FEX - The Financial and Energy Exchange Group

Welcome to The Financial and Energy Exchange Group

29 June 2009

Welcome to the Financial and Energy Exchange Group.

Since my last letter in December 2008, the world has changed materially. We are now, unequivocally, in the middle of the GFC (Global Financial Crisis).

What bottomed in September 2008 with Lehman Brothers Chapter 11 bankruptcy filing has now fully bloomed into a financial market crisis with material declines in global wealth; bank failures; sovereign guarantees of bank debt; trillions of dollars of taxpayer funds invested in supporting crumbling financial systems; and changes to accounting treatment for financial assets.

We are now entering a period of reflection where underlying market structures and regulations are being considered. Near top of mind, at least in the case of US regulators, is the case study of AIG Financial products and the more than US $150 billion in US government support to necessary to allow AIGFP to meet its over the counter (OTC) derivative contract obligations.

At the April 2009 London meeting, G20 leaders pledge to “do whatever is necessary” to repair the global financial system and to restore lending; and to strengthen financial regulation. In short, to rebuild trust and integrity. Shortly thereafter, in May 2009, IOSCO published its interim recommendations on unregulated financial markets and products – with a general focus on OTC markets and specific focus on Securitisation and Credit Default Swaps. Again thereafter, in June 2009, the US Government proposed a major overhaul of the U.S. financial system, including giving new powers to the Federal Reserve to oversee Tier 1 financial companies within the entire financial system.

In Australia, the key financial market regulators recently released their survey of the Australian OTC derivatives markets. This survey was released on the back of the IOSCO (he International Organization of Securities Commissions) unregulated markets report.

FEX operates Australia’s only Australian Market Licensed electronic marketplace for interest rate and foreign currency forward OTC contracts. In this light, FEX considers it timely to engage in the debate over the future of global capital and financial markets. FEX is well positioned to work with regulators and market participants to respond to the clarion call for markets of integrity, efficiency, neutrality, transparency and stability.

Many commentators have laid the blame for many of our current ills on derivatives and OTC markets, wheeling out the famous Warren Buffett quote that “derivatives are weapons of mass destruction”. There have been calls for re-regulation or enhanced regulatory scope to remedy all ills.

However, as is well recognised, the causes of the current capital market ills are varied and complex, and not simply derivatives and OTC-market related. Recently, the Wholesale Market Brokers Association commented that the GFC was caused, not by OTC derivatives themselves, but by “several seismic economic and financial forces” that centred on problems in valuing and hedging complex derivatives. It was further stated that “it is misleading to suggest that the exchange-traded markets have a more robust regulatory model”.

Such a response from OTC market participants is predictable, but equally there is a basis in their position. There are and were many interconnected factors explaining the GFC including globalisation driven financial interdependence, foreign exchange market intervention causing trade imbalances, the economics of US foreign policy and rationalist economist zealotry.

OTC markets are clearly significant in their size. According to the Bank for International Settlements (BIS), there was US$684 trillion in outstanding notional value at June 2008. Of this, US$458 trillion or 67% was for interest rate contracts, including credit default swaps.

OTC markets dwarf exchange traded markets. At the start of 2007, the value of global OTC market activity was 8 times the equivalent exchange traded market activity.

Within Australia, based on Australian Financial Markets Association (AFMA) data, there was AU$80billion of turnover for the 2008 Financial Year, and this was approximately 2 times the equivalent turnover of the combined ASX and SFE exchange traded markets.

By way of geography, in 2007, 43% of value was traded in the UK, 24% in the US, 15% in combined France, Germany and Japan. That leaves 18% for the rest of the world, including Australia.

It is self evident that global financial and capital markets are heading into a new regulatory era – an era of both selective re-regulation and of expanded regulatory scope. However, to paraphrase Henry Mencken, there is always an easy regulatory solution to every market problem. A solution that is neat, plausible and wrong. Regulation is important, but more important is the right kind of regulation and economic structures.

From the perspective of Financial Market regulators, they generally focus on one or more of 3 overarching objectives:

• Maintenance and enhancement of market confidence and integrity through a focus on conduct of market participants and market operators;
• Mitigation of systemic financial risk; and
• Prudential regulation.

