insto - Australian financial markets

Global response, local reaction

In early July, Insto magazine and Mallesons hosted a roundtable on future financial markets regulation, with participation from a wide-cross section of the industry.

PANEL:

• John Barry, Head of securitisation, Australasia
  NAB (by phone)
• Camille Blackburn, Senior executive leader, Investment banks
  ASIC
• Rob Camilleri, Managing director,
  Laminar Advisory
• Grant Lovett, Head of fixed income, Australia and New Zealand
  UBS
• Mark Manning, Senior Manager, Payments System Stability,
  Reserve Bank of Australia
• Robert Pickel, Executive director and chief executive officer,
  ISDA (by phone)

MODERATOR:

• Stuart Fuller,
  Managing partner
  Mallesons Stephen Jaques
  Chairman
  Australian Securitisation Forum

As we move into a new financial year it’s quite an appropriate time to run a roundtable on future trends for regulating the financial markets.

As Mervyn King, the Governor of the Bank of England, said recently “It’s been a year to remember but not to repeat.” There was financial panic, the collapse of several major financial institutions, a remarkable collapse of investor confidence, combined with deleveraging and lack of consumer confidence.

In a recent speech David Lewis, APRA’s general manager, put it this way to his audience: “To what extent was the global financial crisis a market failure; a failure of macroeconomic policy; a failure of risk management; or a failure of regulation? Clearly, each was a factor.”

We can therefore expect to see an increasing number of regulatory bodies focusing on these weaknesses from now on, affecting the way global markets operate. For instance, there’s the Financial Stability Board with its report on market resilience, the Turner Review from the FSA, an action plan from the G20, the Basel Committee’s response to the financial crisis, the work that IOSCO has been doing, and a truckload of reports and consultation papers around the unregulated financial products, the swaps market – in particular credit default – along with short selling and disclosure principles for asset backed securities.

The range of change is staggering. Our panel members explain why.

Fuller: A crisis always provokes a reaction. In your view, Bob, how important in the future is international co-operation of regulation of the financial markets and how do you see that working?

Pickel: Well I think it’s critical and you know given what the derivatives business has been, which is a truly global market, you know we’ve had to address putting in place a structure that works in various jurisdictions and co-ordinate very closely with regulators.

So, I think we’ve got a fair amount of experience doing that and also know how challenging that can be.

You’ve got the international groups, they can at least provide a forum and an opportunity for co-ordination and so I think we’ve got to build on that. But it’s really going to take a lot of commitment and in many cases some willingness to cede control or at least to try to reach a common approach on issues and across jurisdictions so that we don’t have either a race to the bottom, or in terms of regulation or a race to the bottom, but have a relatively the level playing field.

Lovett: In the context of our local derivative business at UBS, we probably do a third of our business in derivatives locally and two-thirds offshore, so that connection is absolutely vital. Some of the domestic banks don’t have that same level of off-shore exposure, but it’s certainly not zero, so we can assume that anybody on the derivatives side of the Australian market is also executing with people offshore. Therefore, being involved in the global regulatory framework is essential.

Fuller: Could it actually come down to how local regulators apply global standards?

Blackburn: We’re very aware of the sorts of points that Grant’s talking about and we hear that again and again from the people we regulate. We have to have close regard to what’s happening internationally and ensure that any steps we take sit comfortably with what those international settings are. That’s not to discount the fact we also have local considerations, be they previous policy settings, or just the dynamics of our market here in Australia.

Fuller: There must be room for local variations because if you assume that there’s a global principle, there have to be pressure points in different jurisdictions and different ways of dealing with problems that arise in different jurisdictions.

Blackburn: I think that’s right. There are certain principles that are truly global in their application and people are participating in a truly global market. There are some other issues that we’re seeing emerging through the international dialogue where the domestic response may be a little bit more moderated.

Manning: In my world, which is basically oversight of the infrastructure that supports payments, clearing and settlement, this international dimension is very well recognised and it’s come through really over the past decade in a series of principles and standards for different elements of market infrastructure. The core principles for systemically important payment systems have now been adopted internationally, and pretty much every jurisdiction is applying those principles in oversight of highvalue payment systems. Then, close on the heels of those principles came the recommendations for securities settlement systems and central counterparties which are, equally, being applied very widely across jurisdictions.

As Camille said, there are bits of tailoring that take place within each jurisdiction reflecting insolvency laws, other legislation, and local idiosyncrasies, but those high level principles are very much adopted. It’s absolutely essential that they are now, given that so much of this infrastructure is operating across borders.

