29 November 2011

Impact of the crisis and EU regulation on the market infrastructure

Two basic features of a financial system are asymmetric information and liquidity transformation. Information is not fully shared between lenders and borrowers, nor is information between issuers and investors, nor information known to different participants in securities markets. Liquidity transformation is performed by traditional banks, whose assets cannot normally be readily liquidated to meet a very large liquidation of their liabilities, and by securities markets, which pool diverse investors with (normally) uncorrelated liquidity needs to provide resources to issuers, who (normally) have much longer economic horizons.

A breakdown of liquidity transformation is what a financial crisis is all about, and it has a very serious economic impact because it stops long-term investment plans, both by the users of funds and by those who fear contagion in the rest of the economy.

Whenever asymmetric information and liquidity transformation are present, the market is vulnerable to failures – states when liquidity transformation breaks down because of coordinated behaviour by market participants, perhaps triggered by an exogenous event that induces fears about the solvency of counterparties or the values of the assets being traded. A breakdown of liquidity transformation is what a financial crisis is all about, and it has a very serious economic impact because it stops long-term investment plans, both by the users of funds and by those who fear contagion in the rest of the economy. Hence the need for governments to correct such market failures.

Today’s financial markets are based largely on securities and derivatives transactions. As I argued above, these markets are also subject to liquidity seizures. In addition, securities markets are characterised by a very large amount of trading, and therefore a very large number of participants, or counterparties. As a result, whenever a crisis occurs (generally producing very large swings in financial asset prices), the event spreads around the financial system through counterparty risk: large movements in asset prices can, in principle, have a large impact on the solvency of market participants.

The crisis increased the authorities’ awareness of these mechanisms, and of course it induced a number of initiatives to help attack perceived fragilities in the financial system. Such initiatives, coordinated by the G20, led the European Commission to undertake its own work aimed at strengthening the financial system. The European Market Infrastructure Regulation (EMIR) is designed to provide a way to minimise counterparty risk in the system, through a quasi-universal recourse to central counterparties. The MiFID Review, among other things, aims at recognising the shaping of a new market architecture, which foresees a much more central role for organised market places in OTC arrangements. Finally, the Commission intends to eliminate artificial inefficiencies in the markets arising from fragmentation in the settlement architecture (through new CSD legislation) and disparities between Member States’ securities laws (through a planned Securities Law Directive).

The crisis increased the authorities’ awareness of these mechanisms, and of course it induced a number of initiatives to help attack perceived fragilities in the financial system.

Electronic records are now kept of all financial transactions. Such records contain information that is essential to describe, in the aggregate and at every point in time, the state of the financial system. In recent years ignorance regarding the state of the financial system and the distribution of debits and credits led to highly elastic responses to shocks and to exceedingly fast contagion through counterparty risk. Infrastructures like T2S that make financial transactions possible will then take a new, crucial role: that of helping authorities and market participants determine the state of the financial system, and in particular the extent to which risks in the system are concentrated.

One of the lessons of the 2008 crisis was the alarming degree of ignorance among the authorities about what was going on in the financial system. This is a paradox, given that authorities were then, as they are now, supposed to perform the function of systemic risk managers.

One of the lessons of the 2008 crisis was the alarming degree of ignorance among the authorities about what was going on in the financial system.

Since then, attitudes have changed. Now it is considered essential that authorities have access to all information relating to the functioning of the financial system. Trade repositories are the first initiative aimed at collecting that information. The Office of Financial Research in the United States has the power to subpoena financial market participants. Data will be used with the objective of aggregating risk positions, across products and across actors. Data will also be used to check consistency with other information sources, such as risk surveys conducted with financial intermediaries (exercises that are, in principle, not very different from the banks' stress tests).

The (ideal) result will be a system where authorities will be able to identify, in time, the sources of risk in the system and risk concentrations.

These are gigantic tasks requiring that a number of different questions be addressed, including operational, legal and conceptual questions. For example, on the operational side, the current structure of trade repositories is such that they collect only transactions data, but do not collect risk data. This prevents the direct construction of a global risk map from the bottom up. The list of open legal issues is also quite formidable. Intuitively, the construction of systemic risk maps requires the use of data that, by its very nature, is owned by private parties. They are naturally concerned about preserving the commercial value of this information. In addition, full and unobstructed access by authorities to the universe of financial transactions raises the problem of providing appropriate safeguards to private market participants. How can we make sure that authorities do not use this information to exercise undue moral suasion-type pressure on private agents to further market outcomes that authorities regard, in their view, desirable? Another legal issue which overlaps with operational problems is the issue of legal entity identifiers (LEIs), which is currently being addressed by regulators.

The (ideal) result will be a system where authorities will be able to identify, in time, the sources of risk in the system and risk concentrations. They will be able to warn market participants as to those risk concentrations. The final effect of all this will be that counterparty risk will be managed much more effectively. Therefore traders' reactions to shocks will not need to be as drastic as they are currently.

Infrastructures like T2S can and should be central actors in this process of construction of the new financial system.

Infrastructures like T2S can and should be central actors in this process of construction of the new financial system. Once more, however, they need to see very clearly what the overall direction is, what the market needs, and they need to use their ingenuity to innovate in a way that helps people address and solve the issues that make the current financial system fragile.