Walt Lukken delivered a State of the Union address to the FIA Asia Derivatives Conference , touching on key issues including consolidation and lack of diversity of clearing members, the changing business model for clearing caused by regulatory costs and Basel III capital requirements, and potential fragmentation of global markets due to the lack of cross-border regulatory coordination. The full text follows.
I want to thank you all for being here, and I’d like to extend a special thanks to Bill Herder and the FIA Asia team for all the hard work that went into the development of this conference.
This conference has been steadily growing since we first launched it in 2005 and we are again at record attendance and support. The demand for networking, education and information is understandable.
In the 11 years that we’ve held this event, there have been quite a few changes in our industry and how we operate. One of the most noticeable changes is the globalization of our markets.
FIA compiles volume data each year, and trading in the Asia-Pacific region makes up more than one-third of global futures and options volume. What’s striking is how evenly that tracks with volumes on American and European exchanges—there is no one single region that drives markets today—it’s truly a global and interconnected marketplace.
At the same time that our markets are forging stronger global networks, our industry is also undergoing significant changes. Most notable are the regulatory changes put in place after the financial crisis.
As we all know, after the financial crisis, the G20 resolved to mitigate systemic financial risk by increasing central clearing. FIA supports that goal because central clearing serves as a highly effective safety mechanism for the futures, options and now swaps industries, minimizing the effects of a default. We’ve made great progress in our efforts to increase central clearing. In the U.S., for example, only about 15 percent of interest rate and credit default swap transactions were cleared before the financial crisis. Today, 75% of these swaps are cleared. That’s good news.
But simply increasing the amount of centrally cleared trades isn’t enough to be truly effective as a tool for systemic risk mitigation. So instead of looking at clearing from this narrow perspective, we need to consider the health of the entire ecosystem of cleared derivatives.
And just like our earth’s ecosystem, the market ecosystem can be fragile. Without proper care and attention, these markets can wither away—to the detriment of our economy. When you step back and look at this entire ecosystem, it’s easy to spot three areas of concern that deserve some further examination.
- First is the consolidation and lack of diversity of clearing members that are the first layer of defense against a customer default.
- Second is the changing business model for clearing caused by regulatory costs and Basel III capital requirements.
- And third is the possible fragmentation of these global markets due to the lack of cross-border coordination.
Healthy markets require diversity and balanced participation
To begin, it’s impossible to have a healthy clearing ecosystem if it isn’t built on a strong foundation made up of numerous and diverse clearing members to hold and manage risk. Without enough clearing members, clearinghouses are not able to spread risk in the case of a default. Instead, that risk is consolidated among a few members, creating a single point of failure in the markets.
Unfortunately, a number of factors are combining to make it very difficult and costly for clearing members to continue operating as usual. At the same time as more trades are being cleared, we’re also seeing unintended consequences of reforms that are making it more challenging for clearing members to continue operating. Ten years ago, there were 94 U.S. registered clearing brokers that offered customer clearing for exchange-traded and cleared products. Today, there are only 55. That’s nearly a 60% decrease in customer clearing members.
With this consolidation, we are also witnessing less willingness from remaining clearing members to service those participants seeking to hedge risk in the marketplace. Several news stories have been written about clearing members off-boarding certain customers whose positions cost too much to carry.
All told, these constricting trends make it more difficult for end-users to hedge risk. And it means that we have a shrinking foundation to absorb a default.
This pulling back by clearing member banks is also being felt on the execution side where banks are less likely to make markets and provide liquidity during challenging market events. Banks used to serve as shock absorbers of the system to make sure there were buyers to every seller and sellers to every buyer. Today the facts show that they are less willing to play that role.
In a recent speech at Harvard University, CFTC Commissioner Chris Giancarlo noted that in the 4.5 trillion dollar bond market, banks are only holding 50 billion dollars in corporate bond inventory, compared to 300 billion before the crisis. As banks play a lesser role in these markets, policy makers must ask themselves who will take their place and what consequences will result from this lack of diversity and increased consolidation.
The Changing Economic Model of Clearing
The second factor worth examining is the changing economic model of clearing caused by regulatory costs and capital requirements. Without the proper incentives and economics, we will witness fewer players in the marketplace and unintended consequences that may actually increase risk to the system despite good intentions by regulators.
Today I want to focus on one of the factors that is turning the clearing model on its head--capital.
To be clear, FIA supports the risk-mitigating goals of stronger capital requirements. In particular, FIA supports the leverage ratio of the Basel III requirements as an important backstop to keep leverage in check.