From a policy perspective, well functioning capital markets provide essential shock absorbers for economies. This was evidenced from the AFC (Asian Financial Crisis) when financial risks could not be effectively priced and transferred. This is also why extensive international development dollars have been spent fostering capital markets in developing economies.

Markets, and especially financial markets, operate on trust. A trust that the pricing reflects actual supply and demand, and that transactions entered into will complete and be honoured. Without trust, markets basically don’t work. The regulatory focus on market confidence is to help ensure that our capital markets continue to actually work.

Systemic financial risk is also a key focus, and currently the key focus for market regulators. Systemic risk is defined by the Bank for International Settlements as the risk that the failure of one market participant to meet its contractual obligations may in turn cause other market participants to default with a chain reaction leading to broader financial difficulties. This is also known as the “Too Big To Fail” problem. It is the risk of a macro-shock that produces nearly simultaneous, large, adverse effects on most or all of the domestic economy or system. The flow from the Financial economy to the Real economy, the US political catch-cry “From Wall Street to Main Street”.

It was the desire to manage and mitigate systemic risk that Governments intervened to the extent they have to support financial systems, ultimately leading to Government debt guarantees.

It is now clearly apparent that global financial regulators have OTC markets and major market participants in their sights, and given their size, scale and systemic risk profile, this is not unexpected.

OTC market regulation discussions initially involved trying to move OTC contracts onto exchanges in order to improve transparency but have now evolved into the central clearing of OTC contracts. However, it is important to note that not all OTC products can evolve into classical exchange-traded products. Evolution is constrained for both technical reasons and econo-strategic reasons.

• From a technical perspective, not all products are suitable for standardisation to the degree necessary to move into the exchange-traded world. Some products, by their design, are structured to meet very specific needs.
• From an econo-strategic perspective, over the counter market participants don’t necessarily want OTC products to “evolve” onto exchange. In Australia for example, given ASX’s profitability and pricing power, market participants are reluctant to surrender power, control and their gate keeping function.

It is also impossible to move all OTC products into central clearing. In Australia, it may not even be necessary. Consistent with international numbers, the most active and liquid OTC products in Australia are interest rate and foreign exchange. The key players (top 5-6 banks) are well capitalised and well regulated and don’t present large current counterparty risks.

Major Australian banks already have pseudo-clearing solutions in place, including through collateralisation agreements. This is possible in Australia because of market size and number of key players where the top 8 participants account for over 80% of activity.

Forcing OTC products onto exchanges can also increase residual and systemic risk of the remaining non-cleared OTC products. Roger Liddell, chief executive of LCH.Clearnet Europe's largest clearing house was recently quoted as stating that: "Clearing houses manage risk, they don't work miracles. In this headlong rush to clearing, we must take care that clearing does not become an end in itself."

In Australia, financial markets and major market participants are overseen by a triumvirate of:

• the Australian Securities and Investments Commission (ASIC) – the market integrity regulator;
  
• the Reserve Bank of Australia (RBA) – the central bank and systemic financial risk regulator; and
  
• the Australian Prudential Regulatory Authority (APRA) – the bank and insurance regulator.
  

Given the stellar work of these agencies and the robust regulatory structures within Australia, Australia has been relatively lightly touched by international market issues.

This regulatory triumvirate also recently released their survey of Australia’s OTC derivatives markets. Within this report, ASIC/APRA/RBA encouraged the Australian OTC industry to continue to build on recent enhancements, and “in particular to take the following steps, working with the authorities as appropriate”:

1. Promote market transparency;
2. Ensure continued progress in the timely negotiation of industry-standard legal documentation;
3. Expand the use of collateral to manage counterparty credit risks;
4. Promote Australian access to central counterparties for OTC derivatives products;
5. Expand the use of automated facilities for confirmations processing;
6. Expand the use of multilateral ‘portfolio compression’ and reconciliation tools; and
7. Increase Australian influence in international industry fora.

These recommendations, consistent with the general thematic objectives of regulators, seek to further enhance the quality of Australia markets and market reputation.

Clearly FEX’s economic interests are aligned with the ubiquity of well functioning and orderly markets. To this end, FEX has positioned itself to work with regulators and market participants to meet their needs in the current and rapidly evolving business environment.

Thankyou for visiting the FEX corporate site.

Brian Price
FEX Group CEO