Fuller: Looking at creating market infrastructure for credit default swaps, with one central counterparty: how do you implement this globally, and how do you regulate the market so that it operates efficiently and doesn’t stop market participants from doing what they need to do to run their businesses?

Pickel: We’re taking that on pretty significantly with the various clearing initiatives and efforts by the European Commission to establish a European clearing house which was largely driven by a perception that the clearing houses that would be established over in the States would be US-based, even though I think the goal was to make it a global institution. In Tokyo and Hong Kong I heard a suggestion about a CDS clearing house down in Australia, but that would lead to fragmentation. It’s essential the market focuses on a handful of, or even one or two, clearing houses which are clearing global systems because I think that will be beneficial in the long term.

Lovett: The only way we can achieve that is if we have an homogeneous product that is able to go into a clearing house (or whatever format the market chooses) where everybody basically has the same trade. The recent initiative to do the ‘big bang’ that Robert mentioned was a key starting point, for example, where credit derivatives trade with the same coupon. It’s been a very significant step that credit derivatives trade with the same coupon and have cash settlement upfront. That means everything that goes into the clearing house doesn’t have any valuation issues, everything is valued the same and that really does have a big impact.

The Australian and Asian markets are targeting September for roll-out of the coupon standardisation initiative.

Fuller: That’s something that’s welcomed by the market, a system to create a homogenous product for general trade, but which doesn’t affect flexibility in doing other trades. It’s just not on one central system. How does this flow into counterparty risk, from a regulator’s perspective?

Manning: Essentially, by having a robust central counterparty on the other side of every single trade in eligible products, you’ve overcome the counterparty credit risk that would occur in the bilateral market. It’s managed on a standardised and conservative basis and as long as the central counterparty has the appropriate risk controls in place – which is where regulatory oversight comes in – you should be confident that it has the financial resources to be able to withstand, in the words of the standards and principles, ‘the failure of the largest participant in extreme but plausible circumstances’. That principle is generally applied to central counterparty oversight internationally. Certainly in the case of the emerging central counterparties for CDS and, for a decade now, at the interest rate swaps central counterparty that LCH runs – SwapClear – the principle has been firmly applied by the regulators.

Pickel: The central counterparty get provides many benefits and people have recognized that. It’s about the concentration of risk and therefore it’s very important to make the regulatory structure around it particularly strong because the institutions involved are ‘too big to fail’ type institutions. The other thing is that you do change the dynamic in your bilateral swap agreement if you pull the trades out and put them into a clearing environment. The trades remain, governed by the master agreement, they have different risk profiles: you may go from an in-the-money position to an outof- the-money position, from where you have collateral, to where you don’t.

Lovett: The other point for counterparty exposure is that every day, by having all these trades in one central spot, the regulators have instant access to exposure. One of the things we learnt from Lehman is that it disrupts the market whilst everybody works out what risk they’ve been left with, and closes it out. Having everything in a central clearing point would mean if there were a failure of an institution that participates in that central clearing, then everybody knows immediately what their exposure is. It’s an instantaneous knowledge and I think time is very important when you have stress in the financial system. To, have that information at everybody’s finger tips at the same time would be a huge advantage.

Manning: To follow on from that, the experience of SwapClear, a central counterparty for interest rate swaps, following the default of Lehman really does highlight the benefits of coordination and access to information. The fact is that it was a completely co-ordinated close out of Lehman’s positions, which involved, in full, the participants of SwapClear. The default management process was well tested, well documented, and fully understood by the participants. What it involved was basically an auctioning of Lehman’s positions to the participants, for each of the currency blocks of swaps cleared by SwapClear. So, essentially, that coordination process did avoid a lot of the uncertainties around who was holding what positions, who was going to replace, and in what order.

Blackburn: The other reason that’s an interesting point, Mark, is that it does demonstrate where the Australian market may differ from some of its international counterparts. The CCP [central counterparty clearing house] debate is focused in Europe and the States. To a lesser extent, we are having an Asian time zone debate but there is a fairly broad acknowledgement that we may not have the level of access immediately that some other jurisdictions might have. So, this issue of transparency in OTC [over the counter] markets which don’t have the benefit of the CCP is a very large one for us at the moment, and we have started a dialogue with industry participants about it.

Fuller: Is there anything, from the asset backed securities markets’ perspective, that the swaps market is doing that will set a good precedent for Australia or are the markets so different that we need to look at it differently for those products?

Camilleri: From a product point of view, we most definitely can develop high level principles and standards and we are well on our way to doing that, but it always comes back to the local market and ultimately how you apply those principles.

