall net benefits for economic growth.
I have spoken a lot about many technical issues. Let me therefore conclude by reminding
you about the ultimate objective of this reform: to rebuild confidence in the financial system,
which has been shattered in the recent years. Not only among market participants but in our
societies as a whole, a good deal of trust has been lost. It is our shared responsibility that our
societies regain this trust.
I wish you, for the rest of today and tomorrow, a successful and fruitful debate and exchange
of views.
Thank you very much for your attention.