Lessons from the pandemic: Has the simpler post-2008
financial system held up? And where do we go from here?
Speech given by
Christina Segal-Knowles
Executive Director
Financial Market Infrastructure Directorate
Official Monetary and Financial Institutions Forum
29 January 2021
I am grateful to Stephanie Haffner, Paul Brione, Pavel Chichkanov, Sarah Crowley, Harpal Hungin,
and Barry King for their help in preparing these remarks. I am also grateful to David Bailey,
Paul Bedford, Lee Foulger, Andrew Hauser, Matt Roberts-Sklar, Nick Jackson and Gerardo Ferrara
for their helpful comments
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The topic of my talk today is lessons we can draw from the market turbulence we saw in March and April
2020.
But before we get there I want to talk about an earlier crisis.
Let's rewind to 2008. On September 15th, Lehman brothers collapsed taking with it one side of $35 trillion in
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derivatives contracts. Most of these derivatives were bilateral contracts a spaghetti bowl of
interconnectedness. As Lehman collapsed and others teetered near the edge, no one knew who was
holding the bag.
The result was panic, which, as explained by Ben Bernanke, may have been a key driver of the severity of
the Great Recession. Its early stages would have been significantly less severe without the confidence
collapse on Wall Street.1
1. Simpler
Now let's fast forward to 2020.
Pandemic. Economic crisis. Market turbulence. But no panic in the banking system.
There were a number of reasons. Banks were stronger. In the UK they were three times better capitalized
than at end 2008. And to be clear -very significant government support and central bank interventions were
required. I'll come back to this later.
But there is one other reason for the missing panic that I want to focus in on.
After the 2008 global financial crisis, the G20 put in place reforms designed to make the global financial
system simpler - to untangle the spaghetti bowl of bilateral derivatives trades that had fed the 2008 panic.2
They incentivised - and for many products mandated - central clearing of derivative trades. Global clearing
has as a result, grown significantly in the past decade. Today, about 60% of credit default swaps are cleared,
as well as 80% of interest rate contracts, up from about 10% and 40% respectively in 2008.3
This brought greater stability to derivative markets by ensuring that if a major financial institution were to
collapse, you needn't worry about a domino effect - with the failing firm's derivatives contracts potentially
threatening the viability of any number of other firms.4
1
Ben Bernanke, Op-Ed at Brookings Institution, 13 September 2018
2
G20 Leaders' Statement Pittsburgh Summit, September 2009.
3
Bank of International Settlements Statistical Release, November 2020
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Although it's not my focus today, reforms to bilateral derivatives trading have also helped to reduce the chance that
bilateral contracts
fuel a panic.
2
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One of the key ways central clearing counterparties CCPs help prevent panic is to be sure that as
markets move, firms quickly pay for changes to their derivatives contracts, and insure against likely further
changes.
First, when derivatives contracts change value, the holders of those contracts exchange money right away.
Losses and gains are promptly allocated to the firms on either side of the trade. This limits the chance that,
other firm is left holding the bag for the defaulter's bad trades. This is
if one side of the trade defaults, the
called variation margin.
Second, CCPs require firms to place pre-paid self-insurance with the CCP to cover the predicted liquidation
costs in the event of their default. Because derivatives markets can be fast moving, a key factor in how large
this self-insurance needs to be is how volatile the markets are. This is known as initial margin.
Importantly in times of market turbulence, both losses and gains of individual participants and required
pre-paid self-insurance will rise. They are inherently pro-cyclical. As Deputy Governor Jon Cunliffe said last
summer, this is a feature, not a bug.5
So did the simpler, post 2008- system work?
In March and April 2020, we saw some of the biggest two-day price moves for some cleared products in the
past decade. In a number of products the price moves were much larger than ever seen before.
There were no major clearing member defaults during the pandemic, so clearing was not tested to the limit.
But UK CCPs were able to provide clearing services without disruption. And, importantly, despite record
market moves, UK CCPs had enough prepositioned resources throughout the episode to cover the
5
Speech by Jon Cunliffe, Financial System Resilience: Lessons from a real stress, 9 June 2020.
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simultaneous default of the two largest banks that use them. In other words, CCPs had enough resources at
all times to cover two defaults of institutions like Lehman.
Evidence from March and April suggests that, when it comes to preventing panic driven by opaque and
complicated interlinkages of exposures, the simpler system is working. There were unprecedented
market moves. But no spaghetti bowl. No widespread panic about who had exposures to whom, and
whether they could pay.
