François Groepe: Game changers in financial markets - regulation,
innovation and cybersecurity
Keynote address by Mr François Groepe, Deputy Governor of the South African Reserve Bank,
at the STRATE, PASA and GIBS Conference, Johannesburg, 29 September 2015.
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Introduction
Good day, ladies and gentlemen.
I would like to thank the organisers of the STRATE, PASA and GIBS Conference for inviting
me to give this keynote address.
I look forward to sharing my views on the developments that can be considered game changers
that may affect financial markets and shall focus primarily on regulation, innovation and
cybersecurity in this context.
A game changer can be defined as "a newly introduced element or factor that changes an
existing situation or activity in a significant way".1
Another way of thinking about game changers may be in terms of what the well-known
Austrian-born economist, Joseph Schumpeter, called "creative destruction". Schumpeter,
writing on economic and social evolution in his work Capitalism, socialism and democracy in
1942, wrote:
The opening up of new markets, foreign or domestic, and the organisational
development from the craft shop to such concerns as US Steel illustrate the same
process of industrial mutation - if I may use that biological term - that incessantly
revolutionises the economic structure from within, incessantly destroying the old
one, incessantly creating a new one. This process of creative destruction is the
essential fact about capitalism.
Inventive economists have since adopted this term to describe the disorderly manner in which
the free market delivers progress.
The disruptive nature of innovation is essential for both progress and prosperity, and the theory
of "creative destruction" gives us some insights into understanding this phenomenon and the
evolutionary changes that follow in its aftermath.
Disruptive innovation brings opportunity in the form of productivity gains, for example, but it
also brings challenges such as increased cyber-threats and vulnerabilities stemming from the
greater degree of interconnectedness and, in the latter case, increased risks of contagion.
Regulation, by necessity, has to keep pace and respond to the changing environment.
Unfortunately, regulators often play catch-up due to the speed of technological change and
innovation as well as their lagging ability to fully understand the technology and the risks that
it may give rise to. Despite this, regulators should promote an environment that is conducive
to technological change and at the very least not become a hindrance or frustrate innovation
as it supports economic development and growth. In this regard, the OECD opines:
One of the important lessons of the past two decades has been the pivotal role of
innovation in economic development. The build-up of innovation capacities has
played a central role in the growth dynamics of successful developing countries.
These countries have recognised that innovation is not just about high-technology
products and that innovation capacity has to be built early in the development
process in order to possess the learning capacities that will allow "catch-up" to
happen ... Ultimately a successful development strategy has to build extensive
innovation capacities to foster growth.2
1. Regulatory developments affecting financial markets
The most recent global financial crisis has impacted negatively on the global economy and
financial markets, and has revealed significant deficiencies in the policy frameworks of many
countries. In an attempt to address these deficiencies, the G-20 has called for financial markets
and regulation to be reformed, with the objective of making financial systems more resilient.
This initiative has accelerated the rate of reform, with governments putting increasing pressure
on regulatory authorities to adhere to and implement international best practice and standards.
Activities offered by financial service providers in the financial system are highly
interconnected, and these services are inseparably integrated into both the domestic and the
international economy, which means that regulatory authorities had to take note of the way in
which these markets are developing and the role they play within the broader global context.
The magnitude of the financial system and regulatory reform has been unprecedented. The
reforms have focused mainly on the banking, insurance and financial markets and providers
of financial services, as well as on the infrastructure supporting these sectors.
As regulatory frameworks develop and reforms are implemented, new aspects to financial
regulation come to the fore. Previously, regulators were mainly concerned with the supervision
of banks and the oversight of payment systems. Now they have to contend with a much
broader universe (which includes non-bank participants in the financial markets) and consider
shadow-banking, how it affects the financial system and financial stability, and how to regulate
these activities. The focus, however, is no longer narrowly on prudential regulation. In this age
where we are confronted with a society that is well informed and digitally connected, that
proactively engages in consumer activism and that places great emphasis on values such as
fairness, the spotlight shines brightly on issues such as market conduct, transparency and calls
to "level the playing fields".
