Speaker: Andrew Bailey, Chief Executive
Event: ICMA Capital Markets Lecture
Delivered: 1 March 2018
Note: this is the speech as drafted and may differ from the delivered version
- This speech gives an overview of the state of financial markets in the UK
- We provide an update on implementation of MiFID II, which is working well for market participants
- Work on the replacements for LIBOR and the transition to alternate reference rates is underway but there are still issues with legacy contracts
It is a great pleasure to be at the International Capital Market Association (ICMA) this morning and can I thank all of you for having the appetite for a speech on wholesale financial markets at breakfast-time. Of course, for the true devotees, I am sure there is nothing at all unusual about this.
And, that’s a convenient introduction to my first point, which is a very long overdue thanks to a former colleague at the Bank of England and I know a mainstay of ICMA, Paul Richards. It is fashionable these days, for obvious reasons, to look for the magic ingredients that make London such a successful wholesale financial centre. What is it that marks London out? There is no single answer, of course, but one thing London does have is a tradition of people who can bridge the worlds of policy and practice and help us to knit the two together. And, I can tell you from more than twenty years of knowing Paul, that he is one of the finest exponents of that art. We first worked together at the Bank when Paul was leading something called Practical Preparations for the Introduction of the Euro. The UK wasn’t going to join the euro area, but the Bank was determined that London would be ready to trade and clear the euro as well as provide the full range of capital market services. And London was ready, thanks in good part to Paul’s work. It was prescient as we now know. Wind the clock forward, and you can probably work out how pleased I was that Paul and ICMA are deeply engaged in work on Brexit and that Paul is chairing a key group on practical plans for reforming London Inter-bank Offered Rate (LIBOR).
While I am on the subject of thank yous, can I also extend it to ICMA, Martin Scheck and all the many people involved in your work. I have to say that for me ICMA is a role model for how we as an authority work with markets and trade bodies. We benefit greatly from your deep knowledge and unfailing willingness to help us and help market participants.
For the rest of the time, I am going to talk about developments in markets, the introduction of MiFID II and say something about our work on LIBOR.
Recent market developments
Throughout last year, one of the themes of discussion on financial markets was just how insulated they were to news, and particularly news which appeared to increase risks to asset values or increase the general level of uncertainty. And, there was no shortage of such news last year. I have seen this before, and as a policymaker who is required to assess risks, it never feels comfortable when markets are so resolute in their ‘treatment’ of risks.
It never feels comfortable when markets are so resolute in their ‘treatment’ of risks.
I should say that in overall financial stability terms, this is only one part of a bigger picture, and there are important countervailing developments, not least the progressive and increasing resilience of the core banking system which is the product of a decade of heavy lifting in terms of policy reforms.
We had to wait until a month or so ago to see sharp falls in the price of risky assets and a corresponding rise in volatility. Realised and implied market volatility spiked and the Chicago Board Options Exchange’s Volatility Index (VIX) experienced its largest ever one day move reaching its highest level since 2015. But falling equity prices were not accompanied by a commensurate increase in spreads of high-yield corporate bonds, and there was little movement in investment-grade spreads.
Volatility may have been amplified by some investors needing to close out leveraged volatility based strategies. The net effect of several large market-based players trading in the same direction created a ‘herding effect’ which may have exacerbated the market moves. We also know that in conditions when market moves become larger, liquidity, which will dampen the effect of smaller moves, will decrease. What we do know is that the experience of the spike in volatility has led to a significant fall in outstanding exposure to inverse VIX products which can be used to sell volatility. Market information also suggests that some large investors reduced their short volatility positions ahead of the spike up in volatility. There are, however, already some indications that short volatility positions are beginning to be re-established.
Stepping back from these events a little, what we have seen in recent times is the lack of inherent market volatility has led to the growth of strategies targeting volatility by investors, thus increasing risk-taking when volatility falls and cutting exposure when it rises. It is not clear yet to what extent such strategies may have contributed to amplifying recent market moves. But there is clearly scope here for pro-cyclical behaviour, and that brings its own risks. It would, of course, be easy to say that such strategies are an inevitable feature of a search for returns in a world of very low, real interest rates though this should not be overdone as an argument since volatility will be traded irrespective of the level of rates. But we should ignore the risks to the financial system that can accompany these strategies. Far from it, we should be vigilant and inquisitive.
If I step back further, it is of course possible to tell stories to explain last year’s dismissal of adverse news as a response to revisions to both the prospects for, and evidence of, growth in the world economy, and a continuation of subdued inflation expectations. These have been key features of the supportive environment for asset prices. With that has come a compression of estimated term premia relative to historical levels, and broader evidence that investors are accepting lower compensation for risk. These are all signals that we need to be on high alert, but in doing so recognise the resilience that has been built into the system post-crisis.
