It’s a pleasure to speak to you this morning. ICSA has an incredibly important role to play in the coming years as we embark on a host of ambitious international and domestic financial regulatory reform.
ICSA’s two objectives - to encourage the sound growth of the global securities markets, and promote information sharing, align very closely with what I’d like to talk to you about today: how regulation aimed at improving stability can also support economic growth.
Needless to say, reform of financial regulation is one of the Coalition Government’s main priorities. We are all aware of the tremendous benefits and prosperity that modern finance, has brought to the UK.
But at the same time we are all sensitive to the risks. The reform of financial regulation should aim to achieve stable and sustainable growth in financial markets and the wider economy.
Your second objective of information sharing reminds me that it is exactly 167 years ago to the day that one Samuel Morse inaugurated the first American telegraph line from Washington DC to Baltimore. Samuel Morse’s telegram carried with it a single, biblical, quote from the Book of Numbers. In capital letters no less, it read:
WHAT HATH GOD WROUGHT!
I expect many emails shared that sentiment in September 2008 .
A modern financial system increasingly dependent on instant communication and electronic trades fell apart as confidence that had been built over a decade was shattered over a weekend.
Markets rely on open access to information, and freedom to act on that information- and when this is hampered, markets are not as efficient or as competitive as they might be. That’s why issues such as data services and intellectual property of indices are important ones in today’s global markets.
The pace of the financial collapse was as startling as its scale and it required immediate actions to rescue the financial system from itself and from total collapse.
To stem the tide of panic, US and UK regulators introduced a ban on short selling that September. Yet only one month later, and over the course of a weekend, the UK had no option but to provide £37bn to both RBS and Lloyds. That in addition to having already nationalised Northern Rock and Bradford & Bingley. This is a situation that we cannot afford to repeat.
And we are pursuing an ambitious agenda of regulatory and market reforms to ensure that that is the case.
On the domestic scene, the tripartite system proved itself to be wholly inadequate.
The government is therefore putting in place an entirely new regulatory architecture consisting of the Financial Policy Committee and the Prudential Regulation Authority sitting within the Bank of England, and the Financial Consumer Authority.
Compared to the dysfunctional tripartite system, this framework will remedy the lack of attention to systemic risk; recognise the intrinsic links between the financial system and the wider economy; and exercise judgement and foresight rather than mere box-ticking.
Reform of regulation is not enough in itself: the structure of banking needs reform too. Last year we set up the Independent Commission on Banking to look at this and we are awaiting the final report and recommendations, due this September.
The Interim report provided a valuable contribution to domestic and international debates on capital surcharges for systemically important firms, creditor loss absorption, and protecting retail operations from more risky banking activities.
But of course, action at a domestic level will not be enough.
Financial services are a truly global industry and regulation must reflect that fact.
There are an incredible number of financial services directives currently being negotiated in Europe, borne out a desire to address the flaws in regulation and market structure that were revealed by the financial crisis.
From EMIR, to the review of MiFID, to the Market Abuse Directive, the UK is seeking to ensure that we implement proportionate and sustainable regulation.
And internationally, through the G20, we are fighting for high international standards of capital and liquidity,
There is a clear need and there is a clear opportunity to revamp domestic and international regulation of the financial system.
But there is also a challenge.
Regulation and growth
How do we ensure that reforms lead to a more resilient, stable and sustainable financial sector that reinforces rather than undermines economic growth? We cannot succumb to knee-jerk regulation that stifles the competition, the innovation, and the technological advantages that have made London such a leading global financial centre.
Indeed, we have already confronted this challenge in designing the Financial Policy Committee, the new macro-prudential regulatory that I referred to earlier.
As well as responsibility for monitoring the resilience of the financial system in its totality, we have balanced this with a symmetrical objective to consider the wider impact of its actions on long term, sustainable, economic growth.
It is vital that we also assess the impact on growth of the current programme of reforms across Europe, and evaluate the long and short term benefits and costs.
I believe that there are five pitfalls we need to avoid:
- Imposition of disproportionate costs
- Regulation that stifles competition by imposing barriers to entry
- Reforms that balkanise markets
- The creation or reinforcing of monopolies
- And finally, regulation that fails to recognise the individual characteristics of different markets
Firstly, the over-zealous application of rules and restrictions can have unintended consequences by imposing costs that are disproportionate to their benefits. Let me give some examples of this:
The EU Short Selling regulation looks to introduce restrictions and disclosure requirements on short selling. Whilst supportive of the overall aims of the regulation, the UK was very clear during negotiations that permanent restrictions on the short selling of sovereign debt and related credit default swaps could have potential ramifications for liquid sovereign debt markets.
And it was is also crucial to recognise that market players that provide a vital market making role with respect to short selling must not be restricted in their operations. Market making does not increase systemic risk or distort markets. Rather it allows markets to function more effectively.
The same arguments apply when we consider issues of High Frequency Trading and Dark Pools in the review of MiFID. Though work is in its early stages, we must be careful not to implement regulation where there is no robust evidence base - which could damage liquid and effective markets.
