Asian Banker SummitMarketsExchanges ConferenceRegulation in Derivatives Markets.docx
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Asian Banker SummitMarketsExchanges ConferenceRegulation in Derivatives Markets.docx
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AsianBankerSummitMarketsExchangesConferenceRegulationinDerivativesMarkets
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RegulationinDerivativesMarkets
JaneDiplockAOChairman,SecuritiesCommissionNewZealand&ExecutiveCommittee,IOSCO
AsianBankerSummit-MarketsandExchangesConference
19April2010,Singapore
I'mdelightedtobebackinSingapore,andinsuchprestigiouscompany,tocontribute-andlearnfrom-thisimportantconference:
NewLandscapes,NewPlayers,NewRules.
Thisisindeedatimelyconferenceanddebate.JustyesterdaymorningonCNBCIheardPresidentObamadescribingthederivativesmarketsasbillionsofdollarssloshingaroundinthesystem,tradingunderthecoverofdarkness.FromallaroundtheworldtherehascomeacallforgreaterlighttobeshedonthetradingofderivativesandGovernmentsareconsideringandreflectingonthebestwaytodothis.
ThisweekhasshockedtheworldwiththedislocationcausedbyavolcanoinIceland.Suddenlyplanesarehaltedandtheplansofmillionsarethrownintodisarray.
Theglobalfinancialcrisishitmanyinthesameway.Itseemedtocomeoutofaclearbluesky.Itleftthemreelingwithshock,unabletotakeintheirlosses.Somewillsufferfromtheaftershocksfortherestoftheirlives.Forallofus,onewayoranother,thefinanciallandscapechangedforever.
Oneofthedifferencesbetweenaglobalfinancialcrisisandavolcaniceruptionis,ofcourse,thatweremainunabletopredictthesenaturaleruptionsortoblameothersforthem.Financialcrises,ontheotherhand,promptanimmediatesearchforhumanagencyandblame.
It'sonlynowthatthefirstshockhassubsidedthatthemostchallengingquestionhascomeintofocus:
whatdoweneedtodoinordertopreventsuchameltdownoccurringagain?
Theregulatoryresponsetothecrisismustbeonethatencouragesthriving,transparent,deepliquidmarkets,anddoesnotreduceinnovationinthosemarkets.Itmustbebasedonappropriateresearchanddata,andevidenceofthepotentialimpactregulatoryinterventionislikelytohave.
Itshouldalsobecalibratedandrefinedthroughconsultationwithmarketparticipants,particularlythosewhosebusinesseswouldbemostcloselyaffected
Derivativestradingmarketshavebeentargetedasaprimescapegoatfortheglobalfinancialcrisis.Infact,overthelastcoupleofdecadestherehasbeenasmuchdistrustofderivativesastherehasbeenenthusiasm.In2002,oneoftheUS'srichestmenandmostsuccessfulinvestors,WarrenBuffett,observedthatderivativesweretimebombsbothforthepartiesthatdealtinthemandtheeconomicsystem:
"financialweaponsofmassdestruction,carryingdangersthat,whilenowlatent,arepotentiallylethal."1
Theseobservationsweremadebeforetheglobalfinancialcrisishit.Sincethen,boththeblameandtherebuttalshavebeenmorevociferous.
DerivativesMarkets
Hedgingofpositionshasbeenacommonwayofmanagingriskforaverylongtime.:
Theyweredevelopedtomanageandlowerrisk,andcrudeversionsofderivativeshavebeeninuseforcenturies.Derivativesbeganbeingsoldoff-exchangeintheearly1980s.Today,theyaccountforvastsumsofmoney-theBankforInternationalSettlementsestimatesthetotaloutstandingnotionalamountat$684trillion(asofJune2008).2
Derivativescertainlybringlegitimatebusinessbenefits.Theuseofderivativestohedgepositionsinbusinessandtooffsetriskiswellunderstoodandanimportantbusinesstool.
TheBaselCommitteeonBankingSupervisionhaspointedoutthatcreditriskprotectionthroughcollateralpledgedagainstpotentiallossesinderivativestransactionsisacornerstoneofriskmanagement.3
Unfortunately,though,thecrisisdemonstratedthatderivativestradingcanalsoconcentrateandheightenrisk.Somecommentatorshavedemonisedderivativesasaproductclass.Idonotagreewiththisanalysis.Nevertheless,amisunderstandingofderivativescanexposemarketparticipantswhousethemtosignificantrisk.Theglobalfinancialcrisishighlightedthecounterpartyrisk,where,eventhoughtheinstrumentmightwellhavebeensound,thecounterpartycouldnotpay.
TheInternationalOrganizationofSecuritiesCommissions'(IOSCO)reportonthesubprimecrisispublishedinMay20084highlightedthefactthatanumberofstructuredproductsrelyingonleveragemagnifiedbothrisksandreturns.
AJanuary2010reportfromtheJointForum5madeupofthefinancialsector'sinternationalstandard-settingbodies,includingIOSCO,remindsusthat"oneofthefactorscontributingtothecrisiswastheinadequatemanagementofrisksassociatedwithvarioustypesofproductsdesignedtotransfercreditrisk.Thisresultedinseverelossesforsomeinstitutions.Theseproductstransferriskswithinandoutsidetheregulatedsectors."