Now, there is a respectable argument that this resilience is concentrated in the banking system and not in the world of market-based finance. Moreover, meanwhile, the reaction to the financial crisis has been to see a shift in the form of financial intermediation from bank balance sheets to market-based activity by investors typically through investment management vehicles. There is a logic to this shift evidence for which can be seen in the rapid, too rapid, growth of bank balance sheets before the onset of the crisis a decade ago. This was particularly pronounced in the trading books of banks. Today, the picture is very different.
But this change in financial intermediation does beg some important questions. Three stand out. First, does the decline in bank intermediation mean that their role as shock absorbers by expanding dealer inventories in times of market correction mean that the system is now at risk in a way that threatens stability? And, second, is the system exposed to pro-cyclical behaviour by investors as they seek to exit en masse? Third, are there features of the structure of the system today, such as the larger number of open-ended investment funds, which mean that there are risks to stability which need to be tackled?
I have argued in the past that I think we should be cautious about assuming that in the good old days dealer inventory stood in the face of the storm and absorbed and checked falling markets. Moreover, the era of larger trading books was short-lived before the crisis, and it didn’t end well. Still, we have to take these risks seriously because it would be tragic if all the progress on bank resilience was undone by a flaw somewhere else in the system. So, what have we learned from recent events? We should be circumspect here. We had a fairly short-lived spike in volatility, and some major price moves. So far, the system has stabilised and the episode was fairly short-lived. And, to be clear, that is not a prediction of what will or will not happen next. So far, the system has dealt with this spike in volatility and fall in asset prices. But, if this is it – and again no prediction intended – it hasn’t been a major system-level event. So, let’s not get carried away.
It won’t deflect us from a number of important pieces of work that we have underway in this field. I would point out two areas here. First, we have been looking hard at the risks from open-ended fund structures following the experience with property funds after the European Union (EU) referendum. Again, that was a major event at the time, which can look a bit less major with the benefit of time and perspective. But, we didn’t know this at the time. What I think is important here is that investor expectations and understanding matches well the form and structure of the investment vehicles they use.
What I think is important here is that investor expectations and understanding matches well the form and structure of the investment vehicles they use.
The second important piece of work, and something on which the FCA and Prudential Regulation Authority (PRA) recently put out papers, concerns algorithmic trading. We have some quite notorious examples of cases where algos are used poorly, and there can be wider fall-out.
To be clear, our intent is not to stand in the way of the use of algos, but rather to ensure that firms have robust governance, risk management and compliance standards. Used well, they are an obvious innovation in trading, but used badly they can cause wider risks to the system.
The last two months have seen another important event, the introduction of Markets in Financial Instruments Directive II (MiFID II) in early January. ICMA played an important role here too, bridging the world of policy and practice, for which many thanks.
For our part, we were very clear that the highest priority was that the introduction of MiFID II, which was a massive undertaking, did not lead to market disruption. Sometimes I get challenged on this, on the ‘rules are rules’ basis – it doesn’t matter what happens to markets as long as the rules are obeyed. No. We have had a lot of experience in London of balancing our objectives whilst ensuring the continuity of markets.
We were very clear that the highest priority was that the introduction of MiFID II, which was a massive undertaking, did not lead to market disruption.
A few days after MiFID II came in, a senior market practitioner said to me, I think as a compliment, that it had gone much more smoothly then they expected. It was too good an opportunity to miss to point out that this probably said more about their expectation than the actuality. But, still, in the world of implementing complex EU legislation, don’t turn down a compliment.
Whatever you think of MiFID II, you can’t deny its ambition. It seeks to boost investor protection and enhance market transparency, efficiency and oversight. An important part of this objective is to migrate significant volumes of trading from over-the-counter (OTC) markets towards more transparent trading venues. If you want to engage in debate on the EU as a rule-making body, then MiFID II is for you – over 30,000 pages of rules.
It is, of course, very early days. But we can now say that the new systems have accommodated heavy trading as market volatility spiked in February, and stood up to the test. We have seen a pronounced downturn in OTC equity trading, as expected. There have been delays in introducing some of the planned measures, notably the double volume cap which limits dark trading. I have no doubt that across the EU, the data systems will get up to speed and enable this to happen and I am relaxed that it will happen robustly without disrupting markets. The European Securities and Markets Authority (ESMA) has said it will happen in March.
Likewise, we have not seen disruption to bond markets. It is hard to pick out any particular MiFID II effects on bond spreads given all the other developments in markets over the last two months.
Capital markets that support the real economy need to be accessible, efficient, clean, resilient and sufficiently liquid. MiFID II tackles these objectives by taking into account the particular role played by venues providing access to capital for smaller firms; extending transparency from equity to bond and derivatives markets, with the aim of promoting efficiency in those markets too, while maintaining access to liquidity; enhancing the scope of instruments within the market abuse regime and the quality of the data provided to us to police it with; and reinforcing the controls in place to support resilience in times of extreme market conditions.
