Walt Lukken, President and CEO of FIA, delivered remarks on global trends in derivatives markets on May 28 during the Shanghai Derivatives Market Forum in Shanghai, China.
Lukken praised the development of the derivatives market in China, saying, “Shanghai is well on its way to becoming a leading center for price discovery and risk management, not only in China but in the whole world.”
Lukken discussed the opportunities and challenges inherent in the transition from over-the-counter trading to exchanges and clearinghouses. “The changes taking place around the world to transform the OTC market are profound and will make exchanges and clearinghouses even more important than they already are,” Lukken said. “There is great value in the exchange and clearinghouse model for price discovery and risk management.”
Lukken urged international regulators to stay alert to the risk that comes from centralizing activity in clearinghouses. “The migration of the swaps market to the exchange/clearing model means that the amount of risk moving into the derivatives clearinghouses will increase dramatically,” he warned. In this context, he emphasized the importance of implementing international standards for financial market infrastructures and highlighted the critical role of the clearinghouse member firms.
He also stressed the importance of international regulatory cooperation to maintain healthy markets and encourage regulators to move towards mutual recognition or substituted compliance as a mechanism for cross-border regulation and oversight. “I am hopeful that regulators will find value in finding ways to cooperate that allows global markets to exist while effectively protecting the marketplace and its participants.
The Shanghai Derivatives Market Forum, now in its 11th year, brings together government officials and industry leaders to discuss the development of the futures industry in China. This year’s SDMF was co-hosted by the Shanghai Futures Exchange and the China Financial Futures Exchange. In addition to FIA’s Walt Lukken, the speakers included Jiang Yang, vice chairman of the China Securities Regulatory Commission, Tu Guangshao, executive vice mayor of Shanghai, Yin Zhongqing, deputy director of the financial and economic committee of the National People’s Congress, and Chen Youan, chairman of Galaxy Futures.
The full text of Lukken’s remarks, as prepared for delivery, is available online here, and follows below:
It is an honor to speak at this distinguished event with so many important officials and industry leaders. I am especially thankful to Yang Maijun, the chairman of the Shanghai Futures Exchange, and Zhang Shenfeng, the chairman of the China Financial Futures Exchange, for inviting me to this prestigious gathering. The success of CFFEX in building a new market for stock index futures in China is a very impressive achievement, and I look forward to the further development of the financial futures markets in China.
I have been asked to speak about the trends in the global derivatives industry. To be honest with you, this is a very challenging topic because there are so many changes that are currently impacting the global derivatives industry.
Making the Markets Safer
Ever since the financial crisis of 2008, the member nations of the Group of 20 have been engaged in a fundamental restructuring of the regulatory framework for derivatives. The goal is simple: to provide greater transparency into the pricing of risk and to provide greater protection from the risk of a catastrophic default by one or more major global financial institutions.
But if the goal is simple, the application of that goal is not simple at all.
In fact, six years after the crisis, we are still working on this new regulatory framework for derivatives. Even in the U.S., where the work has advanced the furthest, there are still many important details that have not yet been finalized. And the impact on market structure is just beginning to unfold.
Rise of the Exchange/Clearing Model
Nevertheless, I believe that there is one trend that is certain to affect us all. This trend is not new, but I believe that it has been accelerated by the financial crisis of 2008 and the G20 reforms that came afterwards.
I am referring to the rise of exchanges and clearinghouses as centers of the financial system.
If you look at the G20 reforms that came out of the Pittsburgh summit in 2009, you can see that one of the core lessons of the financial crisis is that the derivatives exchanges and clearinghouses continued to function without interruption before, during, and after the crisis. During the dark days of September 2008, when Wall Street seemed to be on the verge of panic, the derivatives exchanges and clearinghouses in the financial centers of Chicago, London, Frankfurt, and Singapore continued to fulfill their role as centers for price discovery and risk management.
At that time, I was Chairman of the Commodity Futures Trading Commission, or the CFTC—the government regulator of the futures industry in the United States.
