Masaaki Shirakawa: Issues facing the futures markets and the industry
Remarks by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Japan
Conference hosted by the Futures Industry Association Japan, Tokyo, 26 July 2012.
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Introduction
The futures market is a key building block of the financial structure of an economy, and its
efficiency and soundness contribute to the economic well being of the public at large. The
Futures Industry Association has, I believe, provided important input into the evolution of this
vital market. The Bank of Japan appreciates your efforts, and that is why I am pleased to
appear as the keynote speaker for the FIA Japan Conference today.
To be honest, the futures market in Japan is falling behind those in other international
financial centers. If you were to ask a man or a woman on the street in Tokyo, what he or she
knew about it, you would in all likelihood get a blank face. This is rather unfortunate,
considering that Japan was probably home to the world's first organized futures exchange. In
the early eighteenth century, rice futures began trading in Dojima, Osaka, complete with a
system of margining and cash settlement. The price of rice, which as you know is the staple
food in Japan, was set through day-to-day trading at the exchange in Dojima, called
kome-kaisho, and the trading houses lining the streets around the exchange provided
essential financial services to the ruling warrior class, which relied on rice as its main source
of income. The exchange was ingrained in the economic life of late-feudal Japan for almost
two centuries.
The fact that such a sophisticated market grew organically on its own makes me somewhat
optimistic that, given the right conditions, the futures industry can flourish in Japan. In fact,
margin trading in foreign-exchange, which is quite similar to futures trading, is popular at the
retail level in Japan.
Today, I would like to offer you some thoughts on how to create or enhance the conditions
that would be conducive to increasing public welfare, by embracing financial innovation, as
well as the advancement of futures markets in Japan. For this purpose, I need to reflect on
our experiences of the recent Great Financial Crisis. While almost five years have passed
since the first dislocations in the U.S. mortgage securities market became evident, the global
financial system has not yet recovered to the point where we can confidently venture out
onto new frontiers. This is especially true on the European continent, where confidence in the
outcome of the policies adopted by some euro area members to contain their debt dynamics
has not been rebuilt sufficiently. We are still in the process of tackling issues that came to
light during the crisis, and my remarks will therefore reiterate this point.
There are two broad themes. One is to pick up the many loose ends that manifested
themselves while we frantically dealt with one emergency after another. Broadly speaking,
financial market infrastructures weathered the Crisis relatively well, and yet they have
revealed many weaknesses. In my view, as I will explain later, Japan has done a fairly good
job in this regard. Another theme is more philosophical. While it is very important to reinforce
the structural integrity of our financial architecture, finance cannot function without the trust of
the society. The Crisis has raised questions about the role of finance in the broader society.
Given the public's displeasure with finance in general and speculation in particular, the
futures industry must articulate its case much more strongly if it hopes to thrive in the years
ahead. Criticism against banks and bankers is not as pronounced in Japan today as it was
ten years ago or as we see it now in the United States or Europe, but that should not be an
excuse for us gathered at this Conference to avoid reflecting on this important issue.
I. Improving the infrastructure of financial markets
Let me begin with the infrastructure issues.
During the height of the Great Financial Crisis, especially in the second half of 2008, financial
markets, particularly in the United States and Europe, virtually ceased to function. Market
participants were not lending to each other even in secured markets such as the repo
market. Households and non-financial corporations could not borrow as banks stopped
lending to preserve cash and new debt issues ground to a halt. Stock markets, while they
continued to function, were in a freefall and generated much anxiety. It is not an
exaggeration to say that the global financial system, and hence the economy, was only one
step away from total collapse. Problems with U.S. sub-prime mortgages were exacerbated
many-fold by the lack of transparency regarding the distribution of risk. Another important
factor that amplified uncertainty was the buildup of transaction backlogs. There were
transactions worth billions of dollars and euros, but it was difficult to get any idea of who bore
the ultimate risk. Big swings in market prices suggested that potential losses could be
enormous. Nobody would dare trade in the face of the fear that their counterparty might be
on the losing side of trades and therefore could be teetering on the brink. The issue was
especially acute in the over-the-counter (OTC) derivative markets, including credit default
swaps (CDS), where the sheer volume and arcane processing systems conspired to hide the
true state of affairs even from the most experienced observers.
Thus, it is no wonder that, when the leaders of the Group of Twenty (G20) countries met in
Pittsburgh in September 2009, they decided to do something about this state of affairs.1 As
regards the OTC derivatives markets, the leaders drew heavily from the experiences of the
futures markets, which remained relatively unscathed during the crisis. They decided to
enhance the transparency and resilience of the OTC derivatives market by encouraging the
use of more standard instruments and moving them onto electronic platforms and centralized
clearing. When the reforms are finally in place, which the leaders have promised will happen
by the end of this year, the OTC derivatives market will more closely resemble the futures
market. Even those instruments that could not readily be standardized will be subject to
margining and reporting requirements, concepts that are already proven in the futures
markets.