It is too soon to say whether these aims have been realised. But we can reflect on our experience of the initial implementation. Wholesale firms made a very significant effort to prepare for the implementation of MiFID II, for which many thanks. I know that this comes with a cost. Despite some inevitable roughness around the edges, the preparations paid off with no major operational disruptions to trading – and evidence that the changes have not adversely affected liquidity across equities, bonds and derivatives.
Obviously, we are continuing to monitor the effects of MiFID II, which we recognise will only play out in full over a period of time. Also there is inevitably more to do on implementation for both firms and regulators, particularly on reporting. We expect firms to be working to tackle issues and we also recognise that there remain some important interpretative issues to address.
Prior to implementation we said that our approach to enforcement of MiFID II would be consistent with our general effective and proportionate approach to the use of our enforcement powers. To be clear, it was not our intention to offer forbearance; we expect firms to comply with their obligations. But we thought it important to confirm that we would not use our enforcement powers in a disproportionate manner.
We discussed implementation extensively with firms last year. We are continuing our supervisory engagement with firms and our 2018/2019 Business Plan will set out the thematic work we will conduct over the next year on issues relating to MiFID II.
A key challenge for firms in implementation was the expanded transaction reporting requirements. These involved a step change in both the volume and quality of data we receive regarding transactions taking place in the market.
The FCA, alongside ESMA, undertook extensive technological work to be ready to receive, interrogate and ultimately learn from this dataset. We estimate that under MiFID, we will capture some 30-35 million transaction reports a day, up from 20 million before its introduction. The volume of reports reflects the role of London as a global financial centre. There is a determination on our part to exploit the full possibilities of these data to support our efforts to deter, detect and punish market abuse.
That’s enough MiFID II for one breakfast. Just when you thought it was safe to go out as I have finished on that one, let me end with a few words on LIBOR.
As I have said before, LIBOR reference rates are no longer supported by significant volumes on transactions. This puts panel or submitting banks in a difficult position. Work on the transition to alternate reference rates is underway around the world. In the UK this is being driven by the cross-market group (as referenced earlier) which is focused on sterling bond markets, under Paul’s able leadership. It brings together sell side, buy side and non-financial firms. Its work spans derivative and cash markets, with sub-groups already meeting on bond markets, loan markets, and pensions, amongst other issues.
Work on the transition to alternate reference rates is underway around the world.
In the United States, the Alternative Reference Rates Committee (ARRC) has also been reconstituted to facilitate a broader transition. In Switzerland there is focus now on specific retail and derivatives transition issues. In Japan the Risk Free Rates Working Group is encouraging financial institutions to use the Overnight Indexed Swap (OIS), which is critical to transition. The market led work is now starting in the euro area, and the European Central Bank (ECB) has decided it will publish an overnight rate, starting in 2019.
There seems to be a consensus that interest rate markets will, in future, be centred on the Risk Free Rates chosen by various industry groups – like (Sterling Over Night Index Average) SONIA in the UK and Secured Overnight Financing Rate (SOFR) in the US. The expectation is that this will lead to a stronger financial system. For the many LIBOR users for whom it was never an ideal reference rate, a shift of liquidity into the chosen risk free rates offers an opportunity for better hedges and lower risk exposures.
Those who want to hedge interest rate risks will be able to choose a reference rate that does not include an unwanted, but economically significant, credit risk component. Borrowers should have better access to variable rates that do not make them carry the risk that their interest payments will go up because confidence in their banks has fallen.
This leaves a very big question unanswered. It is all very well to talk about a future with new benchmarks, and one that importantly matches closely to interest rate risk, but what about the very large legacy of contracts? There will be cases where it is not practical or economic to change reference rates. The Intercontinental Exchange (ICE) Benchmark Administration has opened up the prospect of a voluntary arrangement to sustain LIBOR after the end of 2021. I don’t rule this out, but I would stress that I don’t see a prospect of a reversal in the decline of the market activity that LIBOR seeks to measure, and the FCA has not changed its position that it is not going to use powers of compulsion towards submitters beyond that point. My best guess is that some panel banks would already have departed were it not for the voluntary agreement to stay in until the end of 2021 that we were able to obtain.
Now, I would not rule out that it might be possible to produce a form of LIBOR proxy which could satisfy the legal definition of what LIBOR is taken to be and serve as a legacy benchmark. This is at root a question of legal interpretation. Would it, for instance, be possible to create a synthetic LIBOR which amounts to a risk-free rate plus an add-on? I’m not sure, but we are encouraging this issue to be assessed as soon as possible. I do not, to be clear, see this as an alternative to the risk free rates as the best measure of interest rate risk, but it is worth assessing whether this could be the way to assist with the legacy.
Let me conclude. There is as you can see no shortage of issues on the agenda, and I have managed to get through this morning without mentioning the B-word. We will continue to work very closely with ICMA. We appreciate the support you give to us and we benefit from your insights. Thank you for this opportunity.