There's a catch of course. As we think about where we go from here, we will also need to look at CCPs' role
in the performance of system as a whole. Indeed one of the key lessons of the 2008 financial crisis was that
feedback loops and interlinkages mean the system is not the sum of its parts.6 I will come back to this.
2. Global
As we turn to that bigger question, however, we should not lose sight of the fact that the reforms we put in
place to make the system simpler served their intended purpose.
The question now is how to sustain and strengthen this new simpler system. I have two answers:
First of all, keeping the spaghetti bowl untangled means global infrastructure. The deep pools of
liquidity that make central clearing economical don't correspond to national borders.
Derivatives clearing is a global service. UK CCPs clear global markets for interest rates, foreign exchange,
credit default swaps, and commodities. Foreign clearing members make up 63% of the clearing members at
6
Speech by Alex Brazier. How to: MACROPRU. 5 principles for macroprudential policy. 13 February 2017.
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UK CCPs. At the end of 2020 there were £60 trillion of derivative contracts between UK CCPs and EU
clearing members, and £66 trillion between UK CCPs and US clearing members.7
The growth of global infrastructure that spans national borders is a direct result of the reforms we put in place
after 2008 - again a feature not a bug.
This cross-border nature of clearing means that there must be a consistent approach for the regulation and
supervision of cross-border CCPs. The Principles for Financial Market Infrastructure, issued in 2012, provide
that foundation.
It also means that regulators and supervisors must do something difficult and for some, radical: we need to
trust each other.
This trust should not be blind. As a supervisor and regulator, I have a duty to households and businesses in
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the UK to preserve financial stability to protect the UK economy from disruption. So I need to know on an
ongoing basis that large CCPs on which the UK financial system relies are robustly regulated and
supervised. But that should not necessarily mean I have to do the supervision of non-UK CCPs myself.
Indeed if every host authority supervised every CCP that offers services to its banks and other financial
institutions it would be untenable. We cannot have 21 different regulators' hands on the steering wheel
when it comes to critical cross-border infrastructure. That would hardly be a good result for financial stability
- especially in a crisis, where clear and quick decision-making is critical.
The solution is proportionate and informed reliance.8 Informed reliance means that, with sufficient
information and a deep cooperative relationship with the home supervisor, I can defer to them to ensure that
a CCP is as safe to operate in UK as those I regulate and supervise directly. Proportionate means that for
cross-border CCPs that are very important to the UK financial system, I will need more information and even
7
BoE calculations.
8
Principles for Financial Market Infrastructure Responsibility E on Cooperation.
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deeper cooperation and in the event that we are unable to secure this, I may need to resort to supervising
the CCP directly.
This approach is underpinned by the 2013 G20 declaration which emphasizes the importance of regulators
deferring to one another when justified by the quality of the regulatory and enforcement regimes.9 It is also
exemplified in our ongoing cooperation with the US CFTC, which we enshrined in a revamped MOU last
year.
In the UK, we are in the process of designing our approach to our new onshored legal framework for
- known as UK EMIR 2.2. As we do this, we'll be looking to ensure proportionate and
incoming CCPs
informed reliance is at the heart of our approach.
3. Ahead of the curve
My second recommendation for how to sustain the simpler system: keep it under review. Since 2008, the
financial system has evolved. Reforms have been implemented; innovation, preferences, and changes in our
economies have reshaped financial markets. In particular the role of non-banks has grown. We need to be
on the lookout for new fault lines.
The market stress we saw in March and April offers the potential to glimpse of where these fault lines might
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be a real life stress test.
One of those fault lines may have come into view in March. Sharp moves in asset prices catalysed the
sudden and sharp redistribution of liquidity around the system. Market participants were racing to get their
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hands on cash and in particular US dollars. This led to a period of severe market dysfunction, spreading
even to advanced economy government bond markets.
9
G20 Leaders' Declaration, St. Petersburg Declaration, 6 September 2013.
6
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Central banks stepped in to restore market stability in a big way, carrying out lending operations and asset
purchases to limit wider economic consequences. G10 central bank balance sheets have risen by $8 trillion,
or 16% of G10 GDP since March 2020.10 The good news is that extraordinary central bank action succeeded
in restoring stability.
But to conclude "all's well that ends well" in this case would be the equivalent of
someone who had an
electrical fire in their home after a power surge deciding not to bother to look at the wiring because the fire
department arrived quickly and managed to put the fire out without too much damage. We need to open up
the walls.
So what does this have to do with central clearing?
You'll recall earlier I spoke about margin
- variation margin (the losses and gains of individual participants)
and initial margin (pre-paid self-insurance).