Having lived through the financial crisis, I came to the same conclusion as many others: we needed to move over-the-counter derivatives off the opaque books of banks and into clearinghouses where the risks would be more transparent and better managed.
In late 2008, I worked with former Securities and Exchange Commission Chairman Chris Cox and former New York Federal Reserve Governor Tim Geithner to approve the first clearinghouses for credit default swaps—the products that contributed to the near collapse of the financial system.
Since that time, more than 50 trillion dollars in credit products have been cleared through these clearinghouses, bringing greater transparency and safety to this marketplace.
What the three of us recognized at the time, as many other nations did as part of the G20 Pittsburgh Communiqué, was that there is great value in the exchange and clearinghouse model for price discovery and risk management.
If you look back over the last several decades, you can see that the trading of futures and options has exploded in almost every part of the global economy. Fifty years ago, the trading of futures and options was limited to only the commodity sector, and most of the trading was centered in a handful of cities like Chicago, New York, London and Tokyo.
Today, futures and options are used all around the world as risk management tools. Companies are using these tools to protect themselves from price shocks in every type of commodity—corn, wheat, crude oil, copper, plastics, and, yes—even eggs and bacon.
The G20 reforms are pushing over-the-counter markets towards exchanges and clearinghouses. For example, in the U.S., we now have rules that require clearing for certain types of interest rate swaps and credit default swaps. It is estimated that more than 80% of the interest rate swaps market is now being cleared.
In addition to clearing, the CFTC has mandated that these products be traded on exchange-like platforms called Swap Execution Facilities or SEFs, moving away from the traditional dealer markets that have dominated the execution of these products. This transition has been relatively slow up to now, but over time I expect that a larger share of these markets will migrate to the exchange model of trading.
The same trend is happening in Europe. We expect that mandatory clearing will start in Europe by end of this year, and mandatory trading sometime thereafter. And we are seeing similar changes in other parts of the world, notably Australia, Canada, Hong Kong, Japan, and Singapore.
Here in China, you have the advantage of a developed transparent and centralized trading model and the benefit of witnessing the dangers an unregulated OTC market.
The changes taking place around the world to transform the OTC market are profound and will make exchanges and clearinghouses even more important than they already are.
The Economic Consequences of this Transition
So what is the impact of this trend? What are the consequences for the companies who use these markets and the policymakers who oversee exchanges and clearinghouses?
Well, for one thing, there is tremendous re-aligning of the economics and profits that flow through these industries, including the cities that host these businesses.
Let me quote Rahm Emanuel, the former chief of staff for President Obama and the current mayor of Chicago. In the fall of 2012, he came to the FIA’s annual derivatives conference in Chicago to talk to our members. Mayor Emanuel spoke directly about the benefits of the futures industry to the economy of Chicago, estimating that it creates over 100,000 jobs for the citizens of Chicago, and not just any jobs, but high-value jobs in finance and technology.
Standing here today, it is easy to imagine that the derivatives industry can bring the same benefits to the city of Shanghai. Shanghai already is the home for two of the most dynamic and innovative futures exchanges in Asia. The introduction of new contracts has accelerated, and I am excited to hear that more are on the way. Without question, Shanghai is well on its way to becoming a leading center for price discovery and risk management, not only in China but in the whole world.
Too Big to Fail
However, I would like to sound a note of caution about the transitions we’re witnessing. There is one type of risk that the G20 reforms have not eliminated. In fact, you could argue that this risk has actually increased.
I am talking about the risk that the exchanges and clearinghouses could become so large and so interconnected that they become the next “too big to fail.”
This is a particularly serious problem with derivatives. That is because the migration of the swaps market to the exchange/clearing model means that the amount of risk moving into the derivatives clearinghouses will increase dramatically.
For the financial system as a whole, I am confident that the reforms will reduce the amount of risk. But the risk that remains is now being concentrated in the clearinghouses and their clearing members, and this means that we must manage this risk with great care.