Barry: Yes, I think on the securitisation side we have seen certain examples of industry-led initiatives aimed at restoring investor confidence and revitalising our market. The work around our disclosure and transparency is one of the key aspects of that. There has been a lot of work done in the US with Project RESTART and its equivalent in Europe and I think that’s one of several factors that will help bring our investors back into the market, gaining confidence gradually. There’s an objective around standardisation of disclosure, for example. Some investors like to see more granular information on mortgage pools so they can slice and dice the data and look for things like risk layering within deals and compare deals. Consistency in a global investor market is important and in that regard I believe industry experts have an important role to play.

Fuller: But does that lead to the price discovery that you need in the capital markets, that you can clearly get in the swap markets through standardised products and central trading systems?

Pickel: I think there are several focuses for the industry, particularly in the area of transparency. Investors have an interest in a certain amount of transparency in order to price the trade and determine if it’s a trade they want to do. There’s a certain large amount of information in the marketplace, and it grows every day.

Fuller: This also requires a balance between regulator-imposed regulation, and industry-imposed standards, doesn’t it?

Blackburn: It does. ASIC has often spoken about the fact that its role is to take measures to support investor confidence while continuing its mandate of investor protection. To the extent that industry can develop initiatives that address the issue of investor confidence, then I think that industry can expect support from ASIC to achieve that objective. There are some valuable industry initiatives that we are aware of, and we will support them provided that they address the issues that we have identified.

Fuller: So would there be a need for in institutions which were previously unregulated to fall within a regulated environment. In Australia is it ASIC or APRA or the RBA who provide receives that information to get transparency, so that there can be a better overview of the system?

Blackburn: The “unregulated” word lets us point out a key divergence between Australia and other markets. We have a number of regulatory settings in place whereas other places are debating the need to establish them.

Fuller: So does that mean we don’t need more regulation in Australia, or just better supervision and better risk management within organisations?

Blackburn: We’re pretty fortunate in Australia in that we’ve come out of this on an international basis very strongly. As for banking, thanks to our friends at APRA and the RBA, we’re in a relatively strong position and the reality is that, especially since November last year when the guarantee was put in place, Australian companies have been able to raise capital and have been able to enter into long term debt internationally.

We’re keeping a very close eye on what’s happening internationally. We’re participating actively on a lot of the international forums that are talking about these regulatory issues. The extent to which they will be reflected in this jurisdiction will be looked at on a case by case basis.

Fuller: One major difference between our market and offshore markets is around licensing of hedge funds managers and private equity managers. In the US, hedge fund managers are private equity managers and being able to can operate without being regulated by any regulatory agency. They may become regulated in the future. Where I would see the potential for over-regulation is if hedge fund managers and private equity managers are restricted in the investment strategies they may pursue.

In Australia we’ve largely relied on a disclosure regime for both the institutional and retail markets. What we’re coming to is looking at the role of the person promoting or selling the securities or funds. That debate is sharpest around retail financial planners and whether they’re selling or whether they’re advising but I think that debate also will eventually extend into the wholesale market. Look at the promotion, for example of securitisation products, hedge funds, or CDOs and the investment bank promoters. Was their role purely sales and non-advisory and did the more sophisticated clients who invested in or bought those products understand that they were not being advised by those investment banks but rather were being sold those products?

Blackburn: It must be addressed. The fact is that every time we have a market disruption there is a certain category of near retail investors that seem to come out second best. So that is not something we can ignore. The retail market is important in Australia. I expect that there will be an active international debate about investor suitability, and there will be an active debate in Australia also on that point. We need to look at each point of the value chain - the issuers, the developers of the products and their internal controls, the advisers and their roles and systems, and ultimately the information and the tools that are put into the hands of the investors.

Fuller: Yes, it does need to be an informed debate as we currently have objective tests for wholesale or retail, and the question of investor suitability is a subjective one, and will put different requirements and liabilities onto the sellers and distributors of investment products?

Blackburn: I think that institutions that develop these products already have quite strict controls and consider those type of issues. In the current circumstances, we would expect financial services licensees to actively turn their minds to these types of issues, as well as other people in the value chain that are providing advice to their clients.

Lovett: I actually find that the level of retail participation in fixed income products in Australia is pretty low. I think that retail investors in Australia are predominantly equity focused, which to me is a higher risk product than 99 per cent of the fixed income product that is available. So, if there is additional regulation on structured fixed income product, I don’t see that impacting the fixed income business at all.

Barry: From a securitisation standpoint, about 90 per cent of our market is residential mortgage backed securities (RMBS), so it’s a relatively straightforward product and the market is an institutional one. Post GFC, our market will be undoubtedly be less complex, less leveraged and more transparent and I think these factors will help shape the way in which our ABS product is positioned with investors going forward.