But we find that not allowing an offset for initial margin is counter to the goal of increasing central clearing as was encouraged and mandated by the G20, Dodd-Frank, EMIR and other laws globally. Margin that is segregated—as is the case for cleared derivatives transactions—serves as the first layer of protection in a customer default.
The leverage ratio ought to recognize that initial margin is exposure reducing and will always be there during a crisis. Imposing capital requirements on initial margin could be detrimental to the very safety of the system that capital is trying to strengthen. It will increase costs for end users who will, in essence, have to pay twice—once for margining their positions and a second time to rent the balance sheet of its clearing member for those same positions. Banks may be less likely to take on new clients for derivatives clearing with the most harmed being those long-dated directional clients like pension funds and corporates that use these market to hedge.
The leverage ratio’s lack of an offset will put a hard cap on the amount of client funds banks are willing to accept and may harm a clearing houses’ ability to port away customer positions at the time of a default. Ironically, it will incentivize clearing member banks to hold less margin versus more, to carry less liquid collateral versus cash, and to forgo hedgers versus day-traders as clients.
In short, it could make it more difficult for market participants to access cleared derivatives for hedging and it may harm the safety and resilience of our clearing system.
FIA has been working diligently to ensure that the prudential regulators understand the benefits of margin and clearing and we are hopeful that the competing policy objectives can be resolved in a way that promotes a healthy clearing system.
Fragmentation Caused by a Lack of Regulatory Coordination
The last major issue that I see influencing the health of our clearing ecosystem is the possible fragmentation of markets caused by the lack of cross-border coordination. As different countries have implemented various regulations at different times, we’re seeing a number of challenges for firms that clear in multiple countries.
At FIA, we believe deference and substituted compliance is the path forward. Comparable rules and regulations can ensure equivalent regulatory outcomes while reducing the cost of duplicative efforts. Our goal is to ensure that the risks of central clearing are both transparent and effectively managed. But, as you know, this issue is a sticking point between the U.S. and Europe.
While many foreign CCPs have been recognized as equivalent in Europe, the U.S. and Europe have yet to reach an agreement. This has real consequences for our markets, and ripple effects through the global economy. If equivalence cannot be reached, many EU clearing banks on US markets would have putative capital charges and may have to stop clearing altogether.
What it comes down to is this: if global regulations are not well coordinated, markets could balkanize along regional lines, harming participant access, lessening market liquidity and concentrating risk.
I am encouraged that IOSCO’s Cross-Boarder Task Force has acknowledged these concerns and has put out a tool kit earlier this year that will help nations reach principles of comity. I applaud its chair Ashley Alder of the Hong Kong regulatory authority for pushing for more global coordination and harmonization.
Haze of Uncertainty
All of these three factors lead to a haze of uncertainty in the markets and, as we all know, markets despise uncertainty. Without understanding the rules and costs of the game, markets cannot exist and thrive.
The longer this uncertainty remains, the longer it will take for our markets to fully recover and grow.
It is for this reason that FIA exists to be your advocate and to work to develop clear and smart regulations that incentivize sound markets and a culture of compliance. FIA works closely with its members to develop comment letters, best practices, industry standards and even compliance tools like our FIA CCP Risk Review™.
I want to commit to you today that we will continue to work in partnership with our members so you can do your jobs more effectively and we can grow these markets in partnership for years to come.
This is a good segue way to update you on FIA and how it's changing to meet your needs.
Since FIA Asia was founded in 2005, it has served an important role in servicing the development of the Asia derivatives marketplace. But as our industry has globalized and our markets have become increasingly interconnected, FIA needed to grow and expand as well.
Since June of 2013, FIA, FIA Asia and FIA Europe have been working together as affiliates under FIA Global, which helped us to better coordinate policies and priorities. This summer we announced that we would officially tie the knot and merge into one FIA at the beginning of the year.
What does ONE FIA mean for you?
You’ll have a global advocate, with an amplified voice on key international industry issues.
But you’ll retain a strong regional advocate, as our FIA Asia staff will continue to engage and leverage their relationships and expertise on national issues. You’ll have more opportunities for education and networking, because our combined resources allow us to offer more globally focused member services. In short, you’ll get the best of both worlds: global reach and regional expertise.
In addition to the enhanced reach you’ll get from FIA’s merger, we’re also working to expand the services we already offer. We recently re-launched our industry magazine, Market Voice. It has exclusive new features and an expanded global focus. We’re also working to simplify compliance efforts with our FIA CCP Risk Review. This service helps market participants analyze and compare the rules and procedures of CCPs worldwide.
In closing, I am thrilled to be here to participate in this tremendous and growing conference. I’m looking forward to two days of productive and informative conversations, and I hope you are too.
Thanks again for being here.