International regulators are already aware of this potential problem. That was one of the main reasons behind the development of new international standards for clearinghouses—the CPSS-IOSCO Principles for Financial Market Infrastructures. All the major clearinghouses are working hard to meet these new standards and I hope China is considering implementing these important standards.
Basel III is also requiring clearing banks to set aside more capital in case of a default of a customer or clearinghouse. After all, it is the clearing members that provide the lion’s share of the financial resources on which the clearinghouses depend. And it is the clearing members that have the greatest incentives to prevent a clearinghouse from taking on too much risk.
However, with higher capital charges coming from Basel III to many institutions and increased costs of compliance for firms, one unfortunate trend we are likely to see is further consolidation in our industry. This is a continuation of a trend that began over a decade ago.
Ten years ago there were 177 futures commission merchants or FCMs—those U.S. clearing members holding customer funds for trading futures. Now we have only 100. Ten years ago the top 10 clearing members in the U.S. handled 69% of customer trades. Today they handle 77% of customer trades. The top five firms now account for 52% of the customer business compared to 42% ten years before. In contrast, ten years ago total customer funds held by clearing members was $62 billion and now it is $142 billion, a 129% increase.
Clearly, there is a concentration of the clearing business among fewer and fewer firms.
The story is the same for exchanges. While volume in the futures industry over 10 years has increased 191% from 7.2 billion to 21.6 billion, there are fewer exchanges in which that volume flows. Ten years ago there were 18 registered futures exchanges in the United States and today there are only 8.
Higher capital, clearing, and regulatory costs are only going to drive further consolidation. It is ironic that the rules meant to mitigate risk in our markets may have the unintended impact of concentrating risk in the markets and discouraging new entrants. This trend is something that both the industry and regulators should continue to monitor.
Regulatory Trust and Cooperation
As we witness this tidal wave of regulatory change globally, combined with the austerity measures facing many nations and the increasingly globalization of our markets, one trend becomes clear: Monitoring the global regulatory system is going to require a cooperative and pragmatic approach across domestic and foreign regulatory authorities.
No one regulator can police the entirety of the global marketplace without relying on these other partners to help in this effort. And such reliance is going to require pragmatism and building a level of trust between these regulatory partners. As a former chair of an agency, I know this is obviously easier said than done.
I remember when I was CFTC Chairman; I signed a cooperation agreement with then-CSRC Chairman Shang Fulin in February of 2008. While the signing of that document was an important step in furthering the relationship of the CFTC and CSRC, more important was the personal relationship that I developed with Chairman Shang during that time. Building up this level of trust personally between regulators allows you the ability to get through difficult times that you will inevitably face as government officials and allows you to more easily find mutually beneficial compromise.
Let’s look at one cooperative opportunity that today’s global regulators can utilize to make progress: the concept of mutual recognition or substituted compliance.
Mutual recognition or substituted compliance is the concept that one domestic agency with possible legal jurisdiction over a foreign entity and transaction is willing to defer to the foreign authority as long as the foreign rules are comprehensive and comparable.
Such a concept of international comity looks to outcomes rather than the means of achieving such outcomes. There are certainly differences between how each country might regulate, depending on the size of the marketplace, its maturity, its demographics and even cultural distinctions. However, these differences can be minimized by adherence to international principles developed by standard setters such as IOSCO.
I am hopeful that regulators will find value in finding ways to cooperate that allows global markets to exist while effectively protecting the marketplace and its participants. Again, we need all the partners we can get to make this new regulatory regime working safely and effectively.
Conclusion
In closing, I want to say how much I appreciate being a part of this prestigious event and I want to congratulate you on your tremendous progress in building the futures industry in China. I hope our nations work together in friendly cooperation to keep this industry a global leader in fostering innovation while protecting the marketplace and its participants. If we do this, futures markets will continue to make major contributions to the health and vibrancy of our global economy.
Thank you very much.
