On 2 December, FIA CEO and President, Walt Lukken, gave opening remarks at the 13th Annual China International Derivatives Forum (CIDF 2017) in Shenzen, China.
Good morning CSRC Vice Chairman Fang, CFA Chairman Wang, distinguished speakers and honored guests.
Thank you for the opportunity to speak with you today. I wish to thank Chairman Wang of the China Futures Association for inviting me to this prestigious event. A few years back, FIA and CFA signed a memorandum of understanding for further cooperation between our organizations and I am glad to be here today in support of this important mutual goal.
Today I will be speaking to you about the global economy and the global derivatives industry. I wish to start my remarks with a few observations about the global economy and will follow with my views on what is needed for healthy and safe global derivatives markets.
In its latest World Economic Outlook, the IMF noted that economic activity in both advanced and developing economies is forecast to grow. Growth in 2018 is projected at 1.9% for advanced economies and 4.8% for emerging and developing economies.
However, despite these positive signs of growth, the global economy continues to face a number of downside risks. These risk factors include increased protectionism in key advanced economies, heightened and protracted policy uncertainty, the possibility of financial market turbulence, and, over the longer run, weaker potential growth.
Despite a decline in election-related risks in the past year, policy uncertainty remains high. Based on recent developments including protracted post-Brexit negotiations and increased geopolitical risks and tensions, this policy uncertainty could well rise. The world is also facing the potential of increased inward-looking economic policies. The IMF notes that over the longer term, failure to lift potential growth and make growth more inclusive could fuel protectionism and hinder market-friendly reforms. This could lead to disrupted global supply chains, lower global productivity and less affordable tradable consumer goods.
The IMF further notes that these downside risks are interconnected and can be mutually reinforcing. For example, an inward turn in policies could be associated with increased geopolitical tensions and rising global risk aversion.
Therefore, it is imperative that policy makers engage in regular dialogue and work together. National policies inevitably interact and impact across countries (both intentionally and unintentionally) so a well-functioning multilateral framework for international economic relations remains a key ingredient in building strong, sustainable, balanced and inclusive growth.
Working together is not only important in the context of growth in the global economy but also for the growth and health of the global derivatives markets.
Global Derivatives Markets
The cleared derivatives markets play an important role in our economy by providing essential risk management tools. End-users and businesses use futures, options and other derivatives to hedge against price volatility across a number of sectors including currencies, equities, commodities and interest rates. Consumers rely on the markets for price discovery. Therefore, it is important that all global users have access to these risk-mitigation tools.
Over the past few years, the derivatives markets have been impacted by a raft of regulatory and structural changes that were implemented in response to the financial crisis. Almost a decade later, we are still working on this “new” regulatory framework.
We have seen the passage of Dodd-Frank in the United States, which alone generated more than 22,000 pages of regulation. The massive set of regulations, MiFID II, comes into effect on the 3rd of January 2018 across Europe, with an estimated three-quarters of those impacted claiming to not be ready for its effective date. And here in Asia, various reforms are being or have been implemented across the Asia-Pacific region relating to execution, central clearing and reporting of derivatives.
As many in this room have experienced, we continue to feel the cross-border impacts of regulatory rules as trading becomes increasingly borderless.
Overall, FIA supports the goal of these regulatory changes to make the derivatives markets safer. However, it is becoming clear that the unintended consequences and costs of some of the regulatory rules are having an adverse impact on the health of the markets and making it more challenging for market participants to access these markets.
At FIA, our focus is on how best to promote healthy markets against the backdrop of regulation and tightening market conditions.
What do I mean by healthy markets?
Healthy markets are those markets that incentivize good behavior with strong participation by buyers and sellers. Healthy markets are those markets that protect their participants through effective regulation. Healthy markets are those markets that welcome innovation and vigorous competition that lowers prices and promotes liquidity.
Creating healthy markets requires us to balance the goals of protection and growth. FIA believes that in the years since the financial crisis, the scales have tipped too far in one direction, and the result is an unbalanced market environment.
