From A Fine Balance – a speech by Governor Mark Carney, 20 June 2017, at the Mansion House, London
Financial services could serve as a template for broader services trade liberalisation. And with Brexit, we have the coincidence of necessity and opportunity.
Since the crisis the G20 has agreed a series of new international minimum standards to secure the resilience of the banking sector, transform shadow-banking into resilient market-based finance, make derivatives markets safer and end too-big-to fail. Implementation is now being regularly assessed and transparently reported by the FSB and IMF. The playing field for cross-border activities is being levelled.
At the same time, supervisory cooperation has intensified. Information is now readily shared through supervisory colleges. And regular crisis management groups for systemic firms are building confidence in how authorities will behave when things go wrong.
Mark Carney, Bank of England
With the G20’s encouragement, CCPs are now helping to untangle this web and build resilience. Moreover, by netting exposures across counterparties, currencies and products; CCPs are supporting more liquid markets and are lowering costs to end users. That means more resilient financing and better risk management for business and households.
The UK houses some of the world’s largest CCPs. For example, LCH in London clears swaps in 18 currencies for firms in 55 jurisdictions, handling over 90% of cleared interest rate swaps globally and 98% of all cleared swaps in euros. All currencies, products and counterparties benefit from the resulting economies of scale and scope.
Fragmentation of such global markets by jurisdiction or currency would reduce the benefits of central clearing. EU27 firms account for only a quarter of global activity in cleared euro interest rate swaps, and about 14% of total interest rate swaps in all currencies cleared by LCH. Any development which prevented EU27 firms from continuing to clear trades in the UK would split liquidity between a less liquid onshore market for EU firms and a more liquid offshore market for everyone else.
The potential for higher costs is not theoretical. In Japan, for example, where the clearing of yen-denominated swaps by certain Japanese firms must take place onshore, the difference in price between the onshore and offshore markets has generally been in the range of 1-3 basis points.
Such seemingly small price differences translate into significant costs for users given the scale of activity in these markets. Industry estimates suggest that a single basis point increase in the cost resulting from splitting clearing of interest rate swaps could cost EU firms €22bn per year across all of their business. Those costs would ultimately be passed on to European households and businesses.
Moreover if the large stock of existing trades of EU firms – tens of trillions of euros in size – was trapped at a CCP which was no longer recognised by the European Commission, those EU firms would face capital charges as much as ten times higher than today unless and until they could move them.
Fragmenting liquidity would drive up costs somewhat in the remaining market as well. On current volumes, almost 90% of swaps are traded by non-EU firms and could remain in the main UK-based liquidity pool. Given the size of this market, the impacts could be expected to be much smaller, although not insignificant.
Fragmentation is in no one’s economic interest. Nor is it necessary for financial stability. Indeed it can damage it. Fragmenting clearing would lead to smaller liquidity pools in CCPs, reducing the ability to diversify risks and diminishing resilience. And higher costs would reduce the incentives to hedge risks, increasing the amount of risk that the real economy would have to bear.
The Bank of England fully recognises European concerns. I know because I shared similar ones as Governor of the Bank of Canada. These were addressed then through common standards and cooperative supervisory oversight, allowing C$ clearing to move to a more efficient and resilient hub in London. The Bank of England also must concern itself with the resilience of CCPs in other European and non-European jurisdictions that are used by firms that we supervise. These CCPs must be subject to robust regulatory standards and deep reciprocal supervisory cooperation.
To address such issues, we can and should build on current models to develop a new form of regulatory and supervisory cooperation. The European Commission’s proposals announced last week recognise the importance of effective cooperation arrangements between the relevant EU authorities and their overseas counterparts. They include potential provisions for deference to the rules to which a CCP is subject in its home jurisdiction in line with the intent of the G20.26
The Bank welcomes this. The Commission’s proposals, driven in part by Brexit, address an increasingly important and more general issue in the regulation of the international financial system.