Fuller: So, if you look at that from the regulator’s perspective, government and semi-government guaranteed securities should be fairly easy to categorise as “swimming between the flags” because it’s a Federal Government risk. How about when you get to lesser known names, or something that’s less vanilla, like assetbacked securities?

Lovett: If you can clear away the demand for the vanilla capital and the banks no longer have to do that, they can concentrate on the product that is ‘outside the flags’, that more potentially higher margin, riskier product.

Blackburn: That’s a debate that will happen this year, and it’s the right time for it. When we test these propositions, we’ll test at every point of the value chain to make sure the embedded controls exist at each of those points.

Fuller: While there’s a political and a global imperative about reform, there must be some limits to ASIC or APRA or the RBA’s patience for the market to get itself organised before they do come in and prescribe requirements, rather than look at what industry’s come up with itself.

Blackburn: I think that’s a fair comment. All of the relevant authorities at the moment are embedded in the international debates, which feed back into the G20 process. The Australian government committed to implement as fully as they can the G20 initiatives. the Final reports all converge, beginning in September this year. The issue about the regulatory implementation steps are a policy issue for the government, rather than for ASIC.

Fuller: So it does take you into a totally different world doesn’t it? Not only for what should be regulated, but for the liquidity management requirements that central banks and regulators are going to impose, and not only on banks but institutions that fall into that category. What sort of operational oversight will we have of them on a day-to-day basis? I guess the question in Australia with the three peaks, is who is the right regulator and how are they going to be regulated and, then, the interaction between APRA, RBA and ASIC. It also raises the point of whether some institutions should be considered “too big to fail” or “too interconnected to fail”.

Manning: Yes, that’s right. Mervyn King recently said that you’re too big to fail if you are too big. It’s more than size, it’s a question of systemic importance - the role that an institution plays in the overall financial system and the extent to which it is a key player in particular markets. So, an institution might be quite small overall but nevertheless extremely important for a critical component of the financial system. You also mentioned interconnectedness, which is a part of this. It also goes back to the debate about market transparency and the availability of information.

Fuller: So, if a policy driver of the CCP is to effectively disconnect financial institutions, then it’s not going to stop at CDS, is it?

Manning: No. It’s already there for interest rate swaps and we should expect that it will expand in terms of coverage and participation. You also go back to one of Bob’s early points, which is that bringing in a CCP brings other regulatory challenges and the need to ensure that the CCP is super-robust and able to operate as one of the best credits in the market. It’s like putting all of your eggs in one basket, as

long as you then watch that basket very carefully. So, while the role of a CCP will go beyond the CDS market, there are likely to be a number of prerequisites in terms of standardisation, pricing and the reliability of valuations, before that can be put effectively in place.

Lovett: The way that a CDS is constructed, with a fixed coupon in a central clearing house, all those issues disappear, and so if a counterparty fails, there’s actually nothing to do. If you’re operating across the whole market in terms of the inter-connectiveness of derivative trades, you could see a scenario where there’s very limited cross over in terms of unwinding. Where it would become more complicated is the collateral side and obviously that’s where the huge numbers are involved, and that was what brought Lehman down – they had no collateral. We need to be focusing on the collateral side.

Manning: That’s absolutely right. This goes back to the amenability of particular products to central clearing. If products such as credit derivatives can be sufficiently standardised, then you can realise the benefits of central counterparty clearing.

Fuller: If there were one or two things that you could do in the Australian market to radically improve investor confidence and to bring the capital markets back, what would they be?

Camilleri: We’ve all learnt a lot about the GFC, how it was caused and where we’re going. Regulators have looked at all the value chain and said ‘okay, we’re going to regulate rating agencies’, for example, so there’s one outcome. It’s set to improve the whole process but if we’re about to do that, we’ve got to go through the whole learning outcome and look at even things like companies who are providing pricing to the market. Should they be regulated? Are they transparent enough the way they interact with the market? There are debates about liquidity, and how mark to market should work and that will be debated for ever and a day.

Lovett: It is hard to know what we in Australia can do to increase investor confidence, we have a very stable financial system that’s certainly out-performed the rest of the globe. Further investor confidence is really going to come from what happens overseas more so than here and it is the same situation with regulation. We are always going to be captive to global developments to a large degree.

Blackburn: I agree with that. We need to maintain world’s best practice and, given the rate of change internationally, we need to keep a close eye on that change and keep pace with it. Industry is moving very quickly, and the industry initiatives that are underway to address those international themes are very important – particularly those in the securitisation and CDS markets. And, as I said above, if industry is too slow to develop responses in Australia, or doesn’t do this, then regulatory support is another option.