FIA supports three broad principles for healthy markets globally:
- We support smart regulation and enforcement.
- We support end users’ ability to access well-regulated markets, regardless of national borders; and
- We support responsible innovation and fair competition.
To be clear, the increased focus on prescriptive regulations was justified after the crisis. However, we believe regulation should be reviewed and refined to accommodate the current trading environment. Smart regulation does not mean more or less regulation, but the right level of regulation that allows us to keep our markets safe without stifling growth.
The state of the industry
So, what is the current state of the global cleared derivatives industry?
There are a few metrics we can look at:
- From a trading volume perspective, our industry is growing. In the 2016 FIA Volume Survey, we saw the number of futures and options contracts traded on exchanges worldwide increased 1.7%, topping 25 billion contracts in 2016—a record number. There was strong growth in commodity futures and options and interest rate volume hit its highest level since 2007.
- The growth trend has continued in 2017. FIA’s latest statistics show that:
- Worldwide volume of exchange-traded derivatives was 2.234 billion contracts in September 2017, up 8.1% from September 2016.
- Total open interest was 874.4 million contracts at the end of September 2017 which is up 5.4% from 2016.
- Trading in the Asia-Pacific region in September was up 22.7% from September 2016.
- Another metric of industry health is the amount of funds held on behalf of customers. Whilst we don’t have a global figure, we do have access to data in the U.S. According to US CFTC data, the amount of segregated funds for swaps contracts has tripled since 2014 to $80 billion.
This is all good news.
But, contrast these positive trends with the fact that there are fewer clearing members actually clearing, at least in the U.S. where we have data. Since the start of mandatory clearing in the U.S, five firms have left the swaps clearing business globally. We also have anecdotal evidence of clearing members consolidating or exiting certain markets around the world. Overall, the number of clearing members for futures has also decreased in the U.S. by a third since the financial crisis began.
At the same time, the amount of client funds held by clearing members in the U.S. has stagnated since the financial crisis, having not yet returned to pre-crisis levels. To me, these data points show that our markets may be out of balance.
Threats to healthy markets
One factor that may explain this imbalance is the unwillingness of the Basel Committee to recognize the benefits of clearing when creating certain global capital standards for clearing member banks.
One such issue is the treatment of customer margin in the leverage ratio. Responding to the financial crisis, the Basel Committee for Banking Supervision adopted a leverage ratio as a backstop that requires banks to hold capital against actual exposures to loss. Unfortunately, the current standard fails to recognize the collection of customer margin in the central clearing process as an offset to these exposures.
This negatively impacts central clearing by limiting the ability of a clearinghouse to transfer client positions in an orderly manner. One of the essential attributes of central clearing is the ability for customers to move or port their trades and collateral from a failing clearing member to a healthy one. Because customer margin is required to be segregated from the banks’ own money in the form of cash or highly liquid securities, it is always available to protect the continuity and functioning of the cleared derivatives markets in the event of a clearing member default.
However, if the leverage ratio taxes clearing by not recognizing client margin, it is less likely that a healthy clearing member will have the capital capacity to take on a large book of clients from a failing clearing member, thereby increasing the possibility that a clearinghouse would be forced to conduct a fire-sale of these client positions in a distressed market. This could leave many clients unhedged during a crisis and intensify market stress at exactly the wrong moment.
Higher capital, clearing and regulatory costs are only going to drive further consolidation. It is ironic that the rules meant to mitigate risk in our markets may have the unintended impact of concentrating risk in the markets and discouraging new entrants.
FIA has been a tireless advocate on this issue and we have spoken to regulators around the globe on this topic. There is some good news as we understand there will be some movement on this issue. For example, the European Commission has proposed that it will include an offset for initial margin in revised capital requirements.
The US Treasury also recommended in its latest Capital Markets Report that initial margin for centrally cleared derivatives should be deducted from the Leverage Ratio. The US Treasury also recommended that US banking regulators and market regulators conduct regular comprehensive assessments of how the capital and liquidity rules impact the incentives to centrally clear derivatives and whether such rules are properly calibrated.