The Government is currently engaged in a Foresight project that is undertaking a detailed assessment of how these markets may evolve and how this will affect financial stability and competition.
The outcome of this study will help bolster the domestic and international evidence base before taking any decisions on regulation in this area. Arbitrarily reducing trading options now, will ultimately prove more costly in the long run.
We need regulations that are proportionate and founded on evidence and not whims, if we are to demonstrate that our reforms are in Europe’s best interest.
Secondly, there is a risk that regulation singularly focused on stability serves to stifle competition by creating barriers to entry.
The pursuit of stability should not come at the expense of competition.
We must recognise that competitive markets are the key to strengthening the European economy. Competition produces better outcomes for consumers by reducing costs, increasing returns, and creating deeper and more liquid markets.
A recent Treasury Select Committee report on Competition and Choice in the Banking Sector unsurprisingly concluded that regulation can hamper competition by creating disproportionate entry requirements and releasing the pressure on uncompetitive players to exit. The same logic applies to the financial sector as a whole.
Thirdly, we must still go further to realise a single capital market in the EU and we must continue to pursue an open approach to capital markets outside of the EU.
We remain a long way off realising the full potential of a single capital market. Despite having identified 15 barriers to a single clearing and settling market in 2001, the Commission has only succeeded in dismantling two of those barriers to date.
We have an opportunity to make progress in this area through the harmonisation of operational standards of Central Counterparties in EMIR, which I will discuss later, but also through the proposals for Central Securities Depositories to establish common standards for Settlement Systems, and also through the Securities Law Directive by harmonising investor protections and rights.
Yet whilst competition within Europe’s borders is vital, openness beyond Europe’s borders also serves to strengthen our economies.
Based on recent IMF data, last year, non-EU investors provided 27% of the total investment in EU cross-border securities. And we are dependent on that continuing if we are to realise our economic potential.
So we are concerned about the European Commission’s proposals in MiFID 2 that non-EU investment firms should be subjected to a strict equivalence regime. This could seriously undermine investment flows in to the EU. Raising such significant barriers to competition and investment would be a cost disproportional to the gains in stability.
Fourthly, we must ensure that through new regulation we do not inadvertently create new monopolies insulated from competitive pressure.
We welcome the G20 agreement to mandate clearing through Central Counterparties, CCPs, to reduce counterparty risk between institutions. This is an important step forward as the crisis clearly exposed the deficiencies within the over-the-counter derivatives markets: in particular the shortcomings in the management of counterpart credit risk and the absence of sufficient transparency.
But the flip side of greater stability through the use of CCPs is that it will require participants to provide collateral for their trades. This raises the costs of doing business. Without price competition between CCPs these costs will be passed on directly to the consumers in full with adverse effects to the wider economy.
It is critical that there is a level playing field for CCPs across Europe to create the conditions for competition. It is only through competition that service costs for CCPs will reduce.
This does not necessitate clearing houses taking credit exposures to each other in order to ensure interoperability. Rather this is about ensuring open access to information such that counterparties are not locked into a particular clearing choice.
Finally, we must appreciate that different markets have different regulatory needs. The scope of regulation and regulatory structure needs to reflect the realities of individual markets.
For instance, we must consider whether restricting the scope of central clearing to just OTC derivatives makes sense. The UK’s answer is an emphatic no. We must ensure that the clearing obligation and obligation to report trades must apply to all derivatives, not just OTC.
It makes no sense for two economically similar derivatives to have differential obligations. We must close this loophole if the regulation is to have credibility and achieve our objective of reducing systemic risk.
On the other hand, there is the widespread concern over the suggestion in the MiFID review to spread transparency in equities markets to other asset classes such as bonds and derivatives. Yet, whilst this structure has reaped benefits in equity markets, it’s not a logical conclusion that the same would result in other markets.
Both bond and derivative markets are considerably less liquid than equity markets, and extreme care is needed to ensure that transparency requirements are carefully designed to work for each asset class.
As these five dangers of disproportionate costs, barriers to entry, balkanised markets, creation of monopolies and reforms unsuitable for individual markets demonstrate, we must get the right type of reform. Reform that promotes growth and financial stability.
Getting the regulation right is a difficult task. It has to be precise, it has to be effective, and it has to be wary of unintended consequences. Developing a robust evidence base is critical to this goal.
Getting the regulation right also requires balancing the objectives of stability and of competition. Only then can we ensure secure resilient financial markets and sustainable economic growth.
There is plenty more to be done.
Complacency, in any respect, is dangerous. We have seen that in the crisis.
And that brings me back to ICSA second objective: to promote information sharing. Industry engagement with Government, with other member states and with trade bodies is crucial in providing an evidence base for proportionate regulation. Robust analysis and evidenced based positions are needed from market participants and end users to ensure that we end up with a legislative framework that promotes competition, strengthens the single market and enhances market stability.
I look forward to our discussion and your continued contribution to this debate.