Myviewisthatderivativestradingcontributedtotheglobalfinancialcrisis,butwasnotthemaincause.Likepoorvaluations,miss-sellingofproducts,misuseofoff-balancesheetvehiclesandpoorlyunderstoodsercuritisations,theywereacontributor.Somederivativesdestroyedvaluebecauseofsignificantopacityinpricingvaluation,andbecausemanyweretradedoverthecounterratherthaninregulatedexchanges,andthereforetherewasanabsenceoftransparencyinrelationtopositions.
AsGaryGensleroftheUSCommodityFuturesTradingCommissionhasobserved,6thecrisisdemonstratedthatOTCderivativesaddedleveragetothefinancialsystem,withmoreriskbeingbackedupbylesscapital.
Derivativesmarketscontinuetogrowinsize,productrangeandcomplexity,withcomplextradesmakingupanincreasingproportionofnewover-the-counter-and,therefore,unregulated-transactions.
Somehedgefundsandfinancialinstitutionsthattradederivativesdosousingverysmallamountsoftheirowncapitalandverylargeamountsofborrowedmoney.Theeffectofallthisistomakethesederivativesextremelyrisky,whileoftenobscuringthatfact.
Aglobalpushforregulation
Ifirmlybelievethat,ifwearetobuildaframeworkthatwillassistusinavoidingfuturefinancialcrisesinglobalmarkets,wemustbepreparedtoworktogethertobuildaneffectiveregulatoryframeworkforOTCderivatives-onethatwillfunctionalongsidetheregulatoryframeworksforsecuritiesandon-exchangederivatives.
Twenty-firstcenturyfinancialmarketsarenolongergeo-politicalislands.Moneymovesaroundtheworldandbackagainatthetouchofamouse,andregulatoryframeworksmustbejustasagileatleapingborders.
Regulatoryreformmustbethoroughanditmustbeinternational.Nothinglesswilldo.
ThisiswhatG20leadersbelieve.LastyearinPittsburgh7theyagreedthat,by2012,allstandardisedOTCderivativecontractsshouldbetradedonexchangesorelectronictradingplatforms,andclearedthroughcentralcounterparties.Non-centrallyclearedcontracts,theysaid,shouldbesubjecttohighercapitalrequirements.
TheBaselCommittee'sMarch2010report
TheBaselCommitteeonBankingSupervisionrecentlypublishedthefindingsofitsstock-takeoflegalandpolicyframeworksforcross-bordercrisesresolution.8Itsaidthecrisisrevealedthat,althoughlargefinancialinstitutions'cross-borderderivativesactivitiescouldbeinternationallybeneficial,theybroughtwiththemsignificantrisksofcross-bordercontagion.
Thecommitteesaidpolicymakerscouldencouragemoreuseofriskmitigationmechanismsandstrengthenlegalframeworkstoensuretheirenforceability.Thiswouldhelpreduceinterdependenciesamongindividualmarketparticipants,betterinsulatingthemfromthefailureofindividualfinancialinstitutions.Thiswouldalsoreducesystemicriskandmakefinancialormarketfunctionsmoreresilientduringacrisis.
Itrecommendedgreaterstandardisationofderivativescontracts,migrationofstandardisedcontractsontoregulatedexchangesandtheclearingandsettlementofsuchcontractsthroughregulatedcentralcounterparties,andgreatertransparencyinreportingforOTCcontractsthroughtraderepositories.
Thecommitteenotedprogressoverthelasttwodecades,withlegalreformadoptedinmostmajorjurisdictions.Itsawlessprogressinsomeemergingmarketjurisdictions,andsaidfurtherconvergenceandstrengtheningofnationalframeworkswasstronglydesirable.
IOSCOwork
IOSCOwasquicktoreactwhenthesubprimecrisishit.IthadidentifiedconcernsanddecidedtoinitiateworkasearlyasNovember2007,anditsreportonthesubprimecrisiswasreleasedinMay2008.
Thereportnotedtherisksposedbysomecollateralizeddebtobligations(CDOs).Byrelyingonleverage,investorsinsuchCDOswouldmagnifyreturnsbutatsignificantrisk.Itmaderecommendationstobetterprotectpublicmarketsfromthespillovereffectscausedbyactivityonprivatemarkets.
Earlythisyear,theJointForumreleasedareviewonregulationrequestedbytheG20throughtheFinancialStabilityBoard.Itanalysesandmakesrecommendationsonkeyissuesarisingfromdifferentialregulationintheinternationalbanking,securities,andinsurancesectors,focusingonunregulatedorlightlyregulatedentitiesoractivitieswheresystemicriskishigh.
TheissueofcreditrisktransferassociatedwithderivativeswasaddressedbytheJointforumin2005andlaterin2007.
InNovember2008,IOSCOinitiatedareviewofthescopeoffinancialmarketsandinparticularunregulatedfinancialmarketsandproducts.Thisresulted,afterextensiveconsultationwithindustry,inafinalreportinSeptember2009.9
Thisreportexamineswaystointroducegreatertransparencyandoversightinunregulatedfinancialmarketsandproducts.Itaimstoimp
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