It will be important as we move forward to monitor issues such as these to ensure that our markets stay healthy, safe and accessible.
Globally Accessible Markets
What can we as an industry do to ensure our markets remain globally accessible?
Since the advent of electronic trading and the introduction of direct market access, trading on derivatives markets have become increasingly global. A trader today sitting in the most remote outpost could potentially have direct access to virtually any market around the world. A company wishing to hedge its currency risk could do that at an exchange in Europe, the US or here in the Asia-Pacific region.
There are a number of factors that are critical to ensuring the accessibility and success of derivatives markets. I will discuss two briefly today:
- Regulatory Cooperation; and
- Diverse participation.
It is imperative regulatory regimes allow for cross-border access without overly burdensome and duplicative regulations. Otherwise, we risk the balkanization of our markets to the detriment of end-users and market liquidity.
Monitoring the global regulatory system and its impacts across borders requires a cooperative and pragmatic approach between domestic and foreign regulatory authorities. No one regulator can police the entirety of the global marketplace and we will need to rely on partners to help in this effort.
Therefore, when it comes to the different regulations governing cleared derivatives markets, FIA has been a strong proponent of mutual recognition and substituted compliance. Mutual recognition or substituted compliance is the concept that one domestic agency with jurisdiction over a foreign entity and transaction is willing to defer to the home authority as long as the foreign rules are comprehensive and comparable. This is an efficient means of regulating without having to enforce duplicative or conflicting regulatory requirements.
There are certainly differences between how each country might regulate, depending on the size of the marketplace, its maturity, its demographics and even cultural distinctions. However, these differences can be minimized by adherence to international principles developed by global standard setters such as IOSCO and cooperative oversight and enforcement arrangements.
A debate over the proper global regulatory approach for third country supervision is now occurring as the result of a recent EU proposal that would require third-country central counterparties to register with the EU if they are found to be of systemic importance to Europe. This proposal also states that certain CCPs deemed systemically-important to the EU may be required to be relocated to one of the EU27 nations if certain conditions are met. FIA has raised concerns with this proposal for fear that it would lead to conflicting and duplicative regulation. FIA believes that comity by global regulators is imperative for these global markets to function effectively and if regulations meeting international standards and comparable to those of the home country, substituted compliance and recognition are a more efficient and effective way to protect the markets while encouraging market access.
I am hopeful that international regulators will continue to find ways to cooperate that allows global markets to exist while effectively protecting the marketplace and its participants. Again, we need all the partners we can get to make regulatory regimes work safely and effectively.
Based on the experience in the U.S. and what I have observed in Europe and elsewhere, I believe one requirement that is crucial for sustaining markets is a broad diversity of users. A broad ecosystem of market participants is the secret to true liquidity and perhaps the most essential quality of a healthy market.
Whether it is commercial end users hedging risk, financial institutions making markets, asset managers seeking commodity exposure, or automated traders providing liquidity - a diversity of market participants, acting independently, benefits the exchange-traded and centrally-cleared derivatives markets by improving price discovery and by stabilizing the market.
I am encouraged by the steps China is making to allow foreign participation in its futures markets, including the recent announcement to allow for majority ownership of futures brokers by foreign participants. I am also encouraged with the recent approval of the INE rules by the CSRC that would allow foreign participation in this energy market. I am encouraged by Vice Chairman Fang’s remarks this morning indicating that these products are close to being launched. I understand that Iron Ore and other commodity products may also provide access to foreign participants. As China’s markets open up to a diverse base of users, I believe a healthy liquidity will develop in these products, providing price discovery and benchmarks for the global economy. This will further spur the integration of China’s markets with other markets around the globe to the benefit of all.
I look forward with great interest to seeing the continued development and success of China’s derivatives markets.
I hope we can continue to work together to grow the global derivatives markets. If we do this, the cleared derivatives industry will continue to make major contributions to the health and vibrancy of our global economy.
Thank you very much and I wish this conference all the success.