Well in March, UK CCP margin calls grew significantly in response to high levels of market volatility. At their
March peak, daily variation margin calls by UK CCPs were over 5 times higher than their average, at around
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£30bn. And their initial margin requirements grew by over 30%.11 This is not particularly surprising as I said
earlier, one would expect CCP margin to jump in such a dramatic market stress.
10
Speech by Andrew Hauser, From Lender of Last Resort to Market Maker of Last Resort via
the dash for cash: why central banks need new tools for dealing with market dysfunction, 7 January 2021.
11
Bank of England calculations.
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But it also undoubtedly contributed to the liquidity stress some participants faced. At least some of those
scrambling to get their hands on US dollars may have been doing so in order to meet their obligations at
CCPs
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As a priority for 2021, the Financial Stability Board (FSB) is looking at the role of margin in this episode, as
part of its broader work plan to strengthen the resilience of non-bank financial intermediation.12 The Bank is
closely involved.
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This is crucial work we need to understand the role margin played as part of any thorough look behind the
walls.
This means we will need to look beyond aggregate numbers and build up a full and detailed picture to
assess what role CCP margin played
For example:

We need to look at why all CCPs turned out not to be created equal. What drove variation across
firms and are there any lessons learned.
12
FSB Holistic Review of the March Market Turmoil, 17 November 2020.
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
We need to distinguish between variation margin and initial margin. Variation margin flows -which
simply reflect losses and gains in the underlying markets were in many cases much larger than the
increases in initial margin controlled by CCPs' own models.

We need to go more granular than quarterly data to understand the speed of margin increases over
that crucial period in mid-March.

We also need to understand how much of the headline increase in initial margin resulted from
members simply trading more. Our analysis suggests this varied widely across UK CCPs and over
the crisis period. We already know that changing portfolios don't tell the whole story. For almost all
services, volume accounted for well less than half of CCP initial margin increases over March as a
whole, with CCP models a much more important driver.13

Finally, to really get into the walls of the dash for cash, we need to look beyond service-level
aggregates to understand if particular groups of firms saw their margins increase more than across
the service as a whole.
13
Bank of England calculations.
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But even as we delve into margin data, we need to keep in mind that the increase in margin is only one piece
of the puzzle. What matters is that the system as a whole has the right level of liquidity to cope with
volatility in derivatives markets in a stress and that liquidity is in the right place
We need to understand which market participants were caught flat-footed and why.
Thanks to post- 2008 liquidity reforms, banks seemed able to handle the liquidity pressures they faced in
March, including from margin calls. But non-banks such insurers, pension funds, hedge funds and asset
managers have grown in importance over the past decade - we need to examine how well prepared they
were to face the liquidity demands around margins.
It's too early to reach policy conclusions. But to preview the options in front of us:
It's possible we'll want to explore solutions that could reduce the need for CCP margin to rise as much in
stress by pre-positioning more liquidity at CCPs during quiet periods. It's possible we could accomplish this
It's equally possible we'll want to focus on better
by spreading existing good practices in CCP model design.
liquidity risk management, particularly for non-banks. This could make sure market participants self-insure
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against margin calls on their own balance sheets rather than pre-positioning initial margin at the CCP.
Improving transparency around potential margin calls could help support this.
It's possible that we'll want to do some of both.
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The right balance of policy responses will depend on what evidence we find. To be clear, the question here
is not about whether CCP margin is to "blame" for the dash-for-cash. The question is did the system have
enough liquidity ready in the right places to respond to derivative market volatility without adverse
consequences for financial stability.
Whatever we conclude, our policy response will need to take into account the whole story- including the
We don't want to return to the
essential role that margin played in preventing panic. pre-Lehman world of a
spaghetti bowl of counterparty credit risk.
4. Conclusion
So going back to my original questions.
First, what has the experience of March and April told us about the reforms we put in place post-2008 to
make the global financial system simpler?
A: The headline answer is: It worked. When it comes to the crucial goal of preventing panic fuelled by a
spaghetti bowl of bilateral derivatives exposures, the new system held up despite unprecedented stress.
Second, where do we go from here?
A: I have two recommendations:
First, we need global regulatory cooperation in order to avoid reverting to fragmentation and spaghetti. Trust
based on proportionate, informed reliance.
Second, if we want the simpler system to keep working, global regulators need to stay ahead of the curve
and keep the system under review.
We cannot ignore the fire the financial system experienced in March and April last year just because central
banks did a good job putting it out. We need to look behind the walls and address any faults in the wiring.
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Fortunately the FSB working with the Committee on Payments and Market Infrastructure (CPMI) and the
International Organization of Securities Commissions (IOSCO) are doing just that.
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