It is indeed so that regulation and liberalisation happen in cycles, and periods of deregulation
are often followed by periods of re-regulation. Given the devastating effects of the most recent
global financial crisis, the astronomical social costs resulting from it, and the perceptions
around the role that financial engineering and technology alongside deficient supervision and
regulation played in the run-up to the crisis, we have inevitably been catapulted into an epoch
of re-regulation.
Regulators and economic agents alike face a number of challenges at this point in time. These
include:
1. International standards have been developed - for markets, regulators and
participants - to assist with the management of risks and even behaviour. Whether
they are encapsulated in the new Basel III requirements for capital or liquidity, or in
the Principles for financial market infrastructures, or in the codes of conduct, these
standards are introducing requirements that require adherence. Non-compliance with
these standards is likely to lead to hefty penalties. There is a strong demand for
participants to be accountable and responsible, and to incur liability if they are not
playing by the rules. This has resulted in numerous large financial-sector firms being
slapped with fines running into billions of dollars.
2. Standards are inextricably linked to the next point, which is governance arrangements
and remuneration. Governance arrangements have been a focal point for some time
now, and recent events in international markets have highlighted the importance of
good governance and of ethical behaviour from all stakeholders. The global financial
crisis has also refocused the attention of regulators on the remuneration structures of
management and other individuals participating in financial markets and systems.
This, in some ways, can be related to what economist describe as the "agency
problem" and which under certain conditions may result in risk-shifting. This is a key
area of focus of reform in attempts to promote the soundness of the financial sector
in particular, hence governance arrangements and remuneration continue to be
intensely discussed at various international regulatory forums.
3. "Shadow-banking" and "new (non-bank) participants" have come into sharp focus
since the global financial crisis due to their role in the run-up to the global financial
crisis and in financial regulatory arbitrage. Efforts to regulate these entities will
intensify. This is likely to draw criticism from certain quarters but is entirely justifiable.
The reason is that shadow-banking has the potential to transform the financial
environment, to open up markets, to promote financial inclusion, to reduce frictional
costs, and so forth. Hence, the further development of shadow-banking should be
encouraged, simultaneously mitigating any risks that these entities may pose to the
financial system and ensuring that the playing fields are level.
4. Financial market infrastructures (or FMIs), resolution and cross-border issues
constitute a further challenge. Central banks have traditionally fulfilled the role of
lender of last resort to commercial banks. The global financial crisis has shown that
central banks may need to reconsider this function and consider the role of FMIs.
Financial markets are interconnected and integrated internationally, creating a further
challenge for central banks as they need to consider the position and cross-border
transactions of global FMIs.
5. Conduct has already been raised in terms of standards, codes and governance. As
much as financial market participants must come to terms with the fact that there are
now a multitude of regulators to contend with, regulators need to consider the
mandates of other regulators and agree on arrangements or memorandums of
understanding to work with one another to create an enabling environment for a safer
financial sector. It is also vitally important that regulators do not merely regulate
because that is their mandate. It is vital that the impact of regulation is properly
assessed ex ante and that careful consideration is lent to the possible unintended
consequences and the economic costs of unnecessary regulation or
so-called "red tape". Regulators should strive towards smart and effective regulation
as opposed to simply issuing more regulations.
2. Innovation and financial markets
Regulators should not inhibit innovation. However, as custodians of financial stability, central
banks in particular are tasked with the safety and efficiency of financial systems, and should
act appropriately to address any risks that may emerge.
Electronic trading in South African bonds
During 2012, the Bond Market Development Committee, under the auspices of the Financial
Markets Liaison Group, embarked on an initiative to enhance liquidity in the South African bond
market.
The Bond Market Development Committee, chaired by National Treasury, and in consultation
with the World Bank and bond market stakeholders, has made considerable progress and is
currently at an advanced stage of the development of an electronic trading platform; it is
envisaged that the platform will be introduced before the end of this year.
The initial phase will, however, include only government bonds; it will be expanded to corporate
bonds at a later stage. Initially in the electronic trading platform, primary dealers will be the
only "price makers" while the rest of the market will be "price takers" but with full access to
trading and pricing information.
In addition to the general benefits of enhanced market transparency, credit risk management
and trading, the electronic trading platform also aims to improve liquidity by expanding this
platform to include other market participants complying with the requirements as market
makers, in addition to the primary dealers. Competition among market makers is paramount
to supporting liquidity at an instrument level and to minimising transaction cost.
