Financial Stability: Central Counterparties

Lord Tunnicliffe Excerpts

Thursday 10th December 2015 Lords Chamber

[Lord Tunnicliffe (Lab)]

My Lords, I, too, thank the noble Baroness, Lady Kramer, for tabling this debate. Central counterparties are fast becoming one of the most central components of the financial system in the UK. I hope that the Minister will be able to reassure the House that the Government recognise this and are taking proactive, effective steps to alleviate systemic risk.

As has been highlighted, while there are clear advantages to central counterparties, there are also high risks. This is not a new phenomenon; indeed it describes the day-to-day practice of many involved in financial services. However, CCPs present a number of different challenges. While the finance industry is intrinsically a risk management environment, global markets are still incredibly vulnerable and the scale of expansion of CCPs, if not managed properly, could present a threat to the UK economy.

In 2009, the G20 made a commitment that all standardised, over-the-counter derivative contracts should be traded on exchanges or electronic trading platforms and cleared through CCPs. This was one of the many responses felt necessary in the light of the events of 2007-09. It has subsequently increased the recognition of the importance of the role of CCPs in the financial system the world over. In August this year, the European Commission gave the green light to the proposals which will be phased in over three years. Although I am encouraged that a deal has been done, can the Minister explain the five-year gap between the final decision and the Pittsburgh summit?

CCPs’ growing prominence in the financial sector is undeniable. As of January 2015, 50% of the global over-the-counter interest rate derivatives market were centrally cleared, compared to 31% in April 2012. Last month, the Governor of the Bank of England, Mark Carney, stated that the “too big to fail” era for banks had been solved. He announced reforms which meant that the world’s top 30 banks should ensure they hold enough capital to absorb any losses incurred.

In a working paper, the IMF states that we are getting to a point where, due to the highly interconnected nature of CCPs with financial institutions and markets, they are almost becoming too big to fail. Only a few weeks ago, a senior official at the Bank of England questioned whether clearing houses could rely on unfunded commitments from member firms. That would mean that funds would have to be replenished in a period of stress. While there are clearly mechanisms in place, most notably the “default waterfall”, there are obviously still key concerns about how CCPs can be better managed. I would be interested to hear from the Minister the Government’s assessment of how the “too big to fail” concept relates to CCPs.

We fully recognise that there have been a number of notable steps taken by this Government and by the Bank of England to mitigate the risk associated with CCPs, not least the decision to give the Bank responsibility for the supervision of CCPs. This has meant that it is more difficult for CCPs to underinvest in the migration of risks to the wider system. It is vital that the Bank continues to perform this function in the public interest. CCPs should never lose sight of the implications of what could happen if they went into insolvency.

The quality of those who manage CCPs must be beyond doubt. The Minister will know all too well that in this House we are currently debating the certification regime for senior managers in the financial sector. Has such a scheme, statutory or not, been considered in this context? The Bank of England acknowledges that one of the ways in which it can mitigate risks associated with CCPs relates to ensuring that there is a stronger user representation in financial market infrastructure governance. Surely that is another way in which CCPs would become more mindful of their broader remit. Can the Minister give me a breakdown of the various forms of representation, in particular the number of independent directors on both the boards and risk committees of the major CCPs?

I turn to the formal assessment structure in place to oversee the work of CCPs. While the Bank has a supervisory function, the CCPs are not bound by regulation. The Bank says that self-assessment is not self-regulation, as the CCPs’ self-assessment does not replace the Bank’s own judgment but is used as one input to its supervision. Can the Minister say what advantage the CCPs’ own assessment of their working brings to the Bank’s supervision?

The Bank of England states that:

“A CCP should demonstrate that its governance and decision-making processes reflect the risk management purpose of the institution. This means having adequate regard not only to the management of microprudential risks to the institution itself, but also the interests of the financial system as a whole”.

I would be interested to hear whether the Minister could ever conceive of a time when we move from “should” to “must”. Finally on this point, in the Bank’s incredibly helpful note outlining the CCPs’ function, which we have obviously all read, it states that it is in the process of introducing more structured reporting of CCPs. I was wondering whether the Government had any information on a timetable and what form these publications will take.

I will briefly touch on the importance of international co-operation, particularly with regard to our EU partners. In December 2014, clearing members established outside the European Economic Area accounted for 39% of the initial margin requirement at UK CCPs. Co-operation is key. As the Bank of England has acknowledged—rightly, in my view—there are terrific benefits to be had from,

“working with the relevant international authorities”,

and,

“going beyond the minimum levels of co-operation”.

However, as the IMF white paper points out, one of the remaining risks is:

“Diverging interests of authorities in a globally cleared market”.

This means that we need constructive engagement with partners across international bodies, including in Europe. Do the Government agree and is this a priority for them?

European Market Infrastructure Regulation and the associated technical standards constitute a significant body of detailed standards against which supervisors must assess CCPs’ compliance and, related to which, they should report information and assessments to EMIR colleges. We understand that the Bank is continuing to implement the new CCP supervisory framework established by the EMIR. Given all this, and in light of the IMF’s warning that risks are increased when diverging interests are at play, what are the Government doing to ensure that these various regulatory regimes are working together?

As of March 2015, the Bank of England had exercised only its statutory powers to gather information over the last year, rather than using any sanctions. While it says that it intends to conduct reviews, I would be interested to know in what areas they will be conducted, who determines the topic, scope and content of these reviews, and how these reviews would help us to understand and pursue the means of lowering the risks?

I thank the noble Baroness, Lady Kramer, for bringing up this subject. It is one that does not have much saliency. It is very useful that this debate has forced the subject on to the agenda. The noble Lord, Lord Sharkey, was right in using the rather gentle word “concern” and then perhaps moving more realistically to the word “alarming”. This is an inevitable development of our ever-developing financial structure and it is important that the Bank of England and Government get on top of the issues as quickly as possible.