ESMA European Securities and Markets Authority : OECD A Blundell-Wignall speech for ESMA FI Day

G20 Finance CB: LCBM and SDM

ESMA Financial Innovation Day 2015 - 'Innovation in a Capital Market Union: harnessing innovation to improve access to finance and spur investment'

- KEYNOTE ADDRESS AS PREPARED FOR DELIVERY -

Adrian BLUNDELL-WIGNALL, Director, Financial and Enterprise Affairs, and Special Advisor to the Secretary General for Financial Markets, OECD Wednesday, 16 December 2015, 9:30-10:00

Dear Jean-Paul,1 Ladies and Gentlemen, dear ESMA and National Competent Authorities members, and CWG2 colleagues,

It is a pleasure and honour for me to open this event. We have a number of interesting panels today, filled with excellent speakers from a wide range of backgrounds. So this promises to be a very interesting day, providing us with new insights that may help shape our views on financial innovation and the way we address these issues as policy makers.

1. Financial innovation is good but there are risks

As we have discussed here at various occasions, financial innovations can bring many benefits, but also bear risk, both of them typically unknown. We have concluded that policy makers should therefore embrace financial innovation with a watchful eye on financial stability and consumer protection.

But the crisis has taught us that we may easily fail in this effort, as policy makers get carried away by exuberant markets and regulators get captured by successful financial innovators.

However, it is not only exuberance and capture that allow the build-up of risks and eventually create turmoil, it may also be sheer complexity and the inter- dependence of markets and our inability to see the whole picture. There are good innovations: products that complete markets and improve efficiency. There are also bad innovations: those that arbitrage inconsistent regulatory rules and tax systems. These are particularly problematic, because unlike market prices the arbitrage does not close the gap, and it may go on

1 Jean-Paul Servais, Chair of the Belgian FSMA, and Chair of ESMA's Financial Innovation Standing Committee (FISC); http://www.esma.europa.eu/page/Financial-Innovation-Standing-Committee.

2 Consultative Working Group (CWG) of FISC.

indefinitely building up risk in the system. For this reason I have always believed that the 2 most basic principles of regulation are:

1. All financial instruments must be treated in the same way regardless of jurisdiction (something the capital markets union will help);

2. To do no damage, in the sense of interfering with markets and possibly breaking them.
3. Learning from the past: improving regulation to curb risks and reap the benefits of innovations…

   Regulators try to analyse the root causes of crises and try to improve the situation. This was on the minds of G20 leaders when they met in Pittsburgh in 2009 to set out an ambitious financial reform agenda, covering all financial markets segments and players, taking into account lessons learned from the crisis to ensure the 2008 debacle never happened again.

   Six years after Pittsburgh, we have no doubt made progress in creating a better, sounder financial system that serves our citizens and to rebuild the trust our economies need to underpin investment and growth. However, most reforms are still in the process of implementation. This makes evaluating their effects - the intended and unintended consequences - even more complex and challenging. It is also hard to disentangle the effects of reforms from other post-crisis economic developments.

   Also left wanting in some areas is the goal of closing regulatory loopholes, and striving for cross-border harmonisation of reform. For example, achieving a regulatory level playing field in bank regulation has been difficult, not only in national implementation of Basel capital requirements, but also in structural bank reforms. While there should be some scope for differences in implementation of agreed international reforms, material inconsistencies in national implementation of international reforms may lead to some negative effects overall and undermine international coordination.

4. …but open questions remain …

   As we move more fully into the implementation phase of reforms, the issue of understanding the intended and unintended effects of reforms comes to the fore. I think part of the problem is that no one has any idea of what the 'right' financial system looks like - we are always starting from the present and being forced to adjust as new pressures evolve.

   • How much financial innovation do we need to replace reduced lending by a smaller and safer banking sector?

   • We have moved to clearing derivatives as a goal, without asking about the usefulness of some parts of these profitable businesses that play a role in tax and regulatory arbitrage.

   • Certain banking activities have been prohibited affecting liquidity in markets as banks balance sheets are less able to be used in market- making and proprietary trading.

   • Pension funds and insurance companies facing insolvency in the face of zero rates and QE have become a part of innovations in securities lending and the move to alternative assets - with new risks to consider3.

   • How do we assess the rise of a shadow banking sector that this fosters? How do innovations that thrive under less supervisory oversight contribute to a build-up of risks? How do we keep this in check without limiting the shadow banking sector's contribution to financing economic growth?

   A small illustration concerning the 'plumbing' of the financial system and the law of unintended consequences is in order (Figure1).

   
   

   Figure1: 3-month Libor (USD) vs the GC Government Repo Rate

   
   

   0.7

   
   

   0.6

   
   

   0.5

   % Spread

   ICE LIBOR USD 3 Month

   USD 3 Month GC Govt Repo

   
   

   0.4

   
   

   0.3

   
   

   0.2

   
   

   0.1

   
   

   0.0

   
   

   Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 Jul-15 Oct-15

   -0.1

   
   

   Source: Bloomberg.

   The US Government repo rate has passed though USD Libor this year suggesting that it is more expensive to borrow secured than it is unsecured. The same can be seen in the UK gilts market. Finance theory doesn't predict

   
   

   3 We have addressed such issues in our Business and Finance Outlook that we launched in June. We find that this environment has been driving strong demand by institutional investors for yield products, and such demand has been met by a shadow banking system that has facilitated new complex products. These products promise higher yield with lower volatility or synthetic exposure to underlying illiquid securities but with daily liquidity. This is another form of liquidity illusion, and risks are building up that are hard to assess as of yet.

   this. This issue is to do with capital rules and the manner in which collateral is taken into account which raises the cost of renting bank balance sheets in the repo market. But what do we want here? To adjust the rules as banks want? Or alternatively do we want to push banks away from this business and allow innovation to take its course, with smaller repo/derivatives markets and with less warehousing of inventory?

   
   

5. Improving past innovations: the case of securitisation

   Securitisation discussed at last year's Financial Innovation Day is another case in point. Securitisation itself has a long and rather successful history, but was tarnished by the subprime crisis.

   But acknowledging the fact that the lending gap left by the sharp post-crisis decline in securitisation could hardly be filled by traditional bank lending, various concepts of high-quality securitisation - also dubbed "Securitisation 2.0" - were developed to address these concerns.4

   So this is just an example that can show us that chances are that seemingly failed innovations can be revived and improved, and such progress helps to make truly useful innovations to persist and ameliorate financial intermediation.

   Currently there are some innovations out there that are yet untested in a crisis situation. It could be coco bonds, ETFs, and more that will eventually need adjustments to a better, a "2.0" version.

   
   

6. Financial innovation fosters competition ….

Now let me address the role of financial innovation for competition, also because the OECD Competition Committee recently held a "Hearing on Disruptive Innovation in the Financial Sector", focusing on the example of peer-to-peer lending, equity crowd-funding, digital currencies, and payment mechanisms.5

We need innovators to contest markets, stimulate competition and enhance productivity, especially in financial services where network effects can create




4 Improved transparency was needed. For details see e.g. Nassr, Iota Kaousar and Gert Wehinger (2015), "Unlocking SME finance through market-based debt: Securitisation, private placements and bonds", OECD Journal: Financial Market Trends, Vol. 2014/2.

DOI: http://dx.doi.org/10.1787/fmt-2014-5js3bg1g53ln.

5 In which also ESMA's Anne Chone participated, alongside participants from the private sec-tor the UK's Financial Conduct Authority, and myself.