The introduction of the electronic trading platform will enable National Treasury and the South
African Reserve Bank to monitor market-making activities in the secondary bond market, which
could result in the enhanced monitoring of liquidity conditions.
Enhancements to over-the-counter trading
In response to the recommendations of the G-20 and the subsequent Principles for financial
market infrastructures, the South African Central Securities Depository, known as STRATE, is
in the process of addressing the lack of transparency and risk management in over-the-counter
(or OTC) instruments. To address these concerns, the Financial Markets Act was promulgated
and regulation was passed to include the clearing through a central counter party and to record
all the financial transactions of OTC derivatives contracts in a Trade Repository.
Collateral optimisation
In collateral markets, "collateral optimisation" has become a key objective. Not only do banks
invest in systems that optimise the way in which their collateral can be utilised, but vendors
and central securities depositories now also provide these services to their clients. These smart
systems have built-in intelligence which optimises the way in which the collateral is applied
and will substitute assets if required. An example is the Clearstream collateral management
system, which is gaining momentum globally.
The speed of transactions
The need for faster services, trading, transactions and payments is stimulated by a generation
demanding access and speed, accommodated by the proliferation of new technologies,
growing familiarity with technology, and expectations of real-time satisfaction if not gratification
- not only in financial market transactions and payments, but also in communication, services,
social media and entertainment.
Participants in financial markets have created systems which enable the "trawling" of financial
markets to detect opportunities within markets and then to transact on these opportunities
within milliseconds - also termed "high-frequency trading". Not only do these transactions take
place within seconds; the system development and innovation within financial markets makes
it possible to transact from anywhere in the world 24 hours a day, seven days a week.
Blockchain technology
Blockchain technology, another example of the recently trending phraseology, enables the
ordering (grouping) of various transactions in an inexpensive decentralised manner by making
use of a number of servers. These transactions are not only limited to near-real-time payments
but can also include financial market transactions and information relating to the settlement
thereof. Blockchain has the ability to reduce transaction costs, as it takes away the requirement
for intermediaries and is completely decentralised.
Blockchain is still in its infancy and while regulators and markets are still trying to get to grips
with the concept of Bitcoin, newer or more innovative technologies are already on our doorstep.
3. Cybersecurity
The developments in cyberspace are a cause of concern for regulators, financial market
participants, business and informed consumers. With the interconnectedness of systems and
the ease of Internet access, regulators need to understand the cyber-threats that the financial
system is exposed to.
Nearly every week one reads about the latest victim of a cyberattack, and the targets range
from banking systems through consumer information held by retailers to social media
facilitators and even governments.
The rapid developments in technology and the cyber-world have opened the doors to a new
and uncharted frontier. Companies and countries alike are trying to get to grips with this latest
threat and to find ways in which to mitigate the risk while protecting their information and
reputation at the same time.
Governments, central banks, financial service providers and companies are expanding their
cyber-protection capabilities. This means there is a growing demand for the limited technical
skills available in this environment. The focus is, however, not only on prevention. In
responding to security breaches, one has to respond with agility and speed while trying to limit
the damage done and importantly to ensure continuity of service.
Conclusion
In conclusion, I would like to revisit the idea of a "game changer". A game changer can be the
discovery of something as small as a molecule or the invention of something that transforms
the way in which we communicate, like mobile telephony.
The way in which one looks at game-changing innovations will alter the way in which one sees
the world and will affect one's strategies and business plans. Game changers can be perceived
as opportunities or threats, and both the number and the frequency are likely to increase in the
future.
No country can afford to have a myopic view and narrow national focus when it considers the
game changers in financial market developments. Equally, regulators cannot afford to be left
behind and only react to the changes in financial markets. Regulators must work alongside all
stakeholders and not only the incumbents to try to understand the disruptive innovations and
the policy implications thereof. It is important to emphasise the point of incumbents, as Rajan
and Zingales eloquently set out the role that incumbent coalitions play in financial system
developments but also underline how such coalitions may hold back financial sector
development.3
Lastly, regulators need to be agile and forward thinkers and appreciate that their role extends
beyond simply regulating. Their role is to help facilitate progress with the ultimate objective of
improving the quality of peoples' lives.
Thank you.