If this were the end of the story, I would not have brought up the issue today. While the
futures market provides us with a good off-the-shelf model, in the form of exchanges and
their associated clearing infrastructures, that model could be improved further. For example,
although centralized clearing will insulate market participants from the failure of
counterparties, the effectiveness of the arrangement depends heavily on the design of the
system. A clearing house must ensure that its integrity will not be compromised when its
members fail. This is easier said than done. How should it set the initial margin? How
frequently and in what form should it collect variation margins? How much of an additional
buffer should it hold against the risk of margin shortfalls? There will not be a "one size fits all"
solution, but a set of broad principles could be drawn up.
That is why central banks and regulators have been working on the "Principles for Financial
Market Infrastructures," which were published by the Committee on Payment and Settlement
Systems (CPSS) and the Technical Committee of the International Organization of Securities
Commissions (IOSCO) back in April this year. The new Principles contain 24 elements,
covering all aspects of financial market infrastructures including basic governance structures,
day-to-day operations, risk management, and crisis resolution.2 They are designed to ensure
that the infrastructure supporting global financial markets is robust and thus well placed to
withstand financial shocks. Compared with existing recommendations, the new Principles
introduce new or more demanding requirements. For example, clearing houses that are
systemically important and multi-jurisdictional and those that clear complex products will be
required, at a minimum, to withstand the simultaneous failure of the two largest participants,
instead of the largest participant, as in the current set of recommendations. The Principles
will apply to all systemically important payment systems, central securities depositories,
securities settlement systems, central counterparties, and trade repositories, which
collectively clear, settle, and record transactions in financial markets. The Bank of Japan, in
close cooperation with the Japanese Financial Services Agency, has participated in the
international discussions leading to the agreement on the new Principles and is firmly
committed to implementing them as soon as practicable.
Along with this international push for more robust and resilient market infrastructures, there
have also been efforts that reflect Japanese domestic experiences. While the failure of
Lehman Brothers did not cause much disruption in Japan, and hence cross-border spillovers
were minimal, it was found that the crisis resolution mechanism at the Japan Government
Bond Clearing Corporation (JGBCC) could be further improved. It took herculean efforts at
the JGBCC to come up with securities and funds that Lehman Brothers could not deliver
after its bankruptcy filing. It was a close call. Much progress has been made to reduce risk
and ensure the continuity of operations even in extremely stressful situations, especially in
the area of dealing with a large number of fails and raising emergency liquidity.
As I have noted at the beginning, these efforts to strengthen market infrastructures in Japan
are moving forward at a good speed. For example, with respect to the G20 commitment to
move OTC derivative trading onto centralized clearing by the end of this year, Japan has set
up the necessary legal and institutional framework, and is probably the first market of any
significant size to do so. On this basis, the clearing of CDS began from July 2011, and yen
interest rate swaps will also be centrally cleared by this October. Another significant
risk-reducing measure is the shortening of the settlement cycle for JGBs. Since this April, the
settlement cycle of JGBs was shortened to T+2 from T+3, thereby reducing unsettled
positions. Market participants have also decided to begin laying the groundwork for
shortening the settlement cycle further to T+1. Working together, authorities in Japan and the
industry are committed to enhancing the robustness and resiliency of the Japanese market
infrastructure, which should enable Tokyo to thrive in the increasingly competitive quest to
become a global financial center.
Before moving on to my second theme, let me add a few footnotes concerning financial
market infrastructures.
One is the tradeoff that arises from the increasing use of centralized clearing. Centralized
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clearing has unambiguous advantages for example, the mitigation of counterparty risk,
better collateral management, increasing transparency, and enhanced market liquidity
through standardization. These positive effects should augment the robustness and
resiliency of market infrastructure. That is why the G20 has aimed for its wider adoption in
view of the lessons of the Great Financial Crisis. At the same time, centralized clearing has
its own issues. It may increase, if not properly designed, moral hazard among market
participants, who will be less concerned with counterparty risk. Centralized clearing also
concentrates risk in the clearing entity itself, which might become "too big to fail." The Bank
of Japan has always been aware of such a tradeoff and has continually stressed managing it
wisely.
This brings me to the second and third footnotes.
If the negative effects of centralized clearing are to be effectively managed, central banks
and other regulators must strengthen the oversight and supervision of clearing entities. As
we have already seen with the new Basel banking rules, the move will inevitably result in
higher contingency buffers at the clearing entity in the form of collateral or margining
requirements, loss-absorption pools, or paid-in capital. Since the users of centralized
clearing, who are going to face less risk, will not have the incentive to increase the costs of
clearing by committing more financial resources, higher buffers must be imposed by the
authorities. This may increase the costs of trading, but that is a necessary price to pay in light
of our experiences of the Great Financial Crisis.
