FEX - The Financial and Energy Exchange Group

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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 blossomed 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 (AIGFP) and the more than US$150 billion in US government support necessary to allow AIGFP to meet its over the counter (OTC) derivative contract obligations.

At its April 2009 London meeting, G20 leaders pledged to “do whatever is necessary” to repair the global financial system, to restore lending and to strengthen financial regulation. In short, the G20 agreed to take necessary actions to rebuild trust and integrity in global financial systems.

Shortly thereafter, in May 2009, IOSCO (The International Organization of Securities Commissions) published its interim recommendations on unregulated financial markets and products. IOSCO’s recommendations had a general focus on OTC markets and specific focus on Securitisation and Credit Default Swaps. 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, financial markets regulators released a survey of the Australian OTC derivatives markets listing a number of recommendations for the industry to consider.

Within the context of OTC market conduct, 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 continue to enhance OTC market integrity, efficiency, neutrality, transparency and stability.

Many commentators have laid the blame for our current economic 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.

The causes and origins of the current capital market challenges 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 with basis. There 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 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 also 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.

Based on Australian Financial Markets Association (AFMA) data, there was AU$80billion of turnover within Australian OTC markets during 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 increasingly apparent 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.

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

Markets, and especially financial markets, operate on trust. For markets to operate effectively, market participants must have confidence and trust that pricing reflects actual supply and demand, and that transactions entered into will be completed and be honoured. The regulatory focus on market confidence is to help ensure that capital markets continue to actually work.

Systemic financial risk is also a key regulatory focus. Systemic risk is defined by the BIS 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 and adverse effects on most or all of the domestic economy or system. The flow from the Financial economy to the Real economy.

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 nationalisation and part nationalisation of banks and Government bank debt guarantees.

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.

In the early post Lehman and AIGFP discussions, OTC market regulation discussions focused on trying to migrate the trading of OTC contracts onto exchanges in order to improve transparency. These discussions have now evolved into the central clearing of OTC contracts. It is important to note though 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.

Within Australia however, 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."

Australian financial markets and 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 thorough work of these agencies and the robust Australian regulatory structures, Australia has been relatively lightly touched by international market issues.

The aforementioned survey of Australia’s OTC derivatives markets was also developed by ASIC/APRA/RBA. Within this report, the Australian OTC industry was encouraged to continue to build on recent enhancements and “in particular to take the following steps, working with the authorities as appropriate”:

• Promote market transparency;
• Ensure continued progress in the timely negotiation of industry-standard legal documentation;
• Expand the use of collateral to manage counterparty credit risks;
• Promote Australian access to central counterparties for OTC derivatives products;
• Expand the use of automated facilities for confirmations processing;
• Expand the use of multilateral ‘portfolio compression’ and reconciliation tools; and
• 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’s markets and market reputation.

FEX will continue to work with and support regulators and market participants to promote ubiquity of well functioning and orderly markets – the economic welfare of our customers and shareholders are aligned in this goal.

Thank you for visiting the FEX corporate site.

Brian Price
FEX Group CEO