Lastly, the access of clearing entities to central bank services must be well thought out in the
context of wiser management of centralized clearing. The advantages of using central bank
money for settling accounts are obvious. In Japan, the Bank of Japan has long had
constructive relations with various domestic financial market infrastructures, including the
Japanese stock exchanges and the Tokyo Financial Exchange. At the same time, it must be
stressed that an account at the central bank should not be confused with automatic central
bank liquidity provision in times of stress. The Bank of Japan wishes to see operators and
members of all infrastructures further enhance their liquidity management arrangements.
II. The role of the futures industry in the broader society
Now, let me turn to the philosophical issue.
Unless it has provided significant services to public welfare, the futures industry would not
have evolved to where it stands today. Nevertheless, even in the best of times, the futures
markets face some skepticism by the public. Futures trading is a pure transfer of risks.
Participants trade on the basis of their outlook on the direction of prices. Some of them wish
to protect themselves, or hedge, against adverse price movements. Others just bet on the
direction of prices, hoping to profit from it. In pure pecuniary terms, one participant's gain is
another's loss. Although in terms of utility, the whole process is not zero sum because
hedgers' utility is greater in view of risk reduction, the zero-sum nature of the pecuniary gains
and losses leads some people outside the industry to regard such activity as reprehensible,
especially when it seems to encourage wild price swings.
In some jurisdictions, hostility to speculation surfaces as outright bans on futures trading on
certain products. For example, in the United States, the definition of commodities under the
Commodity Exchange Act explicitly states "except onions," while corn, wheat, frozen
concentrated orange juice, and all other kinds of edible products are included. This
idiosyncrasy could be traced to a cornering of the U.S. onion market in 1955, which then led
to the enactment in 1956 of the Onion Futures Act. Potatoes failed to make the list of banned
products in 1964, but lawmakers were persuaded enough to add a ban on the trading of
"motion picture box office receipts" in the recent Dodd-Frank Act. Here in Japan, the
resumption of rice futures, notwithstanding their historic significance that I mentioned at the
outset, has taken a long time.
In the days before the Great Financial Crisis, however, the futures industry could still find
many sympathetic ears for its case. It was a widely shared credo that the pursuit of individual
interest in financial markets would result in the transfer of various risks to those economic
agents who were most willing to take on such risks. Given the different risk preferences of
economic agents, the resulting redistribution of risks to those who were most capable of
managing them was believed to enhance the efficiency of the whole economy. It was
believed that the invisible hand would inevitably bring about a good outcome. The futures
markets, sometimes regarded as the closest one could get to perfect markets, were thus
regarded as increasingly important links in the various chains of risk transfer in economies.
The public could be persuaded that the speculative activities of the futures industry were not
only beneficial to the direct participants but also an essential pillar of the institutions that
realize the optimal distribution of risks within the broader society, and thus should be
encouraged with as few restrictions as possible.
That belief, however, was badly shaken during the Crisis. Not a few people have now come
to believe that the financial industry was only greedily pursuing its self-interest with total
disregard for the benefits to the broader society, and that the culmination of such a trend was
the bailout of the industry at a great cost to taxpayers. As a result, while draconian
prohibitions on the trading of certain products are still the exception rather than the rule,
regulations to curb so-called excessive speculation, such as restrictions or bans on short
selling, have been strengthened during and after the Great Financial Crisis. The public is no
longer willing to give the benefit of doubt to the view that what was good for the industry was
good for the economy.
Now, it is not sufficient for the futures industry to maintain that speculation itself is good. It
must make the case that speculation actually brings about good outcomes. In other words, it
must explain why futures trading is an essential building block of the economy.
Therefore, the industry must reflect on its original purpose. The futures market came into
being so that economic agents could protect against the future movement of prices. For
example, the price of West Texas Intermediate crude oil delivered at Cushing, Oklahoma in
three months' time could be influenced by many factors. If the U.S. economy were booming
and people resumed driving huge pickup trucks, demand would skyrocket and so would the
price for crude oil. On the other hand, if new sources of supply, such as oil sands and shale
oil, were to come on line in significant quantities, a supply glut would send prices of oil
tumbling down. If we knew the probability distribution of all possible outcomes, we could of
course calculate one fair price, but this is never the case. No matter how hard we try to see
the future, it is uncertain. Protection could never be bought unless there were economic
agents that were willing to speculate and take the other side of the transaction.
This does not necessarily mean that all futures trading must be underpinned by an actual
need for protection. Even if two speculators trade against each other, the cumulative effects
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of such activity a continuous process of trial and error should ensure that the resulting
price would be the best-informed guess that society could make. Since each trade is backed
by a financial commitment, there should be little incentive to misquote prices. Substantial
speculative activity should also make it easy to enter and exit the market with the smallest
price impact, i.e., it should enhance market liquidity. Furthermore, such prices are formed in
the most transparent manner. By allowing speculation to go on, society could ensure the
availability of protection against unwanted price movements and be confident that the price
charged for the service is fair enough.
So, one can reasonably conclude that speculation should have a role to play in our economy.
However, there may also be limits to speculation.
As I noted earlier, a futures trade between two speculators, or two agents without any
underlying positions to protect, is a zero-sum game. By itself, such a trade does not create
any new value. A hundred million trades with a profit of one basis point will generate a profit
of 1 million dollars, but that money must come out of the pocket of other market participants.
It just does not make sense to put too many resources into such a venture.
Herein lies a paradox. If appropriately conducted, speculation does bring about useful
outcomes for society. Nevertheless, if there were only speculation, there would be no
economic basis for sustaining it, because the expected return of such activity is zero (or
negative if one factors in the costs). The only reason why speculative activity can continue is
that costs are in effect borne by agents that wish to obtain protection. That sort of structure
suggests that there must be an inherent limit to the level of speculative activity in a futures
market. Growth for growth's sake is not acceptable. Can market forces sort this out? This is a
question that the futures industry must ask itself, and I hope that the industry takes it
seriously.
In this regard, the fact that many commodity futures in Japan are not flourishing might lead
us to conclude that any market that fails to attract a sufficient amount of non-speculative
activity will languish. The market might take care of the balance between speculative and
non-speculative activities. In the case of financial futures, banks have legitimate hedging
needs, and such activity will support a certain level of speculation in the market. Meanwhile,
the depressed levels of activity in financial futures for short-term instruments, in today's
ultra-low-interest-rate environment, might be consistent with the self-correcting forces of the
markets.
Concluding remarks
Today, I have reflected on how far the industry, especially in Japan, has progressed in
meeting the challenges arising from the Great Financial Crisis. I have also pointed out that
the industry still needs to redefine its role in the post-Crisis environment. In order to end my
remarks on a positive note, I would like to quickly outline two opportunities for the industry.
One is that there are still many risks for which the introduction of a traded market could be
beneficial to the economy. An example is longevity risks. As I have stressed on numerous
occasions, Japan is facing acute challenges in terms of demography, which in turn weaken
potential growth. A well-designed product that could deal with longevity risks could facilitate
Japan meeting those challenges.
Another opportunity is in terms of leveraging the advantages of the futures market structure.
One feature that comes to my mind is the transparency of prices. There may be many areas
in which prices determined on futures exchanges could become benchmarks for related
economic activity. The recent attention over the setting of LIBOR seems to confirm such a
view.
Such positive contributions should confirm that the futures industry will continue to perform
useful and indispensable functions within the society.
We are now in a period of great changes. Last night, we heard the remarks of the Minister of
State for Financial Services, Mr. Matsushita. He told us that Japan had implemented and
was planning to introduce many reforms that would enhance the competitiveness of and
strengthen the confidence in the Japanese financial markets. Considering that a period of
change is a period of opportunities, I believe that the industry could potentially accelerate its
growth by satisfying the unfulfilled needs of the Japanese economy.
From a broader perspective, Japan's headline growth figures over the last 20 years remained
low, and the period is often described as the lost decade or decades. Nevertheless, the
impact of the bubble bursting in the 1990s was well contained, relative to what we saw
recently following the Great Financial Crisis. Weak growth, at least in the second decade
after the bursting of the bubble, can be explained, to some extent, by adverse demographic
trends, or more precisely, a failure to adapt to such trends. As I have repeatedly pointed out,
per capita
Japan's growth is about the average among the G7 economies, and the growth of
output per working age population is the highest in the G7.3 Compared with most developed
economies, the increase in unemployment has been modest. Japan no longer offers the
low-hanging fruits found in fast-growing emerging economies, but, as one of the richest
economies, it offers tremendous opportunities. In the financial sector, most Japanese
financial institutions are now beginning to compete from a position of strength. Their credit
spreads remain more stable relative to their global peers, and they are gradually and
carefully filling the void created by the retreating European financial institutions. Since I see
many guests from overseas in the audience today, I would like to stress that if we can
combine the tremendous opportunities that I mentioned with a stable financial system, Japan
could perhaps be one of the most promising markets.
I do hope that the Bank of Japan can continue its dialogue with the industry to facilitate this
process.
Thank you for your attention.